Reliance on Fairness Opinion is Misplaced

Koehler v. NetSpend Holdings Inc., 2013 Del. Ch. LEXIS 131 (May 21, 2013)

A dissenting shareholder sought a preliminary injunction to stop the merger and acquisition of the target company, claiming the sale process was not reasonably designed to maximize the sale price because of the board’s reliance on a weak fairness opinion resting on multiple problematic valuations.

The plaintiff held stock in a publicly traded corporation that was private until it conducted an IPO in late 2010 at $11.00 per share. In 2011, the market price for its stock fell drastically, reaching a low of $3.90 per share. The board believed the market undervalued the company and repurchased stock in fall 2011 and early 2012. As a consequence, company shares traded in the $7-to-$9-per-share range, which, as the board saw it, still did not reflect the company’s long-term potential value.

No market check. Throughout 2011 and 2012, several entities expressed interest in pursuing a merger, including two private equity (PE) firms and the defendant buyer. One of the PE firms proposed to buy a minority stake in the company for $12.00 per share. In contrast, the defendant buyer made a cash tender offer for the entire company at $14.50 per share based on certain conditions. The trading day before the board received the buyer’s indication of interest (IOI), the stock closed at $11.65.

In light of the offer, the company began to negotiate exclusively with the buyer. The board retained Bank of America (BofA) as a financial advisor for the transaction, which drew up a list of nine potential purchasers. The board declined to contact any of them, ostensibly to minimize the risk of leaks and rumors regarding a potential sale. But after the parties had drafted a merger agreement, the company, concerned about meeting its legal obligations, briefly reached out to one company in late December 2012. When its gesture was met with silence, it concluded there was a lack of interest in the market in general in the company.

In early January 2013, the buyer made another offer, increasing the price to $15.25. The board’s counteroffer was for $16.75, including other conditions, which the buyer rejected, suggesting instead that the board shop the company around to other potential bidders. The board declined, deciding an auction would not generate bona fide bidders. In late January, the parties’ negotiations led to agreement on the key terms of the deal, including a price of $16.00 per share in cash; a 3.9% termination fee, amounting to $53 million; and a no-shop provision. In February, the board approved the agreement and decided to recommend the transaction to the company’s stockholders.

On Feb. 19, 2013, BofA presented a fairness opinion to the board judging the deal fair. As a result, the parties executed the agreement. The $16.00-per-share price represented a 45% premium over the company’s stock price one week before the deal. But after the company released favorable earnings on February 13, its stock price increased reducing the premium to 25%. The total value of the transaction was approximately $1.4 billion. Following the announcement, shareholders swiftly filed two separate suits, including this one in the Delaware Court of Chancery, challenging the transaction.

The gist of the plaintiff’s request for an injunction was that the sale process was not conducive to maximizing the price. The board breached its duty of care when it decided not to seek alternative bidders and relied on the weak fairness opinion from BofA.

‘Not good’ indicators of value. In assessing the board’s single-bidder strategy, the Court of Chancery found the directors had “several indicia” as to how the market valued the company. In 2012, its stock price hovered around $8.00 per share even after share repurchases to boost its “true” value. A PE company’s bid for a minority interest was for $12.00 per share. When the board did approach a third party that previously had indicated an interest in the company, it made no offer. Within this context, the court said, the board’s decision to engage in the single-bidder process was not per se unreasonable.

This finding, however, was not the end of the analysis. Rather, the issue was whether, in light of the board’s decision, its actions as a whole produced a “process reasonably designed to maximize price.” For that determination, the court looked closely at the board’s reliance on the fairness opinion.

The BofA opinion rested on several valuations, which the court reviewed in turn.

1. Two valuations that were based on the price of company stock found the transaction fair because the buyer’s offer represented a premium over the stock price.

The court was not persuaded. Considering the volatility of the company stock since it went public in 2010 and the board’s open views that the market undervalued the company, the stock price was “not a good indicator” of its value, it said.

2. Next, the opinion relied on comparable companies and transactions analyses, both of which were problematic, the court stated. As to the former, BofA’s lead banker on the deal admitted that 14 of the 15 comparables were dissimilar to the target company.

As to the latter, the board itself acknowledged in the proxy that most of the comparables were “quite old,” predating the financial crisis, and the targets of the comparables were not “particularly similar” to the company at issue. The court concluded that neither of these analyses was “a strong indication” of the company’s value.

3. Lastly, the bank conducted a discounted cash flow analysis (DCF), which showed that a reasonable price range was between $19.22 and $25.52 per share, well below the $16 deal price.

In his deposition, the CEO used the latter fact to distance himself from the valuation. The DCF method, he said, “really has no commercial reality in terms of valuing a business … where you take five years of forecasted cash flows and discount them back at some sort of arbitrary discounted rates.” This was not a good prediction of how a company would deal with “the next 9/11 or the next fiscal cliff.”

The Court of Chancery zeroed in on these points, finding that an “anomalous DCF valuation” made the fairness opinion a less reliable substitute for a market check. The $16.00-per-share merger price was “20% below the bottom range of values implied by the DCF,” it pointed out with emphasis. In the end, the defendants themselves were “reduced to arguing that the DCF valuation is unreliable here,” the court said. The fairness opinion in this case was a “particularly poor simulacrum of a market check.”

The court concluded that the lack of market check and reliance on a weak fairness opinion, among other factors, indicated the sale process was unreasonable. But even though the plaintiff showed that she faced the threat of irreparable harm without an injunction, the court was “reticent … to enjoin a transaction that affords stockholders a premium in the absence of a competing offer.” In the gap between the parties’ agreement and the closing, the market likely became aware that the company was for sale, but no suitor appeared, the court pointed out. If it imposed an injunction and a material change caused the deal to fail, the harm to stockholders could be “quite large.”

In denying the plaintiff’s request, the Court of Chancery observed that it was unlikely that the directors could meet their burden at trial to prove they acted reasonably, but it made no findings as to whether the $16.00-per-share price was adequate or there was another buyer willing to pay more.

Blindly relying on a fairness opinion – even one prepared by a reliable banker such as Bank of America is not a substitute for valuations based on sound evidence. Valuations of financial interests are prophesies of the future – and like all prophesies they are subjective. At Rosenfarb LLC we produce well supported, well-reasoned and well communicated appraisals that withstand the rigors of litigation. We are a firm of forensic accounting and valuation experts. We understand business, have keen insights and always connect the dots. We understand the litigation process. We frame the issues simply and in alignment with the litigation strategy. We use logic to support our opinions, while creating compelling stories. We are sincere, professional and credible. We are accounting experts with legal acumen.