"Fair value" as an avoidable rule of corporate law: minority discounts in conflict transactions.

• Author: Coates, John C., IV

INTRODUCTION

In 1996, Levi Strauss paid nearly $4 billion in cash to its shareholders,(1) Unusual in size, the freeze-out fit a standard profile--it gave cash and liquidity to most shareholders while allowing the Haas family to obtain 100% ownership of the firm. At the deal's center was a problem raised in every corporate conflict transaction,(2) including management buyouts ("MBOs") and parent/subsidiary freeze-outs: How should minority shares be valued? If the share value is set too high, then a transaction will not make sense for continuing shareholders; if it is set too low, then it will not make sense for continuing shareholders; if it is set too low, then it will not make sense for the shareholders being cashed out. As a rule, huge deals produce huge value disputes, and the Levi Strauss freeze-out proved no exception. Levi Strauss's investment bankers began with an estimated open market value of $189 per share. Bankers for dissident shareholders estimated values nearly double that amount, representing a potential value gap of nearly $2 billion.(3)

Value disputes often concern facts particular to the target firm--such as its earnings potential or its hidden assets and liabilities. The biggest potential issue in the Levi Strauss value dispute, however, arises each time the minority shares were valued: Should the value be "discounted" to reflect the noncontrolling status of the minority shares? Or, should the value instead equal a pro rata share of the firm's total value?

Minority discounts--which can range as high as 35% or more(4)--have a dramatic impact on the price paid in a conflict transaction. If Levi Strauss had included a discount of 35% in fixing the price paid to the shareholders in its recapitalization, the total payout would have been reduced by nearly $1.5 billion. In a copycat financial world strongly influenced by trends and fashions,(5) in which even the marginal excess returns on investment can at tract substantial capital, the law on discounts has a dramatic impact not only on the price paid in conflict transactions, but on the extent to which such transactions are pursued at all.

Part I of this Article shows that the law governing minority discounts is surprisingly unpredictable and obscure in spite of the importance of minority discounts.(6) Even within Delaware, the leading corporate jurisdiction,(7) a survey of the fair value cases on discounts shows that although the Delaware Supreme Court has rejected minority discounts in theory, Delaware chancery courts have applied them erratically in practice.(8)

Part II argues that although the law of "fair value" widely is thought to be a binding, mandatory element of corporate law, it is not.(9) Companies and investors need not subject themselves to the currently unclear and unpredictable law regarding discounts. As with nearly all rules of corporate law, firms and investors may contract around the law regarding discounts (a fact that has led Bernard Black to ask whether corporate law should be characterized as "trivial"). Companies can contract around background corporate law regarding fair value determinations by adopting fair price charter provisions, entering into buy/sell agreements, or issuing redeemable stock.

Together, the legal facts reviewed in Parts I and II present an economic puzzle. Ideal rules of corporate law should be consistent. A rule barring discounts might be expected to increase the ex ante share value because investors would pay to eliminate the risk of conflict transactions at discounted prices. Conversely, one could imagine that a rule permitting discounts might increase the ex ante share value by facilitating control transactions. Yet, with few exceptions, issuing firms generally have not used their ability to contract for either rule.(10) In fact, firms rarely contract around unclear rules of corporate law. In the great majority of instances, firms passively accept the default rules of corporate law, even when those rules are as inconsistent and unclear as Delaware law on discounts.

Part III considers three possible answers to this puzzle, applying concepts from economic theory: transaction costs, network and innovation externalities, and overpayment by investors.(11) Each suggested answer remains tentative and only points the way for future empirical research, but together these answers suggest that avoidable rules of corporate law may be far from trivial, even when they are nonmandatory or nonbinding.

Whatever the answer to the discount puzzle, a consistent rule on discounts would benefit both investors and firms and improve efficiency. Part IV attempts to provide such a rule.(12) Although good theoretical arguments can be made for either rule, a rule that excludes discounts is the better candidate for improving social welfare, as well as the private welfare of investors and the largest number of firms. My conclusion is supported by evidence of actual bargains and theoretical approaches for choosing default contract rules that take account of the asymmetric information confronting firms and investors in the securities markets. A rule against discounts also is more likely to reduce transaction costs. Part IV concludes by arguing that discount law should remain nonbinding in the context of initial public offerings.

