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(Article from Securities Law Alert, April 2019) 

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On April 16, 2019, the Delaware Supreme Court held that the Chancery Court abused its discretion in appraising a company’s shares using the unaffected market price, rather than the merger price less synergies, in an arm’s length transaction following a fair sales process. Verition Partners Master Fund v. Aruba Networks, 2019 WL 1614026 (Del. 2019) (per curiam). The Chancery Court found the deal price less synergies valuation unreliable because “it needed to make an additional deduction . . .  for unspecified ‘reduced agency costs.’” But the Delaware Supreme Court determined that there was no evidence of any agency cost reductions that “were not already captured by [the acquirer’s] synergies estimate.”

The Delaware Supreme Court noted that a stock’s market price “is an important indicator of its economic value.” However, the court underscored that when a company is sold in an arm’s length transaction that is preceded by extensive due diligence, “the price that results . . .  is even more likely to be indicative of so-called fundamental value” than the unaffected market price.

Background

The company at issue (Aruba) was acquired for $24.67 per share in 2015. Before accepting the acquirer’s (HP’s) offer, the company conducted a pre-signing market check with five other potential bidders, none of which showed any interest. The company’s stock price rose twice between its acceptance of the acquirer’s offer and the signing of the final merger agreement. First, the share price increased from $18.37 to $22.24 when news of the transaction was leaked to the press. Second, the stock price rose to $24.81 upon the company’s release of its quarterly earnings, which exceeded analyst expectations. The final merger agreement permitted consideration of a superior inbound offer, but no competing bidder emerged.

Following the merger, certain shareholders sought appraisal. The appraisal petitioners argued that the fair value of their shares at the time of the merger was $32.57 per share, based on a discounted cash flow (DCF) analysis. The company contended that the fair value was $19.10 per share using a deal price less synergies valuation.

Chancery Court Relies on the Unaffected Stock Price Because of Difficulties Estimating Synergies in the Form of Reduced Agency Costs 

The Chancery Court found that the fair value of the company’s shares at the time of the merger was $17.13 per share, based on the company’s average share price during the thirty days prior to the market leak. Verition Partners Master Fund v. Aruba Networks, 2018 WL 922139 (Del. Ch. 2018). The court recognized that the Delaware Supreme Court’s decisions in DFC Global Corp. v. Muirfield Value Partners, 172 A.3d 346 (Del. 2017), and Dell v. Magnetar Global Event Driven Master Fund, 177 A.3d 1 (Del. 2017), “teach that the deal price is . . . entitled to substantial weight.”[1] The Chancery Court noted that the deal was “an arm’s-length transaction” in which the merger price “contained synergies,” and “petitioners failed to identify a bidder who would pay more than” the acquirer. The Chancery Court therefore determined that “the deal price in this case operates as a ceiling for fair value.”

The Chancery Court then acknowledged challenges in calculating the amount of synergies to deduct from the deal price, and particularly in how to account for (a) academic literature suggesting that a deduction for “reduced agency costs” should be made, and (b) Dell’s emphasis on real world indicators of value. Rather than accepting the company’s $19.10 valuation (which was generally consistent with DCF valuations conducted by the company’s financial advisors), the court estimated the company’s merger price minus synergies valuation at $18.20 per share by applying certain academic literature.  The court then disregarded this estimate because it “continues to incorporate an element of value resulting from the merger” in the form of “reduced agency costs that result from unitary (or controlling) ownership,” again relying on academic literature. In the absence of a precise way to calculate reduced agency costs, the Chancery Court looked to the unaffected stock price of $17.13 per share, as a “direct route” to valuation and entitled to substantial weight under DFC and Dell. The court found that both DFC and Dell “endorse using the market price of a widely traded firm as evidence of fair value.”

Delaware Supreme Court Holds That the Fair Value Is Merger Price Less Synergies

The Delaware Supreme Court reversed the Chancery Court’s decision and held that the  fair value was $19.10 per share—the merger price less synergies, as calculated by the company. It found this value “corroborated by abundant record evidence.”

In reviewing the Chancery Court’s analysis, the Delaware Supreme Court first reaffirmed that “fair value” under the Delaware appraisal statute is the “going concern” value—i.e., excluding any value from potential acquisition synergies.  The Delaware Supreme Court then opined that the Chancery Court abused its discretion by attempting to deduct reduced agency costs under the facts of the case.  The Delaware Supreme Court did not outright reject academic literature which has argued that “replacing a dispersed group of owners with a concentrated group of owners can be expected to add value because the new owners are more capable of making sure management isn’t shirking or diverting the company’s profits.” However, the Delaware Supreme Court found that “unlike a private equity deal, the merger at issue in this case would not replace [the company’s] public stockholders with a concentrated group of owners; rather, it would swap out one set of public stockholders for another.” The Delaware Supreme Court stated that “the Court of Chancery’s belief that it had to deduct for agency costs ignores the reality that [the acquirer’s] synergies case likely already priced any agency cost reductions it may have expected.”

The Delaware Supreme Court next rejected the Chancery Court’s view that Dell required deference to the unaffected stock price as “not supported by any reasonable reading” of precedent. It clarified that Dell “did not imply that the market price of a stock was necessarily the best estimate of the stock’s so-called fundamental value at any particular time,” but rather that when a market was “informationally efficient,” the market price was “informative” of—not equivalent to—fair value under the Delaware appraisal statute. Here, the Delaware Supreme Court determined that the deal price “could be seen as reflecting a better assessment of [the company’s] going-concern value” than the unaffected market price because the acquirer “had more incentive to study [the company] closely than ordinary traders in small blocks of [the company’s] shares, and also had material, nonpublic information that, by definition, could not have been baked into the public trading price.” The Delaware Supreme Court finally criticized the Chancery Court’s decision to unilaterally render a fair value award based on an unaffected market price that was lower than the company’s litigation position, which the Court found “injected due process and fairness problems into the proceedings” by raising the prospect of relying on the unaffected market price “late in the proceedings.” The Delaware Supreme Court found it troublesome that “the extent to which the market price approximated fair value was never subjected to the crucible of pretrial discovery, expert depositions, cross-expert rebuttal, expert testimony at trial, and cross examination at trial.” The Delaware Supreme Court stated that this was “antithetical to the traditional hallmarks of a Court of Chancery appraisal proceeding.”