DFC Global Corporation v. Muirfield Value Partners, L.P. , 172 A.3d 346 ( 2017 )

IN THE SUPREME COURT OF THE STATE OF DELAWARE
DFC GLOBAL CORPORATION, §
§ No. 518, 2016
Respondent Below, §
Appellant/Cross-Appellee, § Court Below: Court of
§ Chancery of the State of
v. § Delaware
§
MUIRFIELD VALUE PARTNERS, L.P., § C.A. No. 10107
OASIS INVESTMENTS II MASTER §
FUND LTD., CANDLEWOOD SPECIAL §
SITUATIONS MASTER FUND, LTD., §
CWD OC 522 MASTER FUND LTD., §
and RANDOLPH WATKINS SLIFKA, §
§
Petitioners Below, §
Appellees/Cross-Appellants. §
Submitted: June 7, 2017
Decided: August 1, 2017
Before STRINE, Chief Justice; VALIHURA, VAUGHN, and SEITZ, Justices;
LEGROW, Judge,* constituting the Court en Banc.
Upon appeal from the Court of Chancery. REVERSED and REMANDED.
Raymond J. DiCamillo, Esquire, Matthew D. Perri, Esquire, RICHARDS,
LAYTON & FINGER, P.A., Wilmington, Delaware; Meryl L. Young, Esquire,
Colin B. Davis, Esquire, GIBSON, DUNN & CRUTCHER LLP, Irvine, California;
Joshua S. Lipshutz, Esquire, (argued), GIBSON, DUNN & CRUTCHER LLP,
Washington, D.C., Attorneys for Respondent Below, Appellant/Cross-Appellee,
DFC Global Corporation.
Stuart M. Grant, Esquire, (argued), Kimberly A. Evans, Esquire, Vivek Upadhya,
Esquire, GRANT & EISENHOFER P.A., Wilmington, Delaware, Attorneys for
Petitioners Below, Appellees/Cross-Appellants, Muirfield Value Partners, L.P.,
*
Sitting by designation under Del. Const. art. IV, § 12.
Oasis Investments II Master Fund Ltd., Candlewood Special Situations Master
Fund, Ltd., CWD OC 522 Master Fund LTD., and Randolph Watkins Slifka.
Theodore A. Kittila, Esquire, GREENHILL LAW GROUP, LLC, Wilmington,
Delaware; Daniel M. Sullivan, Esquire, Sarah M. Sternlieb, Esquire, HOLWELL
SHUSTER & GOLDBERG, LLP, New York, New York, Attorneys for Amici
Curiae Law and Corporate Finance Professors arguing in favor of the presumption
the Respondent favors.
Samuel T. Hirzel, II, Esquire, HEYMAN ENERIO GATTUSO & HIRZEL LLP,
Wilmington, Delaware; Lawrence M. Rolnick, Esquire, Steven M. Hecht, Esquire,
LOWENSTEIN SANDLER LLP, New York, New York; Mark Lebovitch, Esquire,
Jeroen Van Kwawegen, Esquire, BERNSTEIN LITOWITZ BERGER &
GROSSMANN LLP, New York, New York, Attorneys for Amici Curiae Law,
Economics and Corporate Finance Professors arguing against the presumption the
Respondent favors.
STRINE, Chief Justice:
In this appraisal proceeding involving a publicly traded payday lending firm
purchased by a private equity firm, the respondent argues that we should establish,
by judicial gloss, a presumption that in certain cases involving arm’s-length mergers,
the price of the transaction giving rise to appraisal rights is the best estimate of fair
value. We decline to engage in that act of creation, which in our view has no basis
in the statutory text, which gives the Court of Chancery in the first instance the
discretion to “determine the fair value of the shares” by taking into account “all
relevant factors.”1 As this Court previously held in Golden Telecom, Inc. v. Global
GT LP,2 that language is broad, and until the General Assembly wishes to narrow
the prism through which the Court of Chancery looks at appraisal value in specific
classes of mergers, this Court must give deference to the Court of Chancery if its
determination of fair value has a reasonable basis in the record and in accepted
financial principles relevant to determining the value of corporations and their stock.
On the record before us, however, the respondent has made two convincing
case-specific arguments why the Court of Chancery’s determination of fair value
cannot be sustained on appeal. For starters, the respondent notes that the Court of
Chancery found that: i) the transaction resulted from a robust market search that
lasted approximately two years in which financial and strategic buyers had an open
1
8 Del. C. § 262(h).
2
11 A.3d 214 (Del. 2010).
opportunity to buy without inhibition of deal protections; ii) the company was
purchased by a third party in an arm’s length sale; and iii) there was no hint of self-
interest that compromised the market check.3 Although there is no presumption in
favor of the deal price, under the conditions found by the Court of Chancery,
economic principles suggest that the best evidence of fair value was the deal price,
as it resulted from an open process, informed by robust public information, and easy
access to deeper, non-public information, in which many parties with an incentive
to make a profit had a chance to bid. But, despite its own findings about the
adequacy of the market check, the Court of Chancery determined it would not give
more than one-third weight to the deal price for two reasons.
The first reason was that there were regulatory developments relevant to the
company being appraised and, therefore, the market’s assessment of the company’s
value was not as reliable as under ordinary conditions. The respondent argues that
this finding was not rationally supported by the record. We agree. The record below
shows that the company’s stock price often moved over the years, and that those
movements were affected by the potential that the company’s industry—payday
lending and other forms of alternative consumer financial services—would be
subject to tighter regulation. The Court of Chancery did not cite, and we are unaware
of, any academic or empirical basis to conclude that market players like the many
3
In re Appraisal of DFC Glob. Corp., 2016 WL 3753123, at *21 (Del. Ch. July 8, 2016).
2
who were focused on this company’s value would not have examined the potential
for regulatory action and factored it in their assessments of the company’s value.
Like any factor relevant to a company’s future performance, the market’s collective
judgment of the effect of regulatory risk may turn out to be wrong, but established
corporate finance theories suggest that the collective judgment of the many is more
likely to be accurate than any individual’s guess. When the collective judgment
involved, as it did here, not just the views of company stockholders, but also those
of potential buyers of the entire company and those of the company’s debtholders
with a self-interest in evaluating the regulatory risks facing the company, there is
more, not less, reason to give weight to the market’s view of an important factor.
The Court of Chancery also found that it would not give dispositive weight to
the deal price because the prevailing buyer was a financial buyer that “focused its
attention on achieving a certain internal rate of return and on reaching a deal within
its financing constraints, rather than on [the company’s] fair value.”4 To be candid,
we do not understand the logic of this finding. Any rational purchaser of a business
should have a targeted rate of return that justifies the substantial risks and costs of
buying a business. That is true for both strategic and financial buyers. It is, of
course, natural for all buyers to consider how likely a company’s cash flows are to
deliver sufficient value to pay back the company’s creditors and provide a return on
4
Id. at *22.
3
equity that justifies the high costs and risks of an acquisition. But, the fact that a
financial buyer may demand a certain rate of return on its investment in exchange
for undertaking the risk of an acquisition does not mean that the price it is willing to
pay is not a meaningful indication of fair value. That is especially true here, where
the financial buyer was subjected to a competitive process of bidding, the company
tried but was unable to refinance its public debt in the period leading up to the
transaction, and the company had its existing debt placed on negative credit watch
within one week of the transaction being announced. The “private equity carve out”
that the Court of Chancery seemed to recognize, in which the deal price resulting in
a transaction won by a private equity buyer is not a reliable indication of fair value,
is not one grounded in economic literature or this record. For these reasons, we
remand to the Court of Chancery to reconsider the weight it gave to the deal price in
its valuation analysis.
The next issue in the respondent’s appeal involves the Court of Chancery’s
discounted cash flow analysis. When the respondent pointed out in a reargument
motion that the Chancellor’s discounted cash flow model included working capital
figures that differed from those the Chancellor expressly adopted in his post-trial
opinion, the Chancellor corrected his clerical error. This would have resulted in the
discounted cash flow model yielding a fair value figure lower than the deal price.
But, instead of stopping there, at the prompting of the petitioners, the Court of
4
Chancery then substantially increased its perpetuity growth rate from 3.1% to 4.0%,
which resulted in the Court of Chancery reaching a fair value akin to its original
estimate of the company’s value. But, no adequate basis in the record supports this
major change in growth rate. During the two decades before the merger leading to
this appraisal, the company experienced rapid growth. The growth of the payday
lending industry and its effect on poor borrowers during this period was a large
driver of the regulatory reforms that the company faced, reforms that would require
the company to write more loans to make the same profits as in the past. As it was,
the record suggested that the management projections used in the Court of
Chancery’s original discounted cash flow model were optimistic and designed to
encourage bidders to pay a high price. Those projections hockey stick up at the last
two years, and therefore more working capital was required to sustain those
increases, and that doesn’t even account for the likelihood that regulatory changes
required more loans (i.e., working capital) to make the same profits as in the past.
During the sales process, the company had to revise its aggressive projections
downward, as it was not keeping pace with them. Even after revising them
downward, the company fell short of meeting them weeks after the transaction
closed. Given the nature of the projection’s outyears, the fact that the industry had
already gone through a period of above-market growth, and the lack of any basis to
conclude that the company would sustain high growth beyond the projection period,
5
the record does not sustain the Court of Chancery’s decision to substantially increase
the company’s perpetuity growth rate in its discounted cash flow model after
reargument.
On cross-appeal, the petitioners argue that the Court of Chancery abused its
discretion by giving weight to its comparable companies analysis, and that the only
correct weighting of relevant factors would have given primary, if not sole, weight
to the discounted cash flow model. We disagree. The comparable companies
analysis used by the Chancellor was supported by the record; this was a rare instance
where both experts agreed on the comparable companies the Court of Chancery used
and so did several market analysts and others following the company. Thus, giving
weight to a comparable companies analysis was within the Chancellor’s discretion.
Finally, the Court of Chancery’s decision to give one-third weight each to the
deal price, the discounted cash flow valuation, and the comparable companies
valuation was not explained. Given the Court of Chancery’s findings about the
robustness of the market check and the substantial public information available
about the company, we cannot discern the basis for this allocation. On remand, if
the Court of Chancery chooses to use a weighting of different valuation
methodologies to reach its fair value determination, the court must explain its
weighting in a manner supported by the record before it.
6
For these reasons, we reverse and remand the Court of Chancery’s ruling. On
remand, the Chancellor should reassess the weight he chooses to afford various
factors potentially relevant to fair value, and he may conclude that his findings
regarding the competitive process leading to the transaction, when considered in
light of other relevant factors, such as the views of the debt markets regarding the
company’s expected performance and the failure of the company to meet its revised
projections, suggest that the deal price was the most reliable indication of fair value.
I.
A. DFC
i. DFC’s Growth
DFC Global Corporation (“DFC”) provides alternative consumer financial
services, predominately payday loans. The 2014 transaction giving rise to this
appraisal action resulted in DFC being taken private by Lone Star, a private equity
firm.
DFC was formed in 1990. Its operations then were entirely in the United
States. Since then, it has made more than 100 acquisitions to grow the business
worldwide.5 By the time of the sale giving rise to this appraisal (i.e., the “merger”
5
App. to Appellant’s Opening Br. at A844 (Petitioners’ Expert Report). This Opinion will refer
to the Petitioners’ Expert Report as PER, and the Petitioners’ Expert Rebuttal Report as PERR.
The Respondent’s Expert Report will be referred to as RER, and the Respondent’s Expert Rebuttal
Report as RERR. In general, citations to the record have been shortened to a short name of the
document, “at,” and the appendix page number. Page numbers beginning with “A” refer to the
Appendix to the Appellant’s Opening Brief, and page numbers beginning with “B” refer to the
7
or “transaction”), DFC operated in ten countries with more than 1,500 locations, in
addition to having a substantial internet lending business. But, the bulk of DFC’s
revenues came from three main markets: the United Kingdom (47%), Canada (31%),
and the U.S. (12%).6 In the U.S., at the time of the merger, DFC operated 292 stores
in 14 states, especially California, Louisiana, and Arizona, and provided loans to
enlisted military personnel.7
DFC entered Canada in 1996 and had 489 stores there as of the merger. DFC
had grown rapidly in Canada, reaching 214 stores by 2004,8 and, by the time of the
merger, DFC could say that it was the “largest alternative financial services retail
store network in Canada based upon revenues and profitability.”9
Particularly relevant for this appraisal, DFC entered the U.K. market in 1999
and embarked on an ambitious expansion. Six years after DFC entered that market,
in 2005, it had 152 stores. By 2009, only four years later, it almost doubled its
footprint in the U.K. to 330 stores.10 And, as of the merger, DFC had nearly doubled
its stores in the U.K. again, reaching 601 locations.11
Appendix to the Appellees/Cross-Appellants’ Answering Brief and Opening Brief on Cross-
Appeal. Certain Joint Exhibits, which did not appear in the appendices are cited as JX__, “at,”
and the relevant page number of that document.
6
PER at A847.
7
DFC, Form 10-K, 2013 at 4, 7. We take judicial notice of DFC’s public filings with the SEC.
See, e.g., Hazout v. Tsang Mun Ting, 134 A.3d 274, 280 n.13 (Del. 2016).
8
JX 409: DFC Investor Presentation at A444.
9
JX 487: DFC, Rating Agency Presentation at B253.
10
JX 309: DFC Global Corp. Investor Presentation at A388.
11
RER at A974.
8
The rapid growth of DFC’s business can be seen in its overall revenues. In
2004, its last fiscal year before becoming a public company, DFC had total revenues
of $270.6 million.12 As of 2013, the last fiscal year before the merger, its total
revenues had increased to $1.12 billion,13 or 314% higher. And, this masked even
stronger growth in certain segments, such as the U.K. market, which experienced
some years with over 60% year-over-year growth.14 DFC’s rapid growth can be seen
in its strong year-over-year revenue growth post-initial public offering:
DFC Total Revenue ($, in millions)15
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Revenue $270.6 $321.0 $358.9 $455.7 $572.2 $530.2 $633.3 $788.4 $1,061.7 1,122.3
YOY Growth -- 18.6% 11.8% 27.0% 25.6% -7.3% 19.4% 24.5% 34.7% 5.7%
DFC’s strong growth exemplifies the payday loan industry’s material growth in the
past two decades.16 Not only did the industry’s traditional storefront payday lending
grow, but the industry’s online market also experienced “rapid” growth.17
ii. DFC’s Equity
DFC’s shares were traded on the NASDAQ exchange from 2005 until the
merger. Throughout its history as a public company, the record suggests DFC never
had a controlling stockholder, it had a deep public float of 39.6 million shares, and,
12
RER at A977.
13
Id.
14
Id. at A974.
15
DFC, Form 10-K, 2008 at 32 (2004–08 figures); DFC, Form 10-K, 2013 at 39 (2009–13 figures);
see also RER at A977.
16
RER at A986.
17
Id. at A987.
9
it had an average daily trading volume just short of one million shares. 18 DFC’s
share price moved sharply in reaction to information about the company’s
performance, the industry, and the overall economy, as the following chart, prepared
by the petitioners’ expert, illustrates. The chart shows that regulatory action at
different times and by different regulators elicited differing responses by the market.
