From Kevin Miller of Alston & Bird, here are some follow-up thoughts to this blog posted earlier this week regarding the recent Maric Capital decision in the Delaware Court of Chancery:
1. This is likely to be a controversial decision as the Maric court’s holding (consistent with the court’s holding in Netsmart) that cash flow projections are material and required to be disclosed appears inconsistent with the Delaware Supreme Court’s decision in Skeen and Chancellor Chandler’s decision in Checkfree.
Compare:
– Maric (VC Strine 2010): “in my view, management’s best estimate of the future cash flow of a corporation that is proposed to be sold in a cash merger is clearly material information.”
and:
– Netsmart (VC Strine 2007): “It would therefore seem to be a genuinely foolish (and arguably unprincipled and unfair) inconsistency to hold that the best estimate of the company’s future returns, as generated by management and the Special Committee’s investment bank, need not be disclosed when stockholders are being advised to cash out. . . . Indeed, projections of this sort are probably among the most highly prized disclosures by investors. Investors can come up with their own estimates of discount rates or (as already discussed) market multiples. What they cannot hope to replicate are management’s insisted view of the company’s prospects.”
with:
– Skeen (Del. Sup. Ct. 2000)(in which the Delaware Supreme Court considered and rejected a claims that the Board of House of Fabrics breached its fiduciary duties by failing to disclose (i) management’s projections and (ii) a summary of the methodologies used and the ranges of values generated by the financial analyses performed by its financial advisor):
“Appellants are advocating a new disclosure standard in cases where appraisal is an option. They suggest that stockholders should be given all the financial data they would need if they were making an independent determination of fair value. Appellants offer no authority for their position and we see no reason to depart from our traditional standard.”
“[plaintiffs] say, in essence, that the settled law governing disclosure requirements for mergers does not apply, and that far more valuation data must be disclosed where, as here, the merger decision has been made and the only decision for the minority is whether to seek appraisal. We hold that there is no different standard for appraisal decisions.”
– CheckFree (C. Chandler 2007): “Although the Netsmart Court did indeed require additional disclosure of certain management projections . . . the proxy in that case affirmatively disclosed an early version of some of management’s projections. Because management must give materially complete information “[o]nce a board broaches a topic in its disclosures,” the Court held that further disclosure was required. . . . Because [the CheckFree] plaintiffs have failed to establish that management’s projections constitute material omitted information, they have failed to demonstrate a likelihood of success on the merits of their claim and, therefore, I deny their motion for a preliminary injunction on this ground.”
2. There also seems to be a disconnect between the Maric court’s view that the court can determine whether the valuation methodology used by a financial advisor in connection with preparing a fairness opinion is appropriate (e.g., based on analogy to the methodologies approved in connection with appraisals) and Chancellor Chandler’s views regarding the limits on the court’s ability to assess a financial advisor’s chosen valuation approach as expressed in his December decision in 3Com.
In Maric, the financial advisor used a discount rate determined by adding additional premia (illiquidity and micro cap premia) to the calculated cost of capital of the company. The proxy disclosed the range of discount rates used as did the discussion materials provided to the special committee, but the special committee was apparently not told why the financial advisor was using a discount rate higher than the company’s calculated cost of capital.
“In the proxy statement, it says that Craig-Hallum selected discount rates “based upon an analysis of PLATO Learning’s weighted average cost of capital.” The proxy statement then indicates that Craig-Hallum used a range of 23% to 27% in conducting its DCF. In that respect, it is the literal case that the DCF analysis presented to the Special Committee used a range of 23% to 27%. But that range was not the result of the analysis of the WACC simultaneously given to the Special Committee. In reality, Craig-Hallum calculated two estimates of a so-called WACC, one using a very loose variation of the capital asset pricing model and one using a comparable companies analysis. These generated discounts rates of 22.6% and 22.5%, both very hefty but both below the 23% bottom disclosed in the proxy statement. These analyses were given to the Special Committee.”
Rather than just requiring disclosure of the additional premia in order to bridge the cap between the cost of capital calculation and the discount rates the deemed appropriate and used by the financial advisor, the Maric court required the disclosure of the valuation ranges that would have resulted from using discount rates equal to the calculated cost of capital.
“Unless the proxy statement is supplemented by a corrective disclosure indicating the value that would be obtained by using the discount rates Craig-Hallum actually calculated, the merger will be enjoined.”
– Maric (VC Strine 2010): “The idea that Craig-Hallum subjectively added a further liquidity discount on top of PLATO’s healthy beta of 1.12 and the other subjective discounts is itself dubious as a valuation practice.
