Who Decides ‘Fair Value?’ In Dell’s Case, a Judge

Here come the lawyers.

Last week, the Delaware Court of Chancery handed down a startling decision with broad implications for the future of corporate takeovers: It determined that the board of Dell Inc. sold the company for $6 billion too little when the formerly public company was taken private by a buyout group led by Michael Dell in 2013.

What was so surprising about the decision was that the judge in the case, Vice Chancellor J. Travis Laster, highlighted that there had been no higher offer for the company and said that the board “and its advisors did many praiseworthy things.” Nevertheless, he ordered Dell to pay the shareholders who brought the lawsuit their portion of the difference.

The decision is sending shudders all over Wall Street and the boardrooms of corporate America, because the court, in effect, overruled “the market.” The decision means that companies don’t simply have a fiduciary duty to find a buyer willing to pay the highest price, but that a judge may ultimately deem what the price should be.

This outcome was applauded by shareholder advocates. And it is likely to lead to a spate of lawsuits and second-guessing over the price of the next big mergers and acquisitions.

Management buyouts like the one that Mr. Dell pursued are often filled with conflicts and self-dealing, dynamics that have produced steady fodder for this column. But in this instance, what is particularly startling and noteworthy is that Mr. Dell and the directors were not found to have done anything underhanded. The judge himself went out of his way to say: “It bears emphasizing that unlike other situations that this court has confronted, there is no evidence that Mr. Dell or his management team sought to create the valuation disconnect so that they could take advantage of it.”

Yet Vice Chancellor Laster still decided that based on Dell’s “fair price,” the company, which is incorporated in Delaware, was sold for too little. “The concept of fair value under Delaware law is not equivalent to the economic concept of fair market value,” he wrote. “Rather, the concept of fair value for purposes of Delaware’s appraisal statute is a largely judge-made creation, freighted with policy considerations.”

The case is part of a growing trend in which hedge funds and other investors jump into a company’s stock after a takeover bid has been announced with the explicit plan of suing the companies to claim the price was too low. The practice — one that is likely to be catapulted even further by this decision — is known as appraisal arbitrage.

“Proponents of appraisal arbitrage will tout the Dell result to encourage the flow of even greater funds into the practice,” Martin Lipton, the famed takeover lawyer, wrote in a memo to clients after the decision.

The implications are clear: “Private equity firms should be expected to ask whether they face routine appraisal exposure in Delaware, no matter how robust the auction, and therefore seek out alternative transaction structures to cap and price their risk (or exit the market entirely),” wrote Mr. Lipton, a founding partner of Wachtell, Lipton, Rosen & Katz.

Oddly enough, one of the firms suing Dell, T. Rowe Price, was deemed to be ineligible to receive a payment because — through a series of technical mistakes — it voted in favor of the transaction. (A shareholder has to vote against the deal to be eligible for a payout.) On Monday, T. Rowe Price said it would make its investors who held Dell shares whole, paying out a total of $194 million.

The rules around Delaware’s appraisal rights of “fair value” are aimed at helping long-term shareholders protect themselves in instances of self-dealing or other chicanery. In recent years, however, using the courts to negotiate “fair value” has become a full-time industry for investment funds and lawyers looking for a quick score.

Wei Jiang, a professor at Columbia Business School, recently noted in a study that Vice Chancellor Sam Glasscock III in Delaware had commented in one case that the shareholders bringing the lawsuit were “arbitrageurs who bought, not into an ongoing concern, but instead into this lawsuit.” Ms. Jiang wrote that “the number of appraisal petitions has increased from a trickle of cases in the early 2000s to over 20 a year in recent years, or close to one-quarter of all transactions where appraisal is possible.”

What’s so peculiar about the Dell decision is that the judge found no chicanery and still didn’t think the price was fair, explaining that it was possible a board’s actions “might pass muster for purposes of a breach of fiduciary claim and yet still generate a sub-optimal process for purposes of an appraisal.”

That’s not to say that Dell’s buyout was a model of perfection; no buyout in which the founder is trying to buy shares from the public will ever be conflict-free. Management always has the distinct advantage, and its decision to pursue a deal often makes it harder to attract competing offers. In its ruling, the Chancery cited a column I wrote about this very issue in the Dell case.

At the same time, Mr. Dell appears to have genuinely tried to make the playing field even for bidders: He spent more time with the Blackstone Group, which ultimately dropped its bid, than with the winning group he led. And the judge said as much in his decision.

All of this raises serious questions for dealmakers and public shareholders: What’s the appropriate way to determine a takeover price? And if the highest bid is not deemed “fair” — assuming the auction is run competently — what is?

Mr. Lipton said he imagined that a “private equity buyer might insist on a provision in the merger agreement allowing it to walk away if a small fraction of the shares — 1 or 2 percent — perfect appraisal rights.

This approach is likely to be unpalatable to selling boards, however, and creates substantial risk that the buyer will exit the transaction when the appraisal cap is exceeded.”

The court’s ruling is likely to make it harder for companies to complete buyouts. That may be a good thing, given that so many shareholders of public companies lose out when the companies they invested in go private and find ways to do substantially better.

But if the decision has the chilling effect that some critics fear — making a judge, not the market, the decider of takeover premiums — it could ultimately make the situation for shareholders even worse.

A version of this article appears in print on June 7, 2016, on page B1 of the New York edition with the headline: A Judge Decides Fair Value for Dell.
 

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