The Debate Over the Efficient Market Hypothesis’ Effect on Contested Valuations

Context Matters

This is the second of a two-part article. The first part, which addresses the efficient market hypothesis, is titled Proponents of the Efficient Market Hypothesis Always Want More Cowbell. Although many valuation practitioners are generally indifferent to context when valuing a business or asset, in litigation, as well as other areas that require valuation services, context matters. In this article, the author discusses how context and the market efficiency hypothesis shape contested valuations in various types of valuation-related disputes.

Summary/Introduction

It is often easy to value publicly traded securities.  If shares in a company trade for $10 per share, those shares are typically worth $10 because that is the market clearing price for buyers and sellers.  It is, perhaps, for this reason that most valuation textbooks focus on the valuation of private companies, not public companies.

Nevertheless, large controversies can arise over the valuation of publicly traded securities and other valuations based on direct market data.  If the three most important factors in real estate are “location, location, and location,” it may be fair to say the three most important factors in understanding the semi-strong form of the efficient market hypothesis’ role in contested valuation are “context, context, and context.”

This is the second of a two-part article.  The first part, which addresses the efficient market hypothesis, is titled Proponents of the Efficient Market Hypothesis Always Want More Cowbell.

Overview of the Efficient Market Hypothesis

The efficient market hypothesis posits that any attempt to “beat the market” is destined to fail.  Failure is inevitable because there are potential market participants trying to profit on both sides of a transaction and their efforts cancel each other out.  This results in a net loss for active investors as their expected marginal costs exceed their expected marginal returns.

There are three forms of the efficient market hypothesis:

• Weak: This form applies to the ability to predict future prices based on previous prices;
• Semi-strong: This form applies to the market’s ability to rapidly and correctly incorporate all publicly available information; and
• Strong: This form applies to the market’s ability to rapidly and correctly incorporate all information, including information that is not publicly available.

It is possible for the market to be efficient yet not reflect the “correct” price.  This occurs when the market is efficient but not aware of material private information, which is the semi-strong form of market efficiency.  Many disputes over the relevance of market prices will turn on what information market participants had, or did not have, as of the valuation date.  Those disputes are often fact-specific and thus beyond the scope of this article, which focuses on generalizations.

Why Context Matters

Many disputes may turn on the valuation of a company or a security, but the valuation is often a means to an end and not the end itself.

From a valuation practitioner’s perspective, context should not matter too much because valuation drivers such as projections, discount rates, and multiples should be similar when valuing the same asset under the same standard and premise of value.  Thus, context does not matter much to a valuation practitioner operating in a vacuum.

However, from a litigator’s and judge’s perspective, context can matter a lot.  Sometimes litigators and judges place substantial emphasis on reasonably informed market data under the assumption that the market is reasonably efficient and is the best arbiter of valuation-related disputes.  Other times, litigators and judges place much less emphasis, or even ignore, reasonably informed market data under the assumption(s) that the market is not reasonably efficient and/or the market data is not relevant.  This explains why context can matter a lot to valuation practitioners.

Second Guess the Market

Sometimes the whole point of the valuation exercise seems to be to second guess the market.  For example, this seems to be the case for some shareholder-related disputes where certain shareholders exercise their appraisal rights and allege the company was sold too cheaply in a change-in-control transaction.  While there have been some cases that have focused on the market (deal) terms, many opinions focus on the “battle of the experts.”

These change-in-control transactions typically occur at a premium to the prevailing market price, and the board of directors often are not found to be disloyal.  If the market is semi-strong efficient, and key inside information was not withheld from the market, there would seem to be little to no need for appraisal actions.

Of course, a nuance is introduced if there is a difference in the standard of value between a publicly traded stock price and the standard required for shareholder-related disputes.  This can happen, for example, if the publicly traded stock price includes an implied minority interest discount as the standard of value for shareholder-related disputes often does not include such a discount.  However, that nuance can only go so far because (1) observed control premiums only go so high and (2) many observed control premiums include a payment for synergies that are not included in the standard of value for most shareholder-related disputes.

Nevertheless, the petitioner in appraisal actions often contends the stock was sold way too cheaply.  The typical case that goes to trial does not seem to entail a stock that traded at $10, was sold for $11, and the petitioner believes the stock was worth $12.  Instead, the petitioner in many cases believes the stock was worth $15, $20, or greater than $20, when the prevailing stock price was $10, which is 50%, 100%, or more than 100% greater than the prevailing stock price.  The typical case that goes to trial, from the petitioner’s perspective, seems to be about much more than just a potential wedge due to different standards of value.

It seems fair to conclude the petitioner (implicitly or explicitly) believes the prevailing market price was inefficient and/or that the “wrong” time was chosen to sell the company.  Of course, there is no such thing as a “wrong” time to sell if the market is semi-strong efficient and there is no material inside information.  Thus, when a petitioner successfully obtains a payment based on a value that is substantially more than the stock and deal prices, it often (implicitly or explicitly) means the finder of fact believed the market for that stock was inefficient.

Perhaps no recent case better demonstrates this point than the Dell appraisal matter.  The Delaware Chancery judge said there was an “anti-bubble [that] both facilitated the MBO [management buyout] and undermined the reliability of the market price as a measure of the Company’s value.”[1]  The “anti-bubble” was a consideration in the judge’s determination that the contemporaneous market price, and higher deal value, were too low relative to the fair value of the petitioners’ shares.

