The Flawed Corporate Finance of Dell and Dfc Global

• Publication year: 2018

The Flawed Corporate Finance of Dell and DFC Global

Charles Korsmo

Minor Myers

THE FLAWED CORPORATE FINANCE OF DELL AND DFC GLOBAL

Charles Korsmo Minor Myers^*

Abstract

In a pair of momentous decisions, the Delaware Supreme Court recently attempted to bring clarity and reason to a corporate law topic of increasing importance: appraisal rights. In both decisions—Dell and DFC Global—the Court insisted that it did nothing more than apply "established principles of corporate finance." Yet in analyzing the financial ideas and concepts at play, the Court made four critical mistakes. First, the Supreme Court ignored the differences between how public markets price risk and how private parties— particularly financial sponsors—price risk. Second, the Court took the well-supported evidence of information efficiency in securities markets as necessarily implying a high degree of value efficiency. It then compounded this error by attributing this value efficiency not simply to the securities market but also to the deal market. Third, the Court succumbed to a flawed analogy between the fiduciary duty and appraisal contexts, implying that conditions of pricing efficiency are met whenever directors satisfy their minimum fiduciary obligations. Fourth, the Court treated company valuation as a mechanical, arithmetical calculation, downplaying the essential role of human judgment. This Article analyzes these errors and considers some potential implications for the future of appraisal rights in particular and for M&A markets and diversified public stockholders more generally.

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Introduction.............................................................................................223

I. The Rise of Modern Appraisal....................................................228

A. The Growth of Appraisal Activity............................................. 229
B. The Empirical Research on Appraisal Rights andM&A .......... 231
C. The Continuing Policy Debate ................................................. 234
D. DFC Global, Dell, and Other Developments............................ 235

1. The Delaware Court of Chancery ...................................... 236

a. Dell .............................................................................. 236
b. DFC Global ................................................................. 241

2. The Delaware Supreme Court............................................ 243

a. DFC Global ................................................................. 244
b. Dell .............................................................................. 248

II. Corporate Finance in DFC Global and Dell............................252

A. Firm-Specific Risks and the LBO Pricing Model ..................... 252
B. Abuse of the Efficient Capital Market Hypothesis.................... 259
C. Conflating the Fiduciary Duty and Appraisal Contexts ........... 269
D. Wringing Common Sense from Appraisal ................................ 273

III. The Road Ahead.............................................................................277

A. Clarifying the Conditions for a Fully-Informational Sales Process ..................................................................................... 277
B. The Fall of Defensive Tactics? ................................................. 279
C. Defining and Quantifying the Concept of "Synergies" ............ 280

Conclusion.................................................................................................281

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Introduction

Over the past decade, the law of stockholder appraisal rights has become an active and hotly debated topic in corporate law scholarship and practice. The dollar value at stake in appraisal claims has grown dramatically, as has the sophistication of the dissenting stockholders. In many cases, the dissenting stockholders are specialists who acquire positions in the target company after the announcement of the transaction with the intent to demand a judicial appraisal of the company—a practice that has been (inaptly) dubbed "appraisal arbitrage."¹

In 2017, the Delaware Supreme Court (Supreme Court) issued a pair of important opinions on the stockholder appraisal remedy—its first serious pronouncements since the rise of appraisal arbitrage. These two opinions—Dell² and DFC Global³ —both involved situations where specialist investors dissented from a public company merger and where the Delaware Court of Chancery (Court of Chancery) determined that the fair value of each company was higher than the merger price negotiated by the target board. Both decisions were reversed by the Supreme Court for failure to justify the decision to depart from the negotiated deal price as the best evidence of fair value.⁴

The Supreme Court clearly intended for these two opinions to stand as testaments to the importance of market pricing in mergers and acquisitions (M&A). The theme of both opinions is that the Court of Chancery should have relied more heavily on the price negotiated by the target company's board of directors.⁵ In both cases, reasonable minds may disagree about whether the fair value of each company should have been the deal price or something more like the fair value found initially by the Court of Chancery. But, as detailed below, whatever one's views on the individual case outcomes, the opinions are problematic in their misunderstandings of basic principles of modern finance. Most fundamentally, the Supreme Court embraces a crude notion of market efficiency, which it wields to dismiss any doubts as to the information content of the deal price.

