The Standard of Review for Dell’s IPO

Dell Technologies Inc. (Dell) has been planning to eliminate its tracking stock (Class V common; NYSE: DVMT) through a merger with a wholly-owned subsidiary that effectively converts the outstanding DVMT shares into a new class of publicly traded Dell common stock. Each DVMT share (which collectively track about half of VMware Inc. [1]) will be cancelled and converted into the right to receive, at the election of the holder, either: (1) 1.3665 shares of Dell Class C common stock, which will be listed on the New York Stock Exchange, or (2) $109 in cash, without interest (subject to a $9 billion cap) (the DVMT Exchange). [2]

However, many tracking stock holders have been reluctant to support the DVMT Exchange. [3] On October 15, activist shareholder Carl Icahn released an open letter to DVMT shareholders disclosing that he had increased his stake from 1.2 percent (as of June 30) to 8.3 percent and that he will do everything in his power “to stop this proposed DVMT merger” including, possibly, offering “a competing partial bid that provides partial liquidity without forcing a merger.” [4]

The DVMT Exchange will only pass if holders of a majority of the outstanding DVMT shares (excluding shares held by Dell affiliates) vote in favor of the transaction—not a simple majority of those in attendance at the special meeting. [5] Despite the uncertainty about the level of DVMT shareholder support for the transaction, Dell had been planning to move forward with it. As of last week, the company still expected to file its definitive proxy statement by the end of this month, around which time it was also planning to also announce the date for its special shareholder meeting, which was expected to occur before the end of this year.

It is too early to say whether the Icahn letter will change that. However, in his letter, Icahn argued that the DVMT shares are massively undervalued and that the DVMT Exchange would amount to a “grand expropriation” of about $11 billion of value—the full discount at which the DVMT shares are trading relative to their stake in VMware [6]—by Michael Dell and Silver Lake.

Icahn is claiming that, were Dell to pursue a traditional IPO followed by a charter-authorized conversion of the DVMT shares into Class C shares, he thinks courts will find that such a conversion “was pursued in retaliation against DVMT stockholders.” Because it would be “tainted by coercion,” Icahn thinks such a “forced IPO conversion” would be evaluated under entire fairness and DVMT stockholders would have “valid claims for substantial damages” that could take “many years” for Dell to fight out in court.

Explaining the “Forced IPO Conversion”

On October 3, Dell filed a Form 8-K disclosing that “as a potential contingency plan in the event that the DVMT Exchange is not consummated, Dell has met with certain investment banks to explore a potential initial public offering of its Class C Common Stock.” [7] We previously wrote about how Dell’s charter provides that once Dell’s Class C stock is publicly traded, Dell’s Board of Directors may (at any time and without any other approval) decide to convert all of its outstanding shares of DVMT into Class C stock, pursuant to a conversion formula set out in the charter. [8] The formula is based on the trailing 10-day volume-weighted average price (VWAP) for the Class C and the DVMT, so that at the time of conversion, the Board will know the exact conversion ratio. [9]

Because of how the formula works, if the DVMT share price drops even a small amount relative to the Class C price during the applicable period (reducing the amount of Class C stock a DVMT holder would receive upon conversion), that could create selling pressure that would further reduce the conversion ratio. This risky spiral is something that DVMT investors presumably want to avoid (see our February 9 report “What Could Happen If a Dell IPO and Anticipated Tracking Stock Conversion Reduces the Value of the Tracking Stock”).

Icahn describes Dell’s consideration of a traditional IPO of its Class C stock as “an empty and ridiculous IPO threat” given that, among other things, it could trigger “up to $20 billion of backflowing shares that could hit the market following a forced conversion of DVMT stock.”

Entire Fairness Might Now Apply to the DVMT Exchange

Under Delaware law, [10] in a transaction with a controlling shareholder, the following six requirements must be satisfied in order to avoid application of entire fairness:

1. The controller must condition the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders;
2. The special committee must be independent;
3. The special committee must be empowered to freely select its own advisors and to reject the transaction;
4. The special committee must meet the duty of care standard in negotiating a fair price;
5. The minority shareholders must be fully informed; and
6. The vote of the minority shareholders must not have been coerced.

This last requirement—no coercion of the minority shareholders (in Dell’s case, the DVMT holders)—could be in jeopardy now that Dell is floating the possibility of a traditional IPO plus a charter-authorized conversion. One could argue that by re-raising the IPO plus conversion option, Dell is attempting to coerce (or, at the very least, pressure) the DVMT shareholders into voting to approve the DVMT Exchange.

