On July 28, 2015, the Delaware Court of Chancery issued a post-trial opinion in which it criticized in particularly strong terms the analysis performed by a financial firm that was retained to value companies that were being sold to a third party or spun off to stockholders (the “valuation firm”). See Fox v. CDX Holdings Inc., C.A. No. 8031-VCL (Del Ch. July 28, 2015). CDX is just the latest decision in which the Chancery Court has awarded damages and/or ordered injunctive relief based in part on a financial firm’s failure to discharge its role appropriately. Calling the valuation firm’s work “a new low,” Vice Chancellor Laster’s opinion is another chapter in this cautionary tale that lays bare how financial firms can be exposed not only to potential monetary liability but, as importantly, significant reputational harm from flawed sell side work on M&A transactions.
The action involved the sale or spin-off of the businesses of Caris Life Sciences, Inc. (“Caris”), a privately-held Delaware corporation that operated through three subsidiaries: Caris Diagnostics, TargetNow and Carisome. Caris’ founder, David Halbert, owned 70.4% of its outstanding equity and an investment fund, JH Whitney VI, L.P., owned 26.7%. To secure financing for TargetNow and Carisome, Caris sold Caris Diagnostics to Miraca Holdings, Inc in the fall of 2011. To minimize taxes, the transaction was structured as a “spin merge,” whereby Caris transferred ownership of TargetNow and Carisome to a new subsidiary, which it then spun off to stockholders. At that point, Caris (owning only Caris Diagnostics) merged into a subsidiary of Miraca.
Most of the equity in Caris not owned by Halbert or JH Whitney (2.9%) consisted of stock options that were cancelled in connection with the Miraca transaction, with each holder having the right to receive for each covered share the amount by which the “Fair Market Value” of the share exceeded the option exercise price. Option holders brought suit challenging, among other things, the value attributed to TargetNow ($47 million) and Carisome ($18 million) for purposes of determining Fair Market Value. Caris’ tax advisor initially arrived at these valuations, and the valuation firm (which was retained at the buyer’s insistence) then supposedly independently arrived at the same results. Based in part on myriad problems with the financial projections and analyses underlying the valuation firm’s work, the Court found that Caris breached its contract with option holders; determined that the value of TargetNow and Carisome combined was approximately $300 million; and awarded damages of approximately $16 million to the option holders’ for their interest.
Takeaways and Analysis
1. The Court repeatedly criticized as results-driven the analyses performed by Caris’ valuation firm regarding TargetNow and Carisome. Contrasting the work performed on the transaction with contemporaneous emails and financial analyses from this same firm, the Court found that Caris’ valuation advisor manipulated downward its valuation of TargetNow and Carisome to achieve a desired zero-tax outcome at the corporate level for the spin-off of TargetNow and Carisome, thereby fatally undermining the credibility of its work.
For instance, for purposes of the challenged transaction, TargetNow was valued at $47.23 million. Three years earlier, however, Caris paid $40 million for TargetNow when it was generating only $1 million in annual revenue. By the time of the Miraca transaction, revenue had increased 5,000% to approximately $50 million, yet the valuation firm and management were suggesting that the Court accept a valuation reflecting an increase in value of only 17%. Likewise, “ordinary course” asset impairment analyses valued TargetNow’s trade name and clinical database alone at $104 million excluding debt. Similarly, JH Whitney, a “sophisticated private equity firm,” gave a presentation to the fund’s advisory board valuing its 26.7% stake in TargetNow at $41 million, implying a $153 million valuation for the company.
The situation with Carisome, valued for purposes of the spin at $17.79 million, was no different. The Court found that the “major purpose’ of the entire Miraca transaction was to provide ongoing funding for Carisome, and the controlling stockholders invested $100 million of the proceeds of the sale to fund that company, reflecting confidence in its prospects. In addition, the valuation firm’s stock option analyses for Caris only months earlier valued Carisome at between $116 and $199 million. This and similar evidence fundamentally undermined the $17.79 million valuation.
