Weil, Gotshal & Manges | Deal Compass, November 23, 2016 commentary of Howard Chatzinoff, Eoghan Keenan and Maryam Naghavi: "Understanding and Managing Appraisal Risk in M&A Transactions" [Another M&A advisor's analysis of standards for appraisal established by Dell case]

Source: Weil, Gotshal & Manges | Deal Compass, November 23, 2016 commentary

Deal Compass – November 2016 Edition

Howard Chatzinoff, Eoghan Keenan and Maryam Naghavi

on November 23, 2016

Understanding and Managing Appraisal Risk in M&A Transactions

The decision by Vice Chancellor Laster of the Delaware Court of Chancery in In re: Appraisal of Dell Inc.[1] has received considerable coverage and discussion in legal publications. More importantly, the decision has resulted in significant concern and uncertainty amongst dealmakers and their legal counsel when negotiating transactions involving the merger of a Delaware corporation where appraisal rights are available to the stockholders of the acquired corporation. While much has been made of the rationale for the Dell decision and many have sought to distinguish it on the facts, the scope of Chancellor Laster’s remarks in the decision should be given careful consideration when evaluating the risk of an appraisal action in Delaware merger transactions, most notably those transactions involving management-led buy outs, private equity-backed going private transactions and targets that have made significant capital investments shortly prior to the sale of the company. However, whether through the negotiation of an appraisal rights condition in the merger agreement or taking advantage of recent amendments to Section 262 of the Delaware General Corporation Law (“DGCL”), dealmakers and their legal counsel can take certain steps to mitigate the risk of an unfavorable outcome in an appraisal action.

The Dell decision is notable for a number of reasons, but in particular because the court clearly distinguished the question of fulfillment of fiduciary duties from the question of “fair value”. Prior to this decision, transaction parties would take some comfort in the establishment of a well-managed process designed to ensure that the directors of the target fully exercised their fiduciary duties. However, in the Dell decision, the court explained that while actions such as establishing an independent committee, running a competitive process, excluding interested directors from the decision-making process and subjecting the transaction to the vote of the majority of unaffiliated stockholders help establish that the decision-making process employed by the board and the information it based its decision on was reasonable, and that the board acted reasonably in light of the circumstances, they do not necessarily indicate that the deal price proposed in the board-approved transaction reflected the “fair value” of the company. Stating that the burden of proof in an appraisal proceeding differs from a fiduciary liability proceeding, the court explained that “[i]n a statutory appraisal proceeding, both sides have the burden of proving their respective valuation positions by a preponderance of evidence”, and that “no presumption, favorable or unfavorable, attaches to either side’s valuation”. The court further explained that “fair value” is not the equivalent of “fair market value” but rather represents the true or intrinsic value of the stock of a corporation. The court clarified that the valuation date to determine “fair value” of a dissenting stockholder’s stock is the closing date and that “if the value of the corporation changes between the signing of the merger and the closing, the fair value determination must be measured by the ‘operative reality’ of the corporation at the effective time of the merger.” All this to say that, while the process adopted by the board of directors (or special committee) of the target is important, it is not determinative when evaluating the likelihood of an appraisal claim being brought and succeeding.

Vice Chancellor Laster acknowledged the recent trend in Delaware courts to presume that the deal price was a good indicator of “fair value,” but emphasized that those cases were decided in connection with transactions which “resulted from an arm’s-length process between two independent parties” and that “no structural impediments existed that might materially distort the ‘crucible of objective market reality.’[2]” The court argued that “[a]mong the other requirements for market efficiency are liquidity and fungibility. Public stock market prices are generally efficient because large numbers of identical shares of stock in a given company trade on a highly liquid market with millions of participants. The deal market, however, dealing as it does with entire companies, rather than individual shares, often lacks both qualities.” The court further argued that in a management buyout, “[a]lthough the literature is far from unanimous in its analysis and policy recommendations, the weight of authority suggests that a claim that the bargained-for price in an MBO represents fair value should be evaluated with greater thoroughness and care than, at the other end of the spectrum, a transaction with a strategic buyer in which management will not be retained.”

While acknowledging that the intrinsic value of a company does not necessarily translate into a price that a buyer is willing to pay in an arms’ length transaction, in addition to the concerns raised by a management buyout, the court pinpointed three additional factors in the Dell transaction to argue that the deal value did not reflect the “fair value” of Dell:

Use of an LBO pricing model: The court argued that a financial buyer evaluates a company based on the IRR that it desires to achieve on its investment and, in the case of the Dell transaction, the financial buyer needed to achieve an IRR of 20% or more to satisfy its own investors. The court concluded that the IRR method tends to undervalue the fair value of the target company and, unlike discounted cash flow methodology, does not reflect the equity value of the target company.
Compelling evidence of disconnect between the market and the reality of operations: While Dell experienced a continuous drop in the price of its shares during the Dell transaction process, both the financial advisors and management agreed that the market “did not get the company” and that the market was focused on short-term results rather than the long-term strategies of the company (e.g., the fact that Dell had recently made nearly $14b in capital investments which had not yet begun to generate the anticipated results). The court argued that a “transaction which eliminates stockholders may take advantage of a trough in a company’s performance or excessive investor pessimism about the company’s prospects (a so-called anti-bubble). Indeed, the optimal time to take a company private is after it has made significant long-term investments, but before those investments have started to pay off and market participants have begun to incorporate those benefits in the price of the company’s stock.”
Limited pre-signing competition: The court argued that go-shop provisions rarely produce meaningful superior bids in an LBO context, so “the bulk of any price competition occurs before the deal is signed.” The court explained that competition does not have to be direct and overt and it sometimes suffices to have prospects of post-signing competition to help raise the price during the pre-signing period; however, the court noted that in the case of a bidding process including several financial investors, there might not be rampant incentives to top offerings given the pre-existing relationships that such financial investors may have. In such situations, the “price established during the pre-signing phase is therefore critical, and it is the presence or realistic threat of competition during this period that drives up the price.”

