Investment Bank Update on Conflicts and Valuation Issues

February 2, 2010

Chancellor Chandler of the Delaware Chancery Court recently issued a decision, In Re John Q. Hammonds Hotels Inc. Shareholder Litigation (C.A. No. 758-CC, January 14, 2011), that should provide some comfort to full service Wall Street banks.  An earlier ruling in this matter (C.A. No 758-CC, October 2, 2009) raised the possibility that ordinary course marketing activities by full service banks could undermine the ability of clients to rely on their advice, even if the banking team was not aware of the activities of other areas of the firm.

Hammonds arose from a sale of a company to a third party in an arm’s length transaction, following a sale process that involved at least three participants.  During the sale process the bids increased from $13 per share to $24 per share.  The merger, however, involved disparate consideration between the controlling stockholders and the minority stockholders.  The minority stockholders received $24 per share in cash, whereas the control shareholder received a package of securities and other contractual rights.  In its prior ruling, the Delaware Chancery Court refused to dismiss the case on a motion for summary judgment in light of, among other things, the failure of the merger agreement to contain (i) a non-waiveable majority of the minority voting provision, and (ii) a majority of the minority voting provision in which approval of a majority of the outstanding minority was required, as opposed to a majority of the voting minority.

In addition, the prior Hammonds decision concluded there were factual issues about the timing and content of contact between the real estate finance group of Lehman (Lehman was the financial advisor to the Special Committee) and the buyer regarding a potential asset-backed securities offering post-merger.  The plaintiff had alleged that the merger proxy contained a material omission because it did not disclose Lehman’s possible conflict of interest in pitching the buyer regarding a securities offering at the same time that Lehman was advising the Special Committee regarding whether to enter into a transaction with the buyer.  The defendant’s claim that “there [was] no evidence that Lehman’s opinion was affected by the purported pitch” was dismissed by the court, which stated that “[t]here is no rule . . . that conflicts of interest must be disclosed only where there is evidence that the financial advisor’s opinion was actually affected by the conflict.”

The Delaware court’s recent ruling applying the entire fairness test to Hammonds sheds further light on Delaware’s views on conflicts of interest, as well as on Delaware’s standards regarding corporate valuations.

Conflicts of Interest

Chancellor Chandler concluded there was no material omission in the merger proxy relating to the non-disclosure of the Lehman contact with the buyer.  The Chancellor noted in particular that:

  • Lehman’s real estate finance group never received any data from the buyer, never submitted a written bid for the financing and never received any business from the buyer.
  • The Lehman banking team never spoke with the real estate finance group about the proposed financing.
  • No members of the board of the seller were aware of the contact by Lehman’s real estate finance group.

KEY TAKEWAY:  Full service Wall Street banks should take comfort that non-coordinated business generation need not necessarily trigger conflicts disclosure.  In fact, in certain circumstances, Chinese Wall policies and procedures may preclude full disclosure.  One should not, however, read too much into the recent Hammonds decision.  It is not clear that the same decision would have resulted if the facts had suggested a coordinated effort by Lehman to obtain the real estate financing, or if Lehman had been more successful in its efforts regarding the financing.

Valuation Highlights

(i)  Fair Value Conclusion.

The court held that the merger resulted from a fair process and resulted in a fair price to the minority stockholders.  The court put particular weight on the nature of the sales process (bids were increased from $13 per share up to $24 per share; a 300% premium to the unaffected stock price) and that the merger was negotiated with a third party in an arm’s length negotiation.  In other words, the control stockholder was not on both sides of the negotiation.  It also found the defendant expert’s valuation conclusion of $14.97 per share to $18.71 more credible that the plaintiff expert’s valuation conclusion of $49 per share.  Thus, any potentially successful claim would have needed to focus on the disparate value of the respective consideration packages.  The plaintiff, however, never challenged the value of the consideration package received by the controlling shareholder.  The plaintiff focused solely on the inadequacy of the $24 per share cash price to the minority stockholders.

(ii) Technical Valuation Highlights.

The court reiterated several basic principles of Delaware valuation/appraisal law:[1]

  • A price established through an arm’s length negotiation with an unaffiliated third party following an active sale process is an independent basis for establishing fairness.
  • A DCF valuation is a preferred analysis because “it merits the greatest confidence within the financial community.”
  • DCF analyses based on management projections made in the ordinary course of business are generally considered to be reliable; conversely, management projections not made in the ordinary course of business are subject to additional scrutiny (and, in Hammonds, were found to be flawed in numerous ways).

Additionally, Chancellor Chandler:

  • Was critical of selected “comparable” companies and “comparable” transactions as not being truly comparable.  He cited substantial differences in:
    • growth prospects;
    • investment strategy;
    • leverage;
    • corporate structure; and
    • business mix.
  • Stated that the comparable transactions, which contained  “a set of only five transactions” was too small of a sample set to draw meaningful conclusions.  It is likely, however, that the set of five transactions was deemed to be too small, at least in part, because of the lack of true comparability.
  • Gave favorable emphasis to the use of the “Convergence Model” in calculating the DCF terminal value (i.e., value creating growth will end during a discrete forecast period, resulting in a perpetuity growth rate equal to the cost of capital).  This model is not equivalent to a zero growth rate assumption.
  • Approved the use of a capital cash flow approach in a DCF analysis, particularly in valuing companies whose capital structure is expected to change over time.  The capital cash flow approach is a DCF methodology that uses an unlevered equity cost of capital to discount cash flows that are adjusted to reflect after tax cash flows on a period-by-period basis (i.e., the interest tax shield is expressly built into the estimated cash flows).  Although Chancellor Chandler stated that the capital cash flow approach is “particularly appropriate” in valuing companies in which the leverage ratio is expected to change over time, such approach is of limited usefulness in most fairness opinion contexts.  Most DCF analyses use stable capitalization ratios to express financing strategies, either industry average leverage ratios or leverage ratios as targeted by management.  That is, fairness opinion practice is typically based on static assumptions as to the percentage allocation of capital between debt and equity, as opposed to forecasting specific amounts of debt or specific changes in debt over the forecast period.  In situations in which a company’s leverage ratio is projected as a static percentage over the forecast period, the free cash flow method, and the use of a weighted average cost of capital, is an easier method to use in a DCF analysis. 

KEY TAKEAWAYS:   In light of the continued growth in the financial sophistication of the Delaware Chancery Court, financial advisors should rethink their historic preference for including “more rather than less” financial analyses in connection with rendering fairness opinions.  This is especially true in situations in which the subject companies have been involved in adequate sales processes.

[1] For a more detailed discussion of Delaware valuation principles, see R. Scott Widen, Delaware Law, Financial Theory and Investment Banking Valuation Practice, 4 NYU Journal of Law & Business (2008).