Footnote: 11 Obviously, this approach has the risk of counting identical risks multiple times – e.g., heaping a liquidity discount based on a small market capitalization on top of a small stock premium. Indeed, the use of a liquidity discount by a sell-side banker is strange for many reasons, including the legal one that such discounts cannot be considered in appraisal. . .”
– 3Com (C. Chandler 2009): “Under Delaware law, the valuation work performed by an investment banker must be accurately described and appropriately qualified. So long as that is done, there is no need to disclose any discrepancy between the financial advisor’s methodology and the Delaware fair value standard under Section 262 (or any other standard for that matter).34 If shareholders believe the financial advisor undervalued the company after reading a summary of its work, they are free to exercise their appraisal rights under Section 262. Indeed, an appraisal action addresses this concern by subjecting the financial advisor’s fairness opinion to scrutiny. Valuing a company as a going concern is a subjective and uncertain enterprise. There are limitless opportunities for disagreement on the appropriate valuation methodologies to employ, as well as the appropriate inputs to deploy within those methodologies. Considering this reality, quibbles with a financial advisor’s work simply cannot be the basis of a disclosure claim.”
Here is news from Tom Bayliss of Abrams & Bayliss:
On May 13th, the Delaware Court of Chancery issued the attached opinion in Maric Capital Master Fund Ltd. v. PLATO Learning, Inc., C.A. No. 5402-VCS. In the eight-page opinion, Vice Chancellor Leo Strine found that the proxy statement issued in connection with the transaction (a) contained a materially misleading description of how the target’s financial advisor derived the discount rate employed in the discounted cash flow analysis supporting its fairness opinion, (b) omitted material information because it disclosed only select portions of management’s financial projections and (c) created a materially misleading impression about discussions between the acquirer and management regarding post-closing employment arrangements.
The opinion provides helpful guidance regarding the frequently litigated subject of investment banker work product descriptions in proxy statements, reaffirms the Court’s views on the importance of disclosing management projections and highlights disclosure issues lurking in pre-signing discussions between potential acquirers and management regarding post-closing employment.
The Facts
Plaintiff Maric Capital Master Fund, Ltd. (“Maric”) sought a preliminary injunction blocking a proposed merger in which Thoma Bravo, LLC (“Thoma Bravo”) would acquire PLATO Learning, Inc. (“PLATO”) for $5.60 per share in cash. Maric alleged that the directors of PLATO had failed to comply with their obligations under Revlon v. McAndrews & Forbes Holdings, Inc. and that the proxy statement issued by PLATO in anticipation of the stockholder vote contained materially misleading omissions. The Court rejected the Revlon arguments in a yet-to-be transcribed bench ruling. In the written opinion issued only hours later, the Court found the proxy statement materially misleading in three respects.
The Proxy Statement’s Description of Craig-Hallum’s Selection of a Discount Rate
The Court found that the proxy statement contained a materially misleading description of how PLATO’s investment banker, Craig-Hallum Capital Group (“Craig-Hallum”), derived the discount rate used in the discounted cash flow analysis supporting its fairness opinion. The proxy statement explained that Craig-Hallum selected discount rates “based upon an analysis of PLATO’s weighted average cost of capital” and disclosed that Craig-Hallum used a discount rate range of 23% to 27%.
However, the proxy statement did not disclose the fact that Craig-Hallum’s actual analysis (based on comparable companies and a “loose variation” of the capital asset pricing model (“CAPM”)) had resulted in rates of 22.5% and 22.6%. The defendants proffered testimony from Craig-Hallum contending that the higher range was appropriate because PLATO was a micro-cap company with illiquid stock and because the “most comparable” of PLATO’s peers had a discount rate of 25%. The Court rejected this explanation because (a) there was no evidence that it was given to PLATO’s Special Committee and (b) “the only tangible evidence of actual analysis by Craig-Hallum” (emphasis in the original) was the work product generating the 22.5% and 22.6% figures.
The fact that the 23% to 27% range employed by Craig-Hallum was “comprised of eyebrow-raising premiums” that were “heaped on top of the core CAPM analysis” (including a technology industry risk premium of 1.4%, a small cap premium of 9.5% and a liquidity discount) heightened the Court’s skepticism.
Noting that the higher discount rate range resulted in a lower DCF value for PLATO and made the merger consideration appear more attractive, the Court concluded that the merger should be enjoined “unless the proxy statement is supplemented by a corrective disclosure indicating the value that would be obtained by using the discount rates Craig-Hallum actually calculated.”
The Proxy Statement’s Disclosure of Management’s Projections
The Court found that the proxy statement omitted material information because it disclosed only a portion of the management projections provided to Craig-Hallum. Specifically, the proxy statement disclosed management’s estimates of revenue, gross profit, operating income, net income and EBITDA through October 31, 2014, but omitted management’s estimates of free cash flow.
