Campbell, Iridium, and the Future of Valuation Litigation
Michael W. Schwartz and David C. Bryan, 67(4): 939 - 956 (August 2012)
Five years ago, two landmark federal court valuation decisions, Campbell and Iridium, held that market evidence—rather than the testimony of paid litigation experts—should be relied on to value corporations for purposes of litigation. While a number of decisions have followed Campbell and Iridium, their full potential to make business valuation litigation less costly and less susceptible to hindsight bias has yet to be realized.
Market Evidence, Expert Opinion, and the Adjudicated Value of Distressed Businesses
Robert J. Stark, Jack F. Williams, and Anders J. Maxwell, 68(4): 1039-1070 (August 2013)
One year ago, The Business Lawyer published an article arguing that courts, when adjudicating the value of distressed businesses, should predominantly defer to “market” evidence, rather than expert opinion. In Campbell, Iridium, and the Future of Valuation Litigation, authors Michael W. Schwartz and David C. Bryan contended that near-universal judicial deference to market data: (1) is supported by recent developments in the case law; (2) would obviate judicial “hindsight bias”; and (3) would enable a more efficient valuation process. Messrs. Schwartz and Bryan further argued that, to solidify the paradigm change, courts should start imposing a pretrial obligation on any litigant intending to present expert valuation opinion to move specially, under Federal Rule of Evidence 702(a), for allowance to do so. This article offers an opposing viewpoint and argues that Messrs. Schwartz and Bryan interpret applicable case law selectively, outside of a broader jurisprudential context, and in a manner that disregards deeply ingrained legal principles. The authors here further contend that: (a) Messrs. Schwartz and Bryan have not presented a compelling case of widespread judicial “hindsight bias”; (b) they have also failed to make a persuasive showing that their proposal will lead to meaningful process efficiencies; and (c) their thesis fails to appreciate the complexity of market dynamics. This article concludes that market evidence tends to require expert interpretation, especially when used to value troubled businesses.
A Further Comment on the Complexities of Market Evidence in Valuation Litigation
Gregory A. Horowitz, 68(4): 1071-1082 (August 2013)
This comment offers another view in the dialogue concerning the use of market evidence in valuation litigation initiated in these pages one year ago. In Campbell, Iridium, and the Future of Valuation Litigation, Michael Schwartz and David Bryan argued that an understanding of the importance of market evidence, and of costs and vagaries of a battle of valuation experts, should lead courts to adopt a rebuttable presumption against the admissibility of expert valuation testimony. Like Messrs. Stark, Williams, and Maxwell, whose views are forcefully advanced in a separate article here, I find this proposal ill-advised, but for somewhat different reasons. I agree with Messrs. Schwartz and Bryan that market evidence is central to any question of value, but argue that the market never speaks for itself, indeed never speaks with a voice capable of lay interpretation. By way of example, I present a “debt discount test” for determining whether the market deems an enterprise to be insolvent (the question at issue in both Campbell and Iridium) and show that, even while this test substantially simplifies the interpretation of market data, expert opinion is inevitably required in its application. The increasing recognition of the importance of contemporaneous market information will improve valuation litigation and narrow areas of good-faith dispute without the need for radical procedural limitations on the adversarial process.
Consequential Damages Redux: An Updated Study of the Ubiquitous and Problematic “Excluded Losses” Provision in Private Company Acquisition Agreements
Glenn D. West; 70(4): 971-1006 (Fall 2015)
An “excluded losses” provision is standard fare as an exception to the scope of indemnification otherwise available for the seller’s breach of representations and warranties in private company acquisition agreements. Sellers’ counsel defend these provisions on the basis of their being “market” and necessary to protect sellers from unreasonable and extraordinary post-closing indemnification claims by buyers. Buyers’ counsel accept such provisions either without much thought or on the basis that the deal dynamics are such that they have little choice but to accept these provisions, notwithstanding serious questions about whether such provisions effectively eviscerate the very benefits of the indemnification (with the negotiated caps and deductibles) otherwise bargained for by buyers. For buyers’ counsel who have given little thought to (or who need better responses to the insistent sellers’ counsel regarding) the potential impact of the exclusion from indemnifiable losses of “consequential” or “special” damages, “diminution in value,” “incidental” damages, “multiples of earnings,” “lost profits,” and the like, this article is intended to update and supplement (from a practitioner’s perspective) the legal scholarship on these various types of damages in the specific context of the indemnification provisions of private company acquisition agreements.
