Wednesday, August 1, 2018

Court Case Insights

Investment Banking

Here are some recent court cases involving business valuations and business damages that we found interesting …

Experts often disagree, and sometimes for equally valid reasons, as the following dispute over a hotel valuation illustrates.

In re EM Lodgings, LLC, 2018 Bank. LEXIS 183 (Jan 25, 2018)

The debtor in this Chapter 11 bankruptcy case owned a hotel that operated under the Marriott brand. While it never filed a reorganization plan, it hoped to refinance and eventually sell the property for enough money to pay off its largest creditor. However, months later, it had not taken any steps reach this goal.

A bank, the hotel’s largest creditor, filed a relief-from-stay motion, alleging that the debtor had no equity in the hotel property and that the property was not necessary for an effective reorganization. The debtor objected, arguing that the hotel was worth more than the money owed to the creditor.

At trial, both sides presented business appraisals based on essentially the same methodology – an income capitalization/discounted cash flow (DCF) analysis. Also, both appraisers performed a sales comparison analysis as a reality check. The creditor’s expert worked for a national hotel consulting and valuation firm, while the debtor’s expert worked for one of the world’s top real estate and investment firms. The different value conclusions were the result of different inputs, which in turn reflected each appraiser’s different view of the hotel’s future performance.

The court explained that the DCF analysis assumed that the property would be held for 10 years and then sold. Cash flow (net operating income) was projected for 11 fiscal years; the first 10 years were discounted to present value. NOI in Year 11 was capitalized by a capitalization rate (exit cap rate) to estimate the reversion rate, which was then discounted to present value. The sum of the components thus provided the estimate of value.

The historical data the creditor’s expert calculated an as-is market value of $5.7 million. The data he relied on indicated a steady decline in the aggregate occupancy rate for the contested property and a group of competitors, from a high of 75% in 2012 to 62% for the year ended October 2017. The data also showed a corresponding decline in revenue per available room (RevPAR) from $78 to $66. The creditor’s expert assumed that the property’s occupancy rate would be 66% for 2018, above the 63% occupancy rate for the hotel’s competitive group. He projected that demand for this type of hotel would be flat into the foreseeable future and the hotel would never again reach the 73% and 78% occupancy rates it achieved from 2011 through 2014.

The debtor’s expert calculated an as-is market value of $7.4 million, projecting a considerably higher occupancy rate (71%) than the opposing expert and a considerably lower stabilized expense ratio of 24%.

In its opinion, the Bankruptcy Court began its analysis by noting that courts struggle to find a “rational rule of decision” when faced with competing appraisals that often state widely divergent value opinions. To solve this dilemma, some courts have picked and chosen “the metrics” each appraiser used, and thusly have recomputed the valuation. Other courts have adopted the valuation of one expert while rejecting the opposing appraisal entirely. Still other courts have assigned a weighting to each opinion of value, “usually ending with a value finding somewhere in the middle.” The Bankruptcy Court said it previously had followed this approach rooted in the belief that “an appraisal by a competent and experienced appraiser, based on accepted valuation methodologies, should not easily be disregarded in the absence of clear error.”

While the court found both appraisers were “highly educated, well credentialed individuals who are each employed by a premier firm in the industry,” it noted that they were both “simply guessing about what the future holds,” which was apparent in the disclaimers contained in their expert reports. Market participants could reasonably find that either appraiser’s projections were credible in light of the available data, the court said. Accordingly, it gave each valuation equal weight and arrived at an as-is market value of $6.6 million. This value, the court found, was substantially less than the amount owed to the bank on the petition date, which was about $7.3 million. Accordingly, the debtor had no equity in the hotel property, the court found.

In its decision, the court went on to note that a lack of equity in the property need not be fatal if a debtor can show it made “demonstrable and timely progress toward a successful liquidation.” In this case, where the debtor did not present evidence that it had taken any steps toward selling or refinancing the hotel, the court found it was appropriate to grant the creditor relief from the stay. Accordingly, the bank had the right to “pursue any and all of its rights and remedies against” the debtor and its assets, including the hotel, the court concluded.

The Delaware Court of Chancery continues to refine the concept of a “Dell compliant” transaction process.

