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(Article from Securities Law Alert, August 2017) 

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On August 1, 2017, the Delaware Supreme Court stated that “the sale value resulting from a robust market check will often be the most reliable evidence of fair value, and that second-guessing the value arrived upon by the collective views of many sophisticated parties with a real stake in the matter is hazardous.” DFC Global Corp. v. Muirfield Value Partners, 2017 WL 3261190 (Del. 2017) (Strine, C.J.). However, the court did not adopt a presumption that the sale price is the best evidence of fair value “in certain cases involving arm’s-length mergers” because it found that 8 Del. C. § 262(h), [1] the Delaware appraisal statute, vests the Chancery Court with discretion to determine fair value “in the first instance.”

Significantly, the Delaware Supreme Court rejected two arguments frequently used to challenge reliance on the merger price. First, the court held that market forces can adequately account for regulatory risk. Second, the court found no basis for a “private equity carve out” to deference to the deal price.

No Presumption in Favor of the Deal Price Applies in Arm’s-Length Mergers

The Delaware Supreme Court rejected the company’s contention that the court “should establish, by judicial gloss, a presumption that in certain cases involving arm’s-length mergers, the price of the transaction giving rise to appraisal rights is the best estimate of fair value.” The court determined that such a presumption “has no basis in the statutory text [of 8 Del. C. § 262(h)], which gives the Court of Chancery . . .  the discretion to ‘determine the fair value of the shares’ by taking into account ‘all relevant factors.’”

In reaching its decision, the Delaware Supreme Court “adhere[d] to [its] prior ruling in” Golden Telecom v. Global GT LP, 11 A.3d 214 (Del. 2010). There, the court expressly declined to “adopt a standard requiring conclusive or, in the alternative, presumptive deference to the merger price in an appraisal proceeding.” Golden Telecom, 11 A.3d 214. The Golden Telecom court found “Section 262(h) unambiguously calls upon the Court of Chancery to perform an independent evaluation of ‘fair value’ at the time of a transaction.” The court reasoned that “[r]equiring the Court of Chancery to defer—conclusively or presumptively—to the merger price, even in the face of a pristine, unchallenged transactional process, would contravene” the statutory language and “inappropriately shift the responsibility to determine ‘fair value’ from the court to the private parties.”

Economic Realities Suggest That the Deal Price from a “Robust” Sales Process Will Generally Provide the Best Evidence of Fair Value 

The DFC Global court made it clear that its “refusal to craft a statutory presumption in favor of the deal price when certain conditions pertain does not in any way signal” its disagreement with the economic principles underlying such a presumption. The court stated that it had “little quibble with the economic argument that the price of a merger that results from a robust market check, against the back drop of a rich information base and a welcoming environment for potential buyers, is probative of the company’s fair value.”

The Delaware Supreme Court explained that “[m]arket prices are typically viewed [as] superior to other valuation techniques because, unlike . . . 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.” The court found that “real world transaction prices can be the most probative evidence of fair value even through appraisal’s particular lens,” which requires consideration of the petitioner’s “pro rata share of the appraised company’s value as a ‘going concern.’” The court underscored that “the purpose of an appraisal is not to make sure that the petitioners get the highest conceivable value that might have been procured had every domino fallen out of the company’s way.” Rather, the court stated that “fair value is just that, ‘fair.’”

Market Forces Adequately Take Into Account Regulatory Uncertainty 

In the case before it, the Delaware Supreme Court found the Chancery Court had erred in finding the deal price “unreliable” because the company’s “future performance [was] dependent upon the outcome of regulatory actions.” The Delaware Supreme Court explained that publicly-traded companies in a broad range of industries “are subject to close regulation, the development of which can affect their future cash flows.” The court stated that “[p]recisely because of that reality, the market’s assessment of [a company’s] future cash flows necessarily takes regulatory risk into account as it does with all the other reasonable uncertain factors that affect a company’s future.” 

There Is No Basis for a “Private Equity Carve Out” to Deference to the Deal Price in Appraisal Actions 

The Delaware Supreme Court held the Chancery Court had further erred by concluding that it could “not give dispositive weight to the deal price because the prevailing buyer” was a private equity firm that “required a specific rate of return on its transaction.” The court found no basis in the “economic literature” or the record for the imposition of a “‘private equity carve out’ . . . in which the deal price resulting in a transaction won by a private equity buyer is not a reliable indication of fair value.”

The Delaware Supreme Court explained that “all disciplined buyers, both strategic and financial, have internal rates of return that they expect in exchange for taking on the large risk of a merger, or for that matter, any sizeable investment of its capital.” The court found the fact “[t]hat a buyer focuses on hitting its internal rate of return has no rational connection to whether the price it pays as a result of a competitive process is a fair one.”

The Chancery Court Must Justify Its Reasons for Weighting Each Valuation Metric 

In the case before the Delaware Supreme Court, the Chancery Court had “afford[ed] equal weight to the deal price, its discounted cash flow model, and its comparable companies analysis” without explaining the basis for its approach.

The Delaware Supreme Court recognized that when faced with competing valuation methods, the Chancery Court may be “tempted to . . . take[ ] every valuation method put in the record, give[ ] each equal weight, and then divide[ ] by the number of them.”

However, the Delaware Supreme Court instructed that the Chancery Court must “explain its weighting in a manner that is grounded in the record before it” when “exercis[ing] its considerable discretion” in an appraisal action. The Delaware Supreme Court observed that “laying down . . . fixed rules that state how competing approaches are to be weighted is impossible.” “In some cases, it may be that a single valuation metric is the most reliable evidence of fair value” while “[i]n other cases, it may be necessary to consider two or more factors.” The court stated that “[w]hat is necessary in any particular case” is for the Chancery Court to set forth its rationale for the weight it accorded to each competing valuation.