Appraisal Rights: Navigating the Maze After DFC Global, Dell, and Aruba

It’s easy to throw up your hands at the current state of the law on appraisal rights in Delaware. In a bit more than a decade an appraisal arbitrage industry has emerged—spawned by decisions that shares purchased post record date may be the subject of an appraisal proceeding without proof that they were not voted in favor of the transaction [1] and abetted by amendments to the statute creating a strong presumption that the interest rate on appraisal awards should be five percentage points above the Federal Reserve discount rate. [2]

The volume of appraisal actions has increased from a low single-digit percentage of deals to something close to 25%. [3] The number of awards below the deal price has been vanishingly small. And market participants and judges have clearly felt that the ability, with little risk and time value protection, to buy post-announcement shares and seek appraisal goes beyond the original purposes of the remedy (however murky those purposes may be).

During the same period, there was considerable flux in the law and lore of appraisal valuation. Discounted cash flow (DCF) analyses went in and out of favor; an “implied minority discount” in public share prices went from established orthodoxy to doctrinal banishment [4]; and the appropriate weight given to the deal price careened widely.

A group of recent Delaware Supreme Court and Court of Chancery decisions (including DFC Global, Dell and Aruba) seems at first blush to further confound the situation, offering, as they do, different ways of thinking about a host of topics and variables—deal price, market price, synergies, agency costs, efficient markets, sales processes, and the intricacies of DCF analyses. In fact, however, those cases may offer beacons that illuminate large sections of the path out of the maze. And they similarly delineate the handful of key issues that remain to be resolved before our escape is complete.

A Quick Look at the Cases

DFC Global. [5] The Court of Chancery had given equal weight to deal price ($9.50 per share), a comparable company analysis ($8.07 per share), and a DCF analysis ($13.07 per share)—resulting in a fair value of $10.21 per share. On reargument, the court was persuaded that in its DCF analysis it should have used certain working capital numbers it had blessed in other portions of the opinion. That change would have substantially reduced the DCF valuation, but the Chancellor further concluded that utilizing those working capital numbers necessarily implied the use a higher perpetuity growth rate than the one it had used in its previous DCF analysis. Utilizing the previously adopted working capital numbers and the arguably correlative perpetuity growth rate actually caused a small increase in the DCF valuation and a revised fair value of $10.30 per share.

On appeal, the Supreme Court reversed and remanded. The Court noted that the Court of Chancery had observed that:

DFC was purchased by a third-party buyer in an arm’s length sale. The sale process leading to the transaction lasted approximately two years and involved DFC’s advisor reaching out to dozens of financial sponsors as well as several strategic buyers. The deal did not involve the potential conflicts of interest inherent in a management buyout or negotiations to retain existing management—indeed, [the buyer] took the opposite approach, replacing most key executives…. [6]

The Court of Chancery had nonetheless determined that the deal price was not fully reliable as a source of fair value because (i) DFC Global was in a trough and its future performance was dependent on regulatory challenges that markets and buyers were likely not able to evaluate and (ii) the buyer was a financial sponsor beholden to certain internal rate of return (IRR) requirements. Neither, in the Supreme Court’s view, provided a persuasive reason for questioning the deal price: markets and buyers routinely price regulatory risk into their assessments of value, and all buyers have return requirements and assume targets will be able to meet them. Accordingly, while declining to establish a presumption in favor of deal price on grounds the statute requires the court to take into account “all relevant factors,” [7] the Court was unable to sustain the Chancellor’s decision to give the deal price only one-third weighting.

Dell. [8] Here the Court of Chancery gave no weight to Dell’s stock price or the deal price. It reasoned that “investor myopia” and more generally an inefficient market rendered the stock price unreliable. And it concluded that the deal price was entitled to no weight because the pre-signing process was confined to private equity buyers whose IRR requirements generate artificially low values and because the post-signing go-shop, although well-constructed, did not provide a true market check because of obstacles to higher bids inherent in MBOs and go-shops.

On appeal, the Supreme Court reversed and remanded. The Court found no evidence of “investor myopia” or other reasons to be skeptical of the stock price as an indicator of value. On the contrary, it noted that Dell stock was widely held and that its price reacted swiftly to changing information. The Court argued strongly that an efficient market made up of many participants making many individual assessments of value is a persuasive valuation mechanism. Similarly, relying upon DFC Global, the Court rejected the notion that the LBO pricing model or private equity return expectations provide reason to be skeptical of their pricing or assessments of value:

The Court of Chancery ignored an important reality: if a company is one that no strategic buyer is interested in buying, it does not suggest a higher value, but a lower one. “[O]ne should have little confidence she can be the special one able to outwit the larger universe of equally avid capitalists with an incentive to reap rewards by buying the asset if it is too cheaply priced.” [9]