Defer to the Market

In other instances, the whole point of the valuation exercise is to identify what was foreseeable as of a valuation date several years in the past, in which case it often makes sense to defer to contemporaneous market participants’ views.  For example, this seems to be the case for many fraudulent transfer lawsuits where the plaintiff contends a company was looted prior to its bankruptcy filing.  These cases often turn (when the transfers are not immune from prosecution due to various safe harbors) on whether the company was insolvent on the disputed transfer date.  Naturally, the plaintiff contends the company was insolvent whereas the defendant contends the company was solvent.  Solvency is ultimately assessed based on valuation-related analyses.

Plaintiffs arguably start with an advantage in fraudulent transfer lawsuits because these lawsuits are typically triggered by a company’s bankruptcy filing within a certain period after the disputed transfer.  We know how this movie ended: the company filed for bankruptcy.  The issue often boils down to whether the subsequent bankruptcy filing was foreseeable as of the earlier disputed transfer date.  The plaintiff’s view boils down to “yes.”  Defendants will typically contend the plaintiff’s view is infected with hindsight bias and will argue the subsequent bankruptcy was not foreseeable.

Defendants also arguably start with an advantage in fraudulent transfer lawsuits because the disputed transfer was often financed with third-party money.  Lenders typically do not lend to companies that are not expected to repay the loan, so a strong argument can often be made that the contemporaneous loan is a real-time indicator of solvency that was backed with real money by real people.  Plaintiffs will typically contend that the defendant’s view is infected with plan-to-succeed bias and will develop arguments for why the contemporaneous decision to finance the loan was not based on reasoned judgment.

Ties (since both sides arguably start with an advantage) appear to go to the defendant as judges often defer to the semi-strong form of market efficiency in this context.  When there are dueling arguments of hindsight bias on one side and plan-to-succeed bias on the other side, with all litigation participants potentially infected with litigation bias, it seems logical for finders of fact to focus on informed contemporaneous market views.  This results in an (implicit or explicit) endorsement of the semi-strong form of the efficient market hypothesis.

Perhaps the best example is contained in the Third Circuit’s decision in VFB v. Campbell Soup Company when it stated:

Absent some reason to distrust it, the market price is “a more reliable measure of the stock’s value than the subjective estimates of one or two expert witnesses.”[2]

Nevertheless, it may be possible to convince a finder of fact that contemporaneous market prices should be ignored even if there is no evidence of material inside information.  This view is addressed in Tronox, where the bankruptcy judge said the market could never efficiently value certain (in this case environmental-related) liabilities.  More specifically, the judge in Tronox stated: “In the W.R. Grace case, the fulcrum issue relating to insolvency was the size of its asbestos liability.  In the instant case, it is the size of Tronox’s environmental liability.  In both cases, the market as a whole, no matter how efficient or inefficient, cannot be relied on to determine solvency or insolvency.”[3]  Thus, it seems fair to say that bankruptcy judges will not always believe that security prices are semi-strong efficient.

Of course, markets that are not fully informed present additional problems.  Advocates for the semi-strong form, but not strong form, of the efficient market hypothesis agree that the market cannot incorporate inside information that it does not know about.  This appears to be why many fraudulent transfer cases seem to focus more on what was allegedly not disclosed, as opposed to whether the market was semi-strong efficient.

Ignore the Market

Perhaps the most interesting debate over the role of market data is when it is a contemporaneous assessment of decisions that must be made in real time.  For example, this occurs when a bankruptcy court must make assessments regarding a restructuring plan as the judge effectively rules on the valuation of securities that are currently trading based on expectations regarding how the judge will rule.

The potential for interested parties to skew the valuation of a security higher or lower can result in unfair outcomes.  It is for this reason that it may be logical to not place complete reliance on market data, even if the market data is derived from a market that is strong form efficient for arguments’ sake.

Treat the Market as a Biased High Figure

An interesting legal debate occurs in cramdown disputes where a restructuring plan is crammed down over the creditor’s objection.  The concept is straight-forward: the objecting creditor must receive a stream of payments that is equal to the value of his claim.  The complication is that value is somewhat in the eye of the beholder.

In Momentive, the debtor successfully imposed below market rate terms in the cramdown.  The bankruptcy court held that the interest rate must be less than the market rate because the market rate contains compensation for components (costs and profits related to arranging a new loan) that do not belong in the cramdown interest rate that will be applied to pre-existing credit exposure.  Contemporaneous market participants did not appear to foresee this ruling, as the value of the affected claims went from above face value (due to the potential for a make whole payment) prior to the hearing, to below face value after the hearing.  Click here for a previous article on this site for further discussion.

Conclusion

It is sometimes said that valuation is both an art and a science.  Perhaps nothing demonstrates that concept better than the role publicly traded market prices can play in a valuation.  It seems like the same market price could be deemed too high (e.g., cramdown), too low (e.g., shareholder appraisal), or just right (e.g., fraudulent transfer).  This explains why the three most important factors in understanding the semi-strong form of the efficient market hypothesis’ role in contested valuation may be “context, context, and context.”

[1] In re Appraisal of Dell Inc., CA No. 9322-CVL (Del. Ch. May 31, 2016).

[2] VFB LLV v. Campbell Soup Co., 482 F.3d 624, 633 (3d Cir. 2007) (external citations omitted).

[3] In re Tronox Inc., 503 Br 239, 302-303 (Bankr. S.D.N.Y. 2013).

Michael Vitti, CFA, joined Duff & Phelps in 2005. Mr. Vitti is a managing director in the Morristown office and is part of the Disputes and Investigations practice. He is also a member of the firm’s Complex Valuation and Bankruptcy Litigation group, focusing on issues related to valuation and solvency. Mr. Vitti has over 20 years of valuation experience.
Mr. Vitti can be reached at (973) 775-8250 or by e-mail to michael.vitti@duffandphelps.com.