Summary
finding the DCF analysis "more reliable than the comparable companies analysis in the context of finding fair value" for the company being valued, and weighting the DCF valuation 85% and the comparable companies valuation 15%
Summary of this case from Prescott Group Small Cap v. Coleman Company, Inc.Opinion
C.A. No. 12207-NC.
Date Submitted: March 6, 2003.
Date Decided: July 30, 2004.
Arthur L. Dent, Esquire and Richard L. Renck, Esquire of Potter, Anderson Carroon LLP, Wilmington, Delaware, Attorneys for Petitioner.
Stephen E. Jenkins, Esquire of Ashby Geddes, Wilmington, Delaware, and Thomas P. White, Esquire of Schiff Hardin Waite, Chicago, Illinois, Attorneys for Respondent.
MEMORANDUM OPINION
Petitioner Robert Michael Lane ("Lane") filed this appraisal action pursuant to 8 Del. C. § 262, seeking a determination of the fair value of the common stock of Respondent Cancer Treatment Centers of America, Inc. ("CTCA" or the "Company"), as of March 20, 1991 (the "Merger Date"), the date on which CTCA merged (the "Merger") into RSJ, Inc. ("RSJ"). Under the terms of the agreement implementing the Merger, Lane, the owner of 100 shares of CTCA common stock, which represented 10% of CTCA's outstanding shares of common stock, was to receive $260.00 per share. Objecting that the Merger consideration was inadequate, Lane made a timely demand for appraisal and satisfied all requirements of 8 Del. C. § 262. For the reasons discussed below, I find that CTCA had a fair value of $1,345,000 as of the Merger Date and, thus, Lane is entitled to $134,500 plus interest at the annual rate of 9.14%, compounded monthly.
The surviving corporation thereafter assumed the name of Cancer Treatment Centers of America, Inc. Its current name is Cancer Leasing, Inc., but "CTCA" will be used for convenience.
I. BACKGROUND
A. The Genesis of CTCA.
The story of CTCA begins at the American International Hospital ("AIH"), a 95-bed hospital located in Zion, Illinois. AIH was (and is) controlled by Richard J. Stephenson ("Stephenson") who, along with several family trusts, indirectly owns AIH in its entirety. Besides providing general medical and surgical services to the local community, AIH, after 1982, focused on cancer care and treatment. Specifically, AIH set out to develop a compassionate, patient-focused treatment model that included alternative therapies. To this end, AIH maintained bed capacity for between 40 and 45 cancer patients on two floors, while a third floor was reserved for providing its general medical and surgical services.
Tr. at 895-99, 994, 998.
By 1988, AIH was facing serious financial problems. The facility, which had been constructed in 1958, was outdated and ill-suited to furnishing quality patient care. AIH's reputation had been severely damaged by the negative treatment it had received in the local press due to its connection with a controversial cancer treatment drug, Laetrile. As a result, the average daily census for cancer patients ("ADC") had reached only 20.5 during the last half of 1987. Operating at well below capacity, AIH had difficulty in meeting its obligations.
Stephenson recruited Lane in order to help turn the tide at AIH. Lane had experience in the fields of health care administration and hospital management. In January 1988, Lane joined AIH as its President and Chief Executive Officer. Yet Lane accepted Stephenson's overtures with more in mind than revitalizing AIH; for Lane, an enticing opportunity presented by AIH was participating in the creation of what Stephenson portrayed as a national network of cancer treatment centers. The plan was to reverse the decline of AIH and then use the funds generated by a resurgent AIH to build a national cancer care network of between 12 and 20 treatment centers which would employ the alternative therapies espoused by AIH. These centers were to be established within five years. During the spring of 1988, Lane, Stephenson, Randall L. Pittman ("Pittman") and Robert Mayo ("Mayo") convened to create and develop CTCA.
During the period of 1976 through 1978, Lane served as Administrative Assistant for Bon Secours Hospital, a 320-bed hospital in Michigan. Subsequently, from 1978 until his hiring at AIH, Lane was the Assistant Executive Director of Timken Mercy Medical Center, a 520-bed medical facility in Ohio, and additionally served as the Manager of Strategic Planning, the Director of Strategic Planning and Research, and the executive responsible for market research at Hospital Corporation of America.
B. The Formation and Business Plan of CTCA
CTCA was incorporated in June 1989 in Delaware. Subchapter S status was elected for tax purposes. Lane was to serve as the President of CTCA. Pittman and Mayo were to serve as the Executive Vice President of Operations and Finance and the Executive Vice President for Development, respectively. Stephenson funded the start-up costs associated with CTCA through advances from AIH. Lane, Pittman and Mayo each received a 10% interest (100 shares of CTCA common stock) in CTCA as an incentive, and Stephenson owned the remaining 70% of CTCA's outstanding common stock. CTCA was staffed by former AIH employees who continued to perform their previous jobs but for a different employer — CTCA.
Lane presents a much different story surrounding the early financing of CTCA. He claims that CTCA was originally formed as a joint venture (the "Joint Venture") among Stephenson, Lane, Pittman and Mayo, and that soon after its formation, the Joint Venture assumed responsibility for certain services of AIH, generating a profit for its efforts.
There is some debate as to what percentage of CTCA Lane initially received. Lane claims that he originally subscribed to and purchased, for $110 in addition to the nearly $250,000 he contributed through the Joint Venture, 110 shares of CTCA common stock, and that this amount was later unilaterally altered by Stephenson. However, Lane does not challenge that alleged reduction in this proceeding, and "there is no dispute that Mr. Lane's equity interest in CTCA was 10% as of the Merger [D]ate." Opening Post-Trial Br. of Pet. Robert M. Lane at 8 n. 2.
The CTCA business model evolved from the cancer treatment model pioneered at AIH: primarily providing care on an inpatient basis, a CTCA multidisciplinary team would oversee a varied regimen of treatment options, including holistic treatments, aimed "not only [at] the patient's physical well-being but also [at] their spiritual well-being, their emotional well-being and their nutritional well-being." Thus, the perceived uniqueness of CTCA lay in its comprehensive, and sometimes experimental, cancer treatments and personal attention to the individual.
Tr. at 47.
Treatments offered at CTCA facilities came to include experimental chemotherapies, such as fractionated dose chemotherapy, as well as other kinds of treatments such as whole body hyperthermia, radiation treatments, psychological services, immunomodulating supportive therapies and nutritional services. Tr. at 47-52.
The CTCA business model sought to capture a niche in the cancer treatment market, namely, those pre-treated cancer patients who had failed their initial round(s) of cancer treatment and who often had been advised of the terminal nature of their illness. This target market largely consisted of potential patients from outside Illinois who were willing to travel to receive treatment on an inpatient basis and who were covered by private commercial insurance and could afford those expenses not paid by insurance. No marketing study was ever conducted in order to determine the size of this market segment.
This market niche may have shielded CTCA from certain macroeconomic trends and industry specific changes occurring during the formation of CTCA and continuing until the Merger Date. By the early 1990's, the economy of the United States was suffering through a recessionary period characterized by high interest rates and rising unemployment. The health care industry was experiencing a move toward managed care and a change in reimbursement rates by Medicare unfavorable to the interests of hospitals. Additionally, a clear trend had emerged that favored providing care on an outpatient basis. However, it was thought that such trends would have a limited impact upon CTCA because of its niche-market focus. See MediTrends Report, RX 74 at 6 (relied upon by both parties and predicting that "most inpatient oncology cases will be limited to experimental treatments and . . . major surgical procedures."). Moreover, cancer cases were expected to rise over the next decade.
CTCA has suggested that competitors of CTCA included the Mayo Clinics, Memorial Sloan Kettering, and M.D. Anderson, each a well-known and well-respected cancer treatment facility with a national focus. However, I am not satisfied that these institutions squarely competed against CTCA due to the experimental and, to an extent, unique nature of treatments offered by CTCA and the ultimate stage of cancer progression of the typical CTCA patient.