19
18
JX 462: DAVID M. SCHARF & JEREMY FRAZER, DFC GLOBAL CORP., JMP SECURITIES at 1.
19
PER at A893.
10
iii. DFC’s Debt
DFC was a highly leveraged company. Its capital structure was comprised of
about $1.1 billion of debt as compared to a $367.4 million equity market
capitalization,20 resulting in a debt-to-equity ratio of 300% and a debt-to-total-
capitalization ratio of 75%.21 DFC’s high leverage “was viewed negatively by both
equity and debt analysts,”22 and, as of all relevant periods, it maintained a non-
investment grade credit rating.23 Indeed, at the beginning of 2014, one equity analyst
noted that revenue declines in DFC’s U.K. operation could have negative effects on
DFC’s ability to both secure new loans and meet the covenants on existing loans.24
And, later in 2014, Standard & Poor’s (“S&P”), a credit rating agency, placed DFC
on its Creditwatch Negative list based in large part on “weaker-than-expected
financial performance, underpinned by new lending guidelines in the U.K.”25 Later,
S&P warned that “[g]iven the extent of the regulatory risk [DFC] is exposed to, we
don’t foresee an upgrade within the next 12 months.”26
20
RER at A1024 n.407; PER at A882.
21
PER at A882.
22
Id.
23
JX 533: IGOR KOYFMAN & KEVIN COLE, STERLING MID-HOLDINGS ASSIGNED ‘B’ RATING, DFC
GLOBAL ‘B’ RATING AFFIRMED, OFF WATCH ON SALE APPROVAL; OUTLOOKS NEGATIVE,
STANDARD & POOR’S RATING SERVS. at 3.
24
JX 358: BILL CARCACHE, DFC GLOBAL CORP., NOMURA at 1.
25
JX 468: IGOR KOYFMAN & KEVIN COLE, DFC GLOBAL RATINGS PLACED ON CREDITWATCH
NEGATIVE AFTER WEAKER BUSINESS PERFORMANCE AND DEFINITIVE BUYOUT AGREEMENT,
STANDARD & POOR’S RATING SERVS. at 2.
26
JX 533, supra note 23, at 3.
11
iv. Regulatory Headwinds
In the years leading up to the merger, DFC faced heightened regulatory
scrutiny. In Canada, DFC confronted a new regulatory environment beginning in
2007 when the provinces in which it operated started regulating it, rather than the
central government.27
In the U.S., the Dodd-Frank Wall Street Reform and Consumer Protection Act
of 2010 created the Consumer Financial Protection Bureau, which was given
regulatory, supervisory, and enforcement powers over DFC.28 At least one industry
observer described these changes in the U.S. as “[s]weeping.”29 The Consumer
Financial Protection Bureau completed an on-site review of DFC in 2013 and found
that DFC was in violation of the Consumer Financial Protection Act. As a result,
DFC had to amend its U.S. practices.
In DFC’s most important market—the U.K.—the Office of Fair Trading,
DFC’s primary regulator there, issued new rules in 2012 for payday lenders
restricting their use of continuous payment authority, a method for lenders to
automatically collect loan balances from borrowers’ checking accounts to withdraw
money very quickly after the money is deposited. In spring 2013, the Office of Fair
Trading identified a number of deficiencies in DFC’s businesses, requiring changes.
27
2016 WL 3753123, at *3.
28
DFC, Form 10-K, 2013 at B144.
29
JX 478: CONSUMER LENDING, FIRST RESEARCH at 3.
12
Then, in the fall of 2013, the Financial Conduct Authority, which replaced the Office
of Fair Trading as DFC’s primary U.K. regulator, identified new regulations that it
would issue in 2014. One of those new regulations tightened affordability
assessments and another restricted rollovers where borrowers defer loan repayments
by paying additional interest and fees. Before this regulation, DFC had not limited
the number of rollovers its businesses would extend to borrowers, but, after this
regulation, DFC would be limited to two rollovers per loan. This was likely to hurt
DFC’s U.K. business because rollovers allowed payday lenders to charge additional,
higher rates of interest and fees and to keep borrowers paying those rates for
extended periods of time. Indeed, as a member of DFC’s management team before
the merger put it, “at one point in time you [could] roll a customer over forever and
never have them pay back the loan but just monthly fees.”30 Thus, a rollover is
essentially an extension of loan terms such that the borrower pays extra fees and
interest and in exchange doesn’t have to pay back the loan as quickly as initially
required.31 Rollovers are lucrative. When the U.S. Consumer Financial Protection
Bureau examined them, it found that “most payday loans are made to borrowers who
renew enough times that they end up paying more in fees than the original loan
amount.”32
30
Testimony of Kenneth Kaminski at A252.
31
RER at A993.
32
JX 478, supra note 29, at 4.
13
Finally, there would be a new cap put in place limiting borrowers’ total cost
of credit. In February 2014, the Office of Fair Trading warned DFC that it might
not be able to meet the Financial Conduct Authority regulations and so, in March
and April of that year, DFC had to take additional steps to make sure it could comply.
The new U.K. regulations were likely to have a negative effect on DFC’s
profitability: “As we [DFC’s management and board] began to better understand the
impact of some of the changes we’d have to make in the U.K., including limiting
rollovers, limiting [continuous payment authority], and all the rest, we recognized
that that was going to have a negative impact on [DFC’s] earnings . . . .”33
B. The Sale Process
Facing headwinds at least as prevalent as the tailwinds that had propelled its
rapid expansion,34 DFC engaged Houlihan Lokey Capital Inc., in the spring of 2012,
to look into selling the company. Houlihan contacted six private equity sponsors
and eventually had discussions with J.C. Flowers & Co. LLC and another sponsor,
as well as an interested third party that Houlihan had not contacted. These three
potential buyers conducted due diligence, but in August one of the three lost interest,
and, in October, J.C. Flowers and the other potential buyer also lost interest. Over
33
Testimony of John Gavin, DFC former board member at A154.
34
Id. at A155 (recording testimony that the board was “always considering strategic
alternatives. . . . But we probably got a little more focused on it in the 2012 time frame. As the
regulatory environment looked to become more onerous in the U.K., and that was the biggest part
of our business, we decided that we needed to make sure we understood what all of our options
were . . . .”).
14
the next year, Houlihan reached out to thirty-five more financial sponsors and three
strategic buyers.
In autumn 2013, DFC attempted to refinance roughly $600 million in Senior
Notes. But, the offering was terminated because of insufficient investor interest.35
If DFC had wanted to go ahead with the refinancing, it would have needed to
increase the bonds’ coupon rate.36 Analysts pointed to the S&P credit rating
agency’s downgrade of DFC from B+ to B after the refinancing was announced and
“market uncertainty around payday lending” as two factors that contributed to the
termination.37 To be clearer about what this means, despite the lucrative fees that
investment bankers make from refinancing a large tranche of public company debt
and syndicating a new issue, Wall Street could not do that for DFC unless DFC was
going to compensate new debtholders with a higher interest rate reflecting DFC’s
uncertain financial condition.
In September 2013, DFC renewed discussions with J.C. Flowers and began
discussions with Crestview Partners about a joint transaction. In October, Lone Star
expressed interest in DFC. In November, DFC gave the three interested parties
financial projections prepared by DFC’s management that estimated fiscal year 2014
35
PER at A859; RER at A981.
36
RER at A982.
37
JX 320: MOSHE ORENBUCH & LESLEY ROBERTSHAW, DFC GLOBAL CORP., CREDIT SUISSE at 1.
15
adjusted EBITDA to be $219.3 million.38 On December 12, DFC learned that
Crestview was no longer interested in pursuing a transaction. On the same day, Lone
Star made a non-binding indication of interest in acquiring DFC for $12.16 per share.
On December 17, J.C. Flowers made a non-binding indication of interest at $13.50
per share.
On February 14, 2014, DFC’s board approved revised management
projections, which were shared with J.C. Flowers and Lone Star. These projections
lowered DFC’s projected fiscal year 2014 adjusted EBITDA to $182.5 million, a
16.8% decrease from the November projections.39 On February 28, Lone Star
offered to buy DFC for $11.00 per share and requested a 45-day exclusivity period.
Lone Star’s offer was lower than its previous indication of interest because of U.K.
regulatory changes, the threat of increased U.S. regulatory scrutiny, downward
revisions in the company projections, reduced availability of acquisition financing,
stock price volatility, and weak value in the Canadian dollar.40 On March 3, J.C.
Flowers informed DFC that it was no longer interested in pursuing a transaction
because “it could not get comfortable with the Company’s regulatory exposure in
38
PER at A945.
39
Id.
40
Stipulated Joint Pre-Trial Order at A116.
16
the U.K.”41 On March 11, DFC entered into an exclusivity agreement with Lone
Star.
On March 26, DFC provided Lone Star with management’s revised
preliminary fiscal year 2014 adjusted EBITDA forecast, which had dropped by
roughly $24 million since February. The next day, Lone Star offered to buy DFC
for $9.50 per share. Lone Star explained this price reduction as a result of “further
downward revisions in company projections, another reduction in available
acquisition financing, continued regulatory changes in the U.K., and a class action
suit against the company that was disclosed in an 8-K filed on March 26, 2014.”42
Lone Star gave DFC twenty-four hours to accept the offer, but later extended that
deadline to April 1.
DFC approved another set of projections at the end of March 2014 (the
“March Projections”) that were shared with Lone Star. These Projections included
a fiscal year 2014 adjusted EBITDA forecast of $153.1 million, a 16.1% decrease
from the February projections.43 But, they remained optimistic, especially in the
later years, implying 17.6% compound annual growth in operating profit over the
41
Id.
42
2016 WL 3753123, at *4.
43
PER at A945.
17
projection period, meaningfully above DFC’s historical 11.0% compound annual
growth from 2008 to 2013 as a comparison of these two charts illustrates.44
Key Metrics From DFC’s Historical Performance ($, in millions)45
2008 2009 2010 2011 2012 2013
Total $572.2 $530.2 $633.3 $788.4 $1,061.7 $1,122.3
Revenue
YOY Growth -- -7.3% 19.4% 24.5% 34.7% 5.7%
Operating $198.0 $181.5 $246.3 $307.2 $387.3 $334.0
Profit
YOY Growth -- -8.3% 35.7% 24.7% 26.1% -13.8%
Key Metrics From the March Projections ($, in millions)46
2014 2015 2016 2017 2018
Total $1,016.4 $1,082.1 $1,188.4 $1,333.4 $1,488.8
Revenue
YOY Growth -9.4% 6.5% 9.8% 12.2% 11.7%
Operating $223.7 $251.3 $304.3 $369.0 $440.3
Profit
YOY Growth -33.0% 12.3% 21.1% 21.3% 19.3%
On April 1, DFC’s board approved the merger at $9.50 per share. The next
day, DFC announced the merger and also cut its earnings outlook, reducing 2014
fiscal year adjusted EBITDA projections from $170–200 million to $151–156
million. Within one week of the merger being announced, S&P placed DFC’s long-
term “B” rated debt on “CreditWatch with negative implications.”47 The merger
closed June 13, 2014. As it turned out, DFC missed its fiscal year 2014 targets, i.e.,
44
Id. at A936.
45
RER at A1015; DFC, Form 10-K, 2013 at 82.
46
JX 444: March Projections Email at A475; id. at A477.
47
PER at A883.
18
for the fiscal year ending June 30, 2014, established in the March Projections made
less than three months before, achieving only $138.7 million in EBITDA compared
to the Projections’ predicted $153 million.48 Given the sizeable gap between DFC’s
projected performance and the poor reality it achieved at the end of June, it seems
likely as of the merger that it was known that DFC had already missed the March
Projections.
C. The Appraisal Trial
To understand the issues on appeal, it is useful to summarize the conflicting
positions of the parties that the Court of Chancery had to address in its post-trial
decision.
i. The Petitioners’ Contentions
The petitioners pressed their case with only a professional valuation expert;
they did not enlist an industry expert and indeed do not seem to have provided other
evidence making the case that either DFC or its industry were poised for impressive
growth. The petitioners’ valuation expert determined DFC’s value only relying on
a discounted cash flow model and used that to come to a fair value of DFC at $17.90
per share, 88% above the $9.50 per share deal price. In other words, the petitioners
48
JX 444: March Projections Email at A477; RER at A1008–09.
19
argue that all of the financial and strategic buyers missed the chance to top Lone Star
at, say $10 per share, and still reap a huge upside of $7.90 per share in value.
He also calculated DFC’s fair value based on a comparable companies
analysis using seven49 of the peer companies that he used to calculate DFC’s beta.
He then calculated EBITDA multiples using the 75th percentile of the peer group,
even though DFC ranked below the 50th percentile in a majority of the key metrics.50
That approach yielded equity values for DFC ranging from $11.38 per share to
$26.95 per share.51 Had he used the 50th percentile, i.e., the median, from his own
comparables sample, his calculations would have yielded equity values ranging from
around $3.00 per share to around $13.00, putting the majority of his observations
below the deal price.52
49
Although the Court of Chancery’s opinion refers to a peer group of nine companies, 2016 WL
3753123, at *19, that group was used by the petitioners’ expert for beta estimation only and not
the comparable companies analysis, compare PER at A949, id. at A950, and id. at A951, with id.
A952; see also RERR at A1070.
50
PER at A907–11, A942–44.
51
Id. at A911.
52
The petitioners’ expert did not give the comparables valuation methodology any weight because,
according to that expert, none of the peer companies were sufficiently similar to DFC and, the
petitioners’ expert argued, multiples-based valuation methods do not necessarily reflect the
fundamental value of a company, do not allow for the inclusion of company-specific operating
characteristics, and do not take into account expected long-term growth in cash flow. The last
argument in particular is, of course, odd. The whole point of a comparables analysis is to infer the
value of the subject company by looking at how the market views the value of other comparable
companies. JOSHUA ROSENBAUM & JOSHUA PEARL, INVESTMENT BANKING 11 (2009). The
market’s assessment of the industry and the comparables are, of course, supposed to be primarily
based in its view of the future earnings.
20
ii. DFC’s Contentions
In contrast, DFC’s expert used both a discounted cash flow model, which
valued DFC at $7.81, and a comparable companies analysis, which valued DFC at
$8.07 per share. He weighted each method equally and so came to a fair value of
$7.94, although he also argued that the $9.50 per share deal price was a reliable
indication of fair value. For the comparable companies analysis, DFC’s expert used
six companies that constituted a subset of the seven used by the petitioners’ expert’s
comparable companies analysis and in calculating the beta for the petitioners’
discounted cash flow model. These six companies were also regularly used by
analysts, others analyzing DFC, and DFC itself as comparable for DFC.53 Like the
petitioners’ expert, DFC’s expert used EBITDA multiples, but, unlike the
petitioners’ expert, DFC’s expert accepted the median values from the multiples
when calculating DFC’s fair value.
DFC’s expert also performed a transaction multiples-based valuation using
merged and acquired companies, which yielded a fair value of $7.69 per share. But,
he did not give this method any weight in his overall fair value calculation because
“it is difficult to obtain accurate information regarding expected synergies in the
price paid for a particular business or the inclusion of a non-compete agreement,
53
PER at A937; JX 402: JOHN HECHT & KYLE JOSEPH, FINANCIAL SERVICES: SPECIALTY FINANCE,
STEPHENS (March 6, 2014), at 19.
