A Year in Review: Developments in the Delaware Courts Related to Financial Advisors

Transcription

1 A Year in Review: Developments in the Delaware Courts Related to Financial Advisors MERGERS & ACQUISITIONS CAPITAL MARKETS FINANCIAL RESTRUCTURING FINANCIAL ADVISORY SERVICES January 2013 HL.com

2 Developments in the Delaware Courts Related to Financial Advisors Today s Speakers Houlihan Lokey Hosts Jennifer Muller, Managing Director Chris Croft, Managing Director Richard De Rose, Managing Director JMuller@HL.com CCroft@HL.com RDeRose@HL.com Guest Speaker Kevin R. Shannon Potter Anderson & Corroon kshannon@potteranderson.com Mr. Shannon is Chair of the firm s Corporate Group and practices primarily in the areas of corporate and commercial litigation, including substantial experience in litigating stockholder class, derivative and other actions in the Delaware Court of Chancery. Prior to joining the firm, Mr. Shannon was a Certified Public Accountant with Deloitte, Haskins & Sells, and a Financial Officer with J.P. Morgan & Company. In light of his financial background, Kevin has been involved in numerous appraisal proceedings and other cases that address financial and accounting issues. He also has been involved in advising numerous special committees in connection with investigations of alleged improper conduct (including accounting irregularities). Due to the Live nature of this presentation, Webcast content is provided on an as is basis. Houlihan Lokey does not guarantee the accuracy, completeness, timeliness or availability of the content. Statements and opinions expressed herein are solely those of the author/presenter and may not coincide with those of Houlihan Lokey. 1

3 Developments in the Delaware Courts Related to Financial Advisors About Houlihan Lokey Investment Banking Services Corporate Finance Financial Advisory Financial Restructuring Mergers & Acquisitions Sellside & Buyside Transactions Leveraged Transactions Minority Equity Transactions Capital Markets Debt & Equity Private Placements High Yield Public Equity Offerings PIPEs Financings Liabilities Management Special Situations Advisory Fairness Opinions Solvency Opinions Valuation Opinions Due Diligence Services Tax & Financial Reporting Valuation Portfolio Valuation & Advisory Services Derivatives Valuation & Risk Management Dispute Resolution & Financial Expert Opinions Chapter 11 Planning Restructuring Debt and Equity Debtor-in-Possession ( DIP ) Financing Exchange Offers Plans of Reorganization Distressed Mergers and Acquisitions 14 Offices Globally, over 850 Employees Comprehensive Industry Coverage Beijing Tokyo Hong Kong Aerospace Defense Government Business Services Consumer, Food & Retail Energy Mumbai Singapore Minneapolis San Francisco Chicago Los Angeles & Newport Beach Dallas London Paris New York Washington, D.C. Atlanta Frankfurt Financial Institutions Media & Telecom Financial Technology Real Estate, Lodging & Leisure Healthcare Technology Industrials Transportation & Logistics Avista Advisory locations 2

4 Developments in the Delaware Courts Related to Financial Advisors Agenda Overview of Investment Bank Conflicts Overview of Valuation Issues Overview of Banker Disclosure Issues 3

5 Investment Bank Conflicts

6 Investment Bank Conflicts Introduction Since van Gorkom, investment banker advice/opinions have been viewed as important elements in discharging directors duty of care in M&A transactions. Section 141(e) of the DGCL: a director is fully protected in relying in good faith on information, opinions, reports or statements he or she reasonably believes are in the advisor s professional competence provided the advisor has been selected with reasonable care. Recent litigation theme: failure of directors to identify, assess and neutralize conflicts of interest on the part of financial advisors. The wide range of activities conducted by large banks can lead to conflicts: Acting in any capacity for any identified counterparty; Past, present and anticipated relationships with potential counterparties; Ownership of debt or equity securities (or derivatives); Acting as a counterparty in a hedging or structured product arrangement; Participation as a lender; or Advising contemporaneous sellers of similar assets. 5

7 Investment Bank Conflicts Introduction (cont.) Investment banker conflicts can impugn the board s exercise of reasonable care. Disclosed conflicts: Did the board act reasonably in retaining the advisor? Undisclosed d conflicts: Did the board exercise care in selecting its advisor? No to either question could affect the board s ability to rely on Section 141(e). In re Del Monte Foods Co. S holders Litig.: [b]ecause of the central role played by investment banks in the evaluation, exploration, selection and implementation of strategic alternatives, this Court.has examined banker conflicts closely to determine whether they tainted the directors process. Reasonable probability of success of proving that the board of Del Monte Foods had breached its duty of care as a result of its financial advisor s s failure to disclose: An unauthorized effort to put Del Monte in play; Its ambition to provide buy-side financing to the acquirer; and That it had orchestrated a joint bid by two PE firms in violation of a confidentiality agreement provision against clubbing. 6