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The Supreme Court's message to the trial courts is simple: absent a culpable breach of duty, trust the market and have faith in the negotiated price.⁶ The court's faith may be not so much in the efficiency of markets as in the perfection of its merger jurisprudence. These opinions leave the impression that a deal process that meets the bare procedural design tests imposed in recent fiduciary duty cases such as MFW,⁷ C&J,⁸ and Corwin⁹ —namely, a deal conditioned on approval by independent directors and a majority of disinterested stockholders— is good enough and will never merit financial recovery for stockholders. Under this view, the statutory appraisal remedy is simply unnecessary as a tool of corporate governance, at least in the public company context. Just as Corwin may have driven a nail into the merger class action, Dell risks smothering the fledgling utility of the appraisal remedy in its crib.

At root, the court appears convinced that we have reached the end of history on merger process design and that recent fiduciary duty case law has "solved" the problem of agency costs in merger transactions. As a prominent financial columnist for Bloomberg has noted, the Delaware courts have reached "a rather hopeful conclusion: After decades of merger litigation, the merger process has been refined and perfected, and now it can for the most part run on its own."¹⁰ We are less sanguine. When the guardians go to sleep, history has a way of roaring back. Without meaningful protection from the courts, exploitation of minority stockholders will increase, and capital formation will be impaired.¹¹ Following Corwin, appraisal is the last judicial sentry still on watch.¹²

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It would be a shame to send this lonely sentry back to its bunk. Whatever one thinks of Corwin,¹³ the fiduciary duty class action it eviscerated was largely a judicial creation, clearly subject to revision by the judiciary. Moreover, by the time of Corwin, a mountain of empirical evidence had accumulated showing that the merger class action was being abused and was not serving any governance function.¹⁴ The appraisal remedy is an altogether different story. Appraisal is a statutory remedy, amended periodically by Delaware's General Assembly.¹⁵ Moreover, the empirical evidence on modern appraisal is positive, finding little evidence of abusive litigation and substantial evidence that it is playing a positive but nascent governance role.¹⁶ The arguments against appraisal have largely been anecdotal or emotional in nature and have thus far been carried forward primarily by law students¹⁷ and prominent deal advisers.¹⁸ Two recently released academic papers mount a defense of the Dell and DFC Global decisions,¹⁹ though both papers succumb to the very same mistakes that the Supreme Court committed in the cases themselves.²⁰

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In this Article, we focus on four errors the Supreme Court committed in applying modern finance theory.²¹ First, in considering how risk bears on the pricing of transactions, the court ignored the difference between how diversified investors price risk and how undiversified investors, like private equity investors, price risk.²² A basic tenet of modern portfolio theory is that, for diversified investors, only market or systematic risks affect asset values, while firm-specific risks are largely irrelevant to pricing. Undiversified investors, on the other hand, must discount for both types of risk. In both opinions, the court devotes pages to the effect of risk on asset prices without recognizing this critical distinction between types of risk.²³ This leads to basic errors in how the court analyzed the legal issues before it. Diversified (public) shareholders need only discount for market risk, while concentrated (private) shareholders must discount for both market and firm-specific risk. For DFC Global, in particular, firm-specific risk was especially high,²⁴ potentially creating a significant gap between the price paid by a private equity buyer and the company's value as a going concern.

The second mistake is to confuse the well-supported evidence of informationally efficient securities markets with crude notions of value efficiency.²⁵ If the past thirty years of financial economics have taught anything, it is that markets can be extremely efficient at arbitraging away new information...