Author’s note: The following is a memorandum from an investment bank to a hypothetical bank client faced with the possibility of a dissent and appraisal action in connection with a sale of the bank.
Confidential Memorandum
To: Community Banker
CEO, Community Bank (“CB”)
Reducing Risk of an Appraisal Action in a Bank M&A Deal
We understand that you believe that it is in the interest of your customers and shareholders to consider a sale of CB, and you have held some preliminary and confidential discussions on this subject with Mid Sized City Bank (“MSCB”). You have asked our advice on how to handle the probable opposition from a group of minority shareholders whom you believe are likely to oppose a proposed sale.
You have discussed a cash merger with MSCB that would produce over $25 per share to your shareholders, more than 30 percent over the $18 per share enterprise valuation delivered less than six months ago for purposes of your employee stock ownership plan (“ESOP”). The difference in value is largely attributable to the synergies to be realized in a merger of CB and MSCB. CB, with its low-cost deposits but low loan demand, is worth a lot more when combined with MSCB’s robust loan portfolio and loan production unit than it is as an independent bank.
Due to hard feelings from an incident that occurred decades ago, some of your minority shareholders are likely to resist a merger no matter what the consideration and whom the merger partner. You are concerned that the minority shareholder group will exercise its right to dissent and demand an appraisal of its shares leading to an appraisal action that would create financial uncertainty for the proposed transaction. No investment banker can eliminate this risk, but we can substantially reduce it through careful structuring of the merger negotiations and process.
You are correct that under the law of Alabama and most other jurisdictions, minority shareholders who do not like the price being paid for their shares in a buy-out requiring a shareholder vote can seek a higher price in court. The standard of value to be applied by the court is “fair value.” The Alabama statute defines “fair value” as the “value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusions would be inequitable.”
The exclusion from value of “any appreciation or depreciation” in anticipation of a merger means that the dissenting shareholders are not entitled to benefit from the synergies expected from the merger. In other words, the dissenting shareholders do not get to benefit from that part of the merger price per share that is attributable to the merger of a bank with a lot of cheap deposits and a bank with a robust lending operation. It is thus possible for the merger price to be more than fair value and for the dissenting shareholders to receive less than the merger price if they go to court.
Except for the statutory provision excluding synergies, the word “value” is not defined and is left to the courts to determine. In Alabama and most other states, judges have the final say about the meaning of “value,” although judges may be influenced by expert testimony from bankers and others. There are very few decisions of the Alabama Supreme Court relating to “fair value” in corporate deals. In one of the leading Alabama cases, James Offenbecher v. Baron Services, Inc., the court adopted a Delaware judicial interpretation of “fair value” and you should ask your law firm if they think the court will be likely to do so again. For purposes of this memorandum we assume that Delaware law will be applied in the absence of Alabama precedent.
Fortunately for your situation, recent decisions of the Delaware Chancery Court and Supreme Court are leading to greater certainty about the outcome of judicial appraisal cases. In a Dec. 14, 2017 case involving the going private transaction of Dell, Inc., the Delaware Supreme Court held that the price at which a merger is effected is a relevant and perhaps a controlling factor in determining “fair value” if arrived at after a well conducted auction process with opportunity for all logical buyers to submit proposals. And in Merlin Partners v. SWS Group, Inc., the Delaware Supreme Curt affirmed a Chancery Court decision held that under the facts of the case “fair value” was less than the deal price, signaling to would-be deal spoilers that there is no longer a free lunch in bringing appraisal actions seeking a higher price.
With this background, we recommend the steps described in the following numbered paragraphs for the purpose of reducing the risk of an appraisal action disrupting a cash merger.
Update Enterprise Valuation. You should update the enterprise valuation prepared for your ESOP. You are fortunate that you have a history of valuations going back several years prepared by us as independent experts applying standard methodologies, including a discounted cash flow analysis based on projections prepared by CB management. Properly done, the enterprise valuation should be the basis for establishing the “fair value” of CB as an independent going concern.
Solicit Proposals to Purchase or Merge. While MSCB may be your preferred merger partner, in order to make sure a deal will withstand scrutiny you need to solicit offers for CB broadly. You should prepare a “book” describing CB and furnish copies to potential acquirers willing to sign non-disclosure agreements. Interested parties should be invited to submit indications of interest. You can then negotiate with parties with the potential to pay the highest price and select the best proposal to be documented with a letter of intent initially and a definitive merger agreement ultimately. While negotiating with the selected buyer you should obtain the information required to demonstrate the portion of the value being paid to the selling shareholders that comes from the synergies implicit in the deal.
Provide for Topping Offers and Break-Up Payments. The definitive merger agreement should provide for the possibility of a topping offer, and associated break-up payment, to make sure that there is not an undiscovered buyer willing to pay a materially higher price.
If you follow the foregoing procedures you are likely to end up with a merger price that is higher than “fair value” because of the synergies resulting from the merger that are benefitting the selling shareholders. Your minority shareholders who dissent and seek appraisal will face the probable embarrassment of receiving less than the merger price for their shares and potentially having to pay for the appraisal proceedings if the court views their dissent as particularly foolish.
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.
