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Delaware appraisal law: searching for fair value

honig-stephenDelaware courts are altering the way in which they deal with minority shareholder complaints that M&A deal proceeds are inadequate.

Just a couple of years ago, upon announcement of a merger or filing of a proxy statement, minority shareholders often brought suit to enjoin the vote, or the closing, based on inadequacy of price, and failure of full disclosure.

Many cases were settled by companies providing increased disclosure, paying plaintiffs’ attorneys’ fees and receiving blanket indemnity in exchange.

But thereafter, courts began questioning the value of much of the increased disclosure, which skepticism tended to take the attorneys’ profit out of such lawsuits, and also tended to reduce “M&A arbitrage,” in which investors purchase target shares in expectation of an increase in deal price.

As courts reduced or denied attorneys’ fees, plaintiffs began turning to the appraisal remedy, and courts then reacted by shrinking the upside in appraisals. Below, a brief history.

Appraisal update: Dell

One of the larger appraisal premiums awarded in Chancery was the $7 billion increase in deal value for Michael Dell’s going private buyout.

On Sept. 27, an appeal from that premium award was heard in Delaware Supreme Court. While the outcome was not known at deadline, based on the court argument it seems that the newly minted Supreme Court’s fondness for adhering to deal price will lead to a reversal of Chancery’s holding.

Chief Justice Leo E. Strine Jr. labeled the decision below “incoherent.” Another justice noted that since the parties’ experts were so far apart, there was great logic in reverting to actual deal price as the best indication of fair market value.

Even in cases like Dell, in which the deal involves insiders and thus may be riper for appraisal claims under the new Delaware jurisprudence, it seems that the freedom of Chancery to find its own appraisal methodology in search of fair value will be closely scrutinized from the top.

Prior practice and ‘Trulia’

The January 2016 Delaware Chancery Court decision in In re Trulia, Inc. is recognized as the moment when non-cash settlement of shareholder lawsuits through incremental disclosure in proxy materials, so-called “disclosure-only settlements,” met their Waterloo.

Before Trulia, companies would agree to the addition of disclosures (which were often trivial) for a release of the company and its directors from all claims that could be asserted against them, with substantial fees paid to counsel.

The exchange was so favorable to companies that it was described in one Chancery opinion as merely “deal insurance.”

Trulia was clear. The court “will continue to be increasingly vigilant in applying its independent judgment to its case-by-case assessment of the reasonableness of the ‘give’ and ‘get’ of such settlements … .”

Disclosure-only settlements would be scrutinized by the court to make sure that future amendments to disclosure met the standard of “plain materiality.” Settlements would not be approved unless releases of companies and directors were limited to matters concerning the amended language.

The court warned “it should not be a close call that the supplemental information is material as that term is defined under Delaware law.”

Thereafter, fee applications became more contested, particularly when disclosure was volitionally expanded by the company itself.

A series of Chancery cases made it clear that counsel filing “mootness fee applications,” the method of seeking legal fees in instances in which the companies themselves expanded their disclosures, could not automatically expect substantial fees (Celgene: sought a fee of $350,000 and counsel was granted $100,000; Keurig: the court determined that original disclosure was adequate and no fees were granted notwithstanding a $300,000 application; Zoom: $50,000 was awarded against a $275,000 application (some disclosures were “mildly helpful to stockholders”)).

Inside and outside Delaware, plaintiffs nonetheless continued to file cases pre-closing, achieving mixed results. These cases, however, tended over time to be filed in federal courts, avoiding the Delaware bias against disclosure-only cases by framing complaints as violations of federal proxy disclosure rules.

In Lusk v. Lifetime Fitness, Inc. (D.C. Minn.), the court in August threw out an investor class action, rejecting claims that the company failed to maximize price by: refusing to convert real estate assets into a REIT; effecting a transaction with a party that was the personal favorite of the president; and failing to provide sufficient information concerning the target president’s rollover agreement.

The court noted the robust sales process undertaken by the target: naming a special committee, hiring financial advisors, doing homework on the substance.

The court found the disclosure of the rollover agreement, by which the president received shares of the acquirer in exchange for target shares, wholly appropriate.

These so-called “inside deals” have been subject to minority complaint, although the reality is that financial acquirers often seek alignment with management through ongoing material stock ownership.

In Haines v. Rocket Fuel, Inc. (D.C. N.Cal.), a class action entered in August questioned the $145 million acquisition price, claiming that the target’s management and board were more interested in their own payouts than shareholder return, complaining about projections and disclosure, and complaining about deal provisions prohibiting the target from soliciting contrary offers and for providing lockup of a material number of shares.

