Mirvis, Theodore N.

By Theodore N. Mirvis

The Delaware Supreme Court heard argument recently in the appraisal proceeding arising out of the 2014 acquisition of DFC Global Corporation by Lone Star, a private equity firm. The Court of Chancery had found that the statutory “fair value” of DFC was higher than the deal price, based on a tripartite equal weighting of the transaction price, a DCF valuation, and a comparable company analysis which the court called “a blend of three imperfect techniques.” One key element of the appeal is the proper role of deal price in fair value determinations. The Court of Chancery noting that the sale process was lengthy, involved financial and strategic buyers, and resulted in an arm’s-length sale with no conflicts determined that the deal price was “one measure” of value. But the court gave the deal price limited weight. It found that the sale process coincided with the company’s being subject to “turbulent regulatory waters” that rendered uncertain its future profitability and even viability; the court suggested that the PE buyer may have understood those uncertainties better than other bidders, and been focused as a financial sponsor on achieving a required internal rate of return consistent with its financing constraints, rather than DFC’s fair value.

The DFC appeal thus raises rather squarely the question of the proper role of deal price in Delaware appraisal determinations of fair value, and the relationship of deal price to other valuation techniques commonly employed, principally DCF.

DFC is the Supreme Court’s first major appraisal case in the current “appraisal arbitrage” environment in which hedge funds purchase shares after the announcement of a sale transaction for the purpose of seeking a judicial determination of “fair value” under the Delaware appraisal statute. It is unwise, of course, to pretend to glean much from judicial questioning or comments during oral argument. That said, the depth and range of the colloquy during the DFC argument covered a number of interesting points:

  • whether the petitioners’ challenge to the primacy of deal price, based in part on a claimed inefficiency in the merger market, created an occasion to rethink the long-standing jurisprudential definition of fair value as based on a proportionate share of the value of the whole company as a going concern and instead reverting to the plain words of the statute which call for determination of the fair value “of the shares.” As the discussion at the argument indicated, that shift that might re-center valuation on the prior market trading prices of the shares. The current focus on going concern value can be viewed as a hugely pro-petitioner judicial gloss on the statutory command, by eliminating any type of “minority discount” associated with the trading prices of individual shares and simultaneously (and, arguably, counter-intuitively) allowing each and every share to be valued as a slice of a pie that typically trades as a whole for far more than each piece is valued in the marketplace.
  • whether the statutory command that valuation be based on “all relevant factors” permits an appraisal court convinced that a sale process was robust and a genuine non-conflicted market check to base its valuation solely on the deal price or whether, in every case, the wording of the statute compels the court to consider, and even take into account, the indirect valuation technique of a DCF analysis along with the other valuation tools typically explored by experts; and whether “all relevant factors” requires some consideration even of a DCF analysis based on projections found to be questionable but not entirely unreliable, and even though DCF underplays or ignores risks that market prices reflect.
  • whether reliance on deal price by appraisal respondents should, or must, be accompanied by expert evidence on the reliability and efficiency of the deal market, whether in general or in the context of the particular sale process at issue.
  • whether the not unusual position taken by petitioner-side experts that posit fair values of 2x the deal price (or higher) yielded by a genuine market check is necessarily grounded on the proposition, whether stated or not, that our capital markets are fundamentally broken or inefficient.
  • whether Delaware’s settled recognition of the legitimacy, as a fiduciary matter, of takeover defensive action by target directors is inconsistent or in a tension with the typical respondent-side claim in appraisal litigation that deal prices are the best if not the exclusive indicators of fair value.
  • whether the appellate deference accorded to the trial court’s factual findings, and the appellate deference owed to matters within the trial court’s discretion, permit a reviewing court to set aside the weighting accorded by a trial court to one or more valuation methodologies in reaching the required point number of fair value.

Not surprisingly, the DFC case attracted considerable interest from the academy. Dueling amicus briefs from law and finance professors were filed. The pro-petitioner amicus brief argued that a presumptive rule of deference to deal price is “bad economics” and, indeed, that a “credible threat” of fair value untethered to deal prices would provide an ex ante benefit by increasing the chance that the deal price would more accurately reflect fair value, as bidders and sell-side board of directors would “internalize the cost of approving a transaction at the lowest end of the range of fair values.” On this view, the threat of appraisal is thought to “catalyze aggressive bidding” and yield higher prices. The professors’ brief went so far as to claim that exclusive reliance on deal prices is “functionally equivalent to eliminating the appraisal remedy altogether,” and that reliance on market outcomes is “conceptually circular” since all markets (it is claimed) are governed by legal institutions. From that perspective, the argument goes, it is “unhelpful” to assert that the appraisal right “distorts” market outcomes since: “Of course it does; all market-governing institutions do.” Interestingly, the brief also suggests that concerns about law-trained judges undertaking financial analyses could be overcome by returning to judicial engagement of “neutral” valuation experts, or by permitting incentives to moderate excessive expert discrepancies via “baseball arbitration” mechanisms and the like.

