4/15/2015
Valuation Issues in Shareholder
Disputes resolved by the
Delaware Court of Chancery
1
ERIC M. ANDERSEN, ESQUIRE, CPA
ANDERSEN SLEATER LLC
[email protected]
3513 Concord Pike
Suite 3300
Wilmington, DE 19803
(302) 595-9102
1345 Avenue of the Americas
2nd Floor, Suite 2100
New York, NY 10105
(212) 878-3697
Agenda
2
1.
2.
3.
4.
5.
6.
Delaware Court of Chancery
Outside of Delaware
When is Fair Value Measured?
Timing of Payment to Dissenting Shareholders
Valuation Guidance by Delaware
Pending Proposals to Change Delaware Appraisal
Statutes
1
4/15/2015
Delaware Court of Chancery
3
 Exclusive Forum to Determine Dissenter’s Rights for
a Delaware corporation
 Large amount of case law regarding valuation
 Chancellor or Vice Chancellor must independently
perform his own valuation
Dissenter’s Rights
4
 Focus of this Presentation
 Not necessary to accuse the board of any wrongdoing
 Must give notice of intent to demand appraisal
before Merger Vote
 Interest runs at 5% plus the federal discount rate
compounded quarterly from close of transaction
 Permitted to Dissent for Shares Purchased After
Transaction Announcement
2
4/15/2015
Class Action
5
 Shareholder accuses board of directors of target
corporation that they breach fiduciary duties when
they approved merger
 Represents all outstanding shares if class
certification is granted
 Damages not awarded unless court finds breach of
the duty of loyalty or good faith
 Must own shares before merger announcement
6
OUTSIDE OF DELAWARE
3
4/15/2015
Triggering Events
7
Although discussions of appraisal rights usually arise
in the context of mergers, in most states, shareholders
are entitled to appraisal rights on a host of other
extraordinary transactions such as significant asset
sales, charter amendments and corporate
conversions/domestications.
Transformative Transactions
8
In Delaware, transactions that may be the economic
equivalent of a merger do not trigger appraisal rights.
But, in other jurisdictions including Virginia, Texas
and New York, many other extraordinary transactions
on which shareholders are required to vote, including
dispositions of substantially all of the assets as well as
certain charter amendments, also give rise to appraisal
rights.
4
4/15/2015
Acquirer Shareholders
9
 In a few states, including Ohio, acquirer
shareholders may also be entitled to dissenters’
rights in connection with majority share acquisitions
and combinations involving the issuance of a
significant percentage of the buyer’s shares.
 For example, in the 2005 stock for stock acquisition
of Gillette, a Delaware corporation, by Ohio
incorporated Procter & Gamble, P&G’s issuance of
more than 30 percent of its shares to Gillette holders
constituted a “majority share acquisition” entitling
P&G shareholders to dissent.
Acquirer Shareholders
10
 Target Gillette shareholders did not have appraisal
rights because of the market-out exception in
Delaware
 Acquirer P&G shareholders could dissent.
 The parties addressed the resulting risk by
conditioning the deal on no more than 5 percent of
P&G’s shareholders exercising dissenters’ rights,
which was met and the transaction closed as
planned.
5
4/15/2015
Market-Out Exception
11
 Even if an extraordinary corporate transaction
triggers appraisal rights, a shareholder of a public
company may not be entitled to appraisal rights if
the target’s state provides for a “market-out”
exception to appraisal.
 The public markets serve as an independent check
on valuation, removing the need for a court’s
determination of fair value.
Market-Out Exception
12
 In Delaware, if a target shareholder holds publicly
traded stock, then the shareholder is not entitled to
appraisal rights (unless the shareholder is required
to accept in the merger any consideration other than
publicly traded stock).
 In some states such as New York and New Jersey,
the “market-out” exception applies even if the public
company target shareholders receive cash in the
merger.
6
4/15/2015
Maryland – Triggering Events
13
 Stockholders of any Maryland corporation have the
right to demand and to receive payment of the fair
value of their stock in the event of





