These trends in Delaware law provide greater incentives and clearer guidance toward reasonable merger processes and disclosures designed to result in judicial deference to directors’ business judgment and to the merger price.
This article was published in the Corporate, Mergers & Acquisitions and Securities sections of Law360 on March 1, 2017. Portfolio Media, Inc., publisher of Law360.
In part one of this two-part series, we discussed two of four recent developments in Delaware law that reduce the liability exposure of corporate boards and controlling stockholders in merger transactions, and also benefit minority stockholders. Both of those developments affect mergers with controlling stockholders. In this second and final part, we discuss the other two developments, which affect mergers without controlling stockholders and mergers subject to post-closing appraisal actions.
Arm’s-length mergers approved by a majority of disinterested stockholders are subject to the business judgment rule.
Delaware courts recently established yet another process under Delaware law in review of post-merger litigation involving a merger with a third party at arm’s length. In those cases, all that is required to ensure the benefit of the business judgment rule is a fully informed, affirmative vote of a majority of the disinterested stockholders. In Corwin v. KKR Financial Holdings LLC, the Delaware Supreme Court (in an opinion by Chief Justice Leo Strine) affirmed the Delaware Court of Chancery’s holding that “the business judgment rule is invoked as the appropriate standard of review for a post-closing damages action when a merger that is not subject to the entire fairness standard of review has been approved by a fully informed, uncoerced majority of the disinterested stockholders.”1 That principle applies whether or not a disinterested and independent majority of the board approved the merger.
The Delaware Supreme Court held that the intermediate standards of review under Unocal and Revlon “are primarily designed to give stockholders and the Court of Chancery the tool of injunctive relief to address important M&A decisions in real time, before closing. They were not tools designed with post-closing money damages claims in mind.”2 The court cautioned, however, that “the doctrine applies only to fully informed, uncoerced stockholder votes, and if troubling facts regarding director behavior were not disclosed that would have been material to a voting stockholder, then the business judgment rule is not invoked.”3 Thus, the key to business judgment review in a post-closing merger case is a transparent, fully disclosed process. The policy behind this doctrine is that “[w]hen the real parties in interest — the disinterested equity owners — can easily protect themselves at the ballot box by simply voting no, the utility of a litigation-intrusive standard of review promises more costs to stockholders in the form of litigation rents and inhibitions on risk-taking than it promises in terms of benefits to them.” The Delaware Supreme Court concluded that under those circumstances the business judgment rule “best facilitates wealth creation through the corporate form.”4
The Court of Chancery recently extended the Corwin doctrine to tender offers. In In re Volcano Corp. Stockholder Litigation, the court held that the business judgment rule applies “irrebuttably” when a majority of the shares held by fully informed, disinterested stockholders are tendered in the first step of a two-step merger.5 The court noted that, “if the business judgment rule is ‘irrebuttable,’ then a plaintiff only can challenge a transaction on the basis of waste — i.e., that it ‘cannot be attributed to any rational business purpose.’”6
Following Corwin and Volcano, the Court of Chancery in In re OM Group Stockholders Litigation granted the defendants’ motion to dismiss at the pleading stage, holding that the irrebuttable business judgment rule applied to a merger even though the complaint “sets forth a disquieting narrative” with respect to the board’s process.7 The complaint alleged that the process undertaken by the board “fell beneath any measure of reasonableness” under Revlon. Threatened by a “vocal dissident shareholder,” the OM board allegedly “rushed to sell OM on the cheap in order to avoid the embarrassment and aggravation of a prolonged proxy fight.” The company’s financial advisers had allegedly “opined that separate sales of OM’s many diverse business units would yield maximum value for OM shareholders.” However, the board opted for a sale of the entire company, hurrying the process to exclude strategic buyers that would be interested in acquiring individual business units. In addition, the board “failed to manage conflicts among its investment bankers” and relied on “manipulated projections that understated OM’s prospects.”