Concluding that “the evidence suggests that the market for Dell’s shares was actually efficient and, therefore, likely a possible proxy for fair value” and that “the trial court’s own findings suggest that, even though this was an MBO transaction,” the features that can insulate such transactions from effective price competition “were largely absent here,” the Supreme Court determined that the trial court’s decision to rely “exclusively” on its own DCF analysis was not grounded in relevant, accepted financial principles. [10]

Aruba. [11] Quoting extensively from DFC Global and Dell, and in particular from the sweeping endorsements of efficient market theory in both cases, the Court of Chancery found that the most persuasive evidence of fair value was Aruba’s 30-day unaffected market price. Unlike DFC Global and Dell, Aruba was sold to a strategic buyer, and thus the deal price likely contained some portion of the synergies expected from the transaction. Under Section 262(h), the “fair value” of the shares is to be determined “exclusive of any element of value arising from the accomplishment or expectation of the merger.” While, as will be seen, the scope of this carve-out is one of the key remaining questions after these cases, it seems quite clear that the language is meant to exclude classic combination synergies.

The Court of Chancery seems to have concluded that, notwithstanding some less than straightforward incentives among the Company’s advisors, the deal process, and hence the deal price, was reliable but for the inclusion of a component of value relating to synergies. Rather than start with deal price and attempt to back out synergies, which the court found was a process inherently tainted by human error, the Chancellor determined to rely upon the market price, which by definition did not include “any element of value arising from the…merger.”

Towards a Synthesis

Taken together one might extract from these and companion cases the following principles:

• The market price of the target’s stock is a powerful indicium of value unless there exist factors that cause that price to be unreliable. Such factors might include rumors of a transaction, a thin or otherwise imperfect market, and the absence of current and reliable information about the target in the marketplace.
• By definition, the market price will not include any component of synergies. Similarly it will exclude other elements of value that may be present in a reliable deal price—a control premium, savings associated with elimination of “agency costs” [12] that would flow from a take private transaction, savings associated with the elimination of “public company” expenses, and like factors.
• The deal price likewise is a powerful indicium of value unless there exist factors that cast doubt on its reliability. Such factors might include conflicts of interest and other fiduciary concerns, a defective sale process, advisors who for some reason fail to fulfill their functions, and like imperfections.
• By definition, the deal price will include some amount of value associated with the consummation of a transaction: a control premium, savings associated with the elimination of “agency costs” and public company expenses and, in a strategic deal, classic synergies.

Those principles, in turn, suggest an orderly approach to the valuation exercise and highlight a few unanswered questions. Under this approach, the first step would be to determine the reliability of both market and deal prices, recognizing that the two may be related because a market price that is for some reason unreliable may make it more difficult to be comfortable with the deal price.

Starting with market price, the questions would be how broad is the market, how good is the flow of information to the market, and whether there has been information in the market (or withheld from the market) that causes the market price to be suspect. [13]

Turning to deal price, the inquiry is more intricate, both because it picks up a host of questions about the process, the parties’ incentives, the deal protection, conflicts and fiduciary issues and because the standard to be applied remains a bit uncertain. Does a process that meets fiduciary standards necessarily yield a price that is a reliable starting point for appraisal purposes? Is the scrutiny for some reason stricter? [14] How should we factor into the analysis the notion in Corwin [15] that an informed, uncoerced vote in favor of the merger effectively blesses the process? One hopes that a substantive determination that the sale process, taken as a whole, actually meets fiduciary standards would be sufficient to confer considerable reliability on the deal price. And one suspects that a process with notable fiduciary flaws would fail to provide support for the deal price even if directors are exonerated under Corwin.

The next step—and it remains one in need of judicial clarification—is to determine what elements of value should be included in fair value or, phrased differently, what constitutes an “element of value arising from the accomplishment or expectation of the merger.” Sometimes silently, and sometimes vocally, courts and commentators have struggled with this question for years. Aruba provides what seems like the starkest answer: by choosing the unaffected stock price the court seems to say that no element of value other than the intrinsic value of the company as a going concern counts (although presumably every stock price has in it some amount of value relating to the possibility that the company will at some future point be bought for a price that includes value for the elimination of agency costs and the transfer of control). And Dell and DFC Global, by all but endorsing the deal prices, provide another answer: both are financial sponsor deals and thus do not have classic synergies, but both prices exceed the unaffected stock price, doubtless in part, and perhaps in large measure, reflecting the value of the elimination of agency and public company costs, and a control premium.

