Delaware Chancery Court weighs in on fair value in an appraisal action
As discussed in our March 2014 and April 2015 newsletters, in the last few years, there have been numerous developments in the law and practice surrounding appraisal rights under Delaware law. That trend has continued with the Delaware Chancery Court's opinion in Merlin Partners v AutoInfo, Inc., which provides additional guidance regarding the courts determination of fair value in an appraisal action.
In the AutoInfo, the target, with the assistance of its financial advisor, contacted 164 potential strategic and financial buyers, 70 of which entered into non-disclosure agreements. The company eventually signed a letter of intent that provided for an acquisition of the company at $1.30 per share. After that prospective buyer walked away, the company executed a letter of intent with Comvest, which contemplated the sale of the company for $1.26 per share. Comvest's due diligence then turned up numerous accounting issues, and subsequent, protracted negotiation, resulted in an agreement for Comvest to acquire the company at $1.05 per share.
Merlin Partners filed an appraisal action, arguing that the fair value of the company was $2.60 per share. In support of this valuation, Merlin presented two comparable companies analyses and a discounted cash flow ("DCF") analysis prepared by Merlin's financial expert. AutoInfo argued that comparable companies and DCF analyses could not be reliably performed with the available data, and that the fair value should be $0.967 per share based on the merger price paid by an unrelated third party, the synergies the buyer took into account in agreeing to $1.05 per share and the strength of the sales process.
Merlin's position seemed well-supported by prior Chancery Court decisions. Although the Chancery Court may consider "any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court" in an appraisal proceeding, in practice this has generally meant some combination of a DCF analysis, a comparable companies analysis and a comparable transactions analysis. The price actually paid in the merger was not generally viewed as part of this analysis, particularly since the Chancery Court's 2010 decision in theGolden Telecom case, where it rejected a target company's argument that the court should defer to the merger price in an appraisal proceeding. In upholding the Golden Telecomruling on appeal, the Delaware Supreme Court noted that: "Section 262(h) unambiguously calls upon the Court of Chancery to perform an independent evaluation of "fair value" at the time of a transaction. [...] Requiring the Court of Chancery to defer—conclusively or presumptively—to the merger price, even in the face of a pristine, unchallenged transactional process, would contravene the unambiguous language of the statute and the reasoned holdings of our precedent."
However, after evaluating the parties' competing analyses, the Chancery Court reached a different result in this case.
DCF Analysis—Merlin used the projections prepared by management in its DCF analysis, a position that would seem sound—Delaware has "a long-standing preference for management projections." That preference, however, is based on the assumption that management's knowledge of the company's operations puts it in the best position to prepare meaningful projections. That was not the case with AutoInfo's management, whose projections were little more than guesswork. The court accordingly found that Merlin failed to carry its burden of proof that the projections could be relied upon, and accordingly disregarded Merlin's DCF.
Comparable Companies Analyses—The court similarly found that Merlin failed to establish that its comparable companies analyses were reliable, noting that the companies it deemed "comparable" ranged from 2 to 300 times larger than AutoInfo, and that the selection of companies failed to take account of the fact that AutoInfo had a different business model that was perceived as riskier by prospective buyers than any of the "comparable" companies' models. The comparable companies analyses were therefore disregarded as well.
Merger Price—The Court then noted that if DCF and comparable companies analyses are non-existent or unreliable, the merger price may be the most reliable indicator of value. Here the Court cited Golden Telecom assupporting this view, noting Vice Chancellor Strine's comment in that case that "it is true that an arm's-length merger price resulting from an effective market check is entitled to great weight in an appraisal." In Golden Telecom, in fact, the Court didn't state that the merger price cannot be taken into account, but instead that it "declined to reform the statute to build in an assumption" that the merger price is the best indicator of value. The court's deference to the merger price is therefore not necessarily inconsistent withGolden Telecom and its progeny, and was supported by at least two recent decisions in the Ancestry.com and CKxcases.
The Court noted that the evidentiary value of a merger price in an appraisal proceeding is "only as strong as the process by which it was negotiated." Here there was no indication of any self-interest or disloyalty, and a thorough sales process featuring arms-length negotiations, no compulsion, adequate information, and a competitive process involving a very large number of potential bidders. The court accordingly gave 100% weight to the merger price.