(1) a merger or consolidation
(2) a share exchange,
(3) a transfer of assets,
(4) a charter amendment altering contract rights of
outstanding stock (unless the right to do so is reserved in the
charter) or
(5) a business combination governed by Section 3-602 or
exempted by Section 3-603(b) (§3-202(a)).
Maryland –Market-Out
14
 The right to fair value does not apply if





(1) the stock is listed on a national securities exchange (unless the
transaction falls under §3-202(d) described below);
(2) the stock is that of the successor in a merger (unless the merger
alters the contract rights of the stock or converts the stock in whole
or in part into something other than stock, cash or other interests);
(3) the stock is not entitled, other than solely because of Section 3106, to be voted on the transaction or the stockholder did not own
the stock on the record date for determining stockholders entitled to
vote on the transaction;
(4) the charter provides that the holders of the stock are not entitled
to exercise the rights of an objecting stockholder; or
(5) the stock is that of an open-end investment company registered
with the Securities and Exchange Commission under the 1940 Act
and the stock is valued in the transaction at its net asset value (§3202(c)).
7
4/15/2015
T. Rowe Price Associates (2008)
Reverse Market-Out
15
 Maryland and Massachusetts reverse the “market-out”
exception in conflict or interested party transactions.
 Narrowed the “market-out” exemption in order to
provide appraisal rights to stockholders of an exchangelisted corporation that are receiving



cash (other than in lieu of fractional shares), or consideration other
than stock or depositary receipts of the successor,
in a merger, consolidation or share exchange in which the directors
and executive officers were the beneficial owners, in the aggregate, of
5% or more of the outstanding voting stock of the corporation at any
time during the prior year, and
the stock held by the directors and executive officers, or any of them,
is converted or exchanged in the transaction for stock of a person, or
an affiliate of a person, who is a party to the transaction on terms
that are not otherwise available to all holders.
Exception to the Reverse Market-out
16
 Compensatory Plan
 Reverse market-out provision does not apply when
the directors’ and officers’ stock is held in a
compensatory plan or arrangement approved by the
board of directors and the treatment of the stock in
the transaction is approved by the board (§3202(d)).
8
4/15/2015
17
TIMING OF PAYMENT TO DISSENTING
SHAREHOLDERS
Interest Rate Arbitrage
18
 Delaware awards dissenters the right to receive
interest (at 5 percent above the Fed discount rate) on
the fair value of their shares from the closing date
until the award is actually paid, irrespective of the
ultimate outcome of the appraisal proceedings — a
relatively meaningful arbitrage opportunity itself in
today’s low interest rate environment.
 The interest is meant to compensate the
shareholders for the fact that, if they exercise
appraisal rights, they do not receive any
9
4/15/2015
Interest Rate Arbitrage
19
 This accruing interest can also represent a significant
additional cost to the company, with the Court of
Chancery recently deciding in CKx that the Delaware
statute did not permit companies to prepay the
petitioner the deal price as a means of stopping the
accrual of interest on at least that portion of a
potential appraisal award.
Other States
20
 Many states such as Illinois, Massachusetts and
North Carolina have tried to remedy the cash flow
problem faced by dissenting shareholders by
requiring the corporation to pay upfront its estimate
of the fair market value for the dissenters’ shares
(with companies often choosing to pay the deal
price).
 Then, at the end of the appraisal proceedings, the
corporation must pay to the shareholder the excess
(if any) of the appraised fair value over the estimated
payment.
10
4/15/2015
Maryland
21
 Interest is award from the date which fair value is to
be determined. 3-211(c)(1)
 Exception: Dissenting shareholder failure to accept
offer from buyer was “arbitrary and vexatious” or
“not in good faith.” 3-211(c)(2)