Although the plaintiffs had alleged a defective process, the court rejected the plaintiffs’ disclosure claims, finding that the proxy statement fully disclosed all material facts and, therefore, the stockholder vote was fully informed and Corwin mandated dismissal. The decision was not appealed. Thus, under Corwin and OM Group, in a merger that is not subject to entire fairness review, the fully informed vote of the majority of shares held by disinterested stockholders invokes the irrebuttable business judgment rule regardless of the sale process so long as the process is fully disclosed. Of course, the prospect of full disclosure normally would encourage design of and adherence to a fair process.
The rise of the merger price as a valid method of valuation in appraisals.
In post-merger appraisal actions, the Court of Chancery traditionally has applied a few accepted methodologies for valuing companies, none of which relied on the actual merger price or the sale process. However, in several recent cases the court has changed course and relied heavily on the merger price as the best indication of value when the sale process met certain standards. Thus, a better sale process again benefits corporations and their stockholders by ensuring a fair merger price and reducing exposure to post-merger appraisal litigation cost.
Under Section 262 of the Delaware General Corporation Law, stockholders in a Delaware corporation may petition the Court of Chancery for appraisal of the “fair value” of their shares after a merger, and the surviving company may be liable if the court determines that the fair value (net of synergies resulting from the merger) is greater than the merger consideration. In a typical appraisal action, as in the damages phase of an action for breach of fiduciary duty involving a merger, the Court of Chancery hears testimony from competing experts on valuation, who typically rely on methodologies that include discounted cash flow (DCF) analyses and review of comparable public companies and comparable transactions. In 2006, the Court of Chancery in IIC Industries noted that “[t]he DCF method is frequently used in this court” and is given “great, and sometimes even exclusive, weight when it may be used responsibly.”8
Deal process does not enter into the analysis under DCF or other conventional valuation methods, and the Court of Chancery has not traditionally presumed that the merger price is fair, regardless of process. In Golden Telecom Inc. v. Global GT LP, the Delaware Supreme Court stated that “even in the face of a pristine, unchallenged transactional process,” the Court of Chancery should not “defer — conclusively or presumptively — to the merger price.”9 The Supreme Court stated that the appraisal statute “neither dictates nor even contemplates that the Court of Chancery should consider the transactional market price of the underlying company.”
In a change of approach, however, the Court of Chancery recently has considered the sale price in appraisal cases after Golden Telecom and has rewarded good sale processes in arm’s-length transactions by finding that the merger price is the fair value. The first such case was Huff Fund Investment Partnership v. CKx Inc., in which Vice Chancellor Sam Glasscock found that the merger price for the corporation, CKx, following an adequate process, was “the most relevant exemplar of valuation available.”10 The court found that a DCF analysis was not appropriate because CKx’s revenue estimates were unreliable, and, without reliable projections of cash flows, the court could not “calculate the enterprise’s fair value with a DCF analysis.” The court also rejected the petitioners’ expert’s “guideline” analyses of public companies and merged and acquired companies because the expert admitted that none of the companies he used were “truly comparable” to CKx.
Instead, the court relied on the merger price, stating that “an arms-length merger price resulting from an effective market check is entitled to great weight in an appraisal” and finding that “the process by which CKx was marketed to potential buyers was thorough, effective, and free from any specter of self-interest or disloyalty.” The court found that “multiple entities made unsolicited, credible bids,” that the company’s board “immediately engaged in a conscientious process with the assistance of a reputable financial advisor,” and that the board “successfully instigated a bidding war for CKx, and also canvassed the market for other potentially interested bidders.” The court concluded that “the process that generated the merger price supports a conclusion that the merger price is a relevant factor in determining CKx’s fair value” and therefore, in the absence of other reliable indicators, the company’s fair value was equal to the merger price.
In several cases following CKx in 2015 and 2016, the Court of Chancery again found that the merger price was more reliable than an expert’s DCF analysis. In In re Appraisal of Ancestry.com Inc., Vice Chancellor Glasscock concluded that, because the projections that served as inputs for the DCF analysis were “problematic,” fair value was “best represented by the market price.”11 The court stated “it would be hubristic indeed to advance my estimate of value over that of an entity for which investment represents a real — not merely an academic — risk, by insisting that such entity paid too much.” The court held that the merger price was equal to fair value.