8 Investment Bank Conflicts In re El Paso S holder Litig., C.A. (Del. Ch. Feb. 2012)( El Paso ) In May 2011, El Paso Corporation ( El Paso ) announced a spin-off of its exploration and production ( E&P ) Business (the Spin-Off ). The company s long-time investment banker was retained to act as its advisor with regard tothespin-off. After the announcement, Kinder-Morgan, Inc. ( KMI ), another pipeline operator, offered to buy El Paso for $25.50 in cash and KMI stock. El Paso s advisor disclosed to the board that it owned 19% of KMI (a $4 billion investment) and thatt two of its partners were KMI directors. Additionally, though undisclosed at the time, the lead banker advising El Paso on the Spin- Off personally owned $340,000 of KMI stock. Owing to the conflict, a second investment bank was retained to advise El Paso with respect to any KMI transaction; however, that bank had no role with respect to the Spin-Off and was to be paid only if the KMI transaction was completed. Although the fist bank was only advising on the Spin-Off, El Paso agreed to pay it $20 million if a sale took place in lieu of the Spin-Off. 7

9 Investment Bank Conflicts In re El Paso S holder Litig., C.A. (Del. Ch. Feb. 2012)( El Paso ) (cont.) KMI raised and then lowered its bid; final deal struck at $26.87 in cash, KMI stock and warrants. Chancellor Strine expressed concern that the first advisor s s financial interest in KMI may have influenced its advice to El Paso. As the advisor in connection with the Spin-Off, the first advisor remained in a position to indirectly exert influence over the KMI transaction. Continued downward valuation of the E&P business was viewed by the Chancellor as suspicious given the huge financial interest in KMI. When El Paso first announced the Spin-Off, the E&P business valued at $8-$10 billion, based on a comparable company analysis. By October 2011, valuation range had dropped to $6-$8 billion. At the same time, KMI s bankers valued the E&P business at $7.9 billion. Chancellor Strine labeled the first advisor s valuation as questionable because market multiples were depressed due to short-term volatility in commodity prices, and were, in the Court s view, inadequate indicators of long term value. Failed to consider control premium upon a sale of the E&P business. 8

10 Investment Bank Conflicts In re El Paso S holder Litig., C.A. (Del. Ch. Feb. 2012)( El Paso ) (cont.) The Court also criticized the second advisor, which was to receive $35 million if the KMI merger was consummated and zilch, nada, zero if the Spin-Off occurred. This asymmetrical incentive, in Chancellor Strine s view, led to odd valuations by the advisor. DCF terminal value for El Paso s pipeline business implied a 0.7% growth rate: at odds with management s testimony that the business had strong growth prospects. Used a higher cost of equity when valuing the E&P business than when valuing KMI. Analysis arguably skewed in favor of the KMI merger (and a fee for the second financial advisor) by overvaluing the equity portion of the merger consideration. The Court ultimately denied a preliminary injunction because El Paso stockholders could turn down the deal if they did not like the price, and because no rival bid existed. 9

11 Investment Bank Conflicts Addressing Investment Bank Conflicts Identifying Potential Conflicts Interview multiple firms. Identify likelycounterpartiesl ti and require disclosure of any material relationships. Discuss nature of relationships; past fees; proximity in time and deal team overlap. How often has the bank(er) pitched the likely counterparties for business? Require disclosure of prior substantive discussions the bank(er) has had with private equity firms, hedge funds or other potential counterparties regarding the company. Is the bank in possession of material non-public information about a likely counterparty as the result of a prior engagement? Require disclosure of all interests in either the company or any of the likely counterparties. Disclosures should encompass members of the deal team as well as the firm in general. 10

12 Investment Bank Conflicts Addressing Investment Bank Conflicts (cont.) Managing Potential Conflicts To the extent conflicts surface, the board needs to balance the severity of the conflict against any unique experience or expertise possessed by the conflicted bank(er). Can the conflict be cured through the imposition of an informational barrier? Through disclosure of the conflict to stockholders? If conflicts are identified on the part of an otherwise indispensible advisor, the role of the conflicted bank(er) should be limited. Consider whether any advice received from the conflicted advisor has been influenced by the conflict. Investment banks are independent contractors with no fiduciary duty to the company, the board or stockholders. Accordingly, the terms of the engagement letter are critical in determining the banker s responsibilities to its client. Consider engagement letter representations regarding areas of potential conflict and covenants prohibiting actions that might constitute a conflict going forward. 11