2. The Court had many issues with the valuation firm’s analyses. Among other things, the Court found that the valuation firm: (i) did not perform a comparable companies analysis even though only months before, during its “ordinary course” work, it deemed another transaction in fact to be comparable (and that transaction implied a significantly higher valuation for TargetNow but such a valuation would have frustrated the goal of a tax-free spin-off); (ii) reached the same valuation for Carisome as the tax advisor despite using materially different inputs in its analysis, such that the “only possible explanation” was that the valuation firm “did not prepare its table independently”; (iii) simply copied the tax advisor’s report, doing so blatantly such that “the output matched . . . even when the inputs differed”; (iv) used for its analysis “the cost method” and rejected other valuation methods, all of which “conflicted with all of its prior valuations”; (v) for the spin-off opined that it is not possible to accurately forecast cash flows notwithstanding that its ordinary course analyses “relied on management projections and used” discounted cash flow analyses based on those projections; (vi) “made significant errors,” including mistakenly using a company’s trailing nine-month revenue for 2010 instead of projected twelve-month revenue for 2011; (vii) based its valuation on the tax advisor’s work, which did not determine the common stock’s fair market value, but instead was intended to determine intercompany transfer tax liability – as a result, certain assets were excluded, including goodwill.
Taken together (and perhaps in some instances individually), these issues led the Court to conclude that the valuation firm’s analyses were “so flawed as to support both an inference of bad faith and a finding the process was arbitrary and capricious.” The Court characterized it as a “new low” in terms of situations leading to decisions criticizing erroneous or outcome-oriented analyses.
In a variety of contexts, the Delaware Chancery Court has seized on evidence that advisors are manipulating their analyses to support an outcome desired by a seller’s management or board to discount or completely disregard the advisors’ work. See LongPath Capital, LLC v. Ramtron Int’l Corp., C.A. No. 8094-VCP (Del. Ch. June 30, 2015); Merlin Partners LP v. AutoInfo, Inc., C.A. No. 8509-VCN (Del. Ch. Apr. 30, 2015); In re: El Paso Pipeline Partners, L.P. Deriv. Litig., C.A. No. 7141-VCL (Del. Ch. Apr. 20, 2015); In re Rural/Metro Corp. S’holders Litig., C.A. No. 6350-VCL (Del. Ch. Oct. 10, 2014); Chen v. Howard-Anderson, C.A. No. 5878-VCL (Del Ch. April 8, 2014); In re Orchard Enter., Inc. S’holder Litig., C.A. No. 7840-VCL (Del. Ch. Feb. 28, 2014).
Analyses performed in the ordinary course of business or on a “clear day” typically will be afforded significantly more weight than analyses based on different methodologies prepared in connection with a particular transaction or for litigation. It also is difficult to overstate the importance a court will attach to contemporaneous emails and analyses, particularly when they conflict with work performed to achieve a desired outcome or for litigation. The Chancery Court has made clear in this series of decisions its view that outside financial firms must maintain the integrity and credibility of their work and their own independence in order for their efforts to provide any support to a transaction that is subject to challenge.
3. The Court’s analysis of witness credibility is noteworthy.
With respect to the controller and CFO, the Court observed that they admitted having “engaged in fraud” with respect to Miraca. The controller testified, for instance, that the projections provided to the buyer were a “fantasy land,” “an impossibility,” and “intentionally exaggerated.” He made these statements in order to persuade the Court not to credit those projections over the ones supporting the valuation firm’s lower valuations leading to a zero-tax outcome. But the Court recognized that, by so testifying, the controller and CFO “entangled themselves in a double liar problem. They asked me to believe them now that they were lying then. . . .” To the Court, they had a fundamental “credibility problem: their willingness to say what they believed would help them in this litigation, regardless of whether it is actually true.” The Court therefore did not credit their testimony even though it also found that neither was “inherently bad or malicious. Like all of us, they are multidimensional. . . . But humans respond to incentives, and powerful incentives can lead humans to cross lines they otherwise would respect.”
The Court also pointed out that, except for the controller and CFO, the defense witnesses seemed honestly to believe that TargetNow and Carisome had “very little value in fall 2011.” The Court attributed this testimony to “hindsight bias” produced by actual results following the Miraca transaction – Target Now did not reach profitability and Carisome did not develop a marketable product. The defense witnesses “testified with conviction that they believed these things in the fall of 2011, but the contemporaneous evidence showed they did not.” To the Court, the “bias results from the fact that those who know the outcome cannot ignore that knowledge as they try to perform an objective evaluation of the” prior situation.
The Court’s references to the “double liar” problem and “hindsight bias” in discounting witness testimony, while at the same time either refusing to vilify those witnesses (in the cases of the controller and CFO) or concluding that the witnesses were testifying honestly but inaccurately (in the case of other company witnesses), reflects a nuanced approach to assessing the credibility of witnesses. And that credibility is just as important as supportive contemporaneous documentary evidence. It goes without saying that a court’s conclusion that a witness is not credible could prove as damaging as contradictory contemporaneous documents.