Freeze-Out of Minority Not “Entirely Fair”—Salem Cellular

In In re Cellular Telephone Partnership Litigation (Mar. 9, 2022), a wholly-owned subsidiary of AT&T, Inc., which was the 98.12% controlling partner of Salem Cellular Telephone Company (the “Partnership”), froze out the minority partners by acquiring the Partnership’s assets and liabilities and then liquidating the Partnership. AT&T paid to the Partnership, and then caused the Partnership to distribute to the minority partners their respective pro rata shares of, the Partnership’s value as had been determined by a major national valuation firm that AT&T had retained (the “Valuation Firm”). Litigation ensued with respect to AT&T’s freeze-out of the minority partners of this and fifteen other AT&T cellular partnerships. In the decision issued March 9, 2022, which related only to the plaintiffs’ fiduciary claims against AT&T with respect to the freeze-out of Salem Cellular’s minority partners (the “Freeze-out”), the Delaware Court of Chancery held that the transaction (which, as the parties had agreed, was subject to the “entire fairness” standard of review because the controller stood on both sides of the transaction), did not satisfy the entire fairness standard and that AT&T therefore had breached its duty of loyalty to the minority partners.

Most notably, the decision suggests that outside appraisal, alone, may not be sufficient to establish entire fairness—at least where, as was the case in Salem Cellular, the court views the controller’s timing and initiation of the transaction at issue to have been opportunistic (i.e., designed to benefit the controller at the expense of the minority); the appraisal was by a firm retained by the controller; and the court views the appraisal as seriously flawed.

Background. Over several years, AT&T had been planning for a buyout of the minority partners’ interests in its controlled joint ventures that held licenses to provide cellular telephone services across the U.S. Salem Cellular involved the buyout of the minority partners in the partnership that held the license for the Salem, Oregon area. Prior to the buyout, AT&T retained the Valuation Firm, which determined the fair value of the partnership to be $219 million (based on a DCF analysis and a comparable companies analysis, weighted 50% each). The plaintiffs, former minority partners in the Partnership, claimed that AT&T had breached its duty of loyalty to the minority partners by freezing them out at an opportunistic time and at an unfair price. The plaintiffs had received a total of $4.1 million in the liquidation. At trial, a valuation expert retained by AT&T (the “Valuation Expert”) testified that based on her own analyses (a DCF analysis, comparable companies analysis, and comparable transactions analysis, weighted 50%, 25% and 25%, respectively) the fair value of the Partnership fell within a range of $171.3 million to $224.1 million. Noting that the Freeze-out price of $219 million fell toward the high end of the range, she opined that the price represented “at least the Fair Value of the Partnership equity interests.”

The court found that neither AT&T’s process nor price were fair, and therefore that it had breached its duty of loyalty. Conducting its own DCF analysis, the court determined that a “reasonable estimate” of the fair value of the Partnership was $714 million (more than three times the Valuation Firm’s valuation). The court awarded the plaintiffs damages of $9.3 million, representing their pro rata share of that amount less what they had received in the liquidation.

Discussion

The court found that the process was unfair. The court wrote: “The only step AT&T took towards instantiating a fair process was to hire a financial advisor to value the Partnership, then use that valuation when setting the price for the Freeze-out.” That step, the court found, was not sufficient to outweigh the lack of fair dealing by AT&T that was evidenced by: (i) the opportunistic timing and initiation of the Freeze-out; (ii) no negotiation process and a coercive structure of the transaction; and (iii) flawed valuation methodologies by financial advisors that had been retained by AT&T.

