Don't Pay Twice for Your Equity!

As described below, counsel for the holders of debt can add significant value for their clients by simply applying a little attention to the appraisal rights issue, and structuring and documenting the transaction. In so doing, the parties can avoid the pitfall of an unintended value transfer and unwieldy post-transaction proceeding. What follows below is a brief summary of the Delaware law on appraisal rights, and a review of how to structure a cash-out merger to facilitate the debt-for-equity exchange, eliminate some or all prior shareholders and reduce the risks of additional post-transaction payouts.

'Fair Value' Appraisal

'Fair value' appraisal is the remedy for dissenting stockholders squeezed out of Delaware companies.

The Delaware General Corporate Law (DGCL) provides a statutory basis for cash-out mergers that extinguish some or all minority stockholders. See Del. Code Ann. Title 8, ” 251-254, 257, and 263. The applicable statutory language allows cash to be used as consideration in a merger transaction, thus extinguishing the minority stockholders' rights to continue as stockholders. See Del Code. Ann. Title 8, ' 251(b), 252(b), 253(a), 254(c), 257(b), and 263(b). Consummating such a merger will trigger appraisal rights under ' 262 of the DGCL, which provides that stockholders dissenting to the merger are entitled to an 'appraisal by the court to determine the fair value of the stockholders' shares.' See In re Appraisal of Ford Holdings, Inc. Preferred Stock, 698 A.2d 973 (Del. Ch. 1997). Note that appraisal rights are generally not an exclusive remedy and that there are additional claims plaintiffs may have for breach of fiduciary duties and other matters. One notable exception is Delaware 'short-form' mergers with 90% stockholders, in which event recent case law provides that a robust statutory appraisal proceeding is now the exclusive remedy for claims arising out of a cash-out merger where there is no fraud or illegality. See Glassman v. Unocal Exploration Corporation, 777 A.2d 242 (Del. 2000).

Establishing 'Fair Value'

In an appraisal action, the only litigable issue is the 'fair value' of the dissenting stockholders' shares on the date of the merger. Cede & Co. v. Technicolor, Inc., 542 A.2d 1182, 1186 (Del. 1988). The DGCL itself provides little guidance on how to calculate fair value. However, in Weinberger v. UOP, the Delaware Supreme Court ruled that courts should broadly consider 'any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.' 457 A.2d 701 (Del. 1983), at 712-713. Following this broad mandate, the Delaware courts have employed many different methodologies to determine fair value in an appraisal proceeding, including commonly used discounted cash flow and comparable company analyses.

The Time 'Fair Value' Is Set

Timing exactly when 'fair value' is calculated is a deceptively important matter, especially when the transaction being considered is a balance-sheet reorganization that could result in an alteration of value of the company's equity. Section 262(h) of the DGCL provides that 'the court shall appraise the shares, determining their fair value exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation.' Although the statute's language might seem to imply that no value from the transaction should be considered, courts interpret this provision as applying to synergies and other remote possibilities and as setting the exact time for calculating fair value at just before the consummation of the merger, giving rise to the appraisal right. See Cede & Co.v.Technicolor, Inc., 684 A.2d 289, 296 (Del. 1996) and Allenson v. Midway Airlines, 2001 WL 811971 (Del. Ch. July 9, 2001) (stating that where value is contributed post-merger, ' 262(h) and Cede IV proscribe the inclusion of the value in determining fair value at the time of the merger).

As a corollary, courts maintain that any value creation from events occurring prior to the technical effectiveness of the merger may be considered when determining fair value. See Allenson, 2001 WL 811971 ('In a two-step merger, to the extent that value has been added following a change in majority control before cash-out, it is still attributable to the going concern ' [V]alue added to the going concern by the 'majority acquirer,' during the transition period of a two-step merger, accrues to the benefit of all shareholders and must be included in the appraisal process on the date of the merger ' That narrow exclusion [of elements of value arising from the accomplishment or expectation of the merger] does not encompass known elements of value, including those which exist on the date of the merger because of majority acquirer's interim action in a two-step cash-out transaction.' (quoting Cede, 684 A.2d at 299).

Therefore, practitioners should take careful note that attention must be paid to the exact legal timing of actions that could alter the value of the company either prior to or after technical effectiveness of the merger.

