PetSmart Is A Significant Loss For Appraisal Arbitrageurs
Well-known to deal lawyers and their clients is the rise of “appraisal arbitrage.” Under Delaware law, stockholders of a Delaware corporation acquired in a merger or consolidation generally may seek appraisal from the Delaware Court of Chancery of the “fair value” of their shares of stock, subject to certain conditions and exceptions outlined in Delaware’s appraisal statute, Section 262 of the Delaware General Corporation Law. The legislative purpose behind that statute is to provide relief to stockholders dissenting from a merger on the basis of inadequacy of price — a statutory replacement for the common law rule that a single stockholder could block a merger. In the last few years, however, opportunistic hedge funds have exploited the statutory remedy as an investment strategy by buying stock in target companies after announcements of mergers for the purpose of seeking appraisal.
That practice may very well subside as the Court of Chancery continues its trend of relying on the merger price as the best indicator of fair value of appraised stock and expands the transaction contexts in which such deference will be given. Indeed, the court’s recent decision in In re Appraisal of PetSmart Inc., 2017 WL 2303599 (Del. Ch. May 26, 2017), deferring to the deal price in a private equity buyout as to which arbitrageurs with nearly $1 billion in shares sought appraisal, may be viewed in the future as a harbinger of significant decline in appraisal arbitrage. Below we discuss this important decision and its impact on future appraisal proceedings.
Background of the Case
PetSmart Inc. is one of the largest retailers of pet products and services in North America. Id. at *3. Founded in 1987, PetSmart experienced strong growth from 2000 until 2012 due largely to favorable dynamics in the pet industry. Id. at *3-4. However, in 2012, PetSmart’s growth began to stall as it faced increasing competition and other headwinds. Id. at *4. Coupled with PetSmart’s slowing growth, its management team struggled to accurately forecast the company’s performance, even for the next quarter, and the difference between the projections and the company’s actual performance oftentimes was significant. Id. In 2013 and early 2014, company management experienced substantial turnover, but the new officers were unable to improve the company’s performance, and certain of their initiatives even caused additional difficulties for the company. Id. at *5. Following the company’s poor financial results for the first quarter of 2014, several of PetSmart’s stockholders (including its largest stockholder) voiced their frustration with the company’s disappointing performance. Id.
Shortly thereafter, PetSmart’s board of directors began to explore the company’s strategic alternatives, and formed an ad hoc committee of independent directors to evaluate options that would increase stockholder value. Id. at *6. The board investigated various strategic options through June and early July 2014, when an activist hedge fund disclosed its acquisition of a large stake in the company and threatened a proxy fight if PetSmart were not sold. Id. at *6-7. After receiving this threat, the board retained J.P. Morgan Securities LLC to advise with respect to the company’s strategic alternatives. Id. at *7.
The board then directed the company’s management to prepare long-term projections. Id. at *8. Prior to this time, PetSmart management had never prepared long-term projections in the ordinary course of business; rather, it prepared one-year budgets that forecasted the company’s quarterly performance for the upcoming year. Id. These short-term projections historically proved unreliable. Id. at *4. Under significant time constraints and intense pressure from the board “to put [the company’s] best foot forward” in light of the discount prospective bidders potentially would apply, PetSmart management prepared multiple sets of progressively more ambitious long-term projections that reflected increasingly aspirational assumptions regarding the value of the company’s growth and cost-cutting initiatives. Id. at *8-12. Ultimately, the board and management settled on a final set of projections (the “management projections”) that approached “insan[ity].” Id. at *12.
In August 2014, the board determined to publicly announce that the company was exploring strategic alternatives, including a possible sale. Id. at *11. J.P. Morgan opened the auction process by contacting 27 potential bidders, comprised of a mixture of strategic and financial buyers. Id. at *12. Fifteen prospective bidders, all financial sponsors, signed nondisclosure agreements. Id. The board discussed with J.P. Morgan whether to formally invite PetSmart’s primary competitor, Petco Animal Supplies Inc., to bid in the auction, but the board determined not to do so based on the risks that Petco would feign interest to gain access to PetSmart’s confidential information and that a Petco-PetSmart merger would not obtain regulatory approval. Id. at *10, 12. The board, however, remained willing to engage with Petco if it expressed a serious indication of interest in a transaction. Id. at *12.
During the auction process, the board continued to consider alternatives to a sale and directed management to strengthen its plan to operate the company on a stand-alone basis. Id. at *13. However, the board determined it unlikely that the company could achieve the results forecasted in the management projections, and the company’s performance stagnated and declined in the third quarter of 2014. Id. at *14. By December 2014, the public auction had narrowed to three financial bidding groups. Id. at *15. PetSmart solicited the bidders’ best and final offers, and BC Partners Inc. submitted the highest bid at $83 per share. Id.