The court then considered the company's arguments that the fair value should be reduced from $1.05 per share merger consideration to $0.967 per share to account for merger-specific elements of the $1.05 price, namely the savings on public company costs and certain executive compensation costs that the buyer intended to eliminate. While the appraisal statute directs the Court to value a company on an ongoing, stand-alone basis, here it found that AutoInfo did not adequately substantiate the value of these savings to the buyer. Although the numbers AutoInfo used were taken from Comvest's internal projections, the reliability of these numbers was not tested, and AutoInfo therefore failed to carry its burden of proof. The court therefore settled on $1.05 per share as the fair value of the AutoInfo shares.
Although the AutoInfo case doesn't break new ground, it is a valuable primer on how the Chancery Court will evaluate appraisal actions. Aside from the rather obvious lesson that valuation methodologies are only as meaningful as their inputs are reliable, the case highlights the importance of process in M&A transactions.
Interestingly, although having generally taken pains to establish that this ruling is not a departure from what may appear to be contrary precedent, in his final paragraph, Vice Chancellor Glasscock states that "where, as here, the market prices a company as the result of a competitive and fair auction, 'the use of alternative valuations techniques like a DCF analysis is necessarily a second-best method to derive value'" (emphasis added), quoting a case that pre-dates Golden Telecom. Although this was merely dicta, we will be looking out to see whether the Court is tipping its hand and indicating that, in parallel with making it easier to commence appraisal claims (see our March 2014 newsletter), the Court will seek to weed out non-meritorious claims by placing a greater degree of deference on a merger price that results from a robust sales process.
Utilizing drag-along rights in private company merger agreements
In our January 2015 newsletter we discussed the recent decision of the Delaware Court of Chancery in the Cigna Health & Life Company v. Audax Health Solutions, Inc.case, which invalidated two purchaser-imposed requirements that are frequently found in private company mergers, specifically the conditioning of payment of merger consideration on receipt of a stockholder release and stockholders' obligation for certain post-closing indemnity obligations not covered through an escrow. In response, some purchasers are insisting that the target company stockholders who consent to a merger (through a joinder agreement or other agreement signed by certain stockholders) stand behind 100% of all post-closing indemnity obligations. In other words, the consenting stockholders are being asked to bear the risk that non-consenting stockholders will not be bound by certain indemnity obligations. While practitioners are continuing to debate how broadly or narrowly to read the Court's decision, risk adverse buyers have been seeking to shift the risk to the target company stockholders and force targets to obtain agreements from nearly all stockholders, giving minority stockholders potential deal hold-up rights, increasing transaction costs and diminishing the structural advantages of using a merger.
In another recent decision, Halpin v. Riverstone National, Inc. (February 2015), the Delaware Chancery Court questioned whether a prospective waiver of appraisal rights by a common stockholder is valid under Delaware law and created another potential deal structuring issue with minority stockholders. Stockholders agreements of private companies frequently include prospective appraisal rights waivers in the form of drag-along provisions. Private equity sponsors and founders rely on drag-along provisions to compel minority stockholders (often employees or other early investors) to participate in certain qualifying sale transactions. Because cash out mergers are frequently used to sell privately-held companies (instead of direct stock sales), drag-along provisions frequently compel the stockholders to vote in favor of the adoption of the merger agreement. Voting in favor of a merger makes a stockholder ineligible for appraisal rights. Some stockholders agreements go further and include an express waiver of appraisal rights on a future sale of the company.
Prior to the Riverstone case, the Delaware Chancery Court has held that preferred stockholders may waive appraisal rights ex ante by contract where the intent to waive the right is clear. In the Riverstone decision, the Chancery Court questioned whether the same rationale applies to common stockholders because the rights of common stockholders are principally governed by statute and common law fiduciary principles. While many M&A parties and practitioners have assumed that appraisal right waivers are valid, the Delaware courts have not directly ruled on the question. Consequently, some practitioners have recommended seeking contemporaneous appraisal right waivers in connection with an actual transaction rather than relying on drag-along provisions alone. In the near term, theRiverstone decision could further diminish the advantages of structuring a sale as a merger and relying on drag-along provisions.
