Appraising the nonexistent: the Delaware courts' struggle with control premiums.

• Author: Carney, William J.
• Position: Symposium: Corporate Control Transactions

The Delaware Supreme Court has concluded that under the Delaware appraisal statute, dissenting shareholders are entitled to the pro rata value of their firm and that the market price of any firm's stock reflects an implicit minority discount from its pro rata value. Thus, to ensure that dissenting shareholders are properly compensated, the Delaware courts have been adding a "control premium" to firm values. As we will demonstrate, this doctrine has resulted in inflated awards to dissenting shareholders, for if the conclusion of the Delaware Supreme Court that market prices do not include a control premium is correct, it does not follow that dissenting shareholders must be paid a premium, and if the conclusion is incorrect, then the theoretical support for paying a premium disappears.

INTRODUCTION

Appraisal proceedings have hardly been the Delaware courts' finest moments. For decades, these courts eschewed evidence based on widely accepted finance methodology, holding instead that determinations of value were questions of law and not fact. (1) It was not until 1983 that the Delaware Supreme Court permitted the introduction of evidence obtained through modern valuation methods. (2) While the current methodology is generally market-based, the courts nevertheless continue to speak of value in ways that show a deep misunderstanding of valuation methodology and a distrust of market values. (3) Indeed, the Delaware Supreme Court has stated that the market price of shares may not be representative of true value. (4) In Smith v. Van Gorkom, (5) the Delaware Supreme Court criticized a board that relied on a 46% premium over the market because it was uninformed about "intrinsic value." (6) More recently, the Delaware Supreme Court rejected an appraised valuation that was 200% above the pre-transaction market value on the basis that the "trial court's decision to reject the addition of a control premium ... placed too much emphasis on market value." (7) The court criticized the chancery court's valuation as too low because it failed to add a control premium to the market price of comparable companies to reach the asserted value of the whole firm, choosing instead to use the "discounted" market price of a small block of shares in the trading market." The pre-announcement market price was $17.25; (9) the consideration paid in the cash-out merger was worth approximately $28; (10) the appraised value initially determined by the chancery court was $51; (11) and the final value awarded after remand, including the control premium, was $73.29. (12) If a shareholder purchased shares immediately before the announcement, the gain was 325%. This bizarre result has received relatively little attention, except to the extent that it has become an accepted part of Delaware law. (13) While the Delaware courts appear to believe they are using the science of financial economics in their valuation efforts, their misunderstandings have led to windfalls for dissenting shareholders.

George Stigler once said that one should have a license to practice Economics; (14) Fred McChesney repeated that caution with respect to law professors attempting to practice it; (15) and yet, courts are forced by necessity to engage in economic valuation. (16) This reality necessitates that those who criticize must provide constructive criticism. Received wisdom in Delaware corporate law now seems to understand that stock market prices are inaccurate in a way that cannot be tested empirically. (17) This wisdom holds that in nearly all cases the market value of stock in any publicly traded company is merely the value of a minority interest which necessarily reflects a minority discount. (18) This reasoning denies that the value of an entire company is simply the market value of its equity plus the market value of its debt. The Delaware courts have accepted this wisdom and have rejected the "aggregate market value" approach to valuing shares of a company in an appraisal proceeding. Under Delaware's current approach, the value of the company as a going concern must include that element of value known as the control premium. (19) This approach poses a fundamental challenge to the "law of one price," (2) which asserts that arbitrage will tend to trade away any difference between price and economic value. (21)

We argue that both the received wisdom and the Delaware approach contain fundamental misconceptions about value. In addition, the Delaware approach creates conflicts in the way minority shareholders are treated in various forced-sale situations (e.g., stock-for-stock mergers and at least some reverse stock splits) that can only be reconciled by rejecting the notion that control premiums inhere in the values of all companies.

Part I is the doctrinal section of this Article. It reviews the Delaware cases that have adopted a "control premium" approach to valuation. We argue that these decisions have misread earlier precedents that required a firm to be valued as a going concern--with all its warts--rather than at a higher liquidation value that would have eliminated agency costs or at a post-transaction value that would have assumed potential synergies from a hypothetical (and thus speculative) business combination.

Part II reviews the literature that argues for the addition of a control premium to the stock price of every publicly traded company. We demonstrate that the basis for this argument is not supported by the presently available evidence. Control premiums are only paid when a bidder perceives that a purchase of control is worthwhile--where there are gains from trade. Moreover, despite the claims of the Delaware courts and some commentators, there are not multiple and separate markets for shares of firms (e.g., trading markets for small blocks and a separate market for corporate control). We expressly exclude consideration of a control premium in second stage takeout mergers, where a control premium has already been paid. We should emphasize that our enterprise is quite limited: we only address the imputation of a control premium in freeze-out mergers where there is no related control transaction.

Part III relaxes the assumption of efficient capital markets and reviews the fairness arguments that revolve around the disparate treatment of shareholders. We explain that these arguments are rejected either by evidence of ex ante payments or the widespread availability of contractual arrangements to allocate the receipt of control premiums. Accordingly, if public investors discount the price they pay for shares to reflect their lack of control over firm policies and agency costs, then compensating them on the basis of the same "minority discount" is not unfair. In other words, shareholders who receive the market value of their shares either through appraisal or selling into the market, generally, get what they paid for.

Finally, Part IV analyzes the structure and language of Delaware's appraisal statute to show that it contemplates paying minority shareholders for what they owned, and that this provides them with full compensation. Here, we show that where market exceptions to appraisal are present, shareholders will always receive as "fair value" the market price with its claimed "minority discount," rather than receive a control premium. To pay more when appraisal is available not only provides those shareholders with a windfall at the expense of the majority, but also creates a conflict in Delaware corporate law. The Delaware Supreme Court's approval of market value as fair value in a recent reverse stock split that eliminated small shareholders highlights the conflict with its use of control premiums in other areas.

Ultimately, we urge courts to presume that market value is the best measure of fair value. The burden should then be placed on dissenting shareholders to prove why and to what extent market value is inadequate. We believe this would improve the accuracy of appraisal valuations and at the same time achieve judicial economies.

1. DELAWARE'S TREATMENT OF CONTROL PREMIUMS

   We begin by tracing how the Delaware courts first rejected the notion of any premium over "going concern value" that might result from a sale or liquidation and then used that same going concern doctrine to conclude that a share was always worth less than its pro rata share of the value of the going concern. The logic of the "going concern" doctrine simply cannot bear this burden. Nonetheless, while denying that any speculative elements of value should be employed, the courts have reached the point where a control premium has become an integral part of the value of every going concern, regardless of how speculative such a control premium might be.

   1. Rejection of Market Values

      Delaware's current control premium confusion began with Chicago Corp. v. Munds, (22) the first Delaware Chancery Court decision to analyze the definition of "value." (23) While the court concluded, when speaking of the dissenting shareholder, that "[w] hat he is deprived of is what he should be paid for," (24) the court's analysis of why market value is not a sufficient arbiter of "value" created a precedent that survives to this day.

      The court based its decision primarily on two arguments: (i) although the version of the Delaware statute in effect at the time of the decision was modeled on a New Jersey statute, it rejected the term "market value" as used in the New Jersey statute and instead used the term "value," (25) and (ii) market value was not an adequate determinant of value because a merger would "destroy [a company's] individual identity and wipe[] out of existence all the stock of [its] kind," thus rendering impossible any replacement in the market. (26)

      The court did note that market values were sometimes valid for items such as chattel and stock in a company not set to merge, since, if paid the market value, an individual "could easily step into the market and replace presumably at the...