DE Supreme Court Clarifies Role of Deal Price In Appraisal Fair Value Determination

Corporate practitioners have been closely following developments in Delaware's shareholder appraisal litigation. Much of the interest concerns the court's “fair value” determination and the risk that an acquiring company will have to pay appraisal petitioners more than the merger deal price, even in an arms-length transaction resulting from a robust market search. In a much-anticipated decision, the Delaware Supreme Court reversed the trial court's fair value determination in DFC Global v. Muirfield Value Partners, No. 518, 2016 (en banc Aug. 1). The court's opinion provides valuable guidance about the relative importance of the deal price in the court's adjudication of the “fair value” of a petitioner's shares.

Background

DFC Global was a payday loan company that was acquired and taken private in 2014 by Lone Star, a private equity firm. Formed in 1990 with operations solely in the United States, DFC grew rapidly through acquisitions to become a worldwide business operating in 10 countries with more than 1,500 locations. It also had an Internet lending business. It became a public company in 2004, and in the next 10 years grew its revenue from $270 million to $1.12 billion. Its shares traded on the NASDAQ exchange, and it had a deep public float.

Facing headwinds from increasingly stringent industry regulations in Canada, the UK and the United States, DFC engaged a financial advisory firm in 2012 to help sell the company. Between 2012 and 2014, the adviser reached out to 35 financial sponsors and three strategic buyers. Eventually, three interested parties emerged and engaged in due diligence. During the diligence period, DFC lowered its earnings projections and the bidders lowered their bids or dropped out. In April 2014, the board approved a merger with Lone Star at $9.50 per share.

The DFC dissenting stockholders who petitioned for appraisal relied on a discounted cash flow model to argue that DFC's fair value was $17.90 per share. DFC, on the other hand, contended at trial that the fair value was $7.94 per share based on equally weighting a discounted cash flow valuation of $7.81 and a comparable companies analysis of $8.07. DFC also argued that the deal price of $9.50 was a reliable indication of fair value.

Following a valuation trial, Chancellor Andre G. Bouchard determined that the fair value of the appraisal petitioners' shares was $10.21 per share. The court arrived at this value by giving equal weight to three inputs: $13.07 from a discounted cash flow analysis using inputs from both petitioners' and respondents' experts; $8.07 per share using DFC's comparable companies analysis, and $9.50 per share representing the deal price.

The trial court also found that the transaction resulted from a robust market search over a two-year period during which financial and strategic buyers had an open opportunity to buy without inhibitions from deal protections. The court, however, did not give more than one-third weight to the deal price for two reasons: because of uncertain regulatory developments, the market's assessment of the company's value was not as reliable as under ordinary conditions; and because the prevailing buyer was a financial buyer, it focused its attention on achieving a certain internal rate of return rather than on the company's fair value.

Discussion

On cross-appeals from both parties, the Supreme Court reversed and remanded providing guidance on several valuation matters:

The Delaware Supreme Court reaffirmed its 2010 holding in Golden Telecom v. Global GT LP, 11 A.3d 214 (Del. 2010, that Section 262(h) gives broad discretion to the Delaware Court of Chancery to consider “all relevant factors” when determining fair value, and that the appeals court must give deference to the trial court's determination if it has a reasonable basis in the record and in accepted financial principles.

The Supreme Court rejected DFC's argument that the court should revisit Golden Telecom and establish by judicial gloss a presumption that in certain cases involving arms-length mergers, the transaction deal price is the best estimate of fair value.

Although there is no presumption in favor of the deal price, the Supreme Court observed that the sale conditions found by the trial court suggest that the best evidence of fair value in this case was the deal price.

The Supreme Court recognized the relative superiority of market prices to other valuation techniques “because, unlike e.g., a single person's discounted cash flow model, the market price should distill the collective judgment of the many based on all the publicly available information about a given company and the value of its shares.” It went on to add that “a singular discounted cash flow model is often most helpful when there isn't an observable market price.”

The Supreme Court ruled that trial court's reservations about the reliability of the deal price based on uncertain regulatory conditions and because the acquirer was a financial buyer focused on achieving its own internal rate of return and financing constraints, were findings not rationally based in the record.

While the trial court has discretion to use different valuation methodologies and weight them, the court must explain the weighting in a manner supported by the record. The trial court's decision to give only one-third weight to the deal price because of these factors was not supported by the record.

Takeaway

Although the Delaware Supreme Court resisted calls to presumptively equate the deal price with fair value in arms-length transactions characterized by a competitive sales process, it expressly acknowledged that “the sale value resulting from a robust market check will often be the most reliable evidence of a fair value.” Further, it cited with approval seven previous cases where the Court of Chancery found the deal price to be the best evidence of fair value when it reflected the results of a nonconflicted open market check.

Conclusion

The decision erodes the primacy previously afforded the discounted cash flow valuation model, and will likely give pause to shareholders considering the merits of appraisal petitions when competitive open market conditions have characterized the transaction. Moreover, reliance on the fact that a private equity firm emerges as the successful bidder will no longer serve as a basis for disregarding the deal price as a reliable indicator of fair value as occurred in DFC and in the recent Dell appraisal decision. Nor will the argument that the company has elected an uncertain or inopportune time to sell as long as the market knows of the challenges.

P. Clarkson Collins Jr. ([email protected]) is a corporate governance and fiduciary litigation partner at Morris James in Wilmington, DE. This article also appeared in the Delaware Business Court Insider, an ALM sibling publication of this newsletter.