21
employment contract, promises, terms, or other aspects to the transaction that would
affect the actual price paid for the business.”54
iii. The Court of Chancery’s Fair Value Analysis
The Court of Chancery noted the “sharp divide” between the experts’
estimates of fair value driven in large part by disagreements about the “proper inputs
and methods” for the discounted cash flow model.55 So, the Court of Chancery spent
much of its post-trial decision resolving the disputes over the discounted cash flow
model. The relatively undisputed inputs were the debt-to-capital ratio, cost of debt,
risk-free rate, and equity risk premium. The Court of Chancery then examined the
disputed components of the weighted average cost of capital (“WACC”), especially
the calculation of DFC’s beta, selected the inputs that it deemed most reasonable,
and concluded that DFC’s WACC was 10.72%, falling near the midpoint of the
experts’ competing 9.5% and 12.4% calculations.
Then, the Court of Chancery adopted management’s March Projections of
working capital, despite DFC’s expert’s approach of independently calculating
working capital as a percentage of total revenue. The Court of Chancery did so
because there was “no compelling reason” to reject these Projections’ estimates of
working capital while also relying on the projections for other elements of the
54
RER at A1034.
55
2016 WL 3753123, at *6.
22
discounted cash flow model.56 Similarly, the Court of Chancery adopted the March
Projections’ estimates of DFC’s cash balances.
The experts also disagreed about how to value DFC’s cash flows beyond the
five-year management projection period. DFC’s expert used a two-stage model
where the first stage was the March Projections and the second stage was a terminal
value calculated using the convergence formula. The petitioners’ expert used a
three-stage model where the first stage was the March Projections; the second stage
was a four-year period following those Projections where the growth rate decreased
linearly from the 11.7% growth rate for 2018, to a perpetuity growth rate of 2.7%;
and the third stage was a terminal value calculated using the Gordon Growth Model
with a 2.7% perpetuity growth rate. The petitioners’ expert also created an alternate
two-stage model using a 3.1% perpetuity growth rate. The Court of Chancery
recognized the uncertainty surrounding the Projections and expressed skepticism of
the linear decrease approach because of that uncertainty, and, therefore, adopted a
two-stage model.57
Then, the Court of Chancery considered the appropriate perpetuity growth
rate. First, the Court of Chancery noted that it “often selects a perpetuity growth rate
based on a reasonable premium to inflation” and “some financial economists view
56
Id. at *16.
57
Id. at *17.
23
the risk-free rate as the ceiling for a stable, long-term growth rate.”58 So, that created
a band between the 2.31% median inflation rate compiled by the petitioners’ expert
and the 3.14% risk-free rate both experts agreed on. The court selected 3.1% because
it was at a reasonable premium to inflation but still a tick below the ceiling, risk-free
rate. Finally, the Court of Chancery made some adjustments to DFC’s free cash
flow to take into account stock-based compensation, which are not at issue on appeal.
Using those determinations, the Court of Chancery constructed its own discounted
cash flow model indicating DFC’s fair value was $13.07 per share.
The Court of Chancery next assessed the comparable companies analysis
DFC’s expert used in his estimate of fair value. The Court of Chancery determined
that an approach using the six peer companies both experts agreed on and the median
value of each fiscal year’s multiple was appropriate for a comparable companies
analysis and otherwise adopted DFC’s expert’s analysis and $8.07 per share fair
value estimate as a component of the fair value calculation overall.
Next, the Court of Chancery considered the relevance of the deal price, $9.50
per share. The Court of Chancery recognized that “[t]he merger price in an arm’s-
58
Id. (emphasis added).
24
length transaction that was subjected to a robust market check is a strong indication
of fair value”59 and, here:
DFC was purchased by a third-party buyer in an arm’s-length sale. The
sale process leading to the Transaction lasted approximately two years
and involved DFC’s advisor reaching out to dozens of financial
sponsors as well as several strategic buyers. The deal did not involve
the potential conflicts of interest inherent in a management buyout or
negotiations to retain existing management—indeed, Lone Star took
the opposite approach, replacing most key executives.60
But, the Court of Chancery also observed that “the market price is informative of
fair value only when it is the product of not only a fair sale process, but also of a
well-functioning market.”61 So, the merger provided “a reasonable level of
confidence that the deal price can fairly be used as one measure of DFC’s value.”62
Finally, the Court of Chancery considered how much weight to give the three
fair value inputs it selected. It reiterated that the three inputs meriting consideration
were the discounted cash flow analysis as modified by its findings, DFC’s
comparable companies analysis, and the deal price. The Court of Chancery
observed:
Each of these valuation methods suffers from different limitations that
arise out of the same source: the tumultuous environment in the time
period leading up to DFC’s sale. As described above, at the time of its
sale, DFC was navigating turbulent regulatory waters that imposed
considerable uncertainty on the company’s future profitability, and
59
Id. at *20.
60
Id. at *21 (emphasis added).
61
Id.
62
Id.
25
even its viability. Some of its competitors faced similar challenges. The
potential outcome could have been dire, leaving DFC unable to operate
its fundamental businesses, or could have been very positive, leaving
DFC’s competitors crippled and allowing DFC to gain market
dominance. Importantly, DFC was unable to chart its own course; its
fate rested largely in the hands of the multiple regulatory bodies that
governed it. Even by the time the transaction closed in June 2014,
DFC’s regulatory circumstances were still fluid.63
And, that “uncertainty impacted DFC’s financial projections.”64 “Consequently,
although a discounted cash flow analysis may deserve significant emphasis or sole
reliance in cases where the Court has more confidence in the reliability of the
underlying projections than in the deal price, I do not believe it merits a
disproportionate weighting in this case.”65 But:
This same uncertainty inherent in the projections underlying the
discounted cash flow analysis was present in the sale process. Although
the sale process extended over a significant period of time and appeared
to be robust, DFC’s performance also appeared to be in a trough, with
future performance depending on the outcome of regulatory decision-
making that was largely out of the company’s control. Lone Star was
aware of DFC’s trough performance and uncertain outlook—these
attributes were at the core of Lone Star’s investment thesis to obtain
assets with potential upside at a favorable price.66
63
Id. (emphasis added).
64
Id. at *22.
65
Id.
66
Id.
26
Furthermore, “Lone Star’s status as a financial sponsor, moreover, focused its
attention on achieving a certain internal rate of return and on reaching a deal within
its financing constraints, rather than on DFC’s fair value.”67 Finally:
The uncertainty surrounding DFC’s financial projections also affects
the reliability of the multiples-based valuation, because this valuation
relies on two years of management’s projected EBITDA. Nonetheless,
the multiples-based valuation may be less prone to long-term
uncertainty compared to the discounted cash flow model, because it
relies only on projections through 2015 rather than 2018, and because
one third of the valuation relies on historical EBITDA data.68
Having expressed doubts about each fair value input, the Court of Chancery
concluded that “each of them still provides meaningful insight into DFC’s value, and
all three of them fall within a reasonable range. In light of the uncertainties and
other considerations described above, I conclude that the proper valuation of DFC is
to weight each of these three metrics equally.”69 Thus, the Court of Chancery
determined that the fair value of DFC was: $9.50 (deal price) + $8.07 (comparable
companies analysis) + $13.07 discounted cash flow analysis ÷ 3 = $10.21 per share.
D. Reargument
After reading the post-trial decision, DFC moved for reargument because the
Court of Chancery had neglected to use the working capital numbers the court had
adopted in its opinion in the discounted cash flow model it used to calculate DFC’s
67
Id.
68
Id. at *23.
69
Id.
27
fair value. With that error corrected, and addressing certain foreign exchange
adjustments, the Court of Chancery’s discounted cash flow model would yield $7.70
per share70—a value similar to its comparable companies analysis—and, using the
previous weighting the Court of Chancery adopted, a fair value of $8.42 per share.71
The petitioners did not accept this simple math correction with equanimity.
Instead, they raised an arguably new contention in their own response and motion
for reargument, which was that the level of working capital in the March Projections
implied that DFC would enjoy another period of above-market growth in the
perpetuity period and therefore that the Chancellor’s selected permanent growth rate
of 3.1% was too low.72
The Court of Chancery considered the motions and issued an order granting
the motions in part and modifying the discounted cash flow model. In that order,
the Court of Chancery acknowledged that it had mistakenly included working capital
estimates based on modified working capital estimates made by DFC’s expert when
the Court of Chancery had intended to just use the unmodified March Projections.
70
The respondent’s expert derived that figure by only replacing the working capital figures in the
Court of Chancery’s model. In response to some of the petitioners’ other contentions in their
Response to the respondent’s motion, he used the petitioners’ expert’s model and derived a $8.30
per share value from the discounted cashflow model and an $8.62 per share fair value.
Respondent’s Expert’s Aff. on Reargument at A1389–90.
71
Id. at A1388, A1390.
72
Petitioners’ Reargument Motion at A1341–49.
28
The Court of Chancery then considered the petitioners’ motion for
reargument. In essence, the petitioners said that there needed to be a particular
relationship between the level of projected working capital in the discounted cash
flow model and the perpetuity growth rate. In that affidavit, the petitioners’ expert
argued that the permanent growth rate is a function of two elements, DFC’s return
on capital and DFC’s reinvestment rate.73 When someone preparing a discounted
cash flow analysis selects a permanent growth rate, so the petitioners’ expert’s
argument went, the underlying projections for those two elements have to be
sufficient to sustain that growth rate.74 As the Court of Chancery put it, “DFC’s
projected revenue and working capital needs have a codependent relationship, i.e., a
high-level requirement for working capital, as reflected in [the management
projections] necessarily corresponds with a higher projected growth rate.”75 The
Court of Chancery then observed that it had selected a 3.1% perpetuity growth rate
so as not to exceed the risk-free rate, but, it now realized that the risk-free rate was
only the upper bound for perpetuity growth rates when companies have reached a
stable stage. And, the March Projections “assume DFC will achieve fast-paced
growth throughout the projection period and therefore imply a need for a perpetuity
73
Id. at A1352.
74
Id.
75
Appellant’s Opening Br. Ex. B at 5 (Reargument Order).
29
growth rate higher than the risk-free rate.”76 So, the Court of Chancery determined
that it needed to adopt a perpetuity growth rate consistent with the “relatively high
level of working capital built into those projections.”77 Based on the contentions in
a supplemental affidavit from the petitioners’ expert,78 the Court of Chancery
concluded that the March Projections would sustain an average growth rate of 3.9%
and a median growth rate of 4.2%.
The Court of Chancery adopted the petitioners’ expert’s suggestion that the
correct sustainable growth rate is the midpoint between the average and median
sustainable growth rates, i.e., the functions of reinvestment and return on invested
capital, underlying the March Projections, 4.0%. This growth rate assumed that,
despite the acknowledged risk of insolvency and shrinkage, DFC would, not only
keep pace with the most dynamic mature industries in perpetuity, but exceed their
growth by a healthy margin, given that 4.0% was fully 27% higher than the risk-free
rate of 3.14%. Taking both revisions into account, the Court of Chancery adjusted
its discounted cash flow model to $13.33 per share, 2% higher than its original DCF
and 40% higher than the deal price, which, when given its one-third weight, resulted
in a fair value of DFC at $10.30 per share, $0.09 higher than the post-trial opinion’s
original award.
76
Id.
77
Id. at 6.
78
Petitioners’ Expert’s Aff. on Reargument at A1352–53.
30
II.
On appeal, the case has reflected an emphasis on one issue that was not
presented fairly to the Court of Chancery. Before us, DFC’s central argument is that
a judicial presumption in favor of the deal price should be established in appraisal
cases where the transaction was the product of certain market conditions. DFC
argues that those conditions pertain to this case and the Court of Chancery erred by
not giving presumptive and exclusive weight to the deal price.
DFC also raises more case-specific issues on appeal. The first is a more
constrained take on its deal price presumption argument, which involves the idea
that based on the fact findings the Court of Chancery made regarding the nature of
the market search, lack of conflict of interest, and other relevant economic factors
bearing on the deal price, the Court of Chancery abused its discretion by only giving
one-third weight to the deal price. More particularly, DFC argues that the two
reasons that the Court of Chancery gave for not giving full weight to the deal price—
the fact that DFC faced increasing regulatory constraints that could not be priced by
equity market participants and the fact that the prevailing buyer was a private equity
rather than strategic buyer—were not rationally supported by the record.
DFC’s next case-specific argument is that the Court of Chancery erred by
markedly increasing the perpetuity growth rate it used in its discounted cash flow
model after recognizing on reargument that it had used the wrong working capital
31
figures in its original model. DFC contends that there was no record evidence
justifying this sizable increase in the perpetuity growth rate.
For their part, on cross-appeal, the petitioners argue that the Court of Chancery
abused its discretion by according weight to a comparable companies analysis,
which the petitioners contend is not a reliable indicator of fair value, and that the
court should have given primary, if not exclusive, weight to its discounted cash flow
model.
Finally, DFC’s overall argument raises another implied argument, which is
that the Court of Chancery’s decision to afford equal weight to the deal price, its
discounted cash flow model, and its comparable companies analysis was arbitrary
and not based on any reasoned explanation of why that weighting was appropriate.
We deal with these issues in the order just outlined. When reviewing a
decision in a statutory appraisal, we use an abuse of discretion standard and grant
significant deference to the factual findings of the trial court.79 This Court “will
accept [the Court of Chancery’s] findings if supported by the record . . . .”80
A.
The first issue we confront is one that did not feature in the same way before
the Chancellor. On appeal, but not below, DFC argued for the creation of a judicial
79
Golden Telecom, Inc. v. Glob. GT LP, 11 A.3d 214, 217 (Del. 2010).
80
In re Shell Oil Co., 607 A.2d 1213, 1219 (Del. 1992).
32
presumption that the deal price is the best evidence of fair value when the transaction
giving rise to appraisal results from an open market check and when certain other
conditions pertain. This focus has generated interest from distinguished law
professors on both sides of the question, who have weighed in with dueling amicus
briefs.
But, before the Court of Chancery, DFC merely argued that the “arms-length,
competitive, and fair sales process” entitled the deal price to receive “significant
weight.”81 DFC made a similar argument in its post-trial brief for the Court of
Chancery.82 So, it is difficult to see how the argument that the deal price under these
circumstances is entitled to a presumption of fair value was properly presented to
the Court of Chancery and therefore can be argued to us now.83 We place great value
on the assessment of issues by our trial courts, and it is not only unwise, but unfair
and inefficient, to litigants and the development of the law itself, to allow parties to
pop up new arguments on appeal they did not fully present below. For that reason
alone, we are reluctant to even consider this argument. Nonetheless, because of its
relationship to more case-specific issues, we explain why, even if this were fairly
presented, DFC has not persuaded us to adopt its position.
81
Respondent’s Pretrial Brief at A58.
82
Respondent’s Post-Trial Brief at A1271–81.
83
Sup. Ct. R. 8.
33
Barb.
i.
