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Delaware Chancery Court Rejects
Management Buyout Merger Price as Best Evidence of Fair Value in
Appraisal Proceeding
Thursday, June 9, 2016
In
In re Appraisal of Dell Inc., No.
9322 VCL, 2016 Del. Ch. LEXIS 81 (Del. Ch. May 31, 2016) (Laster, V.C.),
the
Delaware Court of Chancery determined
that the fair value of the common stock of Dell Inc. (“Dell” or the
“Company”) as of the effective date of a 2012 management buyout (“MBO”)
was $17.62 per share, or $3.74 per share more than the merger
consideration of $13.75 per share plus a $0.13 special dividend.
Although Dell’s directors properly discharged their fiduciary duties,
and the sale process included a go-shop period that triggered a
bidding contest, according to the Court, the MBO underpriced the
Company by more than $5 billion. Notably, the factors responsible for
this divergence included limitations inherent in any MBO-driven sale
process. The Court relied entirely on a discounted cash flow (“DCF”)
analysis to determine fair value. The decision likely will further
increase the frequency in which stockholders of Delaware corporations
pursue statutory appraisal rights, particularly in the MBO context.
Dell, a
PC manufacturer, had transitioned itself by 2012 into a broader
software and computing services company. But this transition, part of
its long-term strategy, had yet to yield results. Meanwhile,
investors and analysts continued to focus on Dell’s deteriorating PC
business and its poor quarterly performance, causing Dell’s stock
price to lag behind management’s internal valuations. In response,
its founder and CEO, Michael Dell, proposed an MBO, the board of
directors formed a special committee (the “Committee”), and a sale
process ensued that focused on financial MBO sponsors as the size of
the transaction would likely preclude a strategic acquisition by a
competing technology firm.
During
this first phase, a buyout group led by financial sponsor Silver Lake
made a series of offers. The Committee deemed each inadequate. A
competing financial sponsor, KKR, also bid, but soon dropped out.
After further negotiations, Silver Lake eventually offered $13.65 per
share, a price within several DCF valuation ranges prepared by Dell’s
financial advisors. The Committee recommended, the board approved,
and the parties signed a merger agreement at that price. The merger
agreement included a go-shop clause.
The
45-day go-shop period produced several competing proposals and,
ultimately, a threat by an insurgent stockholder, Carl Icahn, to
nominate an alternative slate of directors, jettison the merger
agreement, and conduct a tender offer at $14.00 per share. Faced with
growing stockholder opposition to the merger, Silver Lake proposed
amended terms that, after further negotiations, increased the merger
price to $13.75 per share and added a special $0.13 per share
pre-closing dividend. In September 2013, the Company’s stockholders
approved the MBO’s amended merger terms.
In the
appraisal proceeding, Dell contended that the final merger
consideration represented the best evidence of fair value. The Court
of Chancery disagreed. As an initial point, the Court clarified that
“fair value” under Delaware’s appraisal statute is not equivalent to
the economic concept of “fair market value” but is rather a
“jurisprudential concept” that seeks to identify the “true or
intrinsic value” of the stock taken in the merger by considering all
factor bearing on value including, in addition to market value, asset
value, earnings prospects and any other information as of the merger
date bearing on the corporation’s future prospects. It then observed
that markets for whole companies lack the degree of efficiency that
prevails in markets for shares of individual company stock, so
reliance upon deal prices as an indicator of fair value is less
justified. It further noted that this inefficiency may be more
pronounced with MBOs because management assumes the conflicting role
of a buyer and enjoys a significant informational advantage over other
bidders that even extensive due diligence cannot necessarily overcome.
The Court
also distinguished appraisal from a breach of fiduciary duty inquiry,
where the focus is on “the ends the directors pursued and the means
they chose to achieve them.” In contrast, appraisal focuses on the
outcome—the price—as possible evidence of fair value. Thus, even
though, as the Court noted, “the Company’s process easily would sail
through” judicial review under applicable fiduciary duty standards,
that process “still could generate a price that was not persuasive
evidence of fair value.”
Turning
to the Committee’s sale process, the Court concluded that a number of
factors caused the final merger consideration to diverge from fair
value. During the pre-signing phase, Dell only engaged potential
financial sponsors,
i.e.,
buyers who must rely on a leveraged buyout (“LBO”) pricing model to
achieve the required internal rate of return while accounting for
limits on the amount of leverage the target company can support.
Evidence showed that the Committee’s “price negotiations during the
pre-signing phase were driven by the financial sponsors’ willingness
to pay based on their LBO pricing models.” These models do not assess
fair value. The Committee, pre-signing, also heavily relied upon
stock trading prices as a quantitative metric even though a valuation
gap existed between Dell’s stock price and its fair value, the very
gap that motivated the MBO in the first instance. There was also
minimal pre-signing competition.
The Court
further concluded that the amended price terms resulting from the
go-shop period also failed to reflect fair value because the
post-signing offers “keyed off” the original merger price. Go-shop
periods do not frequently produce topping bids in the MBO context. In
the Court’s view, that topping bids materialized in the go-shop phase
suggested the original merger consideration was in fact low. And the
final, amended merger consideration (including the special dividend)
represented only a 2% increase over the original price, and one still
“within the confines of the LBO model.”
Although
the merger price failed as an accurate “price discovery tool,” the
Court agreed that it sufficiently rebutted petitioners’ expert’s
$28.61 per-share estimate, an estimate suggesting the merger
“undervalued the Company by $23 billion.” In the Court’s view, such
value disparity, if true, would have no doubt caused another
technology firm to appear as a strategic bidder.
The Court
next turned to the parties’ experts’ discounted cash flow (“DCF”)
analyses. In the end, however, the Court performed its own DCF
analysis to derive its $17.62 per share fair valuation. This analysis
comported with the Court’s view that the sale process permitted an
undervaluation of several dollars per share. The Court, however,
found it “impossible to quantify the exact degree of the sale process
mispricing,” and so gave the final merger price no weight but rather
relied exclusively on its DCF methodology.
Appraisal of Dell Inc.
cautions against unjustified reliance upon merger prices in appraisal
actions. A robust sale process, arm’s length negotiating and even a
bidding war do not always guarantee an accurate “price discovery
tool.” The opinion further suggests that an MBO-focused sale process
is not necessarily suited to deliver fair value to stockholders. This
observation may have implications in Delaware litigation beyond
appraisal actions.
Copyright © 2016, Sheppard Mullin Richter & Hampton LLP.
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