• Dell’s Board (aka Michael Dell) exclusively controls the timing of a DVMT into Class C conversion and can authorize it when the conversion ratio is most advantageous to Dell and least favorable to the DVMT holders.
• A reasonable investor may feel pressured into voting in favor of the DVMT Exchange rather than rolling the dice and giving Dell the discretion to convert its shares following an IPO of the Class C.

We tend to agree that the timing of Dell’s consideration of a traditional IPO as a potential contingency were the DVMT Exchange not approved has jeopardized the application of the business judgment rule and created an argument that entire fairness applies.

Would Entire Fairness Apply to the IPO?

Under Delaware law, a decision by Dell’s Board to IPO the Class C, in and of itself, generally would not be subject to any form of heightened scrutiny—that is, it should be reviewed under the business judgement rule. There are independent business reasons for doing an IPO (e.g., deleveraging, providing liquidity, acquisition currency, etc.), and the decision to IPO, by itself, does not result in the DVMT holders losing their shares. Nevertheless, if a DVMT holder could prove that the IPO was timed in such a way as to purposefully drive down the value of the DVMT stock prior to a conversion of the DVMT into Class C, the shareholder may have a claim against the Board.

Under Dell’s charter, the conversion of DVMT into Class C occurs “[a]t the option of the corporation” (essentially at the option of Dell’s Board). Michael Dell, who is not only the CEO of Dell, but also the Chairman of its Board, has seven of the 13 total votes on the Board, which means that the decision to convert the DVMT to Class C belongs exclusively to him. [11] Mr. Dell is also the majority stockholder. [12]

Because the conversion mechanic is in the charter, that means DVMT holders are deemed to have acquired their shares with full knowledge that this decision was not delegated to the capital stock committee. Also, the decision to convert, if made when optimal for the DVMT shareholders, almost by definition will be made when suboptimal for the Class A, B and C holders, and the Dell Board still owes a fiduciary duty to them, further complicating the entire fairness analysis. Even though this transaction might otherwise implicate heightened scrutiny under Delaware law, as a result of these facts (and other arguments), that outcome is not clear-cut.

The Tax Implications of Icahn’s Potential Partial Bid

Both the DVMT Exchange (where the exchange precedes the IPO) and the traditional IPO plus conversion alternative (where the IPO precedes the exchange) would likely constitute nonrecognition transactions under the tax rules, meaning that neither Dell nor the DVMT shareholders (assuming they elected all stock in the DVMT exchange) would have to pay any tax.

But if Icahn were to announce a competing tender offer (giving DVMT shareholders that want to sell the opportunity to get cash without forcing all DVMT shareholders out in an exchange/merger), participating DVMT shareholders would recognize capital gain or loss on the sale. For foreign investors who might otherwise be inclined to participate in the DVMT Exchange, selling all of their shares to Icahn would eliminate any risk of dividend withholding tax.

While an Icahn tender could marginally increase Icahn’s leverage over Dell’s Board, such leverage would be largely a matter of optics given that DVMT shareholders currently only have a say over three of the 13 votes on the Board, and even then, they only have about 26 percent of a say (as DVMT only makes up about 26 percent of all of Dell’s outstanding common stock). [13]

Endnotes

1The Class V stock is intended to track the economic performance of about 61% of Dell’s economic interest in the Class V Group, which as of Aug. 3, consisted solely of about 331 million shares of VMware or about 81% of the outstanding equity interest in VMware, according to Dell’s Form 10-Q filed Sept. 11 (and 61% of 81% equals about 50%) (https://www.sec.gov/Archives/edgar/data/1571996/000157199618000034/delltechnologiesq2fy1910q.htm).(go back)

2Dell’s outstanding shares of Class A Common Stock, Class B Common Stock and Class C Common Stock will not be converted or exchanged in the DVMT Exchange and will remain outstanding following the completion of the merger and the DVMT Exchange. If all DVMT holders elect stock, Dell estimates that it would issue a total of approximately 272,420,782 shares of Class C Common Stock, which would represent approximately 30.7% of Dell’s total common stock on a fully diluted basis outstanding immediately after the DVMT Exchange, and approximately 4.6% of the total voting power of Dell’s outstanding common stock. If DVMT holders elect more than $9 billion of cash (the cap), Dell estimates that it would issue a total of approximately 159,590,507 shares of Class C Common Stock, which would represent approximately 20.6% of Dell’s total common stock on a fully diluted basis outstanding immediately after the DVMT Exchange, and approximately 2.8% of the total voting power of Dell’s outstanding common stock.(go back)