CTCA was also formed in order to provide marketing, managerial, operational, and administrative outsourcing services to an anticipated national cancer treatment network. CTCA aggressively pursued its own marketing by advertising in a variety of media and enhanced customer satisfaction through the use of the "patient travel" package. A CTCA senior medical director and a CTCA chief medical officer, who remained abreast of recent developments in the field of cancer care, were available to help supervise hospital operations. CTCA also would oversee a variety of functions at the hospitals it serviced, including maintenance, equipment and supplies management, medical record keeping, securing insurance coverage and reimbursement, and quality assurance.
CTCA largely ignored the more traditional method of attracting patients through physician referrals, focusing instead upon direct advertising.
The cancer patients, who would in many instances travel long distances to the treatment center, were picked up at the airport and, during the ensuing limousine trip to the facility, watched an informational video concerning their stay, their treatment and the hospital staff who would tend to their needs. Every stage of the journey was paid for by CTCA, which had established long-term contracts with a major airline for the necessary air travel.
CTCA additionally developed sophisticated accounting services and was solely responsible for all billing and collection efforts. It supplied clinical case management services for preapproval and precertification cases, arranging with third-party health insurance companies in order to ascertain the level of coverage prior to implementing treatment. Significantly, CTCA, in conjunction with American Express, devised a management information system that could function as the "platform for developing multiple centers." Into this system, care providers entered notes and orders at bedside terminals. This diagnostic and medical services information was integrated with revenue cycle functions, resulting in increased information flows and, ultimately, efficient billing and collection.
Tr. at 52. Lane claimed that this system was "one of the first fully integrated clinical and financial information systems" to be implemented in a hospital setting. Id.
Thus, CTCA sought not only to supply outsourcing services to, but also to own and operate the facilities of, a national network of cancer treatment centers. These centers were to target an undetermined number of end-stage, affluent cancer patients who, with a strongly inelastic demand for treatment, were willing to travel extensive distances and obtain care that generated substantial profit margins for the unique treatments offered by CTCA. Critical to meeting the goals of the founders of CTCA would be continued expansion to new geographic markets through the opening of new facilities.
C. CTCA and AIH
On July 1, 1989, CTCA and AIH more formally memorialized their business relationship in the Management Services Agreement (the "MSA"). By its terms, the MSA lasted for one year and would be renewed automatically on a year-to-year basis on the same terms unless either party provided notice to the contrary no less than 90 days prior to the end of any term. While the MSA was in effect, CTCA was compensated for services provided to AIH on the basis of actual costs plus a 20% markup, with a possibility for a bonus payment.
PX 6.
Id. at 4-5.
Under the leadership of Lane, and aided by CTCA, AIH rebounded. In 1988, the ADC for AIH increased by 11.5 patients to 32, and then further to 38.9 in 1989. Collection rates soared from $.53 on the dollar to about $.95 on the dollar. Clearly, the situation at AIH, though not completely resolved, had improved dramatically. But the appetites of Stephenson, Lane and their colleagues aspiring to create a national network of cancer treatment centers through CTCA would not be satisfied by merely enhancing the performance of a lone hospital in northern Illinois. Thus, from 1988 through 1990, CTCA urgently pursued what would ultimately be regarded as a disastrous search for a suitable site to open a second cancer treatment center.
Tr. at 54.
See discussion infra Part I.E.
D. CTCA Expands, Albeit with Great Difficulty.
Throughout 1988 and 1989, CTCA fruitlessly searched for a second hospital to serve as a cancer treatment center. With the passage of time, the attempts of CTCA to find a new location only grew more frantic. In mid-1989, CTCA thought it had finally succeeded in its efforts; the target site was the recently-closed City of Faith Hospital, associated with Oral Roberts University in Tulsa, Oklahoma. The City of Faith Hospital was a general medical and surgical hospital, with a licensed capacity of 294 beds. Its facilities were in good condition. However, the City of Faith Hospital came with certain baggage: it did not enjoy a good rapport with the local practitioners and populace, in part attributable to the diverging opinions regarding its prior efforts. Despite these reputational concerns, CTCA decided to expand to Tulsa. CTCA became obligated as lessee on a 15-year lease for a portion of the City of Faith facility (the "Lease") with Oral Roberts University, and formed Memorial Medical Center and Cancer Institute, Inc. ("MMC") as a separate corporation to operate the facility. Under an oral agreement (the "MMC Oral Contract"), MMC was to reimburse CTCA at cost for services provided. Initial forecasts for MMC prepared by Phillip Picchietti ("Picchietti") at Pittman's instruction reflected an initial source of cash as "CTCA management fee from AIH."
The Lease also contained an option to renew for an additional 15 years. RX 27.
Stephenson, Lane, Pittman and Mayo each held the same percentage in MMC as they owned in CTCA. MMC was incorporated under the laws of Oklahoma on May 3, 1990.
At the time of trial, Picchietti was CTCA's chief financial officer. He had also served as the assistant vice president of finance for both AIH and CTCA.
RX 5.
On April 12, 1990, Stephenson sent a letter (the "April 1990 Memorandum") to Lane, Mayo, and Pittman addressing certain issues regarding CTCA and the MMC expansion. Stephenson informed his fellow shareholders of his views on eight different topics. Stephenson first addressed the mission of CTCA:
1. We must first have a clear idea, and a commitment shared by all of us as to our objectives and their respective priorities. I have viewed this venture as having three primary objectives which have respective priority as follows:
a. The first priority is to protect the American International Hospital operations and keep them viable and profitable. AIH is the "cash cow" that makes possible its own survival and growth, and the opportunity presented to you vis a vis CTCA, et al. Unless we protect it, both AIH and CTCA development will be in jeopardy. We cannot afford to do anything that would deprive AIH of requisite income, interfere with its banking relationships, impede further program enhancement, or prevent the financing of the new hospital. Although this is the primary objective, I believe that AIH is at greater risk than I had ever expected. For example, looking at present levels, think about what would happen to AIH if its net income went back to 1988 levels?
b. The second objective is the development of CTCA-Tulsa which is a major operation and will take a great deal of effort and ingenuity. It is still not clear to me how, or why, we are proposing to manage Tulsa in the way we are, where and how we are going to attract our patients, what the front money cash need will be, etc. I need to have a clear handle as to how much money is to be invested as well as answers to the other queries raised.
c. As planned, I think the timely development of other centers is also extremely critical. We all know that the market has a preference for treatment near home. Unless we find ways to cater to this preference within the narrow window of opportunity available to us, we are not going to maximize the profit potential that I have so long envisioned.
RX 34 at 2. Stephenson reiterated his fear of the MSA disturbing the progress and upgrading of AIH:
8. I am very much concerned that the proposed consulting agreement as drawn will cause very serious problems with AIH's bank and the financing arrangements necessary to build the new hospital building. Of course, that would not be acceptable to me and I assume that there exists agreement among all of you that I should not have this risk.Id. at 5.
Stephenson then went on to express his opinions regarding the nature and status of the future funding of CTCA:
5. I thought it was clearly understood that the proposed equity sharing arrangement (70%-30%) was intended to reflect a claim on the profits and/or "value" of the CTCA operation. It was understood that AIH would provide to CTCA a determinable amount of money to give CTCA a start. However, such investment would be first returned to me before profits of CTCA would be distributed under the proposed CTCA equity sharing arrangement. I did not intend a permanent assignment of a big portion of AIH cash flow, nor an indirect sharing of AIH profits triggered by said assignment.
Id. at 4.
Throughout the April 1990 Memorandum, Stephenson opined that issues of control, and recognition of his dominant position, were not being adequately addressed. Furthermore, Stephenson directed that "all of the money paid out under the proposed consulting agreement with AIH . . . must be invested solely in the CTCA operations and will not be available to you, except to pay taxes, until profits are distributed from those operations or a sale of the CTCA operations is concluded." The weight of those convictions of Stephenson, the majority shareholder in both AIH and CTCA, would not be lost upon Lane, Mayo, and Pittman.
