Delaware Chancery Court Rejects Management Buyout Merger Price as Best Evidence of Fair Value in Appraisal Proceeding
In In re Appraisal of Dell Inc., No. 9322 VCL, 2016 Del. Ch. LEXIS 81 (Del. Ch. May 31, 2016) (Laster, V.C.), the Delaware Court of Chancery determined that the fair value of the common stock of Dell Inc. (“Dell” or the “Company”) as of the effective date of a 2012 management buyout (“MBO”) was $17.62 per share, or $3.74 per share more than the merger consideration of $13.75 per share plus a $0.13 special dividend. Although Dell’s directors properly discharged their fiduciary duties, and the sale process included a go-shop period that triggered a bidding contest, according to the Court, the MBO underpriced the Company by more than $5 billion. Notably, the factors responsible for this divergence included limitations inherent in any MBO-driven sale process. The Court relied entirely on a discounted cash flow (“DCF”) analysis to determine fair value. The decision likely will further increase the frequency in which stockholders of Delaware corporations pursue statutory appraisal rights, particularly in the MBO context.
Dell, a PC manufacturer, had transitioned itself by 2012 into a broader software and computing services company. But this transition, part of its long-term strategy, had yet to yield results. Meanwhile, investors and analysts continued to focus on Dell’s deteriorating PC business and its poor quarterly performance, causing Dell’s stock price to lag behind management’s internal valuations. In response, its founder and CEO, Michael Dell, proposed an MBO, the board of directors formed a special committee (the “Committee”), and a sale process ensued that focused on financial MBO sponsors as the size of the transaction would likely preclude a strategic acquisition by a competing technology firm.
During this first phase, a buyout group led by financial sponsor Silver Lake made a series of offers. The Committee deemed each inadequate. A competing financial sponsor, KKR, also bid, but soon dropped out. After further negotiations, Silver Lake eventually offered $13.65 per share, a price within several DCF valuation ranges prepared by Dell’s financial advisors. The Committee recommended, the board approved, and the parties signed a merger agreement at that price. The merger agreement included a go-shop clause.
The 45-day go-shop period produced several competing proposals and, ultimately, a threat by an insurgent stockholder, Carl Icahn, to nominate an alternative slate of directors, jettison the merger agreement, and conduct a tender offer at $14.00 per share. Faced with growing stockholder opposition to the merger, Silver Lake proposed amended terms that, after further negotiations, increased the merger price to $13.75 per share and added a special $0.13 per share pre-closing dividend. In September 2013, the Company’s stockholders approved the MBO’s amended merger terms.
In the appraisal proceeding, Dell contended that the final merger consideration represented the best evidence of fair value. The Court of Chancery disagreed. As an initial point, the Court clarified that “fair value” under Delaware’s appraisal statute is not equivalent to the economic concept of “fair market value” but is rather a “jurisprudential concept” that seeks to identify the “true or intrinsic value” of the stock taken in the merger by considering all factor bearing on value including, in addition to market value, asset value, earnings prospects and any other information as of the merger date bearing on the corporation’s future prospects. It then observed that markets for whole companies lack the degree of efficiency that prevails in markets for shares of individual company stock, so reliance upon deal prices as an indicator of fair value is less justified. It further noted that this inefficiency may be more pronounced with MBOs because management assumes the conflicting role of a buyer and enjoys a significant informational advantage over other bidders that even extensive due diligence cannot necessarily overcome.
The Court also distinguished appraisal from a breach of fiduciary duty inquiry, where the focus is on “the ends the directors pursued and the means they chose to achieve them.” In contrast, appraisal focuses on the outcome—the price—as possible evidence of fair value. Thus, even though, as the Court noted, “the Company’s process easily would sail through” judicial review under applicable fiduciary duty standards, that process “still could generate a price that was not persuasive evidence of fair value.”
Turning to the Committee’s sale process, the Court concluded that a number of factors caused the final merger consideration to diverge from fair value. During the pre-signing phase, Dell only engaged potential financial sponsors, i.e., buyers who must rely on a leveraged buyout (“LBO”) pricing model to achieve the required internal rate of return while accounting for limits on the amount of leverage the target company can support. Evidence showed that the Committee’s “price negotiations during the pre-signing phase were driven by the financial sponsors’ willingness to pay based on their LBO pricing models.” These models do not assess fair value. The Committee, pre-signing, also heavily relied upon stock trading prices as a quantitative metric even though a valuation gap existed between Dell’s stock price and its fair value, the very gap that motivated the MBO in the first instance. There was also minimal pre-signing competition.
The Court further concluded that the amended price terms resulting from the go-shop period also failed to reflect fair value because the post-signing offers “keyed off” the original merger price. Go-shop periods do not frequently produce topping bids in the MBO context. In the Court’s view, that topping bids materialized in the go-shop phase suggested the original merger consideration was in fact low. And the final, amended merger consideration (including the special dividend) represented only a 2% increase over the original price, and one still “within the confines of the LBO model.”
Although the merger price failed as an accurate “price discovery tool,” the Court agreed that it sufficiently rebutted petitioners’ expert’s $28.61 per-share estimate, an estimate suggesting the merger “undervalued the Company by $23 billion.” In the Court’s view, such value disparity, if true, would have no doubt caused another technology firm to appear as a strategic bidder.
The Court next turned to the parties’ experts’ discounted cash flow (“DCF”) analyses. In the end, however, the Court performed its own DCF analysis to derive its $17.62 per share fair valuation. This analysis comported with the Court’s view that the sale process permitted an undervaluation of several dollars per share. The Court, however, found it “impossible to quantify the exact degree of the sale process mispricing,” and so gave the final merger price no weight but rather relied exclusively on its DCF methodology.
Appraisal of Dell Inc. cautions against unjustified reliance upon merger prices in appraisal actions. A robust sale process, arm’s length negotiating and even a bidding war do not always guarantee an accurate “price discovery tool.” The opinion further suggests that an MBO-focused sale process is not necessarily suited to deliver fair value to stockholders. This observation may have implications in Delaware litigation beyond appraisal actions.