The fair value appraisal standard is embedded in New York’s statutes governing stock buyouts in shareholder oppression cases under §1118 of the Business Corporation Law (BCL) and in dissenting shareholder cases triggered by mergers under BCL §623. While there exists a solid body of New York case law surrounding the fair value standard, lawyers and business appraisers involved in New York fair value proceedings are well advised to pay close attention to case law developments in the Delaware Court of Chancery under that state’s counterpart dissenting shareholder statute (Delaware has no statutory counterpart to New York’s shareholder oppression statute) which also employs the fair value standard. The consistently sophisticated and thorough analysis found in the Chancery Court’s rulings in all areas of corporate law, including stock valuation, implicitly is acknowledged in the many New York judicial opinions that cite and follow Delaware precedent.
So without further ado, following are summaries of three, noteworthy Chancery Court decisions handed down earlier this year involving dissenting shareholder appraisals under the fair value standard. If I had to pick a single headline for all three cases, I’d say it’s the relevance of post-merger events — reflected in cash flow projections or arising from contractual rights associated with preferred shares — in deciding fair value as of the merger date. But the cases also discuss a number of other, important appraisal issues concerning valuation approaches and various aspects of the discount rate.
In Gearreald v. Just Care, Inc., 2012 Del. Ch. LEXIS 91, C.A. No. 5233-VCP (Del. Ch. Apr. 30, 2012), Vice Chancellor Donald F. Parsons, Jr. determined the fair value of a privately held prison healthcare services company known as Just Care, Inc. that was acquired by merger with a national provider of prison services for $40 million. The dissenting shareholders of Just Care held both preferred and common shares.
The dissenters contended the company’s fair value was $55 million while the company claimed a value of $33 million notwithstanding the $40 million acquisition price. The dissenters’ appraiser relied exclusively on an income approach utilizing the Discounted Cash Flow analysis (DCF), having considered and rejected market approaches. The company’s appraiser utilized a DCF analysis and comparable public companies analysis, which he weighted two-thirds and one-third, respectively.
Most of the difference between the two valuations was due to (1) whether the DCF analysis should include cash flow projections under two growth scenarios contemplating additional post-merger prison facilities, and (2) the appropriate small company size premium applicable to the company’s cost of equity.
Vice Chancellor Parsons ruled that one of the growth scenarios, involving what would be the company’s first out-of-state facility providing a new type of services, was too speculative to be included, and that the other, more modest expansion at the existing facility could be included with a probability weighting of two-thirds. Other highlights of the court’s valuation analysis include:
- In developing his cost of capital, the company’s appraiser assumed a capital structure consisting of 100% common equity, whereas the dissenters’ appraiser used a capital structure consisting of 5% debt, 35% nonconvertible preferred stock and 60% common equity. The court rejected the former, which arose directly out of the expectation of the merger, and accepted the latter as the structure that the company would have maintained as a going concern. However, because the preferred shares had no history of receiving dividends, the court treated the company’s capital structure as if it was composed of 5% debt and 95% common equity.
- The company’s appraiser applied a historical equity risk premium of 6.47% while the dissenters’ appraiser applied a supply side equity risk premium of 5.73%. The court sided with the dissenters’ appraiser, stating that “the academic community in recent years has gravitated toward greater support for utilizing the supply side equity risk premium.” (For more on this topic, read here a guest post by Jeff Risius.)
- The company’s appraiser utilized an equity size premium, reflecting the company’s small size, of 9.53% compared to the dissenters’ appraiser’s 4.11%. The latter purported to reflect an adjustment for “liquidity effect” built into the size premium and therefore required to be eliminated under Delaware’s fair value standard prohibiting discounts for lack of marketability. The court did not acccept the adjustment, reasoning that the type of liquidity effect captured in the size premium data “arises in relation to transactions between Just Care and its providers of capital and, as such, is part of the Company’s value as a going concern.”
Vice Chancellor Parsons ultimately concluded a company value of $34.2 million using a weighted average cost of capital (discount rate) of 17.69%. Coincidentally or not, the outcome mimics the $40 million acquisition price which included a $6 million escrow to pay post-merger claims.
In Shiftan v. Morgan Joseph Holdings, Inc., C.A. No. 6424-CS (Del. Ch. Jan. 13, 2012), Chancellor Leo E. Strine, Jr. held, in the context of a pre-trial partial summary judgment motion, that in determining the value of the dissenters’ Series A preferred shares, the court can consider the shares’ redemption rights that would have been triggered automatically six months after the company was acquired by merger.
The dissenters held preferred stock in an investment bank called Morgan Joseph Holdings, Inc. which merged into another investment bank at the end of 2010. The shares carried an automatic redemption right at $100 per share that would have been triggered on July 1, 2011. The company contended that any redemption of the shares could only have been paid from “Excess Cash” as defined in the certificate of incorporation, and that the company would not likely have had Excess Cash as of the trigger date had the merger not occurred. The dissenters asked the court to rule in advance of the appraisal trial that, as a matter of law, the redemption was not subject to an Excess Cash requirement and that the court may consider a non-speculative, contractually required redemption event set to occur six months after the merger when determining the fair value of the preferred stock.
Chancellor Strine agreed with the dissenters on both counts. First, he found that the certificate of incorporation provided for two, discrete redemption rights triggered by different events including Excess Cash, but that the date-triggered, automatic redemption right at $100 per share was not conditional upon Excess Cash. Chancellor Strine also found that the dissenters’ reading of the certificate was supported by the company’s marketing materials used to attract investors.
