Ryan v. Tad's Enterprises, Inc.

COURT OF CHANCERY OF DELAWARE, NEW CASTLE
709 A.2d 682; 1996 Del. Ch. LEXIS 54 (1996)


Minority shareholders of Tad's Enterprises (5.5% / 31,600 shares) brought an appraisal action in Delaware court after a cash-out merger in which they were offered $13.25 per share.  Even though Tad's stock had traded at between $0.25 and $4.00 prior to the merger, the plaintiffs claimed their shares were worth significantly more than the merger price.

Tad's Enterprises had three main businesses:  six steakhouses in the New York City area that had been sold immediately before the cash-out merger, an algae supplement marketing company (Cell Tech), and an alternative energy power producer (EPG).  THe steakhouses were sold on May 4, 1988 and on the next day, Tad's Enterprises effected a cash-out going-private merger in which minority shareholders received  $13.25 per share, based on a board appraisal of the company's sales proceeds, Cell Tech and EPG.  After the merger, the majority shareholders retained control of the restructured company.

During discovery the plaintiffs learned that the majority shareholders had sold the company's six steakhouses  without obtaining any independent valuation and had negotiated for themselves a $2 million consulting/non-compete agreement as part of the restaurant sale. The minority shareholders added claims of fiduciary breach, as Delaware law permits, on the ground the asset sale and merger lacked fair dealing and a fair price.

The court agreed with the plaintiffs on the merits and concluded:

The following excerpts from the court's opinion focus on the valuation of Cell Tech:

d) The Valuations of Cell Tech and EPG

The plaintiffs next claim that the Tad's board undervalued Cell Tech and EPG in the Merger. Specifically, the plaintiffs argue that in arriving at the Merger price, (a) the board valued Cell Tech based solely on Tad's historical dollar investment in that business ($ 563,000), without taking into account Cell Tech's significant future earnings potential; and that (b) EPG was valued at net book value ($ 1,136,000) which not only was an improper measure of EPG's fair value, but also was understated because it was the product of accelerated depreciation accounting treatment.

The plaintiffs also point to post-Merger events as confirming the unfairness of the board's valuation of Cell Tech. Four months after Cell Tech was valued at $ 563,000 for purposes of the Merger, the manager of Cell Tech, Daryl Kollman, and his wife offered to buy Cell Tech from Newco for $ 1,330,000, payable in three year notes. The Townsends rejected that offer. Later, in September 1989, one and one-half years after the Merger, the Townsends granted the Kollmans an option, exercisable for six months, to purchase Cell Tech for $ 4,400,000. The option was not exercised. Finally, in August 1990, two and one-half years after the Merger, the Kollmans purchased outright the assets of Cell Tech from Tad's (then a subsidiary of Newco) for $ 3,789,470. Approximately $ 3.5 million of that purchase price took the form of a ten year note at 19% annual interest; another $ 200,000 took the form of a five year note at 13% annual interest. In that transaction, Tad's also obtained the right to receive certain additional "override" payments based on Cell Tech's future revenue. Between August 1990 and the October 1994 trial, those "override" payments totaled $ 741,568. The plaintiffs argue that the foregoing facts establish that the board's $ 563,000 valuation of Cell Tech in the Merger was not fair.

The plaintiffs contend that the board's valuation of EPG was also not fair. As earlier noted, EPG was valued at its book value less an outstanding $ 400,000 loan, for a net book value of $ 1,136,000. That net book value figure reflected the accelerated depreciation of EPG's capital assets over five years, rather than over those assets' thirty year useful life.

