Valuation Issues in Shareholder Disputes resolved by the Delaware Court of Chancery

Valuation Issues in Shareholder Disputes resolved by the Delaware Court of Chancery 1 ERIC M. ANDERSEN, ESQUIRE, CPA ANDERSEN SLEATER LLC ERIC@ANDERSENSLEATER.COM 3513 Concord Pike Suite 3300 Wilmington, DE 19803 (302) 595-9102 1345 Avenue of the Americas 2 nd Floor, Suite 2100 New York, NY 10105 (212) 878-3697 Agenda 1. Delaware Court of Chancery 2. Outside of Delaware 3. When is Fair Value Measured? 4. Timing of Payment to Dissenting Shareholders 5. Valuation Guidance by Delaware 6. Pending Proposals to Change Delaware Appraisal Statutes 2 1

Delaware Court of Chancery Exclusive Forum to Determine Dissenter s Rights for a Delaware corporation Large amount of case law regarding valuation Chancellor or Vice Chancellor must independently perform his own valuation 3 Dissenter s Rights 4 Focus of this Presentation Not necessary to accuse the board of any wrongdoing Must give notice of intent to demand appraisal before Merger Vote Interest runs at 5% plus the federal discount rate compounded quarterly from close of transaction Permitted to Dissent for Shares Purchased After Transaction Announcement 2

Class Action Shareholder accuses board of directors of target corporation that they breach fiduciary duties when they approved merger Represents all outstanding shares if class certification is granted Damages not awarded unless court finds breach of the duty of loyalty or good faith Must own shares before merger announcement 5 6 OUTSIDE OF DELAWARE 3

Triggering Events Although discussions of appraisal rights usually arise in the context of mergers, in most states, shareholders are entitled to appraisal rights on a host of other extraordinary transactions such as significant asset sales, charter amendments and corporate conversions/domestications. 7 Transformative Transactions In Delaware, transactions that may be the economic equivalent of a merger do not trigger appraisal rights. But, in other jurisdictions including Virginia, Texas and New York, many other extraordinary transactions on which shareholders are required to vote, including dispositions of substantially all of the assets as well as certain charter amendments, also give rise to appraisal rights. 8 4

Acquirer Shareholders In a few states, including Ohio, acquirer shareholders may also be entitled to dissenters rights in connection with majority share acquisitions and combinations involving the issuance of a significant percentage of the buyer s shares. For example, in the 2005 stock for stock acquisition of Gillette, a Delaware corporation, by Ohio incorporated Procter & Gamble, P&G s issuance of more than 30 percent of its shares to Gillette holders constituted a majority share acquisition entitling P&G shareholders to dissent. 9 Acquirer Shareholders Target Gillette shareholders did not have appraisal rights because of the market-out exception in Delaware Acquirer P&G shareholders could dissent. The parties addressed the resulting risk by conditioning the deal on no more than 5 percent of P&G s shareholders exercising dissenters rights, which was met and the transaction closed as planned. 10 5

Market-Out Exception Even if an extraordinary corporate transaction triggers appraisal rights, a shareholder of a public company may not be entitled to appraisal rights if the target s state provides for a market-out exception to appraisal. The public markets serve as an independent check on valuation, removing the need for a court s determination of fair value. 11 Market-Out Exception 12 In Delaware, if a target shareholder holds publicly traded stock, then the shareholder is not entitled to appraisal rights (unless the shareholder is required to accept in the merger any consideration other than publicly traded stock). In some states such as New York and New Jersey, the market-out exception applies even if the public company target shareholders receive cash in the merger. 6

Maryland Triggering Events Stockholders of any Maryland corporation have the right to demand and to receive payment of the fair value of their stock in the event of 13 (1) a merger or consolidation (2) a share exchange, (3) a transfer of assets, (4) a charter amendment altering contract rights of outstanding stock (unless the right to do so is reserved in the charter) or (5) a business combination governed by Section 3-602 or exempted by Section 3-603(b) ( 3-202(a)). Maryland Market-Out 14 The right to fair value does not apply if (1) the stock is listed on a national securities exchange (unless the transaction falls under 3-202(d) described below); (2) the stock is that of the successor in a merger (unless the merger alters the contract rights of the stock or converts the stock in whole or in part into something other than stock, cash or other interests); (3) the stock is not entitled, other than solely because of Section 3-106, to be voted on the transaction or the stockholder did not own the stock on the record date for determining stockholders entitled to vote on the transaction; (4) the charter provides that the holders of the stock are not entitled to exercise the rights of an objecting stockholder; or (5) the stock is that of an open-end investment company registered with the Securities and Exchange Commission under the 1940 Act and the stock is valued in the transaction at its net asset value ( 3-202(c)). 7

