Wednesday, April 18, 2018

Court Case Insights

Investment Banking

The lesson of the following shareholder redemption case is this: take good care when writing corporate buy-sell agreements.

Hornberger v. Dave Gutelius Excavating, Inc., 2017 Pa. Super. LEXIS 1044 (Dec. 15, 2017)

A land surveyor worked for the defendant excavation construction business. In 2006, the plaintiff bought 1% of the company’s common shares. A shareholder agreement gave the company the right to redeem shares if the stockholder died or left employment. In case of death, the value of the deceased stock-holder’s shares was the stock’s fair market value as determined by the company’s independent CPAs. In case of termination, the agreement the value of shares had to be calculated based on the “adjusted net book value,” also as determined by the company’s independent CPAs, subject to provisions excluding goodwill and trade name value, and adjusting accounts receivable and payable and tangible assets to their fair market values.

The surveyor left the company’s employment, and the company obtained a valuation from an independent CPA, who valued the plaintiff’s shares applying a 30% minority discount and a 5% discount for lack of marketability (DLOM). The plaintiff refused to surrender his shares, and the defendant sued.

At trial, the plaintiff’s CPA expert testified that discounts were not appropriate in this instance since the shareholder agreement did not specifically call for them, although it did specify other adjustments. When questioned by the trial court, the expert admitted that, if the agreement had not included a list of particular adjustments, he would have considered applying a minority discount and DLOM to calculate the adjusted net book value. The defendant’s expert maintained that the specified provisions in the agreement did not limit any other adjustments the CPA firm thought appropriate to value the contested shares based on “current valuation methodologies.” He noted that the intent behind the agreement was “to keep the value of each share much lower so as not to reward any shareholder/employee who decides to voluntarily leave.”

The defendant also offered testimony from a second CPA who opined that, when calculating the adjusted net book value in a closely held corporation, it was customary to apply minority and marketability dis-counts (presumably to obtain a per share value for a minority interest). The initial valuation was thus correct under the agreement, this expert concluded.

In its opinion, the trial court noted the agreement did not include a definition of “adjusted net book value.” Rather, the agreement said to use the adjusted net book value with three qualifications. When a contract term lacked a definition, “we have to look to the standard, the normal and accepted practices within the industry,” the trial court added. Based on the initial expert report and the trial testimony of both CPAs, the court endorsed the use of the minority discount and DLOM.
The plaintiff appealed, arguing that the trial court’s conclusion was erroneous, as the shareholder agreement did not expressly include the application of such discounts. The plaintiff further noted the agreement specified different methodologies to determine the value of a deceased shareholder’s interest as opposed to the value of a terminated shareholder’s interest. Because the agreement did not include the phrase “fair market value” in prescribing how to value the shares of a terminated stockholder, it was improper to apply fair market value discounts, the plaintiff argued. The company again argued that just because the agreement identified certain adjustments, this did not preclude the independent CPAs from making additional adjustments that they determined “to be customary in the accounting industry.”

In its ruling, the appeals court agreed with the defendant, noting that the plaintiff expert’s conclusion that adjustments were not appropriate here was not based on the expert’s accounting or valuation expertise, but on his interpretation of contract language. The court disagreed with that interpretation. It noted that the agreement expressly provided for a valuation by the company’s CPAs. “That valuation, by its terms, is an adjustment to book value based on the expertise of (the company’s) CPAs.” Under the agreement, “the application of that expertise” was subject to the three express provisions related to goodwill, accounts payable/receivable, and the valuation of real and personal property. Requiring the accountants to make the three adjustments “cannot reasonably be understood to preclude the application of any other adjustments that valuation experts would ordinarily make,” the appellate court said.


The outcome of the following Delaware statutory appraisal case turned on the importance of the “deal price” versus other possible indications of value.

Dell, Inc. v. Magnetar Global Event Driven Master Fund Ltd., 2017 Del. LEXIS 518 (Dec. 14, 2017)

This matter arose out of the 2013 leveraged management buyout (MBO) led by the company’s founder, Michael Dell (Dell). The deal price of $13.75 per share represented a 37% premium over the company’s then publicly traded share price. In contrast, the fair value as determined by the Delaware Chancery Court was $17.62 per share. The Chancery thus concluded that the buyout price was about $7 billion too low.