1. DELAWARE DISCOUNT LAW IS UNCLEAR

   1. Appraisal and Entire Fairness

      Conflict transactions continue to have wide-ranging effects on the control of public companies in the United States.(13) Valuing minority shares is at the heart of every conflict transaction. Frequently, the minority shareholders have no choice as to whether they will participate in a given conflict transaction, such as where the transaction is sponsored by a controlling shareholder and no voluntary steps are taken to condition the transaction on approval by the minority shareholders or the independent directors. As a result, the price paid in a conflict transaction often will be neither the result of a true arm's-length negotiation nor otherwise reflect the subjective value placed on the shares by the minority shareholders.(14) Minority share value is set or negotiated by transaction participants in the shadow of corporate law that provides for two relevant judicial proceedings:(15) (1) appraisal proceedings under section 262 of the Delaware General Corporation Law ("DGCL")(16) and (2) "entire fairness" cases, in which courts assess whether the shareholders are treated fairly in conflict transactions(17) such as MBOs and freeze-outs.

      Nearly all MBOs and freeze-outs involve either a cash merger, a short-form merger,(18) or both, and appraisal rights are triggered in Delaware by all short-form mergers and all cash or part-cash mergers.(19) Appraisal proceedings were not created to address conflict transactions,(20) nor are they limited to conflict transactions.(21) Commentators are in general agreement, however, that the most defensible rationale for the continuation of the appraisal remedy is that it polices such transactions,(22) and the appraisal remedy now is invoked most often in that context.(23)

      Not only do conflict transactions frequently give rise to contested appraisal proceedings, but Delaware case law holds that such transactions are not entitled to the protections of the business judgment rule.(24) Instead, freeze-outs, MBOs, and other conflict transactions are closely scrutinized by the courts under an exacting judicially developed "entire fairness" test.(25) That test requires the transaction proponent to demonstrate affirmatively that the transaction both is the product of "fair dealing" and reflects a "fair price."(26)

      Corporate law thus provides shareholders with two different methods of obtaining judicial oversight of the price paid in a conflict transaction. The case law arising out of these two types of judicial proceedings is the background against which value disputes between minority shareholders and sponsors of conflict transactions are resolved. It is to this case law that participants in the Levi Strauss transaction turned in deciding whether minority shareholders were to be paid a discounted price of $2.5 billion or an undiscounted price of $4 billion.

   2. Fair Value and Fair Price

      Appraisal statutes entitle shareholders to a cash amount determined by reference to the "fair value" of the stock. "Fair value" is determined by a court, and is not defined in statutes.(27) Beginning in 1983 with Weinberger v. UOP, Inc., Delaware courts have developed an open-ended definition of "fair value" that requires the appraising court to consider "techniques ... generally considered accepted in the financial community and otherwise admissible in court, subject only to [the court's] interpretation of [DGCL section 262]."(28) Fair value may thus include consideration of the asset, market, and earnings values; future prospects; and any other element affecting "intrinsic value."(29)

      Since Weinberger, Delaware courts have considered various valuation methodologies proposed by the parties and their experts. Neither the Delaware legislature nor the Delaware courts have shaped or restricted valuation generally; methodological choices are made by the fact-finder on a case-by-case basis.(30) With the prominent exception of discounts and control premiums,(31) everything is permitted, nothing forbidden.(32)

      In entire fairness cases, corporate fiduciaries are required to show that the terms of a proposed conflict transaction include a "fair price," and Delaware courts look to appraisal cases for guidance in deciding whether a given price is fair, even when a merger does not trigger appraisal rights. Delaware courts have stated that "fair value" in an appraisal proceeding will be a "fair price" in an entire fairness case.(33) That is not to say that a price approved as "fair" in a given conflict transaction will always precisely equal fair value as determined in a related appraisal,(34) but nothing in the Delaware case law...