On Monday, when a Delaware court ruled that Dell Computer’s then-CEO Michael Dell and Silver Lake Partners underpaid shareholders by about $6 billion, or 22%, when they took computer giant Dell Inc. private in 2013, many readers were left scratching their heads.
Those of a pro-shareholder bent asked: Who were the dastardly board members and financial advisors who went along with this highway robbery? Others, adopting the dealmakers’ perspective, wondered: Who exactly was the mystery buyer champing at the bit to pay $31 billion for Dell in 2013, when the market for Windows PCs was in free fall, when tablets and smartphones were on the march, and when enterprises were moving toward cloud services, building their own servers, or buying them from cut-rate Taiwanese and Chinese outfits?
But the ruling doesn’t actually find that the buyout team did anything wrong, nor does it imagine that any real world buyer was waiting in the wings prepared to fork over $17.62 per share—the judge-determined “fair value” for the company—rather than the $13.96 per share, counting certain dividends, that the buyout group paid. (The highest competing bid at the time, from investor Carl Icahn and Southeastern Asset Management, was valued at a little over $14 per share, but had arguable downsides in its details.)
Remember that the price Michael Dell’s group paid represented a 28% premium over the stock price ($10.88) on the day before news of the merger deal first leaked to the press in January 2013, and a 39% premium over the 90-day average stock price ($9.97) before that date.
Remember also that the buyout group bid won the endorsement of proxy advisory firms Institutional Shareholders Services and Glass Lewis & Co., as well as rating agency Egan-Jones Rating Co.
And remember, finally, that bad earnings news kept rolling in for both Dell and its industry throughout the bidding process, prompting Indigo Equity Research in August 2013, for instance, to call Dell a “sinking ship,” and to label Michael Dell’s turnaround plan as “fundamentally flawed.”
No Dell officer or board member was found to have breached any fiduciary duty to shareholders in Monday’s ruling, for instance, and it certainly accuses no one of fraud.
In fact, Vice Chancellor J. Travis Laster of the Delaware Chancery Court actually had some positive words for the company board’s conduct. Its special merger committee and its advisors—mainly J.P. Morgan Chase and Evercore Group—actually “did many praiseworthy things,” Laster wrote, “and it would burden an already long opinion to catalog them.” (His ruling was 114 pages.)
Nevertheless, the auction process the special committee ran, though not crooked, simply didn’t end up providing shareholders with “fair value” for their shares as Delaware law defines it, Vice Chancellor Laster concluded.
The result may seem counterintuitive. But as Laster noted, “The concept of fair value under Delaware law is not equivalent to the economic concept of fair market value. Rather, the concept … is a largely judge-made creation, freighted with policy considerations.”
In this article, I’ll try to shed a little light on this puzzling, seemingly paradoxical situation.
So if there was no breach of duty, why did the plaintiffs win?
This was an appraisal suit, not a breach of fiduciary duty suit. The only thing at issue in an appraisal suit is whether plaintiffs received “fair value” for their shares when the merger was approved in September 2013. The issue of “why” they may not have received fair value is not the question. The definition of fair value is vague; it’s the shareholder’s “proportionate interest in a going concern,” i.e., his shares’ “true or intrinsic value” under all the circumstances.
What’s an appraisal suit?
In the olden days, if a company wanted to merge, it needed the approval of 100% of its shareholders. That stopped being the case over a century ago. Today, for a Delaware corporation, you generally only need 51% approval.
But in a nod to the past, dissenting shareholders who feel they’ve had an all-cash offer crammed down on them are entitled to sue for an appraisal. The court then determines the fair value of their shares, and that’s what they get, in lieu of the negotiated merger price. Theoretically, there’s a risk that the court could find the fair value to have been lower than the merger price, but that’s exceedingly rare.
In any case, in addition to the court-determined fair value price, the plaintiff also gets accrued interest of 5% over the federal funds rate. Some critics think that’s too much, since it means there’s relatively little downside to bringing an appraisal suit. Even if you lose—i.e., the judge thinks the original merger price was fair—you’ll still get what you would’ve gotten if you’d approved the merger, plus interest.
How will Dell pay the $6 billion that shareholders were underpaid?
They won’t have to pay anything remotely like that. Only shareholders who vote against a merger are entitled to bring an appraisal suit, and a fairly small number did in Dell’s case.
As it happens, the largest plaintiff among the dissenters, T. Rowe Price Group, inadvertently voted all its shares for the merger, though it meant to vote against, so it ended up being ineligible for the appraisal. (That’s a long story, told in a separate 69-page opinion Vice Chancellor Laster published back in March.)
The Wall Street Journal estimates that Dell will only have to pay about $35 million to the remaining appraisal plaintiffs as a result of Monday’s ruling, with about $25 million of that going to the hedge fund Magnetar Capital. (For more on Magnetar’s strategy, see here.)
