Mark Opper

Law & Valuation
Professor Palmiter
Spring, 1999



In Smith v. Shell Petroleum, Inc., an engineer miscalculated the value of the Shell’s oil and gas reserves, and this information was distributed to shareholders as a disclosure prior to a cash-out merger. The value of the company’s estimated discounted future net cash flows were understated by $3 per share.  The Court of Chancery found this understatement to be material, in that it may have affected the plaintiff shareholder’s view regarding the merger.  The plaintiff used an expert witness to determine the value, and this witness used present value equity analysis, comparative deal market analysis, and trading market analysis. The defendant’s expert used discounted cash flow analysis and trading market analysis.


How should the value of the minerals owned by Shell be determined and what is the proper remedy for an undervaluation before a cash-out merger?


Mineral appraisers have several methods available to them, and the best method will depend on the circumstances surrounding the situation.  Should there be an undervaluation, the court will examine both parties’ proposals and then determine a remedy, taking into account the amount of understatement and other circumstances surrounding the merger, as well as the circumstances surrounding future use of the resources.


Several valuation methods that could be used by the Delaware courts, which decided Smith v. Shell Petroleum, Inc, include the following: discounted cash flow, comparable company/comparable acquisition, trading market approach, and liquidation value. The circumstances surrounding the case may determine which method may be the most useful. The discounted cash flow approach determines the value of a company by using the present value of its future cash flows.  The comparable company/comparable acquisition approach uses similar corporations or similar transactions to determine pricing multiples, in order to determine the shareholder’s equity in the original corporation.  The trading market approach determines what a company’s market price would have been on the day of a merger if there had been no speculation regarding the merger.  Finally, liquidation value is the amount that a stockholder would be entitled to if the company sold all of its assets and ceased operating, and is very useful for valuing natural resource corporations.

In this case, the court rejected both sides proposed remedies, and chose to construct one of its own, choosing to award $2 per share to the plaintiff, taking the uncertainty of successful production of mineral reserves into account. The paper then goes on to discuss the attributes of appraisal of mineral property.  Finally, IRS treatment of mineral valuation is discussed, including an applicable Federal Regulation.



In the vast landscape of the law, valuation issues can arise almost anywhere. However, one of the more fertile areas of valuation theory and technique continues to be corporate law. Specifically, valuation issues arise frequently in the context of mergers and business consolidations and the fiduciary duties that attach during the negotiation process. In this review, I will address a fiduciary breach that occurred when a firm's majority shareholder purchased minority interests after disclosing erroneous information as to the company's true value.

Generally, a cause of action due to inadequate disclosure may be grounded on a breach of duty of care, a breach of the duty of loyalty, or both. In some cases, plaintiffs are claiming that misrepresentations concerning specific assets of a firm have been made. Such claims are proper even when the fiduciary's omission is unintentional. One such case, and the case study of this law and valuation review, is the 1990 decision from the Delaware Court of Chancery, Smith v. Shell Petroleum, Inc.[1]

The factual and legal arguments from Shell can be best understood in light of the valuation methods used in the case.  Analyzing the preferred methods at the outset will assist our understanding of the legal and valuation arguments raised by the opposing sides. Following the case analysis, I will also consider how professional mineral valuators differ from other real estate and business valuators, and finally, discuss the position of the IRS as to land valuations with respect to mineral properties.


Judges and attorneys are frequently uninformed about valuation techniques and the reasoning behind the different methodologies. This overview of valuation methods commonly used by Delaware and other court systems will provide an analytical framework with which to evaluate the Shell opinion. Examining different valuation methods helps us consider how a given technique may be more or less useful depending on the circumstances.

The Weinberger crout broke new ground in its day, holding that  firms fair value should consider future value in addition to historical indicators.  The court also noted that reviewing the valuation techniques commonly accepted in the financial community was appropriate as well. The valuation methods most often used today, and ones that were argued in Shell, are as follows:


First, the Discounted Cash Flow approach ascertains the value of a company by using the present value of its future cash flows. This theory is premised on the idea that the total value of a company's assets is the equivalent to the present value of the expected cash flow from the corporation's held assets. DCF calculations are conducted with three basic variables of cash flow projections, the discount rate, and terminal value. The DCF valuation:

V=Present Value of cash flows + Present Value of terminal value,


cash flows = cash flow forecasted during the projection period,

terminal value = the value of the firm at the end of the forecast period, and
present value = the present value as of the valuation date using the debtor's weighted average cost of capital as the discount rate.
Today, DCF is widely considered a legitimate technique. In Cede & Co. v. Technicolor, Inc., a Delaware court officially endorsed the method and stated that "[I]n many situations, the discounted cash flow technique is in theory the single best technique to estimate the value of economic interest."[3]


Another popular valuation method that can be used to value both private and public companies is the comparable company and comparable acquisition methods. The guiding principle here is that a corporation is worth its stock market value plus a control premium. Under this method the valuator must first identify comparable corporations to the one under consideration. Factors that signal comparability include the products, earnings, nature of competition, markets, size of the businesses, capital structure, depth of management, book value, growth prospects, and risks.