Price which the buyer offered
Information Furnished to Stockholder
“Other circumstances [the Court] considers relevant.”
“Anti-Arb” Exception
22
 Under an “anti-arb” exception in Washington, the
company is not required to make the mandatory
down payment to any shareholders who acquired the
shares after the announcement of the deal, meaning
that such a post-signing buyer will be exposed to the
cash flow issue should they choose to later exercise
dissenters’ rights.
11
4/15/2015
23
When is Fair Value Measured?
Definitions of Value
24
 Treasury Regulations
 Fair Market Value: “the price at which property
would change hands between a willing buyer and a
willing seller when the former is not under any
compulsion to buy and the latter is not under any
compulsion to sell, both parties having reasonable
knowledge of the relevant facts.” (Treasury Reg.
20.2031-1(b); Revenue Ruling 59-60, 1959 1 C.B.
237)
12
4/15/2015
GAAP – Financial Reporting
25
Fair value: “the price that would be received to sell
an asset or paid to transfer a liability in an orderly
transaction between market participants at the
measurement date.” (ASC 820)
Revised Model Business Corporation Act
26
Fair value: “the value of the shares immediate before
the effectuation of the corporate action to which the
shareholder objects, excluding any appreciation or
depreciation in anticipation of the corporation action
unless exclusion would be inequitable.” (Revised
Model Business Corporation Act, 1984)
13
4/15/2015
State Comparison
27
 In Delaware, the court is tasked with appraising the
fair value of the company immediately prior to the
completion of the merger, which may be months
after the deal price was struck (but without giving
effect to any of the anticipated benefits of the
merger, such as synergies).
 By comparison, in California, the fair value for
dissenters is appraised as of immediately prior to the
announcement of the relevant transaction.
Delaware Definition
28
 “the Court shall determine the fair value of the
shares exclusive of any element of value
arising from the accomplishment or
expectation of the merger or consolidation,
together with interest, if any, to be paid upon the
amount determined to be the fair value.” – 8 Del. C.
§262(h)
14
4/15/2015
New York
29
 New York’s statute directs the court to measure as of
the close of business on the day prior to the date of
the shareholder vote but also to take account of the
impact on value of the transaction giving rise to the
appraisal remedy.
Maryland
30
 If merger is by a controlling shareholder with over
90% or more shares, then on day notice is given to
the shareholders. 3-202(b)(1)(i)
 Any other transaction, on the day the stockholders
voted on the transaction objected to. 3-302(b)(1)(ii)
 Fair value may not include any appreciation or
depreciation which directly or indirectly results from
the transaction objected to or from its proposal. 3302(b)(2)
15
4/15/2015
31
VALUATION GUIDANCE BY DELAWARE
Management’s Financial Projections
32
 Expert cannot accept without stress testing
 Historical Analysis
 Market Research
 Industries Studies
 Prepared in the Ordinary Course vs.
 For fairness opinion
 For litigation
 For getting loan from financial institution
16
4/15/2015
Discounted Cash Flow
33
 Primary valuation methodology if the company is
established and has a history of positive cash flow.
 If management cannot create projections that are
reliable, then a discounted cash flow is not
appropriate. Answers Corp. Shareholder Litigation.
Preferred Stock
34
 Conversion to Common Stock
 reducing per share value by increasing outstanding shares
 Liquidation Preference: If company is liquidated,
preferred stock takes first $25 million in proceeds.
Orchard Enterprises. Valuation was not permitted
to take into preferred stock conversion because a
liquidation never occurred i.e. hypothetical.
17
4/15/2015
Preferred Stock
35
 If preferred stock has a mandatory redemption at a
price and date that is certain, the valuation must
account for redemption rights. Shiftan v. Morgan
Joseph Holdings, Inc.
 If the preferred stock provision is hypothetical, then
those rights to do effect valuation of common stock.
 If the event will definitely happen sometime in the
future, then right must be included in valuation
analysis.
Transaction Price is Fair Value
36
 “Significant and atypical valuation challenges.” Huff
Fund Investment P’ship v. CKx, Inc.