T. Rowe Price Associates (2008) Reverse Market-Out 15 Maryland and Massachusetts reverse the market-out exception in conflict or interested party transactions. Narrowed the market-out exemption in order to provide appraisal rights to stockholders of an exchangelisted corporation that are receiving cash (other than in lieu of fractional shares), or consideration other than stock or depositary receipts of the successor, in a merger, consolidation or share exchange in which the directors and executive officers were the beneficial owners, in the aggregate, of 5% or more of the outstanding voting stock of the corporation at any time during the prior year, and the stock held by the directors and executive officers, or any of them, is converted or exchanged in the transaction for stock of a person, or an affiliate of a person, who is a party to the transaction on terms that are not otherwise available to all holders. Exception to the Reverse Market-out Compensatory Plan Reverse market-out provision does not apply when the directors and officers stock is held in a compensatory plan or arrangement approved by the board of directors and the treatment of the stock in the transaction is approved by the board ( 3-202(d)). 16 8

17 TIMING OF PAYMENT TO DISSENTING SHAREHOLDERS Interest Rate Arbitrage 18 Delaware awards dissenters the right to receive interest (at 5 percent above the Fed discount rate) on the fair value of their shares from the closing date until the award is actually paid, irrespective of the ultimate outcome of the appraisal proceedings a relatively meaningful arbitrage opportunity itself in today s low interest rate environment. The interest is meant to compensate the shareholders for the fact that, if they exercise appraisal rights, they do not receive any 9

Interest Rate Arbitrage 19 This accruing interest can also represent a significant additional cost to the company, with the Court of Chancery recently deciding in CKx that the Delaware statute did not permit companies to prepay the petitioner the deal price as a means of stopping the accrual of interest on at least that portion of a potential appraisal award. Other States 20 Many states such as Illinois, Massachusetts and North Carolina have tried to remedy the cash flow problem faced by dissenting shareholders by requiring the corporation to pay upfront its estimate of the fair market value for the dissenters shares (with companies often choosing to pay the deal price). Then, at the end of the appraisal proceedings, the corporation must pay to the shareholder the excess (if any) of the appraised fair value over the estimated payment. 10

Maryland Interest is award from the date which fair value is to be determined. 3-211(c)(1) Exception: Dissenting shareholder failure to accept offer from buyer was arbitrary and vexatious or not in good faith. 3-211(c)(2) Price which the buyer offered Information Furnished to Stockholder Other circumstances [the Court] considers relevant. 21 Anti-Arb Exception 22 Under an anti-arb exception in Washington, the company is not required to make the mandatory down payment to any shareholders who acquired the shares after the announcement of the deal, meaning that such a post-signing buyer will be exposed to the cash flow issue should they choose to later exercise dissenters rights. 11

23 When is Fair Value Measured? Definitions of Value 24 Treasury Regulations Fair Market Value: the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. (Treasury Reg. 20.2031-1(b); Revenue Ruling 59-60, 1959 1 C.B. 237) 12

GAAP Financial Reporting 25 Fair value: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (ASC 820) Revised Model Business Corporation Act 26 Fair value: the value of the shares immediate before the effectuation of the corporate action to which the shareholder objects, excluding any appreciation or depreciation in anticipation of the corporation action unless exclusion would be inequitable. (Revised Model Business Corporation Act, 1984) 13

State Comparison 27 In Delaware, the court is tasked with appraising the fair value of the company immediately prior to the completion of the merger, which may be months after the deal price was struck (but without giving effect to any of the anticipated benefits of the merger, such as synergies). By comparison, in California, the fair value for dissenters is appraised as of immediately prior to the announcement of the relevant transaction. Delaware Definition 28 the Court shall determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with interest, if any, to be paid upon the amount determined to be the fair value. 8 Del. C. 262(h) 14

New York 29 New York s statute directs the court to measure as of the close of business on the day prior to the date of the shareholder vote but also to take account of the impact on value of the transaction giving rise to the appraisal remedy. Maryland 30 If merger is by a controlling shareholder with over 90% or more shares, then on day notice is given to the shareholders. 3-202(b)(1)(i) Any other transaction, on the day the stockholders voted on the transaction objected to. 3-302(b)(1)(ii) Fair value may not include any appreciation or depreciation which directly or indirectly results from the transaction objected to or from its proposal. 3-302(b)(2) 15

