Over-Reaction to Use of Merger Price to Determine Fair Value

Posted by Philip Richter, on Friday, May 1, 2015

The Delaware Chancery Court has used the merger price in the underlying transaction as the primary or sole factor in determining the “fair value” of dissenting shares in two recent appraisal cases. The Delaware Supreme Court recently upheld one of those decisions. However, the court’s use of the merger price in both cases was based on the same limited fact situation, suggesting that—contrary to much of the recent commentary—the merger price will not frequently be used as a key factor in determining fair value in appraisal cases.

The limited fact situation in which the court in both cases found the merger price to be the best indication of value involved:

• the standard available financial analyses being particularly unreliable indications of value—because of the absence of (a) ordinary course projections and (b) sufficiently comparable companies or transactions (due to unique business circumstances); and

• the sale process being a particularly reliable indication of value—because it was conducted at arm’s length and with an effective market check.

In the past, the court sometimes has accepted, but most often has rejected, consideration of the merger price as a relevant factor in determining appraised fair value. Instead, to determine fair value—which the Delaware appraisal statute defines as going concern value immediately prior to the merger, excluding any value arising from the merger itself—the court typically has relied primarily or exclusively on a Discounted Cash Flow (DCF) analysis. The court has also relied at times on analyses of comparable companies and transactions as a check on the DCF analysis results—but has considered the merger price, when considered at all, as a factor secondary to the financial analyses.

In a departure from common practice, Vice Chancellor Glasscock found in Huff v. CKx (Nov. 1, 2013) (affirmed by the Supreme Court in a ruling issued without an opinion (Feb. 12, 2015)) that the merger price was the best indicator of the fair value of the CKx dissenting shares. Vice Chancellor Glasscock again found the merger price to be the best indicator of fair value in his appraisal of the dissenting shares in In re Appraisal of Ancestry.com (Jan. 5, 2015). Notably, in Laidler v. Hesco (June 25, 2014)—the appraisal case decided by the Chancery Court between CKx and Ancestry, which has attracted far less attention and commentary—Vice Chancellor Glasscock rejected use of the merger price in determining appraised fair value on the basis that the transaction there, by contrast with CKx, had been “nothing like” an arm’s length competitive process. Under those circumstances, the court stated, the merger price, which had been “decided by the 90 percent parent,” was not a reliable indicator of value.

Based on these recent cases, and in particular the Supreme Court’s endorsement of the CKx decision, we can expect that the merger price may be used as the primary or even exclusive factor in determining appraised fair value more often—but, nonetheless, absent further developments, only when the standard financial analyses available are particularly unreliable (i.e., there are no ordinary course projections or sufficiently comparable companies or transactions available) and the sale process was conducted at arm’s length and with an effective market check.

Failure to Adjust the Merger Price When Used to Determine Fair Value

A critical issue that arises when the merger price is considered in determining fair value in an appraisal proceeding is that the Delaware appraisal statute requires that fair value be determined exclusive of “any element of value arising from the accomplishment or expectation of the merger.” Thus, presumably, in determining appraised fair value, there should be an adjustment downward from the merger price to exclude the impact on value of expected merger synergies and to exclude value attributable to the control premium reflected in the merger price, and an adjustment upward to account for any non-merger-related increase in value between the signing and closing of the merger.

In CKx, however, the court declined to make any adjustments. The court reasoned that there was no evidence as to whether or not value arising from the merger itself had been included in the merger price, as there was no indication that the cost savings attributable to the merger could have been accomplished only through the merger or that the buyer had included the cost savings when determining the merger price. The issue of exclusion of the value of a control premium was not addressed.

In Ancestry, the court again gave only glancing attention to the issue of adjustments to the merger price, noting simply that the acquiror, as a financial buyer, “had no apparent synergies.” The court relied on a DCF analysis as a “double-check” on the merger price’s reflection of value, stating that it derived comfort in using the merger price because the DCF result was within a few cents of the merger price.

