On December 14, the Delaware Supreme Court issued its much-anticipated opinion in the appraisal proceeding from the 2013 acquisition of Dell Inc.[1] Along with August’s DFC Global opinion,[2] the court’s pronouncements in Dell will have lasting effects on the way that appraisal valuations play out for years to come. In particular, the case(s) will have a durable impact on (a) how courts weigh competing financial methodologies for assessing fair value, (b) how to scrutinize the bidding process and procedures, and (c) whether courts should distinguish among strategic bidders, financial bidders, and management bidders in making fair-value assessments.

The dispute in the Dell case goes back to the $25 billion private-equity financed management buyout (MBO) of the personal computer manufacturer, orchestrated by its founder (and 15 percent shareholder) Michael Dell and sponsored by Silver Lake Partners. The deal attracted widespread attention, not only because of its size but also because Dell was an iconic (though struggling) American company whose celebrity founder and CEO was going all-in to turn around its prospects.  Long before the MBO, the atrophying market for PCs left Dell in a midlife crisis, causing it to chase increasingly daring opportunities to pivot (including several acquisitions of enterprise software firms). Analysts and investors remained unimpressed by these moves, however, with few willing to sign on to Mr. Dell’s persistently sanguine divinations about the company’s long-term prospects. Frustrated by the market’s skepticism, Mr. Dell ultimately found an investor who wholeheartedly concurred with his views: Mr. Dell himself, via an MBO.

He set about recruiting several sponsors for the deal, eventually partnering with Silver Lake. Significantly, Dell’s key strategic competitors—such as Hewlett-Packard—never became active bidders, and the field of financial bidders quickly shrank to Silver Lake and a few other private equity players. (Carl Icahn briefly entered the mix as well, proposing a leveraged recap of Dell with no acquisition.)  Ultimately, the Silver Lake MBO proposal was the last one standing, offering a cash bid of $13.75 per share (worth slightly more after adjusting for anticipated dividends), and representing a 37 percent premium.  The proposed deal was subsequently approved by 57 percent of Dell’s shareholders.[3]

Several dissenters perfected their appraisal rights under Delaware law – a statutory process permitting them to eschew the financial terms of the merger in favor of a judicially determined appraisal of fair value, taking into account “all relevant factors.” This action ensued, occupying the good part of three years before Vice Chancellor Laster (VCL) of the Delaware Chancery Court. As has come to be the norm in such cases, the opposing sides offered wildly divergent accountings of fair value, with the petitioners’ expert proffering an estimate of $28.61 per share and the respondent’s expert countering with $12.68. This process ultimately culminated in VCL’s 2016 opinion[4] awarding dissenters an appraised value of $17.62 per share (plus statutory interest).

Although the court’s statutory discretion in appraisal is broad, VCL based the opinion wholly on his own hybridized discounted cash flow (DCF) valuation of the company, which he assembled from components of the expert reports. VCL accorded no weight to either the deal price or Dell’s pre-announcement market price. He reasoned that in private equity deals—particularly those that involve a motivated MBO bidder—market prices can fall prey to severe information problems, whereby bidders rationally economize on their bids, fearful that outbidding the others (particularly the management team) is a telltale sign they overpaid—the so-called “winner’s curse.” Finding such concerns present here, VCL opted to give 100 percent weight to his DCF valuation.

In Thursday’s unanimous opinion, the court substantially reversed this decision, under the (traditionally lenient) “abuse of discretion” standard. Specifically, Justice Valihura’s opinion held that the Vice Chancellor’s complete reliance on DCF was against the weight of the evidence and sound financial principles.[5] In addition, the Supreme Court’s analysis marched through several other technical issues with the Chancery Court’s DCF analysis, affirming some and reversing others. While these ancillary issues are of some interest, make no mistake: Dell v. Magnetar will be most remembered for its “hard look” at the Chancery Court’s putative discretion in evaluating and weighing validation methodologies and process considerations.

Justice Valihura’s opinion acknowledged that valuation is not an exact science and that the Chancery Court has significant discretion in formulating an appraisal fair value: “There may be no perfect methodology for arriving at fair value for a given set of facts, and the Court of Chancery’s conclusions will be upheld if they follow logically from those facts and are grounded in relevant, accepted financial principles. ‘To be sure, fair value does not equal best value’.” (pp 36-7, quoting DFC Global) Nevertheless, the court held, the Chancery Court’s discretion over valuation comes with an important caveat: “But, whatever route it chooses, the trial court must justify its methodology (or methodologies) according to the facts of the case and relevant, accepted financial principles.” Applying this test here, the court found VCL’s opinion wanting, writing “we reverse because there is a dissonance between the key underpinnings of the decision to disregard the deal price and the facts as found, and this dissonance distorted the trial court’s analysis of fair value.” (p 38)

In particular, the opinion singles out several elements of dissonance on which to base its reversal:

