This article is part one of a two part series. In the second part, forthcoming, I discuss in detail the differing roles and level of valuation expertise of the investment banker compared to the independent valuation analyst for M&A transactions and litigation.
In M&A litigation, the parties to the lawsuit each typically retain an independent valuation analyst (“valuation analyst”), rather than an investment banker, to estimate the fair value of the target company stock and to provide expert testimony.
As illustrated by recent Delaware Chancery Court and Delaware Supreme Court decisions on shareholder appraisal rights, merger and acquisition (“M&A”) disputes often include elements of breach of fiduciary duty by the target company’s board of directors or its special committee. Such alleged breaches often relate to the board’s oversight of the M&A deal process. These disputes may also involve allegations of proxy violations related to inadequate disclosure of material information that investors should have been provided in order to make an informed decision when casting their votes.
This discussion includes specific court cases and focuses on the following topics:
- Events that can lead to M&A disputes and examples of when a court decided that the M&A deal process was flawed
- Examples of when the investment bank’s fee structure led to a flawed deal process
- The use of management-prepared financial projections and examples of when these financial projections were accepted or rejected by a court
Events That May Lead to M&A Disputes
Some observers believe that a robust pre-signing market check may result in a higher final bid, and believe that a post-signing, go-shop period yields little transaction pricing benefit.
This is because any new bidder in a go-shop period has a ticking clock to submit a higher bid. That new bidder often lacks the necessary time to conduct the same level of due diligence that was conducted by earlier bidders.
Deal processes may be considered flawed if there appears to be too much reliance on a go-shop period—rather than the pre-signing period—to extract the highest price. This was one area of dispute in In re Appraisal of Dell Inc.
Legal counsel to shareholders sometimes find it challenging to identify flaws in the deal process prior to the litigation discovery procedure. This is because proxy statements do not always provide sufficient detail about the deal process.
To avert disputes, sometimes proxies provide a detailed timeline of all discussions. The level of disclosure may be an area of contention between counsel who represent entities involved in a transaction and counsel who represent shareholder plaintiffs.
The following discussion summarizes several judicial decisions where the court determined that the M&A deal process was flawed.
Blueblade Capital Opportunities LLC v. Norcraft Companies, Inc.
- The deal price was previously rejected as too low by the target’s board of directors.
- The chief executive officer seemed more interested in obtaining post-merger employment and in receiving payment under a tax receivable agreement than in securing the highest price for the shareholders.
- There was no robust pre-signing market check. No other pre-signing bidders were sought by the board of directors or by the board’s financial adviser.
- The stock was thinly traded, which made the efficient (or semi-efficient) market theory less relevant.
- The go-shop period was fruitless due to the existence of a sizable break-up fee, an unlimited right to match any higher offer, and the right of the suitor to begin tendering shares during the go-shop period.
City of Miami General Employees’ and Sanitation Employees’ Retirement Trust v. C&J Energy Services, Inc.
- C&J Energy Services, Inc. (“C&J”) did not engage in any market check prior to agreeing to merge with Nabors Industries Ltd.
- The C&J board of directors delegated the primary responsibility for negotiations to its chief executive officer.
- No special committee was formed, and four members of the C&J board of directors were guaranteed five-year terms with the merged entity.
- The court enjoined the shareholder vote for another 30 days to further attempt to solicit interest from other bidders. This judicial order was premised on the lack of other bidders emerging during the five months following announcement of the deal. There was no judicial ruling on the fairness of the merger price.
Dunmire v. Farmers & Merchants Bancorp of Western Pennsylvania, Inc.
- The merger was not the product of a robust deal process. The transaction was undertaken at the insistence of the Snyder family, which controlled both Farmers & Merchants Bancorp of Western Pennsylvania, Inc. (“F&M”) and NexTier Bank N.A. (“NexTier”) and stood on both sides of the transaction. No other bidders for F&M were considered.
- The transaction was not conditioned on obtaining the approval of a majority of the minority of F&M stockholders.
- Two of the three members of the special committee had business ties with the Snyders.
- F&M engaged Ambassador Financial Group as its financial adviser, but only to “render an opinion as to the fairness of the exchange ratio that would be proposed by [FinPro] to the NexTier board.”
