A Reality Check on the Appeal of the DFC Global Appraisal Case

A peculiar appeal is currently before the Delaware Supreme Court. The case involves the judicial appraisal of DFC Global, a company acquired by a private equity firm in 2014. Approximately 12 percent of DFC stockholders dissented, and the Court of Chancery found that the fair value of the company was $10.30 per share, slightly higher than the $9.50 transaction price that the board had negotiated. On appeal, DFC Global has asked the Delaware Supreme Court for a rule of law that the Court of Chancery must defer to the merger price in an arm’s length transaction where there was a “robust” sales process.

What is bizarre about the request from DFC Global is that the Court of Chancery already routinely defers to the merger price when the court is convinced that the sales process was thorough enough to generate a reliable price. Moreover, the court has developed a sophisticated and careful approach to determining when such deference is warranted. In the appraisal of Lender Processing Services, for example, the court examined, among other things, the level of competition among bidders before the deal was signed, the reliability of the information supplied to bidders, the lack of collusion between the company and bidders or favoritism to a particular bidder, and any post-signing developments that would materially increase or decrease the value of the firm. Existing law, in other words, supplies exactly what Delaware is known for: predictability for potential parties to a transaction and safeguards for non-controlling stockholders.

It is, therefore, a little difficult to say what rule of law the company is seeking. At trial, the Court of Chancery did not defer to the merger price for the simple reason that it was not convinced that the negotiated price fully reflected the fair value of the company. If the company is truly arguing on appeal that the court abused its discretion, then it is subtly asking for a major change in the law. Such a change would necessarily strip the Court of Chancery of its ability to evaluate and respond to the actual facts of the case and compel the court to award the deal price even when it has serious misgivings about the transaction.

This attempt to alter Delaware’s appraisal jurisprudence fits into a broader effort by a coterie of deal advisors to undermine appraisal rights and shield opportunistic transactions from judicial scrutiny. This effort has no basis in the available evidence, however. A recent paper by Wei Jiang of Columbia Business School and her co-authors, for example, noted that “[a]ppraisal petitions are more likely to be filed against mergers with perceived conflicts of interest, including going-private deals, minority squeeze outs, and acquisitions with low premiums, which makes them a potentially important governance mechanism.”

The reaction in Delaware to the increase in appraisal activity over the last five years has been sensible. The widely respected Corporation Law Council of the Delaware bar was charged with studying appraisal arbitrage for the Delaware legislature. In its resulting report, the council explicitly recognized the role of appraisal in protecting public company stockholders, noting that fiduciary duty litigation “may not be sufficient to ensure that the merger price reflects the fair value of the acquired shares.” This governance role for appraisal in public company M&A has august roots in Delaware. The architect of Delaware’s modern corporate law—Professor Ernest Folk—observed that “[a]ppraisal rights in the hands of ‘recalcitrant’ or ‘troublesome’ shareholders have, in the past, served as a countervailing power to force the insiders to tailor their plans to minimize the number of dissenters by getting the best deal possible.”

The council recommended only minor amendments to the appraisal statute as deterrents against nuisance suits. To the dismay of deal advisers, the council stuck to the evidence and declined to recommend a dramatic overhaul of appraisal mechanics or of the appraisal remedy more generally.

The DFC Global appeal invites the Delaware Supreme Court to make the kind of radical change that the council and legislature—following careful study—explicitly declined to make. And the chosen vehicle is a transaction that market participants greeted with suspicion.

The sale of DFC Global attracted criticism from the moment it was announced. The deal price was a mere 6 percent premium over the company’s unaffected stock price. One large holder immediately complained that the price was “absurdly low” and that the “process seemed to be geared to a single buyer in the absence of competition.” After reading the proxy statement, another substantial stockholder protested that DFC “did not run anything resembling a robust sales process.” A stock analyst suggested that the company’s Canadian subsidiary alone was worth nearly as much as the transaction price. The proxy advisor ISS recommended that stockholders vote against the transaction.

At trial, the Court of Chancery ultimately concluded that the sale process was not quite as bad as the critics had alleged. In fits and starts, the process plodded on for over two years, even if the final negotiation involved a ham-handed grant of exclusivity to the buyer. Also, there was no obvious self-dealing of the sort that would indicate a clear fiduciary breach.

The court, however, after considering the evidence presented at trial, manifestly did not have full confidence in the process. Among other things, it articulated a concern that the board had agreed to sell the company while in “turbulent regulatory waters that imposed considerable uncertainty on the company’s future profitability, and even its viability.”

