Analysis

Del. Courts Spend Summer Reining In Appraisal Suit Excess

By Matt Chiappardi

Law360, Wilmington (September 7, 2017, 6:49 PM EDT) -- The Delaware courts over the past summer curtailed the notion that stock value appraisal is mostly an exercise in on-paper financial analysis, giving strong deference to market price and delivering a potent blow to investors who expect to always receive a bump in share price, experts say.

The summer of 2017 could be seen as the season of appraisal decisions for both the Delaware Chancery and Supreme courts, with four major rulings that upended the practical norm that deal price was a floor in nearly all cases, with the value having a good chance of going up once it was put under the judicial microscope.

But the rulings in the four cases — Clearwire Corp., DFC Global Corp., PetSmart Inc. and SWS Group Inc. — all boiled down to the opposite conclusion, and, experts say, instead positioned deal price as more of a ceiling unless it can be shown there was some sort of flaw in the marketing process.

“This idea that we want a do-over of the valuation process, that’s getting a little bit out of fashion,” said University of Pennsylvania corporate law professor Jill E. Fisch. “Deal price being a ceiling is attractive to those concerned about appraisal arbitrage. If you’re not going to get more than deal price anyway, there’s no moral hazard from bad incentive.”

Experts say the package of rulings has two primary and related takeaways. The courts are moving away from championing the popular valuation method known as discounted cash flow analysis, or DCF, a centuries-old technique that examines the value of an asset over time, in favor of a market-price first approach. And that spells bad news for the appraisal arbitrage investment strategy, in which funds will buy up stock of a targeted company once a merger is announced, in hopes of scoring a higher share value through a post-deal appraisal petition.

“I think we have seen the stronger recognition of discomfort with the application of DCF evaluation and an increased tendency to what the market deems to be the appropriate price or value of the company, “ said Lawrence Hamermesh, professor of corporate and business law at Widener University Delaware Law School. “DFC Global makes that quite explicit.”

In DFC Global, the Delaware Supreme Court reversed a Chancery Court decision that the payday lender’s private-equity buyer overpaid by roughly $100 million when it bought the company for $1.3 billion in 2014.

Chancellor Andre G. Bouchard’s ruling focused on what he said was the uncertain regulatory environment surrounding the payday lending industry, and he rejected the actual deal price as an adequate metric for appraisal.

But the state’s justices disagreed, finding that in DFC Global’s case, the actual market price was the best indicator of the stock’s fair value.

That line of thinking was also bolstered by the other appraisal decision in the Chancery Court over the summer.

In the PetSmart decision in late May, Vice Chancellor Sam Glasscock III found that the deal price of $83 per share in the retailer’s $8.7 billion purchase by private equity buyers was an adequate indicator of fair value, and rejected DCF-based arguments that the per-share price should have been bumped up to $128.78.

Vice Chancellor Glasscock called the DCF valuations “post-hoc” analyses that implied there was some sort of “massive market failure” not indicated in any other evidence, and noted that the wildly different valuations from both sides factored into his decision to go with deal price.

The vice chancellor and other Chancery judges have expressed similar sentiment before, an indication that DCF analysis, for all its utility in the investment analysis universe, has limits that the court does not want to be “woodenly tied to,” Fisch said.

Alter just a few variables, and you can get disparate results in the extreme.

“There is skepticism that DCF is really this precise science and that judges are going to get it right in an objective way, even if it’s done carefully and in good faith,” Fisch said. “We want appraisal evaluation to be meaningful, but at the same time we recognize that judges aren’t investment bankers.”

In appraisal evaluations of Texas-based bank and broker-dealer SWS Group’s $350 million purchase of Hilltop Holdings Inc., and Clearwire’s $3.6 billion buyout by Sprint Nextel Corp., both results came in below the actual deal price.

The results of the Clearwire case were dramatic, with the fair value coming in at nearly 60 percent below the actual deal price, but both decisions were bound by statutory requirements to ignore synergies in an appraisal analysis.

Experts said both decisions lend credence to the idea that deal price is becoming a ceiling that can only be smashed with the showing of merger flaws.

In an ironic twist in the DFC Global case, the Supreme Court did not go as far as embracing the petitioners’ argument that in a deal without questions on its process, the Chancery court should presume deal price is the fair value, a finding experts say could foreclose on any appraisal of a trouble-free transaction.

“In appraisal cases, and any cases, the courts don’t like presumptions,” Hamermesh said. “They never have. If you start to speak of presumptions, the Supreme Court will say ‘Don’t talk to me like that.’”

But even though the court didn’t create a so-called bright-line rule on deal price as presumptive, some experts say the justices tipped the scales in favor of market action over financial theory.

“The Delaware Supreme Court essentially found that, assuming a fair and open process, theoretical value is not likely to be as good as market outcome,” said Alston & Bird LLP partner Kevin Miller. “Financial analysis is a poor substitute for the market, and great deference should be given to the deal price as a starting point.”

If that is indeed the case, it would dampen enthusiasm and opportunity for appraisal arbitrage, and in other cases this past summer, the Chancery Court decided that fair value was either deal value or below.

“The appraisal arbitrage business model is at risk,” Miller said. “In order to justify significant investment in their funds and earn adequate returns, they need to have a fair number of viable opportunities for awards above deal price. This will limit the number of those opportunities.”

Joshua D.N. Hess, a partner with Dechert LLP, says, however, that all hope is not lost on the arbitrage investment strategy, and the courts have left the door open for results that could still generate big paydays for investors.

But those spoils are only available if petitioners pick the right cases, he said.

“If you have the right case, there’s still tremendous upside potential,” Hess said. “It’s not going to be the old days, where every merger presented the opportunity for windfall, but bring the right case and the Chancery Court will reward you.”

Those “right cases,” experts say, are the ones where there are legitimate questions about the deal process, even if those concerns don’t rise to the level of a breach of fiduciary duty.

Fisch contended that part of the reason the state Supreme Court didn’t go with a presumptive rule is that the justices “could imagine a space where court intervention would be warranted” in a deal where the market price is not really fair. There is “wiggle room between flaws and actual breaches of fiduciary duty,” where post-closing remedies could be deserved, she said.

This becomes especially important in a landscape where the Delaware courts have clamped down on post-closing relief, particularly through the controversial Corwin v. KKR Financial Holdings LLC ruling that allowed many breach of fiduciary duty claims to be "cleansed" by a fully informed shareholder vote, according to Hess.

“In the wake of a clear shutdown of post-closing remedies, appraisal is still the most attractive avenue for post-closing recovery,” Hess said. “It’s distilled into more economic valuation terms, less about bad acts and more about the actual substance of the economics of the deal.”

Fisch also said that post-closing remedies appear to be drying up in part because the financial community has been heeding trends from the Delaware courts and adjusting accordingly.

“If you compare mergers from today to 10 years ago, companies and bankers do a much better job of monitoring the process of shopping the company, and deal protection methods now have a greater amount of standardization,” she said. “If it’s a good process, then the deal price should be fair.”

--Editing by John Blakeley and Pamela Wilkinson.

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