Indeed, just recently, two more suits were filed in Delaware federal court complaining about proxy omissions (PharMerica: alleging lack of detailed projections, use of non-GAAP financials, nondisclosure of conflicts by executives having pre-deal discussions of their own retention; HSN: lack of adequate company projections on standalone and pro-forma bases).

Delaware courts have rapidly moved to protect pricing of non-predatory M&A transactions from claims of minority shareholders.

The appraisal remedy

Meanwhile, as more minority shareholders turned to appraisal as a remedy, the Delaware courts began directing their attention to appraisal law.

Section 262 of the Delaware General Corporation Law provides that stockholders objecting to an acquisition price may preserve their rights to have Chancery determine the “fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation.”

A dissenting shareholder can ask the court to increase the price received under the deal, but without including any value accruing from synergies in strategic acquisitions. Additionally, “the Court shall take into account all relevant factors.”

Relying on appraisal rights seemed promising until quite recently. For example, the original Chancery opinion in DFC Global v. Murifield found fair value in excess of deal price in an analysis consistent with the historical approach of the Delaware courts in applying the appraisal statute broadly, considering various elements of value.

Chancery in DFC calculated fair value by averaging three different factors: traditional discounted cash flow, which calculated proposed future income; the deal price; and valuation for comparable companies.

The court did a lot of math, questioned the cash flow model and adjusted its metrics, questioned deal price by suggesting that the parties did not give adequate weight to regulatory uncertainties, and selected an unsupported methodology of giving each of three factors equal weight.

In its Aug. 1, 2017, decision on appeal from Chancery’s DFC opinion, the Delaware Supreme Court reversed, restricting future courts from such a freewheeling approach (at least in “vanilla” M&A transactions).

Although the statute requires taking into account “all relevant factors,” Chief Justice Leo E. Strine Jr., noting that DCF’s process for shopping the deal was arm’s length and without any “hint of self-interest,” stated that “economic principles suggests that the best evidence of fair value was the deal price, as a result of an open process, informed by robust public information … .”

Strine questioned why Chancery second-guessed the deal price because of upcoming regulatory developments: Why would Chancery presume that an acquirer would fail to factor that into its pricing? And since there were numerous bidders, the court noted that “the collective judgment of the many” is more likely to be accurate than any “individual guess.”

The Supreme Court also disagreed that the acquirer, a financial buyer, might not pay fair value because it was “focused … on achieving a certain internal rate of return,” noting that “any rational purchaser of the business should have targeted a rate of return that justifies” the price.

Finally, the Supreme Court pointed to economic performance after closing to support its conclusion that deal price was correct (moving the focus from identifying fair value based on information known at the time the deal price was struck).

In reversing Chancery’s opinion and remanding for a recalculation of fair value, Strine strongly hinted at the appropriate decision in a vanilla transaction: a chancellor “may conclude that … in light of other relevant factors … the deal price was the most reliable indication of fair value.”

And indeed, in recent Delaware cases, Chancery has moved in the direction of confirming deal price (in Clearwire, Chancery found fair value to be less than half of the merger price; in SWS Group, it reached a similar result, noting that the Delaware appraisal statute makes it clear that the value of synergies in strategic acquisitions is not considered).

Commentators have observed that, absent exceptional circumstances, Delaware appraisals likely will consider deal price as a cap and not a floor. Such a view might discourage reliance on appraisal to redress the claims of minority shareholders.

In what instances would appraisal still appear to be a promising route for aggrieved shareholders? In cases in which the process of negotiating the transaction is flawed or is not sufficiently robust and granular; in which a controlling shareholder is cashing out of the target; or in which there are management buyouts.

The bottom line: Although there is no automatic presumption that, on appraisal, fair value is equal to deal price in a robustly negotiated transaction, DFC and similar cases must be read as creating such presumption de facto.

Conclusion

Delaware courts have rapidly moved to protect pricing of non-predatory M&A transactions from claims of minority shareholders. This is not surprising philosophically; Delaware courts have always been prone to permit market forces to operate freely absent predatory action harming the minority.

The effect of moving away from disclosure-only settlements and from easily questioning deal price by appraisal is that the plaintiffs’ bar must dig into the facts of each case to determine if the M&A process was sloppy or unfairly weighted in favor of management or major shareholders, before minority shareholders will have substantial hope of increasing deal price through litigation.

Stephen M. Honig practices at Duane Morris in Boston.

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