Another key problem for DFC in presenting this argument now is that a
similar argument was presented and rejected recently by this Court in Golden
Telecom.84 In Golden Telecom, the respondent company argued that this Court
“should adopt a standard requiring conclusive or, in the alternative, presumptive
deference to the merger price in an appraisal proceeding.”85 In rejecting that
argument, this Court focused on the key language in 8 Del. C. § 262, stating that
dissenting shareholders “shall be entitled to an appraisal by the Court of Chancery
of the fair value of the stockholder’s shares of stock under the circumstances
described” elsewhere in the section.86 The statute elaborates:
Through such proceeding the Court shall determine the fair value of the
shares exclusive of any element of value arising from the
84
11 A.3d 214 (Del. 2010). Golden Telecom was an odd case to argue for deference to the deal
price. The transaction in this case and the ones in the many cases when the Court of Chancery has
found that the deal price was the best evidence of value reflected the results of a non-conflicted,
open market check. E.g., In re PetSmart, Inc., 2017 WL 2303599, at *27–*31 (Del. Ch. May 26,
2017); Merion Capital LP v. BMC Software, Inc., 2015 WL 6164771 (Del. Ch. Oct. 21, 2015);
LongPath Capital, LLC v. Ramtron Int’l Corp., 2015 WL 4540443, at *25–*26 (Del. Ch. June 30,
2015); Merlin P’rs LP v. AutoInfo, Inc., 2015 WL 2069417 (Del. Ch. Apr. 30, 2015); In re
Appraisal of Ancestry.com, Inc., 2015 WL 399726 (Del. Ch. Jan. 30, 2015); Huff Fund Investment
Partnership v. CKx, Inc., 2013 WL 5878807, at *11–*14 (Del. Ch. Nov. 1, 2013); Union Illinois
1995 Inv. Ltd. P’ship v. Union Fin. Grp., Ltd., 847 A.2d 340, 357–58 (Del. Ch. 2004). By contrast,
the transaction in Golden Telecom was conflicted and did not involve a process whereby buyers
not tied to the company’s major stockholders would have felt welcome to bid and succeed. In fact,
Golden Telecom’s two largest shareholders owned more of the buyer than they did of Golden
Telecom. Glob. GT LP v. Golden Telecom, Inc., 993 A.2d 497, 508 (Del. Ch. 2010), aff’d, 11
A.3d 214 (Del. 2010).
85
Golden Telecom, 11 A.3d at 216.
86
8 Del. C. § 262.
34
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. In determining such fair value, the Court shall take into
account all relevant factors.87
In particular, this Court focused on § 262’s requirement that the Court of
Chancery consider “all relevant factors” and that “fair value” entails “the value to
the stockholder of the firm as a going concern.”88 Thus, this Court concluded:
Section 262(h) unambiguously calls upon the Court of Chancery to
perform an independent evaluation of “fair value” at the time of a
transaction. It vests the Chancellor and Vice Chancellors with
significant discretion to consider “all relevant factors” and determine
the going concern value of the underlying company. Requiring the
Court of Chancery to defer—conclusively or presumptively—to the
merger price, even in the face of a pristine, unchallenged transactional
process, would contravene the unambiguous language of the statute and
the reasoned holdings of our precedent. It would inappropriately shift
the responsibility to determine “fair value” from the court to the private
parties. Also, while it is difficult for the Chancellor and Vice
Chancellors to assess wildly divergent expert opinions regarding value,
inflexible rules governing appraisal provide little additional benefit in
determining “fair value” because of the already high costs of appraisal
actions.89
DFC would have us depart from the reasoning of Golden Telecom. But, we
are not convinced we should do so. As Golden Telecom found, § 262(h) gives broad
discretion to the Court of Chancery to determine the fair value of the company’s
shares, considering “all relevant factors.” That statutory language was a key feature
87
Id. at § 262(h).
88
Golden Telecom, 11 A.3d at 217.
89
Id. at 217–18 (second emphasis added).
35
in Weinberger v. UOP, Inc.90 Before Weinberger, the Court of Chancery had
historically employed the so-called Delaware Block Method to determine the value
of shares at issue in an appraisal.91 Although “[t]he exact origin of the Delaware
Block Method is a source of confusion,” there is no confusion that it was a judicial
gloss on the appraisal statute, rather than something inevitably stemming from the
text.92 This Court has described the Delaware Block Method this way:
The Delaware Block Method actually is a combination of three
generally accepted methods for valuation: the asset approach, the
market approach, and the earnings approach. Under the Delaware
Block Method, the asset, market and earnings approach are each used
separately to calculate a value for the entire corporation. A percentage
weight is then assigned those three valuations on the basis of each
approach’s significance to the nature of the subject corporation’s
business. The appraised value of the corporation is then determined by
the weighted average of the three valuations.93
One of the three approaches comprising the Delaware Block Method, the
market value approach, focused on the market prices of securities when there was
an active market and where no special circumstances existed to render the price
unreliable.94 This approach is encapsulated by the observation that “[w]here there
90
457 A.2d 701 (Del. 1983). Weinberger was itself not an appraisal case but this Court recognized
its interpretation of the appraisal statute as binding on appraisal proceedings as well. See, e.g.,
Cede & Co. v. Technicolor, Inc., 684 A.2d 289, 296 (Del. 1996).
91
EDWARD P. WELCH ET AL., FOLK ON THE DELAWARE GENERAL CORPORATION LAW § 262.10, at
9-229 (6th ed. 2017).
92
Joseph Evan Calio, New Appraisals of Old Problems: Reflections on the Delaware Appraisal
Proceeding, 32 AM. BUS. L.J. 1, 30 (1994).
93
Paskill Corp. v. Alcoma Corp., 747 A.2d 549, 555 (Del. 2000).
94
Cede & Co. v. Technicolor, Inc., 1990 WL 161084, at *18 n.39 (Del. Ch. Oct. 19, 1990).
36
is a free and active market, averaging of market prices on the last trading day before
the announcement of a merger will reflect the fair market price.”95
By the time of Weinberger in 1983, important developments in corporate
finance and economics had occurred, such as the articulation of the capital asset
pricing model and the efficient market hypothesis, and concepts related to those,
such as the discounted cash flow method of valuation.96 Weinberger eliminated the
Delaware Block Method as the exclusive valuation methodology for appraisal.
Weinberger ascribed this result to two amendments to the appraisal statute: i) the
1976 amendment that added the concept of “fair value” to the statute for the first
time;97 and ii) the 1981 amendment that mandated the Court of Chancery “take into
account all relevant factors.”98 Weinberger found that these statutory amendments
demonstrated “a legislative intent to fully compensate shareholders for whatever
their loss may be, subject only to the narrow limitation that one cannot take
95
FOLK, supra note 91, § 262.10
96
BRADFORD CORNELL, CORPORATE VALUATION 39 (1993) (describing, in a book published in
1993, the “voluminous” literature on the efficient market hypothesis and pointing to two papers,
including one from 1970, as the “best summaries”); RICHARD A. BREALEY ET AL., PRINCIPLES OF
CORPORATE FINANCE 214 (2008) (“In the mid-1960s three economists—William Sharpe, John
Litner, and Jack Treynor—produced an answer to [the problem of determining expected risk
premia]. Their answer is known as the capital asset pricing model or CAPM.”); Calio, supra note
92, at 48 n.222 (“A 1975 survey of 33 major corporations revealed that 94% of those companies
used the discounted cash flow technique to evaluate investment projects.”).
97
60 Del. Laws, c. 371, § 7 (1976) (“[T]he Court shall appraise the shares, determining their fair
value exclusive of any element of value arising from the accomplishment or expectation of the
merger.”).
98
63 Del. Laws, c. 25, § 14 (1981) (“In determining such fair value, the Court shall take into
account all relevant factors.”).
37
speculative effects of the merger into account.”99 Weinberger therefore held that the
Delaware Block Method would no longer be the exclusive valuation method for
appraisal, and instead adopted “a more liberal, less rigid and stylized, approach to
the valuation process,”100 which included “proof of value by any techniques or
methods which are generally considered acceptable in the financial community and
otherwise admissible in court.”101
ii.
Since Weinberger, and Golden Telecom itself, the key language in § 262 that
those cases focused upon has remained unaltered. But, DFC would have us put a
judicial gloss on the broad “all relevant factors” language, by determining that a
particular factor is more relevant than others when certain conditions pertain. We
do not, however, view the statutory language as inviting us to do so. Nor are we
persuaded it is advisable to do so.
As we shall discuss, we have little quibble with the economic argument that
the price of a merger that results from a robust market check, against the back drop
of a rich information base and a welcoming environment for potential buyers, is
probative of the company’s fair value. But, not only do we see no license in the
statute for creating a presumption that the resulting price in such a situation is the
99
Weinberger, 457 A.2d at 714.
100
Id. at 704.
101
Id. at 713.
38
“exclusive,” “best,” or “primary” evidence of fair value, we do not share DFC’s
confidence in our ability to craft, on a general basis, the precise pre-conditions that
would be necessary to invoke a presumption of that kind. We also see little need to
do so, given the proven record of our Court of Chancery in exercising its discretion
to give the deal price predominant, and indeed exclusive weight, when it determines,
based on the precise facts before it that led to the transaction, that the deal price is
the most reliable evidence of fair value.102 For these reasons, we adhere to our prior
ruling in Golden Telecom. If the General Assembly determines that a presumption
of the kind sought is in order, it has proven its attentiveness to our appraisal statute
and is free to create one itself.
As our preceding discussion presages, our refusal to craft a statutory
presumption in favor of the deal price when certain conditions pertain does not in
any way signal our ignorance to the economic reality that the sale value resulting
from a robust market check will often be the most reliable evidence of fair value,
and that second-guessing the value arrived upon by the collective views of many
sophisticated parties with a real stake in the matter is hazardous. In fact, the
Chancellor himself, and his colleagues on the Court of Chancery, understand this, as
both the decision in this case and other decisions of the Court make clear.103
102
See cases cited supra note 84.
103
2016 WL 3753123, at *20 (“The merger price in an arm’s-length transaction that was subjected
to a robust market check is a strong indication of fair value in an appraisal proceeding as a general
39
C.
Having rejected DFC’s argument that the Court of Chancery was required to
give presumptive weight to the deal price, we thus now turn to the more record-
specific argument about the role of the deal price in this case. DFC argues that in
any assessment of the economic value of something—be it a company, a product, or
a service—economics teaches that the most reliable evidence of value is that
produced by a competitive market, so long as interested buyers are given a fair
opportunity to price and bid on the something in question. This argument is sensible
and in accordance with economic literature.104 It also accords with the generally
accepted view that it is unlikely that a particular party having the same information
as other market participants will have a judgment about an asset’s value that is likely
to be more reliable than the collective judgment of value embodied in a market
price.105 This, of course, is not to say that the market price is always right, but that
one should have little confidence she can be the special one able to outwit the larger
matter and this Court has attributed 100% weight to the market price in certain circumstances.”);
see also, e.g., cases cited supra note 84.
104
See, e.g., CORNELL, supra note 96, at 47 (“[T]he [efficient market hypothesis] states that the
market assessment of value is more accurate, on average, than that of any individual, including an
appraiser.”); Barry M. Wertheimer, The Shareholders’ Appraisal Remedy and How Courts
Determine Fair Value, 47 DUKE L.J. 613, 655 (1998) (“The best evidence of value, if available, is
third-party sales value.”); BREALEY ET AL., supra note 96 at 373; Burton G. Malkiel, Are Markets
Efficient?, WALL ST. J. (Dec. 28, 2000) (“Most of us economists who believe in this efficient
market theory do so because we view markets as amazingly successful devices for reflecting new
information rapidly and, for the most part, accurately.”).
105
See BREALEY ET AL., supra note 96 at 373.
40
universe of equally avid capitalists with an incentive to reap rewards by buying the
asset if it is too cheaply priced.
i.
Of course, the definition of fair value used in appraisal cases is a
jurisprudential concept that has certain nuances that neither an economist nor market
participant would usually consider when either valuing a minority block of shares or
a public company as a whole. But, those features do nothing to undermine the ability
of the Court of Chancery to determine, in its discretion, that the deal price is the most
reliable evidence of fair value in a certain case, and that’s especially so in cases like
this one where things like synergy gains or minority stockholder discounts are not
contested. In fact, if one were to look at the face of our appraisal statute, a case like
the one before us today might seem simple. Precisely because DFC’s shares were
widely traded on a public market based upon a rich information base, the “fair value
of the stockholder’s shares of stock”106 held by minority stockholders like the
petitioners, would, to an economist, likely be best reflected by the prices at which
their shares were trading as of the merger.
But, in Cavalier Oil Corporation v. Harnett,107 and other cases,108 this Court
eschewed that reading of the statute and adopted a definition of fair value that is a
106
8 Del. C. § 262.
107
564 A.2d 1137, 1144 (Del. 1989).
108
See e.g., Cede & Co., 684 A.2d at 298; Tri-Cont’l Corp. v. Battye, 74 A.2d 71, 72 (Del. 1950).
41
jurisprudential, rather than purely economic, construct. That definition requires
according the petitioner in an appraisal her pro rata share of the appraised company’s
value as a “going concern.”109 By requiring that petitioners be afforded pro rata
value, the Court required that any minority discount be ignored in coming to a fair
value determination.110 At the same time, by valuing the company on its value as a
“going concern,” the Court seemed to require the excision of any value that might
be attributable to expected synergies by a buyer, including that share of synergy
gains left with the seller as a part of compensating it for yielding control of the
company.111 As the Court of Chancery observed in Union Illinois,112 Cavalier Oil
and its progeny seem to require the court to exclude “any value that the selling
company’s shareholders would receive because a buyer intends to operate the
subject company, not as a stand-alone going concern, but as a part of a larger
enterprise, from which synergistic gains can be extracted.”113 This mandate seemed
inspired by a desire to honor the statute’s command that the court “determine the fair
value of the shares exclusive of any element of value arising from the
109
Cavalier Oil, 564 A.2d at 1144.
110
Id. at 1145.
111
Id. at 1144 (“[T]he company must be first valued as an operating entity by application of
traditional value factors, weighted as required, but without regard to post-merger events or other
possible business combinations.”). The Court later said that, in order to value a company as a
going concern, synergies must be excluded. M.P.M. Enterprises, Inc. v. Gilbert, 731 A.2d 790,
797 (Del. 1999) (“[S]ection 262(h) requires that the Court of Chancery discern the going concern
value of the company irrespective of the synergies involved in a merger.”).
112
Union Illinois 1995 Inv. Ltd. P’ship v. Union Fin. Grp., Ltd., 847 A.2d 340 (Del. Ch. 2004).
113
Id. at 356.
42
accomplishment or expectation of the merger,”114 although that statutory language
could be interpreted to address the narrower, if still important, policy concern that
the specific buyer not end up losing its upside for purchase by having to pay out the
expected gains from its own business plans for the company it bought to the
petitioners. But, the broader excision of synergy gains could have also been thought
of as a balance to the Court’s decision to afford pro rata value to minority
stockholders.
