Dell Appraisal: Chancery Court Grants Appraisal Award, Rankles Deal Community

Practical Law Legal Update w-002-6816 (Approx. 10 pages)

Dell Appraisal: Chancery Court Grants Appraisal Award, Rankles Deal Community

by Practical Law Corporate & Securities

Background

The Dell going-private transaction is summarized in What's Market, Michael Dell and Silver Lake Partners/Dell Inc. Merger Agreement Summary. In the years leading up to the acquisition, Dell Inc. faced new challenges from changing consumer preferences for mobile tech and increased competition from down-market computer manufacturers and cloud-based storage service providers. Michael Dell, the company's founder, CEO, and 15.4% stockholder, set out to change the company's focus from selling PCs to selling software and enterprise services. To that end, between 2010 and 2012, the company spent approximately $14 billion to acquire 11 businesses. Though Michael Dell was optimistic about the prospects for these new businesses, their integration and reflection in the company's operating results was not immediate.

Throughout this period, the market continually discounted the long-term prospects of the company while maintaining its focus on the company's quarterly results. Projections prepared by management in July 2012 supported valuations for the company that were significantly higher than its stock price. Because of this continuing discrepancy, Michael Dell decided to propose a management buyout (MBO) to the board and take the company out of the public eye. Michael informed the board that he would not proceed with the offer without the board's approval and engagement of a financial advisor. In response, the board formed a special committee with full powers with respect to any proposed transaction, as well as any other strategic alternatives that it determined to be advisable.

During the first week of September 2012, the special committee entered into confidentiality agreements with the private equity firms Silver Lake and KKR, and Michael Dell himself. No strategic buyers, however, were approached at that point (or during the pre-signing phase at all). The special committee's financial advisor JPMorgan explained to the committee how private equity buyers could be expected to evaluate a potential transaction. JPMorgan explained that in a leveraged buyout deal:

The buyer, or sponsor, pays with a relatively small amount of equity and a significant amount of debt.
Sponsors seek returns on their equity investment and use financial leverage to increase potential returns.
A sponsor typically expects to realize a return within three to five years via a sale, IPO, or recapitalization.
Sponsors evaluate investments with an internal rate of return (IRR) analysis, which measures return on equity.
The IRR will be the primary means that the sponsor uses to determine the appropriate purchase price.

JPMorgan also advised that interest from strategic buyers would likely be low, but that even so, limiting the process to Silver Lake and KKR would create a lack of competition.

Shortly after, JPMorgan provided several potential valuation ranges for the company on the basis of management's projections and various test cases. The valuations based on a discounted cash flow (DCF) analysis produced ranges around $20 per share and as high as $27.00 per share. The company's stock price, meanwhile, had closed the previous day at $9.66.

The committee received bids from Silver Lake and KKR; both bids were in line with the valuations of previous LBOs, but were otherwise well below JPMorgan's DCF analyses. As the company's short-term operating performance deteriorated (particularly in the PC business), KKR dropped out of the bidding. The committee managed to negotiate a raised bid with Silver Lake at $13.65 per share in cash, with Michael Dell accepting a lower amount for his rollover. The merger price was below several of JPMorgan's valuation indications for the company and the proxy materials added that the committee did not seek to determine a pre-merger going-concern value. The board recommended the transaction on the basis of the certainty of the cash consideration and the generous premium over where the company's stock had been trading.

The parties' merger agreement contemplated a 45-day go-shop, a two-tier break-up fee, and a one-time match right. During the go-shop period, the company—with the assistance of a second financial advisor hired specifically to run the go-shop process—solicited bids from 60 parties. Little came of this effort beyond engagement by Carl Icahn, who made several offers for a leveraged recapitalization deal. The Michael Dell-Silver Lake buyer group eventually amended their offer to $13.75 per share, plus a special dividend and certain changes to the merger agreement's deal protections. The merger was eventually approved by the stockholders, though by a narrower margin than is typical for public deals. The petitioners sought appraisal for their shares.