• Opportunistic timing and initiation of the transaction. The court found that AT&T’s “primary purpose” in freezing out the minority partners was to capture for itself, and to deprive the minority partners of, the anticipated significant increase in value of the Partnership that was expected to occur based on an evolving “data revolution.” AT&T had argued that its objective was to simplify its complex corporate structure and eliminate the associated high administrative costs. The court agreed that AT&T had these objectives, but concluded they were not the “primary motivation.” The court pointed, first, to AT&T’s own planning materials, which reflected its desire over many years to buy out its minority partners in its cellular telephone partnerships in light of its expectation, which turned out to be correct, of “an explosion in data usage” that would lead to profitable new businesses and products for the partnerships. In its planning, the court noted, AT&T “specifically focused on the Partnership” and certain other entities “because the minority investors could be eliminated unilaterally.” Also, the court observed that the anticipated savings from avoiding distributions to the minority partners of the Partnership dwarfed the administrative savings from the Freeze-out, making it unlikely that administrative savings were the primary motivation. The court concluded: “AT&T acted because it anticipated a period of significant growth in data-driven wireless businesses, wanted 100% of the benefits for itself, and did not want to share the benefits with the minority partners.”
• No negotiation and coercive structure of the transaction. In determining that the process was unfair, the court noted that “no special committee or other independent bargaining agent negotiated on behalf of the minority.” Although the partnership had a minority representative on the Executive Committee, and the Executive Committee could have empowered the minority representative to negotiate, AT&T “did not engage with the minority representative” and kept the minority partners “in the dark.” In addition, AT&T “did not condition the Freeze-out on a majority-of-the-minority vote.” While not required, such a vote would have been a “positive factor” for AT&T in meeting its burden to substantiate fairness, the court stated. Further, the transaction was structured to be “coercive.” AT&T offered to buy the minority partners’ interests at a 5% premium to the Valuation Firm’s valuation, and at the same time told the minority partners that they otherwise would be cashed out in the subsequent liquidation in which no premium on the valuation would be paid. The “two-tier offer…pressured the minority to accept the front-end price…,” the court wrote. Notably, a majority of the minority partners (by both number and interest) did not accept the front-end offer, notwithstanding the coercive structure—which, the court reasoned, was “strong evidence that the offer was unfair even with a 5% premium.” Finally, the court pointed to evidence that, at the special meeting at which AT&T voted its controlling interest to approve the Freeze-out, AT&T had provided false answers and had refused to provide answers to questions posed by the minority partners (relating to, for example, AT&T’s relationship with the Valuation Firm and whether other valuations had been obtained).
• Flawed valuation methodologies by possibly non-independent financial advisors. AT&T argued that the process was fair because it had engaged an independent valuation firm to determine the valuation and had set the price based on that valuation, and, moreover, the fairness of that valuation had been confirmed by an independent valuation expert. The court was skeptical as to the “independence” of both financial advisors, however. With respect to the Valuation Firm, first, the court stated that AT&T’s hiring an independent financial advisor in connection with its conflicted transaction was not “striking”—indeed, it would have been striking if AT&T had not done so, the court commented. Moreover, the court noted that “AT&T hired and paid [the Valuation Firm],” and stated that, as Delaware appraisal proceedings have shown, “valuation professionals reach outcomes that are influenced by the interests of the party that retains them….” The court noted further that AT&T, over several years, had repeatedly engaged the person acting as the lead partner from the Valuation Firm, including when he had been employed at two other firms (in one of which cases AT&T had to obtain a waiver of his non-compete agreement so that he could act for AT&T). This “looked less like the engagement of a truly independent outside advisor and more like the continuation of a longstanding business relationship with an individual who knew how to deliver the answer AT&T wanted,” the court wrote. Moreover, the court found that “the evidence [was] mixed” as to “what [the Valuation Firm] did.” On the negative side, for example, “AT&T withheld important pieces of information from [the Valuation Firm]”—such as board presentations about the buyout and certain revenue information, both of which “steered [the Valuation Firm] towards [AT&T’s] preferred valuation,” according to the court. The court concluded that, “[o]n the whole,…AT&T’s interactions with [the Valuation Firm] provide[d] additional evidence of an unfair process.” With respect to the Valuation Expert, the court seemed to express skepticism as to her independence as well, based on AT&T having used her “repeatedly” as a trial expert in various cases involving its freeze-outs in other partnerships, as well as her approaches in this case being inconsistent with approaches she had taken in other similar cases.

The court found that the price was unfair. The court found that neither the Valuation Firm nor the Valuation Expert “used persuasive valuation methodologies,” and that there was evidence that the price was unfair.