3On Oct. 5, a Sept. 27 letter from a Dell shareholder to Dell’s Board was released to the public. In it, a registered investment advisor asked Dell to increase the consideration by 20 percent (from $109 in cash or 1.3665 shares of Class C to $130.80 in cash or 1.6398 shares of Class C, preserving the $9 billion cash cap). (See https://www.sec.gov/Archives/edgar/data/1040198/000090266418003638/p18-1878px14a6g.htm.) In addition, shareholder advisory firm Institutional Shareholder Service Inc. (ISS) issued a report Oct. 5 indicating that a DVMT Exchange at an increased price would be a better option than the traditional IPO plus charter-conversion alternative.(go back)

4Icahn’s Oct. 15 letter to DVMT shareholders, “Icahn Beneficially Owns Over 16.5 Million Shares, or 8.3%, of Dell’s DVMT Stock; Icahn Will Vote AGAINST Dell’s Proposed DVMT Merger,” (https://www.sec.gov/Archives/edgar/data/921669/000114420418053722/tv504782_ex-1.htm).(go back)

5According to amendment no. 2 to Dell’s preliminary proxy statement/prospectus dated Oct. 4, “If you fail to vote or abstain from voting on the adoption of the merger agreement or the amended and restated certificate of incorporation of the Company, the effect will be the same as a vote against the Class V transaction” (https://www.sec.gov/Archives/edgar/data/1571996/000119312518293366/d681091ds4a.htm).(go back)

6As of Sept. 5, there were about 199 million DVMT shares outstanding, which collectively represent an economic interest in about 61.1% of 331 million shares of VMware (or about 202.241 million shares of VMware). Using Icahn’s recent trading prices for DVMT ($91.74) and VMware ($141.29), the DVMT shares are collectively trading at about $18 billion when they represent an economic interest in VMware that is worth about $29 billion, a difference of about $11 billion.(go back)

7The Form 8-K went on to state that “[t]here is no assurance that the Board will determine to proceed with an initial public offering of its Class C Common Stock in the event that the DVMT Exchange is not consummated,” (https://www.sec.gov/Archives/edgar/data/1571996/000119312518291390/d633285d8k.htm). On Oct. 4, Dell filed an amendment to its preliminary proxy statement that also addressed this contingency plan: “Since the announcement of the DVMT Exchange, the Company has conducted meetings with various Class V stockholders. In those meetings a number of Class V stockholders expressed concerns regarding the economic terms of the DVMT Exchange. The board of directors and the Special Committee continue to believe that the DVMT Exchange is in the best interests of the Class V stockholders and the Company remains committed to the DVMT Exchange. However, in light of such feedback and the continued strength of the Company’s financial and operational performance, in late September 2018, the Company began to re-evaluate an initial public offering of the Class C Common Stock as a potential contingency plan in the event that the DVMT Exchange is not consummated. As part of that evaluation, representatives of the Company and Silver Lake Partners recently met with certain investment banks to explore a potential initial public offering.”(go back)

8 See Section 5.2(r) “Conversion of Class V Common Stock into Class C Common Stock at the Option of the Corporation” of Dell’s fourth amended and restated certificate of incorporation, dated Sept. 6, 2016: https://www.sec.gov/Archives/edgar/data/1571996/000119312516703370/d253636dex31.htm.(go back)

9The formula also applies a conversion premium (20 percent if converted in the first year following the IPO, 15 percent if converted in the second year and 10 percent thereafter) to the trailing 10-day VWAP of the DVMT divided by the trailing 10-day VWAP of the Class C over that same period.(go back)

10Kahn v. M&F Worldwide Corp. (Del. Supreme Court Mar. 14, 2014).(go back)

11See pages 212, 256 and 257 of Dell’s Oct. 4 amendment to its preliminary proxy statement.(go back)

12See pages 212 (“Mr. Michael Dell, who is Chairman of the Board and Chief Executive Officer of the Company, and his wife’s trust together beneficially owned common stock representing approximately 66.2% of the total voting power of our outstanding common stock as of August 31, 2018, through ownership of Class A Common Stock and Class C Common Stock.”) and 271 of Dell’s Oct. 4 amendment to its preliminary proxy statement (reporting beneficial ownership of 350,859,401 shares of Class A Common Stock and 526,921 shares of Class C Common Stock).(go back)

13 https://www.sec.gov/Archives/edgar/data/1571996/000119312518293366/d681091ds4a.htm and https://www.sec.gov/Archives/edgar/data/1571996/000157199618000034/delltechnologiesq2fy1910q.htm(go back)