31 VALUATION GUIDANCE BY DELAWARE Management s Financial Projections Expert cannot accept without stress testing Historical Analysis Market Research Industries Studies Prepared in the Ordinary Course vs. For fairness opinion For litigation For getting loan from financial institution 32 16

Discounted Cash Flow Primary valuation methodology if the company is established and has a history of positive cash flow. If management cannot create projections that are reliable, then a discounted cash flow is not appropriate. Answers Corp. Shareholder Litigation. 33 Preferred Stock Conversion to Common Stock reducing per share value by increasing outstanding shares Liquidation Preference: If company is liquidated, preferred stock takes first $25 million in proceeds. Orchard Enterprises. Valuation was not permitted to take into preferred stock conversion because a liquidation never occurred i.e. hypothetical. 34 17

Preferred Stock If preferred stock has a mandatory redemption at a price and date that is certain, the valuation must account for redemption rights. Shiftan v. Morgan Joseph Holdings, Inc. If the preferred stock provision is hypothetical, then those rights to do effect valuation of common stock. If the event will definitely happen sometime in the future, then right must be included in valuation analysis. 35 Transaction Price is Fair Value Significant and atypical valuation challenges. Huff Fund Investment P ship v. CKx, Inc. no comparable companies no comparable transactions management s projections are not reliable Court found that Merger Price is Fair Value 36 Buyer was a third-party (arms-length) Sales Process in which all Potential Acquirers Were Contacted for Interest 18

Market Approach 37 Because the Company did not have any earnings or positive cash flow to perform a DCF, using last twelve months revenue multiples for comparable companies was appropriate. Nine Systems Corp. S holders Litig. An expert valuation tends to be more credible when it is based on a blend of techniques that serve to cross-check on another s results. Market Approach Using market approach is questionable when using only one company as the comparable company. AT&T Mobility Wireless Operations; IQ Holdings Inc. v. American Commercial Line Also, questionable when 38 one company is not comparable; or comparable transaction was done under significantly different market conditions. 19

Tax Affecting 39 Application of Income Taxes to the Earnings of Flow- Through Entity Such as an S Corp. Income tax consequences for an S Corp s profits are charged directly to the entity s shareholders, unlike C Corp s where income taxes are paid at the entity level. Tax affecting means that an appraiser reduces earnings of the S Corp by the income tax consequences, thereby making the after-tax earnings of the S Corp more comparable to that of a C Corp, where income taxes are paid at the entity level. Delaware Approach to Tax Affecting 40 Applying 40% corporate tax rate rejected because minority group would be denied the value they would have received as continuing S Corp shareholders, because there was no evidence that the company would convert to a C Corp. Applying no tax rate because it overstated the value of the S Corp at the shareholder level, as upon its sale an S Corp receives no premium over a C Corp from a universe of C Corp buyers, and market-based analysis using C Corp comparables is misleading. 20

Delaware Approach to Tax Affecting To capture the precise advantage of the S Corp structure to the minority shareholders, the court considered the difference between the value that a minority member would receive if the company was a C Corp and the value received as an S Corp. 41 The court embraced the leading Tax Court cases (Gross, Heck and Adams), which have given life to the advantages of S corporation status by refusing to tax affect the... earnings at all. Delaware Approach to Tax Affecting 42 The court estimated what an equivalent, hypothetical pre-dividend S Corp tax rate would be, assuming annual earnings of $100 and highest marginal tax rates. Delaware Open MRI Radiology Associates, P.A. v. Kessler. Applied 29.4% effective tax rate to corporate earnings. to treat the S Corp shareholder as receiving the full benefit of untaxed dividends, by equating its after-tax return to the afterdividend return to a C Corp shareholder. Taxed Dividends at 15% 21

Tips for Experts Terminal Value - Growth into Perpetuity Preference for Gordon Growth Model 43 Cap Rate of projected earning in Year 6 (for 5 years of projections) Discounted Back to Year 0 Exit Multiple Mixing and Matching Income and Market Approach Plans to Improve Cash Flow that are not Speculative can be Included (e.g. expansions or acquisitions) Tips for Experts (Cont d) Court will review each company deemed comparable of guideline companies Use discounted cash flow method when projections are made by management in the ordinary course of business. Delaware Chancery Court typically applies a control premium to value indications derived from the guideline public company methodology Control premium should exclude the impact of synergies 44 22