We have discussed previously the difficulties inherent in determining what is a merger synergy and how to quantify its value. Similar complexity is inherent in determining the amount of the merger price that reflects a control premium—as well as how much of a control premium is simply attributable to the sheer volume of purchases of shares in a merger (as opposed to the value of control). We have noted in previous memoranda and articles that these difficulties may underlie the courts’ previous reluctance to use the merger price at all as a basis for determining appraised fair value. (See, e.g., our article, “Delaware Appraisal: Practical Considerations” (Oct. 17, 2014).) To the extent that the court follows the CKx precedent and the merger price may be more frequently used as a primary or the exclusive factor in determining fair value, we expect that the parties in appraisal proceedings and the courts will have to grapple more often with the difficult and uncertain issues relating to adjustments for merger synergies, control premiums, and post-signing pre-closing developments.

In anticipation of this development, a party to a merger possibly should seek to quantify the merger synergies and control premium aspects of the merger price and to negotiate an agreement with respect to these values in the merger agreement—particularly in the case of a strategic buyer (where merger synergies are likely). The utilization of this technique may, of course, be limited because of lack of guidance from the court and the difficulties in deriving estimates that the parties will agree to.

Proposed Amendment to the Appraisal Statute to Permit Tolling of Statutory Interest

Under DGCL Section 262(h), interest is payable on an appraisal award, from the effective date of the merger through the date of payment of the award, at a rate that is 5 percent over the Federal Reserve discount rate. In CKx, after the court had determined that fair value would be based on the merger price, but then extended the proceedings so that the parties could submit evidence supporting any adjustments that should be made to the merger price, CKx sought the court’s permission to pay the merger price and toll the further accrual of the statutory interest on that undisputed portion of the ultimate appraisal award. The Chancery Court held that it did not have statutory authority to toll the interest; and the Supreme Court has affirmed that holding.

The Delaware Legislature is currently considering an amendment to the Delaware statute to permit tolling of the interest in a case, such as CKx, where the respondent company wishes to pay a part of the anticipated appraisal award before the proceeding has been completed in order to toll the further accrual of the statutory interest on that amount. In the event the amendment is adopted, a number of new practical and strategic factors will have to be considered in a company’s determination whether, when, and how much to pay in advance of the final determination of an appraisal award. (See our memorandum, “Proposed Appraised Statute Amendments Would Permit Companies to Lower Their Interest Cost” (March 23, 2015).) We discuss below the likely effect of the amendment, if it is adopted, on appraisal arbitrage.

Other Developments

A development that occurred early in the first quarter of 2015 (and that we discussed in our article on appraisal in the Fried Frank 4th Quarter 2014 M&A Quarterly (published in January 2015)) was the Chancery Court decision in Merion Capital v. BMC Software (Jan. 5, 2015)—which confirmed the December 2014 holding in In re Appraisal of Dole Food Company—that a dissenting shareholder who purchases shares after the record date for the stockholder vote on the transaction need not prove that the shares were voted against the transaction in order to exercise appraisal rights.

In early April 2015, a group of corporate law firms submitted a joint letter to the Delaware Corporate Law Council urging that the Legislature amend the appraisal statute to override these decisions and make appraisal rights unavailable to shareholders who have no right to vote on (and therefore dissent from) the underlying transaction. The firms advocate that appraisal rights be denied to anyone who purchases shares of the target company after announcement of a transaction or, at a minimum, after the record date for the vote on the transaction. There is no indication at this point that there is momentum within the Legislature for consideration of the approach advocated by the law firm group.

A separate development was the Chancery Court’s broad discovery order in Dole requiring that the petitioning stockholders produce all pre-litigation valuation or analytical materials that they had prepared, reviewed, or otherwise considered when deciding whether to purchase or sell the target company’s shares or to seek appraisal.