Are appraisal suits common?
They didn’t use to be, but have become so in the past 15 years or so, rising to “over 20 a year in recent years, or close to one-quarter of all transactions where appraisal is possible,” according to a recent study by Columbia Business School professor Wei Jiang and three others. They seem to have gotten turbocharged by a ruling in 2007 that permitted people—in practice, mainly hedge funds—to buy shares after a merger has been announced and for the express purpose of voting against it and then seeking an appraisal. This practice is called appraisal arbitrage.
Today, seven hedge funds account for almost 50% of the dollar value of all appraisal litigation, according to Jiang’s study, led by Merion Capital, Magnetar, Merlin Partners, Ancora, and Quadre Investments.
Are these suits abusive?
They’re controversial. Plaintiffs have a high rate of success in appraisal suits, especially in those involving management buyouts and private equity deals, making it hard to label them nuisance suits. Maybe the prospect of these suits will spur controlling shareholders and insiders to treat minority shareholders more fairly. But the Delaware house did recently pass a bill that would take modest steps to reduce the number of these suits. Experts disagree over whether this bill would achieve its goals, though—some argue it could even backfire, spurring even more such suits.
Doesn’t the judge have to at least give deference to the negotiated merger price, rather than just setting his own?
No. Under the law, in fact, the judge is not supposed to do that. He’s to make a fresh determination. Now it’s true that if it’s a completely arms-length transaction—a merger with unaffiliated third-parties—judges do, in practice, seem to treat the merger price as a very good indicator of the stock’s fair value. But in management buyouts—where inside information and friendships and psychological sensitivities all cloud the picture—there seems to be almost the opposite presumption.
If there’s a bidding process, like there was in Dell’s case, why isn’t the winning bid, by definition, the “fair value” of the shares?
Vice Chancellor Laster felt that the market for selling a going concern is “unavoidably less efficient” than the market, say, for a stock on an exchange. “The M&A market has fewer buyers and one seller, and the dissemination of critical, non-public due diligence information is limited to participants who sign confidentiality agreements,” he wrote.
Here, at the early stages of discussion, he stressed, the board spoke to only two prospective buyers—Silver Lake and Kohlberg Kravis & Roberts—and KKR dropped out early. It then reached out to Texas Pacific Group, but TPG wasn’t interested.
But the company was also shopped around after the signing.
Right. Here’s what happened. Dell tasked Evercore with shopping the company for 45 days—a so-called “go-shop” period—and incentivized Evercore, with the prospect of a success fee, to find one. Among the best prospects Evercore approached were HP, which wasn’t interested, and Blackstone.
Blackstone made a bid, but then dropped out. Eventually, Carl Icahn (with Southeastern Asset Management) also bid.
Icahn’s offer caused Dell to postpone and then adjourn its originally scheduled shareholder’s meeting in July 2013, recognizing that Icahn’s proposal might win.
The buyout group then sweetened its offer and won the vote in September.
What did Vice Chancellor Laster think about that? He found that, for a variety of reasons, “MBO go-shops rarely generate topping bids,” so that the damage done by the absence of more competition at the pre-signing phase could never be overcome. The inherent problems with MBO go-shops include the fact that “incumbent management has the best insight into the company’s value, or at least is perceived to,” and many prospective buyers are reluctant to outbid an insider, like Michael Dell, out of fear of being branded as a hostile takeover artist.
How did the judge calculate Dell’s value?
To begin with, and importantly, he refused to credit “LBO pricing models,” which the special committee’s advisors had, indeed, used when courting potential MBO partners. In those, the advisor backs into a price that will offer a financial buyer the prospect of earning a fat return on investment of at least 20% over the ensuing years. Laster felt this resulted in an artificially low price.
Instead, Laster used a “discounted cash-flow model” (DCF)—where you compute the expected cash flow over a period into the future and then compute the present value of that cash flow.
Of course, choosing to use a DCF model hardly ends the discussion. Using DCF models, the plaintiffs’ expert, Bradford Cornell of the California Institute of Technology, computed a fair value share price of $28.61, while the defendants’ expert, Glenn Hubbard, dean of Columbia’s business school, arrived at $12.68.
Laster grappled with these competing approaches—which produced valuations that were $28 billion apart—and ultimately came up with $17.62 per share as the best figure.
He’s considered to be brilliant. “He’s an extraordinary judge who is scrupulous about getting the law right, and has the courage to do that even when it angers powerful people,” says Minor Myers, a Brooklyn Law School professor who has studied appraisal suits. “He also understands human nature. He’s able to see: What incentives does this person face? Why might that have worked well in certain situations, and why might that have misfired in certain situations?”
But Laster has faced criticism that he has an excessive desire to make headlines.
Will there be any appeals?
