The short and puzzling life of the "implicit minority discount" in Delaware appraisal law.

• Author: Hamermesh, Lawrence A.

The "implicit minority discount," or "IMD," is a fairly new concept in Delaware appraisal law. A review of the case law discussing the concept, however, reveals that it has emerged haphazardly and has not been fully tested against principles that are generally accepted in the financial community. While control share blocks are valued at a premium because of the particular rights and opportunities associated with control, these are elements of value that cannot fairly be viewed as belonging either to the corporation or its shareholders. In corporations with widely dispersed shareholdings, the firm is subject to agency costs that must be taken into consideration in determining going concern value. A control-block-oriented valuation that fails to deduct such costs does not represent the going concern value of the firm. as a matter of generally accepted financial theory, on the other hand, share prices in liquid and informed markets do generally represent that going concern value, with attendant agency costs factored or priced in. There is no evidence that such prices systematically and continuously err on the low side, requiring upward adjustment based on an "implicit minority discount."

Given the lack of serious support for the IMD in finance literature, this Article suggests that the Delaware courts may be relying on the IMD as a means to avoid imposing upon squeezed-out minority shareholders the costs of fiduciary misconduct by the controller. Where either past or estimated future earnings or cash flows are found to be depressed as a result of fiduciary misconduct, however, or where such earnings or cash flows fail to include elements of value that belong to the corporation being valued, the appropriate means to address the corresponding reduction in the determination of "fair value" is an upward adjustment to those earnings or cash flows.

This approach to the problem of controller opportunism is more direct, more comprehensive in its application, and more in keeping with prevailing financial principles than the IMD that the Delaware courts have applied in the limited context of comparable company analysis. The Delaware courts can therefore comfortably dispense with resorting to the financially unsupported concept that liquid and informed share markets systematically understate going concern value.

INTRODUCTION I. WHENCE IMD? A. The Doctrinal Soil of the IMD: The Backdrop of Delaware Supreme Court Precedent B. The Initial Appearance (and Rejection) of the IMD C. The IMD Takes Root D. The IMD Goes from Permissible to Mandatory II. THE FINANCE BEHIND DELAWARE APPRAISAL LAW A. The Value of the Firm B. Third-Party Sale Value and Synergies C. Agency Costs D. The Benefits of Control E. Summing Up: The Pratt Diagram F. Discounts 1. Illiquidity Discounts 2. Closed-End Funds 3. Nonvoting Stock III. THE TREATMENT OF FINANCE IN DELAWARE APPRAISAL LAW A. Consistent with Finance, but with One Exception B. The Supposed Finance Behind the IMD C. Why the Delaware Bench and Bar Fell into Error IV. PULLING UP THE WEED: DOES REJECTING THE IMD IMPAIR THE UTILITY OR FAIRNESS OF THE APPRAISAL REMEDY? CONCLUSION INTRODUCTION

Our recent article on the subject of share valuation began with the observation that the 1983 Weinberger decision (1) "revolutionized appraisal law." (2) One of Weinberger's critical (although perhaps long-overdue) contributions was its recognition that in assessing share value in appraisal cases, courts should be guided by "proof of value by any techniques or methods which are generally considered acceptable in the financial community." (3)

For many decades the Delaware courts have embraced a standard of valuation in appraisal cases that awards dissenting stockholders their proportional share of the value of the "going concern." (4) In the years after Weinberger admonished that valuation should employ techniques generally acceptable in the financial community, Delaware's "going concern" standard has had a largely happy and fruitful marriage with modern principles of finance. Under those principles, the value of the firm, of which the dissenting stockholders receive a proportionate share, is represented by the net present value of the firm's future free cash flows. (5) With Weinberger's salutary blessing, this approach to valuation has conic to dominate Delaware valuation proceedings. (6) Most commonly identified as the "discounted cash flow" or "DCF" approach, this valuation approach fits comfortably within the legal parameters of appraisal proceedings. Under those parameters, stockholders in appraisal proceedings, who by statute may not share in the benefits arising from the transaction giving rise to the appraisal proceeding, (7) do not receive a value that includes synergies or benefits of control; (8) nor do they receive a value that fails to take into account the agency costs that are part of the corporation's "operative reality" (9) and that are therefore a component of the anticipated free cash flows of the going concern. (10)

As sometimes happens in rapidly developing bodies of law, however, a doctrinal weed sprung up in the late 1990s in what was otherwise a largely harmonious, well-tended garden of finance and law. In a rapid succession of cases over a period of less than ten years, there developed what is now known in the Delaware case law as the "implicit minority discount," or "IMD." (11) It is this recently sprouted concept that is the central focus of this Article.

