Aruba and the Flawed Corporate Finance of Dell and DFC Global

Charles Korsmo is Professor of Law at Case Western Reserve University School of Law and Minor Myers is Professor of Law at Brooklyn Law School. This post is based on a recent article by Professors Korsmo and Myers, forthcoming in the Emory Law Journal, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Using the Deal Price for Determining “Fair Value” in Appraisal Proceedings (discussed on the Forum here) and Appraisal After Dell, both by Guhan Subramanian.

The Delaware Supreme Court’s recent opinion in Verition Partners v. Aruba Networks marks the Court’s first tentative steps to make sense of DFC Global and Dell, the Court’s major rulings on the appraisal remedy from 2017. The two opinions, strewn with conflicting asides and observations, were equal parts momentous and muddled. Their problems run deeper, however, than simply the widespread confusion over their precise meaning. As we explain in a recent article, The Flawed Corporate Finance of Dell and DFC Global, the Court made a number of serious missteps in applying basic principles of modern finance. These mistakes colored all of the legal conclusions that the Delaware Supreme Court drew in reliance upon them and threaten to have deleterious and wide-ranging effects on Delaware law. The Court’s efforts in Aruba mark only the beginning of a long-term clean-up effort.

The appraisal right is a statutory remedy that, in Delaware, entitles a stockholder to dissent from a merger transaction and instead receive the “fair value” of its shares, as determined in a proceeding before the Delaware Court of Chancery. In prior work, we documented the dramatic increase in the number and size of appraisal petitions earlier in this decade, primarily driven by sophisticated specialists who acquire positions in the target company following the announcement of a merger with the intent to demand appraisal. These so-called appraisal arbitrageurs are largely responsible for the transformation of the stockholder appraisal from a little-used curiosity to a potent option for dissenting stockholders and a topic of heated debate.

DFC Global and Dell were the Court’s first serious treatment of the remedy since the rise of appraisal arbitrage. Indeed, they represent the most significant changes to the law of appraisal since since Weinberger v. UOP modernized the remedy in 1984. Both DFC Global and Dell involved situations where specialist investors dissented from a public company merger, and where the Court of Chancery, following trial, ultimately found fair value to be higher than the negotiated merger price. In both cases, the Supreme Court reversed, finding that the trial courts had failed to justify the decision to depart from the negotiated merger price. The Supreme Court clearly intended both decisions to stand as testaments to the importance of respecting market pricing in mergers, and to the high burden appraisal petitioners should face in attempting to convince a court that a negotiated price is not the best evidence of fair value. The message sent to the trial courts is simple: absent a culpable breach of duty, trust the market price.

In both decisions, the Court insisted that it did nothing more than apply “established principles of corporate finance.” As we show in our recent article, however, the Court made four serious mistakes in its use of modern finance, all of which persist even after Aruba.

First, in considering how risk bears on prices, the Court ignored the difference between how diversified investors price risk, and how undiversified investors price risk. A basic tenet of modern portfolio theory is that well-diversified investors need only consider market or systemic risks—which cannot be diversified away—but may safely ignore firm-specific risks. Undiversified investors, however, must discount for both types of risk. In many mergers, both the officers and directors controlling the target company and the private equity managers controlling the buyer may be undiversified, potentially driving a wedge between the value of the company to them and its value as a going concern to diversified (public) stockholders. In both opinions, the Supreme Court spends a great deal of time extoling the ability of markets to accurately price risk without recognizing this critical distinction between types of risk, and the implications for what a private buyer might be willing to pay in a merger.

Second, the Court confused well-supported evidence that securities markets are generally informationally efficient with crude notions of value efficiency. The past several decades of financial economics have taught, however, that markets can be extremely efficient at arbitraging away new information without any assurance that prevailing prices will be “accurate” in a fundamental sense. The Court then compounds this error by ascribing to the deal market (the market for entire companies) the efficiency of stock markets (the market for individual shares). The market for entire companies, however, involving a limited universe of buyers for companies that lack exact substitutes, is unavoidably less efficient than the stock market, which involves deep markets for largely fungible shares. While the Aruba opinion partially backed away from earlier statements implying value-efficiency, the opinion still failed to recognize the differences between stock markets and deal markets.

Third, rather than evaluate the kinds of factors that would indicate whether the conditions of pricing efficiency were met in the sale of a company, the Court in DFC Global and Dell simply assumed that they were met whenever the target company’s directors met their minimum fiduciary obligations. This assumption has no basis in economics, corporate finance, or auction theory. Fiduciary duty liability—focused on personal liability for directors and thus properly concerned the possibility of risk-aversion—is deliberately and appropriately forgiving of director misbehavior. The result, however, is that instances abound where directors may have satisfied increasingly deferential fiduciary standards while nonetheless failing to conduct a sales process that generates a price that is reliable evidence of fair value. Grafting fiduciary standards into the very different context of appraisal is a category error that misses the point of the inquiry.

Finally, the Supreme Court on occasion treated valuation as a mechanical exercise, failing to appreciate the unavoidable need for human judgment. In DFC Global in particular, the Court reversed a post-trial adjustment the Court of Chancery had adopted to its discounted cash flow analysis, while leaving other related adjustments in place. Viewed in isolation, the Supreme Court’s analysis of the individual adjustments was reasonable, with one not-insignificant problem: taken together, they generated a valuation the trial court had clearly rejected as implausible.

These mistakes are a problem for the law of appraisal, and they also may metastasize to other areas of Delaware law. For example, the Supreme Court’s apparent embrace of a some rough-hewn version of the efficient market hypothesis is in deep tension with Delaware law’s longstanding tolerance for defensive tactics such as the poison pill. Delaware law has long permitted a board of directors to employ such tactics to fight off a takeover—even one at a large premium to the market price, and manifestly favored by the stockholders—solely for the reason that the offer (and the market) undervalues the company. In addition, Delaware law has long recognized that the damages for a fiduciary breach are calculated by using same approach as for statutory appraisal. This generates a perverse result: In a third-party sale, the DFC Global and Dell decisions might not just limit the utility of the appraisal remedy but may also render fiduciary protections largely nugatory. If stockholders received the deal price, they were unharmed.

The Aruba decision does little to resolve these problems. The trial court ruling at issue in Aruba was one of the first to grapple with the disarray left in the wake of DFC Global and Dell. The Court of Chancery felt compelled by the “market efficiency” logic of those cases to equate the statutory “fair value” to the pre-announcement trading price. On appeal, the Supreme Court rejected this approach but otherwise failed to say much about the Pandora’s box of open questions that arise from DFC Global and Dell: market efficiency, treatment of agency costs, control premia, synergies, and so on.

Together with Aruba, Dell and DFC Global may present a bizarrely high burden for a trial court to find fair value above the negotiated price, and this could seriously limit the ability of the appraisal remedy to protect stockholders. Over the past year, appraisal petitions have dropped precipitously. While deal advisers may cheer this development, investors should not be so pleased. The emerging empirical evidence suggests that appraisal was the rare form of stockholder litigation that held out real promise in targeting and deterring management misbehavior (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3039040; https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2766776; https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2894434; https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3067491). Without a meaningful appraisal remedy, opportunistic transactions may escape meaningful scrutiny in the Delaware courts, a decidedly unwelcome result that will leave minority investors exposed and inhibit capital formation through Delaware firms.

The complete article is available for download here.

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