Id. at 5.
MMC commenced business operations in May 1990. Immediately, MMC was beset by problems. From the beginning, MMC was greeted by a chilly reception from the local medical community and general populace. It had inherited some of the discontent from its association with Oral Roberts and the City of Faith Hospital. Additionally, at the time of MMC's opening, there already existed excess hospital capacity in Tulsa. Local media provided coverage that could only be described as negative. Thus, the local market viewed MMC, at best, as an interloping competitor in a tight market or, at worst, as a competitor who was the successor entity of the maligned City of Faith Hospital. Despite the efforts to bridge this gap, which included marketing efforts aimed at local chiropractors, physicians, and church organizations, the hostility continued.
The ADC of MMC further suffered from what Lane claims was a bias toward directing patients to AIH instead of MMC. Lane testified that, although it was originally agreed that patients would be steered in equal numbers to MMC and AIH, in fact, in order to boost census counts at AIH, a disproportionate number of patients were directed to Zion instead of Tulsa. Indeed, the April 1990 Memorandum stated: "The first priority is to protect the American International Hospital operations and keep them viable and profitable. AIH is the `cash cow' that makes possible its own survival and growth and the opportunity presented to you vis a vis CTCA." Furthermore, though subject to certain constraints, patients treated at AIH, by virtue of the contracts with CTCA, generated a higher return for CTCA than those treated at MMC. However, this alleged steering of patients to Zion does not go unchallenged.
Tr. at 92.
RX 34 at 2.
CTCA claims the exact opposite: that patients were being shifted from AIH to MMC in order to boost ADC counts at, and the attractiveness of, MMC. See Post-Trial Resp. Br. of Resp't Cancer Treatment Centers of America, Inc. at 11. I need not resolve this issue.
Even aspects of the expansion which at first appeared benign or even favorable soon metamorphosed into nightmares. CTCA was obligated to pay approximately $2 million for capital equipment it had purchased at a steep discount from Oral Roberts University. Upon further inspection, though, some of the equipment turned out to be unusable. Moreover, while the terms of the Lease were initially favorable to MMC, payments due under the Lease dramatically increased after the fifth year.
It is impossible to tell from the record how much of the equipment CTCA purchased from Oral Roberts University was of little or no value.
The payments were at the outset favorable to MMC when judged on a per-square foot basis. There is some debate whether the negotiated rates were as favorable when compared on a per patient basis. See Tr. at 1152.
The already grave situation in Tulsa would be further complicated by the deterioration in the relationship between MMC (and CTCA) and Oklahoma Blue Cross. Oklahoma Blue Cross's reimbursements accounted for approximately 28% of MMC's revenues, and it was the largest insurer in the local area. Initially, CTCA had failed to ascertain the reimbursement rates of Oklahoma Blue Cross; in fact, the reimbursement rates paid by Oklahoma Blue Cross for the treatment provided by MMC were significantly lower than those paid to AIH by comparable insurers. Furthermore, another blow to the credibility and reputation of MMC occurred when MMC was discovered to have substantially overcharged Oklahoma Blue Cross for nutritional supplements. Thus, MMC was faced with the near-Herculean task of negotiating for favorable rates from a disadvantageous starting point against a large, hostile insurer.
In 1990, CTCA unsuccessfully attempted to secure a line of credit for itself and MMC from LaSalle National Bank. Notably, during negotiations with LaSalle National Bank, representatives of CTCA and MMC, when asked pointedly about their perception of continuing the status quo under the MSA, replied that no change was foreseeable. Documents prepared for and presented to LaSalle National Bank depicted the markup under the MSA as a subsidy to MMC; the amounts represented as flowing from AIH through CTCA to MMC were reflected as debt owed to CTCA.
RX 44; Tr. at 803.
This procession of unfavorable developments was eventually reflected in the operational and financial statistics of MMC. In May 1990, MMC had an ADC of 3. By December 1990, it was 10. This pace of patient development paled in comparison to management projections of up to 60 by December 1990. MMC also suffered from relatively large (in comparison to AIH) marketing expenses per patient admitted; during the first year of operations, per patient marketing expenses nearly doubled from $6,329 to $11,544. Moreover, MMC needed additional computer equipment that would cost $800,000.
Tr. at 177; RX 70 ex. B.
RX 70 ex. B.
Tr. at 783-84; RX 5.
For 1990, MMC lost more than $5 million. Operating under the MMC Oral Contract, MMC, as reflected in its financial statements, owed CTCA approximately $2.9 million by the end of 1990. And this figure was an understatement, for in addition to the amount derived from services provided pursuant to the oral agreement, CTCA had advanced $3.6 million to MMC for working capital by the end of 1990. However, at the end of 1990, $3.2 million of these loans were removed from the books by a CTCA assignment of notes for that amount to the CTCA shareholders, who in turn reassigned their notes to MMC. Thus, in the 1990 financial statements for MMC, its auditors, Arthur Andersen Co., cautioned: "The accompanying financial statements have been prepared assuming that [MMC] will continue as a going concern. As discussed in Note 1 to the financial statements, [MMC] has suffered a loss from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern." E. Developments at AIH and MMC During Early 1991
RX 57 at R000347.
In Illinois, while the situation at AIH had shown marked improvement, tensions were increasing between Stephenson and the AIH board of directors. By 1991, AIH was operating at or beyond the capacity of its aging building. However, it was confronted with a more pressing issue: due to the condition of the AIH facility, AIH was threatened with the loss of its Medicare certification, its Joint Commission on Accreditation of Health Care Organizations accreditation, and its Illinois licensure. The AIH board of directors, faced with the necessity of upgrading and expanding AIH, came to resent at some level the monies paid to CTCA by AIH under the MSA's 20% markup, and the existing relationship between AIH and CTCA was coming under strain.
The parties dispute the degree to which the AIH board of directors was offended by the payments made to CTCA. Suffice it to say, there existed some tension over the subject of the MSA. Two AIH directors did take the preliminary step of retaining a lawyer to meet with Stephenson regarding their concerns.
Nevertheless, AIH decided to press forward with its plans for constructing a new hospital building. Accordingly, by the end of 1990, negotiations with the City of Zion were well underway for the issuance of bonds to finance AIH's undertaking. In order to obtain the necessary approvals for its expansion, AIH needed to submit a Certificate of Need ("CON") application to authorities in Illinois and also to seek bond financing in conjunction with the City of Zion. AIH submitted its CON application on December 28, 1990. In the CON application AIH projected its ADC as:
---------------------------------------------------------- | 1991 | 1992 | 1993 | 1994 | | | | | | | 41 | 45 | 53 | 58 | -----------------------------------------------------------
TR. at 901-02, 913-17.
RX 56 at HCC00261.
Concurrently, as AIH found itself in limbo in Zion, MMC continued to decline in Tulsa. For the first two months of 1991, MMC lost approximately $1 million, and estimated that in order to continue operations, another $1.4 million was needed. Vendors began to insist upon immediate payment and operations were disrupted. The condition of MMC had deteriorated to such an extent that its auditors expressed substantial doubt about its viability as a going concern. Thus, by the end of 1990 or the early part of 1991, some consideration was given to shutting MMC's doors. A CTCA management team visited Tulsa in early 1991 to decide whether MMC could be salvaged. Ultimately, Joseph Gagliardi ("Gagliardi"), a turnaround expert, was retained to oversee operations at MMC.
RX 26. Lane notes that the financial statements indicating this loss were unaudited.
Picchietti noted: "We had drug vendors, medical supply vendors, our airlines, gas stations, all put us on credit hold and COD. In many cases we had to put off surgeries, and the financial state of affairs were jeopardizing patient care at the time." Tr. at 837.
