In re Appraisal of Orchard Enterprises, Inc.: Court of Chancery Declines to Give Liquidation Preference of Preferred Stock Effect in Appraisal of Common Stock
September 5, 2012
In In re Appraisal of Orchard Enterprises, Inc., 2012 WL 2923305 (Del. Ch. July 18, 2012), the Court of Chancery, in a post-trial decision, determined that the petitioners, certain common stockholders of The Orchard Enterprises, Inc. (“Orchard”), were entitled to $4.67 per share, rather than the $2.05 per share they received in a going-private transaction.
Orchard is a specialty music company which primarily generates revenue through the retail sale of a catalog of licensed music through digital stores such as Amazon and iTunes. Prior to the going-private transaction, Orchard was traded on the NASDAQ stock exchange. A large block, around 40%, of Orchard’s common stock was owned by Dimensional Associates, LLC (“Dimensional”), which also owned nearly all of Orchard’s preferred stock. Because the preferred stock could vote on an as-converted basis, Dimensional controlled 53% of the voting power of Orchard’s outstanding stock.
In July 2010, Orchard’s common stockholders were cashed out for $2.05 per share in a merger with Dimensional (the “Merger”). The petitioners claimed that the value of each Orchard common share was $5.42 at the time of the Merger. Respondent Orchard maintained that the Merger was generous and that in fact each share of common stock was only worth $1.53. The Court stated that the primary issue behind the parties’ price disparity was whether a $25 million liquidation preference of Orchard’s preferred stock should be taken into account when valuing the common stock.
The certificate of designations governing Orchard’s preferred stock required payment of a $25 million liquidation preference to Dimensional in three circumstances: (i) a dissolution of the company, (ii) a sale of all or substantially all of Orchard’s assets leading to a liquidation, or (iii) a sale of control of Orchard to an “unrelated third party.” The Court held that the liquidation preference was not triggered by the Merger, noting that Dimensional still owned the preferred stock and could potentially receive the preference in the future.
Despite the fact that the liquidation preference was not triggered, Orchard asserted that the Court was required to take the liquidation preference into account during the valuation process. Orchard first argued that the common stock could not be properly valued without subtracting the $25 million preference because the preference was implicitly a negotiated part of the Merger. The Court quickly rejected this argument as “non-factual.” The Court held that the plain terms of the preferred stock’s certificate of designations required the payment of the liquidation preference in only three scenarios, none of which the Merger triggered.
The Court also rejected Orchard’s “market-based” argument that the value of the common stock should be reduced because the liquidation preference effectively created a $25 million dollar liability that should be factored into the appraisal price. According to Orchard, the real-world implications of Dimensional’s voting control and contractual rights as a preferred stockholder made payment of the preference a near certainty.
Siding with petitioners, the Court concluded that Orchard’s position was wrong as a matter of law. The Court found that the untriggered contractual rights of the preferred stock reflected only speculative value. In the context of an appraisal proceeding, the Court held that it could not assign value to a liquidation preference based on the occurrence of uncertain future events that did not have to occur by any particular time.
Although acknowledging that this argument “may be grounded in market realities,” the Court held that it nonetheless conflicts with the Delaware Supreme Court’s determination that an appraisal must be focused on a company’s going-concern value. That is, the company must be valued without regard to the possibility of liquidation or other “post-merger events or … possible business combinations.” Thus, because the specific terms of the preferred stock’s certificate of designations were not triggered by the Merger, the voting control and other blocking rights of the preferred stock were not accorded any value.
After resolving the liquidation preference issue, the Court went on to resolve various disputes between the parties over the proper valuation methods and metrics. The Court rejected a comparable companies or precedent transaction analysis, instead relying on a discounted cash flow (“DCF”) analysis.
Of note to practitioners familiar with the Court’s treatment of DCF analyses, the Court commented on the appropriateness of using a supply-side premium as opposed to a historical equity risk premium. The Court noted that in Global GT LP v. Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010), aff’d, 11 A.3d 214 (Del. 2010), it discussed a perceived shift in the academic community to favoring the supply-side equity risk premium.