Valuing the Exchanged Debt

For appraisal purposes, that old equity may not be so 'under-water' after all. Regardless of the valuation methodology employed to determine the value of the enterprise, it is settled law that the value of any debt outstanding immediately prior to the effectiveness of the merger must be subtracted from enterprise value to arrive at 'fair value' in a Delaware appraisal action. See e.g., Borruso v. Comm. Telesystems Int'l, 753 A.2d 451 (Del. Ch. 1999) (the value of the debt is subtracted from the enterprise value derived from a Comparable Company analysis to determine the 'fair value'); Kleinwort Benson Ltd. v. Siglan Corp., 1995 WL 376911 (Del. Ch. 1995) (the value of the debt is subtracted from the enterprise value derived from a DCF analysis to determine 'fair value'); Rapid American Corp. v. Harris, 603 A.2d 796 (Del. 1992) (the value of the debt is subtracted from the enterprise value derived from a Comparable Company analysis to determine the 'fair value'); and In re Vision Hardware Group, 669 A.2d 671 (Del. Ch. 1995) (the value of the debt is subtracted from the enterprise value derived from a DCF analysis to determine 'fair value').

It is notable that, in Rapid American Corp. and In re Vision Hardware Group, the parties acknowledged that the debt was to be deducted, with the sole issue being exactly what was to be the measure of so-called 'value' of that debt.

What is not inherently obvious, however, is exactly how one determines that value for the calculation. And in the case of distressed debtors, the issue can be more precisely stated as follows: Which measure is proper, the face value or the discounted market value of the debt? Advisors and creditors alike should note that, because distressed debt often trades at a significant discount to face value, the choice of face or market value could have a significant impact on the equity value of a debtor and, therefore, the fair-value payments in an appraisal proceeding.

Although it may seem initially counterintuitive, Delaware courts have adopted a general rule that market value, not the face value, is the proper measure of the value of the debt to be subtracted from enterprise value when calculating fair value. Rapid American Corp., 603 A.2d at 804.

Accordingly, as a general matter and often to the consternation of distressed debt holders, the Delaware courts have placed a right in the hands of dissenting stockholders to claim for themselves (and perhaps a burden on Boards of Directors to seek for the company) the value inherent in any market discount.

Fortunately for distressed debtors and the holders of its debt (and the persons advising them), there is an important exception to the general market-value rule laid out by the Delaware Chancery Court in Vision Hardware. In that case, the court determined that there are limited circumstances when it is appropriate to use the face value rather than the market value of the debt. These circumstances may be found to exist when a company is on the 'brink of bankruptcy' and, accordingly, has 'no means to seize any of the value represented by the discount of its debt.' In re Vision Hardware Group Inc., 669 A.2d at 679.

As discussed in more detail in Part Two of this article (appearing next month), in order to claim the benefits of this exception, one must demonstrate that a debtor is on 'the brink of bankruptcy' through a showing that the debtor is: 1) facing insolvency, 2) in likely default on its obligations and 3) simply unable to refinance its own debt.

In next month's conclusion of this article, we discuss practical steps to avoid paying old equity that is truly 'under water.'

Michael J. Sage and Mark E. Palmer are partners in the New York office of Stroock & Stroock & Lavan LLP in the Financial Restructuring Group. The authors gratefully acknowledge Douglas Mintz, an associate in Stroock's Financial Restructuring Group, for his assistance in editing and researching matters addressed in this article.

First of a Two-Part Article

In certain cases, a company may seek to exchange its outstanding debt for equity while also extinguishing (or 'squeezing-out') the interests of some or all of its prior shareholders. The need to reduce or eliminate shareholders typically stems from perfectly valid business reasons, including a desire to avoid becoming a reporting company under federal securities laws, to limit ongoing obligations to many small shareholders or to change the equity sponsor. In addition, the parties may seek to effect the transaction 'out-of-court' due to a perception (or the reality) that bankruptcy proceedings would take longer or damage the business.