Outcome

The Chancery Court held that the merger price, as amended, undervalued the company and that the company's fair value as of the closing date was $17.62 per share.

A significant portion of the court's decision is devoted to anticipating and answering two potentially vexing questions:

Why should stockholders be entitled to additional consideration even if the directors have not breached their fiduciary duties?
Why is the negotiated merger price not the best indicator of the company's value?

To the first question, the court explained that the analyses for fiduciary duty cases and appraisal actions are focused on different issues. In a case analyzing whether the board breached its fiduciary duties, the court considers whether the directors should be subjected to personal damages and the crux of that analysis lies in the reasonableness of the board's decision-making process. The final price can inform that analysis, but a board can conduct a reasonable though imperfect process, arrive at a price that undervalues the company, and still avoid liability.

In appraisal actions, by contrast, the court's analysis is indeed focused on the price, which is "all that matters"; the reasonableness of the board's process is entirely beside the point. Consequently, a sale process that "might pass muster" for purposes of a breach claim can still generate a price that is deemed to have undervalued the company for appraisal purposes. Here, the court confirmed that the board's sale process would "sail through if reviewed under enhanced scrutiny." Nevertheless, the price still undervalued the company as a going concern.

The court also explained how Delaware law distinguishes between the economic concept of fair market value and fair value for purposes of the appraisal statute. Here the court cited to the Delaware Supreme Court's Golden Telecom decision for the principle that market-price data is not considered conclusive evidence of the company's fair value as of the closing (11 A.3d 214, 217-18 (Del. 2010)). Rather, Section 262(h) of the DGCL mandates that the court consider all relevant factors in arriving at a determination of fair value, of which the negotiated merger price is only one.

The court acknowledged a recent slate of Chancery Court decisions that have relied on the merger price in appraisal decisions. These decisions are discussed in Practice Note, Appraisal Rights: How Is Fair Value Determined?: Merger Price. The court distinguished these cases (in all of them, the court held that other evidence of fair value was weak) and explained why the merger price may not always be the best indicator of value:

Appraisal decisions are meant to determine the fair value of the company as of the closing, while the negotiated merger price provides a value as of the signing. A substantial delay between signing and closing, such as for the stockholder vote or regulatory approval, can make the merger price less reliable by the time of the closing.
While a public company's stock price reflects market efficiency with respect to shares and the ability to trade them, it is not as strong an indicator of value for the entire company as a whole. Therefore, a merger price that has been negotiated chiefly as a premium to the prevailing market price is not reliable evidence of the company's fair value.
The limitation on the reliability of the stock price is especially pronounced in management buyouts, where strategic buyers are frequently excluded from the process. Though they may be invited to bid during the go-shop phase, by then they face the reality of a management team that would prefer to continue with the negotiated MBO deal.
A negotiated, arms'-length merger price may include synergies, which are excluded for purposes of appraisal proceedings.

With these principals in mind, the court delved into the merger price negotiated for Dell and found that it did not reflect the company's fair value. The court gave three primary reasons:

The buyer group's LBO pricing model undervalued the company.
The market's short-term focus had depressed the company's stock price, making it a poor representation of the company's true value.
The pre-signing process had lacked meaningful competition among potential bidders.

The LBO Pricing Model Undervalued the Company

The court reemphasized that the highest price that a bidder might pay for a company does not automatically reflect the company's fair value as a matter of Delaware law. In this case, that discrepancy was particularly likely because only private equity bidders were involved in the pre-signing auction. As the court explained, the price that a financial sponsor is willing to pay typically diverges from the company's fair value because:

The sponsor needs to achieve internal rates of return of 20% or more to satisfy its own investors.
There is a limit on how much debt financing the company and the sponsor can rely on to finance the deal.

As a result, while the LBO pricing model only solves for the sponsor's internal rate of return, a DCF analysis aims to decipher the present value of the company. Here, the record indicated that the pre-signing negotiations were driven by the sponsors' need to generate their preferred return, even as their bids consistently came under most of the special committee's financial advisors' estimates of the company's value based on DCF analyses.