In re In re AOL Inc., Del. Ch. LEXIS 63 (February 23, 2018)

This dissenting-shareholder matter was filed after the 2015 merger of AOL with Verizon. On May 11, 2015, AOL’s board unanimously approved the merger agreement. A day later, the parties announced the deal. The deal closed on June 23, 2015, and dissenting shareholders later asked the Delaware Court of Chancery for a fair-value determination under the state’s statutory appraisal rights statute.

During the merger process, AOL’s board members met regularly to discuss “the deal landscape, includ­ing the potential transaction with Verizon.” AOL decided not to pursue an auction. An AOL representa­tive later explained that AOL, because of the nature of its business – technology and content provider – was “fragile.” He said that technology and media companies did not have hard assets but were based on relationships “that I think are almost impossible to be managed if a media company or a technology company is for sale.”

In a contemporaneous TV interview at the time of the merger, AOL’s CEO was asked why AOL did not pursue an auction as part of its sale process. The CEO explained he was “committed to doing the deal with Verizon.” He also said that there had been lots of rumors; after all, AOL was a public company. “If somebody wanted to come do a deal with us, they would have done it."

An appraisal proceeding in a fair value matter requires the court to value the company as a standalone “going concern” or as an “ongoing enterprise occupying a particular market position in the light of future prospects.” The court must not impose a minority discount and must deduct synergistic value or other value that the parties expect to result from the transaction.

In DFC Global and Dell, the Delaware Supreme Court found that the appraisal statute precluded the adoption of a presumption in favor of the deal price where certain preconditions were met. Rather, the trial court must consider “all the relevant factors” surrounding a transaction, the high court noted. But it also found that, if certain conditions are met, the deal price likely is the best evidence of fair value.

In this case, the Court of Chancery was to determine whether the sales process was “Dell compliant.” According to the court, “Dell compliant” meant: “Information was sufficiently disseminated to potential bidders, so that … an informed sale could take place, … without undue impediments imposed by the deal structure itself. In other words, before I may consider the deal price as persuasive evidence of statutory fair value, I must find that the deal process developed fair market value.”

In this case, the court found that the sales process accompanying this transaction “was insufficient to this task.” AOL rejected an auction and decided to deal with bidders other than Verizon individually. The court said it understood AOL’s reasoning, but when “front end” information sharing is limited, there has to be a “robust” post-agreement period. Concerning the front end, here rumors seemed to ensure that the market knew that AOL was in play; the company received plenty of coverage and various potential buyers expressed interest in doing some kind of deal. Further, the company responded to third parties that indicated a serious interest. The problem, the court found, was the post-agreement period, particularly statements from AOL’s CEO about his commitment to doing a deal with Verizon. These statements could prevent other bidders from pursuing a deal, particularly when viewed in tandem with some of the deal protections. The Court of Chancery thus decided the unique circumstances made it impossible to find the deal price was the best evidence of fair value.

The Court of Chancery went on to state that it was “unable, in a principled way, to assign the deal price any weight” as a portion of the fair value determination. But the court used the deal price as a “check.”

The court agreed with both parties’ experts that in this case a discounted cash flow (DCF) analysis was the most reliable method to achieve fair value. Both experts were highly qualified, but, for reasons the court did not state, the petitioners abandoned their expert’s value determination ($68.98 per share) and agreed to the court’s using the DCF model the company’s expert had presented as a starting point. The company’s expert arrived at a value of $44.85 per share.

Based on the various adjustments to the company expert’s DCF valuation, the court ultimately determined the fair value on the date of the merger was $48.70 per share – thus, less than the $50 per share deal price. In its opinion, the court also said it was aware of an incongruity in its findings. On the one hand, the court had found the deal price was not reliable evidence of fair value because of the flawed sales process. On the other hand, the court’s DCF analysis resulted in a price that was even lower than the deal price. The court explained the discrepancy by pointing to synergies that might have been included in the deal price and that had to be excluded in the fair value determination.

© 2018 J.J.B. Hilliard, W.L. Lyons, LLC., Member NYSE, SIPC and FINRA. You may not reproduce or distribute any part of this newsletter without Hilliard Lyons’ prior written consent. We believe that the information in this newsletter is relia­ble, but we do not guarantee its accuracy, and it may be condensed or incomplete. This newsletter is for infor­mation purposes only, and is not intended as financial, investment, legal, or consulting advice.