The board met on Dec. 13, 2014, to discuss the offers and the possibility of continuing to operate the company on a stand-alone basis. Id. Recognizing that the management projections posed significant execution risk, J.P. Morgan prepared two valuations of the company on a stand-alone basis, one based on the management projections, which returned a valuation of $78.25-$106.25 per share, and another based on sensitivity analyses it conducted, which returned a valuation of $65-$95.25 per share. Id. J.P. Morgan also delivered its fairness opinion that the $83 per share offered by BC Partners was fair from a financial point of view to the stockholders of the company. Id. After deliberating regarding the company’s prospects on a stand-alone basis and the aggressiveness of the management projections, the board determined to accept BC Partners’ offer to acquire the company for $83 per share, concluding that it provided the best opportunity to maximize value for PetSmart stockholders. Id. at *17, 28.
The parties signed the merger agreement the following day. Id. at *17. In the company’s merger proxy, PetSmart disclosed the management projections but noted that the company had not historically prepared long-term projections and “caution[ed] stockholders not to place undue reliance on the[m].” Id. at *18. PetSmart also disclosed the sensitivity analyses that J.P. Morgan performed, explaining that the analyses were prepared to assist the board in evaluating the downside risk should the company fail to perform in line with the management projections. Id. PetSmart’s stockholders overwhelmingly approved the transaction, and it closed on March 11, 2015. Id. at *18, 28. No indication of interest or topping bid emerged prior to closing. Id. at *18. PetSmart’s performance improved during the fourth quarter of 2014, but then declined in the beginning of 2015 and through closing. Id. at *19-20.
Multiple hedge funds acquired PetSmart stock after the announcement of the deal and sought appraisal by the Delaware Court of Chancery of the fair value of that stock. Id. at *2-3. The petitioners asserted that the fair value of the company was $128.78 per share based on their expert’s discounted cash flow (DCF) analysis, while the respondent requested that the court defer to the $83 per-share merger consideration. Id. at *2. Following trial, the court issued a memorandum opinion in which it accepted the respondent’s position and found the fair value of PetSmart to be $83 per share as of the closing of the merger. Id. at *41.
The Court’s Analysis
The court began its analysis by evaluating the sale process to determine if the deal price accurately reflected the fair value of the company. Id. at *27-31. The court first reaffirmed the principle that a sale process need not achieve perfection for a merger price to serve as a reliable indicator of fair value, id. at *27, then identified numerous facts in the record indicating that the auction yielded fair value, including:
- The auction process was widely publicized, putting the “whole universe of potential bidders” on notice;
- The sale process was not rushed, and the board was prepared to abandon a sale and continue to operate the company on a stand-alone basis if the process failed to generate a sufficient price;
- The company contacted 27 potential bidders, including both strategic and financial bidders, and did not shut out potential bidders or favor any particular bidder;
- The merger consideration was higher than the company’s stock price had ever traded and reflected a 39 percent premium over the company’s unaffected stock price; and
- No indication of interest or topping bid emerged, notwithstanding the company’s improved performance in the fourth quarter of 2014.
Id. at *27-28. Accordingly, the court concluded that the sale process, “while not perfect, came close enough to perfection to produce a reliable indicator of PetSmart’s fair value.” Id. at *27.
The court then proceeded to reject the petitioners’ “nitpick[ing]” of the “well-constructed and fairly implemented” auction process and their criticisms of purported market dynamics that impeded higher bids. Id. at *29-31.
First, the court found the evidence contradicted the petitioners’ contention that increased regulatory scrutiny of the amount of leverage in private equity buyouts prevented bidders from obtaining the financing necessary to fully fund their bids. Id. at *29.
Second, the court rejected the petitioners’ argument that only financial sponsors submitted bids and those bids were generated using leveraged buyout (LBO) models designed to provide the funds “a certain internal rate of return that will always leave some portion of the company’s going concern value unrealized.” Id. The court explained that “the evidence [was] clear that [J.P. Morgan] made every effort to entice potential strategic bidders and none were interested” and that “the Board would have been receptive to a deal with Petco if only it would have expressed a serious indication of interest.” Id. Further, the record demonstrated that “the private equity bidders did not know who they were bidding against and whether or not they were competing with strategic bidders,” and, consequently, “[t]hey had every incentive to put their best offer on the table.” Id.
Third, the court found the petitioners’ suggestion that the company initiated the sale process at an inopportune time in response to pressure from an activist stockholder to be unsupported by the evidence, as the record reflected that the board had begun evaluating a sale before the stockholder threatened a proxy fight, took its time with the sale process despite the stockholder’s demands, was ready and willing to continue to operate the company on a stand-alone basis, and was prepared to defend against a proxy contest if necessary. Id. at *30 & n.353.