In Merlin Partners v. AutoInfo Inc., the company’s expert did not even attempt to offer conventional valuation methodologies.12 The petitioners’ expert performed a DCF analysis and two comparable-companies analyses, while the company’s expert relied entirely on the merger price and “market evidence regarding the strength of AutoInfo’s sales process.” Then-Vice Chancellor John Noble gave no weight to the DCF analysis, finding that the projections on which it was based were not prepared in the ordinary course of business, but rather in an effort to market the company. The court also rejected the comparable-companies analyses, finding that the companies used differed from AutoInfo in size and business model. As to the merger price, the court stated, “[t]he dependability of a transaction price is only as strong as the process by which it was negotiated. For example, a transaction that implicates self-interested parties or an inadequate market check may generate a price divergent from fair value.” “When it is the best indicator of value, the Court may assign 100% weight to the negotiated price.” Moreover, the court stated that there is no need for the merger price to be corroborated by any particular valuation methodology. “Where, as here, the market prices a company as the result of a competitive and fair auction, ‘the use of alternative valuation techniques like a DCF analysis is necessarily a second-best method to derive value.’” Thus, the court placed full weight on the merger price in determining fair value.
Continuing this line of analysis, the Court of Chancery relied on the merger price in determining fair value in LongPath Capital LLC v. Ramtron International Corp.13 There, then-Vice Chancellor Donald Parsons concluded that the merger price, which was $3.10 per share, was “a reliable indication” of the company’s fair value. The court found that the sale process was “lengthy, publicized [and] thorough.” Finding that a DCF analysis was inappropriate because management projections were unreliable, that there were no comparable companies, and that the comparable-transactions approach did not provide “a reliable indication of fair value,” the court weighted the merger price at 100 percent in determining fair value. In Ramtron, unlike the earlier cases, however, the court found that there was evidence of synergies and discounted the merger price by $0.03 in finding the fair value.
The Court of Chancery’s new-found emphasis on merger price addresses the often-lamented fact that opposing experts are able to use the DCF method to arrive at widely differing results. In Merion Capital LP v. BMC Software Inc., the Court of Chancery concluded that, because there were “uncertainties” in the DCF analysis and “in light of the wildly-divergent DCF valuation of the experts,” the merger price was “the best indicator of fair value.”14
The Court of Chancery recapped the recent appraisal decisions relying on merger price in Merion Capital LP v. Lender Processing Services Inc.15 There, Vice Chancellor J. Travis Laster listed three factors that “contribute to this court’s determination that the sale process that the Board conducted provided an effective means of price discovery.” Those factors are: (a) “meaningful competition among multiple bidders”; (b) that “adequate and reliable information about the Company was available to all participants, which contributed to the existence of meaningful competition”; and (c) “the absence of any explicit or implicit collusion, whether among bidders or between the seller and a particular bidder or subset of bidders.” The court’s DCF analysis derived a value of $38.67, which was 4 percent higher than the merger consideration of $37.14 per share.
The court reviewed 10 Court of Chancery opinions issued since the Delaware Supreme Court’s ruling in Golden Telecom in 2010. In five of those cases, the Court of Chancery “has given exclusive weight to the deal price, particularly where other evidence of fair value was unreliable or weak.” In the other five cases, the court “has declined to give exclusive weight to the deal price in situations where the respondent failed to overcome the petitioner’s attacks on the sale process and thus did not prove that it was a reliable indicator of fair value.” The court concluded that, because the petitioner’s “DCF analysis depends heavily on assumptions,” it should give 100 percent weight to the merger price.