From the factors summarized above, it appears that the Delaware courts intend to place greater scrutiny on the “fair value” of transactions involving management of the acquiring party, financial sponsors generally (both as a result of anticipated IRR mandates and assumed relationships amongst financial sponsors), transactions relying upon a post-signing go shop period to satisfy the market check and transactions where the target company’s stock price is depressed. Whether one or more of these factors will become more likely to result an unfavorable appraisal rights outcome remains to be seen as the case law develops, but transaction parties should give careful consideration to the circumstances of the transaction in evaluating the risk of an appraisal claim being brought and resulting in an unfavorable outcome and determining what actions should be taken by the parties to mitigate that risk.

From the buyer’s perspective, the inclusion of an appraisal right closing condition in the merger agreement in favor of the buyer is frequently raised as a desirable means to mitigate the risk of appraisal rights being exercised. The condition provides that holders of no more than a certain percentage of a company’s shares (e.g., 5%) have sought an appraisal of the fair value of their target company shares. The inclusion of this condition provides comfort to the buyer both by potentially deterring stockholders from seeking to exercise their appraisal rights (there is no appraisal action if the transaction does not close) and by giving the buyer the ability to walk away from the transaction if the holders of too many shares exercise their appraisal rights. However, the appraisal condition is not without its faults. Buyers will need to carefully consider the shareholder base of the target company before seeking an appraisal condition as it could result in providing minority shareholders hold-up value over the transaction. Such deal uncertainty is exactly why target company boards are generally loath to agree to appraisal conditions and will usually strongly resist the inclusion of an appraisal condition. Following the Dell decision, many anticipated that buyers would be more successful in negotiating the inclusion of an appraisal condition in public merger transactions where appraisal rights are available. However, in the five months that have passed since the Dell decision, we have not seen a meaningful increase in the number of merger agreements including an appraisal condition. Of the 64 transactions with a deal value of greater than $500m announced between June 1, 2016 and November 17, 2016, only two agreements include an appraisal rights closing condition. In the seven months prior to the Dell decision, only three of the 74 transactions with a deal value greater than $500m included an appraisal condition. According to the 2014 ABA Deal Points Study, of all the public company transactions with a deal value of greater than $100m which were announced in 2013, only 3% included an appraisal condition in all cash deals and only 26% included an appraisal condition in part cash, part stock deals.

Even prior to the Dell decision, the number of appraisal proceedings has steadily increased over the last few years as investors have pursued appraisal claims as an investment strategy, with the risk of loss mitigated by the statutory interest accruing on the value of the shares for which appraisal is sought. Under Section 262(h) of the DGCL, unless the Court of Chancery determines otherwise for good cause, interest on an appraisal award accrues from the effective date of the merger through the date of payment of the appraisal award at a rate of 5% over the Federal Reserve discount rate, compounded quarterly. Recognizing the concerns raised by its corporate constituency regarding the increasing use of appraisal actions as an investment strategy and the significant cost incurred by the interest imposed during the life of an appraisal proceeding (often lasting three or more years), the Delaware legislature recently amended Section 262 of the DGCL to impose a minimum shareholding requirement for petitioners bringing an appraisal claim and empowered buyers to significantly decrease the potential interest payments that such petitioners may receive during a pending appraisal claim. The amendment, which became effective on August 1, 2016, provides that the courts must dismiss any appraisal proceeding where the total number of shares entitled to appraisal does not exceed 1% of the company’s outstanding shares eligible for appraisal or the value of the merger consideration for such shares in the transaction does not exceed $1 million. This exception should have the effect of cutting off minor appraisal claims that are more of a nuisance than a threat to deal certainty or the economics of most public company transactions.

More importantly, Section 262 of the DGCL has also been amended to allow the surviving company in the merger to make a voluntary cash payment of the merger consideration to the holders seeking appraisal, without any negative inference by the Court of Chancery, which could significantly reduce if not eliminate the amount of interest that accrues during the appraisal process. Following such a payment, the stockholder seeking appraisal would only be entitled to interest on the excess, if any, of the fair value of the shares as determined by the Court of Chancery over the amount paid by the surviving company (plus any interest that may have accrued between the date of the merger and the date of the merger consideration payment to such stockholder).

The ability of the surviving company in the merger to pay the merger consideration on the shares for which appraisal is sought immediately following the closing of the merger has the potential to significantly deter questionable appraisal claims. By eliminating the guaranteed rate of return provided by statutory interest, stockholders bringing an appraisal claim will now need to carefully consider the financial impact of pursuing an appraisal proceeding, including legal costs incurred in pursuing the claim, the market risk of investing the merger consideration to other investors during the pendency of the appraisal claim and, of course, the outcome of the Delaware courts’ finding that the fair value is less than the merger consideration. While the Dell decision may have the effect of making buyers less certain about the outcome of appraisal proceedings, if buyers begin to adopt the practice of promptly paying the merger consideration to shareholders seeking appraisal, the recent amendments to Section 262 of the DGCL should reduce the occurrence of such proceedings.

[1] In re: Appraisal of Dell, Inc. (Del. Ch. May 31, 2016)

[2] Highfields Capital, Inc. v. AXA Fin., Inc., 939 A.2d 34, 42 (Del. Ch. 2007)

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