Similar to many stockholders agreements for privately-held companies, the Riverstone stockholders agreement granted the target corporation the power, subject to certain restrictions (e.g., same price and terms), to require the minority stockholders to tender and/or vote their shares in favor of certain change of control transactions approved by a majority of the target's stockholders. The Riverstone agreement did not include an express waiver of appraisal rights. In this case, the 91% controlling stockholder of Riverstone approved the merger agreement and merger, and the parties closed the merger before the notice of appraisal rights was sent to the non-consenting stockholders and before the period for exercising appraisal rights had lapsed. After the closing, Riverstone sent an information statement to the minority stockholders informing them that the majority stockholder had approved the merger agreement and that the closing had occurred. The information statement attempted to invoke the drag-along right to compel the minority stockholders to consent to the merger in order the make the minority stockholders ineligible to exercise statutory appraisal rights. The information statement informed the minority stockholders that they may be entitled to appraisal rights under Delaware law but that the cash merger payment would only be available to stockholders who relinquished that right by signing the attached written consent. One of the minority stockholders (which happened to be a competitor of the purchaser) refused to sign the written consent and brought appraisal actions. Riverstone counter-claimed and sought to have the drag-along rights specifically enforced.
The minority stockholders argued that the drag-along right was unenforceable because a common stockholder cannot waive its statutory right to appraisal ex ante—here, in a stockholders agreement in return for consideration that is to be set later by the controlling stockholder. In the final analysis, the Court decided the case on narrower grounds. The Court assumed that prospective waivers could be valid but held that Riverstone did not exercise its drag-along rights in accordance with the unambiguous language of the stockholders agreement, which did not allow the drag-along rights to be exercised after the merger was consummated. In other words, because the target company did not demand a vote in favor of the sale before the merger was accomplished as required by the stockholders agreement, Riverside may not specifically enforce the drag-along rights, even if a waiver of appraisal is otherwise enforceable.
The minority stockholder also argued that drag-along rights should only be enforceable if they are exercised prior to the closing of the sale. Otherwise, minority stockholders would not be able to seek to avoid an oppressive merger by application to the Delaware Chancery Court. The Court also did not rule on this point in its decision.
Pending further guidance from the Delaware courts, model stockholders agreements should include drag-along provisions that compel stockholders to vote in favor of deal prior to closing or after closing and require them to sign a written consent to a transaction subject to a drag-along right within a specified period of time after receiving notice of the transaction. We also recommend including an express waiver of appraisal rights as part of the drag-along provisions. Controlling stockholders should also carefully review and follow the procedures set forth in the drag along provisions. If Riverstone had included an express waiver of appraisal rights in its stockholders agreement and/or exercised the drag-along rights in accordance with their terms, it is possible the outcome of the case may have been different and forced the Court to decide whether prospective waivers are valid. Some practitioners are also considering forming companies as LLCs rather than corporations as a structural solution because LLCs are largely contractual and could include prospective waivers of appraisal rights. This solution may not work for companies that have venture capital or other investors who are required to invest in C corporations.
In many private company mergers, the parties may not be overly concerned about the actual threat of minority stockholders exercising appraisal rights. In most cases, smaller common stockholders and employee stockholders will want their cash proceeds as soon as possible and not want to deal with the delay and expense of an appraisal proceeding, especially where the transaction is an arms-length deal with no conflict of interest concerns. Nevertheless, purchasers seek certainty and frequently negotiate to shift the risk to the selling stockholders—by imposing closing conditions that limit the percentage of shares that exercise or remain eligible to exercise appraisal rights as of closing and by obligating the selling stockholders to indemnify the purchaser for any amounts paid on account of appraisal actions in excess of the deal price and the expense of appraisal actions.
If drag-along rights must be exercised prior to closing—either by the terms of the stockholders agreement or to ensure enforceability—target companies will need to approach stockholders prior to closing. If the transaction requires regulatory approvals or otherwise requires a post-signing period to satisfy closing conditions, the stockholders can be notified after signing. But in transactions where a simultaneous signing and closing are possible, this would mean approaching the stockholders prior to signing and announcement. Whether this is feasible will depend on considerations specific to a particular transaction, including the composition of the stockholder base, confidentiality concerns, etc. If it is not feasible to approach the minority stockholders prior to signing, the parties will need to provide for a period between signing and closing.