13 Investment Bank Conflicts Addressing Investment Bank Conflicts (cont.) Managing Potential Conflicts (cont.) The fee structure should be tailored to mitigate any potential for conflicts. If aconflict develops, the fee for second advisor di should be paid out of the fee otherwise payable to the conflicted advisor. Second advisor needs to have an active role in the process. 12

14 Valuation Issues

15 Valuation Issues Valuation Issues Recent cases have been decided by the Delaware Court of Chancery (the Court ) that provide guidance with respect to key valuation issues and with respect to appropriate financial analyses. The cases are: In re Southern Peru Copper Corporation S holder Litig., C.A. No. 961-CS (Del. Ch. Oct. 14, 2011) ( Southern Peru ); In re El Paso S holder Litig., C.A. No CS (Del. Ch. Feb. 29, 2012) ( El Paso ); Gearreald v. Just Care, Inc., C.A. No VCP (Del. Ch. Apr. 30, 2012) ( Just Care ); and In re Appraisal of Orchard Enterprises, Inc., C.A. No CS (Del. Ch. July 18, 2012) ( Orchard ). Each of these cases are highly fact specific, but key takeaways can be found in the following categories: Consistency Market Indicia Projections Comparables Capital Structure Equity Risk Premium Discount Rate Company-Specific Risk Premium 14

16 Valuation Issues Valuation Issues (cont.) Consistency In both Southern Peru and El Paso, the Court was critical of seeming inconsistencies in the analyses undertaken by the respective financial advisor. In Southern Peru, Minera Mexico, S.A. de C.V. ( Minera ) was purchased by Southern Peru Copper Corporation ( SPCC ) from SPCC s controlling stockholder in a stock-for-stock transaction. The major inconsistency highlighted by the Court was the financial advisor s move from an analysis that (i) relied on the market price of SPCC s common stock (which was widely traded on the NYSE) and (ii) indicated that SPCC was overpaying for Minera, to a relative valuation that used the discounted cash flow values of SPCC and Minera, closed the valuation gap and allowed the advisor to provide a fairness opinion. Other inconsistencies in the financial analyses included (a) using a lower discount rate for Minera, the weaker of the two companies, than for SPCC, (b) applying the stronger company s EBITDA multiple to Minera, and (c) optimizing Minera s cash flows for expansion opportunities but not doing the same for SPCC. In El Paso, in the context of a cash and stock transaction, the Court was critical of the fact that the financial advisor used an 11.8% cost of equity in valuing El Paso Corporation, but then used a substantially lower 7.5% rate in valuing the stock of its acquirer, Kinder Morgan Inc., a company that was, in most respects, very similar to El Paso. 15

17 Valuation Issues Valuation Issues (cont.) Market Indicia Southern Peru suggests that where there is an active, liquid market for a company s stock, the market price of that stock is a relevant valuation factor. Similar implications were suggested in bankruptcy court rulings (e.g., Iridium and VFB LLC v. Campbell Soup Co.). 16

18 Valuation Issues Valuation Issues (cont.) Projections In Just Care, the Court confirmed that management projections made in the ordinary course of business will generally be deemed reliable. However, when they are made outside the ordinary course of business, or when their reliability may be impaired by management s selfinterested motives, such projections will not be accorded the same deference by the Court. In this case, Just Care, Inc. ( JCI ) had never prepared projections beyond the current fiscal year. Moreover, the projections in question were prepared at a time when JCI s CEO and CFO were advocating a transaction with a private equity group over a competing acquisition of JCI by a subsidiary of The General Electric Company (the JCI Acquisition ). In that circumstance, the Court held that JCI had the burden of proving the credibility of the projections. 17