Effect on Appraisal Arbitrage

A statutory amendment—such as the one advocated by the group of law firms, as noted above—that would eliminate appraisal rights for shareholders who buy their shares after announcement of (or, alternatively, after the record date for the stockholder vote on) a transaction likely would cause a significant reduction in appraisal arbitrage. However, there is no indication that the Legislature is considering any such amendment. The amendments being considered by the Legislature, to permit the tolling of statutory interest, if adopted, would, in our view, be likely to discourage appraisal arbitrage to some extent. After all, in CKx, the petitioner waited about four years, and in Ancestry, the petitioner waited over two years—just to have the court determine that the appraised value was the same as the amount the acquiror had paid in the merger years earlier. In addition, the Supreme Court’s affirmation of the use of the merger price to determine fair value may discourage appraisal claims to the extent that there is a perception that there is an increased risk of the court determining fair value to be equal to (or below) the merger price.

However, in our view, the current developments in the use of the merger price in determining fair value and (if adopted) the proposed tolling of interest are not likely to result in a significant reduction in appraisal arbitrage or the volume of appraisal claims because:

• Use of the merger price in determining fair value will likely continue to be limited. Based on CKx, Laidler, and Ancestry.com, the circumstances in which the merger price will be considered a key factor in determining appraisal should continue to be limited—i.e., where the merger is a third party transaction with a robust sale process and reliable results from standard financial analyses are unavailable. (Notably, these are the very cases least likely to result in a determination of fair value in an appraisal that is significantly higher than the merger price.)

• Complexity relating to merger price adjustments will highlight the possibility of fair value determinations below the merger price. As discussed above, we expect that any increased use of the merger price as a basis for fair value will underscore the complexity of the adjustments required by statute—which will lead to more uncertainty as to whether appraised value could be below the merger price in any given case (particularly in the case of strategic transactions with significant expected synergies).

• The tolling of interest and the utilization of the merger price to determine fair value will likely discourage “weaker” appraisal claims but not “stronger” claims—and thus are likely to drive appraisal activity to the “right” situations. While there has been much commentary about “above-market statutory interest” encouraging appraisal arbitrage, it is not at all clear that the interest rate actually is “above-market” for all relevant purposes, nor that tolling would make a significant difference. Our view is that the proposed amendment to permit the tolling of interest, if adopted, and the utilization of the merger price to determine fair value, if increasingly prevalent, would likely reduce the volume of “weaker” appraisal claims (i.e., those that are made with respect to transactions that are unlikely to result in an appraisal award that is significantly higher than the merger price) and would not reduce the volume of “strong” claims. At the same time, we believe that the number of shares included in strong cases likely would increase and that the settlement of strong cases likely would become more difficult and unlikely as a large upfront payment made by the company during an appraisal proceeding would reduce the incentive a company now has to settle to avoid continued accrual of the statutory interest.

These developments highlight the trend we have identified in previous publications—that appraisal awards significantly above the merger price are likely in “interested” transactions without a robust sale process but not likely in arm’s length third party transactions with a robust sale process. As discussed, we expect that the key effect of recent developments will be not to reduce the volume of appraisal activity significantly, but to drive appraisal activity to those deals where there is the greatest potential for awards significantly higher than the merger price.

We have updated below (to include the most recent appraisal decisions) the charts included in certain of our previous memoranda.

Please see our previous memoranda relating to appraisal and the topics discussed above:

• “Proposed Appraisal Statute Amendments Would Permit Companies to Reduce Their Interest Cost” (March 23, 2015)

• “Chancery Court’s Use of the Merger Price in Determining Fair Value in Appraisal Actions—What Will the Impact Be?” (Feb. 10, 2015)

• “Delaware Appraisal Decisions—Merger Price and Market Price are Relevant Indications of Appraised Value; Internal Valuation Materials Must Be Produced; and a Dissenting Stockholder Who Bought Shares After the Record Date Need Not Prove How the Shares Were Voted” (Fried Frank M&A Quarterly 4th Quarter 2014)

• “Delaware Appraisal: Practical Considerations” (Oct. 17, 2014) (published by the American Bar Association)

• “New Activist Weapon—The Rise of Delaware Appraisal Arbitrage: A Survey of Cases and Some Practical Implications” (June 18, 2014)

Delaware Appraisal Decisions 2010—Feb. 2015: Premium Over Merger Price

Delaware Appraisal Decisions 2010—Feb. 2015: Valuation Methodologies Used

Court Leaves Open Whether Appraisal Rights May Be Waived By Agreement—Halpin v. Riverstone

Underscores need for explicit waiver of appraisal rights in, and compliance with the terms of, a drag-along provision

In a separate appraisal-related development, in Halpin v. Riverstone (Feb. 26, 2015), the Delaware Chancery Court raised—and left open—the issue whether common stockholders, by agreeing to a “drag-along” provision in an agreement among stockholders, waive their statutory appraisal rights.