Valuation Gap

The court's second factor for why the merger price did not evidence Dell's fair value was the "widespread and compelling evidence" of a gap between the market's perception of the company's value and the company's prospects as a going concern. This gap was driven by:

Analysts' focus on short-term, quarter-by-quarter results, which were consistently downbeat.
The company's acquisition of 11 businesses, which had been made too recently before the buyout of Dell Inc. to be reflected in its operating results and its stock price.

Here the court cited to literature supporting the point that periods of low stock prices are particularly opportunistic times for management to pursue an MBO, since the low stock price has a tendency to anchor negotiations.

Limited Pre-Signing Competition

The court stressed that the target company's best opportunity to obtain the best price for its stockholders is during the pre-signing phase, regardless of the fact that the company has negotiated a post-signing go-shop. The court belittled the value of the go-shop as a tool for finding better offers, pointing to the fact that private equity firms rarely get into bidding wars with each other as a cultural matter and also assume a "winner's curse" mentality that prevents them from attempting to top the initial agreed price. (The winner's curse is an assumption that the initial private equity buyer, which negotiated a deal with management—which knows the company better than anyone—must have negotiated the price most worth paying, and that paying any more would be foolish.)

Because of its skepticism of the value of the go-shop, the court placed more emphasis on the pre-signing period and highlighted that the special committee initially engaged with only two financial sponsors and never contacted any strategic buyers during that period. In light of its comments about the weakness of the LBO pricing model, the court had little confidence that a process with two private equity bidders could have generated a bid that properly valued the company.

Lack of Go-Shop Activity Does Not Entirely Close the Valuation Gap

The go-shop period did, in fact, generate two higher bids, one of which fell away and the other of which eventually caused the buyer group to increase its offer. Based on that activity, the company made a straightforward argument: if anyone else thought that Dell Inc. was being bought on the cheap, they would have submitted a bid. The very fact that only two superior bids emerged, and the buyer group topped them with its amended offer, must have meant that the negotiated price represented the company's fair value.

The court acknowledged the force of this argument to a degree and held that it was persuasive enough to negate the valuation of $28.61 per share that the petitioners sought. However, the court held that the go-shop process was not enough on its own to negate smaller valuation gaps because:

Other financial sponsors would have faced the same constraints on their bids (the need to achieve an IRR in the range of 20% within a few years) as those bidders who had gotten an earlier start.
The superior bids came from other financial sponsors, who use the problematic LBO pricing model.
The fact that a go-shop extends an invitation to third-party bidders, and that a particularly determined bidder can overcome the structural and timing disadvantages of being an interloper, does not mean that the go-shop can be trusted to unlock the company's true value. The obstacles for a third-party bidder are still high and success must be somewhat likely for the third party to even bother submitting a superior offer—even though, had it been involved in the process from the outset, it might have submitted such a bid.
A go-shop is particularly unlikely to generate a topping bid for a company as large and complex as Dell Inc. Professor Guhan Subramanian testified that the negotiated merger was 25 times larger than the largest negotiated merger to have ever been successfully deal-jumped, which would have made a successful bid literally unprecedented.
The threat of the winner's curse prevents other bidders from bothering to submit bids. In this case in particular, given the crucial role that Michael Dell himself would play in the company's ongoing operations, a bidder would shy away from competing with a buyer group in which Michael Dell was participating.

DCF Analysis Provides Best Evidence of Fair Value

In light of the above analysis, the court set aside the negotiated merger price as an indicator of fair value and instead set out to arrive at that value on the basis of the DCF analyses prepared by each side's valuation expert. Here the court noted somewhat ruefully that the two experts, applying similar valuation principles, generated opinions that differed by 126%, or approximately $28 billion, which the court called a recurring problem. The court stated that the differences in the experts' projections were driven primarily by the projected cash flows they used. Using its own determinations of the correct inputs for the DCF analysis, the court concluded that the fair value of Dell Inc. was $17.62 per share.