Appraisal Arbitrage—Is There a Delaware Advantage?
Gaurav Jetley and Xinyu Ji; 71(2): 427-458 (Spring 2016)
The article examines the extent to which economic incentives may have improved for appraisal arbitrageurs in recent years, which could help explain the observed increase in appraisal activity. We investigate three specific issues. First, we review the economic implications of allowing petitioners to seek appraisal on shares acquired after the record date. We conclude that appraisal arbitrageurs realize an economic benefit from their ability to delay investment for two reasons: (1) it enables arbitrageurs to use better information about the value of the target that may emerge after the record date to assess the potential payoff of bringing an appraisal claim and (2) it helps minimize arbitrageurs’ exposure to the risk of deal failure. Second, based on a review of the recent Delaware opinions in appraisal matters, as well as fairness opinions issued by targets’ financial advisors, we document that the Delaware Chancery Court seems to prefer a lower equity risk premium than bankers. Such a systematic difference in valuation input choices also works in favor of appraisal arbitrageurs. Finally, we benchmark the Delaware statutory interest rate and find that the statutory rate more than compensates appraisal petitioners for the time value of money or for any bond-like claim that they may have on either the target or the surviving entity.
Our findings suggest that, from a policy perspective, it may be useful to limit petitioners’ ability to seek appraisal to shares acquired before the record date. We also posit that, absent any finding of a flawed sales process, the actual transaction price may serve as a useful benchmark for fair value. We conjecture that, while the statutory interest rate may not be the main factor driving appraisal arbitrage, it does help improve the economics for arbitrageurs. Thus, the proposal by the Council of the Delaware Bar Association’s Corporation Law Section to limit the amount of interest paid by appraisal respondents—by allowing them to pay appraisal claimants a sum of money at the beginning of the appraisal action—seems like a practical way to address concerns regarding the statutory rate. However, paying appraisal claimants a portion of the target’s fair value up front is akin to funding claimants’ appraisal actions, which may end up encouraging appraisal arbitrage.
Finding the Right Balance in Appraisal Litigation: Deal Price, Deal Process, and Synergies
Lawrence A. Hamermesh and Michael L. Wachter, 73(4) 961-1010 (Fall 2018)
This article examines the evolution of Delaware appraisal litigation and concludes that recent precedents have created a satisfactory framework in which the remedy is most effective in the case of transactions where there is the greatest reason to question the efficacy of the market for corporate control, and vice versa. We suggest that, in effect, the developing framework invites the courts to accept the deal price as the proper measure of fair value, not because of any presumption that would operate in the absence of proof, but where the proponent of the transaction affirmatively demonstrates that the transaction would survive judicial review under the enhanced scrutiny standard applicable to fiduciary duty-based challenges to sales of corporate control. We also suggest, however, that the courts and expert witnesses should and are likely to refine the manner in which elements of value (synergies) should, as a matter of well-established law, be deducted from the deal price to arrive at an appropriate estimate of fair value.
A Case for Eliminating Quarterly Periodic Reporting: Addressing the Malady of Short-Termism in U.S. Markets with Real Medicine
W. Randy Eaddy, 74(2) 387-416 (Spring 2019)
The author maintains that “short-termism” is a serious malady for which the only effective remedy is (1) elimination of quarterly periodic reporting on Form 10-Q, and the companion disclosure regime of quarterly earnings releases and conference calls, (2) conversion to annual-only periodic reporting on Form 10-K, coupled with a new annual earnings guidance requirement, and (3) retention of current interim disclosure of select material events on Form 8-K. The author reviews how the current quarterly disclosure regimes lead inevitably to short-termism behaviors, and are temptations to other problematic conduct, by corporate actors and market participants. The author contends that the proposed disclosure regime would reduce substantially such behavior and temptations, without compromising the quality of disclosures, protection of investors, or effectiveness of the capital markets system. The author argues that only such a fundamental change from the short-term timetable of the current disclosure regimes can curb short-termism, promote longer term and more strategic focus by corporate actors, and lead analysts, investors, and other market participants to focus on longer-term value propositions.