See supra note 32 and accompanying text.
F. Turmoil at CTCA, the Merger, and Subsequent Actions
On December 5, 1990, Stephenson, Picchietti, and Hopkins met in order to discuss the financial situation at CTCA. At the meeting, an ADC of 45 for AIH and an ADC of 24 for MMC were projected for 1991. The forecast anticipated the opening of a new facility in October 1991 and assigned an ADC of 4 for the initial few months after opening. Two weeks later, the forecast was presented to the MMC board of directors. At that meeting, the proposed 1991 budget, dated December 14, 1990, based on that forecast, was rejected.
Picchietti, who prepared the budget, stated that Pittman directed him to include a third facility with an ADC of 4, despite Picchietti's voicing of his concerns over the failure of MMC and the lack of available financing options for any expansion. Tr. at 854.
The testimony concerning Stephenson's acceptance of this forecast was contradictory.
RX 67; Tr. at 834-35.
For 1990, CTCA received $10.6 million in revenues, of which $2.6 million consisted of fees and interest owed by MMC, and incurred $9.2 million in expenses. Under the MSA, in 1990, AIH paid $7,934,900 in management fees to CTCA. Thus, for 1990 CTCA earned $1.4 million in net income. The debt owed by MMC to CTCA totaled $3.5 million, a figure which, as previously noted, underestimated the true amount of debt to CTCA that had been incurred by MMC.
RX 58. The income statement for CTCA for 1990 is set forth infra note 133.
Lane admits to having assigned the notes on December 31, 1990. However, Lane disputes that this write-off was ever reflected on the books of CTCA. Pet'r's Opening Br. at 24.
Operationally, CTCA lost focus upon its mission and core competencies. Much of the time of CTCA managers, including Lane, was directed at saving MMC. Absorbed in the task of rescuing MMC, Lane failed to develop a management staff to operate CTCA. Instead, Pittman, who served primarily as a financial officer, was tapped to supervise operations at CTCA.
Dissatisfied with the perceived abandonment of developing a national cancer treatment network and at the perceived favoritism displayed by Stephenson toward AIH over CTCA and MMC, by the end of 1990 Lane concluded that any expansion of CTCA, while still possible, would only be achieved through internally-generated cash flows. Though there are conflicting accounts, I find that Lane offered his resignation on December 31, 1990, but was initially rebuffed by Stephenson. Subsequently, on January 2, 1991, Stephenson terminated Lane's employment relationship with CTCA. By this time Pittman had also left the Company; he had resigned on December 31, 1990. Thus, with the departure of these two key managers, CTCA was without upper level management, a condition which remained through the Merger Date.
A budget, dated March 11, 1991, for MMC incorporated the projected ADC figures that had been presented to the MMC board (and not accepted by it) in December 1990 (the "Revised Budget"). This budget projected an ADC of 24 for MMC for 1991. Although this document bears the date of March 11, 1991, it is not known if management adopted this budget at that time, or if the date is merely a function of when it was reprinted.
PX 29.
The Merger was accomplished through a written consent executed by Stephenson and was never considered by the CTCA board of directors. Under the Merger, CTCA merged into RSJ, an entity wholly-owned by Stephenson. At about the same time, MMC merged into SRJ, Inc., an Oklahoma corporation owned and controlled by Stephenson (the "MMC Merger"). The MMC Merger eliminated the minority shareholders in MMC. Ultimately, Stephenson wholly-owned both MMC and CTCA.
PX 34 at LP0000636; PX 35.
PX 34 at LP0000646. Although the Merger Date is a day after the MMC Merger, neither party has suggested that this is material and, for convenience, the mergers will be considered as occurring at the same time.
Pursuant to the Merger's terms, CTCA common stockholders could receive $260.00 for each of their CTCA common shares. The aggregate amount of consideration in the Merger was apparently derived by multiplying the book value of CTCA by 50%. The CTCA board of directors (or Stephenson individually) neither commissioned an independent determination of the fairness of the terms of the Merger nor sought to ascertain the inherent value of the Company.
G. It is Not All Bad News
Despite the problems that CTCA was encountering, there were positive signs. First, CTCA had net income of $1.4 million in 1990. Second, although MMC was not turning toward profitability in early 1991, its ADC was increasing to a number which, at least some thought, could lead to profitability. Finally, the projections of ADC set forth in AIH's CON anticipated a growth in patients that could provide the groundwork for the national network envisioned by Stephenson, Lane and the others.
In short, the Merger occurred during a time of crisis for CTCA. Depending upon several potential developments after the Merger, such as the possibility turning MMC around or finding new sources of funding (including, perhaps, an even greater contribution by Stephenson), CTCA might prosper or it might decline. The nature of the statutory appraisal process limits the analysis to that which is known or can be reasonably projected at the time of the Merger. The future of CTCA was an open question at that time; with its limited history and its uncertain prospects, CTCA's value may be subject to robust debate.
H. Procedural Background
Lane and Pittman dissented from the Merger and filed this appraisal proceeding on July 18, 1991. Similarly, they dissented from the MMC Merger and sought appraisal under Oklahoma law. On February 24, 1998, the Oklahoma Court concluded that "MMC had no value as of March 1991." This decision was based upon the perceived credibility of the parties' experts, and that the
Mayo, who was the other minority shareholder in CTCA and who was promoted to President of CTCA after the Merger, did not pursue an appraisal action.
Lane v. Mem'l Med. Ctr. Cancer Inst., Inc., No. CJ931630, slip. op. at 6 (Dist.Ct. Tulsa County Okla. Feb. 24, 1998), aff'd, No. 91,058 (Okla.Civ.App. May 11, 1999).
court took no comfort in the 1991 budget numbers prepared under the direction of plaintiffs. Plaintiffs['] projections had never been achieved from day one. Th[e] court believe[d] that a willing buyer would have been confronted with massive debt and no immediate future for the turn-around of the corporation in March of 1991.
Id.
The Oklahoma Court concluded that the transferring of MMC debt from CTCA to the shareholders and the subsequent contribution of it to MMC was merely designed to allow for certain tax deductions and thus added no value to MMC. The Oklahoma Court also found that MMC lost $5 million in 1990, and, despite the "best efforts" of "a previously proven marketing company — CTCA —" MMC could not attract patients to Tulsa. Finally, the Oklahoma Court discredited the Revised Budget:
The 1991 budget was not accepted in the Dec. 1990 board meeting and it was a work in progress. . . . The plaintiffs were involved in [attracting patients to MMC] and in revising numbers as 1990 worn [sic] on with no success in sight.
Id.
Any projected numbers, the Oklahoma Court noted, "proved to be wrong."
Id.
After the appellate proceedings in the Oklahoma appraisal action were resolved, CTCA sought dismissal of this action pursuant to Court of Chancery Rule 41(e) on June 15, 1999, for Lane's failure to prosecute. This Court, after initially granting that motion, subsequently granted the Plaintiff's Motion for Reargument. In 1999, Pittman and CTCA reached a settlement, thereby leaving Lane as the lone Petitioner in this matter.
Lane v. Cancer Treatment, 1999 WL 1204848 (Del.Ch. Nov. 17, 1999) ( Lane I).
Lane v. Cancer Treatment Ctrs. of Am., Inc., 2000 WL 364208 (Del.Ch. Mar. 16, 2000) ( Lane II). Lane retained new counsel on March 29, 2000; CTCA again moved to dismiss this action under Court of Chancery Rule 41(e) on February 21, 2001. That motion was denied on April 11, 2001. Lane v. Cancer Treatment Ctrs. of Am., Inc., 2001 WL 432445 (Del.Ch. Apr. 11, 2001).