Second, Chancellor Strine held that the post-merger automatic redemption is relevant to the court’s determination of fair value in the appraisal proceeding. The Delaware Supreme Court, he observed, “has required this court to take into account all non-speculative information bearing on the value of the shares at issue in an appraisal.” While the preferred shareholders’ ability to receive the $100 per share redemption price “would of course have depended on whether Morgan Joseph had sufficient legally available funds to effect the redemption,” Chancellor Strine explained,
that specific, non-speculative contractual right was inarguably an important economic factor bearing on the value of the Series A as of the Merger date that any reasonable investor or market participant would have taken into account.
Looking ahead to the trial, Chancellor Strine lays out the two “related but discrete tasks” the court must perform. First, the court must determine the company’s fair value as a going concern as of the merger date. Second, the court must determine the proper allocation of that value to the preferred shares taking into account the legal right of the preferred shareholders to the automatic redemption representing “contractual claims on the company’s value.”
In re Orchard Enterprises, Inc., C.A. No. 5713-CS (Del. Ch. July 18, 2012), also decided by Chancellor Strine, is a nice counterpoint to Shiftan. Similar to Shiftan, Orchard involved primarily a dispute whether fair value in a dissenting shareholder appraisal must take into account a $25 million liquidation preference owed by the company under certain circumstances to the holders of its preferred stock. In contrast to Shiftan, where the dissenting shareholders advocated recognition of contractual redemption rights to boost the fair value award, in Orchard it was the company, controlled by a majority shareholder who held most of the preferred shares, that asked the court to recognize the preferred shares’ liquidation preference in order to dilute the fair value award.
Prior to the going-private merger, Orchard was a NASDAQ traded company that distributed digital content from its licensed music catalogue. In 2008, when the business was suffering due to the economy, Orchard’s majority shareholder tried unsuccessfully to find a buyer for the company willing to pay the $25 million liquidation preference for the preferred shares held entirely by the majority shareholder. In 2009, the majority shareholder initiated a going-private merger that ultimately resulted in an offer of $2.05 per common share. In 2010, the merger became effective after the offer was approved by the board and by a majority of the minority shareholders. The going-private agreement left the preferred shares in place without providing for any payment of the liquidation preference.
In the subsequent appraisal proceeding, the dissenters contended that their shares were worth $5.42 each while the company argued that the merger price ($2.05) was generous and that the fair value was only $1.53. The largest part of the disparity stemmed from the inclusion by the company, and the exclusion by the dissenters, of the $25 million liquidation preference for the preferred shares.
Here’s how Chancellor Strine summarized the company’s position:
Although Orchard admits . . . that the liquidation preference was not triggered by the Going Private Merger and that Dimensional [the majority shareholder] in fact still owns the preferred stock and may obtain the liquidation preference in the future, Orchard claims that as a market reality, Dimensional could demand the liquidation preference as a precondition to any third-party merger and that therefore the full $25 million liquidation preference must be deducted from the enterprise value of Orchard before calculating the value of its common stock in this statutory appraisal.
The court didn’t buy the argument, calling it “incredibly confusing, illogical and non-factual,” and stating that it “dances around the plain terms of the amended Certificate of Designations, which make clear that payment of the liquidation preference is only triggered upon the occurrence of three events,” none of which was implicated by the going-private merger. As of the merger date, Chancellor Strine noted, “the liquidation preference had not been triggered, and the possibility that any of the triggering events would have occurred at all, much less in what specific time frame, was entirely a matter of speculation.”
The court thus valued the company’s preferred shares on an as-converted basis, recognizing the preferred shares’ right to participate in dividends. Chancellor Strine next determined the enterprise value of the company as a going concern. Here are some of his key findings:
- The dissenters’ appraiser relied solely on a DCF analysis, while the company’s appraiser relied on a weighting of DCF, comparable companies and comparable transactions analyses. The court found that the market analyses were not reliable and that the DCF method should be given exclusive weight in the appraisal. Chancellor Strine’s lengthy critique of the company appraiser’s market-based analyses is must reading for business appraisers.
- With respect to management’s cash flow projections, the court adopted the company appraiser’s weighting of base case (90%) and aggressive case (10%) projections, as opposed to the dissenters’ appraiser’s 50/50 weighting.
- Both appraisers calculated a discount rate using three methods: CAPM, the build-up rate model and the Duff & Phelps Risk Premium Report model. Chancellor Strine described himself as “uncomfortable” and “ambivalent” about using the latter two methods which he criticized as not “well accepted by mainstream corporate finance theory as a proper way to come up with a discount rate” and as involving “a great deal of subjectivity.” He instead endorsed the CAPM method as one that “is generally accepted, involves less (but still more than comfortable) amounts of subjectivity, and should be used where it can be deployed responsibly.”
- As did Vice Chancellor Parsons in Just Care, Chancellor Strine found it appropriate to apply a lower, supply side equity risk premium over the higher, historical equity risk premium.
- Chancellor Strine rejected the company appraiser’s inclusion of a 1% company-specific risk premium in his calculation of the discount rate under the CAPM method which, he noted, is designed to measure systemic risk whereas “company-specific risks should be addressed by appropriate revisions in cash-flow estimates.”
- Chancellor Strine accepted (albeit unenthusiastically) the 6.3% size premium applied by both appraisers, but rejected the company appraiser’s argument that the size premium should be adjusted upward if the court uses supply-side rather than historical equity risk premium.
Based on the appropriate weighting of the company’s financial projections, and applying a discount rate of 15.3%, Chancellor Strine ultimately arrived at a value of $4.67 per share as of the date of the going-private merger, or more than twice the merger price.