Ruling on Dell Buyout May Not Be Precedent Some Fear

For a $24.9 billion deal, it is a piddling sum: an extra $24.7 million plus about $12 million in interest.

Yet a Delaware judge’s recent ruling that the deal — the 2013 buyout of Dell — had shortchanged shareholders by that amount has roiled a debate on how it may affect buyouts more broadly.

The law firm of Wachtell, Lipton, Rosen & Katz has criticized the decision for forcing a buyer to pay a 30 percent higher price in a “fully shopped” deal. According to the law firm, this decision may lead to shareholders “losing out” as private equity firms fear to do deals and hedge funds seek to win big on appraisal awards.

My DealBook colleague Andrew Ross Sorkin wrote that the decision was “likely to lead to a spate of lawsuits and second-guessing over the price of the next big mergers and acquisitions.”

Matt Levine at Bloomberg Views criticized the opinion’s methodology for its reliance on Dell being the only one willing to pay this price in the marketplace and moreover willing to take the risk of taking the company private.

Much of the criticism has centered on the fact that the Delaware judge — in deciding that the fair value of Dell shares was $17.62 a share, far above the $13.65 paid by the buyout consortium led by the company’s founder, Michael S. Dell — found that there was no significant fault with the conduct of the company’s directors and that no other bidder had emerged for Dell shares.

So should we be worried that this decision will change buyouts?

The answer is probably no, because of the deeply weird nature of appraisal and this case.

First, let’s keep in mind how small the outcome of this case was. Some 20 Dell shareholders are entitled to an additional $37 million.

The ruling came in an appraisal rights proceeding. In such a proceeding, shareholders of a company are allowed to go to court and argue that they were not paid fair value for their shares in the acquisition. The different amount is based on the court’s determination of whether the acquisition price was the fair value of the shares.

Under the arcane laws of appraisal, only Dell’s shareholders who voted against this acquisition and properly exercised appraisal rights will get the extra amount. (Some shareholders’ cases, including T. Rowe Price, which would have received over $200 million, were thrown out on procedural grounds.)

The purpose of appraisal rights is not to say what the company’s market price should have been. Appraisal is about giving shareholders a remedy if they think the negotiated deal price is just not good enough.

Appraisal is thus about finding a judicially determined “fair value” — the standard the court determines whether to award more money to a dissenting shareholder. The terms “market price” and “fair value” can have different meanings, and fair value is not necessarily the price paid in the market.

This difference is at the heart of the dispute over this decision and highlights the battle going on over appraisal rights themselves. Courts are struggling to figure out what “fair value” is in light of the emergence of hedge funds specializing in exercising appraisal rights.

Historically, appraisal proceedings were reduced to a corporate finance exercise as each party hired an expert to value the company using discounted cash flow and other methodologies.

In the case of the Dell buyout, Glenn Hubbard was Dell’s expert (yes, that Glenn Hubbard, the dean of Columbia’s Graduate School of Business and former chairman of the Council of Economic Advisers under President George W. Bush). He calculated fair value was $12.68 a share. Brad Cornell, a professor at the University of California, Los Angeles, was the expert for the dissident shareholders. He came out at $28.61.

What is a judge, who is not an expert in valuations, to do?

Frustration in recent years over this battle of the experts has led Delaware courts to change how they calculate appraisal prices.

Instead of simply having to puzzle through conflicting expert opinions, judges have in recent cases looked to the merger price to determine if the price was fair. So long as the price paid was negotiated through an arm’s-length process, the court deemed this to be fair value. The underlying assumption of course was that the fairly bargained market price was fair value.

Vice Chancellor J. Travis Laster of the Delaware Court of Chancery found that the process was not entirely complete because the Dell board did not reach out to all parties, something I had highlighted during this dispute.

To be fair, however, the Dell board did later bend over backward to try to get things right.

Vice Chancellor Laster also asserted that because the pricing was based on a leveraged buyout model, it was not a market price. That model is one where the buyer’s price is based on what it thinks its returns will be and is used by private equity firms. In this situation, a private equity firm would pay only what would produce a targeted rate of return.

This is not quite so neat in the real world, but the use of a leveraged buyout model to price this transaction led the judge to determine that the market price was not a reliable one, because it showed merely the price the private equity firm could pay, not one that was “fair value.” In contrast, Vice Chancellor Laster argued that a strategic acquirer, a competitor of Dell, for example, would pay what the company was worth, closer to fair value.

Because the buyout price was not a good one to determine fair value, the judge instead conducted an old-style appraisal proceeding where he used a discounted cash flow analysis to compute “fair value” using the expert opinions. Discounted cash flow analysis is a financial technique that values the future revenue streams of the company to determine an investment’s potential. This type of analysis involves numerous estimates including what the company will earn in the future.

A different result was thus inevitable, and that is how the court got to $17.65 a share.

The decision highlights the problems with appraisal generally. Judges are being forced to apply a law and to value companies based on a notion of fair value that is uncertain at best.

As a result, the Dell case is unlikely to be a game changer. The market price is likely to continue to be the price used because it is so difficult to compute “fair value” otherwise.

The opinion may affect management buyouts, but that may not be such a bad thing — forcing would-be managers to work hard to justify buying their own companies would be better for shareholders. In any case, management buyouts are rare these days; only two were proposed in 2015, according to Factset MergerMetrics.

Yet there will be probably no impact outside management buyouts. Indeed, if the amount at stake in the Dell case had been more significant, I would hazard a guess that the judge just might have hesitated.

In the end, I agree in large part with the critics of the Delaware ruling. They just assume that the opinion will become the norm. I don’t think so for the reasons above.

But let’s keep one goal in mind about this decision and its ruling. If appraisal isn’t there to serve as a check on management — or to be something more than the acquisition price — what is it good for? Not much.

Steven Davidoff Solomon is a professor of law at the University of California, Berkeley. His columns can be found at nytimes.com/dealbook.

A version of this article appears in print on June 8, 2016, on page B3 of the New York edition with the headline: Ruling That Dell Buyout Shorted Shareholders May Not Be Major Precedent.

Copyright 2016 The New York Times Company