By way of background, in mid-2012, Dell informed the company’s board of directors that he wanted to pursue a management buyout but would not go ahead without the directors’ approval. The board formed a special committee that hired JPMorgan Chase & Co. as its financial advisor. JPMorgan noted that “there was a low probability of strategic buyer interest in acquiring the Company.” Ultimately the committee and the buyout group negotiated the sale of the company for the total merger consideration to $13.75 per share as well as pay a special cash dividend of $0.13 per share and a $0.08 third quarter dividend. The total value of the deal was $13.96 per share. Although a majority of stockholders approved the deal, a number of shareholders petitioned the Delaware Court of Chancery for a fair value determination under the state’s appraisal statute.
In its finding, the Chancery opined that a statutory appraisal determination was different from an inquiry into a breach-of-fiduciary-duty claim. An appraisal was an inquiry into whether the stockholders received fair value for their shares in the transaction. Even if a sales process was fair in terms of a breach of fiduciary claim, it could prove suboptimal for purposes of an appraisal.

The sales process the company undertook, the Chancery said, “easily would sail through if reviewed under enhanced scrutiny,” and those in charge of the merger “did many praiseworthy things.” But the court found a number of factors compromised the sales process and caused a mispricing whose effect could not be quantified. For this reason, the Chancery decided to disregard the deal price altogether.

One of the problems the Chancery noted was a “valuation gap” between the company’s intrinsic value and its market value because the company’s investors were too focused on short term profit. The court also noted that no strategic buyers had participated in the sales process, which meant there were only financial sponsors that all used the leveraged buyout analysis to determine their bid price rather than valuing the company as a going concern. The effect was a deal price below fair value. Using its own valuation process, the court arrived at a statutory fair value of $17.62 per share. The company appealed the Chancery’s decision to the Delaware Supreme Court.

The company’s overarching argument to the Supreme Court was that the Chancery abused its discretion in giving no weight at all to the deal price. The company noted that Delaware law did not require that the deal price had to be the “most reliable” or “best” evidence of fair value in order for the deal price to be considered in a fair value determination. Moreover, the law did not require the Chancery to disregard the deal price entirely if the court was unable to “unequivocally quantify the precise amount of sale process mispricing.” The company also accused the Chancery of creating a rule that said that deal prices resulting from MBO transactions were suspect and should be disregarded. Finally, the company contended that the Chancery’s ruling against the deal price had no support in the facts of the case. The petitioners responded by stating that the Chancery had considered “all relevant factors,” as required under the appraisal statute, and had provided ample reasons why the deal price did not reflect fair value.


The Supreme Court agreed with the petitioners that the Chancery considered all the relevant factors, but found that the Chancery’s decision not to assign any weight to any market based indicator of fair value contradicted its own factual findings and justified a remand. There was “a dissonance” between the rationale the Chancery gave for disregarding the deal price and the facts the Chancery found, the Supreme Court said.


In its opinion, the Supreme Court found the Chancery’s reasoning for disregarding the deal price was flawed, since it erroneously presumed there was a valuation gap between Dell’s market price and funda-mental price. But the evidence showed that analysts had scrutinized the company’s long-term prospects and the market had been able to account for the company’s recent mergers and acquisitions, the Supreme Court said. It noted that the Chancery’s analysis ignored the efficient-market hypothesis “long endorsed by this Court.” The theory “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,” the Supreme Court stated. In the instant case, there was no indication that the market was not efficient. There were no signs that it lacked a sufficiently strong base of public stockholders, that the company’s stock was not actively traded, that investors had limited access to company information, or that the company had a controlling shareholder. The investors were not shortsighted, as the Chancery presumed, but “they just weren’t buying Mr. Dell’s story,” the Supreme Court said.


“The Court of Chancery ignored an important reality: if a company is one that no strategic buyer is interested in buying, it does not suggest a higher value, but a lower one,” the Supreme Court said. All prospective bidders, excepting the buyout group, decided against pursuing a deal because there was trepidation about the prospects of the PC industry and the success of Dell’s turnaround strategy, the court noted.


In summary, the Supreme Court reversed and remanded. It said it would not dictate the use of the deal price even though there were sound economic and policy reasons to do so. But if the Chancery decided to adopt the deal price, it could do so “with no further proceedings.” If the Chancery decided to go “another route,” it had to provide an explanation “consistent with the record and with relevant accepted financial principles.”