The potential candidates of comparison can be further analyzed by using financial statements, which can give a more accurate, numerical view of each firm. After appropriate companies are located, the valuator must arrive at pricing multiples and then apply them to the corporation being valued. One can then determine the value of the stockholder's equity. Once a ratio (usually a price/earnings multiple) is produced for the "comparable company", the multiple can be used to arrive at the value by multiplying the variable for the target by the median or average multiple earlier obtained.

The similar method of comparable acquisition attempts to compare comparable transactions. The valuator can consider the size and time of the transaction, as well as the principal businesses or products of the companies. The more similar the transactions and products are, the more dependable the analysis will be, all else being equal.


The trading market approach seeks to find what a company market price would have been on the day of a merger in the absence of speculation as to the merger, acquisition, or sale. The trading market value is determined by picking a date preceding the speculation concerning the merger, and adjusting the stock price on that day to account for developments that occurred between the selected day and the merger day.

The courts have been more reserved with respect to this type of valuation. One problem is that the resulting values depend heavily on the selected date used, which is purely arbitrary. Also, stock prices do not always move in lock-step with the market as a whole (or even with other firms in the same industry), and therefore the level of speculation can be too great for the courts to accept. A third drawback to the trading market value is that the price doesn't always equal the true value while in operation as a going concern.


Finally, the liquidation value is the amount that a stockholder would be entitled to assuming the company sold its assets and ceased its operations. This approach is akin to the net asset value and is determined by subtracting the value of the company's liabilities from the value of its assets on the hypothetical merger or ending date. This approach ignores the reality of the firm continuing business as a going concern, and therefore courts usually require additional methods of analysis at appraisal proceedings.

Although the liquidation value is often seen as less useful in comparison with other methods, this technique becomes quite powerful when valuing natural resource companies. As a practical matter, the value of resource companies (such as mineral and oil and gas) is highly dependent on the underlying physical assets of the business. Hence, under certain circumstances, the liquidation value should be, and is, given great weight when ascertaining the fair value of resource and mineral holding companies. We now turn to the case study, which involves a large oil and gas resource company.


In Smith v. Shell, a Shell engineer miscalculated the value of the company's oil and gas reserves when he failed to include information regarding nearly 300 million barrels worth of such resources. The information was distributed to the shareholders as a disclosure prior to a cash-out merger. The reports reflected an understatement of the company's estimated discounted future net cash flows by nearly $1 billion, or $3 per share.

The Court of Chancery found that the understatement of the reserves "would have been viewed by a reasonable investor as significantly altering the `total mix' of the information available" to the plaintiffs, and was therefore material. The value of the minerals was in issue in both determining the liability for fiduciary duty breach and again when the judge decided the remedial aspect of the case. Multiple arguments were put forth on both sides of the valuation issue. First, I will address these positions, and then I will consider which view Vice-Chancellor Hartnett decided to follow.


The plaintiff's expert witness in Shell used three methods of valuation. The first was the present value equity analysis, which determined the liquidation value of the company's natural resource holdings and its productive assets' value on a return of investment basis. Second, the comparative deal market analysis compared the present value of equity figures to other acquisitions in the oil and gas industry. Last, the trading market analysis was used to augment the shares' market price with an acquisition premium.

The defendant, Shell, also employed a valuation expert.  This valuator used a discounted cash flow (DCF) analysis of the untapped reserves and used a trading market method on the firm's productive assets. The trading market and merger market valuations were similar to the plaintiff’s comparative deal and trading market method.  Ultimately, the court found that reserves were worth 1 billion, or $3 per share.  This amount, as mentioned earlier, constituted a material breach when it was omitted from disclosure materials.


Defendant's Proposals

As to the proper remedy, the defendant first wanted the class members to be required to promptly choose to either retain the merger consideration which they already received, or to forfeit the pay out and instead receive an amount equal to the shares determined by an appraisal proceeding. Shell assumed that this decision by the class members would be made following additional disclosures that accurately represented the shares' value.