• The court observed that AT&T’s own internal analyses indicated a substantially higher value for the Partnership.  The court cited contemporaneous documents showing that “AT&T placed a significantly higher value on the Partnership and its sister entities [(i.e., its other cellular partnerships)] than it paid.” AT&T’s internal analyses “provide[d] persuasive valuation evidence,” the court stated, as “a buyer who possesses material nonpublic information about the seller is in a strong position (and is uniquely incentivized) to properly value the seller.”
• The court noted that the outside valuations did not take into account the significant value to the Partnership of its contractual entitlements under a Management Agreement with AT&T. The Management Agreement required AT&T to provide a 25% premium to the Partnership for shared revenues and a 10% discount to shared expenses. These rights were ignored in the valuations because AT&T had not complied with these requirements. The court stated that, while the analyses thus reflected the historical reality, ignoring the value of these rights–and the litigation asset resulting from AT&T’s having “pervasively disregarded” them–rendered the analyses inaccurate, undervaluing the Partnership by at least 25%.
• The court criticized the judgments made by the experts in their analyses. The court found that the Valuation Firm and the Valuation Expert had relied on unsupportable assumptions and inputs in their respective DCF analyses, in part due to data provided by AT&T that was unreliable. Among the problematic assumptions in the court’s view were: (i) concededly unreliable subscriber counts from AT&T (by the time of the Freeze-out, due to both industry developments and AT&T’s faulty record-keeping, AT&T “could not provide basic information about its subscribers or the Partnership’s”); (ii) the use of a blended corporate tax rate for the Partnership of 38.5% (“even though the Partnership is a pass-through entity that does not pay tax at the entity level”); and (iii) the use of an “artificially low perpetuity growth rate” of 1.5% (which was lower even than the expected inflation rate, and thus treated the Partnership as a “wasting asset”).
• The court commented that the Valuation Expert, by reaching different judgments than the Valuation Firm, “cast doubt” on the latter’s analyses. The court repeatedly noted where the Valuation Expert’s judgments in her analyses differed from those made by the Valuation Firm–such as her relying 25% on a comparable companies analysis while the Valuation Firm relied 50% on that methodology, and her excluding two companies from the comparable companies analysis that the Valuation Firm had included. These differences arguably undermined the validity of the Valuation Firm’s analysis, the court stated.
• The court noted that the Valuation Expert’s approaches were inconsistent with those she had taken in other similar cases. For example, in this case, she accorded no value to a step-up in basis, while she had valued a step-up in basis in a similar freeze-out in which she had been involved; and, in this and two other cases involving similar wireless company freeze-outs, she had used “three different weighting schemes” (50-50% to a DCF and a comparable companies model in one case; 50-30-20% to a DCF, a comparable companies, and a comparable transactions model in another case; and 50-25-25% to a DCF, a comparable companies, and a comparable transactions model in this case).
• The court stated that the comparable companies and comparable transactions analyses undervalued the Partnership by not taking into account the “unique” nature of the spectrum licenses the Partnership held. The court described the Partnership (and AT&T’s other cellular partnerships) as “unique because their primary asset was their spectrum licenses, which were the ‘crown jewel’ of AT&T’s wireless business.” In addition, the court stated, “[t]he partnerships also were unique because they were organized as pass-through entities for tax purposes and remitted the overwhelming majority of their earnings as distributions to partners.” It was therefore “difficult,” in the court’s view, “to find public companies with comparable assets, operations and business models.”

The court awarded relief based on the partnership’s “operative reality” prior to the challenged transaction. The plaintiffs advanced a theory of damages rooted in the present value of the distributions they would have received as minority partners but for the Freeze-out. The court stated that it agreed with the “basic approach” of valuing the interests in the Partnership at the time of the Freeze-out, but not with using the present value of distributions to quantify the damages award. The court reiterated that the question of fairness in a controller freeze-out context is based on whether each minority investor received “the equivalent in value of what he had before.” The court emphasized that this question required valuation of the Partnership not as a stand-alone entity, but taking into account its “operative reality” at the time of the transaction. AT&T’s financial advisors had treated the Partnership as a “wasting asset,” rather than as “an essential part of AT&T’s nationwide wireless network, which AT&T operated on an integrated basis, and which was expected to be entering a prolonged period of growth as a result of the data revolution.” The court, stating that “the validity of the DCF model as a conceptual approach is beyond question,” conducted its own DCF analysis, using as the “basic framework” the DCF analysis prepared by the Valuation Firm, as modified by the Valuation Expert, but “fixing” the “erroneous and unreliable assumptions” therein, and “giv[ing] the benefit of the doubt” to the plaintiffs. The court revised assumptions for the projections, created forecasts for the partnership, and, in a detailed analysis over 34 pages long, arrived at a “responsible estimate” of $714 million for the value of the Partnership. The plaintiffs were entitled to 1.88% of that amount ($13.4 million), less what they had already received in the liquidation ($4.1 million)—thus, the court awarded damages of $9.3 million.