Fourth, the court rejected the petitioners’ argument that the board was ill-informed, finding that a director’s memory lapse at trial regarding financial details nearly three years later did not suggest that the board was uninformed, particularly given that director’s extensive testimony regarding other aspects of the sale process, and that the petitioners’ assertion that the board failed to obtain advice regarding the company’s value on a stand-alone basis was contradicted by the record. Id. at *30.
Fifth, the court rejected the petitioners’ contention that J.P. Morgan had conflicts of interest that impugned the results of the sale process, determining that the board was aware that J.P. Morgan, as a large institutional bank, had ties to some of the large private equity firms that submitted bids, and that it was inconsequential that J.P. Morgan had been retained by Petco in connection with its initial public offering in the fall of 2015 because J.P. Morgan had not pitched that engagement until after the sale process had ended. Id. The court also found no conflict arising from J.P. Morgan’s previous engagement taking public an airline owned by a PetSmart director. Id.
Finally, the court declined to find that the merger consideration was stale as an indicator of fair value by the time of closing, concluding that PetSmart’s fortunes did not take “a miraculous turn for the better” as asserted by the petitioners, but rather that the company’s positive performance in the fourth quarter of 2014 was temporary, as evidenced by the company’s underwhelming performance in the first quarter of 2015. Id. at *31.
The court next evaluated the reliability of a DCF analysis as an indicator of PetSmart’s fair value. Id. at *31-32. To do so, the court first analyzed the reliability of the management projections, explaining that projections provide the key inputs for a DCF analysis and that “if the data inputs used in the model are not reliable, then the results of the [DCF] analysis likewise will lack reliability.” Id. at *32 (internal citations and quotation marks omitted).
After recounting the circumstances in which the court has determined projections to be insufficiently reliable to support a DCF analysis, the court found that the management projections “are saddled with nearly all of the telltale indicators of unreliability.” Id. at *32-33. First, PetSmart had not historically prepared long-term projections; it had only prepared one-year forecasts for budgeting purposes. Id. at *33. Confounding this issue, the management team that prepared the management projections was inexperienced and faced significant time pressure. Id. Second, the short-term forecasts that PetSmart’s management had prepared in the past were frequently inaccurate, often by large margins. Id. Third, the management projections were not prepared in the ordinary course of business, but rather during a sale process in which management was told to “put their best foot forward” to bidders. Id. at *34. Finally, the management projections were designed to be overly aggressive to offset the discount that potential bidders would apply. Id.
The court rejected the petitioners’ various attempts to defend the reliability of the management projections. The court found that the existence of an even more aggressive set of projections and other internal documents reflecting higher potential cost savings did not suggest that the management projections were reliable, explaining that the management projections remained the product of aggressive prodding by the board and the savings reflected therein represented management’s best estimate under the circumstances. Id. at *34-35. The court also found that the company’s post-signing performance did not suggest the management projections were reliable, noting that the company’s “mixed” financial results did not align with the performance forecasted in the management projections. Id. at *34. Accordingly, the court determined that the management projections were not reliable forecasts of PetSmart’s expected future cash flows, and any DCF analysis based on the management projections would be “meaningless.” Id. at *35 (internal citations and quotation marks omitted).
The court next evaluated the reliability of projections prepared by BC Partners and the executive it had arranged to become CEO of PetSmart post-acquisition, rejecting them as reflecting how PetSmart would be run as a private company under BC Partners and with new management, and thus not reflective of PetSmart’s “operative reality” as a going concern as of the closing of the merger. Id. at *35-36.
The court did, however, consider a DCF valuation based on the sensitivity analyses of the management projections that J.P. Morgan had conducted, explaining that the analyses had been prepared at the board’s request to provide it a more realistic understanding of the company’s expected future cash flows, and were thus more reliable than the other projections in the record. Id. at *37. Using the sensitivity analysis that it viewed as most reliable, the court proceeded to review the DCF models offered by each party’s expert, and found the analysis submitted by the respondent’s expert, which yielded a valuation range of $82.79 to $86.96, to be the most reliable DCF analysis that could be performed. Id. at *37-40.
The court then weighed the reliability of that DCF value against the reliability of the merger consideration and determined to give exclusive weight to the latter, though noted that the DCF analysis was “confirmatory.” Id. at *40. The court reasoned that the DCF valuation still depended on the unreliable management projections and that the petitioners’ position would reflect a “massive market failure ... [i]n the wake of a robust pre-signing auction.” Id. at *40-41. As such, the court found the company’s fair value to be equal to the $83 per-share merger consideration. Id.
The court’s decision in PetSmart to defer to the deal price represents a significant defeat for appraisal arbitrageurs and perhaps is a watershed moment in Delaware appraisal jurisprudence, signifying increased judicial deference to the “elegance” of the deal price, Id. at *40 n.439, whereby the court will not second-guess the price to which a willing buyer and willing seller have agreed in an arm’s-length transaction in the market absent unusual circumstances.
