Section 262 of the DGCL provides a statutory remedy for stockholders who do not vote in favor of certain M&A transactions (generally cash mergers) to petition the corporation to buy their stock at a price equivalent to the “fair value” of the stock, subject to compliance with certain procedures. A recent appraisal action in the Delaware Court of Chancery breathed new life into at least certain appraisal claims by challenging the recent company-favorable decisions holding that fair value for purposes of an appraisal was equal to the deal price.
In In re: Appraisal of Dell Inc., Vice Chancellor Laster of the Delaware Court of Chancery used a DCF analysis to conclude that the fair value of Dell Inc. at the effective time of the management buyout was $17.62 per share, more than 28% higher than the $13.75 deal price, and ordered the company to pay the petitioners the fair value in cash plus legal interest, compounded quarterly, from the date of closing until the date of payment. In its appraisal ruling, the court held that the merger price did not reflect the fair value of the company as a going concern for purposes of an appraisal even if the court acknowledged that the directors fully abided by their fiduciary duties in running a sale process and approving the management buyout (note that the fiduciary duty issues were not the subject of the court’s review).
The Dell decision adds to the concern by deal parties that they will face rising costs and distractions from appraisal actions even as the risk of disclosure-focused deal litigation has declined. Although this case can be read as applying narrowly to conflicted transactions such as management buyouts, it may create an incentive for hedge funds who use appraisal actions as a form of investment strategy and for the plaintiffs bar to bring appraisal actions based on alleged conflicts in a sales process. The decision also serves as a reminder that while a judge is free to select from a number of valuation methods, including the deal price – and may rely on experts to determine the company’s DCF value – it is ultimately in the judge’s sole discretion to determine the company’s fair value which the court clarified should be measured: (i) in terms of the company’s intrinsic value, (ii) as a going concern, (iii) on the date of the closing of the merger.
On June 16, 2016, Delaware Governor Jack Markell signed into law a bill that is intended to reduce the incentive of nuisance appraisals and discourage interest-rate appraisal arbitrage. The new law amends Section 262 of the DGCL by (i) imposing a minimum shareholding requirement for public company petitioners of 1% of the company’s outstanding shares or $1 million in value based on the deal price and (ii) allowing companies to pre-pay the appraisal award before the Delaware Court of Chancery makes a final value judgment on the appraised shares, in order to limit the statutory accrual of interest on the appraisal amount. (The de minimis requirement does not apply to short-form mergers under Sections 253 or 267.) These amendments take a step in the right direction by curtailing certain incentives by petitioners to file and drag out appraisal proceedings. However, in light of the Dell decision and the ease by which a stockholder may perfect an appraisal (and create settlement value), we would expect appraisals and arbitrage to continue in public deals and gain increased traction in the private context as appraisal actions become more prominent (e.g., Good Technology), particularly in transactions that are viewed as “conflicted” transactions by the petitioners.
Dell: Final Merger Consideration Was Not the Best Indication of Value
In Dell, after a lengthy recitation of the facts, the court explained that the final merger consideration was not the best evidence of fair value. Although the court acknowledged that in at least five decisions since 20131 the deal price was found to be the most reliable indicator of fair value, it noted that there was no rule requiring the court to defer to the merger price. The court explained that the deal price is not always reliable in many situations, due to: (i) the difference in the reference point for determining price for a deal (which occurs at signing) and fair value in an appraisal (which occurs at closing); (ii) the “thinner” M&A market as compared to the “thick and liquid” attributes of the capital markets which underpin the efficient capital markets hypothesis and (iii) the inclusion of synergies in the deal price which may cause a deal price to be higher than the fair value in an appraisal.
The court then contrasted what is generally considered in an appraisal inquiry with what a court reviews in the context of a breach of fiduciary duty claim and noted that while the two inquiries are certainly related, they are not the same. The court noted that because the standards for the inquiries are different, even if a transaction passes fiduciary muster, an appraisal proceeding could still result in a higher fair value award. The court then noted that the sale process in this case was laudable and opined that in a liability proceeding, this court “could not hold that the directors breached their fiduciary duties.” However, it found that there were a number of pre- and post-signing factors which undervalued the company.
During the pre-signing process, the court noted that these factors were: (i) the use of an LBO pricing model, which had the effect of undervaluing the company due to the private equity buyers’ need to achieve particular IRR levels; (ii) evidence of a significant valuation gap between the company’s deal value and its actual value, which was driven by the market’s short-term focus; (iii) the lack of meaningful pre-signing competition among private equity bidders who the court noted generally do not want to bid against one another and (iv) the lack of meaningful outreach to strategic bidders. The court also noted that the post-signing go-shop, which allowed Dell to “shop” the company for a limited period after signing, did not elicit fair value in the merger due to the LBO model constraints previously described and the general reluctance on the part of a competing bidder to jump management in a buyout. The court noted that the fact that two higher bids for the company emerged despite these factors demonstrated that the deal price did not appropriately reflect fair value. Other factors that provided downward adjustments to value included Michael Dell’s unique value to a bidder and his affiliation with the buyout group.
Dell: DCF Exclusively Used to Derive Fair Value
Having concluded that the sale process mispriced the company’s shares, the court assigned no weight to the final merger consideration and instead relied on the DCF methodology exclusively to derive fair value. It noted that in a DCF method, one first estimates the values of future cash flows for a discrete period. Then, one must determine the value of the entity attributable to the future cash flows, which are then estimated to produce a so-called terminal value using the “perpetuity growth rate.” Finally, the value of the cash flows for the discrete period and the terminal value are discounted back to the relevant period.
The court reviewed each of the DCFs offered by each party’s expert as well as certain of their inputs to the DCF (i.e., forecasts, perpetuity growth rate, taxes, inputs to the weighted average cost of capital, adjustments to cash). It ultimately based its valuation on two adjusted forecasts provided by Boston Consulting Group and a member of the buyout group. The two values were then averaged to arrive at a fair value of $17.62 per share.
For private deals, we continue to recommend that buyers request closing conditions requiring that no more than a certain percentage of a company’s shares (e.g., 5%) shall have sought an appraisal, in order to limit deal expenses and business distraction due to appraisal actions. We also continue to recommend that buyers seek indemnification coverage for appraisal claims from the company or participating stockholders who are signatories to the merger agreement. In our experience, this indemnity has become a common feature in private deals. Some buyers may also request that sellers enforce contractual drag-along rights or waivers of appraisal rights to compel a stockholder’s participation in the deal. While a drag-along provision, if timely exercised, may help to compel a stockholder’s participation in the deal, the ability of a company to enforce a stockholder’s contractual waiver of appraisal rights to preclude a statutory right to appraisal remains uncertain following a recent Delaware Chancery ruling (Halpin v. Riverstone) last year.
In public deals, while buyers may consider asking for an appraisal condition, in competitive bidding situations buyers likely will not be able to seek an appraisal condition (because of deal certainty risk) unless market practices change. Appraisal conditions in public deals remain rare partly because appraisal conditions themselves carry deal risk by giving minority stockholders hold-up value and therefore may not necessarily benefit the buyer in the long run.
See a copy of In re: Appraisal of Dell Inc., C.A. No. 9322-VCL (May 31, 2016).
See a copy of the changes to Section 262 in House Bill No. 371.