no comparable companies
no comparable transactions
management’s projections are not reliable
 Court found that Merger Price is “Fair Value”
 Buyer was a third-party (arms-length)
 Sales Process in which all Potential Acquirers Were Contacted
for Interest
18
4/15/2015
Market Approach
37
 Because the Company did not have any earnings or
positive cash flow to perform a DCF, using last
twelve months revenue multiples for comparable
companies was appropriate. Nine Systems Corp.
S’holders Litig.
 “An expert valuation tends to be more credible when
it is based on a ‘blend of techniques’ that ‘serve to
cross-check on another’s results.”
Market Approach
38
 Using market approach is questionable when using
only one company as the comparable company.
AT&T Mobility Wireless Operations; IQ Holdings
Inc. v. American Commercial Line
 Also, questionable when


one company is not comparable; or
comparable transaction was done under significantly different
market conditions.
19
4/15/2015
Tax Affecting
39
 Application of Income Taxes to the Earnings of Flow-
Through Entity Such as an S Corp.
 Income tax consequences for an S Corp’s profits are
charged directly to the entity’s shareholders, unlike C
Corp’s where income taxes are paid at the entity
level.
 Tax affecting means that an appraiser reduces
earnings of the S Corp by the income tax
consequences, thereby making the after-tax earnings
of the S Corp more comparable to that of a C Corp,
where income taxes are paid at the entity level.
Delaware Approach to Tax Affecting
40
 Applying 40% corporate tax rate rejected because
minority group would be denied the value they
would have received as continuing S Corp
shareholders, because there was no evidence that the
company would convert to a C Corp.
 Applying no tax rate because it overstated the value
of the S Corp at the shareholder level, as upon its sale
an S Corp receives no premium over a C Corp from a
“universe” of C Corp buyers, and market-based
analysis using C Corp comparables is misleading.
20
4/15/2015
Delaware Approach to Tax Affecting
41
 To capture the precise advantage of the S Corp
structure to the minority shareholders, the court
considered the difference between the value that a
minority member would receive if the company was
a C Corp and the value received as an S Corp.
 The court “embraced” the leading Tax Court cases
(Gross, Heck and Adams), which have “given life to
the advantages of S corporation status by refusing to
tax affect the . . . earnings at all.”
Delaware Approach to Tax Affecting
42
 The court estimated what an equivalent, hypothetical
“pre-dividend” S Corp tax rate would be, assuming
annual earnings of $100 and highest marginal tax
rates. Delaware Open MRI Radiology Associates,
P.A. v. Kessler.
 Applied 29.4% effective tax rate to corporate
earnings.

to treat the S Corp shareholder as receiving the full benefit of
untaxed dividends, by equating its after-tax return to the afterdividend return to a C Corp shareholder.
 Taxed Dividends at 15%
21
4/15/2015
Tips for Experts
43
 Terminal Value - Growth into Perpetuity
 Preference for Gordon Growth Model
Cap Rate of projected earning in Year 6 (for 5 years of projections)
 Discounted Back to Year 0


Exit Multiple

Mixing and Matching Income and Market Approach
 Plans to Improve Cash Flow that are not Speculative
can be Included (e.g. expansions or acquisitions)
Tips for Experts (Cont’d)
44
 Court will review each company deemed
“comparable” of guideline companies
 Use discounted cash flow method when projections
are made by management in the ordinary course of
business.
 Delaware Chancery Court typically applies a control
premium to value indications derived from the
guideline public company methodology

Control premium should exclude the impact of synergies
22
4/15/2015
Tips for Experts (Cont’d)
45
 Do not apply a control premium to the value from
the Discounted Cash Flow method unless there are
special circumstances.
 Must have in-depth support for the application of a
company specific risk premium.
 Must support the selection of valuation multiples
with detailed financial analysis and consideration of
qualitative factors.
 Provide electronic copy of models so the Court could
manipulate based its rulings
Purpose of Management’s Creation of Projections
46
 Importance of management’s contemporaneously-
prepared projections (Merion Capital, L.P. v. 3M
Cogent, Inc.)
 Management’s projections created specifically for a
merger should not be accorded the same deference
as those prepared in the ordinary course of business
(Gerreald v. Just Care, Inc.)
23
4/15/2015
Proposed Expansion at Valuation Date
47
 Rejected a scenario including expansion into a new
market as being too speculative, because the
business did not have a history of expanding into
new markets and had not received an RFP for work
in the new market. Gerreald v. Just Care, Inc.
 Accepted a scenario including a new facility at a
center where the business already operated, had
previously expanded its operations, and had land
available for the expansion
 Due to the related uncertainty, the Court riskweighted the expansion case
Proposed Expansion at Valuation Date
48
 Included value from “specific expansion plans or
changes in strategy” that are “not the product of
speculation” Delaware Open MRI Radiology
Associates, P.A. v. Kessler,
 Same standard used when determining whether to
include acquisitions - Nine Systems Corp.
(standalone company did not have the capital to
fund either acquisition).
24
4/15/2015
“Comparable” Transactions or Companies
49
 “[R]eliance on a comparable companies or comparable
transactions approach is improper where the purported
‘comparables’ involve significantly different products or
services than the company whose appraisal is at issue, or
vastly different multiples” Appraisal of the Orchard
Enterprises, Inc.
 Expert’s comparable companies and transactions analyses
were unreliable due to, among other things,




