Two recent appraisal decisions from the Delaware Court of Chancery provide additional guidance on when the court will defer to the merger price as evidence of fair value. In the first decision, In re Appraisal of PetSmart,1Vice Chancellor Slights determined that the process leading to the sale of PetSmart—in the context of an arm's-length, going-private transaction with a third-party, private equity acquirer—was reasonably designed and properly implemented to attain the fair value of the company.
There are three key takeaways from PetSmart. First, the case provides helpful guidance regarding factors that the court considers relevant when evaluating the reliability of projections. Finding management's projections "fanciful," the court noted several facts that signaled their unreliability, including that: (1) PetSmart's management had no history of creating long-term projections; (2) management's prior one-year forecasts frequently overshot actual results; (3) the projections were not created in the ordinary course of business, but instead for use in an auction process; and (4) management created the projections with pressure from PetSmart's board to be aggressive in order to drive up the company's perceived value during the sale process. The court concluded that, to be reliable, projections should reflect the company's "expected cash flows," not merely results that are "hoped for."
Second, the court is willing to consider post-closing evidence when evaluating the reasonableness of a company's projections. Although traditionally the court only considered facts "known or knowable" at the time of a merger, this position appears to have been relaxed somewhat in recent years. In PetSmart, for example, the court compared post-closing comparable stores sales growth and EBITDA to the projections used in the sales process, and rejected the petitioners' argument that the post-closing evidence bolstered the reliability of the projections, finding that the company was "massively underperforming" its projections in certain respects.
Last, Vice Chancellor Slights concluded by observing that the decision to "defer" to the deal price as a reliable indicator of fair value "project[ed] a certain elegance that is very appealing"—particularly where there was a $4.5 billion discrepancy between the deal price and the petitioners' "post-hoc valuation" (a 45 percent difference), which was unsupported by any evidence of "confounding factors" that would have caused such a "massive market failure." The court noted that, unlike market participants in arm's-length transactions that are incented to value a company as accurately as they can, paid experts presenting dueling and often widely divergent valuations based on discounted cash flow (DCF) analyses have very different incentives. Thus, the court warned that Delaware courts must remain "mindful" that the DCF method is subject to manipulation and guess-work while objective indicia in the form of a market-tested deal price is "not burdened by such litigation-driven confounding influences."
The second decision, In re Appraisal of SWS Group,2did not fit the mold described in PetSmart, and Vice Chancellor Glasscock rejected the deal price as evidence of fair value on the way to concluding that fair value fell below the deal price. This case involved the merger of SWS into a subsidiary of Hilltop, a substantial creditor of SWS. Several years before the merger, Hilltop and SWS entered into a credit agreement containing certain anti-takeover clauses—including a covenant prohibiting SWS from undergoing a sale—which would place SWS' debt in default if a stockholder acquired more than 24.9 percent of its stock. Hilltop was unwilling to waive this covenant during the sales process, which the court found to have granted Hilltop a "partial veto power over competing offers," contributed to a "problematic process," and affected the deal price.
After the court rejected the petitioners' comparable companies analysis (finding that, because of SWS' unique structure, size, and business model, it had few, if any, peers), the court was left with only one valuation method: the DCF analysis. The court employed management's three-year projections as the starting point, reasoning that management had historically prepared such projections, and rejected the petitioners' two-year extension to the projections as improper. The court next resolved the disputes between the parties' experts regarding the remaining inputs to the DCF model. This included adopting: (1) the respondents' long-term growth rate of 3.35 percent, which was the midpoint between inflation and the expected long-term growth rate of the economy; (2) the petitioners' use of the supply-side equity risk premium, noting that there was no reason in the record to depart from what the court has recognized as the "default method" for appraisal actions; (3) the petitioners' beta, which was based on a blended median of peer returns; and (4) the midpoint of the experts' size premium approaches.
Running these inputs through the respondents' DCF model, the court concluded that the fair value of SWS was $6.38 per share—below the merger price of $6.92. The court observed that this result was "not surprising" because the deal was a "synergies-driven transaction," whereby Hilltop shared valued arising from the merger with SWS. While the court did not go into detail regarding the amount of synergies in the deal, Delaware's appraisal statute requires that the determination of fair value be adjusted to exclude "any element of value arising from the accomplishment or expectation of the merger." Here, the respondents argued that the merger price would have been lower but for certain benefits that Hilltop would derive from the SWS acquisition, including cost savings related to an integration of SWS into an existing subsidiary and the resulting reduction of SWS' overhead.
For more information about appraisal litigation in the Delaware Court of Chancery, please contact William B. Chandler III, Brad Sorrels, or another member of the securities and governance litigation practice at Wilson Sonsini.