The plaintiffs contend that the defendants knew that the use of a book value based on accelerated depreciation would understate EPG's fair value. Indeed, during the trial Mr. Bressler admitted that the Board "knew the depreciation was very heavy and, therefore, the profit and loss was not an accurate measure of its value to us." (Tr. at 566). If the board knew that the artificially high annual depreciation charges distorted the profit and loss statement, then, the plaintiffs argue, they must also have known that those charges would also distort EPG's balance sheet. * * *

The defendants have failed to respond both to the foregoing challenges of the EPO and Cell Tech valuations and to the plaintiffs' prima facie showing that the Merger price was unfair. That is, the defendants have made no effort to show that those valuations were fair. Instead, they attempt to sidestep the entire fairness issue by arguing that the appropriate measure of damages is Tad's statutory appraisal value, which (defendants claim) is less than the value the plaintiffs seek as the measure of damages. Because the defendants made no serious effort to defend the fairness of the board's valuation of EPO or Cell Tech, and because the Court has found that the plaintiffs' fair price arguments are meritorious and that the value of Tad's far exceeds the Merger price (see Part IV, infra), it follows that the defendants have failed to establish that their valuation of Tad's in the Merger was fair.

* * *

To summarize, the defendants have failed to prove to the Court's satisfaction that the Asset Sale and the Merger were the product of fair dealing or that they yielded a fair price. The absence of any adequate independent representation or procedural safeguards to protect the minority shareholders' interests; the absence of persuasive evidence that the consulting and non-competition agreements had significant value; the $ 563,000 valuation of Cell Tech in the Merger, followed by a $ 1.3 million offer for that same business (which the Townsends rejected) only four months later; and the defendants' failure to justify the board's valuation of Cell Tech and EPG -- all impel me to conclude that the Asset Sale and Merger cannot pass the test of entire fairness. The defendants, accordingly, are liable to the plaintiffs for breaching their fiduciary duty of loyalty. The question then becomes: what is the extent of that liability?

B. The Damages Valuation

Having determined the nature of the damages to be awarded, the Court must next determine the appropriate valuation for each of the disputed components of Tad's at the time of the Merger. The following table provides an overview of the parties' valuation positions n21 and the result this Court ultimately reaches:

Valuation:

Tad's 
Board
The 
Plaintiffs
The
Defendants
The 
Court
Asset Sale 
6,224,750 
8,224,750 
6,224,750 
8,224,740
per share
$ 10.87 
$ 14.37 
$ 10.87 
$ 14.37 
Excess Tax Reserve 
-- 
1,366,695
--
1,366,795
per share 
--
$ 2.39 
--
$ 2.39
Indemnification 
(337,518)
--
(337,518) 
--
per share 
($ 0.59) 
--
($ 0.59)
--
Cell Tech
563,000 
3,872,390 
833,000 
2,923,760
per share 
$ 0.98
$ 6.77
$ 1.46 
$ 5.11
EPG
1,136,000 
2,390,000 
772,005 
1,136,000 
per share
$ 1.99 
$ 4.18 
$ 1.35 
$ 1.99 
Other Claims
-- 
1,617,000 
-- 
-- 
per share 
--
$ 2.83 
--
--
TOTAL n22 
7,586,232 
17,470,935 
7,492,732 
13,651,265 
per share 
$ 13.26 
$ 30.54 
$ 13.10 
$ 23.86 

n21 Actually, the plaintiffs contend that the fair value of Tad's is $ 31.07 per share and the defendants contend that the fair value is $ 13.69 per share. However, both of these figures are based on an error m calculation. Both the plaintiffs and the defendants assume that the $ 6,224,750 net proceeds from the Asset Sale (determined by the Tad's board) are net of the $ 337,518 payment to the Townsends relating to the Asset Sale indemnity. However, as the Tad's board meeting minutes (DX 77 at 6-7) and the Tad's proxy statement (PX 86 at 11) make clear, that is not so. The error is corrected here.

n22 The difference between the board's valuation of Tad's ($ 7,586,232) and the value realized by Tad's shareholders ($ 7,579,848) is accounted for by the Board having rounded the $ 13.26 per share value down to $ 13.25 per share.
 

[After discussing the reasons for adjusting the asset sale price (the consulting/non-compete agreement and the indemnifiation and tax reserves), the court turned to the valuation of the other two businesses.]