The second potential remedy supported by Shell was the holding of a new trial to be held in order to determine the proper remedy. If there were such a trial, Shell felt it would be appropriate to consider several factors, which included: the extent to which shareholders generally do elect an appraisal and the number of shareholders who chose appraisal here; the extent of any causal relationship between the Court's findings and an actual change in decision for a `reasonable' shareholder in the context of all of the material information properly supplied to the Class; and that the disclosure effects related to liquidation analysis, which is only one valuation factor in an appraisal proceeding.

The defendant's arguments failed since the supplementary disclosure documents would correct the inadequate information too late to have a compensatory effect on the Class. Holdings breached a fiduciary duty, even if inadvertently, and times and circumstances do not remain static over the five-year period. Investors have moved their money elsewhere, and financial conditions have changed.

Plaintiff's Proposal

The plaintiff believed the proper remedy to be the difference between the amount of the merger consideration already paid to the class and the fair value of the shares as appraised in the future proceeding. The plaintiff's proposal to the court was also rejected as lacking support in Delaware and being generally unfair. The Delaware appraisal statute 8 De1.C. § 262 allows a shareholder to seek an appraisal, but if he does so, he must forgo the merger consideration until after the completion of the appraisal action.

The shareholder faces financial risks by choosing the appraisal option. He or she loses the use of his money during the appraisal, which can be quite lengthy. In addition, there is always the chance that the court could appraise the shares at a lower amount than the merger consideration. The shareholder may also be hurt if he acts alone or with only a small number of other shareholders, since the legal struggle for a higher price could be more costly than beneficial. As an investor, the shareholder is always weighing the options of where to put his time and his money. The court realized the difficulties that face a disgruntled shareholder under 8 De1.C. § 262 and reasoned that it wouldn't make sense for the class members to have the advantage of the cash in hand for 5 years with no "appraisal risk".

The plaintiff's proposal was also rejected because the plaintiff's remedy presupposes that every class member would have sought an appraisal if Holdings (Shell) had disclosed properly. The court also considered the fact that Shell had inadvertently understated their oil reserves. More importantly, the judge understood that the values of the oil reserves are subject to differing opinions. The court then followed Weinberger in contemplating that it was likely that most of the shareholders would have accepted the cash-out price even knowing about the extra reserves.

The Court's Decision

The court ultimately found the proposals by each side unacceptable. "Because the remedies proposed by the parties have been rejected, this Court must devise its own remedy. In doing so this Court, as a Court of Equity, must strive to find an equitable remedy and it traditionally has had broad discretion in doing so." The court looked at the value of $3 per share that was the value of the understatement of the reserves, and proceeded to award $2 per share.

Clearly, the court considered the lack of candidness as an oversight and not a bad faith attempt to buy at an artificially low price. The court decided not to give the full $3 per share back to the class, since the mere fact of having $3 per share worth of reserves in the ground ignores the fact that uncertainty surrounds the successful production of the minerals. Since production costs and oil prices can fluctuate, the uncertainty, said the court, would not justify a full refund of $3 per share.

The Delaware Supreme Court declined to reevaluate Hartlett's economic findings and without modification, (affirmed the Chancery Court's judgment[6]


Proper valuation techniques can differ substantially between various industries and various products. In Shell, the attorneys and judge had to primarily deal with the legal issues of fiduciary duties, merger appraisal statutes, and remedies.  But what about the value of the reserves themselves? The values clearly impacted the tenor of the case. Perhaps if these minerals in question were really only worth $100 million instead of $1 billion, then there would not have been a fiduciary breach. The damages awarded must have been based on the value of the minerals, but how much can the discovery of physical assets in the ground really alter a company's worth? Surely the value of mineral rights must be considered in a different light than, let's say, a company’s worth. The next section provides an introduction into the minds of mineral resource valuators.


First, the differences between mineral property appraisal and conventional real estate appraisal are substantial. Mineral property requires specialized knowledge not possessed by an ordinary land appraiser. Mineral property is special-purpose, location specific, and limited-market property. The best properties of this type will consist of a special blend of land, geology, property rights, and, of course, markets.

The valuations, or appraisals, of mineral property are important for two main reasons. First, they aid the public by advising them on issues concerning value. Second, they provide a uniquely objective, unbiased estimation of a property's worth while adhering to business practices in the industry and the tenets of law. The opportunities for mineral valuators are vast. There are two large categories of when these valuation services are needed most.

