STEINER CORPORATION V. BENNINGHOFF:
AN ANALYSIS OF THE COURT'S VALUATION PROCESS
Law & Valuation
Appraisal statutes provide a method for minority shareholders who dissent from a proposed merger to determine the fair value of the shares. However, if a court chooses not to take evidence of fair dealing, or the lack thereof, into account, then this may lead to inconsistencies in valuation and may discourage inequitable dealing by corporations.
Should fairness be taken into consideration when conducting an appraisal after a dissent to a merger?
Yes. Although the Steiner court did not take fairness into account when valuing the shares, they probably should have, especially considering that Delaware courts do.
Steiner Corp. v. Benninghoff is a Nevada case involving an appraisal after a dissent by minority shareholders to a proposed merger. The corporation appointed a Special Committee to represent the minority interest, which hired its own independent counsel to determine a value for the shares. Although the merger was approved by a merger, the Benninghoffs dissented, requesting information regarding the method leading to valuation of the shares. At trial, both sides offered expert testimony regarding the valuation.
Dissenting shareholders are given the right to the "fair value" of their shares. 4 main factors are used to determine fair value, although the Steiner court only used two, pre-merger market value discounted for illiquidity and the pre-merger enterprise value as a whole, arriving at a value of $1407 per share, which was approximately $200 more per share than what was offered to the shareholders.
It has been observed that where dissenting shareholders receive a favorable result, it is usually because there was some form of unfair dealing, which resulted in an unfair price. Thus, it has been proposed that the circumstances revealing any unfair dealing should be taken into account when performing a valuation based on an appraisal statute.
Many factors revealing unfair dealing have been determined. These factors include: behavior of the majority shareholders, providing inadequate disclosures to the shareholders, refusing independent representation of the minority, failing to obtain independent valuations, as well as others. The Delaware courts have chosen to use these factors when conducting a fairness analysis when determining fair value under an appraisal statute. In contrast, the Steiner court did not take fairness into account when determining the value of the shares.
If the Steiner court had taken fairness into account, the corporation would have met several of the factors, including providing independent representation and the use of an outside valuation firm. The court did explicitly find a lack of bad faith on the corporation's part. However, based on the analysis of the court, it appears that fairness was not part of their consideration. First, the court did not determine if the company met an initial burden of proving that the valuation was fair, which would have led to a summary judgment-like conclusion, thus avoiding judicial valuation. Second, if not, the court could have used the fairness factors as evidence of the credibility of the valuation and any assumptions used by the valuators. The court obviously did not do this because it only accepted two of the assumptions provided by the valuators, even though it had found that there was no bad faith. Finally, the court could have used the evidence of fair dealing to determine one of the rejected factors to determining fair value, which is "any other factor bearing on value." One problem with choosing not to take fairness into account was that the court's methods had some inconsistencies leading to a higher price, which could have been alleviated or at least explained by using fairness factors.
As the Steiner court chose not to take evidence of fair dealing into account, than the dissenting shareholders were definitely entitled to a judicial valuation. However, this may discourage corporations from using equitable methods and may lead to more dissents.
IntroductionScholars in the field of valuation claim that the modern purpose of the appraisal statutes is to prevent misconduct by majority shareholders. However, an analysis of Steiner reveals that even when a corporation’s actions reveal aspects of fair dealing this has little impact on the judicial valuation process. Summary of the Court’s Findings of Facts and Conclusions of LawTo avoid the potential imposition of an accumulated earnings tax, Steiner Corporation, a privately owned company, merged with Steiner Holding Corporation and offered to repurchase the minority shares at $1200 per share. Steiner Corporation v. Benninghoff, 5 F.Supp.2d 1117, 1121 (Nev. D.C. 1998). The merger was conditioned on an approval vote by a majority of the minority. Id. at 1121. Before determining the purchase price, the board of directors appointed a Special Committee of outside board members to represent the interests of the minority. Id. at 1122. The Special Committee retained independent counsel and hired J.P. Morgan Securities (JPM) to perform the valuation. Id. JPM assigned a value for the corporation between $1100-$1500. Id. In turn, the Special Committee reported the range of $1100-$1400 to the board of directors (without providing an adequate reason for the devaluation from $1500). Id Negotiations between the Special Committee and the board resulted in the $1200 offer to the shareholders. Id.