Tips for Experts (Cont d) 45 Do not apply a control premium to the value from the Discounted Cash Flow method unless there are special circumstances. Must have in-depth support for the application of a company specific risk premium. Must support the selection of valuation multiples with detailed financial analysis and consideration of qualitative factors. Provide electronic copy of models so the Court could manipulate based its rulings Purpose of Management s Creation of Projections 46 Importance of management s contemporaneouslyprepared projections (Merion Capital, L.P. v. 3M Cogent, Inc.) Management s projections created specifically for a merger should not be accorded the same deference as those prepared in the ordinary course of business (Gerreald v. Just Care, Inc.) 23

Proposed Expansion at Valuation Date Rejected a scenario including expansion into a new market as being too speculative, because the business did not have a history of expanding into new markets and had not received an RFP for work in the new market. Gerreald v. Just Care, Inc. Accepted a scenario including a new facility at a center where the business already operated, had previously expanded its operations, and had land available for the expansion Due to the related uncertainty, the Court riskweighted the expansion case 47 Proposed Expansion at Valuation Date Included value from specific expansion plans or changes in strategy that are not the product of speculation Delaware Open MRI Radiology Associates, P.A. v. Kessler, Same standard used when determining whether to include acquisitions - Nine Systems Corp. (standalone company did not have the capital to fund either acquisition). 48 24

Comparable Transactions or Companies 49 [R]eliance on a comparable companies or comparable transactions approach is improper where the purported comparables involve significantly different products or services than the company whose appraisal is at issue, or vastly different multiples Appraisal of the Orchard Enterprises, Inc. Expert s comparable companies and transactions analyses were unreliable due to, among other things, Inclusion of companies with a significantly lower enterprise value, Inclusion of companies that were not in a comparable industry, Omission of companies the Court considered comparable, and Lack of enough multiples to provide sufficient foundation for the analysis. Merion Capital, L.P. v. 3M Cogent, Inc., 50 Proposed Amendments to Appraisal Delaware Statute Section 262 25

Interest Reduction Amendment 51 This amendment would provide an option for a company in an appraisal proceeding to pay a cash amount to the dissenting shareholders before the appraisal proceeding ends (an upfront payment ). Statutory interest would accrue thereafter only on the unpaid portion of the ultimate appraisal award. The upfront payment would presumably be nonrefundable, as there is no clawback mechanism provided in the proposed amendment for a company to recoup any amount paid out that turns out to have exceeded the ultimate appraisal award. De Minimis Amendment 52 Appraisal petitions would be dismissed if the shares seeking appraisal were traded on a national securities exchange and (a) the value of the merger consideration applicable to the shares seeking appraisal is less than $1 million or (b) the shares seeking appraisal represent less than 1 percent of the total outstanding shares of the class entitled to appraisal rights. The threshold minimums would not apply in the case of appraisal following a short-form merger (since appraisal may be the only remedy available to dissenting shareholders in a merger in which there is no stockholder vote). 26

Weak Appraisal Claims 53 Those that are made with respect to transactions that are unlikely to result in an appraisal award that is significantly higher than the merger price. Currently, weak claims may be made simply based on settlement value, calculated in large part as the present value of the merger price plus the statutory interest. Settled relatively quickly, the focus of these claims is the additional amount provided by the interest factor. Weak Appraisal Claims 54 Successor company may make a large upfront payment (representing a significant percentage of the merger price), to attempt to reduce the economic value of a weak appraisal claim. 27

Strong Appraisal Claims Not Affected 55 Those that are made with respect to transactions that are likely to result in an appraisal award that is significantly higher than the merger price. Court has awarded appraisal amounts significantly exceeding the merger price in cases where there was an interested party transaction without a robust sale process Upfront Payment Reduces Risk For Shareholder 56 Upfront payments in appraisal cases would significantly reduce the risks for petitioners associated with bringing appraisal petitions. An upfront payment representing a large percentage of the merger price would result in petitioners having only limited capital at stake during the proceeding (providing an opportunity for a highly leveraged yet low-risk investment with the potential for outsized returns on the limited capital invested) Use the upfront payment from the outset to fund costs of the proceeding. 28

Option for Upfront Payment Not Used 57 Acquirer would be unlikely to make an upfront payment if its cost of debt is equal to or greater than the statutory interest rate, if the company is a credit risk, or if the company believes the payment would significantly facilitate or favor the petitioners case or make reaching a settlement more difficult. Acquirer would not want to prejudice its argument in the proceeding by making an upfront payment that exceeds the amount it is arguing represents fair value (even if the company believes that the appraisal award will significantly exceed that amount). 29