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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.