Although 83% of the minority shareholders as well as nine members of the Steiner family surrendered their shares, seven members of the Benninghoff family (17%) dissented from the merger. Id. at 1121. With limited success, the Benninghoff’s attempted to obtain information regarding the method of valuation performed by JPM. Id. at 1122. Given that notice of the merger and the day of the vote were only a month apart, the Benninghoff’s lacked the opportunity to obtain their own professional advice as to the value of the corporation. Id. At trial the corporation offered both JPM and Dr. Allan Kleidon as experts, and the Benninghoff’s offered David Nolte of Arthur Anderson. Id.
N.R.S. § 78.476 gives dissenting shareholders the right to the “fair value” of their shares. The court identified the following four factors as determinative of “fair value”:
1) Pre-merger market value discounted for illiquidity;2) Pre-merger enterprise value as a whole;3) Pre-merger net asset value, and;4) Any other factor bearing on value. Id. at 1123.For the first prong of the four-prong test the court used a “market comparable” approach by comparing the company’s subsidiaries to a number of similar publicly traded companies to arrive a market multiple with which to multiply Steiner’s earnings. Id. at 1126. With this method the court determined a market value of $515,534. It discounted the market value 25% for illiquidity, subtracted the corporation’s debt, added excess cash and divided by shares outstanding for a final value of $1191 per share for prong one. Id. The second prong of the analysis included a discounted cash flow (DCF) analysis and an acquisition method. Id. at 1129-37. The debt-free DCF method resulted in a value of $1273 per share and the acquisition method produced a value of $1958 per share. Id. The two results in step two were weighted 70% and 30%, respectively, to arrive at a total value for the second prong of $1479 per share. Id. at 1137. The third prong consisted of the pre-merger net asset value of the company and the fourth prong consisted of weighing other evidence of fairness. Id. at 1138. Neither prongs three nor four were assigned a value due to the court finding that these methods lacked credibility. Finally, the court assigned a weight to the four methods, 25%, 75%, 0%, 0%, respectively, and arrived at a final valuation for the corporation of $1407 per share. Id.
Role of Evidence of Fair DealingAccording to Barry M. Wertheimer, “The Shareholder’s Appraisal Remedy and How Courts Determine Fair Value,” 47 Duke L.J. 613 (1998), the modern purpose of the appraisal statute is to “protect minority shareholders from unfair fundamental transactions involving conflicts of interest.” Id. at 712. Wertheimer further states that…in cases where the dissenting shareholders achieve a favorable result, there almost invariably is evidence that the acquiring party acted inequitably or engaged in overreaching… On the other hand, in appraisal cases where the acquiring party achieves a favorable result, there is evidence that the acquiring party did not act inequitably. These cases typically involve a third-party arms-length transaction, or other indicia of fair dealing. In short, there is a strong correlation between the particular equities of each case and the result reached. Given the purpose of the appraisal remedy, this is a desirable outcome. Id. at 678-79.Citing a number of cases, Wertheimer identifies factors of unfair dealing such as offering an obviously unfair price, providing inadequate disclosures to the shareholders, failing to provide independence in the valuation process, refusing independent representation of the minority on the board and other such indications self-dealing. Id. at 679-684. The appearance of these factors, according to Wertheimer, results in the courts rightly determining the value of a minority’s shares in excess of the company’s offering price. Id. Wertheimer’s comments and observations seem to indicate that the behavior of the majority shareholders is a factor in determining “fair value” and plays a significant role in the judicial valuation process.
Likewise in Ryan v. Tad Enterprises, Inc. the court applied an “entire fairness analysis” which included, as its first step, an evaluation of the “fairness of the negotiation and the approval process in the transaction.” 709 A.2d 682, 689 (Del. Ch. 1996). In Ryan, there was ample evidence of self-dealing such as failing to obtain independent valuations, including high non-compete payoffs to the majority shareholders, and lack of bargaining for optimal shareholder buy-out prices. Id. at 691-93. After examining the merger and valuation procedures, the Ryan court concluded, “the defendants failed to carry their burden of proving the Asset Sale and the Merger were the product of fair dealing.” Id. at 693. Only after making a determination about the fairness of the merger proceedings did the court undertake to actually begin its valuation of the company. Like Wertheimer, the Ryan court seemed to believe that indicators of fairness or unfairness in the initial merger transaction are important factors in determining “fair value”.