The Court found this omission “odd,” and confirmed the view articulated in In re Netsmart that “management’s best estimate of the future cash flow of a corporation that is proposed to be sold in a cash merger is clearly material information.” The Court concluded that the proxy statement omitted material information “by, for reasons not adequately explained, selectively removing the free cash flow estimates from the projections provided to PLATO’s stockholders.” The Court held that the merger should be enjoined “[u]ntil this information is disclosed.”
The Proxy Statement’s Disclosure of Discussions Between Thoma Bravo and Management Regarding Employment
The Court found that the proxy statement’s description of management contact with Thoma Bravo was materially misleading. The challenged disclosure explained that ‘”[i]n reaching their decision to approve the merger and the merger agreement,’ PLATO’s special committee and board considered ‘the fact that Thoma Bravo did not negotiate terms of employment, including any compensation arrangements or equity participation in the surviving corporation, with [PLATO’s] management for the period after the merger closes.”‘
The Court determined that the statement suggested that the “decision whether to sell PLATO to Thoma Bravo was unaffected by any understandings between Thoma Bravo and the company’s management about future economic arrangements.” But the factual record developed during discovery established that PLATO’s CEO had “extended discussions with Thoma Bravo.” The CEO was “led to believe” that the typical equity incentive package could be expected, and he was “assured” that Thoma Bravo “typically liked to keep existing management after an acquisition.”
The Court acknowledged that these discussions may not have been “negotiations” over a formal employment agreement, but it found that the proxy statement created the “materially misleading impression that management was given no expectations regarding the treatment they could receive from Thoma Bravo.” The Court ordered that the proxy statement be corrected to “clarify the extent of the actual discussions between [the CEO] and Thoma Bravo.”
Take-Aways
1. The Court’s skepticism about Craig-Hallum’s discount rate serves as a warning to financial advisors and their lawyers, as well as to lawyers representing boards relying on financial analysis. As a substantive matter, the Court’s discussion about “eyebrow raising premiums” layered on top of a discount rate calculation based on CAPM indicates that the Court may not be receptive to a tool often used by financial advisors to rationalize discount rates that appear too low when compared to those of comparable companies.
The Court’s insistence that “actual analysis” support the chosen range of discount rates employed in a discounted cash flow valuation suggests that financial advisors will have an increasingly difficult time in Delaware relying on “judgment” to justify departures from ranges derived using accepted valuation methodologies.
2. The Court’s analysis helps illuminate the difference between disclosure claims that can be dismissed as mere “quibbles” with a financial advisors’ analysis and disclosure claims that can result in deal-stopping injunctions and large fee awards to plaintiffs’ lawyers.
Here, the disputed facts involved a financial advisor that chose a discount rate outside the range implied by its own valuation analysis. If Craig-Hallum had chosen a discount rate at the high end of a derived range, the Court might well have overruled the challenge.
3. The Court’s decision to require the disclosure of the valuations implied by Craig-Hallum derived discount rates (rather than its selected range of discount rates) demonstrates how a disclosure deficiency may result in what amounts to a “penalty” disclosure.
Here, the target will likely end up disclosing a per share value implied by a discounted cash flow analysis which neither its board nor its financial advisor believe is supportable. In the context of a contested solicitation where the result is expected to be close, this type of penalty disclosure could easily provide substantive ammunition to an insurgent soliciting against the transaction.
4. The opinion’s emphasis on the importance of disclosing management projections is yet another data point in a range of opinions that many practitioners find difficult to reconcile. See, e.g., In re 3Com S’holders Litig., C.A. No. 5067-CC, 2009 WL 5173804, at *2 (Del. Ch. Dec. 18, 2009).
Although the Maric Capital opinion could be read to apply only to partial disclosures, the Court’s language and reasoning is broadly applicable. Especially when considered together with Vice Chancellor Laster’s musings in In re Zenith National, C.A. No. 5296-VCL (Del. Ch. Apr. 22, 2010) (Transcript), the Maric Capital opinion suggests that target companies subject themselves to a significant risk when they fail to disclose management projections provided to financial advisors. The opinion also helps answer an often-posed question regarding how much of management’s forecasts should be disclosed – if the management projections include free cash flow estimates, they should be disclosed absent some articulated justification.
5. The opinion’s holding regarding Thoma Bravo’s discussions with management underscores the danger of failing to describe (or giving a misleading impression of) preliminary discussions between a potential acquirer and management regarding post-closing employment and compensation, even when those discussions stop short of formal negotiations over contractual matters. The opinion indicates that Delaware courts remain particularly sensitive to the potential conflicts raised by pre-signing employment related discussions with high-level management.