Flawed Deal Process and Investment Banker Fee Structure
Sometimes the terms of the investment banker compensation can give rise to a flawed deal process. In an article published in the Harvard Law Review, Guhan Subramanian cites one example of a properly structured fee arrangement and one example of an improperly structured fee arrangement for a target company’s investment banker.
In the properly structured fee arrangement example, Subramanian cites Merrill Lynch serving as financial adviser to the Sports Authority, Inc., during its leveraged buyout. The fee was the sum of 0.50 percent of the purchase price up to a price of $36.00 per share and an additional 2 percent above $36.00 per share. The acquirer initially offered $34.00 per share, but Merrill Lynch then negotiated a higher price of $37.25 per share, thereby collecting 2 percent of the incremental $1.25 per share.
In the improperly structured fee arrangement example, Subramanian cites Evercore serving as financial adviser to Dell Inc. during its leveraged buyout. Evercore received a monthly retainer fee of $400,000, a flat fee of $1.5 million for the fairness opinion, and a fee equal to 0.75 percent of the difference between the initial bid during the pre-signing phase and any subsequent higher bid Evercore could obtain during the go-shop period. This structure gave Evercore the incentive, if it opted to do so, to minimize the negotiated price during the pre-signing phase so as to widen the difference between the pre-signing price and any higher price during the go-shop period, upon which the 0.75 percent contingency fee was based.
Use of Management-Prepared Financial Projections
It is generally accepted that the target company’s management is in the best position to prepare company financial projections. This is particularly true if the target company regularly prepares financial projections during its annual planning process. A special committee, formed for the purpose of overseeing the deal process, may amend the financial projections prepared by company management. This may occur when (1) the special committee concludes that the financial projections are either optimistic or pessimistic or (2) multiple sets of financial projections are prepared that are contingent on various scenarios.
There may be occasions when the company financial projections are too optimistic, which can cause a rift in negotiations. In these situations, revisions to the financial projection may be made by the special committee or by the investment banker at the direction of the special committee.
Alternatively, there may be occasions when the target company’s financial projections are too downward-biased. There may be parties who are more focused on closing the deal expeditiously without too much regard for price. Examples of when parties are driven to complete the deal may include (1) a chief executive officer who has negotiated a higher pay package during the deal process to remain with the merged company or (2) an executive of the suitor who also has a board seat with the target company or a close relationship with some of the target’s executives.
The investment bank serving as financial adviser to a target company’s board of directors may assist in making or revising financial projections. This may occur when the target company is not well-versed in making projections. The target company management may provide financial projections based on generally accepted accounting principles (“GAAP”). The banker may convert the GAAP-based net income projections to cash flow projections in order to develop a discounted cash flow valuation. When provided with multiple financial projections, the investment banker or valuation analyst rendering the fairness opinion may apply judgment in determining the reliability of each financial projection.
The following discussion summarizes several judicial decisions where financial projections were an issue in the dispute.
Judicial Rejection of Management Financial Projections
- In re Appraisal of PetSmart Inc.—Vice Chancellor Slights of the Delaware Chancery Court noted that financial projections in prior cases were found to be unreliable when “the company’s use of such projections was unprecedented, where the projections were created in anticipation of litigation, where the projections were created for the purpose of obtaining benefits outside the company’s ordinary course business, where the projections were inconsistent with a corporation’s recent performance, or where the company had a poor history of meetings its projections.”
The Chancery Court also observed that the company management had no history of creating financial projections beyond short-term earnings guidance.
Judicial Acceptance of Management Financial Projections
- Cede & Co. v. Technicolor, Inc.—Chancellor Chandler of the Chancery Court accepted the company financial projections and rejected the petitioner expert’s alteration of those projections, writing that, “When management projections are made in the ordinary course of business, they are generally deemed reliable.”
The judicial opinion also noted that the subject company management had a very good track record of meeting earnings guidance (i.e., financial projections).
Judicial Rejection of Third-Party Financial Projections
- In re Radiology Assocs., Inc.—The Chancery Court rejected the petitioners’ valuation analysis because the prospective financial inputs were too speculative. The Chancery Court reached this conclusion due to the fact that the company management neither created the financial projections nor gave any guidance to the third party that created the projections.\
Judicial Acceptance of Second Set of Projections
- Delaware Open MRI Radiology v. Kessler—Vice Chancellor Strine of the Chancery Court opined about the fairness opinion’s exclusion of financial projections that were based on the company’s expansion plans: “In essence, when the court determines that the company’s business plan as of the merger included specific expansion plans or changes in strategy, those are corporate opportunities that must be considered part of the firm’s value” as a going concern (also citing Cede & Co. v. Technicolor, 684 A.2d 289 at 298-99, and Montgomery Cellular Holding Co., Inc. v. Dobler, 880 A.2d 206 at 222 (Del. 2005)).
