Chancery shames accounting firm over subpar valuation

Fox v. CDx Holdings, 2015 Del. Ch. LEXIS 194 (July 28, 2015)

Why would a reputable financial firm abandon its standard practices and risk producing a valuation so misleading and erroneous that the Delaware Court of Chancery recently described it as a “new low.” This was a question the court visibly grappled with in its ruling on a suit by employee option holders who claimed their company’s top management had intentionally, and to the option holders’ detriment, undervalued certain assets.

The suit arose in connection with a spin/merge transaction a healthcare company undertook to raise money to keep two promising but as yet unprofitable business units afloat. The company’s two top executives decided to structure the merger in a way that would result in zero corporate tax liability for the company’s controlling shareholders.

To do so, they ended up enlisting the help of two major accounting firms. The first firm produced an IRS-driven valuation based on manipulated projections top management supplied. When the eventual buyer raised questions about certain underlying assumptions and the methodology employed, the seller agreed to procure a second opinion from a different accounting firm that in the past had done stock-option-related valuations for the seller.

While the second firm’s earlier valuations followed standard methodologies and produced consistent outcomes, the transaction-related valuation deviated from the firm’s earlier approach and produced an aberrant result. The reason, the Chancery determined, was that this appraisal was nothing more than a “copy job” of the first firm’s valuation—and a bad one at that since the firm's employees committed elemental errors that significantly affected the value determination.

To find out more about the court’s assessment of the work and case, click here.