II. EXPERTS' TESTIMONY
All too often in appraisal actions, the Court is presented with two competing experts espousing "wildly divergent" interpretations of the circumstances confronting the corporation. This case is no exception. Lane's expert, Robert J. Cimasi ("Cimasi"), contends that the fair value of CTCA was $16,400,000 as of the Merger Date. In stark contrast, CTCA's expert, Richard S. Baehr ("Baehr"), concludes that the fair value of CTCA was zero. In order to understand the divergence of their conclusions, the views of the experts must be reviewed.
Cede Co. v. Technicolor, Inc., 2003 WL 23104613, at *2 (Del.Ch. Dec. 31, 2003).
PX 41 § 7, at 2.
RX 87 at 3.
A. Cimasi
Cimasi is an accredited senior appraiser through the American Society of Appraisers and a certified business appraiser through the Institute of Business Appraisers. He has two decades of experience with a focus on financial and economic aspects of health care. The recipient of an Associate Degree in Real Estate Appraisal from Meramec Community College and a Bachelor of Arts in Valuation Science from Lindenwood College, he is president of Health Capital Consultants, which he founded in 1993. Before then, he had worked for Physicians International where he had devoted most of his efforts to the business aspects of medical practices.
Cimasi utilized three approaches to determine the fair value of CTCA. The three methodologies employed by Cimasi were a discounted cash flow ("DCF") analysis, a comparable transactions approach, and a guideline publicly traded company method. Cimasi then assigned the resulting fair values generated by each approach a weight he deemed appropriate and calculated a weighted average in order to arrive at the fair value for the common stock of CTCA.
1. Business Reality Confronting CTCA at the Time of the Merger
In conducting his analyses, Cimasi first made certain generalized assumptions about the business of CTCA and, more particularly, the effect of certain industry-specific and macroeconomic trends on CTCA as a niche market player, the foreseeable future of the relationship between CTCA and MMC, the continued existence of the MSA, and the prospects for the national expansion of CTCA. While acknowledging the general trend toward outpatient care, Cimasi minimized its consequences for CTCA because of the market targeted by CTCA. The inelastic demand, and, to a lesser degree, the relative affluence, of the niche market would also counteract any negative effects of a slumping economy. Moreover, the combined ADC of AIH and MMC had been growing, and cancer diagnoses were anticipated to increase greatly. Finally, the expanding influence and pressure exerted by third-party payors created a competitive advantage for CTCA, proven by its 90% to 95% reimbursement rate, which exceeded industry norms. Therefore, although recognizing the existence of certain negative macroeconomic and industry trends, Cimasi concluded that any impact upon CTCA would be negligible and that the combined ADC of MMC and AIH would increase.
Cimasi then turned to establishing the rate at which CTCA would grow. The growth rate would be driven by increases in the combined ADC; Cimasi computed the annual ADC growth from the beginning of 1988 until the Merger Date to be approximately 12, or an annual ADC increase of 12 patients during that time period. He then reduced this calculated annual ADC growth by 40%, arriving at an annual ADC growth of 7 patients. Thus, for the first projected year, Cimasi assumed a combined ADC for CTCA of 65.38 — an average of 41 patients at AIH and 24.38 at MMC.
Tr. at 323-24.
Id. at 325.
Cimasi asserted that, despite the bleak picture painted by CTCA, MMC was not to be closed any time soon. No evidence suggested any intention to close MMC, and any such closing of MMC would be contrary to the business model of CTCA. Additionally, Cimasi noted that MMC, as a start-up, was expected to operate at a loss for some time. Finally, the facts demonstrated the success of MMC: combined ADC had risen from 48.3 in January of 1991 to 57.3 in March of 1991 and had risen despite Stephenson's steering of patients from MMC to AIH. Thus, the ADC of MMC was quickly nearing Lane's claimed projected break-even figure for MMC of 14.7. Surprisingly, Cimasi further claimed that were MMC to close down, CTCA would suffer no ill effects.
Cimasi posited that because CTCA, and not MMC, was the lessee for the Tulsa facility, "if MMC would have closed, then CTCA would have had a choice. They could have either the very next day opened up XYZ because they held the lease and another provider entity would have slipped right in. . . . Or they could have taken the patients up to Zion until Zion was maxed out and then found another facility where the circumstances would have been different." Tr. at 381. According to Cimasi, this transfer of patients would have increased cash flow due to the increased rate of return (20%) achieved at AIH. "[S]econdly, you would have much sooner gone into the operated centers in our model." Id. at 385.
As to the development of national cancer treatment centers, Cimasi predicted that not only would MMC remain open, but that CTCA would establish three new cancer treatment centers within the next five years, a projection he characterized as "conservative." Cimasi noted that all evidence, in terms of the business model and CTCA projections, stressed the importance of expanding. This forecast was based upon his experiences with rollups that had doubled their number of sites each year, Lane's experiences at Hospital Corporation of America, which had added over 100 sites to its network over a four-year period, and the market's capacity and demand for such services, as evidenced by the historical increases in aggregate ADC.
Tr. at 607.
For instance, Stephenson noted in his April 12, 1990 letter that "the timely development of other centers is . . . extremely critical." RX 34 at 2.
Cimasi particularly notes that the December 14, 1990 budget reflected the opening of a new center by fall 1991, and the testimony of Dr. R. Michael Williams ("Dr. Williams"), then CTCA's senior medical director and chief medical officer, that he sought a California medical license in anticipation of the opening of a facility in Brea, California.
Tr. at 26.
Cimasi addressed the status of the MSA and the MMC Oral Contract. He concluded that the MSA, with its 20% return over costs, would remain in place for the foreseeable future. This belief was based upon the lack of concrete action to alter the terms of the MSA and the MSA's automatic renewal feature. Cimasi, relying upon Lane's interpretations and perceptions, discounted the impact of the April 1990 Memorandum. Finally, he hypothesized that had AIH given proper notice under the MSA of its intention to terminate the agreement, CTCA could have moved all of its patients elsewhere and withdrawn the vital services that had been outsourced to CTCA.
Lane testified that he "was never aware of any discussion to change the cost plus 20 percent arrangement" and that "[i]t would not have made any sense for Cancer Treatment Centers to have built up a staff, invested several million dollars in a computer system to develop all of the new ads and make major investments if an arrangement to earn a reasonable profit was temporary." Tr. at 1290.
Cimasi also theorized that the MMC Oral Contract would be altered from one reimbursing costs to one providing the same rate of return under the MSA, that is, a 20% markup of actual costs. Cimasi characterizes the 20% markup as a "typical deal" in the industry and, thus, saw it as reasonable based on his experience. Furthermore, Cimasi relied upon the testimony of Lane that it was always contemplated that MMC would pay CTCA a 20% markup on services provided.
Tr. at 296.
Id. at 444. Cimasi testified he had been involved in several deals with an arrangement "far in excess of 20 percent." Id. at 443-44.
2. DCF
Working from these general assumptions, Cimasi predicted the performance of CTCA over a five-year interval beginning immediately after the Merger Date. Cimasi developed cost projections for AIH and MMC (collectively, the "managed centers") as well as for three new centers which CTCA would directly operate. The revenues were then calculated by marking up the expenses by 20% and allocating the resulting revenue figure to the individual centers on the basis of the ratio of projected ADC of an individual center to the projected total ADC of the combined centers. Thus, the key assumptions under Cimasi's approach are those associated with the projected expenses.
To derive projected expenses, Cimasi presented various growth rates regarding different categories of expenses and extrapolated from historical data. Thus, for example, Cimasi assumed an annual growth rate of 4% for salaries and employee benefits on the basis of inflation and increases in patient census. In contrast, Cimasi assumed projected annual declines in professional fees and advertising of 7% to 2% on the assumption of economies of scale. Cimasi did not deduct any expenses related to interest upon the debt of CTCA, as the valuation he conducted was assumed to be debt free. Cimasi then subtracted taxes, at a rate of 40%, to arrive at net income.