19 Valuation Issues Valuation Issues (cont.) Comparables In valuing a digital music distribution company, the defendant s expert in Orchard relied on comparable companies that were, in the Court s view, behemoths with only divisions and subsidiaries in the music distribution business. In rejecting the analysis, Chancellor Strine noted that although the comparables were in a related space, none of them derived most of their revenue by obtaining the right to and then distributing digital access to music. The Court was also highlyhl critical of the defendant s d experts choice of multiple. l The comparables yielded a mean market value of invested capital to EBITDA multiple of and a median multiple of However, instead of using either the mean or median multiple, the defendant s expert used a self-chosen multiple of 11 because Orchard had a lower liquidity ratio and lacked tangible net worth. The Court chastised the expert for not being able to explain why those factors were important or how they correlated to a lower multiple than the mean or median of the comparables. Chancellor Strine observed that when an expert throws out his sample and simply chooses his own multiple in a directional variation from the median and mean that serves his client s cause, he is not using the comparables method in any reliable way that accords with my understanding of its proper deployment. In El Paso, the Court was critical of the financial advisor s s reliance on market multiples that were temporarily depressed due to volatility in the commodities markets as an indication of long-term value. 18

20 Valuation Issues Valuation Issues (cont.) Capital Structure As a condition to the JCI Acquisition, JCI was obligated to redeem its outstanding preferred stock and to repay its existing indebtedness. Accordingly, the defendants expert chose a 100% equity capital structure in valuing JCI. By contrast, the expert for the plaintiffs relied on JCI s historical capital structure. In Just Care, Vice Chancellor Parsons indicated that the correct capital structure for an appraisal of JCI is the theoretical capital structure it would have maintained as a going concern, without regard to any changes made in anticipation of the transaction in question. Prior cases have indicated that, in an appraisal proceeding, it is not appropriate to look to the capital structures of industry peers, unless the subject company is, in fact, attempting to achieve a similar capital structure. The Court in both Just Care and Orchard treated the subject company s preferred stock as common equity to reflect how the preferred stock actually functioned from an economic perspective. 19

21 Valuation Issues Valuation Issues (cont.) Equity Risk Premium ( ERP ) In both Just Care and Orchard, the Court followed the precedent set in Global GT LP v. Golden Telecom, Inc. (993 A.2d 497 (Del. Ch. 2010), aff d d, 11 A.3d 214 (Del. 2010)) and adopted Ibbotson s supply-side ERP over the historical ERP. Notwithstanding the fact that the Delaware courts have historically sanctioned the use of the historical ERP, over the past two years, the Court has taken notice of the fact that, more recently, the academic community has gravitated t towards greater support for using the supplyside ERP. Given these recent cases, it can be expected that the Court will presume that a supply-side ERP is the appropriate metric to be applied when there is no persuasive evidence to the contrary. 20

22 Valuation Issues Valuation Issues (cont.) Discount Rate Consistent with prior decisions, Chancellor Strine, in Orchard, criticized the build-up model as being not well accepted by mainstream corporate finance theory as a method for determining a discount rate. The Court was also critical in using multiple models to calculate the discount rate and blending them together. In a colorful passage, Chancellor Strine remarked: Even if one were to conclude that there are multiple ways to come up with a discount rate, that does not mean that one should use them all at one time and then blend them together. Marc Vetri, Mario Batali and Lidia Bastianich all make a mean marinara sauce. Is the best way to serve a good meal to your guest to cook up each chef s recipe and then pour them into a single huge pot? Or is it to make the hard choice among the recipes and follow the chosen one as faithfully as a home cook can? This home cook will follow the one recipe approach and use the recipe endorsed by Brealey, Myers and Allen and the mainstream of corporate finance theory taught in our leading academic institutions, i.e., the CAPM method. 21

23 Valuation Issues Valuation Issues (cont.) Company-Specific Risk Premium Consistent with prior cases, in Orchard, the Court disapproved of the use of a company- specific risk premium in a CAPM calculation, especially when there are no concerns regarding the reliability of management s projections. While the Court recognized that a company-specific risk premium is sometimes used as a convenient way to reflect the fact that a company has risk factors that have not been captured by the ERP and size premium, the Court believes the better approach (and the one more consistent with corporate finance theory) is to take such factors into account through adjustments to the company s cash-flow estimates. 22

24 Banker Disclosure Issues

25 Banker Disclosure Issues Banker Disclosure Issues Claims of inadequate disclosure typically arise in the context of a stockholder attempt to enjoin a transaction. The stockholder usually asserts that the public disclosures omitted material information -- rather than alleging that the disclosures were false. The alleged omissions often relate to the banker s analysis and opinion. The issue is whether a reasonable stockholder would consider the omitted information important in a decision pertaining to its stock. It is not enough that the additional information might be helpful to the stockholder. It must significantly alter the total mix of information available. Whether omitted information is material is context specific and must be evaluated in light of the nature of the transaction and the other information available. As the Court of Chancery explained in In re Midas: The mere fact that some issues may have proved material in a past case cannot endow that issue with talismanic properties or reduce it to a magic word forever after. That is, the materiality of any fact, projection, or figure cannot be divorced from the particular circumstances facing the defendant company and the challenged transaction. 24