3. Cell Tech Damages

The plaintiffs advance three separate valuations of Cell Tech. The first assumes a rescission of the Cell Tech sale. Under that approach, the plaintiffs claim entitlement to: (i) their proportionate share of all Cell Tech profits between the Merger date and the August 1990 sale of Cell Tech to Daryl Kollman, (ii) all payments received from Kollman between the August 1990 sale and the date of trial, and (iii) the present value of all future (i.e., override) payments. Because this valuation would amount essentially to an award of rescissory damages, it will not be considered for that reason. n23 See Part IV A, supra of this Opinion.
n23 In conjunction with their calculation of rescissory damages, the plaintiffs also rely on a so-called "cash collection" methodology which, at the eleventh hour, they attempted to introduce into the case by slipping a reference to it into the pretrial order. Because the plaintiffs failed to provide the defendants with fair pre-trial notice of their intention to use this methodology, the Court will not consider it either.
Second, the plaintiffs advocate a "liability action" valuation methodology, based upon the value of the notes the Kollmans paid to purchase Cell Tech in August 1990. To that value plaintiffs add the discounted value of all override payments Tad's received from the Kollmans through the October 1994 trial date, plus the discounted value of projected override payments receivable between October 1994 through July 2000. The sum of these amounts is claimed to represent Cell Tech's value at the time of its sale to the Kollmans in August 1990. From that value the plaintiffs subtracted Cell Tech's after-tax earnings for the period May 1988 through August 1990, to arrive at a net valuation of $ 4,070,490 for Cell Tech as of the Merger date.

The defendants contend that this approach would also be tantamount to awarding rescissory damages in a slightly different form, because it rests upon 20/20 hindsight and fails to take into account the significant business risks Cell Tech faced at the time of the Merger. Specifically, the defendants argue that this methodology does not reflect the risks that Cell Tech's future profitability depended critically upon the continued success of a single "fad" product line, and that Cell Tech's business could be shut down at any time by a U.S. Food and Drug Administration ("FDA") enforcement action. n24 Finally, the defendants argue that this valuation approach fails to account for the Townsends' nearly $ 1 million post-Merger investment in Cell Tech, and assumes an unrealistically low discount rate. I conclude that these objections are well founded and reject this second approach as well.

n24 Prior to 1988, Cell Tech had been found by the FDA to have violated various provisions of the Federal Food, Drug & Cosmetics Act by, inter alia, making unsubstantiated therapeutic claims. (DX 28).
The plaintiffs' third methodology is a discounted cash flow valuation -- an approach the defendants also advocate. In that context, the only subject on which the parties disagree concerns the projections of future Cell Tech cash flows that should be used in the model. For the following reasons, the Court adopts this methodology to value Cell Tech for purposes of determining an appropriate damages award.

The record discloses significant evidence of Cell Tech's value as reflected in the dealings between the Town sends and Daryl Kollman in connection with the sale of Cell Tech. Four months after the Merger, Kollman offered to buy Cell Tech for approximately $ 1.33 million, payable in three year notes. The Townsends' rejection of that offer evidences their belief that Cell Tech was worth more than $ 1.33 million. The question is how much more. As earlier stated, one year later the Townsends granted the Kollmans an option to purchase Cell Tech for $ 4.4 million, but the Kollmans did not exercise that option. Finally, two years after the Merger, the Kollmans purchased Cell Tech outright for $ 3.8 million, consisting mostly of notes payable at 19% interest, plus an override on future sales. By 1990, however, Cell Tech's circumstances had changed dramatically and other value-creating events unrelated to the Merger had intervened.

These indications of value, while helpful to some extent, are not a satisfactorily reliable measure of Cell Tech's value at the time of the Merger. Thus, while these post-Merger values should and will be considered as a "reality check" of any independently determined valuation of Cell Tech as of the Merger date, the discounted cash flow valuation methodology that both sides have used and endorsed is the approach that merits the] greatest confidence.