It is easy to begin to see a typology of elements of value in excess of pure going concern value here. First might be elements of value that would be present in any transaction in which the target became wholly owned—the elimination of agency costs, the elimination of public company expenses and the transfer of control (although note that some or all of these—especially the elimination of public company expenses—would feel more like classic synergies if the transaction were a merger of two public companies). Next would be elements of value that the target could achieve in a wide range of transactions largely because of attributes peculiar to the target itself. Included in this category might be greater access to capital, or economies of scale. Finally there would be classic synergies that relate to the particular transaction or the particular buyer, for example elimination of duplicate distribution systems or research and development functions. Where any particular element of value or savings fits on this continuum is, to say the least, not crystal clear. But the cases pointing to deal price, and the scarcity of cases prior to Aruba simply using unaffected stock price, certainly suggest that some elements of value on this spectrum are meant to be included in “fair value” for appraisal purposes. [16]

So where does this leave us? First, we are meant to put significant trust in efficient market theory, relying as a starting point on both market price and, if resulting from a strong process, deal price. Second, we need some additional guidance on what will or will not jeopardize initial reliance on deal price. And third, we still need a fair amount of guidance on what, if anything, to subtract from deal price in a sponsor deal, on what to subtract from deal price in a strategic deal, and on what, if anything, to add to market price in either type of deal.

As to the third group of questions there seems, as noted above, to be support for trying to separate combination benefits into two categories—one consisting of benefits the target would realize from any deal, and which therefore feel more like attributes of the target than of the acquiror or the particular transaction, and the other consisting of elements of value that are specific to the deal or buyer in question. Under this approach, the first category—the elimination of agency costs and public company expenses, a control premium and perhaps other generic benefits like access to capital or the ability to operate at scale—would be benefits that are included in a determination of the target’s fair value, and the second group—true synergies—would be excluded. Proceeding in this manner would be consistent with sponsor acquisitions where deal price is endorsed as fair value à la DFC Global and Dell and would require that strategic deals get a harder look. Such a look might well require either adding basic going private benefits to market price or subtracting true synergies from deal price—a choice dictated in part by the reliability of the market and deal prices and in part by the difficulty of assigning values to the different categories of benefits.

Bottom line: There are still some turns before we are out of the maze, but the recent cases have taken us pretty far toward showing us the way out.

Endnotes

1E.g., In re Appraisal of Transkaryotic Therapies, Inc., Civ. A. No. 1554-CC (Del. Ch. May 2, 2007).(go back)

22007 Delaware Laws Ch. 145 (H.B. 160) (amending § 262(h), Title 8, Del. Code).(go back)

3Wei Jiang, Tao Li, Danqing Mei, & Randall Thomas, Appraisal: Shareholder Remedy or Litigation Arbitrage?, 59 J. L. & Econ. 697 (2016).(go back)

4See Lawrence A. Hamermesh & Michael L. Wachter, The Short and Puzzling Life of the “Implicit Minority Discount” in Delaware Appraisal Law, 156 U. Pa. L. Rev. 1 (2007).(go back)

5DFC Global Corp. v. Muirfield Value Partners LP, 172 A.3d 346 (Del. 2017).(go back)

6Id. at 359 (quoting In re Appraisal of DFC Global Corp., No. 10107-CB, 2016 WL 3753123, at *21 (Del. Ch. July 8, 2016).(go back)

7Id. at 366.(go back)

8Dell, Inc. v. Magnetar Global Event Driven Master Fund Ltd, 177 A.3d 1 (Del. 2017).(go back)

9Id. at 29 (quoting DFC Global, 172 A.3d at 366-67).(go back)

10Id. at 6.(go back)

11Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., No. 11448-VCL, 2018 WL 922139 (Del. Ch. Feb. 15, 2018).(go back)

12Lawrence A. Hamermesh & Michael L. Wachter, Finding the Right Balance in Appraisal Litigation: Deal Price, Deal Process, and Synergies (Feb. 26, 2018) (unpublished working paper).(go back)

13In Aruba, the Chancellor suggested three possible questions bearing on the reliability of the market price of the target stock. First, the parties were apparently aware during the course of negotiations that Aruba would beat its guidance for the quarter and chose to announce earnings alongside the merger—apparently in order to increase their chances of having the deal approved. Second, there was a possibility that the nature of the market and the information available to the market could change between signing and closing. And finally, the parties chose to use a 30-day unaffected market price as a measure of fair value, whereas a different period may have resulted in another value.(go back)

14The Court of Chancery decision in Dell certainly suggests it is. In Aruba, the court examined whether the absence of competition or the incentives of the negotiators undermined an otherwise “run-of-the-mill” transaction where there was no breach of fiduciary duty (ultimately finding that they did not because, even though under different circumstances the price may have been higher, the transaction process was not exploitive).(go back)

15Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015).(go back)

16Note also that in determining fair value in the past Delaware courts have adopted the concept of an “implicit minority discount”, which posits that common stock of corporations consistently trades at values below the pro rata value of the corporation’s free cash flows due to agency costs associated with a minority interest. This becomes relevant when conducting a comparable company analysis.(go back)