From Leiden tot Delaware: How empirical legal research on valuation biases was used in a US courtroom
A paper by Marc Broekema and colleagues found that psychological biases can have a detrimental impact in corporate disputes – a conclusion recently cited by the Delaware Court of Chancery in the US.
In 2016, the Delaware Court of Chancery in the US published its Opinion in the Dell Inc. statutory appraisal action, which arose out of the 2013 management buyout led by the company’s founder, Michael Dell. After having been publicly listed for 25 years, the company went private and Michael Dell acquired Dell for $13.96 per share. Some shareholders did not agree with the defined price and started an appraisal proceeding. The petitioners’ expert used a DCF analysis (a common and prominent business valuation method) to opine that the company had a fair value of $28.61 per share on the closing date, while the respondents’ expert used a DCF analysis to opine that the company had a fair value of $12.68 per share on the closing date. How can it be that two highly respected valuation experts, applying the same valuation principles, generated valuations that differed by 126%, or approximately $28 billion? In a recent paper, Marc Broekema and his colleagues adopted a psychological lens to better understand the source of such widely differing valuation outcomes in valuation disputes. The paper was recently cited by that same Delaware Court of Chancery in a recent valuation dispute involving telecom giant AT&T.
In this blog, we will discuss (1) what valuation disputes are and why these are problematic; (2) the main findings of our recent paper on biases in valuation disputes; and (3) a recent Memorandum Opinion issued by Court of Chancery of Delaware in which the paper was used.
Biases in valuation disputes
Valuation disputes typically arise when there is disagreement in perceptions of the fair value of the shares in a company. Valuation issues are becoming increasingly frequent and important, also in light of the recent Dutch scheme of arrangement (known as WHOA) where a comparison is to be made between the reorganisation value of a company (going concern) and its liquidation value. Only if the former is higher than the latter does the proposed restructuring and continuation of a company make sense. Even though the prominent DCF method is a robust, advanced and well-developed valuation method, widely differing valuation outcomes can still be observed when different valuators value the same company using the same valuation method and the same information, as illustrated by the Dell case. How can this be possible?
In a recent paper by Marc Broekema and his co-authors in the Journal of Behavioral Finance, it was demonstrated that business valuators can be susceptible to so-called biases. Specifically, the paper showed that business valuators are unconsciously affected by the interests of their clients. If a valuator represents the buyer in a transaction or dispute, they are more likely to arrive at a fair value that is lower than when a valuator represents the seller in that same situation. Hence, it appears that the financial interests of valuators’ clients affects their valuations, a bias that the authors have dubbed the ‘engagement bias’.
US Delaware Court of Chancery on biased valuations
With more than 200 years of judicial precedent, the Delaware Court of Chancery is a non-trial jury court that is recognised as the US’ most prominent forum for handling corporate disputes, involving the affairs of thousands of companies, including the majority of Fortune 500 companies and companies listed at the New York Stock Exchange and NASDAQ.
On March 9 2022, the Court of Chancery of Delaware issued a Memorandum Opinion – a post-trial ruling – in favour of former investors in a regional telecom operator in Oregon (US), named Salem Cellular Telephone Company. According to the Memorandum Opinion, AT&T caused Salem to transfer all of its assets and liabilities to an AT&T affiliate for $219 million, dissolved Salem, sent each shareholder in Salem a payment equal to their pro rata share of the liquidating distribution, and continued to operate the business of the dissolved company Salem.
The minority shareholders received approximately $4.1 million for their interest in Salem (which was 1.881%), based on the valuation of Salem conducted by respected valuation firm PwC on behalf of AT&T.
However, the minority shareholders asserted they were paid an unfair price. In the end, the Delaware Court ruled that AT&T had failed to establish that the transaction was the product of both fair dealing – which includes examining factors such as the independence of financial advisors and the quality of their valuation opinions – and fair price (i.e. the Entire Fairness Test). As a result, the Court ruled that the plaintiffs are entitled to damages of $9.3 million, excluding pre- and post-judgement interest.
A relevant observation in this Memorandum Opinion is AT&T’s defence that their valuation advisor PwC was an independent firm. However, the Court noted that ‘valuation professionals reach outcomes that are influenced by the interests of the party that retains them, even when ostensibly acting as disinterested experts’. In arriving at this conclusion, the paper by Marc Broekema and his co-authors was cited and discussed to support the claim that valuators can be biased as a result of their clients’ interests.
This recent case not only highlights the key role that valuations typically play in corporate disputes, it also stresses the importance of empirically testing foundational principles, such as the independence and objectivity of valuators. We consider it encouraging that a leading Court is aware of the detrimental impact that psychological biases can have in corporate disputes, and are pleased our work has been cited as part of this case.