First, there are market-related transactions that include: 1) the purchase of property or royalty, 2) the sale of property of royalty, 3) an exchange of property, 4) financing security for bonding, 5) management decision making, 6) mine development, and 7) mine expansion. The other set of events requiring mineral appraisal covers the more legally related situations. These include 1) eminent domain and condemnation, 2) property taxation and appeals, 3) estate or inheritance tax, 4) mining lease or royalty disputes, 5) business or marital dissolution, 6) bankruptcy or loan foreclosure, and most importantly for this review, 7) company merger or liquidation.

Unlike common stocks, financial instruments, bonds, and commodities listed on open exchanges, the shares of private mineral companies, individual mining properties, mineral production royalties, and mineral interests are traded less often. The market price for publicly listed stocks are available instantaneously whereas the actual prices on mineral properties may not be as readily available or as easily determined. The lack of trading creates a gap in information and an even greater need for professional valuators who understand the minerals industry. In addition, the valuation of mineral rights is more complicated because information pertaining to geologic, mineral processing, and mineral product markets is needed to complement the traditional real estate appraisal calculations.


Any discussion of asset valuation would be incomplete without a glimpse of the IRS treatment of the asset. With respect to the appraisal of mineral properties and mining businesses, the IRS has instituted some specific rules and requirements. These requirements are generally created for ascertaining estate and gift tax burdens, but become useful when debating what the values of mineral properties should be in other contexts.

The Treasury Regulations have defined fair market value as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts". The definition is identical for estate as well as gift tax and is the usual way business valuators think of "fair market value". The Treasury Department has instituted rules applicable to oil and gas wells, mines, and other deposits in 26 CFR § 1.611-2(c) and (d) that pertain to the determination of the fair market value of mineral properties.[8]

Section (c) states that when evaluating, on a particular date, the total recoverable units (tons, barrels, etc.) of product reasonably known or believed to exist in a given location on a specific day; the estimation must be made according to the method current in the industry and in the light of the most reliable and accurate information available.

The Regulations, in section (d), covers the determination of the fair market value of the mineral properties. It says that due weight must be given to a series of factors having a bearing on the market value, such as 1) actual sales and transfers of similar properties, 2) cost, 3) bona fide offers, 4) royalties and rentals, 5) market value of stock or shares, 6) partnership accountings, 7) valuation for state and local taxation, 8) records of litigation in which the property value was at issue, and 9) other disinterested appraisals by proper methods.

Although the IRS is concerned about the valuation of mineral property to determine the amount of basis a company can take, the analysis and reasoning of the IRS's position sheds light on mineral valuations unrelated to tax issues. For instance, when determining basis the IRS requires the fair market value of mineral property to be determined in light of the circumstances known at that date, regardless of later discoveries or improvements in mineral treatment or extraction methods. This gives us a sense of how the government wants to know the value immediately; otherwise, it will allow overly generous tax treatments.

A taxpaying firm wants its basis to be as high as possible and will do much to create this figure. Subtracting a high basis from amounts realized leads to a lower tax bill. The IRS has decided to put limitations on the value of this figure, knowing that a taxpayer would want to raise the basis value of his investment for virtually any reason conscionable.


When valuing assets, objectivity is hard to come by. Taxpayers will advocate one value, and the government will support the other. Plaintiffs and defendants, through their experts, will also fight with vigor, in hopes of convincing a judge that his value is the correct one. The experts, professional mineral property appraisers, are perhaps the best option for courts, as well as investors, to rely on. The answer is an expensive one, but these valuators, if court appointed, seem to be the only party knowledgeable enough to understand the valuation issues and objective enough to value the assets in an unbiased, disinterested manner.

[1] Smith v. Shell Petroleum, Inc., 1990 WL 186446 (Del. Ch.)
[2]  Jay W. Eisenhofer and John L. Reed, Valuation Litigation, 22 Del. J. Corp. L. 37 1t 110.  This article was used for the entire valuation overview.
[3]  See also Steven P. Lamb & John Day, Some Courts are Using New Approach to Set Dissenting Shares’ Value, NAT’L L.J., June 17, 1991, at S8.
[4]  Michael R. Schwenk, Valuation Problems In the Appraisal Remedy, 16 Cardozo L. Rev. 649 at 670.  This article was the primary source for this section.  See also Shell Petroleum, Inc. v. Smith, 606 A.2d 112 (1992).
[5] Shell Petroleum, Inc. V. Smith, 606 A.2d 112 (1992).
[6] Id.
[7] was an invaluable resource here.
[8]  26 C.F.R. § 1.611-2(c) and (d), see also Http://