One commonly used non-bankruptcy mechanism to eliminate shareholders and to vest ownership with the holders of exchanged debt is a statutory cash-out merger. Other mechanisms, such as pre-exchange or post-exchange reverse splits, although on their face attractive, may be more trouble than they are worth. Such mechanisms will not avoid the basic obligation to pay 'fair value' for fractionalized shareholders, some of the increase in equity value resulting from debt cancellation. For these reasons, as well as the accepted protections found in statutory mergers, a merger's certainty might be preferred. Although the cash-out merger is relatively straightforward, its use creates unique issues that necessitate specialized structuring. One such potentially costly issue is the impact of statutory shareholder appraisal rights after the transaction. If mismanaged or overlooked at the structuring stage, these appraisal rights can result in an intrusive court process and in significant payments to prior shareholders. Notwithstanding the potential cash outlay, the issue of appraisal rights risks being overlooked for two reasons: First, it seemed obvious to all involved that the old equity has no value and is clearly 'under-water.' Second, the question was delegated to the company's counsel whose focus was on matters that directly affect existing officers, directors and shareholders (such as signing, closing and releases) and not on matters with post-closing consequences only to new ownership. Experience shows that, due to misaligned incentives, other issues may be 'glossed over' by the company's counsel. For example, Board approval for the merger may be treated as a purely 'technical' matter even though Delaware courts can be unforgiving and deny important Business Judgment Rule protection to directors who do not inform themselves and discuss alternatives in an actual meeting when approving the merger. As a seemingly basic but sometimes ignored rule of thumb: Have the meeting and document legal and financial advice and other material factors considered. Since former directors may be indemnified, the new owners should demand this simple act of compliance and risk management.

As described below, counsel for the holders of debt can add significant value for their clients by simply applying a little attention to the appraisal rights issue, and structuring and documenting the transaction. In so doing, the parties can avoid the pitfall of an unintended value transfer and unwieldy post-transaction proceeding. What follows below is a brief summary of the Delaware law on appraisal rights, and a review of how to structure a cash-out merger to facilitate the debt-for-equity exchange, eliminate some or all prior shareholders and reduce the risks of additional post-transaction payouts.

'Fair Value' Appraisal

'Fair value' appraisal is the remedy for dissenting stockholders squeezed out of Delaware companies.

The Delaware General Corporate Law (DGCL) provides a statutory basis for cash-out mergers that extinguish some or all minority stockholders. See Del. Code Ann. Title 8, ” 251-254, 257, and 263. The applicable statutory language allows cash to be used as consideration in a merger transaction, thus extinguishing the minority stockholders' rights to continue as stockholders. See Del Code. Ann. Title 8, ' 251(b), 252(b), 253(a), 254(c), 257(b), and 263(b). Consummating such a merger will trigger appraisal rights under ' 262 of the DGCL, which provides that stockholders dissenting to the merger are entitled to an 'appraisal by the court to determine the fair value of the stockholders' shares.' See In re Appraisal of Ford Holdings, Inc. Preferred Stock, 698 A.2d 973 (Del. Ch. 1997). Note that appraisal rights are generally not an exclusive remedy and that there are additional claims plaintiffs may have for breach of fiduciary duties and other matters. One notable exception is Delaware 'short-form' mergers with 90% stockholders, in which event recent case law provides that a robust statutory appraisal proceeding is now the exclusive remedy for claims arising out of a cash-out merger where there is no fraud or illegality. See Glassman v. Unocal Exploration Corporation , 777 A.2d 242 (Del. 2000).

Establishing 'Fair Value'

In an appraisal action, the only litigable issue is the 'fair value' of the dissenting stockholders' shares on the date of the merger. Cede & Co. v. Technicolor , Inc., 542 A.2d 1182, 1186 (Del. 1988). The DGCL itself provides little guidance on how to calculate fair value. However, in Weinberger v. UOP, the Delaware Supreme Court ruled that courts should broadly consider 'any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.' 457 A.2d 701 (Del. 1983), at 712-713. Following this broad mandate, the Delaware courts have employed many different methodologies to determine fair value in an appraisal proceeding, including commonly used discounted cash flow and comparable company analyses.

The Time 'Fair Value' Is Set

Timing exactly when 'fair value' is calculated is a deceptively important matter, especially when the transaction being considered is a balance-sheet reorganization that could result in an alteration of value of the company's equity. Section 262(h) of the DGCL provides that 'the court shall appraise the shares, determining their fair value exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation.' Although the statute's language might seem to imply that no value from the transaction should be considered, courts interpret this provision as applying to synergies and other remote possibilities and as setting the exact time for calculating fair value at just before the consummation of the merger, giving rise to the appraisal right. See Cede & Co.v.Technicolor, Inc., 684 A.2d 289, 296 (Del. 1996) and Allenson v. Midway Airlines, 2001 WL 811971 (Del. Ch. July 9, 2001) (stating that where value is contributed post-merger, ' 262(h) and Cede IV proscribe the inclusion of the value in determining fair value at the time of the merger).