The competing academic amicus brief argued for deference to deal price whenever the transaction results from an arm’s-length auction process. The brief argues that post-hoc DCF analysis need not be “plumbed” in such cases, and that unpredictable appraisal litigation “distorts market behavior.” In addition, deference to market prices is argued to exclude the “interestedness that inheres in expert valuations” where paid experts (unlike buyers in the marketplace) are not penalized for setting values too high. The brief argues that appraisal litigation, and its “cottage industry” of valuation experts, has chilled bidders from participating and encouraged lower prices from bidders who must factor in post-transaction litigation as a “tax.” The overall claim is to create a “safe harbor for arm’s-length auction transactions” in order to confine appraisal litigation “to those situations where it belongs.”

The DFC argument came two weeks after the Court of Chancery’s ruling in the appraisal case arising out of the 2015 private equity purchase of PetSmart, Inc. Both sides in the DFC appeal invoked the PetSmart decision during argument in the Supreme Court: DFC cited it as adding to the list of recent Chancery decisions adopting the deal price as fair value; the petitioners cited it as another “wrong” decision.

In PetSmart, appraisal was sought for some 10% of the outstanding shares by a group of hedge funds, with shares largely purchased after the record date the largest example to date of appraisal arbitrage, representing some $1 billion of shares (at the deal price). The appraisal petitioners advocated for a fair value of $128.78/share as compared to a deal price of $83 share implying an undervaluation in the sale process of some $4.5 billion, or 55%. PetSmart found that the deal price was the fair value, based on the robustness of the public auction sale process, and as confirmed in a DCF analysis of sensitivities to the management projections to account for the lack of confidence in the projections that were prepared for use in the sale process. In re Appraisal of PetSmart, Inc., Consol. C.A. No. 10782-VCS (May 26, 2017). (Wachtell Lipton represented PetSmart in the sale and in the defense of the appraisal proceeding.)

The PetSmart opinion came after a four-day trial (thirteen fact witnesses and four testifying experts) that covered both the details of the sale process and presented conflicting expert views on the legitimacy of a DCF analysis predicated on the projections prepared for the sale process. The opinion began with a reminder that the statutory command to consider “all relevant factors” is not “a license for judicial freestyling beyond the trial record.” Based on a close review of an extensive record, the Court of Chancery found that PetSmart had proven that the sale process “was reasonably designed and properly implemented to attain the fair value of the Company,” and, that, contrariwise, the petitioner had failed to carry their burden that a DCF analysis based on the management projections provided to bidders in the sale process (and published in the proxy statement) was a reliable measure of fair value. The court found the projections to be “at best, fanciful” and found no evidentiary basis to conclude that a DCF analysis based on other projections of expected cash flows would produce a number more reliable than the deal price.

The PetSmart auction process was public, open and wide: 27 potential bidders were contacted, including three strategic buyers none of whom elected to participate; 15 PE funds signed NDAs; the court found no evidence of favoritism; the final winning bid was at a level that remained unchallenged post-signing. Nonetheless, the PetSmart court did not embrace, or advance, any prescriptive rule in favor of exclusive deference to deal prices. The court observed that every sale process will not be perfect, and that the relevant considerations will be “deal and company specific” with the focus “sharpened by the arguments offered by counsel.” The court seemingly eschewed any new doctrinal approach in concluding that the sale process “came close enough to perfection to produce a reliable indicator of PetSmart’s fair value.” The sale process, the court found, was “well-constructed and fairly implemented,” leading it to conclude without ruffles or flourishes that the deal price was the result of a “proper transactional process,” and thereafter a reliable indication of fair value. The court concluded that it would “defer” to the deal price “not to restore balance after some perceived disruption in the doctrinal Force, but because that is what the evidence presented in this case requires.”

The PetSmart opinion rejected head-on the contention that PE firms utilizing an “LBO model” do not pay fair value because of their required internal rates of return. In that regard, the court noted that both DCF and LBO models rely on a view of expected cash flows, and that the evidence at trial did not support the view that LBO models drive lower valuations or negatively impacted the PetSmart auction. The court referenced an important academic study which concluded that both strategic and financial bidders on average pay more than the company’s value under current management 16.7% more in the case of strategic bidders, and 11.7% more in the case of financial bidders. The study posits that the levels at which strategic bidders are willing to bid is based on “synergies,” which are excluded from the fair value determination by statute. The study also finds that 22.4% of the target companies studied (mature but poorly performing companies) are valued higher on average by financial bidders than by strategics. Alexander S. Gorbenko & Andrey Malenko, Strategic and Financial Bidders in Takeover Auctions, 69 J. Fin. 2513 (2014).

The DFC appeal can be decided in any number of ways, with or without touching on any of the fundamental issues that recur in Delaware appraisal litigation. Some additional guidance would doubtless be welcome. The number of Delaware appraisal cases has grown steadily over the past three years, to more than double the average of the prior eight years. More importantly, the value of appraisal claims in the last two years (at the deal price) eclipses the total of all prior years of the modern era, and reaches $2 billion per year. The Delaware legislature has (thus far) declined to limit the appraisal remedy to shares owned before announcement of the deal or even as of the record date that are proven to have voted against (“dissented” from) the merger. Re-balancing will have to come, it appears, from another quarter.