Depreciation and amortization were deducted as expenses and later added to arrive at cash flow. However, in comparison to Baehr's amounts for depreciation and amortization, Cimasi's values, based on the assumption of the opening of the operated centers, are high. See discussion infra Part III.C.3.
To calculate projected yearly cash flows, Cimasi then added to net income amounts for the non-cash expenses of depreciation and amortization. Next, Cimasi adjusted the resulting figure for increases in working capital and fixed assets. Thus, Cimasi arrived at a projected net cash flow for each of the five projected years following the Merger Date.
Again, these projected values substantially deviate from those projected by Baehr due to the assumption of the opening of the operated centers.
Cimasi then discounted his projections by a Weighted Average Cost of Capital ("WACC") equal to 27.43%. Cimasi determined a discount rate through the Adjusted Capital Asset Pricing Model, which Cimasi claimed is ideally suited for small, closely-held companies. This model is "based on several risk and return conditions, that when totaled, result in an estimate of the rate of return that an investor would most likely require." Accordingly, Cimasi utilized five variables to arrive at this sum. First, Cimasi included a risk-free rate at the Merger Date of 8.36%. To this he added an equity risk premium of 7.1% and a "health care industry risk premium adjustment" of 2.01%. Finally, he included a "size premium" and a company-specific risk premium, equal to 5% and 12%, respectively. The summation of these five components equals 34.47%.
PX 41 § 6.9.
To arrive at the WACC, Cimasi next needed to determine the cost of the debt. To do so, Cimasi averaged three values: CTCA's cost of debt (11.19%), the cost of debt for (guideline) public companies (10.32%) and Moody's Corporate Baa bond rate (10.09%). The result of this computation was 10.53%. Because CTCA's target capital structure was 25% debt and 75% equity, the WACC was calculated to be 27.43%.
For a terminal value, Cimasi increased (by 5%) the net cash flow of projected year 5, and assumed that this amount, with an annual growth rate of 5%, would be returned in perpetuity. Cimasi next capitalized the projected terminal cash flow by 22.43%. This terminal value was then discounted accordingly (at 27.43%) to arrive at a fully discounted (as of the Merger Date) terminal value. With the summation of these discounted cash flows, Cimasi derived a present fair value of the business enterprise of $18,309,901.
Cimasi next departed significantly from the analysis of Baehr and included a "control premium." The control premium, Cimasi claimed, was justified because of the inclusion of an inherent minority discount due to the use of market prices in establishing the WACC. Accordingly, Cimasi added 20% of the present fair value of the business enterprise ($3,661,980) to the present fair value of the business enterprise to arrive at a total present fair value of the business enterprise of $21,971,881. To determine the present fair value of CTCA, Cimasi subtracted $4,052,300 in interest bearing debt and arrived at $17,920 per share.
3. Comparable Transaction Approach
In addition to relying upon the DCF analysis, Cimasi also employed a comparable transaction methodology to determine the fair value of CTCA. To do so, Cimasi initially selected hospital management and specialty hospital companies which he considered comparable to CTCA and which had been involved in transactions evidencing their enterprise value. Next, he derived, for each comparable company, the arithmetic mean, the average, the weighted mean and the median for a series of ratios for each of the companies, which included a price-to-revenue ratio, a price-to-earnings before interest and taxes ratio and a price-to-earnings ratio. Cimasi, taking the weighted mean for each ratio, computed a fair value for CTCA of $9,836,000, or $9,836 per share.
4. Guideline Publicly Traded Companies Methodology
The final methodology utilized by Cimasi for determining the fair value of CTCA was the guideline publicly traded companies methodology. Pursuant to this approach, Cimasi selected comparable companies that were categorized in the same Standard Industrial Classification ("SIC") Code as CTCA. For the set of comparable companies, Cimasi then calculated the weighted price-to-revenue, weighted price-to-EBITDA, weighted total invested capital ("TIC"), and weighted TIC-to-EBITDA ratios; he then chose to rely equally upon only the weighted TIC and weighted TIC-to-EBITDA ratios. Analyzing both the data presented in the 10K and 10Q reports of the chosen comparable companies, and again applying a 20% adjustment to correct for a perceived minority discount inherent in market-based price data, Cimasi averaged the two values so derived. The result was a fair value for CTCA of $18,259,000, or $18,259 per share.
These codes appear in a company's EDGAR filings and indicate the company's type of business.
Cimasi judged the similarity between CTCA and the subset of companies based upon the services provided, market capitalization, and amount of revenues.
5. The Fair Value of CTCA
Cimasi weighted the resulting value of each approach and arrived at a single figure representing the fair value of CTCA. He afforded the DCF analysis a 50% weighting, the comparable transactions approach a 20% weighting and the comparable companies approach a 30% weighting. The end result was a fair value for CTCA as of the Merger Date of $16,400,000, or $16,400 per share. Accordingly, under Cimasi's analysis, Lane would be entitled to $1,640,000 for his holdings in CTCA.
B. Baehr
Baehr has been engaged in health care consulting for more than a quarter of a century, and his work encompasses financial advice, strategic planning, and litigation support upon a variety of industry-related subjects. Before beginning work in the health care consulting industry, Baehr had received a graduate degree from the Sloan School at the Massachusetts Institute of Technology. After graduating in 1975, Baehr worked for Amherst Associates, ultimately serving as the Chief Operating Officer and the Chairman of the Board of Directors from 1982 to 1988. From 1988 until 1992, he was employed by Ernst and Young, becoming the partner heading its Midwest Finance and Planning practice in Chicago. Baehr founded his own consulting firm, Richard A. Baehr Associates, in 1992. Additionally, he has served as a director of several health care-related entities.
In reviewing the general condition of CTCA as of the Merger Date, Baehr first explored macroeconomic and industry trends, noting that as of the Merger Date the economy was in a recession, an established trend toward outpatient care existed, a falling number of cancer patients treated on an inpatient basis, technological enhancements leading to earlier detection of cancer and a reduced need for extended patient stays, and the overall increased competition between cancer treatment institutions for both regional and local market share. He next focused upon three aspects of CTCA: its relationship with AIH, its relationship with MMC, and its prospects for expansion.
Baehr acknowledged, though, the exceptions to this trend recognized in the MediTrends Report, supra note 8.
Baehr observed that AIH faced great uncertainty. AIH had entered negotiations with the City of Zion for issuing bonds in order to finance its facilities' expansion. Furthermore, ADC at AIH had remained flat since mid-1988. Baehr characterized the 20% markup under the MSA as "unrealistic" and concluded that a reasonable, informed investor would not assume that the status quo under the MSA would continue indefinitely, especially given the state of AIH, the above-market return the MSA represented, and the restrictions that would inevitably be imposed by the bond financing. Nonetheless, Baehr projected that the payments by AIH to CTCA would increase annually by 5%.
Tr. at 1135.
Baehr's reference to what "a reasonable, informed investor" would assume may be criticized as potentially reflecting a failure to appreciate the differences between a statutory appraisal action to determine "fair value" and the more common undertaking of seeking to determine "fair market value." See, e.g., Union Ill. 1995 Inv. L.P. v. Union Fin. Group, Ltd., 847 A.2d 340, 355 (Del.Ch. 2004). The goal, of course, is to ascertain the corporation's intrinsic value as a going concern without consideration of factors such as lack of marketability, a minority interest discount, or synergies that might result from the combination. I am satisfied, however, that Baehr's phraseology (here and in the few other instances in which he employed words more appropriate for a "fair market value" analysis) is the product of imprecise word choice and not the result of a lack of understanding about the process for which he was engaged. His methodology is generally acceptable. His analysis of the facts and the projections which he draws from those facts regarding, in this instance, the future of the markup under the MSA are not unreasonable in this context.
In particular, CTCA notes that provisions prohibiting financial dealings with affiliated entities would have precluded AIH from subsidizing CTCA.