In this memo, Milbank Tweed’s Bob Reder discusses a recent court decision – In Re Sunbelt Beverage Corp. – in which the Delaware Chancery Court applied the entire fairness standard in reviewing a freeze-out merger involving Sunbelt Beverage Corporation. In siding with a minority shareholder, the court determined that the merger’s sole purpose was to exclude a minority shareholder from participating in an attractive post-merger transaction.
Here are some thoughts from the memo:
Typically, care is taken in corporate transactions in which minority shareholders are treated differently from the majority to incorporate procedural devices aimed to ensure the transaction will survive an entire fairness analysis. There is no per se rule that prohibits the majority from using its superior voting power to “freeze out” the minority; however, courts will not simply defer to such use of majority power, but rather will closely scrutinize the process employed. If the court perceives that the process is unfair, then it becomes exceedingly difficult for the majority to carry the burden of establishing both fair dealing and fair price. It’s incumbent on dealmakers and their legal counsel to resist the temptation to allow the majority to flex its muscle without taking the necessary procedural steps to shift the burden of proving entire fairness to the minority.
A while back, a member noted how there have been some successful responses to SEC comments regarding cautionary language when it comes to an opinion provider’s contingent fees. For example, below is an excerpt of a response (culled from this full response):
Also in our conversation, you indicated that the Staff believes it would be appropriate to include cautionary disclosure relating to the fact that a significant portion of Credit Suisse’s fee is contingent upon the consummation of the merger. In response, we respectfully disagree with this comment and do not believe that such additional disclosure is necessary or appropriate. Our reasons for not adding the additional disclosure requested by the Staff include:
– A review of the proxy statements for the largest M&A transactions in 2008 indicates that disclosure of cautionary language regarding contingent fees is not customary.
– In response to objections by issuers, the Staff has not insisted on disclosure responsive to similar comments:
– Staff comments and issuer responses in connection with the Sirius/XM Satellite transaction are available here, here and here.
Ultimately resulting in the following comment and response:
“Risk Factors, page 16
We note your statement in response to our prior comment four that neither company believes that the transaction’s contingency fee arrangements raise potential risk factor disclosure issues relating to the independence and quality of their respective financial advisor’s recommendation. Please disclose whether either Board considered the issue at all and, if so, why they concluded that the contingency fee arrangements do not compromise the independence and quality of their respective financial advisor’s recommendation.
In response to the Staff’s comment, the disclosure on pages 35 and 42 has been revised to reflect that each of the SIRIUS Board of Directors and the XM Board of Directors reviewed the material terms of the engagement letters of their respective financial advisors, including the contingent fee structure which was considered to be customary and appropriate for this type of transaction.”
Please note, if requested by the Staff, the Company would consider including similar disclosure on page 8 of the Proxy Statement under the caption “THE MERGER–Reasons for the Merger; Recommendation of Sun’s Board of Directors” to indicate that the Company’s Board reviewed the material terms of the Credit Suisse engagement letter, including the contingent fee structure which it considered to be customary and appropriate for this type of transaction.
– See also Staff comments and issuer responses in connection with the Host Marriott/Starwood transaction, available here and here.
Ultimately, no risk factor type disclosure was required. See this amendment to a Form S-4.
As noted in the Host Marriott/Starwood correspondence with the Staff:
– a contingent fee arrangement between a company and its financial advisor is customary for transactions of this nature;
– the Proxy Statement fully responds to the requirements of Item 1015(b)(4) of Regulation M-A to describe “any material relationship that existed during the past two years or is mutually understood to be contemplated and any compensation received or to be received as a result of the relationship . . ;”
– the requested disclosure reflects a conclusion (i.e., that the contingent nature of the financial advisor’s fee constitutes a conflict of interest) and we believe that it is sufficient to disclose the factual information regarding the amount and structure of the fee from which recipients of the Proxy Statement may reach their own conclusion; and
– the Delaware Court of Chancery has considered contingent fee arrangements and expressed doubt that a large investment bank with “serious reputational interests at stake” would advise its client in such a manner as to maximize its fee. See In re Toys “R” Us, Inc. Shareholder Litig., 877 A.2d 975, 1005 (Del. Ch. 2005) (holding that there was no basis to conclude that the potential fees to be paid to a financial advisor influenced its advice to the Toys “R” Us board of directors).
Based upon the foregoing, the Company does not believe that additional disclosure is necessary or appropriate. If the Staff continues to believe that such disclosure is necessary, we respectfully request the opportunity to discuss with you at your earliest convenience.