In important respects, PetSmart expands the contexts in which the court will defer to the merger price rather than use the DCF valuation method, thereby further limiting the situations in which fair value may be determined by the often-volatile, assumption-based DCF valuation method on which arbitrageurs have relied for their returns. Most notably, the court assuaged transaction planners’ concerns, arising from the decision last year in In re Appraisal of Dell Inc., 2016 WL 3186538, at *29 (Del. Ch. May 31, 2016), that private equity buyouts might be viewed as inherently resulting in a deal price below fair value because of the use of LBO pricing models, which derive a price a financial sponsor can pay while still achieving a particular internal rate of return. In PetSmart, the court soundly rejected that proposition, explaining that it would be improper for it to rely on economic theory absent record evidence supporting the application of the theory in the particular case, and finding no such evidence in the trial record. 2017 WL 2303599, at *1 & 29 n.352. The court further noted the fallacy of the proposition, observing that both strategic and financial acquirers generally pay more than a target company’s value and that financial bidders may even be willing to pay more than strategic bidders in certain contexts because they may be more inclined to take on risk. Id. at *29 n.352.
Also noteworthy is the court’s rejection of the petitioners’ argument that the deal price was not reflective of PetSmart’s fair value because the transaction occurred during a valuation low point or period of uncertainty. Id. at *29-30 & n.353. The court found inapposite In re Appraisal of DFC Global Corp., 2016 WL 3753123, at *22 (Del. Ch. July 8, 2016), modified on rearg., Consol. C.A. No. 10107-CB (Del. Ch. Sept. 14, 2016) (declining to rely exclusively on deal price because transaction occurred while company was in performance trough and experiencing significant internal turmoil and regulatory uncertainty), finding that the record demonstrated that PetSmart’s struggles and the industry headwinds it faced were well-known to the market and not of recent origin, and that its improved fourth-quarter 2014 performance (which was followed by poor results in the first quarter of 2015) did not suggest that the company’s problems were transitory. PetSmart, 2017 WL 2303599, at *29-31 & n.353. In so doing, the court distinguished the “acute regulatory uncertainty” involved in DFC from the everyday problems and underperformance plaguing many companies for sale, thereby indicating that only in rare circumstances will the court decline to rely on the deal price because the transaction was inopportunely timed. Id. at *30 n.353.
In addition, the court made clear that it will not undertake a DCF valuation, let alone rely on that methodology rather than defer to the deal price, absent record evidence showing that the management projections to be used are reliable estimates of the company’s expected future cash flows. Thus, the court will not use projections simply because they were management’s best estimates or were disclosed in the merger proxy or tender offer statement. Nor will the court rely on projections that never were approved by the board or used by management to run the business. The court also will not use projections that represent an aspirational sales case or an estimate of the company’s performance as part of the buyer (and not as a going concern). And, critically, the court will not use projections that were created or altered by a party’s paid expert to achieve a litigation outcome that diverges from market reality.
Lastly, the PetSmart decision is an important precedent for Chancery litigators because it allows a corporate defendant to use its executives’ deposition testimony as evidence at trial over a plaintiff’s objection. Parties in Chancery proceedings often stipulate to the admissibility of deposition testimony of fact witnesses, subject to any evidentiary objection as if the testimony were live at trial. In recent years, though, certain plaintiffs firms have refused to observe this common practice, and a decision by the Court in ACP Master Ltd. v. Sprint Corp., 2017 WL 75851, at *3 (Del. Ch. Jan. 9, 2017), holding that a corporate defendant’s use of its executives’ deposition testimony was inadmissible hearsay, served to further embolden them. However, in PetSmart, the court allowed the company to use the deposition testimony of its executives who did not testify at trial pursuant to Court of Chancery Rule 32(a)(3)(B), reasoning that the deposition testimony was admissible even if the company could have brought the witnesses to testify at trial because the witnesses were “out of the state of Delaware” and, without evidence it had “actively taken steps to keep the deponent from setting foot in the court-room,” the company had not “procured” their absence. 2017 WL 2303599, at *5 n.37 (internal quotations, citations, and alterations omitted). For the same reasons, the court also held that the witnesses were “unavailable,” and thus the deposition testimony was not inadmissible hearsay under Delaware Rule of Evidence 804(a)(5) and (b)(1). Id. In addition, the court permitted the company to proffer deposition testimony of witnesses who testified at trial on its behalf under the “rule of completeness” codified in Court of Chancery Rule 32(a)(4) and Delaware Rule of Evidence 106. Id. at *16 n.211.
This article was originally published in the June 29, 2017 issue of Law360.