Major aspects of “fair dealing” the Ryan court looked for are described by Alan Palmiter, Corporations: E&E, chapter 17, page 13 and include “negotiation by a team of the subsidiary’s outside directors…, full disclosure, approval by minority shareholders by conditioning the vote on a majority of the minority shareholders…, and not timing the merger to avoid an obligation to pay a higher contract price.” As noted, Steiner conditioned the merger on a majority vote by the minority shareholders, of which 83% approved the merger. Steiner also appointed a Special Committee to represent the interest of the minority, and the committee in turn retained independent legal counsel and an outside valuation firm. Negotiations took place between the Special Committee and the majority shareholders to determine a final price. Additionally, the Steiner court ruled that neither side acted in bad faith regarding the events surrounding the merger or the litigation. 5 F.Supp.2d 1117,1138-39 (D. Nev. 1998). Even though the District Court in Nevada is not bound by Delaware decisions, Nevada, having few appraisal cases on which to rely, cites to many of Delaware’s cases. However, unlike the Delaware court, the court in Steiner completely disregarded the aspects of fairness in the Steiner merger.
The Nevada court could have used the aspects of fairness in the merger in at least three different ways. First, similar to the Ryan case, it could have used the aspects of fairness to decide in a summary judgment-like fashion if the company met its initial burden of proving that its valuation was fair. This entry-level method rightly allows the company to avoid a judicial valuation by engaging in fair dealing in its business practices. In addition, given that courts traditionally refrain from interfering with business judgments, it is consistent to impose this justification on the court ordered valuation process.
Second, the court could have used the lack of bad faith on the corporation’s part as evidence of the credibility of the assumptions used by the independent valuation performed by JPM. However, out of the approximately ten conflicts between the parties on the valuation assumptions, the court accepted only two of JPM’s, one of which already agreed with Nolte’s. Part of this rejection by the court of JPM’s assumptions may be explained by JPM’s inability to reproduce all the related documents it used in its original valuation of the company. JPM claimed that it “routinely” destroys such documents despite the standard of practice in the appraisal industry prohibiting such destruction. Id. at n3. Nevertheless, the court did rely on JPM despite the lack of corroborating data when JPM’s assumptions closely approximated or matched those of Nolte’s.
For example, in the first prong of the fair price analysis the parties performed a “market comparable” valuation. JPM and Kleidon produced a range of value of $514,290—$551,030 and $364,500—$579,000, respectively. Nolte gave one value of $515,534. Id. at 1128. The court chose Nolte’s value because it fell comfortably between the two ranges offered JPM and Kleidon. Id. Not relying on JPM’s higher range would have forced the court to better justify its choice. Likewise in determining the market risk premium for the CAPM equation, the court again used JPM’s numbers to the detriment of the company. Kleidon and Nolte disagreed on the proper method to determine the market risk premium, but JPM used the same method as Nolte. Id. at 1134. Here the court used “the preponderance of the evidence” test to support its use of Nolte’s and JPM’s lower numbers. Id. It should be noted that nowhere else in the opinion in the multitude of conflicts is “the preponderance of the evidence” test evoked. Therefore, the court’s use, or lack thereof, of the corporation’s assumptions tends to show that aspects of fair dealing in the merger process provided little weight in establishing the credibility of the corporation’s assumptions.
Finally, the court could have used evidence of fair dealing in its fourth prong of the fair price analysis. The fourth prong of the “fair price” test included consideration of “any other factor bearing on value.” Id. at 1123. The court defined this prong as going “more to the credibility or reliability of the results achieved under the other prongs than to any independent method of valuation.” Id. at 1137. This language evokes the use of fairness in the Ryan case. Unlike Ryan, instead of an entry-level analysis, this prong contributes it own weight to the entire valuation. However, the court only considered and rejected the evidence that some members of the Steiner family cashed in their shares for $1200. Id. The court argued that the willingness of Steiner family members to take a tax hit by cashing in their shares, as opposed to passing the shares in their estates, was not evidence that the price was “an absolutely super, once-in-a-lifetime deal.” Id. at 1137-38. Although the court should have only been considering if this was evidence of a “fair price”, the court refused to give any weight to this evidence based on the court’s lack of belief that is was a “super, once-in-a-lifetime deal.” Id.