Baehr supported the reasonableness of this projection by noting that the payments made by AIH to CTCA had decreased by $2.5 million, or 30% in fiscal year 1990-1991. Tr. at 1139-40.
Baehr next reviewed the relationship between CTCA and MMC. He noted that MMC was locked in a downward spiral, unable to meet management's ADC projections and losing money. Furthermore, no written agreement existed between MMC and CTCA. Finally, a significant portion of the debt owed by MMC to CTCA had been written off but MMC was still perceived as unable to meet its remaining obligations. He concluded that MMC ultimately detracted from the health and prospects of CTCA. Moreover, Baehr observed that CTCA was obligated on the lease for the City of Faith hospital in Tulsa, and that, after five years, the terms of that lease became very unfavorable to CTCA.
Regarding CTCA's own future, Baehr did not believe it was reasonable to predict that CTCA would open any new cancer treatment centers in the near future. At the time of the Merger, there were no specific plans to open a new facility and what little management existed was consumed with turning MMC around and managing AIH. Thus, the growth of CTCA would be minimal.
Unlike Cimasi, Baehr only utilized a DCF analysis in order to determine a fair value for CTCA. Baehr proposed four scenarios for determining the fair value of CTCA, labeled 1a, 1b, 2a, and 2b. The differences in the scenarios depended on the choice of the following inputs: whether MMC would close at the end of 1991 (1a and 1b) or remain open indefinitely (2a and 2b), and whether the reimbursement rate from AIH would remain constant at a 20% markup (1b and 2b) or be reduced to 10% (1a and 2a). Then, within each of the four scenarios, Baehr conducted a DCF analysis based upon that scenario's defining constraints and certain assumptions (including ADC growth, expenses and capital investments) in order to determine cash flow over a five-year projection period.
Baehr did conduct a comparable companies analysis, but used it only as a check against the results of his DCF analysis. A discussion of this effort appears in Part III.D., infra.
In order to calculate the net income before interest and taxes, Baehr projected both the revenues (in the form of management fees received) and the expenses of CTCA for a five-year period. In scenarios 1a and 1b, Baehr assumed that ADC at AIH would peak in 1992, and remain constant thereafter. Some of the patients from the then-closed MMC would be transferred to AIH. Meanwhile, in scenarios 2a and 2b, in which MMC would remain operational, combined ADC was predicted to peak in 1992 and remain constant thereafter. The ADC of MMC would grow at a modest rate, while that of AIH would decline, thus resulting in a redistribution of relative ADC. The management fees paid under the MSA and the MMC Oral Contract are, in part, functions of an allocation of CTCA home office costs; Baehr allocated these costs based upon projected patient days at the two entities. AIH was then presumed, depending upon which particular scenario, to pay either a 10% or 20% markup over costs. MMC, however, was presumed to pay only costs allocated to it. Finally, a constraint was placed upon the management fees received by AIH: Baehr accepted that, "[i]n the case of AIH, management fees [are] assumed to be subject to a ceiling. Namely, it has been assumed that AIH will, in future years, pay no more than it did in the year ended December 31, 1990, with an allowed increase for inflation of 5.0 percent per year."
MMC was also presumed "to pay additional fees associated with directly attributable indebtedness and depreciation and pay lease payments for [Oral Roberts] as a pass-through separate from management fees." RX 87 at 28.
Id.
Operating expenses for CTCA were projected, based upon various assumptions, from the expenses for the fiscal year ended December 31, 1990. The various categories of expenses were themselves divided into fixed and variable components. A rate of inflation was calculated for each specific category of expense, and those categories were adjusted accordingly.
Certain expenses were based upon 1991 budgeted amounts.
Baehr then also deducted interest and depreciation. The interest expense was based upon the CTCA schedule of payments noted in the 1990 audited financial statements. Similarly, amounts for depreciation and amortization were based upon the audited financial statements of 1990. Notably, the depreciation expenses for assets attributable to MMC were considered to be included in the fee paid by MMC, with any remaining expense allocated on the same basis as operating expenses.
Baehr then deducted taxes at a tax rate of 38%. To derive cash flow, Baehr added back depreciation and amortization and also added back interest expense. Baehr finally adjusted the amount thus derived to provide for capital expenditures in each projected year and changes in working capital. Having done so, Baehr arrived at a projected net cash flow.
This was done to "obtain a `debt-free' cash flow in each year." RX 87 at 29.
Baehr proceeded to discount the projected stream of net cash flows. Baehr calculated a WACC of 27.9%. For the cost of equity component, Baehr utilized the Capital Asset Pricing Model with a relevered beta of 1.47, a risk-free rate of return equal to a long-term Treasury bond (twenty year maturity) as of March 20, 1991, of 8.36%, and a market premium over the risk-free rate of 7.1%. Baehr also added a small stock premium of 6.34% and a specific risk premium of 10%.
This specific risk premium provides for additional risks posed by uncertainties concerning operational performance, financial status, and management capabilities.
Finally, Baehr calculated a terminal value. Baehr assumed that CTCA achieved a steady state by 1995, and that a residual growth rate of 0% would apply in perpetuity. Thus, Baehr divided the projected net cash flow for 1995 by 27.9% and discounted that by 27.9% to March 20, 1991, to determine the terminal value. After adding the discounted net cash flows to the terminal value, Baehr subtracted the debt owed by CTCA, calculated from the obligations of CTCA as of December 31, 1990, which equaled $3,993,000.
Thus, in all but one scenario, that of 2b, Baehr derived a negative value for CTCA. Specifically, in scenarios 1a, 1b and 2a, Baehr calculated a fair value of CTCA of ($4,084,878), ($4,084,878), and ($767,114), respectively. Only in scenario 2b, with the assumptions that AIH would continue to pay a markup under the MSA of 20% (subject to 5% cap) and that MMC would continue to operate and pay all obligations (including the escalating Oral Roberts lease obligation), did CTCA have a positive fair value of $622,915. Therefore, based on his perception of the implausibility of the assumptions underlying scenario 2b, Baehr concluded that CTCA had a going concern value of $0 as of the Merger Date.
III. ANALYSIS
Having satisfied the requirements of Section 262 of the Delaware General Corporation Law, Lane is entitled to his pro rata share of the fair value of the common stock of CTCA as of the Merger Date. "The underlying assumption in an appraisal valuation is that the dissenting shareholders would be willing to maintain their investment position had the merger not occurred." Thus, as is often recited, Section 262's concept of "fair value" denotes a "`proportionate interest in a going concern.'"
8 Del. C. § 262.
Paskill Corp. v. Alcoma Corp., 747 A.2d 549, 553 (Del. 2000).
Cavalier Oil Corp. v. Harnett, 564 A.2d 1137, 1144 (Del. 1989) (quoting Tri-Continental Corp. v. Battye, 74 A.2d 71, 72 (Del. 1950)); see also Paskill Corp., 747 A.2d at 553; Gray v. Cytokine Pharmasciences, Inc., 2002 WL 853549, at *6 (Del.Ch. Apr. 25, 2002); Nagy v. Bistricer, 770 A.2d 43, 55 n. 23 (Del.Ch. 2000) ("[T]he purpose of an appraisal is to provide stockholders who are no longer owners of the previous entity with their fair share of its value as a going concern as of the date of the merger.").
In determining the fair value to which Lane is entitled, "the Court shall take into account all relevant factors." Moreover, "the parties to an appraisal action must be afforded the opportunity to present evidence of fair value consisting of `any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.'" But the broad scope granted to the Court in determining fair value is constrained by the theoretical underpinnings of the appraisal action, for the determination of fair value is to be "exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation." It is this narrow statutory exclusion, and its subsequent interpretation, which constitutes the principal limit imposed upon the Court's quest to divine fair value. Thus, while the Court has been accorded broad latitude under Section 262 of the DGCL in its inquiry to determine fair value, the exclusionary language of Section 262 precludes the Court from considering every element which may influence the value of an entity.