26 Banker Disclosure Issues Retention of Bankers and Potential Conflicts The terms of the banker s engagement Total fees, percentage contingent on transaction The banker s prior work or relationship with the parties involved Any other potential interests in the transaction at issue, such as stock ownership In re Micromet (concluding that the stockholder failed to present evidence from which the Court reasonably could infer that the size and nature of [the financial advisor s] s] Amgen holdings in this case would be likely to impede its ability effectively and loyally to perform its assignment. ). 25

27 Banker Disclosure Issues The Disclosure of Company Projections Disclosure is usually required when the banker received and relied upon the projections. Also consider whether disclosure of projections might be confusing or misleading to stockholders (more information is not always better). Dent v. Ramtron Int l Corp.: in light of the circumstances presented and other information disclosed, the projections prepared by management and provided to the banker were deemed not material. Upside, downside, and base case projections In re Micromet: not required to disclose upside projections provided to the financial advisor because they did not rely on them and some directors deemed the projections unreliable and overly optimistic. The level of detail required In re Answers: Although all of this granular information might be of interest to Answers shareholders, the information regarding revenue, EBITDA, and cash-on-hand already provided in the Proxy Materials is sufficient to allow shareholders to evaluate the Proposed Transaction in light of these factors. 26

28 Banker Disclosure Issues Disclosures Relating to the Banker s Analysis and Opinions Stockholders are entitled to a fair summary of the substantive work performed by the banker and relied upon by the board. A fair summary generally includes: the basic valuation exercises performed; the key assumptions relied upon by the banker; and the range of values generated by the banker s analysis. Not all analysis prepared by the banker and given to the board must be disclosed. In re Micromet: not required to disclose the sum-of-the-parts analysis prepared by the financial advisor at the request of the board because they did not rely on the analysis and it suggested a valuation range similar to the DCF valuation range that was disclosed. Additional disclosures may be required to remedy partial or incomplete disclosures. Disclosures of other communications In re Ancestry: required to disclose that the banker advised the Company that it would be difficult to provide a fairness opinion based on the initial management projections. 27

29 Q&A

30 Disclaimer 2013 Houlihan Lokey. All rights reserved. This material may not be reproduced in any format by any means or redistributed without the prior written consent of Houlihan Lokey. Houlihan Lokey is a trade name for Houlihan Lokey, Inc. and its subsidiaries and affiliates which include: Houlihan Lokey Capital, Inc., a California i corporation, a registered broker-dealer and SIPC member firm, which h provides investment banking, private placement, merger, acquisition and divestiture services; Houlihan Lokey Financial Advisors, Inc., a California corporation, a registered investment advisor, which provides investment advisory, fairness opinion, solvency opinion, valuation opinion, restructuring advisory and portfolio management services; and Houlihan Lokey (Europe) Limited, a company incorporated in England which is authorized and regulated by the U.K. Financial Services Authority and Houlihan Lokey (China) Limited, a company incorporated in Hong Kong SAR which is licensed in Hong Kong by the Securities and Futures Commission, which provide investment banking, restructuring advisory, merger, acquisition and divestiture services, valuation opinion and private placement services and which may direct this communication within the European Economic Area and Hong Kong, respectively, to intended recipients including professional investors, high-net-worth companies or other institutional investors. Houlihan Lokey gathers its data from sources it considers reliable; however, it does not guarantee the accuracy or completeness of the information provided within this presentation. The material presented reflects information known to the authors at the time this presentation was written, and this information is subject to change. Houlihan Lokey makes no representations or warranties, expressed or implied, regarding the accuracy of this material. The views expressed in this material accurately reflect the personal views of the authors regarding the subject securities and issuers and do not necessarily coincide with those of Houlihan Lokey. Officers, directors and partners in the Houlihan Lokey group of companies may have positions in the securities of the companies discussed. This presentation does not constitute advice or a recommendation, offer or solicitation with respect to the securities of any company discussed herein, is not intended to provide information upon which to base an investment decision, and should not be construed as such. Houlihan Lokey or its affiliates may from time to time provide investment banking or related services to these companies. Like all Houlihan Lokey employees, the authors of this presentation receive compensation that is affected by overall firm profitability. 29