As a corollary, courts maintain that any value creation from events occurring prior to the technical effectiveness of the merger may be considered when determining fair value. See Allenson, 2001 WL 811971 ('In a two-step merger, to the extent that value has been added following a change in majority control before cash-out, it is still attributable to the going concern ' [V]alue added to the going concern by the 'majority acquirer,' during the transition period of a two-step merger, accrues to the benefit of all shareholders and must be included in the appraisal process on the date of the merger ' That narrow exclusion [of elements of value arising from the accomplishment or expectation of the merger] does not encompass known elements of value, including those which exist on the date of the merger because of majority acquirer's interim action in a two-step cash-out transaction.' (quoting Cede, 684 A.2d at 299).

Therefore, practitioners should take careful note that attention must be paid to the exact legal timing of actions that could alter the value of the company either prior to or after technical effectiveness of the merger.

Valuing the Exchanged Debt

For appraisal purposes, that old equity may not be so 'under-water' after all. Regardless of the valuation methodology employed to determine the value of the enterprise, it is settled law that the value of any debt outstanding immediately prior to the effectiveness of the merger must be subtracted from enterprise value to arrive at 'fair value' in a Delaware appraisal action. See e.g., Borruso v. Comm. Telesystems Int'l , 753 A.2d 451 (Del. Ch. 1999) (the value of the debt is subtracted from the enterprise value derived from a Comparable Company analysis to determine the 'fair value'); Kleinwort Benson Ltd. v. Siglan Corp., 1995 WL 376911 (Del. Ch. 1995) (the value of the debt is subtracted from the enterprise value derived from a DCF analysis to determine 'fair value'); Rapid American Corp. v. Harris , 603 A.2d 796 (Del. 1992) (the value of the debt is subtracted from the enterprise value derived from a Comparable Company analysis to determine the 'fair value'); and In re Vision Hardware Group , 669 A.2d 671 (Del. Ch. 1995) (the value of the debt is subtracted from the enterprise value derived from a DCF analysis to determine 'fair value').

It is notable that, in Rapid American Corp. and In re Vision Hardware Group, the parties acknowledged that the debt was to be deducted, with the sole issue being exactly what was to be the measure of so-called 'value' of that debt.

What is not inherently obvious, however, is exactly how one determines that value for the calculation. And in the case of distressed debtors, the issue can be more precisely stated as follows: Which measure is proper, the face value or the discounted market value of the debt? Advisors and creditors alike should note that, because distressed debt often trades at a significant discount to face value, the choice of face or market value could have a significant impact on the equity value of a debtor and, therefore, the fair-value payments in an appraisal proceeding.

Although it may seem initially counterintuitive, Delaware courts have adopted a general rule that market value, not the face value, is the proper measure of the value of the debt to be subtracted from enterprise value when calculating fair value. Rapid American Corp., 603 A.2d at 804.

Accordingly, as a general matter and often to the consternation of distressed debt holders, the Delaware courts have placed a right in the hands of dissenting stockholders to claim for themselves (and perhaps a burden on Boards of Directors to seek for the company) the value inherent in any market discount.

Fortunately for distressed debtors and the holders of its debt (and the persons advising them), there is an important exception to the general market-value rule laid out by the Delaware Chancery Court in Vision Hardware. In that case, the court determined that there are limited circumstances when it is appropriate to use the face value rather than the market value of the debt. These circumstances may be found to exist when a company is on the 'brink of bankruptcy' and, accordingly, has 'no means to seize any of the value represented by the discount of its debt.' In re Vision Hardware Group Inc., 669 A.2d at 679.

As discussed in more detail in Part Two of this article (appearing next month), in order to claim the benefits of this exception, one must demonstrate that a debtor is on 'the brink of bankruptcy' through a showing that the debtor is: 1) facing insolvency, 2) in likely default on its obligations and 3) simply unable to refinance its own debt.

In next month's conclusion of this article, we discuss practical steps to avoid paying old equity that is truly 'under water.'

Michael J. Sage and Mark E. Palmer are partners in the New York office of Stroock & Stroock & Lavan LLP in the Financial Restructuring Group. The authors gratefully acknowledge Douglas Mintz, an associate in Stroock's Financial Restructuring Group, for his assistance in editing and researching matters addressed in this article.