Salem Cellular Telephone Company (the “Partnership”) was a Delaware general partnership that held a license to provide cellular telephone services in a geographic area centered around Salem, Oregon. Minority partners owned 1.881% of the Partnership, while the remaining controlling interest was held by an indirect, wholly-owned subsidiary of AT&T, Inc. In October 2010, AT&T caused the Partnership to transfer all of its assets and liabilities to a recently formed affiliate of AT&T, liquidate the Partnership, and pay liquidating distributions to the minority partners based on their pro rata share. As consideration, AT&T paid the Partnership $219 million in cash based on an appraisal done by a valuation firm (PwC) retained by AT&T.
Vice Chancellor Laster ruled that the transaction functioned as a freeze-out of the minority partners and is subject to the entire fairness standard of review. As a result, AT&T bore the burden of establishing “to the court’s satisfaction that the transaction was the product of both fair dealing and fair price.”1 The court found that AT&T failed on both accounts.
The court ruled that AT&T breached its duty of loyalty to the minority partners by failing to follow a fair process, citing the following factors:
- AT&T did not employ any procedural protections to ensure fairness to the minority partners. No special committee or other independent bargaining agent negotiated on behalf of the minority partners, and no one had the ability to veto the deal.
- While the Partnership had a minority representative on the Executive Committee, and the Executive Committee could have empowered the minority representative to negotiate, AT&T did not engage with the minority representative.
- AT&T did not condition the transaction on a majority-of-the-minority vote.
- AT&T hired an outside valuation firm (PwC) that had a long-standing relationship with AT&T. The court indicated “the evidence is mixed” regarding the process, procedures, information reliance, assumptions, and analyses done by PwC in its appraisal of the Partnership. The court also found that AT&T withheld certain critical information that limited PwC’s ability to value the Partnership.
- AT&T created a coercive, two-tier offer that pressured the minority partners to accept a pre-transaction price at a 5% premium to the PwC valuation or else be cashed out following the transaction at the lower PwC value.
- AT&T acted for the primary purpose of acquiring the minority partners’ interests “before the data revolution caused the value of the Partnership to increase” and for less than the value that the minority partners otherwise would have received in distributions estimated in other AT&T internal analyses.
AT&T also breached its duty of loyalty to the minority partners by imposing an unfair price. While the transaction was based on the PwC valuation, AT&T did not rely on PwC’s valuation to prove the fairness of the transaction price. Rather, AT&T hired a second expert who determined a value range of $171.3 million to $224.1 million for the Partnership and opining that the $219 million determined by PwC “represent[ed] at least [the] Fair Value of the Partnership equity interests.”
The court cited critical problems with both appraisals of the Partnership.
- As an over-arching matter, the court was critical of the financial information reported for the Partnership. AT&T’s legacy system for allocating subscriber revenues and expenses to a given geographic market (including the Partnership) was outdated and inaccurate. AT&T was unable to know the number of subscribers who resided in the Partnership’s service area and “could not say whether the [Partnership’s] subscriber counts were off by 25%, 50%, or even 75%.”
Related, AT&T disregarded metrics specified in the Partnership’s Management and Network Sharing Agreement (the “Management Agreement”) to allocate revenues and expenses to the Partnership and instead used “their own judgment about what would be ‘fair and reasonable.’” The court indicated that the allocation methodology in the Management Agreement would have produced more favorable financial results for the Partnership relative to the method used by AT&T.
- The court concluded that AT&T failed to prove that the use of comparable public company multiples and comparable M&A transaction multiples as applied in this case provided reliable evidence of the fair value of the Partnership. As such, the court focused its critique on the discounted cash flow (“DCF”) method used by the experts.
- The source of financial projections used in the valuations contained incorrect or unsupportable assumptions regarding beginning subscriber counts, subscriber additions, subscriber churn rates, subscriber mix, average revenue per user, and population growth rates. The projections also largely omitted the impact of connected devices on the Partnership’s financial performance. For these and other reasons, the court concluded that AT&T failed to prove the financial projections “were sufficiently reliable to support a meaningful valuation estimate.”
- Both appraisals applied AT&T’s blended tax rate of 38.5% “even though the Partnership is a pass-through entity that does not pay tax at the entity level.”
- Both appraisals used a perpetuity growth rate of 1.5%, which the court concluded “was unreasonably low” and had the effect of treating the Partnership as a “wasting asset” since the perpetual growth rate was lower than expected inflation.
For these and other reasons, the court concluded that AT&T completed the transaction “in a manner that was not entirely fair” and breached its duty of loyalty to the minority partners. For purposes of crafting a remedy, the court sought “to determine the value of what the plaintiffs had before the [transaction] based on the operative reality of the Partnership at that time of the transaction.”
The court relied on the DCF method to realize its remedy. In spite of the criticisms raised by the court about the accuracy of the Partnership’s financial information, it used the financial projection model employed by AT&T’s experts as a basic framework because “the financial records that AT&T maintained are all that we have.” However, the court corrected several of the “erroneous and unreliable assumptions” used by AT&T’s experts to “arrive at a responsible estimate of damages.”
Following is a summary of the primary assumptions used by the court in its DCF analysis.
- The court generally used more favorable estimates for subscriber counts, subscriber additions, subscriber churn rates, subscriber mix, average revenue per user, and population growth rates. The assumptions were sourced to either market research reports or estimates for AT&T’s wireless business overall.
- The court used a tax rate of 0% in its valuation because the operative reality of the Partnership was that the plaintiffs received distributions from an entity that did not pay an entity-level tax. The omission of an entity-level tax also considered the plaintiff’s contention that the purpose of the court’s analysis was to estimate damages rather than to conduct an appraisal of the Partnership.
- The court estimated a weighted average cost of capital (WACC) by using AT&T’s financial metrics for most components, including AT&T’s beta, cost of debt, tax rate, and capital structure, citing that the Partnership was a market-level entity that operated as part of AT&T’s nationwide business. However, the court included a size risk premium because the Partnership was a smaller company than AT&T and operated in a non-diversified local market that made its revenues vulnerable to competitive and economic conditions within its geographic footprint.
- The court used a perpetuity growth rate of 2.7%, which adopts the high end of the range for real growth in GDP offered by the experts. The higher growth rate recognized that “AT&T anticipated significant growth in its wireless business and that although the legacy voice wireless was maturing, AT&T expected growth from a host of other wireless-related businesses.”
The court’s concluded damages remedy implies a valuation of $714 million for the Partnership, a premium of 226% to the transaction price.
- Cinerama, Inc. v. Technicolor, Inc., Supreme Court of Delaware, July 17, 1995.