- In re United States Cellular Operating Company—Vice Chancellor Parsons of the Chancery Court concluded that financial projections should include reasonably anticipated capital expenditures, stating that “This is not a situation where projecting capital expenditures to account for conversion to 2.5G and 3G is speculative. Industry reports included such expenditures and the Companies themselves ‘anticipated’ it. Therefore, Harris should have incorporated the effects of this expected capital improvement in his projections.”
This decision notes that the company management had no prior experience with preparing long-term financial projections. The fairness opinion was rendered by a firm that worked alongside management developing a set of projections.
Judicial Rejection of Second Set of Projections
- In re PLX Technology Inc. Shareholders Litigation—Vice Chancellor Laster of the Chancery Court rejected the use of a second set of financial projections that were based on growth initiatives. The Chancery Court reached this decision despite the financial projections having been prepared in the ordinary course of business.
In reaching its decision, the Chancery Court reasoned that, “to achieve even higher growth rates, particularly in 2017 and 2018, the December 2013 Projections contemplated a third layer of future revenue. It depended on PLX introducing a new line of ‘outside the box’ products that would use the ExpressFabric technology to connect components located in different computers, such as the multiple servers in a server rack. To succeed with this line of business, PLX would have to enter the hardware market and compete with incumbent players like Cisco.”
 In re Appraisal of Dell Inc., C.A. No. 9322-VCL, 2016 WL 3186538 at *38-49 (Del. Ch. May 31, 2016). Numerous academic papers were cited to support the credence that the go-shop period following the pre-signing phase rarely results in topping bids. In general, most transaction price competition occurs before the deal is accepted in principle. One footnote in the Dell opinion cited the following quote from M&A attorney Martin Lipton during an interview of Mr. Lipton by one of the expert witnesses in this matter, Professor Guhan Subramanian: “The ability to bring somebody into a situation [pre-signing phase] is far more important than the extra dollar a share at the back end [go-shop phase]. At the front end, you’re probably talking about 50%. At the back end, you’re talking about 1 or 2 percent.”
 C.A. No. 11184-VCS, 2018 WL 3602940 (Del. Ch. July 27, 2018), opinion by Vice Chancellor Slights; synopsis from Jill B. Louis and Rashida Stevens, “Chancery Court Cites Flawed Process in its Resort to Traditional Valuation Methodology,” The National Law Review (September 6, 2018).
 C.A. No. 9980-CB, 2018 WL 508583 (Del. Ch. Jan. 23, 2018); synopsis from Yaron Nili, “Delaware Court Preliminarily Enjoins Merger Due to Flawed Sales Process,” Harvard Law School Forum on Corporate Governance (December 7, 2014).
 C.A. No. 10589-CB, 2016 WL 6651411 (Del. Ch. Nov. 10, 2016).
 Guhan Subramanian, “Deal Process in Management Buyouts,” Harvard Law Review (December 2016): 41.
 In re Appraisal of PetSmart, Inc., Consol. C.A. No. 10782-VCS, 2017 WL 2303599 at *32 (Del. Ch. May 26, 2017).
 Cede & Co. v. Technicolor, Inc., C.A. No. 7129, 2002 WL 23700218 at *7 (Del Ch. (Dec. 31, 2003, revised July 9, 2004), citing In re Radiology Assocs., Inc. Litig., 611 A.2d 485, 490-91 (Del. Ch. 1991).
 In re Radiology Assocs., Inc. Litig., 611 A.2d 485, 490-91 (Del. Ch. 1991).
 Delaware Open MRI Radiology v. Kessler, 898 A.2d 290 (Del. Ch. 2006), endnote no. 51.
 In re U.S. Cellular Operating Co., No. Civ.A 18696-NC, 2005 WL 43994 at *37 (Del. Ch. Jan. 6, 2005).
 In re PLX Technology Inc. Stockholders Litigation, C.A. No. 9880-VCL, 2018 WL 5018353 at *52 (Del. Ch. Oct. 16, 2018).