by James H. White III and Michael G. Rediker
Among the major uncertainties surrounding corporate mergers and divestitures is the judicial appraisal process for mergers and asset sales where a court can be called upon to second guess the deal terms negotiated by the parties. Under the Alabama corporate statute, in a judicial appraisal action a judge determines “fair value,” and the corporation whose stockholders have instigated the appraisal action are entitled to be paid in cash the amount determined by the court, whether more or less than the deal price. The possibility that the value determined by judicial appraisal could be substantially higher than the negotiated value is a disincentive to do a deal, and a risk that must be carefully managed by the professionals retained to assist with the transaction.
The Alabama corporate statute defines fair value as “…the value of the shares immediately before the effectuation of the… [transaction], excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.” The central word “value” is not itself defined in the statute and the Alabama Supreme Court has not had much opportunity to consider the meaning of “fair value” in the context of a judicial appraisal. However, the comment to the “fair value” definition in the Alabama Code notes, “There is considerable Delaware case law on the subject [of fair value]…”; and one of the few Alabama Supreme Court cases interpreting “fair value” is explicitly based on Delaware decisions. In Delaware the judge in charge of the appraisal must consider “proof of value by any techniques or methods which are generally considered in the financial community and otherwise admissible in court.”
Recent decisions of the Supreme Court of Delaware have led to substantial changes in the way its Chancery Court determines “fair value.” In summary, the Delaware Supreme Court has expressed skepticism about the formerly favored discounted cash flow valuation methodology (“DCF”) in which opposing experts develop adversarial valuation reports based on cash flow projections and cost of capital estimates that the Chancery Court evaluates before performing its own DCF analysis. While not ruling out DCF valuations, especially for closely held corporations or in the absence of a robust marketing process for the corporation being divested, the Delaware Supreme Court has questioned the DCF work product of both the experts and the Chancery Court. The Supreme Court is bemused by how frequently the experts disagree on value by large amounts, and questions the ability of “law-trained judges” to arrive at the correct conclusion about fair value using the DCF method.
The Delaware Court has stated a preference for market based valuation methods and has gone so far as to favor the “efficient market hypothesis” which teaches that “the price produced by an efficient market is generally a more reliable assessment of fair value than the view of a single analyst, especially an expert witness who caters her valuation to the litigation imperatives of a well-heeled client.” In a recent case the Delaware Chancery Court has actually ruled that, based on an active public market for the target’s stock, fair value was best represented by the market price of the stock prior to the deal being publicly known, even though that price was less than the deal price. In a merger or sale of assets transaction the Court has indicated that it will accept as fair value the deal price actually negotiated if the deal price was agreed through a process open to an offer from a large number of financially responsible parties, and there is no “inside dealing.”
The practical significance of the recent Delaware precedents is that in planning a deal where there is a possibility that a shareholder group might trigger a disruptive judicial appraisal, it is important to consider the questions of (i) whether the target’s stock is actively traded, (ii) whether there is an insider group on both sides of the transaction (as occurs in a management buy-out), (iii) whether the deal price was “shopped” to a representative group of potential purchasers, and (iv) whether the agreed price was open to being trumped by a “topping offer.” If the answer to all of these questions is “yes,” then fair value is likely represented by the deal price actually negotiated or the publicly traded price unaffected by the deal. If the answer to question (i) is “no” and the answer to the other questions is “yes,” it is possible that the deal price actually negotiated will be determined to be “fair value.” If the answer to two or more of the questions is “no” then determining fair value becomes much more difficult and will likely involve careful consideration of all recognized approaches to value including the deal price, such trades in stock of the target as have occurred, comparable company and comparable transaction analysis, and DCF analysis, with the analyst (whether expert witness or judge) deciding what weight to give to each valuation method based on the factual circumstances.
Whether or not an appraisal action is a possibility, retained legal counsel and the engaged investment banker both have important responsibilities. The investment banker may be called on to make sure that the process of the transaction is not subject to criticism and that the deal price is a candidate for determining a ceiling on the fair price. In addition to attending to the transaction process, the investment banker must perform the research and analysis required to assess the fairness of the deal price using all of the relevant valuation methodologies that are subject to being applied in a judicial appraisal process.
Since 1968 Jim White has advised businesses, individuals, non-profits and municipalities on a wide range of financial matters. He founded Porter White & Company in Birmingham in 1975 and presently serves as chairman. Jim can be reached at (205) 252-3681 or jim@pwco.com. Michael G. Rediker, CFA is an investment banker with Porter White & Company in Birmingham. He can be reached at (205) 458-9135 or rediker@pwco.com.