Whatever the exact policy reason, the pro rata share of going concern value
formula has been used in our state’s appraisal jurisprudence for a good time now and
no party to this appeal takes issue with it. But, when that formula is distilled down,
the basic economic concept of fair market value remains central to our statutory
concept of fair value. Basically, Cavalier Oil focuses the appraisal proceeding on
the fair market value of the company being appraised, putting aside any issues
relevant to the value of petitioners’ share blocks and trying to exclude any portion
of value that might be attributed to a synergy premium a buyer might pay to gain
control. That is, in sum, our case law has been read to value the company on its
stand-alone value.
114
8 Del. C. § 262(h).
43
ii.
In economics, the value of something is what it will fetch in the market.115
That is true of corporations, just as it is true of gold. Thus, an economist would find
that the fair market value of a company is what it would sell for when there is a
willing buyer and willing seller without any compulsion to buy. And, outside of the
appraisal context, this Court has often embraced these concepts of value: “[I]n many
circumstances a property interest is best valued by the amount a buyer will pay for
it. . . . a well-informed, liquid trading market will provide a measure of fair value
superior to any estimate the court could impose.”116
Because businesses like corporations are assumed to be valuable to their
115
E.g., HAROLD WINTER, ISSUES IN LAW & ECONOMICS 39 (2017) (“To an economist, when
considering a seller ‘who is willing, but not required to sell’ a property at some price, that price
would have to exceed a value based on whatever is important to the seller.”); N. GREGORY
MANKIW, PRINCIPLES OF ECONOMICS 390 (8th ed. 2016) (“According to neoclassical theory, the
amount paid to each factor of production depends on the supply and demand for that factor.”).
This understanding has a long pedigree. E.g., ALFRED MARSHALL, PRINCIPLES OF ECONOMICS 8
(1895) (citing Adam Smith and observing “[t]he value . . . of one thing in terms of another at any
place and time, is the amount of that second thing which can be got there and then in exchange for
the first.”).
116
Applebaum v. Avaya, Inc., 812 A.2d 880, 889–90 (Del. 2002); see also Poole v. N. V. Deli
Maatschappij, 243 A.2d 67, 70 n.1 (Del. 1968) (“Fair market value is defined as . . . the price
which would be agreed upon by a willing seller and a willing buyer under usual and ordinary
circumstances, after consideration of all available uses and purposes, without any compulsion upon
the seller to sell or upon the buyer to buy.”); State ex rel. Smith v. 0.15 Acres of Land, More or
Less, in New Castle Hundred, New Castle Cty., 376, 169 A.2d 256, 258 (Del. 1961) (“Fair market
value has been defined . . . as the ‘price which would be agreed upon by a willing seller and a
willing buyer under usual and ordinary circumstances, without any compulsion whatsoever on the
seller to sell or the buyer to buy’”) (quoting Wilmington Housing Auth. v. Harris, 93 A.2d 518,
521 (Del. 1952)).
44
equity owners because of the profits they generate,117 economics and corporate
finance instruct rational participants in any sale process that they should base their
bids on their assessments of the corporation’s ability to generate further free cash
flows, and to discount that to present value in formulating their offers.118 Likewise,
the same principles instruct stockholders who buy shares of public companies to
consider the free cash flows of those companies in the form of dividends and their
ability to increase them over time.119
Market prices are typically viewed superior to other valuation techniques
because, unlike, e.g., a single person’s discounted cash flow model, the market price
117
One of the reasons, of course, why a control block trades at a different price than a minority
block is because a controller can determine key issues like dividend policy.
118
Of course, some businesses provide certain non-common benefits, such as those that might
come from owning a sports team or entertainment business, beyond what their cash returns would
suggest. But, the typical approach teaches “[c]ompanies create value by investing capital to
generate future cash flows at rates of return that exceed their cost of capital.” TIM KOLLER ET AL.,
VALUATION: MEASURING AND MANAGING THE VALUE OF COMPANIES 15 (2010); see also id. at
101 (“In broad terms, a company’s value is driven by its ability to earn a healthy return on invested
capital (ROIC) and by its ability to grow. Healthy rates of return and growth result in high cash
flows, the ultimate source of value.”). This is, after all, one of the reasons why discounted cash
flow models are so often used in appraisal proceedings when the respondent company was not
public or was not sold in an open market check: “The enterprise [discounted cash flow] model is
a favorite of academics and practitioners because it relies solely on how cash flows in and out of
the company.” Id. at 115. The reason for that is not that an economist wouldn’t consider the best
estimate of a private company’s value to be the price it sold at in an open sale process of which all
logical buyers were given full information and an equal opportunity to compete. Rather, the reason
is that if such a process did not occur, corporate finance instructs that the value of the company to
potential buyers should be reflected in its ability to generate future cash flows.
119
See, e.g., BREALEY ET AL. supra note 96, at 91 (“This discounted-cash-flow (DFC) formula for
the present value of a stock is just the same as it is for the present value of any other asset. We
just discount the cash flows—in this case the dividend stream—by the return that can be earned in
the capital market on securities of equivalent risk.”).
45
should distill the collective judgment of the many based on all the publicly available
information about a given company and the value of its shares.120 Indeed, the
relationship between market valuation and fundamental valuation has been strong
historically.121 As one textbook puts it, “[i]n an efficient market you can trust prices,
for they impound all available information about the value of each security.”122
More pithily: “For many purposes no formal theory of value is needed. We can take
the market’s word for it.”123 But, a single person’s own estimates of the cash flows
are just that, a good faith estimate by a single, reasonably informed person to predict
the future. Thus, a singular discounted cash flow model is often most helpful when
there isn’t an observable market price.124
For these reasons, corporate finance theory reflects a belief that if an asset—
such as the value of a company as reflected in the trading value of its stock—can be
120
See e.g., CORNELL, supra note 96, at 35–38.
121
KOLLER ET AL., supra note 118, at 326 (“[T]he extent to which company valuations based on
the fundamental approach have matched stock market values over the past four decades is
remarkable.”); id. (“[M]anagers can safely assume that share prices reflect the markets’ best
estimate of intrinsic value.”); id. at 333 (“Market valuation levels are determined by the company’s
absolute level of long-term expected growth and performance—that is, expected revenue and
earnings growth and expected ROIC.”); id. at 354 (“[S]tock price data suggest that the market digs
deeply beneath not just reported earnings but all of a company’s accounting information in order
to understand the underlying economic fundamentals.”).
122
BREALEY ET AL., supra note 96, at 373.
123
Id. at 13.
124
See ROSENBAUM & PEARL, supra note 52, at 109 (“[Discounted cash flow models are] an
important alternative to market-based valuation techniques . . . . A [discounted cash flow model]
is also valuable when there are limited (or no) pure play, peer companies or comparable
acquisitions.”); see also CORNELL, supra note 96, at 100 (“The strength of [a discounted cash flow
model] is that it can be applied in virtually any situation”).
46
subject to close examination and bidding by many humans with an incentive to
estimate its future cash flows value, the resulting collective judgment as to value is
likely to be highly informative and that, all estimators having equal access to
information, the likelihood of outguessing the market over time and building a
portfolio of stocks beating it is slight.125
Other realities emphasize why real world transaction prices can be the most
probative evidence of fair value even through appraisal’s particular lens. As the
preceding discussion emphasizes, fair value is just that, “fair.” It does not mean the
highest possible price that a company might have sold for had Warren Buffett
negotiated for it on his best day and the Lenape who sold Manhattan on their worst.
Rather, as the Court of Chancery has put it in another context:
A fair price does not mean the highest price financeable or the highest
price that fiduciary could afford to pay. At least in the non-self-dealing
context, it means a price that is one that a reasonable seller, under all of
the circumstances, would regard as within a range of fair value; one that
such a seller could reasonably accept.126
Capitalism is rough and ready, and the purpose of an appraisal is not to make sure
that the petitioners get the highest conceivable value that might have been procured
had every domino fallen out of the company’s way; rather, it is to make sure that
they receive fair compensation for their shares in the sense that it reflects what they
125
See, e.g., CORNELL, supra note 96, at 35–38.
Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1134, 1143 (Del. Ch. 1994), aff’d, 663 A.2d 1156
126
(Del. 1995).
47
deserve to receive based on what would fairly be given to them in an arm’s-length
transaction.
The real world evidence regarding public company M&A transactions
underscores this. Various factors prevalent in our economy, which include
Delaware’s own legal doctrines such as sell-side voting rights, Revlon,127 Unocal,128
the entire fairness doctrine, and the pro rata rule in appraisals, have caused the sell-
side gains for American public stockholders in M&A transactions to be robust.129
Part of why the synergy excision issue can be important is that it is widely assumed
that the sales price in many M&A deals includes a portion of the buyer’s expected
synergy gains, which is part of the premium the winning buyer must pay to prevail
and obtain control.130 For that reason, there is a rich literature noting that the buyers
in public company acquisitions are more likely to come out a loser than the sellers,
as competitive pressures often have resulted in buyers paying prices that are not
justified by their ability to generate a positive return on the high costs of acquisition
and of integration.131 As one authority summarizes:
127
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986).
128
Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985).
129
G. Andrade, M. Mitchell, & E. Stafford, New Evidence and Perspectives on Mergers, 15 J.
ECON. PERSP. 103 (2001).
130
E.g., BOS. CONSULTING GRP. & TECHNISHE UNIVERSITAT MUNCHEN, DIVIDE AND CONQUER:
HOW SUCCESFUL M & A DEALS SPLIT THE SYNERGIES 9 (2013) (“To arrive at a transaction price
acceptable to the seller, in most cases, the acquirer must agree to share expected synergies.”).
131
As to this point, it is notable that under the leading corporation statute used outside of Delaware,
the Model Business Corporation Act, an appraisal petition cannot be filed in a public company
merger, for cash or the stock of another public company, unless it is an “interested transaction.”
48
According to McKinsey research on 1,415 acquisitions from 1997
through 2009, the combined value of the acquirer and target increased
by about 4 percent on average. However, the evidence is also
overwhelming that, on average, acquisitions do not create much if any
value for the acquiring company’s shareholders. Empirical studies,
examining the reaction of capital markets to M&A announcements find
that the value-weighted average deal lowers the acquirer’s stock price
between 1 and 3 percent. Stock returns following the acquisition are
no better. Mark Mitchell and Erik Stafford have found that acquirers
underperform comparable companies on shareholder returns by 5
percent during the three years following the acquisitions.132
Similarly, another study summarized its findings by simply stating: “Target firm
shareholders are clearly winners in merger transactions.”133
iii.
DFC argues that, with a company like itself, it was particularly unlikely that
the market would somehow miss out if it had great growth prospects. After all,
DFC’s stock was listed on a major U.S. exchange, traded actively, and had moved
sharply over the years when the company was poised for growth or facing dimming
prospects.134 And, DFC was also actively examined by the debt markets, which rated
MODEL BUS. CORP. ACT §§ 13.02(b) (Am. Bar Assoc. Bus. L. Section 2016) (denying appraisal
rights for shareholders of public companies who receive cash or stock in a merger unless the
merger is an “interested transaction”); 13.01 (defining “interested transaction”). In those cases,
stockholders who wish to challenge the merger must do so by filing an equitable action arguing
that the merger resulted from a breach of fiduciary duty.
132
KOLLER, ET AL., supra note 118, at 434–35.
133
Andrade et al., supra note 129, at 110; cf. U. Malmendier et al., “Winning by Losing: Evidence
on the Long-Run Effects of Mergers,” NBER Working Paper No. 18024, Apr. 2012 (describing
findings that, in close bidding contests for corporate control, winners tend to underperform losers
over the following three years).
134
2016 WL 3753123, at *6; PER at A935; see also supra chart accompanying note 19.
49
and analyzed its creditworthiness.135 And of course, here, these market participants’
judgments were supplemented by those of the numerous strategic and financial
buyers who were contacted by Houlihan during the sales process and given a chance
to buy DFC and to receive non-public information about it.
Because the Court of Chancery found that the sales process was robust and
conflict-free, DFC argues that the Court of Chancery erroneously relied on two
factors to diminish the role of the deal price in its fair value determination. To wit,
that: i) DFC “appeared to be in a trough, with future performance depending on the
outcome of regulatory decision-making that was largely out of the company’s
control”; and ii) Lone Star’s status as a financial sponsor “focused its attention on
achieving a certain internal rate of return and on reaching a deal within its financing
constraints, rather than on DFC’s fair value.”136 Although the Court of Chancery
has broad discretion to make findings of fact, those findings of fact have to be
grounded in the record and reliable principles of corporate finance and economics.
Despite the vigorous efforts of the petitioners to justify the Court of Chancery’s fact
findings for according the deal price one-third weight, we fail to discern an adequate
record to support them.
135
PER at A883.
136
2016 WL 3753123, at *22.
50
a.
First, the Chancellor found that the deal price was unreliable because DFC
was in a trough with future performance dependent upon the outcome of regulatory
actions, but he cited no economic literature to suggest that markets themselves
cannot price this sort of regulatory risk. The payday lending industry is hardly
unusual in being subject to regulatory risks. Publicly traded companies in industries
like tobacco, energy, pharmaceuticals, and certain commercial products are subject
to close regulation, the development of which can affect their future cash flows.
Precisely because of that reality, the market’s assessment of the future cash flows
necessarily takes regulatory risk into account as it does with all the other reasonable
uncertain factors that affect a company’s future.137 In this case, the payday lending
industry was long subject to regulatory risk, albeit of a changing character.138 As
137
Since the 1980s, a robust economics literature has developed around the premise that
“unanticipated changes in regulation result in a current change in security prices, and the price
change is an unbiased estimate of the value of the change in future cash flows to the firm.” G.
William Schwert, Using Financial Data to Measure Effects of Regulation, 24 J.L. & ECON. 121,
121–22 (1981); see also John J. Binder, Measuring the Effects of Regulation with Stock Price
Data, 16 RAND J. ECON. 167, 181 (1985) (conducting event studies around regulatory changes in
regulated industries and finding “it is extremely difficult to find announcements in the regulatory
process that are unanticipated by the market, even when the announcements are carefully studied
to eliminate those that do not appear to have a major effect on expectations”). And, the corollary
of that is “[i]f regulation has implications for the value of securities, the effects of regulation are
impounded into prices at the time when they are first anticipated. Subsequent security returns only
reflect the equilibrium expected returns to assets of comparable risk, unless the actual effects of
regulation deviate from the originally anticipated effects.” Schwert, supra, at 122.
138
See supra pp. 12–14.
51
one equity analyst report observed, regarding the industry, “[r]egulatory risk is
persistent, but [it] has always been.”139
Beyond the reality that prevailing economic theories assume that markets take
information about all sorts of risk, including regulatory risk, into account and price
that information into the things traded on those markets,140 the record reveals that
equity analysts, equity buyers, debt analysts, debt providers and others were in fact
attuned to the regulatory risks facing DFC. For one thing, in the years leading up to
the merger, DFC’s stock price fluctuated, but it had an overall downward trend.141
Although the Canadian regulatory reform did not appear to negatively affect DFC’s
stock price, the extensive U.K. regulatory overhaul did seem to contribute to the
decline in stock price.142 This highlights an important point.