• The Chancery Court concluded that there was a valuation “gap” between the company’s pre-bid stock price and intrinsic valuation, due in part to myopic short-termism among the “price-setting” shareholders. The court found this inconsistent with evidence that Dell’s stock seemed to be traded in an efficient market.  The opinion spends considerable time discussing how the Dell stock price reacted quickly to news and investors had long known about the company’s attempts to sell.  Effectively, the court found that Dell’s price was determined in a capital market that was “semi-strong” efficient, and that the price routinely reflected all publicly available information.
• The Chancery Court also had found that the participation of only financial bidders in the process depressed bidding, casting doubt on the integrity of the deal price. The Supreme Court was unwilling to make that inference, holding that absence of strategic bidders does not ipso facto imply that the price is suspect, particularly when (as here) strategic bidders were solicited but ultimately did not bid
• The Chancery Court also held that special considerations pertaining to MBOs make the deal price particularly questionable, since one bidder is inherently better informed than others, and will have the critical services of the incumbent manager locked up. Once again, the Supreme Court was unpersuaded on several grounds. First, it found that the go-shop in this instance was adequate for the task of encouraging other bidders to stay in the process. Second, while the court acknowledged that an informed bidder can exacerbate winner’s curse problems (e.g., p 56), appropriate due diligence procedures are an adequate response, and in this case the due diligence process was comprehensive. Finally, the court found that Mr. Dell’s inherent value to the company was perhaps not as central to other bidders as petitioners asserted, since several competing bidders did not envision retaining him should their bids prove successful.

In the end, Justice Valihura’s opinion found that factors related to market and deal price deserved at least some weight alongside DCF in the trial court’s reckoning: “There is no requirement that a company prove that the sale process is the most reliable evidence of its going concern value in order for the resulting deal price to be granted any weight.” (p 60)

The Supreme Court then proceeded to analyze the Vice Chancellor’s DCF calculation, though here it is fair to say that the critiques were largely minor and technical.  Most concerned tax adjustments in both free cash flow estimates and discount rate assumptions. The court affirmed Vice Chancellor Laster’s decision to use effective tax rates rather than marginal tax rates to compute the weighted average cost of capital, holding that it was a reasonable exercise of discretion.  It reversed on the tax treatment of overseas free cash flows, holding that on remand the Chancery Court should attempt to estimate the actuarial effects of repatriation on such cash flows (rather than simply apply the same effective tax rates).  Lastly, the opinion upheld the Chancery Court’s decision to credit Dell with only a $650 million contingent liability against fair value notwithstanding the fact that, following GAAP, the company had set aside a much larger amount (around $3 billion).  Here, the court emphasizes that GAAP accounting and fair valuation are not identical, and that the latter must also account for the probabilities that the liability will ever be recognized.

Finally, the court addressed the allocation of lead plaintiff expenses, where VCL had held that the statute required the remaining petitioners to divide them pro rata.  The issue had become sensitive, because the largest appraisal petitioner, T. Rowe Price, had been dismissed from the case but nonetheless extracted a significant settlement on the basis of the appraisal award, leaving a much smaller class of petitioners to foot the bill. Here the court reversed, finding that the statute did not preclude requiring T. Rowe to pay its fair share, and noting that the purpose of the statutory fee allocation formula (preventing free riding) should also prevent opportunism by a party who would seek to reap the benefits of an attractive settlement.

When the dust finally settled, Justice Valihura remanded the case back to the Court of Chancery to render an opinion consistent with (a) the Supreme Court’s holding, and (b) the Chancery Court’s continued broad discretion in selecting and fashioning an appraisal valuation methodology.   How VCL reconciles the obvious tension between these two instructions will no doubt prove interesting.  Effectively, it appears that the Vice Chancellor is free on remand to use his equitable discretion to find fair value but in a manner consistent with the evidence in the case—evidence that the court clearly believes warrants putting positive weight on deal price (if not also market price).

Although legal scholars and pundits will debate this doctrinal moment for years to come, the following five observations warrant special notice:

1. Judicial Review with Bite: Read together, Dell and DFC Global clearly suggest that the Chancery Court’s room to maneuver is not as capacious as the “abuse of discretion” standard seems to suggest. Even though the Supreme Court acknowledged some of the very same categorical concerns identified by VCL (such as the “winner’s curse” in MBOs), the opinions (and particularly Dell) signal a likely pull-back in the historically deferential standard of review. The Chancery Court retains nominally broad discretion to divine fair value in whatever way it sees fit, but now—much like the canonical algebra student—it is required to “show its work.”
2. Financial-Bidder Carve-Out: Second, the Chancery Court’s distinction between “financial bidders” and “strategic bidders” ultimately proved to be an impediment to analysis. As is typical among private equity bidders, Silver Lake demanded a large “hurdle rate” before it would make an equity investment from its limited partners’ funds. While one can be justifiably skeptical about whether such LBO valuations always deliver fair market values, such skepticism need not be warranted when there is competitive bidding among motivated buyers. Somewhat counter-intuitively, in fact, as to the threat of appraisal, auction theory tends to point in the opposite direction—i.e., for weaker appraisal rights: Unlike strategic bidders, financial bidders are typically thought to have highly correlated valuations over the target company’s assets, a concern that can spawn “winners curse” problems, with bidders worrying that winning the auction means they have bid too much for the target.  In such settings, rational bidding can prove tepid, which in turn can affect prudent auction design. A well-known insight from the economics literature is that a seller in a common-values auction should impose a lower reserve price on opening bids, so as to induce greater participation by and learning among bidders as the auction unfolds.[6]  Thus, to the extent that the appraisal plays the role of a type of “reserve price” in an auction, there may be sound economic reasons for relaxing that reserve price in financial-buyer auctions.
3. Semi-Strong Efficiency and Pricing: Although the Supreme Court’s opinion makes much of the fact that Dell’s stock was traded in an efficient market, the import of this observation becomes increasingly unclear as the remainder of the opinion unfolds. Although Justice Valihura initially hints that efficient pricing means that the target’s pre-deal trading price should also receive valuation weight, she never closes the loop on this issue. There may be good reason for such cautiousness: In corporate finance, the presence of semi-strong efficient capital markets is usually thought a precondition for deploying the Capital Asset Pricing Model to do DCF valuation; it is not typically grounds for discounting such approaches. Moreover, efficient market prices are simply expectations about the future; and thus, if market participants expect that, say, a founder and block shareholder is going to stonewall an otherwise lucrative business plan, the efficient market price will reflect that anticipated agency cost.  But that does not necessarily mean that such minority discount concerns should affect the appraisal value.
4. Process Matters: Fourth, Dell makes clear that the Supreme Court’s appraisal jurisprudence implicitly encourages parties to use “best practices” that will provide structural protection for public shareholders—an effort that began as far back as Weinberger v. UOP.[7] After Dell, one can safely assume that courts will focus even more intently on whether the merger price emerged from a robust and value-maximizing deal process. This finding is likely consistent with economic theory, since a robust bidding process with significant disclosure and participation can often substitute for strong dissenters’ rights.  As this trend unfolds, it suggests that appraisal proceedings may start migrating away from valuation methodologies and towards principles of optimal market and auction design.  While this development has advantages, it comes with a significant practical drawback: As a sub-discipline of financial economics, auction theory is far more technically demanding than discounted cash flow analysis.  As one of us has  noted elsewhere,[8] over the last three decades of Revlon-doctrine litigation, Delaware courts have gone to great measures to avoid having to confront and adjudicate difficult arguments over auction design, deliberately loading more of the work onto DCF valuation. To the extent that this course is about to reverse (at least in appraisal cases), the technical demands on lawyers, experts, and judges may become even harder.
5. Fiduciary Duties: Finally, this decision will spark considerable discussion about how appraisal jurisprudence relates to Delaware’s common law of fiduciary duties. For example, might the progressively more deferential view the court has taken to Revlon claims carry over to appraisal jurisprudence, where a good process is now key to establishing the primacy of merger price? In addition, the constraints imposed by Corwin v. KKR Financial Holdings[9] on post-closing damages proceedings arguably pushed more litigation activity into appraisal. How would a court approach deal price in appraisal when the triggering transaction “was approved by a fully informed, uncoerced vote of the disinterested shareholders,” so that under Corwin, the business judgment rule applies? Answering these questions requires one to determine whether appraisal rights and fiduciary rights are (or should be) complements or substitutes to one another.  Although appraisal is a statutory right (at least in theory), Dell seems at least in part consistent with a raft of recent cases where the court appears to be reacting to a perceived flood of opportunistic merger litigation.

ENDNOTES

[1] Dell v. Magnetar et al., Case No. 565, 2016 (Del. Sup. Ct. Dec.  14, 2017).

[2] DFC Global Corporation v. Muirfield Value Partners, L.P., et al., C.A. No. 10107 (Del. Aug. 1, 2017).

[3] This approval percentage is biased downwards by the decision of Mr. Dell to vote his 15 percent interest in proportion to the vote of disinterested shareholders.

[4] In Re: Appraisal of Dell Inc., C.A. No. 9322-VCL (Del. Ch. 2016).

[5] Although it often plays a role in appraisal calculus, comparable companies analysis did not figure into this case in any extensive way.

[6] See Choi, Albert, and Eric Talley. 2017. “Appraising the ‘Merger Price’ Appraisal Rule.” SSRN: https://ssrn.com/abstract=2888420.

[7] 457 A.2d 701 (Del. 1983) (rejecting the old Delaware “block” method, and ushering in the modern practice of allowing for “proof of value by any techniques or methods which are generally considered acceptable to the financial community”).

[8] For elaboration on this point, see Talley, Eric. 2017. “Finance in the Courtroom: Appraising Its Growing Pains,” in Delaware Lawyer 35(2): 16-19 (Summer 2017).

[9] 125 A.3d 34 (Del. 2015).

This post comes to us from Eric Talley, the Isidor and Seville Sulzbacher Professor of Law, and Jeffrey Gordon, the Richard Paul Richman Professor of Law, both at Columbia Law School.