Two recent Delaware Chancery Court decisions, In re Orchard Enterprises, CA No. 5713-CS (Del. Ch. July 18, 2012) and In re Synthes, CA No. 6452-CS (Del. Ch. Aug. 17, 2012), have reignited concerns regarding the Delaware Courts’ application of the legal principles of appraisal under Section 262 of the DGCL in a manner that substantially undermines a controlling stockholder’s ability to extract a control premium for its shares in a merger or, in a freeze-out transaction, to pay less for the minority shares than the value a third party might be willing to pay to acquire control. An examination of that issue also raises concerns regarding the tendency of the Delaware courts to treat fair value for purposes of appraisal as being identical to fair price under the entire fairness test (“The fairness of the Merger price is an analytical question ‘common to both the entire fairness and appraisal claims.’ For the purposes of fair value, I will address the claims as one . . .” In re Sunbelt Beverage at *6 (Del. Ch. Jan. 5, 2010)).
In Orchard, the Court held that:
[A]ccording to settled law as originally set forth by the Delaware Supreme Court in Cavalier Oil Corporation v. Harnett, [in appraisal ]the petitioners are entitled to receive their pro rata share of the value of Orchard as a going concern. In re Orchard, Slip Opinion at 2-3.
Consistent with that view, the Delaware Courts have held that the application of a minority discount at the shareholder level would deprive shareholders seeking appraisal of their proportionate interest in the company as a going concern and, in fact, the addition of a control premium to valuations based on a comparable/guideline public company approach is necessary to in order to correct for the lack of a control premium in the public trading values of the shares used for valuation purposes. See e.g., Berger v. Pubco, No. 3414-CC, 2010 WL 2025483 (Del. Ch. May 10, 2010), in which Court said “Under Delaware law, it is appropriate to add a control premium when appraisers use a comparable public company methodology. This has been the teaching of cases following the Delaware Supreme Court’s decision in Rapid-American Corp. v. Harris. [603 A.2d 796 (Del. 1992)].”
The Orchard Court went on to note that:
Although Delaware law putatively gives majority stockholders the right to a control premium, Cavalier Oil tempers the realistic chance to get one by requiring that minority stockholders be treated on a pro rata basis in appraisal. In re Orchard, Slip Opinion at 17-18.
Similarly, according to the Synthes Court:
It is, of course, true that controlling stockholders are putatively free under our law to sell their own bloc for a premium or even to take a different premium in a merger. As a practical matter, however, that right is limited in other ways that tend to promote equal treatment, for example, by the appraisal remedy that requires pro rata treatment of minority stockholders without regard to minority discounts . . .” In re Synthes, Slip Opinion at 29-30.
However, rather than “temper” the chance for a majority stockholder to obtain a control premium, it might be more accurate to say that the way in which these Courts are interpreting the appraisal statute substantially undermines, if not effectively eviscerates, the ability of a majority stockholder to extract a control premium or, in a freeze-out transaction, to pay less for the minority shares than the value a third party might be willing to pay to acquire control.
Consider two examples:
Company TC is 51% owned by JM with the balance of its shares owned by a diverse group of public stockholders.
After considering its strategic alternatives, Company TC’s board determines that a sale of the company is its best strategic option. JM concurs but advises Company TC’s board that he will insist on a 10% premium for his shares as they carry control. Company TC’s board forms a special committee of independent directors unaffiliated with JM to oversee the potential sale of Company TC and the special committee, with the assistance of independent legal and financial advisors, engages in an extremely lengthy and broad sales process.
Company A offers to buy Company TC for an aggregate amount that reflects the fair value of all of the outstanding equity of Company TC. It is solidly within the implied aggregate equity valuation reference ranges indicated by commonly performed valuation analyses. Company A does not expect to realize any material cost savings or synergies as a result of the transaction. Taking into account and carefully considering the impact of the 10% control premium on the price per share to be received by minority stockholders, and following the receipt of the opinion of the special committee’s financial advisor that the price to be received by the minority stockholders pursuant to Company A’s offer was fair from a financial point of view to the minority stockholders, the special committee and the board approved the proposed transaction.
After the transaction is announced, minority stockholders of TC file suit alleging that the Board of TC breached their fiduciary duties and that the purchase price for their shares was not entirely fair. In addition, other minority stockholders that did not vote in favor of the transaction demand an appraisal of the fair value of their shares in accordance with Delaware law.
After trial, the Court addressing both claims held that (i) citing In re Tele-Communications, Inc. and Levco v. Reader’s Digest, although it is not free from doubt that the entire fairness standard applied to the proposed transaction, even assuming it did, the transaction satisfied both the fair process and fair price prongs of the entire fairness test and (ii) citing Cavalier Oil, the control premium paid to JM needed to be included in the going concern value of TC in calculating the appraised fair value of a minority share. Consequently, Company A ends up paying the control premium more than once – first to JM and later to the minority stockholders that sought appraisal on a proportionate basis.
Company KT is 51% owned by members of the KT family with the balance of the shares owned by a diverse group of public stockholders.
Disappointed over the poor market performance of KT shares, the KT family decides to propose a freeze-out merger in which the shares not owned by members of the KT family would be acquired for cash. The KT Board forms a special committee of independent directors unaffiliated with the KT family to consider the KT family proposal and negotiate with the KT family. The special committee is also authorized to decline to recommend a transaction if it does not believe it to be in the best interests of the minority stockholders. After lengthy negotiations with the KT family resulting in a higher proposed purchase price and several meetings at which the special committee received advice from its legal and financial advisors, including an opinion from the special committee’s financial advisor that the higher proposed purchase price was fair from a financial point of view to KT’s minority stockholders, the special committee recommended and the board approved the proposed transaction.