That Weinberger got rid of the Delaware Block Method does not mean that
the pre-transaction trading price of a public company’s shares is not relevant to its
fair value in appraisal, particularly given the focus on going concern value.143
Historically, appraisal actions have had the most utility when private companies are
139
JX 554: JOHN HECT ET AL., INITIATING ON NON-PRIME CONS. FIN, JEFFRIES at 1.
140
See sources cited, supra note 137.
141
See also supra chart accompanying note 19.
142
Id.
143
Cooper v. Pabst Brewing Co., 1993 WL 208763, at *8 (Del. Ch. June 8, 1993) (“Where there
is an established market for a corporation's stock, market value must be considered in appraising
the value of the corporation's shares.”); Cede & Co., 1990 WL 161084, at *18 (“[M]arket price is
a relevant factor of some weight where the market is active and where no special consideration
indicating that it should be given no weight is present.”).
52
being acquired or for public companies subject to a conflicted buyout, situations
where market prices are either unavailable altogether or far less useful. When, as
here, the company had no conflicts related to the transaction, a deep base of public
shareholders, and highly active trading, the price at which its shares trade is
informative of fair value, as that value reflects the judgments of many stockholders
about the company’s future prospects, based on public filings, industry information,
and research conducted by equity analysts.144
And, during the relevant period, DFC’s regulatory risk was being watched by
two other key sets of folks who had money at stake: potential buyers in the sale
process and participants in the debt markets.
The buyers who were part of the sales process—and who ultimately decided
not to pursue a transaction with DFC—considered regulatory risk. In the spring of
2012, Houlihan contacted six financial sponsors about a possible transaction. Three
parties were interested and conducted due diligence. But, by October of that year,
all three lost interest. Over the next year, Houlihan contacted an additional thirty-
five financial sponsors and three strategic buyers. Three interested parties emerged
and were given access to management’s projections. Lone Star and J.C. Flowers
144
See, e.g., BREALEY ET AL., supra note 96, at 373 (“In an efficient market you can trust prices,
for they impound all available information about the value of each security.”); CORNELL, supra
note 96, at 39 (“[O]n average, market forecasts and market valuations will be at least as accurate
as those produced by individual investors and appraisers, no matter how expert.”).
53
submitted non-binding indications of interest in late 2013, and only one party, Lone
Star, continued to express interest after receiving additional projections from
management in early 2014.145 That these other potential buyers dropped out of the
sales process after receiving confidential information about DFC suggests that these
parties were aware of the “trough” DFC was in at the time and the uncertain future
regulatory risk it faced, and ultimately did not think a transaction with DFC was
145
Admittedly, the petitioners point to evidence from Lone Star’s files indicating that it thought it
was taking an opportunity to buy DFC at trough pricing and that it could reap the upside of this
risk. Stipulated Joint Pre-Trial Order at A136. One would expect a buyer to think it made a wise
decision with an upside, and, to be candid, it is in tension with the statute itself to argue that the
subjective view of post-merger value of the acquirer can be used to value the respondent company
in an appraisal, as the statute’s exclusion of transaction-specific value seems to be directed at the
concern a buyer who pays fair value should not have its economic upside for taking that risk
expropriated in the appraisal process, a result that if it were the law, would discourage sales
transactions valuable to selling stockholders. That a buyer views itself as having struck a good
deal is far from reliable evidence that the resulting price from a competitive bidding process is an
unreliable indicator of fair value. For starters, here the Court of Chancery’s own comparable
companies analysis and that of the petitioners’ expert if he used the median multiple resulting from
his analysis suggested that Lone Star was paying a substantial premium to gain control of DFC at
$9.50. So did the Court of Chancery’s discounted cash flow model when calculated in accordance
with the original assumptions the Court of Chancery adopted in its post-trial decision. And, one
would think that the buyer who paid the highest price in a competitive process had the most
confidence there was an upside and must think that post-purchase gains would justify its purchase;
otherwise, no sale would ever occur in the world. That Lone Star expected to profit does not mean
that the collective view of value that results from the deal price is not a reliable indicator of fair
value; to hold otherwise, is to adopt a non-binary view of fair value in which only the upside view
of what could happen in the future is taken into account. Perhaps most importantly, under the
Court of Chancery’s view, the discounted cash flow value of DFC was somehow 62% above the
value implied by a consideration of its worth when valued on par with public companies like it,
and 38% above the deal price resulting from a lengthy open market check. This suggests that daily
traders in the company’s equities, Wall Street lenders who passed on the chance to refinance DFC’s
debt and to syndicate even more acquisition debt, and the types of buyers who would consider
buying a payday lender all missed out on a big chance to reap outsized gains.
54
worth pursuing. Indeed, J.C. Flowers cited the regulatory risk facing the company
as its reason for not wanting to pursue a transaction with DFC.
Finally, the debt markets for DFC took into consideration the regulatory risk
DFC was facing. In the fall of 2013, the same time that Houlihan was actively
seeking buyers for DFC, DFC attempted to refinance around $600 million in Senior
Notes. But, there was not enough investor interest and the offer was terminated. In
other words, participants in the public bond markets weren’t convinced they would
get their money back if they gave it to DFC, and DFC was not offering enough
interest to compensate investors for the risk they saw in the company. Furthermore,
in a May 2014 presentation to certain rating agencies, DFC discussed the recent U.K.
regulatory changes and the challenges it was causing DFC, including its negative
effect on DFC’s revenue.146 DFC also discussed the U.S. regulatory environment
and mentioned that the Consumer Financial Protection Bureau had conducted an on-
site review of DFC in 2013, and since then the company undertook certain corrective
actions to enhance compliance.147 At the same time, DFC claimed that there was
long-term opportunity to grow and expand as competitors struggled under the stricter
regulatory framework. But, the Chancellor found that one of the reasons Lone Star
lowered its offer to $9.50 was because its financing available for the transaction had
146
DFC Rating Agency Presentation at B261.
147
Id. at B262.
55
fallen by $100 million due to DFC’s reductions in projected EBITDA,148 which were
of course related to the stricter regulations in the U.K.149 This confirms that debt
investors also cared about and tracked DFC’s regulatory challenges and took them
into account when deciding if and at what yield it would invest in DFC’s debt. As
is the case with refinancings, so too do banks like to lend and syndicate the
acquisition debt for an M&A transaction if they can get it done. That is how they
make big profits. That lenders would not finance a buyout of DFC at a higher
valuation logically signals weakness in its future prospects, not that debt providers
and equity buyers were all mistaken. So did the fact that DFC’s already non-
investment grade debt suffered a downgrade in 2013 and then was put on a negative
credit watch in 2014.150
Thus, the record demonstrates that the markets factored regulatory risk into
DFC’s pricing. Although the Court of Chancery gave DFC credit for being in a
“unique position,”151 that story was the same one that DFC told to sell itself to
numerous buyers, the debt markets, and its existing stockholders. That this growth
148
2016 WL 3753123, at *22.
149
See id. at *3 (“On January 30, 2014, DFC cut its adjusted EBITDA projections again, lowering
its fiscal year 2014 forecast from $200–240 million to $170–200 million, noting the continued
difficulties with the U.K. regulatory transition.”).
150
JX 320, supra note 37, at 1; JX 468, supra note 25, at 2–3.
151
2016 WL 3753123, at *22.
56
story was not accepted by the markets does not mean that the markets ignored it.152
Rather, the equity and credit markets were intensely focused on the extent to which
DFC could address the new regulatory burdens and how they affected its potential
for future growth.
b.
The second reason the Chancellor gave for finding the deal price unreliable
was that Lone Star, a private equity firm, required a specific rate of return on its
transaction with DFC. But, all disciplined buyers, both strategic and financial, have
internal rates of return that they expect in exchange for taking on the large risk of a
merger, or for that matter, any sizeable investment of its capital.153 That a buyer
focuses on hitting its internal rate of return has no rational connection to whether the
price it pays as a result of a competitive process is a fair one.154 That is especially
152
Consistent with the market’s reaction, there is also evidence in the record to support the
proposition that DFC was not going to navigate the U.K. regulatory changes it faced in 2014
without experiencing commercial losses as it did the Canadian changes. See supra page 14.
153
BREALEY ET AL., supra note 96, at 129–30 (describing internal rates of return as a prevalent
form of analysis for companies engaging in new projects); see also id. at 118 fig. 6.2 (describing
survey result that seventy-six percent of CFOs use internal rate of return for evaluating investment
projects); cf. id. at 891–93 (arguing that mergers should be analyzed based on determining if the
merger results in economic gain, i.e., if the two firms are worth more together than apart).
154
Indeed, were it true that hitting an internal rate of return was somehow incompatible with
achieving fair value, it would be hard to explain the results of studies that have shown that for
specific sets of targets in auction-type situations, financial sponsor buyers, who ostensibly are the
most disciplined users of internal rates of return to make investment decisions, place a higher value
on them than strategic buyers, despite the conventional wisdom that strategic buyers can count on
greater value from mergers through synergies. Alexander S. Gorbenko & Andrey Malenko,
Strategic and Financial Bidders in Takeover Auctions, J. CORP. FIN. (forthcoming) (manuscript 4–
5), https://ssrn.com/abstract=1559481. And, of course, private equity buyers have to compete with
strategic buyers and thus the potential synergy gains of other buyers and its effect on the bids they
57
so when there are objective factors that support the fairness of the price paid,
including: i) the failure of other buyers to pursue the company when they had a free
chance to do so; ii) the unwillingness of lenders to lend to the buyers because of
fears of being paid back; iii) a credit rating agency putting the company’s long-term
debt on negative credit watch; and iv) the company’s failure to meet its own
projections. Importantly, the Court of Chancery determined that there was no
conflict of interest. Indeed, the court observed that “[t]he deal did not involve the
potential conflicts of interest inherent in a management buyout or negotiations to
retain existing management—indeed, Lone Star took the opposite approach,
replacing most key executives.”155
Especially untenable is the idea that the deal price cannot be relied upon as a
reliable indicia of fair value because lenders would not finance the acquisition by
Lone Star at a higher price. Lenders get paid before equity.156 They make profits
by lending. If lenders fear getting paid back, then that is not a reason to think that
the equity is being undervalued. Furthermore, the fact that the ultimate buyer was
alone at the end provides no basis for suspicion given the Chancellor’s own view of
can make will influence the price any buyer of any type has to pay to prevail. Relatedly, the
absence of synergistic buyers for a company is itself relevant to its value.
155
2016 WL 3753123, at *21.
156
WILLIAM J. CARNEY, CORPORATE FINANCE 195 (2005) (comparing equity and debt as
substitutes and noting that debt instruments “are promises to pay a fixed sum on a specified date,
together with periodic payments of interest” distinct from equity, which is “a residual claim,
entitled to all remaining assets on liquidation after all other claims are paid.”).
58
the process and the uncontradicted evidence of record finding that: i) there was no
conflict of interest; ii) Houlihan had approached every logical buyer; iii) no one was
willing to bid more in the months leading up to the transaction before management
significantly adjusted downward its projections; and iv) management continued to
miss its targets after Lone Star was the only buyer remaining. Thus, the record does
not include the sorts of flaws in the sale process that could lead one to reasonably
suspect that the ultimate price paid by Lone Star was not reflective of DFC’s fair
value. For these reasons, we cannot sustain the Chancellor’s decision to give only
one-third weight to the deal price because the factors he cited in giving it only that
weight were not supported by the record.
D.
DFC’s next case-specific argument is that the Court of Chancery improperly
revised its discounted cash flow valuation to increase the perpetuity growth rate it
used from 3.1% to 4.0%—a 29% increase in the growth rate—after it acknowledged
on reargument that it had made a clerical error and used a lower working capital
number in its model than it intended. The Court of Chancery adopted the working
capital estimates from the March Projections in its opinion, but in its model, the
Court of Chancery inadvertently used DFC’s expert’s working capital estimates,
which were lower than those in the March Projections. Just correcting that error
59
alone would have resulted in a discounted cash flow value of $7.70 per share.157 This
value would have been corroborated by the Court of Chancery’s comparable
companies analysis, which indicated a value of $8.07 per share, and would have been
far more in line with the $9.50 deal price than the $13.07 per share value resulting
from its original discounted cash flow calculation.
i.
But, in their own motion for reargument, the petitioners argued that the Court
of Chancery’s original discounted cash flow analysis, even with the corrected
working capital figures, contained a fundamental methodological flaw,158 albeit one
that apparently also infected elements of their own expert’s analyses prepared for
trial. Specifically, the petitioners maintained that “the Court failed to take into
account the required correlation between a company’s [permanent] growth rate,
discount rate, and level of working capital necessary to sustain growth.”159 By using
the working capital estimates contained in the March Projections and adopting a
3.1% permanent growth rate, the petitioners’ argument went, the Court of Chancery
had supposedly used variables at odds with each other,160 leading to “illogical
results.”161 As the petitioners explained it, because DFC is a lending business,
157
Respondent’s Expert’s Aff. on Reargument at A1338.
158
Petitioners’ Reargument Motion at A1342.
159
Id.
160
Id. at A1342–44.
161
Id. at A1344.
60
DFC’s “revenue and working capital outflows have a codependent . . . and
directionally consistent relationship that should be reflected in any free cash flow
calculation.”162 Because the March Projections predicted a revenue growth rate of
11.7% in their final year, then, with an estimated $90 million of working capital to
support that growth, that together they implied a higher ongoing investment in
working capital and therefore a higher growth rate in the perpetuity period.163
DFC disagreed with the petitioners’ contention, arguing that this sort of
change was not appropriate for a motion seeking reargument because the petitioners
did not “demonstrate that ‘the Court has overlooked a controlling precedent or
misapprehended the law or facts of the case,’” which the methodological error was
not,164 and because the petitioners’ argument essentially “rehashes an issue already
considered” by the Court of Chancery, selecting an appropriate perpetuity growth
rate.165
ii.
Instead of simply correcting the clerical error, however, the Court of Chancery
not only fixed its working capital assumption, but then revised sharply upward its
162
Id.
163
Id. at A1345. The lack of development of the record for this crucial change to the discounted
cash flow model is also a good illustration of why all parties are poorly served when this sort of
material change is raised for the first time in a motion for reargument.
164
Respondent’s Opposition to Petitioners’ Reargument Motion at A1376–77.
165
Id. at A1381.
61
estimate for the perpetuity growth rate in response to the petitioners’ argument. The
Court of Chancery stated:
5. In re-examining the working capital assumptions in its discounted
cash flow analysis, the Court realizes that it misapprehended another
material fact in constructing its model, namely, the need to maintain
an appropriate correlation between the level of projected working
capital and the perpetuity growth rate. In the Opinion, the Court
adopted the 3.1% perpetual growth rate from [petitioners’ expert’s]
two-stage discounted cash flow model, which was performed as an
alternative to his three-stage growth model. In doing so, the Court
observed that a sharp growth rate drop-off “from the projection
period to the terminal period is not ideal but not necessarily
problematic.” In reconsidering the issue, however, the Court
realizes it failed to appreciate the extent to which DFC’s projected
revenue and working capital needs have a codependent relationship,
i.e., a high-level requirement for working capital, as reflected in
DFC’s March Projections, necessarily corresponds with a high
projected growth rate.