Abandon ship! Don't let antitrust risk sink your deal
Recent antitrust challenges to mergers, including the FTC's recent federal court victory, have forced parties to abandon at least three deals in the past few months. This string of antitrust scrutiny serves as a useful reminder of how important it is to undertake a thorough antitrust risk assessment of proposed deals in advance of signing in order to minimize chances of an extended and expensive government review and maximize the chances for a successful, efficient outcome.
While many transactions do not present substantial antitrust risk, for those that do, the merging parties face sizable costs and significant risks, including uncertainty of, or delay in, closing, steep financing commitment costs mounting over time while a deal is pending, the burden and expense of defending the transaction before the government, management distraction from day-to-day business, and in some cases daunting contractual monetary penalties in the form of a reverse break-up fee and/or ticking fees if the matter is pending for a prolonged period of time or never closes at all. Consulting with antitrust counsel well before the agreement is inked allows the parties to determine a best path forward, build in appropriate protective provisions, and allocate risk between the parties in an informed way.
Rolling the dice in court and losing with nearly $1 billion in expenditures on the line
Imagine this nightmare scenario: the FTC filed a complaint to block your $3.5 billion deal, a federal judge sided with the government, issuing a preliminary injunction, and you have been forced to abandon the transaction, leaving the company with almost $1 billion in total costs related to a deal that will never close. Sysco is facing that scenario. By the time a federal judge issued an injunction on June 23, 2015 to block Sysco's proposed acquisition of US Foods, first announced in December 2013, the company had already been saddled with delay, costs, and distraction related to the Second Request and litigation defense. If it decided to abandon the merger, it was also looking at a $300 million termination fee to US Foods. Even with so much at stake, Sysco announced it was terminating the merger. Sysco's president and CEO, Bill DeLaney, explained that the company "review[ed] whether to appeal the Court's decision [but] concluded that it's in the best interests of all our stakeholders to move on."
According to Sysco's SEC filings, Sysco spent $355 million through March 2015 in costs associated with the merger, including integration planning, financing, and legal costs to defend the transaction. After deciding to terminate the merger, Sysco added on top of that the payment of the $300 million termination fee to US Foods, as well as another $12.5 million termination fee to Performance Food Group, the divestiture buyer Sysco presented to the FTC in a failed attempt to assuage the FTC's concerns. Sysco will also incur additional expenses as the company begins redeeming $5 billion worth of bonds related to the deal. All told, Sysco will have spent approximately $1 billion and ended up right where it started.
One, two, three—you're out!
Sysco-US Foods is not the only recent merger to come under fire and ultimately fail to close. The now-terminated merger represents the third transaction that was recently abandoned by the parties in the face of questions from the antitrust agencies. Since April of this year, the DOJ Antitrust Division has forced the parties to abandon numerous other transactions, including another deal that required payment of a reverse break-up fee and a major deal that offered significant divestitures that nevertheless failed to assuage DOJ concerns:
- the National CineMedia and Screenvision $375 million transaction was abandoned just prior to going to trial with the DOJ; and
- the Applied Materials and Tokyo Electron $9.39 billion merger was abandoned, in part, due to DOJ opposition, despite the fact that the parties offered divestitures.
In both cases, the deals were pending for over a year and the parties incurred substantial expenses. The Applied Materials-Tokyo Electron deal, for example, was pending for 580 days and the parties spent approximately $140 million before terminating the deal. National CineMedia paid a $26.8 million reverse breakup fee to Screenvision, as well as approximately $14.1 million in legal and other merger-related costs.
Commenting on recent deals, agency officials have been skeptical of the prudence of the parties even attempting some of these proposed transactions. DOJ Deputy Assistant General for Litigation David Gelfand said companies "are trying to push the envelope a little too far." Bill Baer, the head of the DOJ's Antitrust Division was blunter when he said: "There are some ideas that should never get out of corporate headquarters. It wastes the time of my people. Basically at the end of the day it's an embarrassment for companies to get out there and invest in something, get its shareholders all excited and then have to pull out at the last minute."