In sum, in post-merger appraisal cases, the trend in the Court of Chancery is to defer to a merger price that is the result of a sufficiently robust sale process and to prefer the merger price method over conventional methodologies, including DCF. As in AutoInfo, where the process is sufficient, a company may even choose to rely entirely on the merger price to prove fair value, possibly reducing the cost of retaining valuation experts. Increased judicial reliance on the merger price encourages companies to improve their sale processes and also discourages appraisal arbitrage and appraisal litigation generally. Appraisal arbitrage is the controversial investment strategy of buying shares after a merger is announced for the purpose of asserting appraisal rights.16 Increased reliance on the merger price method of valuation results in a more efficient merger process and reduces the buyer’s risk of exposure to post-merger appraisal litigation. “From the point of view of the arbs, if the gain is not there, they will not file.”.17
Corporations may adopt forum-selection bylaws specifying Delaware as the exclusive venue for litigation.
Delaware companies can ensure the application of these corporate-friendly developments by employing Section 115 of the Delaware General Corporation Law, which became effective on Aug. 1, 2015. This section permits Delaware corporations to adopt bylaws or charter provisions that require “any and all internal corporate claims,” including claims in the right of the corporation for breach of fiduciary duty and statutory claims, to be brought in Delaware courts.18 Thus, by using forum-selection bylaws and charter provisions, Delaware corporations can ensure their ability to take advantage of these trends in Delaware law and avoid the uncertainty of litigation in other forums that plaintiffs may view as favorable to them.
Conclusion: Recent trends in Delaware law encourage the use of a robust sale process and full disclosure that ultimately benefits all stockholders.
These trends in Delaware law provide greater incentives and clearer guidance toward reasonable merger processes and disclosures designed to result in judicial deference to directors’ business judgment and to the merger price. Mergers between companies and their controlling stockholders get the benefit of the business judgment rule when they are conditioned on approval by an independent, fully functioning special committee and the fully informed, uncoerced vote of a majority of the minority shares. Mergers between companies with controlling stockholders and third parties get the benefit of the business judgment rule when the controller gets only pro rata consideration with other stockholders. In arm’s-length mergers free of controller conflicts, defendants get the benefit of the business judgment rule when fully informed, uncoerced holders of a majority of disinterested shares vote in favor of the merger. Finally, Delaware courts will increasingly defer to the parties’ agreed-upon merger price when the price is the product of a meaningful competition among multiple bidders and adequate and reliable information is available to all participants. The best way to avoid costly litigation and potential liability in mergers is to engage in a reasonable, transparent and fully disclosed sale process, which benefits both corporate defendants and stockholders.
1 125 A.3d 304, 305-06 (Del. 2015).
2 Id. at 312.
4 Id. at 313.
5 143 A.3d 727, 738 (June 30, 2016) (Montgomery-Reeves, V.C.), aff’d sub nom Lax v. Goldman Sachs & Co. (Del. Feb. 9, 2017).
6 Id. at 737 n.16 (quoting Cede & Co. v. Technicolor Inc., 634 A.2d 345, 361 (Del. 1993)).
7 Consol. C.A. No. 11216-VCS (Del. Ch. Oct. 12, 2016) (Slights, V.C.).
8 Gesoff v. IIC Industries Inc., 902 A.2d 1130, 1155 n.138 (Del. Ch. 2006).
9 11 A.3d 214, 217-18 (Del. 2010).
10 C.A. No. 6844-VCG (Del. Ch. Nov. 1, 2013).
11 Consol. C.A. No. 8173-VCG (Del. Ch. Jan. 30, 2015).
12 C.A. No. 8509-VCN (Del. Ch. Apr. 30, 2015).
13 C.A. No. 8094-VCP (Del. Ch. June 30, 2015).
14 C.A. No. 8900-VCG (Del. Ch. Oct. 21, 2015).
15 C.A. No. 9320-VCL (Del. Ch. Dec. 16, 2016).
16 See Booth, Richard A., The Real Problem with Appraisal Arbitrage (Sept. 7, 2016). Villanova Law/Public Policy Research Paper No. 2016-1026, at 2. Available at SSRN: https://ssrn.com/abstract=2836093
17 Id. at 27 n.71.
18 8 Del. C. § 115.