This regulatory risk in the UK and U.S. was unique to the firm, and very real. But it would not have worried public equity investors. A central tenet of modern portfolio theory is that the expected return on a firm depends only on its systematic risk, its exposure to the risk of the market as a whole. Firm-specific or unsystematic risk of the sort facing DFC Global could be diversified away by public investors. Any merger transaction required abandoning a capital structure perfectly suited to bearing that firm-specific risk—public holdings by diversified investors—in favor of a far inferior capital structure: a concentrated equity position held by a single financial sponsor. Such a financial sponsor could not diversify away the firm-specific risk, and would necessarily have to discount for it.

The buyer was not alone in discounting for firm-specific risk. The directors and officers of DFC Global themselves held large, undiversified investments in the company.. They thus had a powerful incentive to offload the firm’s regulatory risk through a sale of the company, even at a discount to its value to diversified stockholders as a going concern. Notably, the CEO was at retirement age and owned nearly 3.4 percent of the company in stock and options. Had the company failed, it would have been a calamitous development for the CEO—but not for diversified public stockholders.

This suggests a serious conflict between DFC’s management and its other stockholders that may well have prompted the court’s skepticism of the transaction. Surprisingly, the role of this conflict in the transaction has received almost no attention in the appeal, even though Delaware case law has recognized this sort of conflict as a problem. For example, then-Vice Chancellor Leo Strine held in In re Lear that a CEO’s exposure to non-diversifiable risk at a time when he was worried about retirement generated a conflict. Strine observed that it was “silly” to ignore the possibility that CEO stock ownership in a risky firm could “create incentives that actually give managers reasons to pursue ends not shared by the corporation’s public stockholders.” Likewise, the CEO “had powerful interests to agree to a price and terms suboptimal for public investors so long as the resulting deal” secured the CEO’s personal financial objectives of cashing out his equity stake.

A related issue in the DFC Global appeal is that the deal’s private equity sponsor priced the company’s uncertain future differently than public markets would have. A similar issue has arisen in the appraisal proceedings involving Dell and PetSmart. The argument, briefly stated, is that the price paid by a private equity buyer in an LBO is not necessarily a reliable indicator of a firm’s value as a going concern, because the PE buyer will discount future cash flows at a rate equal to its target internal rate of return, which is almost always substantially higher than the company’s cost of capital. As a result, at least in the absence of competitive pressure from strategic bidders, the price paid by a PE buyer may be less than the value of the company as a going concern.

In PetSmart, the court suggested that the high IRR target of PE buyers would be offset by the greater post-transaction risks associated with their use of leverage. This is obviously true, and beside the point. The relevant question is not whether the PE buyer is getting some sort of free lunch or windfall, but whether the price paid is reflective of the value of the target firm as a going concern. And it will frequently be the case that a company will have a lower cost of capital—and, consequently, a higher value—as a public company with an equity base of diversified stockholders, rather than a single, undiversified, highly-leveraged owner. The efficient sharing of firm-specific risk is one of the crowning achievements of public equity markets.

At the very least, given the regulatory uncertainty that faced DFC Global—of minimal concern to ordinary, diversified investors, but a serious threat to the concentrated insiders and private equity sponsors—the Court of Chancery may rightfully have been suspicious of the decision to sell in the first place. The court’s conclusion—that the fair value of the stock was slightly higher than the price the board negotiated—is entirely consistent with that suspicion.

A virtue of Delaware law is that it affords the Court of Chancery the latitude to make precisely that sort of reasoned determination based on the trial record. As Eric Talley of Columbia Law School has noted, a workable bright-line rule for such cases is a mirage. In many ways, DFC Global is an example of a case where appraisal can serve a valuable governance purpose: where conflicts and mistakes appear likely to have harmed stockholders, but where the blunderbuss of personal liability for fiduciary breach may be too blunt. It would be an error to accept DFC Global’s invitation to tie the Court of Chancery’s hands in future cases in a misguided effort to turn appraisal into an ersatz form of fiduciary liability.

This post comes us from Professor Charles R. Korsmo at Case Western Reserve University School of Law and Professor Minor Myers at Brooklyn Law School. They are the principals of Stermax Partners, which provides compensated advice on stockholder appraisal and manages appraisal-related investments, and they have economic interests in the outcome of appraisal proceedings. They have no economic interest in the outcome of the DFC Global proceeding.