While these mergers may be extreme examples, they are emblematic of what can go wrong in a merger review and the fact that closing is not assured to any deal facing substantive antitrust hurdles. Parties should undertake a thorough antitrust risk assessment of their proposed deal on the frontend to avoid or minimize the costs of a merger closing being delayed due to regulatory review. Where appropriate, antitrust counsel can work with the corporate transaction team to build provisions into the definitive agreement that ensure that you are as protected as possible, subject to deal negotiation dynamics, should you end up in the nightmare scenario.
For example, when considering whether to enter into a potentially antitrust-sensitive deal, parties should consider several risk-shifting contractual provisions, like reverse breakup fees, divestiture limitations, termination provisions, and obligations to litigate.
Other provisions in the definitive agreement can also turn out to be important during the pendency of an investigation, such as cooperation provisions and efforts clauses. Cooperation provisions can ensure that both parties have access to documents and consult with each other before communicating with the government. Alternatively, one of the merging parties may be given the authority to lead the antitrust defense. Whatever the scenario for your deal, antitrust counsel will work with the corporate M&A team to develop the appropriate medley of risk-shifting and other provisions for your deal.
Rep and warranty insurance: trends and key considerations
Over the last several years, transactional insurance, or representation and warranties insurance ("R&W Insurance"), has become a more prominent part of the M&A landscape. For example, private equity and venture capital firms are increasingly using R&W Insurance to obtain a "clean break"—relatively speaking—when exiting their portfolio company investments. In this brief article, we thought we would provide a high-level overview of these policies, and our observations regarding trends and key considerations.
R&W Insurance policies provide a number of key advantages to sellers and buyers. Key advantages to sellers include: increased deal proceeds at closing (since the policy will be used in lieu of a typical indemnity escrow); and, for private equity and venture capital firms, the ability to distribute proceeds to their limited partners promptly after receipt (without the need to escrow a material portion of the proceeds for future indemnification claims). While buyers have shied away from this product historically, in the current M&A climate (where sellers typically have a significant amount of leverage), buyers are using R&W Insurance to advantage their bids and win deals, particularly when acquiring businesses from private equity and venture capital firms. In addition to helping them win deals, buyers also expect that these policies will have other advantages for them as well, including a creditworthy insurer as a source of recovery and enhanced recovery terms as compared to what they could typically negotiate in a market M&A agreement.
Generally speaking, an R&W Insurance policy insures buyers for breaches of the seller's representations and warranties up to a specific "limit." In most transactions, the amount of the limit tends to be equal to the amount that a buyer would expect to place into escrow in a traditional deal not involving R&W Insurance. Additionally, there is typically a retention (or deductible) on the order of 1% of the transaction value, which is typically funded in part by the buyer and in part by means of a seller escrow (usually 0.5% of the transaction value). It is this difference—the difference between the 0.5% seller escrow in a transaction with R&W Insurance and the traditional escrow (e.g. 10% of the transaction value)—that provides the seller with increased deal proceeds at closing.
With that as a backdrop, we thought it would be useful to highlight current trends and a few key points to consider when considering R&W Insurance.
- Introduce R&W insurance early in the process. Our clients have been most successful with R&W Insurance, when they have introduced it very early in the process. In a competitive sales process, we recommend that sellers include the concept as a condition to the bid—or, at minimum, as a material factor in the bidding process. We encourage our clients to work with their advisors to ensure that it is included in the bid solicitation process as early as possible.
- Structure as a "seller-flip." While not universal, when we see R&W Insurance policies used, we typically see them structured so that the buyer (and not the seller) is the insured. There are several reasons for this. Most notably, from the seller's perspective, it is preferable to have the buyer deal directly with the insurer (and not the seller) on any post-closing claims. We typically advise sellers to engage with an insurance broker to scope the coverage, identify any potential gaps in coverage (see below) and then bring a proposed policy to the buyer early in the negotiations. If done correctly, and particularly as part of the competitive sales process, we have found that sellers can utilize these policies very effectively to achieve a relatively "clean break" from their investment post-transaction.