The Steiner court’s failure to use any one of these three methods to weigh in fair-play indicates that dissenter’s rights, at least in this court, entitle the dissenter to an accounting of value regardless of the terms of the merger. In this way any minority shareholder, whether nine or one, is entitled to a judicial determination of value. Additionally, if the courts apply favoritism consistent with this opinion, the valuation achieved will always be greater than that offered by the company. This use of the appraisal statute does not encourage a corporation to use equitable methods in determining shareholder price in a cash-out merger. Likewise it encourages dissenter actions regardless of the price offered by the company. In the limit, the appraisal statute in Nevada could make normally sound economic decisions such as mergers too expensive for small independent companies since, to satisfy minority shareholders, it would have to offer prices obviously above any reasonable enterprise value.
Inconsistencies in the Methods of ValuationWhile the court took pains to be as precise in its valuations as possible, it overlooked three major inconsistencies, all of which favored the dissenters. Before the court undertook the valuation process it addressed several areas of conflict. One of these areas involved the imposition of either imposing a control premium or a minority discount to the market comparable method in prong one of the fairness test, and the DCF and acquisition methods in prong two, respectively. Id. at 1124.
The court recognized that the market comparable approach had an inherently minority value and the DCF and acquisition approach were control values. Id. To resolve the issue, the court opted to add neither a discount nor a premium to any of the methods. Id. This seemed equitable given the controversy surrounding this issue and since the court would arrive at it’s final price using a weighted average of both types of values, minority and control. However, when the court arrived at its results in all the prongs of the test, it applied a 30% weight to prong one and a 70% weight to prong two. Id. at 1138. The only reason the court gives for the difference in weighting is that the DCF method was “stress[ed]” at trial. Id. There is no real evidence that the DCF method achieved a more reliable valuation given the conflicts between the parties in determining the appropriate assumptions to use and the seemingly arbitrary choices of the court. In effect, this difference in weighting applied a premium to the market comparable’s approach by giving the lower result less weight in the final analysis. This result seems inconsistent with the arguments presented by the court in its refusal to impose any discount or premium. Since the court cited a number of different authoritative sources in justifying the use of the market comparable method, it seems inconsistent that it would weigh this recognized method lower than any other valuations.
Secondly, the court overlooked an inconsistency in the DCF method. To arrive at a net income figure for tax purposes, the court deducted from earnings interest, depreciation, and amortization. Id. at 1131. >From this net income figure the court subtracted out the appropriate amount of tax (43%) and then added back depreciation, amortization and after-tax interest. However, a conflict arose with the after-tax interest amount. Id. The court noted that Steiner, having several European subsidiaries, could only deduct for tax purposes approximately 62% of its interest expense. Id. Therefore, to arrive at after-tax net cash flows, only that interest expense actually deductible should be added back on an after tax basis. Id. The court said that, “the net effect is to reduce the interest expense added back by only 62% of 43%, or 26.66%.” Id. The court failed to recognize the balance needed in the equation: if only 62% of the interest expense is actually deductible, then deducting all the interest expense to arrive at net income results in a falsely lower amount of taxes and a higher cash flow total. Given that interest expense was over a million dollars, this error had a tremendous effect on the cash flow analysis.
Finally, the court’s third major inconsistency was relying on the “acquisition method” for which it cites no authority and gives no analysis or explanation of the tools used even though this methods results in a valuation considerably higher than any other used. Id. at 1137. In using all other methods of valuation the court cites a number of cases or financial texts that use or validate the method. In addition to citing to other cases, the court took considerable time in explaining the other methods and walking through each of its steps. On the other hand all the court says about the “acquisitions method” is that it is a simulated third party sale transaction that “hinges on the assumption that the company being valued is being sold to a third party.” Id. It appears as though the court applied a multiple of 1.3 to the last twelve-month’s of Steiner’s earnings. Id.
Unlike in the market comparable’s approach, the court did not identify the companies used to arrive at the multiple. Nor did the court address whether or not this was an accepted method of valuation in the financial community, which it did for the other methods of valuation. Perhaps to alleviate the lack of rationale, the court assigned it a weight of 30% when it combined the value with the DCF method. Since the acquisition method resulted in a valuation $700 higher than the other valuations, it had a significant impact on the final result and deserved further examination and explanation.
ConclusionAlthough the Delaware courts incorporate the circumstances surrounding the merger event in determining the “fair value” of the corporation, this incorporation does not apply in all districts. Consequently, lawyers should argue for uniform adoption of the Delaware “entire fairness” analysis. The “entire fairness” analysis encourages and rewards equitable corporate behavior while it discourages excessive litigation, which should be the goal of the appraisal statutes. Likewise, lawyers should become more familiar with the methods used in the appraisal process so as to detect inconsistencies when their experts fail.