The discounted cash flow valuation model is well-established and accepted in the financial community. Applied as of the Merger date, that methodology also best implements the Court's determination that any award of damages should reflect the Merger value Tad's would have been given had no fiduciary violations occurred. Moreover, that approach does not incorporate any values caused by unrelated, independent post-Merger events, and thereby avoids the risk that elements of rescissory damages might reappear through the back door.

The plaintiffs' cash flow projections, discounted at a rate of 17.7%, yield a valuation for Tad's of $ 3.9 million. The defendants' projections, discounted at a rate of 30%, result in a valuation of $ 833,000. The $ 3.1 million difference is largely attributable to the parties' differing assumptions about Cell Tech's revenue growth and what discount rate is appropriate. Those two disputed items are now addressed.

(a) Revenue Projections

The parties' revenue projections as of the Merger date are depicted in the chart below:

 
 
1987
1988
1989
1990
1991
1992
1993
Plaintiff's 
797
3,073 
3,679 
7,852
16,757 
16,757
16,757
Defendant's
797
3,073
4,608
6,912 
9,677
13,548
16,257
FY to Apr. 30 (1987 and 1988 Hist) (1989-1993 Proj) (all in 000)

In my view, the more credible cash flow projections are those advocated by the plaintiffs. I base that conclusion upon several facts that were known or readily apparent at the time of the Merger. First, Cell Tech, in the hands of Daryl Kollman, was worth at least of $ 1.33 million. That Kollman offered -- and the Townsends rejected -- $ 1.33 million only four months after the Merger, strongly evidences that neither Cell Tech's managers nor the Townsends believed that Cell Tech was worth as little as $ 833,000 as of the Merger date.

Second, at the time of the Merger, Kollman was Cell Tech's most likely buyer. ] During the Townsends' periodic employment contract negotiations with Kollman, Kollman repeatedly expressed his dissatisfaction with the compensation structure of Cell Tech. (See, e.g., Tr. at 564). Moreover, it is apparent that Kollman's continued management of Cell Tech was crucial to Cell Tech's continued success. Those circumstances created a foreseeable possibility (if not likelihood) that Kollman would offer to acquire Cell Tech. Indeed, the fact that only four months after the Merger Kollman offered to purchase Cell Tech, and only one year later the Townsends granted the Kollmans the $ 4.4 million option to buy Cell Tech, further supports the inference that the Townsends probably anticipated an eventual purchase of Cell Tech by the Kollmans before the Merger in May, 1988.

Third, and finally, in adopting the plaintiffs' projections I cannot ignore Cell Tech's actual performance. By the 1990 fiscal year, Cell Tech's annual sales were close to $ 10 million; by the time of the trial, they were running close to $ 40 million. (DX 57; PX 139). That performance is consistent with Daryl Kollman's prediction, expressed in a letter he wrote to the Townsends before the Merger, that Cell Tech had "been in the 'hard work, low profit' stage for the last three years ... [but had] just started the rapid growth phase which precedes the 'hang onto your hats' phase." (PX 15). For this reason as well, the defendants' highly conservative revenue projections for Cell Tech at the time of the Merger lack credibility. n25

n25 The defendants also challenge of the plaintiffs' projections on the grounds that the plaintiffs failed to account for Kollman's profit participation and to subtract a debt owed by Cell Tech to its former owners, and that they also erroneously included a franchise fee in Cell Tech's profits. On that score I am satisfied that the plaintiffs have either proved the defendants' objections to be misguided, or have otherwise adequately explained the basis for their experts' choice of numbers. (Revised Post-Trial Reply Brief of Petitioners and Plaintiffs in the Consolidated Actions at 30-34).

Accordingly, I adopt the plaintiffs' "total free cash flow" projections, which are as follows:

Fiscal Year to Apr. 30
Court
1989
290.0 
1990
169.3
1991
361.3
Terminal value
5,350.4
(b) Discount Rate

The other subject of the Cell Tech valuation dispute is the appropriate discount rate. On that issue, the defendants have the better side of the argument. Although both sides argue that their respective discount rates are supported by the Capital Asset Pricing Model ("CAPM"), their chosen rates differ vastly. The plaintiffs' discount rate is 17.7%; the defendants', 30%.