Whatever the outcome in DFC, the case has occasioned renewed attention to some of the fundamental aspects of appraisal litigations:

1. It is not apparent why as discussed during the DFC argument the fair value standard ought not hew to the statutory reference to the value “of the shares” (not the going concern value of the entity), especially when the very next phrase in the statute shears off “any element of value arising from the accomplishment or expectation of the merger.” That exclusion has always been understood to eliminate synergy value attributable to the transaction. But the words fairly support requiring a minority discount, which would deny dissenting stockholders the significant lift created by a control-changing transaction. On that view, of course, deal price likely would become a hard ceiling, not merely one indicator of fair value.

2. Without diminishing the importance of addressing anew the role of deal price in fair value determinations, it should be noted that determinations above deal price have been quite rare in non-interested transactions, viz., outside of the controlling stockholder and MBO context. Excluding controlling stockholder cases (and DFC and Dell, also currently on appeal), in the public company appraisal cases decided over the past 20 years, the median premium to deal price is 0.0% and the average premium to deal price is well under 5%. (Those results admittedly do not take into account settlement levels, which are likely significantly higher given the exorbitant claims sometimes advanced to produce settlement.) Those results might lend support to those who contend that the appraisal remedy should be limited to controlling stockholder/conflict transactions.

3. Given the fundamental equitable distaste for per se rules, it seems unlikely that DFC will result in a simple always/never light-switch for reliance on deal prices as fair value. What the case does portend is a renewed and likely nuanced appreciation of the subtlety of that issue. There has always been a fundamental weakness in petitioner-side claims for fair value at a level that no one would pay or consider paying in a process that, under any normal view, checked the market. On the respondent side, as in DFC, it is difficult to see why any price higher than what a genuine market check revealed could possibly be fair value. Absent conflict of interests that can be shown to have warped the process, genuine exposure to the market ought to be determinative. Adopting that view would not amount to a per se rule or eliminate appraisal as a remedy. It would simply relegate appraisal to the context in which it can be effective and where it arguably belongs: conflict transactions and seriously flawed sale processes.

4. Nor is it helpful to utilize Revlon-style reasonableness review to determine when the deal price deserves primacy or even exclusivity. Fiduciary review under Revlon/enhanced scrutiny is very broad in scope. It covers not just what happened i.e., was there an effective market check. Fiduciary review increasingly focuses on the corporate governance conduct of the board, the content of the board deliberations, the role and interest of the sell-side bankers, etc. None of that bears upon the simple question that fair value asks: did the sale process function to reveal the fair value of the company in the marketplace. The focus in appraisal should be on the market’s decision, not the board’s decision.

5. Relatedly, procedural innovation may reduce some of the cost that renders appraisal litigation so expensive as to induce settlement regardless of merit. Discovery and trial in the sale process should be limited to verifying what happened, to presenting a record that produces confidence that the market was fairly and effectively checked. There is no warrant in an appraisal proceeding for chasing down every question about what transpired in every board meeting, or whether every director understood every banker presentation underlying an ultimate fairness opinion, or whether every twist and turn in the process appears correct in the rear view mirror. Absent unusual circumstances, there ought not be multiple depositions of every director, every banker on the deal team, every officer who touched the process, or close examination of whether every banker’s beta or WACC choice can withstand the glare of hindsight, or why any participant in the sale process did or did not do everything they did or did not do. Again, it’s the market’s decision that ought to matter not the board’s, and not even the banker’s. In PetSmart, the court referred to the petitioners’ multiple attacks on the auction sale process as being “left to nitpick at the details and to invent certain prevailing market dynamics” claimed to have confounded the reliability of the deal price. Nitpicking and invention of that sort ought to end.

6. Further, if fair value can be equated with a deal price resulting from a genuine market check, it should also be possible to avoid the significant expense of valuation experts unless and until it is determined by the court that, in a particular case, the sale process was inadequate to reveal the market fair price. Trials in appraisal proceedings can be bifurcated, with the sale process addressed first. If the sale process is found lacking in some important respect that renders it unreliable as a value indicator, at that point both sides can retain valuation experts and proceed to analyze and present DCF and other alternative valuation techniques. But if the court is satisfied that the sale process yielded fair value, there ought be no reason to go further. The statutory requirement “to take into account all relevant factors” need not mean that a court cannot stop once it has heard enough to determine fair value. If a well-functioning sale process yielded $X in a well-functioning market, nothing else can be relevant (or at least not on the upside; synergies, of course, would remain deductible if proven). There is great force in the concluding statement in PetSmart that reliance on the deal price has “a certain elegance that is very appealing,” since market participants are penalized for inaccurate valuations, unlike paid experts in litigations utilizing DCF analyses that are, at best, volatile and uncertain.

The DFC appeal indeed may turn into a crossroads. Regardless, there is much that hopefully can be clarified, and simplified, by guidance that only the Delaware Supreme Court can provide.


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