The court, finding that the controlling stockholder had not properly exercised its drag-along right, noted—but left unanswered—two important issues relating to the waiver of appraisal rights by minority stockholders:

• Can a minority stockholder agree to waive its statutory right to appraisal?

• Assuming a stockholder can agree to waive its statutory right to appraisal, does its agreement to a drag-along provision implicitly constitute a waiver of appraisal rights?

A drag-along provision requires minority stockholders to vote in favor of and participate in a transaction if requested to do so by the majority stockholder. On the other hand, the exercise of appraisal rights requires that the shares not have been voted in favor of the transaction and that the merger consideration not have been received. Thus, if common stockholders can legally agree in advance to waive statutory rights for consideration to be determined later by a controlling stockholder, then, arguably, a drag-along provision (because the affirmative vote requirement precludes the dissent from the merger required for the exercise of appraisal rights) would effectively result in the waiver of appraisal rights.

While drag-along provisions are common in stockholder agreements between controlling stockholders and minority stockholders, no Delaware decision has determined whether common stockholders may agree in advance to waive their statutory right to appraisal. The court did not answer this question in Halpin. In addition, while the court noted in Halpin that a contractual waiver of a statutory right, where permitted, is effective only to the extent clearly set forth by the parties in the contract, the court also did not answer the question whether the absence of an express waiver of appraisal rights in the Halpin drag-along provision was itself fatal. Instead, the court found it unnecessary to decide these issues because it concluded that the majority stockholder had not properly invoked the drag-along right and that, therefore, the minority stockholders were not obligated to vote in favor of the merger and thus could seek appraisal rights.

The drag-along provision in Halpin provided that, when the 91% controlling stockholder “propose[d]” to enter into a change of control transaction, the controller could, on providing “notice in advance” to the minority common stockholders, require that the minority stockholders vote in favor of the transaction. The court interpreted the notice provision as requiring that the notice be received prior to a stockholder vote on the merger. The controller, however, provided notice only after it had already approved the merger by written consent and had consummated the merger. The notice stated that the controller had “exercised its drag-along right” and was now requiring that the minority stockholders execute a written consent approving the merger. The drag-along provision did not include an explicit waiver of appraisal rights.

The court presumed for purposes of its analysis that, as the company had argued, the sole purpose of the drag-along was to accomplish a waiver of appraisal rights. The court held that, given the requirement in the drag-along provision that advance notice of the merger be given, the drag-along required that notice be given prior to a vote on the merger. The court further determined that by itself approving and consummating the merger, and only then requesting that the minority stockholders sign a written consent approving the merger retrospectively, the controller was seeking action that the drag-along did not provide for. Even assuming the validity of appraisal waivers, then, contractual compliance was not effected and the minority stockholders were free to exercise appraisal rights, according to the court.

Thus, after Halpin, it remains an open question whether a drag-along provision would be enforceable if it (i) clearly provides for forfeiture of appraisal rights by common stockholders and (ii) is exercised properly. (The court noted that, by contrast, it is well established Delaware law that preferred stockholders may contractually waive appraisal rights—because their rights are derived largely by contract whereas common stockholders’ rights are mainly governed by statute and the common law relating to fiduciary relationships).

Practice points. Controllers seeking to enforce a waiver of appraisal rights through a drag-along should:

• include in the drag-along agreement an explicit acknowledgment by the minority stockholders that they waive their appraisal rights if the drag-along is invoked; and

• exercise the drag-along precisely in accordance with its terms—for example, if the drag-along calls for a vote in favor of the merger, request the vote before the controller itself approves and consummates the merger, and comply with any prescribed time periods or other requirements of the drag-along provision.