6. The Court also based its selection of a 3.1% growth rate on the theory
that a company’s perpetuity growth rate should not exceed the risk-
free rate, which both parties agreed was 3.14% in this case. But this
proposition is only applicable to companies that have reached a
stable stage. The March Projections assume DFC will achieve fast-
paced growth throughout the projection period and therefore imply
a need for a perpetuity growth rate higher than the risk-free rate.
7. Because the Court adopted the working capital assumptions in the
March Projections, the Court should have adopted a perpetuity
growth rate more consistent with the relatively high level of working
capital built into those projections. In Petitioners’ motion for
reargument, [petitioners’ expert] demonstrates that, as a matter of
economics, the March Projections support an average sustainable
growth rate of 3.9% and a median sustainable growth rate of 4.0%,
representing the midpoint of the median and average growth rates
underlying the March Projections, is proper in this case. Although
a perfect projection of the future is never attainable, the 4.0%
perpetuity growth rate that [petitioners’ expert] derived using a
62
recognized economics formula corrects the Court’s original model
in a reasonable manner. Therefore, the Court adopts this higher
perpetuity growth rate in its revised discounted cash flow model.166
On appeal, DFC argues that this change was unjustified by the record.
iii.
We agree with the respondent that the record evidence does not rationally
support the Court of Chancery’s decision to increase its original discounted cash
flow model value on reargument from an original rate that was just shy of the ceiling,
risk-free rate for a stable-state company, to a much higher 4.0% perpetuity growth
rate. By embracing the idea that using the March Projections required increasing the
perpetuity growth rate, the Court of Chancery compounded its reliance upon the
Projections that assumed DFC could grow rapidly again through 2018. The
aggressive upward move to increase the perpetuity value on reargument by 0.9%
inflated the Chancellor’s original discounted cash flow estimate to $13.33, which
was 40% above the deal price. Simply given the Court of Chancery’s own findings
about the extensive market check, the value gap already reflected in the court’s
original discounted cash flow estimate of $13.07 should have given the Court doubts
about the reliability of its discounted cash flow analysis. And, a less-than-clear
expert affidavit, not well grounded in record evidence, on a reargument motion
where there was no opportunity for cross-examination of the petitioners’ expert to
166
Appellant’s Opening Br. Ex. B at 4–6 (Reargument Order).
63
better understand his contentions, is a poor basis to switch out the vehicle driving a
large part of the value in a discounted cash flow analysis.
Our non-exclusive reasons for finding that the record did not support the 29%
upward increase in the perpetuity growth rate made after reargument are:
a) the linkage of projected working capital in the March Projections to
DFC’s perpetuity growth rate the petitioners urge is
methodologically suspect and not supported by anything in the
Projections themselves or testimony about them;
b) the increase in the perpetuity value failed to take into account that
DFC and its industry had already experienced nearly a generation of
rapid growth;
c) the petitioners’ assertion that DFC was primed for another period of
rapid growth was not grounded in any testimonial or document
evidence either about DFC specifically or the payday lending
industry more generally;
d) DFC was experiencing strong regulatory pushback and, that
pushback was affecting DFC’s profitability and working capital, i.e.,
loans, that DFC would need to make to generate profits; and finally
e) the petitioners’ assertion was at tension with several of their expert’s
own assumptions in his original analysis, including his assumptions
64
that DFC’s beta was most akin to the beta of a company performing
in line with the overall market and that DFC was therefore at a
steady state of growth.
We now discuss each reason in turn.
a.
First off, we are not convinced that the petitioners’ description of the
methodological tension they identified in the Court of Chancery’s initial approach
to the discounted cash flow model accurately describes best practices in using
discounted cash flow models for valuation. Specifically, the idea that in a discounted
cash flow model, there is a “required correlation,”167 between the level of working
capital growth in the specifically projected years and the terminal growth calculation
does not fit well with general principles of valuation. The Gordon Growth Model,
which the Court of Chancery used in its calculations and which no one disputes is
an appropriate tool here, is “used to value a firm that is in ‘steady state’ with
dividends growing at a rate that can be sustained forever.”168 Other texts on
valuation suggest that the perpetuity growth rate should be based on the expected
long-term industry growth rate,169 on the assumption that in this period the company
167
Id. at A1342.
168
ASWATH DAMODARAN, INVESTMENT VALUATION: TOOLS AND TECHNIQUES FOR DETERMINING
THE VALUE OF ANY COMPANY 323–24 (2002).
169
ROSENBAUM & PEARL, supra note 52, at 132; KOLLER, supra note 118, at 214.
65
being valued will grow with its industry or economy as a whole, rather than exhibit
its own distinct growth characteristics. But, as the petitioners’ expert asserted, their
entire theory was based on the belief that “the last explicit period’s [of the March
Projections] revenues and operating margins have not reached a steady state.”170
Indeed, if the record unambiguously supported the proposition that DFC was to
continue a new spurt of growth past 2018, it would have been more appropriate to
project out to a point where steady-state growth began.171 By doing that, the
appraiser would have to assess with discipline the next period after the projections
end and also the potential that the period might be negative, as well as that another
period of above-market growth might be followed by a terminal growth rate more
like inflation than the risk-free rate. Especially when, as here, the underlying
projections assumed away important downside risks during the projection period, a
consideration of downside scenarios, not just positive ones, must factor into this
process, whether a multi-stage model is used or the future is encapsulated in a single
perpetuity growth value. Put simply, the theoretical link the petitioners urge between
the discounted cash flow model’s optimistic forecast period and the perpetuity
period is not as strong as they suggest or as the Chancellor accepted.
170
Petitioners’ Expert’s Aff. on Reargument at A1351.
171
KOLLER, supra note 118, at 214; CORNELL, supra note 96, at 144; cf. BREALEY ET AL., supra
note 96, at 95 (“[R]esist the temptation to apply the [constant-growth discounted cash flow]
formula to firms having high current rates of growth. Such growth can rarely be sustained
indefinitely, but the constant-growth DCF formula assumes it can.”).
66
To this point, the petitioners don’t situate changes in DFC’s working capital
in the specific payday lending context where, like other types of lenders, DFC’s
working capital is largely driven by loan growth. Industries are different. By way
of example, a home builder might purchase a large quantity of lumber in year 1 in
anticipation of building many houses in year 2, and thus experiencing material
revenue increases in year 2. There is no record evidence suggesting that payday
lenders booked working capital in this manner or that the 2018 working capital
(which already supported hockey stick growth in that period) portended boom years
ahead. That sort of story is not in the petitioners’ briefs themselves or any other part
of the record. In other words, DFC’s loan growth had to come from somewhere and
the petitioners never put their finger on where that would be.
Likewise, the Court of Chancery understood that the March Projections were
designed to help sell the company at a favorable price, and thus assumed very strong
growth through 2018. Had the petitioners’ expert believed that the working capital
in the March Projections signaled another year of strong growth in 2019, and for
years after, it is difficult to understand why the Projections did not say that was so
and why it was so. As the record before us stands, the petitioners’ assertion that
those Projections silently projected another period of above-market growth beyond
2018 is without support in the Projections themselves, management testimony, or
industry analysis.
67
As important, if one number is to encompass the future, as the perpetuity
growth rate did here, and even if it should account for company-specific
performance, it not only has to account for the possibility that the company might
have another period of above-market growth, but also the possibility that it would
fail altogether, or in the long run not keep up with the real growth of the economy.172
And, the original perpetuity growth rate used by the Court of Chancery for DFC was
already bullish as it was nearly at the risk-free rate, and this assumed that DFC would
grow at that rate forever. Adding another 0.9% to that assumption, by implying that
the unbroken, sunny sky assumptions of the March Projections implicitly signaled
another period of robust, above-market growth is an enormous step, which had to be
rooted in record evidence that the Chancellor had found to determine viable growth
prospects justifying that huge move forward.
b.
We next note that the Court of Chancery’s assumption that DFC would
outpace the growth of the real economy did not take into account an important reality
that is found undisputed in the record. DFC was not a startup in a brand new industry
but had already experienced a period of strong growth. Since 1990, it had gone on
172
KOLLER ET AL, supra note 118, at 95–96 (“[D]eveloping reasonable [long-term growth]
projections is a challenge, especially given the upward bias in growth expectations . . . . [G]rowth
decays very quickly; high growth is not sustainable for the typical company. . . . . [C]ompanies
struggle to maintain high growth because product life cycles are finite and growth gets more
difficult as companies get bigger.”).
68
a buying spree, with over 100 acquisitions resulting in, among other things, 900 retail
stores by the time of the transaction.173 It had also experienced strong revenue
growth: for example, from 2008-13, DFC’s European operations had enjoyed a
21.7% compound annual growth rate.174 And in the U.S. and Canada, DFC already
had grown enormously in the past. More generally, DFC had more than one year of
20-30% year-over-year revenue growth.175 This was true of the payday lending
industry as a whole. The record thus suggests, if anything, a matured industry whose
period of above-average growth was past.
c.
Nor can we find in the record any evidence supporting a reasonable inference
that DFC was actually primed for a new, extended period of high growth beyond the
projection period in the March Projections that already implied robust growth. The
absence of evidence here is not surprising given that the petitioners did not present
an industry expert, rely upon management testimony, or even point to analyst
commentary on the likely growth of the payday lending industry in the markets
where DFC operated. Instead, they solely presented at trial, and on reargument, the
views of a professional expert in valuation. Determining the perpetuity growth rate
of any company always hazards error as it involves an important prediction distilled
173
PER at A844.
174
Id. at A936.
175
Id.
69
into one number; calculating one based on a supplemental affidavit of a valuation
expert not grounded in record evidence or subject to cross-examination in the context
of a reargument motion increases the speculative risk in that endeavor.
That danger was even higher here, where the Court of Chancery’s original
discounted cash flow model already was founded on projections that the Chancellor
himself was concerned were too rosy.176 And, there were other reasons to believe
that the March Projections were too positive. Finding that the working capital set
forth in those Projections implied another period of materially higher growth was at
odds with the Court of Chancery’s own finding that “DFC was navigating turbulent
regulatory waters that imposed considerable uncertainty on the company’s future
profitability, and even its viability.”177 Those risks were supported in the record by
the fact that DFC’s long-term debt was non-investment grade and was on negative
credit watch.178
Notably, less than three months after those Projections were approved, DFC
missed its targets for the full 2014 fiscal year by about 10%.179 And, of course, these
Projections predicted revenue and profit growth in the 11-12% and 19-21% ranges
respectively, which was better than much of DFC’s recent performance, and as good
176
2016 WL 3753123, at *22
177
Id.
178
PER at A883.
179
JX 444: March Projections Email at A477; RER at A1008–09.
70
as many of the years during its faster-growth period. Looked at another way, the
Projections involved the assumption that the company would experience 17.6%
compound annual growth in operating profit when in the historical 2008-13 period
its operating profit had experienced only 11% compound annual growth. This was
a context where the record reflects many reasons to suspect that the reversal in
revenue growth would continue into the future. For one thing, check cashing, one
of DFC’s material businesses, was in decline because fewer people used checks.180
For another, DFC had 601 stores in the U.K. as of 2014, an area twice the size of
Pennsylvania and slightly smaller than Oregon.181 How many new stores could they
expect to open there?
And, the petitioners do not explain what exactly it is about 2018 that implies
rapid growth for the next period. In their Motion for Reargument, the petitioners
simply state that “[a]s explained in detail in the [expert affidavit], the working capital
projections in the March Projections at the 10.72% discount rate adopted by the
Court require the application of a PGR higher than 3.1%.”182 The affidavit isn’t
more illuminating. It states, based on the original expert report, that “the last explicit
period’s revenues and operating margins have not reached a steady-state,”183 and
180
RER at A973.
181
United Kingdom: Geography, CIA WORLD FACTBOOK,
https://www.cia.gov/library/publications/the-world-factbook/geos/uk.html#Geo (last visited July
18, 2017).
182
Petitioners’ Reargument Motion at A1347.
183
Petitioners’ Expert’s Aff. on Reargument at A1351.
71
that because those Projections “reflect a $90 million increase in working capital for
fiscal year 2018,” “a much higher PGR than 3.1%” is required.184 But, that does not
explain why, even if the March Projections were not already optimistic, that increase
in working capital would be sustained in a fashion that fits with a perpetuity growth
rate 27% greater than the risk-free rate.
Given the real risk of default, the actual record of declining performance by
the company, and DFC’s failure to meet the Projections before the transaction
closed, a strong argument can be made that the March Projections should have been
discounted, or some substantial weight given to another discounted cash flow model
more balanced in terms of its considerations of the company’s vulnerability. Yet,
despite these risks and rather gloomy outlook, the Court of Chancery swallowed the
March Projections whole, generously giving DFC credit for a period of projected
growth until 2018. Thus, the original perpetuity growth rate itself seems generous
to the petitioners, in light of the evidence in the record. After all, as the petitioners’
expert admits, no company is likely over time to grow at a rate much faster than the
rate of inflation,185 and that, at best, a company might reach the rate of nominal gross
domestic product growth for the economies it operates in.186 The Court of
184
Id. at A1353.
185
PER at A877.
186
Id. at 878. The petitioners’ expert also points out that at least some economists believe that the
ceiling for a company’s long-term growth should be the relevant risk-free rate, which, here, is
lower than nominal gross domestic product growth. Id.
72
Chancery’s initial perpetuity growth rate—3.1%—already gave DFC credit for
growing in perpetuity above the 2.31% median inflation rate and just a shave below
the 3.14% risk-free rate that is viewed to be the ceiling for a stable, long-term growth
rate.
The Court of Chancery’s decision is all the more puzzling because this was
not the sort of situation where a company conducts an auction to sell itself and only
after a winning bidder is locked in at a particular price does good news start to flow
in. Rather, the facts here suggest the opposite: after Lone Star obtained exclusivity,
the news about DFC just kept getting worse.187 In earlier parts of the process, in
fact, potential buyers took a pass when DFC was in a stronger position.
d.
Not only that, but the robust historical growth across the entire industry had
also triggered a multinational pushback by regulators concerned about payday
lenders’ treatment of financially vulnerable citizens. And, the result of that pushback
undermines the petitioners’ contentions that DFC was primed for a new spurt of
growth, and that the historical relationship between revenues and working capital
would remain the same. Beginning in 2012, DFC started to be regulated in more
than the “limited amount” it had been historically in the U.K., 188 its most important
187
RER at A1007.
188
PER at A847.
73
market.189 And, of course, this was also accompanied by greater regulatory scrutiny
in the U.S. and other markets.
In contrast to the Canadian regulatory changes occurring around 2012, which
had focused in part on aspects of payday lending that did not have as much effect on
DFC’s preexisting businesses,190 the new regulations DFC was facing in the U.K.
were both more strict191 and more likely to affect its business The proposed
regulatory changes in the U.K. bear directly on the issue of whether the March
Projections’ estimates of working capital involved an implicit prediction of another
period of strong growth beyond 2018. As discussed earlier,192 the regulatory changes
in the U.K. fundamentally involved a public policy decision that the payday lending
industry was extracting excessively unfair returns from its customers. Thus, the
changes that DFC confronted limited its ability to reap as much profit from each of
its loan customers as it had in the past, by constricting such practices as rolling over
debt repeatedly, using methods to reliably and automatically deduct payments from
borrower accounts, and by requiring stricter assessments of creditworthiness. And,
across all of its markets, this concern about whether the payday lending industry was
189
Id.