After the transaction was announced RP, a large, well-capitalized private equity fund, sent a letter to the special committee offering to acquire all of the outstanding shares of KT, including those owned by members of the KT family, for 10% more per share than the KT family had offered to pay for the minority shares. The 10% premium reflected the premium RP was willing to pay in order to acquire control of KT and RP’s proposal was contingent upon the KT Board granting RP an option to acquire shares representing 19.9% of KT’s then outstanding shares at the same per share price RP was offering so that, together with the shares held by minority shareholders, RP could garner sufficient votes to approve its proposed transaction. The KT family issued public statements that they were only buyers, not sellers, and the KT family controlled board refused to grant RP the option on which the RP proposal was conditioned. Minority stockholders sued the KT Board alleging that they had breached their fiduciary duties and that the purchase price for their shares was not entirely fair. In addition, other minority stockholders that did not vote in favor of the transaction demand an appraisal of the fair value of their shares in accordance with Delaware law.
After trial, the Court addressing both claims held that: (i) citing Mendel v. Carroll, as a matter of Delaware law, a controlling stockholder is not obligated to pay the same price per share to acquire the minority shares it does not own as a third party would be willing to pay to acquire control as the controlling stockholder is not required to pay for something it already owns and the board was not obligated to grant an option diluting a preexisting controlling stockholder; and (ii) citing Cavalier Oil, the value of the control premium implied by RP’s offer needed to be included in the going concern value of KT in calculating the appraised fair value of a minority share. Consequently, the KT family has to pay the control premium to the minority stockholders that sought appraisal anyway.
While it is arguably rational that, in the absence of a controlling stockholder, the fair value of share in an appraisal action would be equal to a proportionate interest in the company as a going concern (including any applicable control premium), it is not clear that a minority discount is inappropriate in calculating the fair value of a share where a preexisting controlling stockholder affirmatively seeks to legally extract or retain the benefits of a control premium for themselves. A closer reading of Cavalier Oil and Rapid American raises concerns that the Court of Chancery may have over generalized the holdings in those decisions.
The primary issue in Cavalier Oil was whether a minority discount was appropriate due to the small size of the petitioning stockholders holding, not whether a minority discount was appropriate because the controlling stockholders were attempting to legally extract a control premium for themselves.
Cavalier’s final claim of error is directed to the Vice Chancellor’s refusal to apply a minority discount in valuing Harnett‘s EMSI stock. Cavalier contends that Harnett‘s “de minimus” (1.5%) interest in EMSI is one of the “relevant factors” which must be considered under Weinberger’s expanded valuation standard. Cavalier Oil v. Harnett, 564 A.2d 1137, 1144 (Del. 1989).
The holding of Rapid American may be the subject of similar over-generalizations, as the control premium approved by the Delaware Supreme Court was applied to the guideline public companies valuations of three wholly owned subsidiaries of the parent company that was the subject of the appraisal proceeding as part of a sum of the parts analysis and not to a guideline public companies valuation with respect to the parent company itself. Though arguably the result is the same, it appears the Court may have been narrowly addressing the fact that, because Rapid, the Parent company, owned a controlling interest in its subsidiaries, a control premium needed to be added to values of those subsidiaries indicated by a sum of the parts, guideline public companies analysis to obtain a value for the parent company as a going concern.
Harris urged the trial court to add a premium at the parent level to compensate all of Rapid’s shareholders for its 100% ownership position in the three subsidiaries. WMA’s valuation technique arrived at comparable values using the market price of similar shares. These shares presumptively traded at a price that discounted the “control premium.” Rapid-American Corp. v. Harris. 603 A.2d 796, 806 (Del. 1992).
The rigid adherence to the arguable principle that, in appraisal, a stockholder is always entitled to a pro rata portion of the going concern value of the company, even where there is a controlling stockholder, is particularly anomalous when one considers that one of the guiding principles of appraisal is to compensate shareholders for what was taken from them. It would seem difficult to argue that purchasers of Google shares in its IPO or Facebook shares in its IPO had any expectation that they, even when taken together with all other minority shareholders, were acquiring the ability to control either of those companies and consequently odd that they should be entitled to be compensated in an appraisal proceeding as if those minority stockholders, rather than the majority stockholders, controlled those companies.
Furthermore, for a variety of reasons, including those highlighted in the above examples, it should not generally be assumed that fair value for purposes of appraisal is identical to fair price under the entire fairness test.
1 This assumption is important, as any portion of the control premium paid out of the cost savings and synergies expected to be achieved by the buyer rather than the going concern value of the company would not be included in the calculation of the appraised fair value of a share. Nevertheless, it is not an unreasonable assumption, particularly where the company is being acquired by a private equity firm or a new entrant in the industry or business.
2 See also Shannon Pratt: “In the Delaware case of Cavalier Oil v. Harnett, the corporation argued that the minimal interest that the shareholder maintained in the corporation, 1.5% of outstanding common stock, was a “relevant factor” to be considered in the valuation for the purposes of the proceeding.” Jay E. Fishman, Shannon P. Pratt, William J. Morrison, “Standards of value: theory and applications” John Wiley & Sons, Inc. (2007).