Why the Decision Could Affect Private Equity Activity

The decision in Dell has raised alarms in many circles. Stated most starkly, the decision—however valid its justifications on the basis of existing precedent—gives no credit to a price negotiated in a fair process with no intimation of favoritism or other untoward conduct on the part of the target board of directors. The negation of the merger price could theoretically affect all public mergers, including those entered into with strategic buyers. In any deal in which the buyer has deemphasized the value of a particular line of business or projection that the court considers intrinsic to the company's value, the deal is at risk of an appraisal judgment.

Some of the court's explanation for why the negotiated merger price is an unreliable indicator of value is more particular to management buyouts than other deals. The winner's-curse dilemma, for example, is most heightened when members of management are intimately involved in the buyer's bid. However, much of the underlying analysis is applicable to all deals with financial sponsors. The weakness of the LBO pricing model—a particular point of focus in Dell—has the potential to undermine virtually any deal entered into with a private equity firm. Strategic buyers are also vulnerable on this point to the extent that their bid is mostly premised on paying a premium to the target company's pre-announcement trading price.

The effect of the decision may be that financial sponsors will be unable to predict with confidence their exposure to appraisal claims. To the extent that their solution will be to condition the closings of their deals on increasingly tight dissenting-shares closing conditions (a suggestion discussed below in Practical Implications), this will still have the effect of increasing closing uncertainty.

Why the Decision Involves a Special Situation

Some practitioners and observers have been more sanguine about the effect of Dell on the M&A market. They point to several factors that make this case somewhat unusual or otherwise not as disconcerting as others have taken to feeling about it:

Dell Inc. had gone on a particularly large and particularly recent spree of acquisitions—$14 billion worth between 2010 and 2012—soon before its 2013 sale. It is not unreasonable to assume that the value of those businesses would not yet be reflected in the company's stock price. Companies that have been operating in the ordinary course before their sale have less cause for concern that they are holding on to value that the market has yet to fully digest.
Dell Inc. was operating in an industry that was being buffeted by extraordinary changes in consumer preferences, making it particularly hard to quantify its business. Because of that and other short-term difficulties, the court found "widespread and compelling evidence" of a valuation gap between the market's perception of the company's value and its true worth. Where the evidence of a gap is less than widespread and compelling, the court may be more willing to rely on the parties' negotiated price.
Owing to the size of Dell Inc. and the complexity of its challenges, Michael Dell himself may have been particularly vital to the company in ways that other CEOs may not always be. The winner's-curse dilemma, therefore, may have been stronger in Dell than it will ordinarily be in other deals.
Because of the size of his rollover stake, Michael Dell was a net purchaser in the deal. From that perspective, he was disincentivized to add to the merger price. (This should be true in many management buyouts.)
As the Chancery Court has ruled several times, as long as the DCF analysis is unreliable (for example, if management's projections were not prepared in real time), the court will still rely on a merger price negotiated at arms' length.
As a result of the court's decision earlier in the month to exclude stockholder T. Rowe Price from the process because of its accidental vote in favor of the transaction, a relatively small additional payment is actually being required of the buyer group—approximately $37 million for 20 stockholders (see In re Appraisal of Dell Inc., (Del. Ch. May 11, 2016)). (We have seen this argument made, but we do not view it as a strong one. The Delaware judiciary has hardly shied away from imposing large judgments when it has deemed them appropriate. For example, Vice Chancellor Laster, the judge in Dell, himself ordered a $148 million judgment in Dole Food.)