- Be proactive about identifying "gaps" in coverage.One of the bigger points of contention when negotiating transactions with R&W insurance is the scope of the insurance coverage. In recent years, the scope of R&W insurance has broadened to the point that many buyers are comfortable with it as their primary source of recovery for indemnification claims. And some buyers have even become comfortable with an R&W Insurance policy as their sole source of recovery (subject to the limited seller escrow described above). However, for many buyers considering an R&W Insurance policy, they will be very focused on ensuring that the policy, itself, when combined with the seller indemnification obligations, provides them with the same protection that they could otherwise negotiate in a market M&A agreement. For general representations and warranties, there is not usually much difference. However, when it comes to specific indemnities, insurance exclusions, and some specific fundamental matters (such as intellectual property), there can be a "gap"—and sometimes a significant gap—in coverage when comparing R&W Insurance to standard market M&A terms.
In this regard, it is extremely important for transaction participants to fully understand as soon as possible in the process the proposed scope of the R&W Insurance coverage. For many insurers, typical "exclusions" from coverage include: matters of which the insured (typically the buyer) is aware, matters that are subject to price or working capital adjustments, certain regulatory matters (such as those relating to healthcare laws, unfunded benefit plans and FCPA compliance).
As noted above, for sellers that are likely to be subject to a number of exclusions, the utility of R&W Insurance can be greatly compromised, because (among other things) the seller will then be forced to reserve proceeds to cover the exclusions. So, we recommend that our clients speak with their brokers early in the process to identify any potential known gaps in an effort to ensure that they are addressed early in the process. If there are gaps in coverage, then sellers may want to consider ways to proactively close the gap as part of the sale dynamic. This could include a limited agreement to indemnify for the gap items up to some intermediate cap. But, of course, the broader the scope of this gap indemnity, the less valuable the R&W Insurance policy is in actually obtaining a clean break. In general, we have found that a little advanced planning and strategizing can go a long way in improving the effectiveness of the product.
- Other policy terms. In addition to the exclusions, several other policy terms are important in understanding the scope of coverage available to the buyer and any gap coverage for which a seller may have exposure. Key terms of R&W Insurance policies for buyers and sellers to consider generally include the following:
- Eliminating the right of subrogation against the seller
- Limiting the number and scope of exclusions
- The definition of "Covered Losses"—in many cases, buyers will be able to achieve better protection with respect to coverage for diminution in value and recoveries based on multiples of damages than they might otherwise receive in a standard, "market" purchase and sale agreement
- The term of the policy, which frequently lasts for six years (even for general representations and warranties)
- The amount of the premium—frequently between 2–5% of the policy limit
- The amount of the policy "retention"—frequently 1% of the transaction value (but subject to a step-down after a period of time)
- Coverage for specific/special indemnities—this may be difficult if there is known liability, but should otherwise be something that the insurer will cover depending on the nature of the matter
- Negligent misrepresentation and fraud coverage—One of the advantages of the "seller-flip" structure is that the buyer should be able to obtain coverage for negligent misrepresentation and fraud by the seller of which the buyer is unaware
- Loss payee coverage and the right to assign—This will be important for leveraged and other transactions where the buyer may need to collateralize or otherwise assign the policy coverage
- The definition of "covered costs"—buyers should try to obtain coverage for defense costs related to third party claims as well as all costs of claim prosecution
R&W insurance going forward
Although we have seen increased use of R&W Insurance policies in transactions over the last several years, there is still a fair amount of uncertainty as to whether or not the recent growth in usage of these policies will continue; or whether, the recent trend will be fleeting. The answer to this question will depend, almost exclusively, on whether or not R&W Insurance achieves the key objectives identified above: a clean break for sellers and the same (or better) representation and warranty coverage for buyers. With very little insurance claims history to date, it is hard to know for certain one way or the other whether R&W Insurance will actually satisfy these key objectives over the long term. However, in the short term, in light of the increased interest in placing R&W Insurance shown by insurers and the current seller-favorable M&A climate, we expect to see these policies with increasing frequency in private M&A transactions.