The financial/empirical assertion of the IMD is quite simple: no matter how liquid and informed the financial markets may be, all publicly traded shares persistently and continuously trade in the market at a substantial discount relative to their proportionate share of the value of the corporation. (12) This discount, it is said, arises because the stock prices on national securities markets represent "minority" positions, and minority positions trade at a discount to the value of the company's equity. (13) The consequence of the IMD in appraisal proceedings is limited in scope, but substantial in scale: in applying a valuation technique (known as "comparable company analysis," or "CCA" (14)) that estimates subject company value by reference to market trading multiples observed in shares of comparable publicly traded firms, the result must be adjusted upward by adding a premium to offset the "implicit minority discount" asserted to exist in the comparable companies' share prices. (15) In the last several years, the size of this upward adjustment (and the supposed discount that it "corrects") has been routinely fixed, even without supporting expert testimony, at 30%. (16)

As we show below, (17) however, not a single piece of financial or empirical scholarship affirms the core premise of the IMD--that public company shares systematically trade at a substantial discount to the net present value of the corporation. To the contrary, the one treatise on which the Delaware courts have repeatedly relied in invoking the IMD has, in its most recent edition, explicitly warned against routinely applying an upward adjustment in order to offset some supposed IMD. (18)

Moreover, the Delaware courts' application of the IMD has rendered their valuation jurisprudence internally inconsistent. Even as they have recently come to insist on adjusting for the putative IMD when using a CCA, the Delaware courts have consistently (and properly) declined to make any such upward adjustment to the results of discounted cash flow (DCF) analysis. That position stems from the courts' correct recognition that DCF analysis can provide the best measure of the value of the enterprise and that the value of the enterprise, alter deducting off the value of the debt, measures the value of the firm to its equity holders and thus its going concern value. No adjustments are necessary to the DCF method to offset any implicit minority discount. And indeed, the courts make no such adjustment, even when the DCF analysis relies on market multiples--in substance, a CCA approach--to estimate terminal value. (19)

Fortuitously, in some cases, where allegations of incumbent board wrongdoing are combined with the appraisal case, the IMD may result in the correct answer when it offsets an incumbent controller's wrongful acts. But, as we have argued previously, (20) that result can be achieved more directly by accepting petitioner's evidence that the respondent's anticipated cash flow projections or other operational performance measures are too low. In short, our core submission is that the Delaware courts, in their valuation of shares (particularly in squeeze-out mergers), should abandon the IMD and rely instead on a more direct approach to addressing concerns about past or future abuse by controlling stockholders. The arsenal of corporate finance techniques available to measure going concern value, correctly applied, would award shareholders the appropriate amount.

We reach this conclusion in the following steps. In Part I, we review the fortuitous and haphazard means by which the IMD sprouted up in Delaware valuation law. Part II outlines the finance principles that generally underlie Delaware valuation law, and Part III argues that while such law is generally consistent with those finance principles in both concept and application, the IMD is not. Finally, Part IV suggests how the IMD can easily and fairly be excised from Delaware appraisal law, and how alternative, financially supportable valuation methodology can address controlling stockholder opportunism, as long as the Delaware courts remain true--as we expect they would--to Weinberger's admonition to remain open to evidence from the financial community.

1. WHENCE IMD?

   As previously noted, the focus of our inquiry is the Delaware courts' recent assertion of the IMD--the proposition that share prices in reasonably active markets systematically and substantially understate the pro rata present value, net of debt, of...