Practice Points

• A controller should be mindful that obtaining a financial advisor’s or expert’s valuation or a fairness opinion, standing alone, may not render a conflicted transaction “entirely fair.” The court reiterated in Salem, that “entire fairness” requires more than that the transaction was legally and contractually permissible—it must have been “actually fair.” The decision suggests that setting the price for such a transaction based on a financial advisor’s valuation or fairness opinion may not, without additional protections for the minority holders (such as use of a special committee to negotiate on behalf of the minority), be sufficient to establish “entire fairness.” The court wrote that the fair dealing inquiry “d[id] not turn on whether AT&T did the bare minimum” required under the partnership agreement or permitted under Delaware law, but on whether “there were steps designed to ensure fairness to the minority.” At the same time, we note that the factual context of this case included, in the court’s view, among other negative factors, flawed methodologies by possibly non-independent financial advisors, and, perhaps most importantly, apparently opportunistic timing by the controller to deprive the minority holders of anticipated significant additional value, as well as internal valuations showing that the controller itself had valued the company substantially higher. If not for these negative factors, the judicial result may well have been different. Accordingly, controllers should consider carefully the potential benefits in mitigating litigation risk that are afforded by conducting a process that provides appropriate protections for the minority holders, including selecting independent advisors, using a special committee, and/or requiring a majority-of-the-minority vote.
• Depending on the facts and circumstances, determining the value of the company at the time of closing may require: (i) appraising its value as part of the controller’s integrated holdings, rather than its value as a stand-alone company; (ii) appraising the value of its contractual entitlements, even if the benefits were not received due to a counterparty’s breach; and (iii) appraising the value of its litigation claims, such as for contractual entitlements not received due to a counterparty’s breach. With respect to (i), in Salem Cellular, the court emphasized that much of the value of the Partnership was based on its being part of AT&T’s integrated national cellular network. “The value of AT&T’s network lay in the promise of ubiquity, and the Partnership market area was critical to that offering.” As a result, the court noted, AT&T subsidized the Partnership by providing capital at its weighted average cost, rather than the higher cost the Partnership would have had to pay if it were a stand-alone entity operating an isolated cellular network. Further, the court noted, the Partnership “also benefited from other relationships with AT&T” and, because of its pass-through status, it could make distributions to its investors that were not reduced by entity-level taxes. With respect to (ii) and (iii), in Salem Cellular, the court considered the loss of the Partnership’s contractual entitlements under the Management Agreement (which had never been provided by AT&T), and the Partnership’s ability to bring a claim against AT&T for breaches of that agreement, as part of what the minority partners “had” that was “taken” from them in the Freeze-out.
• An outside expert retained by a buyer (rather than a special committee) may be viewed by the court with skepticism. Moreover, based on the court’s commentary in Salem Cellular, depending on the facts and circumstances, such skepticism may be compounded if a specific individual is engaged whom the buyer has repeatedly engaged before, or for whom the buyer went to surprising lengths to secure the engagement (such as having obtained a waiver of a non-compete agreement applicable to the person). In any event, an advisor should be provided with access to all of the necessary background and financial materials and information relevant to its valuation, and the buyer (or committee) should not “steer” the advisor’s determinations. In addition, generally, material conflicts, or material prior engagements of and other material relationships with, the financial advisor should be disclosed in connection with the transaction.
• An additional financial advisor, engaged to support a previous advisor’s analysis, should, to the extent possible, explain why its revisions to (or different approaches from) the other advisor’s analysis do not undermine the credibility of that advisor’s work. While, clearly, a second-engaged advisor should conduct an analysis based on its own best judgments, it should, where possible and appropriate, explain, for example, that a wide range of inputs, or a specific different methodology adopted by the first-engaged advisor, also would be justified. In addition, a buyer’s (or special committee’s) decision to engage a second advisor to support conclusions of the first advisor should be made only after careful consideration. Finally, a buyer (or special committee) should consider carefully a decision not to call the advisor on whom it relied for the transaction. (In Salem Cellular, the court noted that it viewed as strange AT&T’s decision not to rely at trial on, or even to call for testimony of, the advisor that had valued the company for the transaction.)
• Controllers with similar structures for various entities should be aware that the valuations and actions taken in one situation may be used against them in another situation. In addition, a financial advisor should, to the extent appropriate, be consistent in its approaches across similar transactions. If the approaches taken are different, the valid reasons therefor should be explained.
• Controllers, when setting up entities with minority owners, should consider specifying a process and/or price for a buyout. The partnership or shareholders agreement might, for example, provide for a call right at a specified or formula price, and/or a specified safe harbor process, for a buyout by the controller.
• M&A participants should keep in mind the court’s deep sophistication with respect to DCF analyses and financial analysis generally. Salem Cellular serves as another reminder that the court, with its extensive experience with DCF analyses in the statutory appraisal rights context, is willing, able, and generally inclined to examine in great detail the underlying assumptions and judgments made in a DCF analysis presented to it, and to conduct its own DCF analysis if necessary to correct flaws it perceives. Further, we note that–after commenting that “outside counsel” had “shape[d] the record for litigation” such that “AT&T’s internal documents did not openly reveal AT&T’s valuations” of the Partnership–the court, “digging into” a supporting spreadsheet for an AT&T management presentation used to obtain CEO approval for the buyouts, disregarded the conclusions reflected on the spreadsheet and determined that AT&T actually “had much higher valuation expectations.”