Inclusion of companies with a significantly lower enterprise value,
Inclusion of companies that were not in a comparable industry,
Omission of companies the Court considered comparable, and
Lack of enough multiples to provide sufficient foundation for the
analysis. Merion Capital, L.P. v. 3M Cogent, Inc.,
50
Proposed Amendments to Appraisal
Delaware Statute Section 262
25
4/15/2015
Interest Reduction Amendment
51
 This amendment would provide an option for a
company in an appraisal proceeding to pay a cash
amount to the dissenting shareholders before the
appraisal proceeding ends (an “upfront payment”).
 Statutory interest would accrue thereafter only on
the unpaid portion of the ultimate appraisal award.
 The upfront payment would presumably be
nonrefundable, as there is no clawback mechanism
provided in the proposed amendment for a company
to recoup any amount paid out that turns out to have
exceeded the ultimate appraisal award.
De Minimis Amendment
52
 Appraisal petitions would be dismissed if the shares
seeking appraisal were traded on a national securities
exchange and


(a) the value of the merger consideration applicable to the shares
seeking appraisal is less than $1 million or
(b) the shares seeking appraisal represent less than 1 percent of the
total outstanding shares of the class entitled to appraisal rights.
 The threshold minimums would not apply in the case of
appraisal following a short-form merger (since appraisal
may be the only remedy available to dissenting
shareholders in a merger in which there is no stockholder
vote).
26
4/15/2015
“Weak” Appraisal Claims
53
 Those that are made with respect to transactions that
are unlikely to result in an appraisal award that is
significantly higher than the merger price.
 Currently, “weak” claims may be made simply based
on settlement value, calculated in large part as the
present value of the merger price plus the statutory
interest.
 Settled relatively quickly, the focus of these claims is
the additional amount provided by the interest
factor.
“Weak” Appraisal Claims
54
 Successor company may make a large upfront
payment (representing a significant percentage of
the merger price), to attempt to reduce the economic
value of a weak appraisal claim.
27
4/15/2015
“Strong” Appraisal Claims Not Affected
55
 Those that are made with respect to transactions that
are likely to result in an appraisal award that is
significantly higher than the merger price.
 Court has awarded appraisal amounts significantly
exceeding the merger price in cases where there was
an interested party transaction without a robust sale
process
Upfront Payment Reduces Risk For Shareholder
56
 Upfront payments in appraisal cases would
significantly reduce the risks for petitioners
associated with bringing appraisal petitions.
 An upfront payment representing a large percentage
of the merger price would result in petitioners having
only limited capital at stake during the proceeding
(providing an opportunity for a highly leveraged yet
low-risk investment with the potential for outsized
returns on the limited capital invested)
 Use the upfront payment from the outset to fund
costs of the proceeding.
28
4/15/2015
Option for Upfront Payment Not Used
57
 Acquirer would be unlikely to make an upfront
payment if its cost of debt is equal to or greater than
the statutory interest rate, if the company is a credit
risk, or if the company believes the payment would
significantly facilitate or favor the petitioners’ case or
make reaching a settlement more difficult.
 Acquirer would not want to prejudice its argument in
the proceeding by making an upfront payment that
exceeds the amount it is arguing represents fair value
(even if the company believes that the appraisal
award will significantly exceed that amount).
29