190
Testimony of John Gavin, DFC former board member at A184 (describing the new Canadian
regulations as “at price points and with restrictions that were very palatable and allowed us to
operate profitably. That’s not where the U.K. ended up.”).
191
“Melissa Soper, Senior Vice President of Government Relations and Corporate Administration,
described the United Kingdom’s restrictions on relending as ‘more stringent’ as compared to those
in Canada.” RER at A994.
192
See supra pp. 12–14.
74
fairly treating its clients pervaded regulatory comment and consideration, and
portended a future where a greater number of loans would be required than in the
past to generate the same profits.193 So, if anything, the record suggests that DFC’s
lending was in the process of being less profitable. Even by the second half of 2013,
DFC’s results began to reflect the U.K.’s new regulatory environment, including
higher default rates and lower profitability, and that was before the Financial
Conduct Authority’s more stringent regulation came into effect.194 The petitioners
do not address these realities, beyond the statement that DFC’s revenues, lending
volume, and working capital are related. But, these developments, which are
supported by the record, contradict the unsupported contention of the petitioners,
accepted by the Court of Chancery, that the relationship between DFC’s revenue and
its working capital would remain the same.195
193
RER at A990 (reporting DFC “experienced higher loan defaults” during U.K. regulatory
transition); id. (describing 32% year-over-year increase in loan loss provisions from 2012–13); id.
(“[DFC] experienced higher costs and higher delinquencies as a result of the change from
automatically withdrawing funds from customers’ accounts . . . .”); id. at A1015 (describing
DFC’s shifts in lending that required more working capital); id. at A1016 (finding that working
capital as a percentage of revenue “could increase over time”); JX 309: DFC Investor Presentation
at A403 (showing 29% jump in loan losses as U.K. regulatory transition began); JX 444: March
Projections Email at A510 (describing “lower effective pricing” on new loan types being used
more frequently to help comply with U.K. regulations).
194
Id. at A990. These effects continued in 2014. Id. at A1007–08.
195
Petitioners’ Reargument Motion at A1344–45.
75
e.
The petitioners’ argument on reargument was also in tension with their initial
position as presented by their expert. The petitioners’ expert used a 2.7% perpetuity
growth rate in his three-stage model and, in his alternative two-stage model,
proposed a 3.1% perpetuity growth rate.196 And, both the two-stage and three-stage
models used the March Projection’s working capital figures, which the Court of
Chancery adopted over DFC’s expert’s modified working capital figures.197 In
fairness to the petitioners’ expert, his three-stage model produced a result equivalent
to a two-stage model using a 3.5% terminal growth rate, $17.90 per share, but it is
still telling that he selected a lower terminal growth rate when constructing his
standalone two-stage model, and that even that relatively high terminal growth rate
was lower than the one he urged on reargument.198 Indeed, the petitioners’ initial
expert report stated: “[b]ased on my review of economists’ long-term growth
estimates, DFC Global’s management projections and long-term growth rates in the
record, it is my opinion that a reasonable long-term growth rate falls between the
average estimates of the inflation rate (2.3%) and the risk-free rate as of the
Appraisal Date (3.1%).”199
196
2016 WL 3753123, at *17.
197
Id. at *16.
198
PER at A905.
199
Id. at A879–80 (emphasis added).
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Furthermore, it is difficult to square the petitioners’ contention on reargument
that DFC was not approaching a point where it could be considered at steady state
in 2018 to calculate the perpetuity value with the beta that the petitioners’ expert
used in calculating DFC’s cost of capital. Beta measures expected market risk.200 It
represents the covariance between the rate of return on a company’s stock and the
overall market return.201 A stock with a beta of 1.0 should have an expected return
equal to that of the market,202 and “[e]quity betas increase with the risk of the
business.”203 DFC had a historical two-year weekly levered beta204 of 1.59.205 The
petitioners’ expert relied on a relevered peer-based beta in addition to DFC’s
relevered historical beta, reaching a beta range of .83-1.18 for his cost of capital
calculation, “due to concern that DFC Global’s high leverage and the potential
200
SHANNON P. PRATT & ROGER J. GRABOWSKI, COST OF CAPITAL 271 (5th ed. 2014) (“[B]eta is
a function of the expected relationship between the return on an individual security (or portfolio
of securities) and the return on the market.”).
201
ROSENBAUM & PEARL, supra note 52, at 128; SHANNON P. PRATT & ROGER J. GRABOWSKI,
COST OF CAPITAL IN LITIGATION 35 (2011); see also id. at 160.
202
Id. at 35.
203
PRATT & GRABOWSKI, supra note 200, at 203; id. at at 194 (“Many high-tech companies are
good examples of stocks with high betas. . . . The classic example of a low-beta stock would be a
utility that has not diversified into riskier activities.”).
204
“Published and calculated betas for publicly traded stocks typically reflect the capital structure
of each respective company. These betas are sometimes referred to as levered betas, that is, betas
reflecting the leverage in the company’s capital structure.” PRATT & GRABOWSKI, supra note 200,
at 243. “If the leverage of the [company to be valued] differs significantly from the leverage of
the [comparable companies] selected for analysis . . . it typically is desirable to remove the effect
that leverage has on the betas,” i.e., unlevering, “before using them as a proxy to estimate the beta
of the subject company . . . on one or more assumed capital structures (i.e., relever the beta).” Id.
at 244.
205
PER at A952.
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impact of the U.K. regulatory changes on DFC Global’s recent stock returns mean
that its firm-specific beta estimate might not represent the best estimate of the
Company’s long-term systematic risk, as well as to minimize the impact of
measurement error from estimating beta based on a single company’s beta.”206 But,
a beta around 1.0, which indicates that a company was reaching a point of
maturation,207 suggests that the petitioners’ expert believed that DFC’s forward beta
as of 2014 would be more akin the market as a whole rather than like its earlier one.
Perhaps there is a way to reconcile the petitioners’ point that DFC’s beta should also
be seen as like the average market beta as of 2014, but that it should still be seen
beyond 2018 as a hard-charging growth company. But, the reargument record does
not do so, and there is an obvious rub between these contrary inferences, with the
only coherent principle being that using both together inflates DFC’s discounted
cash flow value.208
206
A887–88 (emphasis added).
207
PRATT & GRABOWSKI, supra note 200, at 211 (“Over time, a company’s beta tends toward its
industry average beta.”).
208
This would, of course, not be the first case in which experts’ assumptions about future growth
and their estimate of forward-looking beta were at odds. In Golden Telecom, Glob. GT LP v.
Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010), aff’d, 11 A.3d 214 (Del. 2010), for example,
the respondent’s expert opined that the subject company did not have any reasonable expectations
for above-market growth, but that its beta should be relatively high, id. at 511–12, 518. By
contrast, the petitioners’ expert testified that the company would grow rapidly beyond the
projection period, but argued for using a forward beta trending toward a lower industry average,
using betas from companies operating in more mature markets. Id. at 513, 518. As in this case,
what tended to render their analyses consistent, was that by using contrary inferences for different
parts of their models, they generated results benefitting their clients. What these situations make
clear is the often impossible task the Court of Chancery has in sifting through this kind of input to
make an underlying determination of fair value that is reliable.
78
*****
It may be that after the period covered by the March Projections, there is a
reasonable basis to assume a perpetuity growth rate higher than the 3.1% originally
assumed by the Court of Chancery. But, as noted, any assumption of this kind has
to address not only the possibility for an additional period of growth higher than the
economy as a whole, but also the risk of industry contraction, or, even worse,
company insolvency. An assumption of a perpetuity growth rate of 4% not only
assumed that DFC would keep pace with inflation, but in fact would markedly
exceed it. If that assumption is to be based on the working capital used in the March
Projections themselves, there has to be some reliable evidence that the working
capital in those projections was in fact somehow designed to generate future outsized
growth in the years after 2018. The why for that has to relate to DFC’s business and
industry. As it stands, the record has nothing of that kind in it.
If, upon remand, the Chancellor decides to rely upon a discounted cash flow
analysis generating a value higher than his original model after it was adjusted to
use the March Projections’ working capital figures, he must identify a basis in the
record to assume that after 2018 the company would continue to grow at a rate above
the 3.14% risk-free rate, in view of the reality that: the growth rate in the
management projection period was already aggressive and involved projections that
the company did not meet even in the short-term period before closing; the fact that
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the company had already had a lengthy period of aggressive growth that brought on
regulatory counteraction; and, the absence of evidence in the record suggesting that
the company had the ability to continue to expand in its markets, given its prior
periods of rapid expansion.
E.
We now reach the petitioners’ cross-appeal. On cross-appeal, the petitioners
argue that the Court of Chancery abused its discretion by giving weight to its
comparable companies analysis. Indeed, they argue that the result of the discounted
cash flow model should have been given predominant weight, and the deal price
little, if any, weight.
As to the Chancellor’s comparable companies analysis, the petitioners object
for three reasons: i) the Chancellor, using EBITDA metrics from fiscal years 2014
and 2015 for the three calculations, relied on “trough years” for DFC’s performance;
ii) the comparable companies analysis would have yielded wildly different results if
single years had been used and that draws into question its accuracy; and iii) none
of the six companies selected as peers were, in fact, comparable to DFC. None of
these arguments persuade this Court that the Chancellor abused his discretion.
The petitioners’ first contention about the comparable companies analysis
amounts to a recitation of its general, unsupported contention that DFC was primed
for a surge in growth that was missed by the markets because of regulatory
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uncertainty and that market-based methods of valuation are inherently unreliable
except when things are going really well. But, we are unaware of an accepted
corporate finance or economic theory that suggests that market-based insights into
value become inherently unusable in downturns or because of regulatory change. It
was well within the Chancellor’s discretion to view the comparable companies
analysis as providing relevant insights into DFC’s value based on inferences from
how the market valued companies in the same industry, facing most of the same
risks.
The petitioners’ second contention about the comparable companies analysis
in some ways contradicts the first. The fair value figure DFC’s expert and the
Chancellor used was derived from the median of full year 2013 and 2014 and part
year 2014 financials. If DFC, and the industry as a whole, were truly in a period of
volatile financial performance due to regulatory uncertainty, priming them for future
growth, a blend of three of the most relevant years of financial results was a
reasonable way to be more accurate as to DFC’s future performance than attempting
to guess the single year that is most representative. When the petitioners’ expert
conducted his comparable companies analysis, which admittedly he did not use as
part of his fair value calculation, he did essentially the same thing, but used the 75th
percentile figures rather than median.209 But, as the Chancellor noted, the
209
PER at A910–11.
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petitioners’ expert admitted “that using the median or 50th percentile is a more
common benchmark, and that this was the only valuation he could recall in which
he used the 75th percentile.”210 Indeed, in some ways using the median figures was
giving DFC the benefit of the doubt because most of its operating metrics, including
revenue, gross profit, EBITDA, and EBIT, were below the median.211 Only gross
profit margin, EBITDA margin, and EBIT margin were at or above the 75th
percentile.
The petitioners’ third argument for the unreliability of the Court of Chancery
analysis of the respondent’s comparable companies estimate of fair value was that
the peer group companies were not comparable to DFC. But, the six companies
comprising the peer group used by the Chancellor and DFC’s expert were in fact a
subset of the seven companies the petitioners’ expert used in his comparable
companies analysis.212 Although the petitioners’ expert argued that “none of the
comparable companies had a mix of businesses and geographic locations that were
sufficiently similar” to DFC,213 there was ample evidence in the record214 to support
the Chancellor’s decision that the six comparable companies both experts used were,
in fact, sufficiently comparable for this analysis. As the Chancellor observed:
210
2016 WL 3753123, at *20.
211
PER at A942.
212
2016 WL 3753123, at *20.
213
PER at A908.
214
E.g., id. at A938–41.
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Each of the six companies both experts used was comparable to DFC,
as evidenced by the experts’ agreement on them and by their use in peer
group analyses that six different firms (including DFC itself, Lone Star,
and Houlihan) used to evaluate DFC for various reasons from April
2013 to June 2014. Four of these peer companies were used by all six
firms in their analyses.215
Finally, as to the petitioners’ argument that the discounted cash flow analysis
was the most reliable indicator of fair value, and should have been given more weight
than the comparable companies analysis, there were ample reasons for the
Chancellor to doubt the reliability of the discounted cash flow model on this record.
It was therefore not an abuse of discretion for him to consider other factors in
reaching a decision about DFC’s fair value.
F.
Finally, we will address an issue implied in DFC’s argument, that the Court
of Chancery’s decision to give equal weight to the deal price, its comparable
companies valuation, and its discounted cash flow valuation cannot be justified by
reference to the record. Because we have determined that the Court of Chancery’s
reasons for giving the weight it did to the deal price were not supported by the record,
we arguably do not need to reach this larger issue. But, because this issue is present
in many appraisal cases, we will address it. When faced with briefs and expert
reports written by highly-skilled litigators in concert with men and women of
215
2016 WL 3753123, at *9.
83
valuation science that often come to ridiculously varying positions, the Court of
Chancery may well feel tempted to turn its valuation decisions into a more
improvisational variation of the old Delaware Block Method, but one in which the
court takes every valuation method put in the record, gives each equal weight, and
then divides by the number of them. When life is sloppy and unpredictable, the
visual appeal of a mathematical formula to create an impression of precision is
understandable.
But, in keeping with our refusal to establish a “presumption” in favor of the
deal price because of the statute’s broad mandate, we also conclude that the Court
of Chancery must exercise its considerable discretion while also explaining, with
reference to the economic facts before it and corporate finance principles, why it is
according a certain weight to a certain indicator of value. In some cases, it may be
that a single valuation metric is the most reliable evidence of fair value and that
giving weight to another factor will do nothing but distort that best estimate. In other
cases, it may be necessary to consider two or more factors. As one appraisal treatise
points out, “laying down in advance fixed rules that state how competing approaches
are to be weighted is impossible.”216 What is necessary in any particular case though
216
CORNELL, supra note 96, at 263. That treatise recommends great weight to market-based
approaches and caution with discounted cash flow models because those models are “easily
abused” such that “value can be created out of thin air by optimistic forecasting. Therefore, the
weight applied to a [discounted cash flow model] forecast should be directly proportional to the
confidence that can be placed in the cash flow forecasts.” Id. at 264.
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is for the Court of Chancery to explain its weighting in a manner that is grounded in
the record before it. That did not happen here. In this case, the decision to give one-
third weight to each metric was unexplained and in tension with the Court of
Chancery’s own findings about the robustness of the market check.
III.
Taken together, our findings require us to reverse and remand this case to the
Chancellor to reassess his conclusion as to fair value in light of our decision. We do
not retain jurisdiction, and leave the Chancellor with the discretion to address the
open issues using procedures he finds the most helpful. The Chancellor need not
reopen the evidentiary record, and the extent of further submissions of the parties, if
any, is entirely within his discretion, based on his determination as to what is most
helpful to him.
85