Business Valuation and the Delaware Court of Chancery
Last month we had the pleasure to welcome Moin Yahya as visiting scholar at our law school. Moin is Associate Professor at the University of Alberta Faculty of Law and former Commissioner at the Alberta Utilities Commission. With this occasion, Moin delivered a talk at the Edinburgh Centre for Commercial Law. His talk, entitled "The Law and Economics of the Equity Risk Premium: The Delaware Approach" provided fascinating insights into the process and methods used by the Delaware Court of Chancery in determining the fair value of a company.
The talk outlined recent developments on the appropriate measure of the equity risk premium (ERP), a concept that is central to the valuation of shares. More specifically, Moin discussed the recent case of Global GT LP and Global GT Ltd v. Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010), aff'd, 11 A.3d 214 (Del. 2010), in which the Delaware Court of Chancery replaced the historical market returns method of determining the ERP with the supply-side ERP.
The case concerns an appraisal proceeding under Section 262 of the Delaware General Corporation Law. Section 262 (h) provides that in the event of a merger, a stockholder of a Delaware corporation is entitled to an independent appraisal proceeding regarding the fair value of its outstanding shares. In December 2007, Vimpel-Communications (Vimpel), a major Russian provider of mobile telephone services, acquired Golden Telecom, Inc. (Golden), a Russian-based telecommunications company listed on the NASDAQ, at a price of $105 per share. Global GT LP, a minority shareholder in Golden, filed an appraisal rights claim with the Delaware Court of Chancery, believing that Golden was undervalued in the merger. Vimpel's expert claimed that Golden's value was $139 per share, while Golden's expert valued the company at $88 per share. The court carried an independent determination, and estimated the fair value at $125 per share.
Before commencing its own valuation process, the court had to address whether the merger price itself was an adequate statement of fair value. The court found that it was not, due mainly to the fact that the transaction was not carried at arm's-length. Vimpel's two largest stockholders were also the largest stockholders in Golden. Golden made relevant efforts to ensure that the merger price was fair: it appointed a special committee of independent directors to assess the merger; it obtained a fairness opinion from Credit Suisse stating that the $105 price was fair; it secured the unanimous approval of Golden's board of directors. Nevertheless, the court rejected the view that the merger reflected a market-tested price.
The Delaware Supreme Court affirmed this view, arguing that "[s]ection 262(h) unambiguously calls upon the Court of Chancery to perform an independent evaluation of ‘fair value' at the time of the transaction" and that "[r]equiring the Court of Chancery to defer -conclusively or presumptively- to the merger price, even in the face of a pristine, unchallenged transactional process, would contravene the unambiguous language of the statute and the reasoned holdings of our precedent."
In the second half of his decision, Vice Chancellor Strine applied the discounted cash flow (DCF) valuation method to determine the value of Golden, the same method used by both parties' experts. Although they used the same method, the experts disagreed on the value of several variables used in calculating a discount rate, including the equity risk premium (ERP), hence the different share values. The Court sided with the Global financial expert on this issue. After surveying the academic debate regarding the most accurate calculation of the ERP, the court refused to adopt "historic ERP", which had been the more commonly used ERP estimate up to that point, and noted that there is solid academic and professional support for the adoption of the "supply-side ERP".
For a non-US lawyer, Vice Chancellor Strine's decision looks like a chapter from a finance textbook, rather than a court decision. Valuation methods appear to be not a matter of law but one of commercial judgment, which courts should be reluctant to review or second-guess. When a court is confronted with issues of valuation, one would expect that the court rely on expert witnesses, drawn from the accountancy profession, rather than carry on its own, independent valuation.
The Delaware Court of Chancery, however, is no ordinary court. It is widely recognized as the US leading business court in terms of volume of business related cases. Its chancellors and vice chancellors have developed substantial expertise in corporate finance, including an ability to assess an expert's methodology and calculations. This explains why the Court of Chancery enjoys great flexibility, and is entitled to great deference, in conducting its independent appraisal of the fair value of a company.