However, only the defendants have mathematically applied the CAPM to derive quantitatively the discount rate they propose. n26 Moreover, the plaintiffs' 17.7% discount rate relies heavily upon a highly questionable assessment of company-specific risk. In selecting their 30% rate, the plaintiffs' expert derived Cell Tech's beta, (which is a measurement of the risk of a particular company relative to the market) from the beta of a "comparable" company that represented an investment less risky than Cell Tech. The plaintiffs' expert relied primarily upon a New York Stock Exchange-traded company that had a beta of 2.2 and that owns and operates a national health food retail store chain and sells multiple health food products. The plaintiff's expert derived Cell Tech's beta of 2.0 from this "comparable" company's beta of 2.2, thereby suggesting that Cell Tech involved lower risk than did the "comparable" company. The comparison is factually unsupported. The plaintiffs have not persuaded this Court that their 17.7% discount rate is realistic.

n26 The defendants calculated a discount rate of 26.5% using the CAPM. The defendants' expert explained that on the basis of his experience, he considers 30% to be more appropriate, given the risks associated with Cell Tech. Unlike the defendants, the plaintiffs never demonstrated how precisely they derived their discount rate from the CAPM.
I recognize that the defendants' 30% discount rate is unusually high, but the record demonstrates that Cell Tech, at the time of the Merger, was an unusually risky investment. Cell Tech faced regulatory, management, and "fad" product-related risks, any one of which could result in that company's failure. I find it entirely plausible that a prudent investor in a venture of that kind would demand an annual return in the 30% order of magnitude. Accordingly, I adopt 30% as the appropriate discount rate for valuing Cell Tech's projected future cash flows.

The plaintiffs' cash flow projections, discounted at the rate of 30%, yield a $ 2,923,720 net present value for Cell Tech as of the Merger date, which amount is the adjudicated value of Cell Tech for purposes of calculating damages.

4. EPG Damages

The plaintiffs also seek damages for the undervaluation of EPO, measured as their pro rata share of their expert's $ 2,390,000 valuation. Using a similar discounted cash flow methodology, the defendants' expert concluded that EPG should be valued at far less -- $ 445,000.

Although I ultimately do not accept it, I find the defendants' expert's discounted cash flow valuation of EPG to be the more credible. First, the plaintiffs' expert assumed that EPG would realize annual 4% price increases for the power it produces. But EPG's prices are linked to coal prices, and at the time of the Merger, future coal prices were forecasted to be flat or falling. Accordingly, the defendants' assumed 1% growth rate is more realistic. Second, the plaintiffs' expert assumed fixed annual operating and maintenance fees of $ 45,000, even though that figure was based on EPG's experience when one of its two power generators was brand new. The defendants' estimate that these operating costs would rise to $ 60,000 per year is the more plausible. Finally, the higher rate of parasitic power consumption that the defendants' expert assumed is supported by the testimony of the plaintiffs' own expert. Without resolving each disputed detail of the two sets of projections, I am persuaded that the defendants' cash flow projections for EPG are the more accurate, and I accept them.

However, that docs not end the analysis. Although I reject the plaintiffs' valuation of EPG, I cannot accept the defendants' lower valuation either, because it is significantly less than the value that the Tad's board approved in the Merger. To adopt a lower value would be inequitable. Given the adjudicated disloyalty of the directors, I find the $ 1,136,000 value they fixed for purposes of the Merger to be the lowest acceptable valuation of EPG for damages calculation purposes.

V. CONCLUSION

For the reasons previously set forth, judgment will be entered in favor of the plaintiffs and against the defendants in the amount of $ 753,976, plus prejudgment interest calculated at the rate of 7.33% from May 5, 1988 to the date of judgment, plus costs to be determined (in the absence of an agreement among the parties) in a later proceeding. Counsel shall confer and submit a form of order implementing the foregoing rulings.