Practical Implications

In our view, much of the negative reaction to the court's decision is attributable to broader dissatisfaction with the very idea that the stockholders of a public corporation should be allowed to exercise appraisal rights, particularly if the corporation's stock was widely traded before the transaction and the corporation was acquired in a fair process and at a premium to the prevailing market price. In effect, the decision rankles because its analysis resembles that seen in cases that come under the entire fairness standard of review, in which the target company must establish fair dealing and fair price. Although in the appraisal context the board knows it is not at risk of a finding of liability, the effect in every other way is the same—uncertainty of the final price and exposure to costly post-closing litigation. By this argument, the only appropriate avenue for challenging a merger of a public corporation should be to establish that the board of directors of the target company breached its fiduciary duties; if it did not, the stockholders should not be entitled to additional payment.

Another theme that pervades Dell and many appraisal decisions before it is the ruling judge's own discomfort with being put in a position of acting as an arbiter between two sides of financial experts. These types of disputes do not demand legal skills as a primary matter and are an awkward fit for courts of law.

Notwithstanding these misgivings, the appraisal process remains a part of Delaware law, no less so when the target company is publicly traded. To the extent that the decision strikes some as a judicial overruling of market forces, their umbrage is better directed at the statutory regime, not purportedly activist judges. As the Delaware Supreme Court has stated, the statute "places the obligation to determine the fair value of the shares squarely on the court" (Gonsalves v. Straight Arrow Publ'rs, Inc., 701 A.2d 357, 361-62 (Del. 1997)). The Dell court did not invent appraisal rights, nor did it create new law when it determined not to rely on the negotiated merger price. Only an amendment to the Delaware statute can eliminate appraisal rights in public mergers or, less drastically, establish that the court can rely on the merger price in arms'-length deals that do not involve the company's controlling stockholder.

On that front, the Delaware legislature has recently made changes to the appraisal process, though not far-reaching enough to prevent future decisions like Dell. On June 16, 2016, the Governor of Delaware signed into law amendments to Section 262 of the DGCL that will impose limits on appraisal actions against public companies. The amended statute will require the Chancery Court to dismiss appraisal proceedings against public companies if either:

The total number of shares entitled to appraisal is 1% or less of the outstanding shares of the class or series eligible for appraisal.
The value of the merger consideration for the total number of shares entitled to appraisal is $1 million or less.

The amendments will also permit the surviving corporation, at any time before entry of judgment in the appraisal proceedings, to pay each stockholder entitled to appraisal an amount in cash. The interest will only accrue on the sum of:

The difference, if any, between the amount paid by the corporation and the fair value of the shares as determined by the court.
The interest already accrued at the time of the payment, unless paid together with the initial payment.

For further discussion of the amendments, see Legal Update, 2016 DGCL Amendments Proposed on Appraisal Rights, Intermediate-Form Mergers, and Chancery Court Jurisdiction. The amendments take effect with respect to transactions closed on or after August 1, 2016.

Beyond these changes, dealmakers can negotiate around Dell by demanding maximum-dissent closing conditions in their acquisition agreements. It is not uncommon for agreements to condition the closing on no more than 10% of the shares seeking appraisal; the Dell decision may prompt more buyers to demand these conditions and perhaps lower the 10% threshold as well. To glean the current market practice on dissenting-shares closing conditions, use Practical Law's What's Market database for both public merger agreements and private acquisition agreements. In public merger summaries, search within the "Other points of interest" and "Conditions to the tender offer" fields (the latter for tender offers only). In private acquisition summaries, search within the "Appraisal rights closing condition" field.

If appraisal rights are anticipated to be exercised in a given deal, then to avoid a finding similar to Dell's, the board of directors should make a record of its discussion of, and emphasis on, the company's intrinsic value, particularly as based on a DCF analysis. A record that indicates overemphasis on the deal premium or on the potential return for the buyer risks a finding that the deal did not properly value the company. If the board undertakes this analysis (with the aid of its financial advisors), it should be able to demonstrate to the court's satisfaction that the bids it evaluated were bids for the company's fair value. This should also be enough to overcome a lack of strategic bidders in the pre-signing phase if the company has only entertained bids from financial sponsors as Dell did.

Dell Appraisal: Chancery Court Grants Appraisal Award, Rankles Deal Community | Practical Law