Simple Insolvency Detection for Publicly Traded Firms
J.B. Heaton, 74(3) 723-734 (Summer 2019)
This article addresses current limitations of financial-market-based solvency tests by proposing a simple balance-sheet solvency test for publicly traded firms. This test is derived from an elementary algebraic relation among the inputs to the balance-sheet solvency calculation. The solvency test requires only the assumption that the market value of assets equals the sum of the market value of the firm’s debt plus the market value of the firm’s equity. The solvency test is a generated upper bound on the total amount of debt the firm can have and still be solvent or, alternatively, the minimum amount of stock-market capitalization the firm must have if it is solvent at current debt prices. The virtue of the method—apart from its ease of implementation—is that it makes possible the detection of balance-sheet insolvent firms notwithstanding the possibility that not all of the firm’s liabilities—including hard-to-quantify contingent liabilities—can be identified. As a result, the method allows for the detection of balance-sheet insolvent firms that otherwise might escape detection. The method proposed here can identify insolvent firms that should be retaining assets and not paying them out to shareholders as dividends or repurchases, identify stocks that brokers and investment advisers should treat as out-of-the-money call options that may be unsuitable investments, and can help auditors identify publicly traded firms that are candidates for going-concern qualifications and other disclosures.
Asking the Right Question: The Statutory Right of Appraisal and Efficient Markets
Jonathan Macey and Joshua Mitts, 74(4): 1015-1064
In this article, we make several contributions to the literature on appraisal rights and similar cases in which courts assign values to a company’s shares in the litigation context. First, we applaud the recent trend in Delaware cases to consider the market prices of the stock of the company being valued if that stock trades in an efficient market, and we defend this market-oriented methodology against claims that recent discoveries in behavioral finance indicate that share prices are unreliable due to various cognitive biases. Next, we propose that the framework and methodology for utilizing market prices be clarified. We maintain that courts should look at the market price of the securities of a target company whose shares are being valued, unadjusted for the news of the merger, rather than at the deal price that was reached by the parties in the transaction.
R. Garrett Rice, 73(4) 1051-1092 (Fall 2018)
In 2016, the Delaware General Assembly amended section 262 of the Delaware General Corporation Law to provide surviving corporations with the option to prepay stockholders in appraisal cases. Specifically, the amendment gives a surviving corporation the option to pay, in advance of a trial, to determine the stock’s fair value, whatever amount per share that it chooses. Doing so cuts off the statutory interest on the prepaid amount, which theoretically should disincentivize investors from filing appraisal petitions solely to turn a profit from the statutory interest rate—a strategy known as “interest-rate arbitrage.” But in amending the statute, the General Assembly did not specify whether the petitioning stockholders must return to the corporation any amount by which the prepayment exceeds the court’s determination of fair value. The resulting ambiguity has not only caused uncertainty among litigants and costly motion practice in the Delaware Court of Chancery—a consequence, ironically, that the legislative amendment was aimed at avoiding—but has also diminished the amendment’s effect on curbing interest-rate arbitrage and, more generally, appraisal arbitrage. This article explores the history behind the prepayment amendment, including the evolution of Delaware’s appraisal statute and two Court of Chancery cases in which the Court foresaw the need for an effective prepayment system. This article also examines the legislative history of the 2016 amendment and other scholars’ suggestions for dealing with the statutory ambiguity. Finally, the article offers a new model for legislative reform, one that retains section 262’s core and advances the policy objectives that underlie Delaware’s appraisal system.