In re Shell Oil Co., 607 A.2d 1213, 1219 (Del. 1992) (quoting Weinberger v. UOP, Inc., 457 A.2d 701, 713 (Del. 1983)). In fact, the Court may, instead of accepting the methodologies proposed by the parties, create its own model. See Cede Co. v. Technicolor, Inc., 684 A.2d 289, 299 (Del. 1996) ( Technicolor IV).
In re Shell Oil Co., 607 A.2d at 1219.
Only the speculative elements of value that may arise from the "accomplishment or expectation" of the merger are excluded. We take this to be a very narrow exception to the appraisal process, designed to eliminate use of pro forma data and projections of a speculative variety relating to the completion of a merger. But elements of future value, including the nature of the enterprise, which are known or susceptible of proof as of the date of the merger and not the product of speculation, may be considered.
Weinberger, 457 A.2d at 713. See also Technicolor IV, 684 A.2d at 296-97.
With these guiding principles in mind, I turn to ascertaining the fair value of CTCA's common stock. I begin with a consideration of the consequences of the Oklahoma decision. Next, I elaborate on my findings as to the business reality confronting CTCA at the time of the Merger. With the foundation laid, I calculate the fair value of CTCA under a DCF approach and assess the usefulness of the comparable companies and transactions approaches.
Lane points to the arbitrary manner by which Stephenson determined the compensation to be paid to Lane for his shares at the time of the Merger (and a few other examples of conduct that suggest less than a full commitment by Stephenson to his fiduciary duties) as a basis for the Court to reject his testimony and the testimony of his affiliates. See Neal v. Ala. By-Products Corp., 1990 WL 109243, *5 (Del.Ch. Aug. 1, 1990), aff'd, 588 A.2d 255 (Del. 1991) ("If corporate fiduciaries engage in self-dealing and fix the merger price by procedures not calculated to yield a fair price, these facts should, and will, be considered in assessing the credibility of the respondent corporations' valuation contentions.") Stephenson, however, did not materially mislead the other shareholders, as the petitioners in Alabama By-Products had alleged. Instead, book value, an unreliable measure, was used. I have considered this factor, but my assessment of Stephenson's credibility, as reflected in my factual findings, is primarily the product of my consideration of his testimony and its relationship to the documentary evidence.
A. The Oklahoma Decision
On February 24, 1998, the District Court of Tulsa County, Oklahoma, rendered a judgment in the appraisal action pursued by Lane and Pittman as the result of the MMC Merger. That matter was concluded with affirmance on appeal. Previously, this Court concluded "that the factual findings of the Oklahoma Court are, as a general matter, properly considered . . . in this proceeding pursuant to the principles of collateral estoppel."
Lane v. Cancer Treatment Ctrs. of Am., Inc., 2002 WL 1732381, at *2 (Del.Ch. July 3, 2002).
Several factual findings of the Oklahoma Court are relevant to the task of determining the fair value of CTCA. First, the Oklahoma Court found that MMC had no fair value as of the date of the MMC Merger, as "a willing buyer would have been confronted with massive debt and no immediate future for turn-around of the corporation in March of 1991." Thus, I am precluded from assigning any value other than no value to the fair value of MMC. In reaching its result, the Oklahoma Court also found, "[a]ll of the projected census numbers [for MMC] proved to be wrong and all advertising efforts had failed." Clearly, under principles of collateral estoppel, I must accept the failure of the advertising campaign, and the inability of MMC to meet its own forecasts. I must also accept that the Revised Budget was unfinished and, thus, subject to revision. However, as will be explored further, even under theories of collateral estoppel, the application of these previously-found facts to resolving issues presented in the current controversy is not entirely free from ambiguity.
Mem'l Med. Ctr. Cancer Inst., Inc., No. CJ931630, slip. op. at 6.
Id.
Id.
B. The Business Reality Confronting CTCA at the Time of the Merger
In gauging CTCA's business prospects from the evidence available as of the Merger Date, the parties primarily disagree about three issues. First, the parties disagree about the continuing status of the MSA. Second, the parties assert differing predictions regarding the future performance of MMC. Third, the parties espouse competing views on the prospects for CTCA's expansion in the foreseeable future.
1. The MSA
The parties adopt differing stances on the continued payment of the 20% markup under the MSA. In his analysis, Baehr reduced what he considered an artificially high 20% markup to 10%, but presumed that the amounts paid under the MSA would grow by 5% annually for the projected period. CTCA justifies Baehr's altering of the terms of the MSA on several grounds. First, the April 1990 Memorandum expressly and unambiguously disclaimed the eternal subsidization of MMC under the MSA. No notice to terminate the MSA was given before the Merger Date but the absence of such notice only means that the MSA would continue for at least one year, as the MSA continued on a year-to-year basis until notice to terminate was given. Second, AIH would likely be unable to continue payment of the 20% markup fee after completing the bond offering with the City of Zion. CTCA argues that AIH would be unable to afford the 20% markup while bringing its facility up to the required standards, and that legal restrictions, in the form of contractual provisions policing payments made by AIH to related entities which, Baehr claimed, are standard in typical bond arrangements, would preclude continued payment of the 20% markup under the MSA. Thus, Baehr concluded that his adjustments were reasonable.
Baehr substantiated his criticism of the 20% markup as high on the grounds that past contracts (in the 1970's) of AIH with management service companies provided lower levels of compensation, and that outsourcing arrangements presumed that the third party could accomplish the outsourced task more efficiently and less expensively than the customer.
See Tr. at 711-12. Robert Hopkins, CTCA's Assistant Vice-President of Accounting from 1989 to 1993, testified that "it would have been difficult to push money [from AIH] to MMC and CTCA at the present [cost plus 20%] rate" if it would have to float a bond to pay for the renovations. Id.
Cimasi presumed that the 20% markup, a return he characterized as reasonable, would proceed unabated for the foreseeable future. In support of the permanency of the status quo and against Baehr's analysis, Lane makes several arguments. Primarily, Lane notes that no evidence was presented to the effect that efforts were underway to modify the terms of or terminate the MSA. While the April 1990 Memorandum specifically noted that "AIH surpluses" would not continue ad infinitum, it did not address the continued existence of the 20% markup in the MSA, which constitute "management fees." Lane also disputes the effect the bond financing of the AIH improvements would have upon the existing terms of the MSA. First, he notes that nothing in the record questions AIH's ability to pay the 20% markup. Second, he rejects any notion that the bond agreements would necessarily curtail the payment of the management fees by virtue of policing payments to related parties and, furthermore, asserts that any such reasoning, if adopted by this Court, would amount to an impermissible minority discount. Finally, Lane hypothesized that AIH could not simply terminate the MSA because, were it to do so, CTCA could move all of the cancer patients to the Tulsa facility. However, because I find both of the parties' theories flawed, I decline to adopt either one wholesale, and instead arrive at an independent answer.
With equal vigor, Lane contends that nothing in the record supports the conclusions of Baehr in selecting 10% as the new return under the MSA and 5% as the annual growth rate of amounts received under the MSA. Answering Post-Trial Br. of Pet'r. Robert M. Lane at 28-29.
Presumably, this semantic distinction formed the basis of both Lane and Hopkins's testimony that they did not consider the April 1990 Memorandum as a warning that the markup was temporary.
Indeed, Lane notes that Baehr testified that "there clearly would have been legal restrictions as opposed to what appeared to be business considerations by AIH and their board to limit either the growth or the actual level of expenditure or the margin of the business that was being provided by CTCA." Tr. at 1125. Thus, Baehr's expectation that the fee would be reduced had nothing to do with ability to pay.
I conclude that the relationship between AIH and CTCA would continue indefinitely. No evidence is to be found in the record supporting any inference that the MSA would be terminated, or that CTCA was to be replaced, as of the Merger Date. No readily available alternatives to CTCA's continued service under the MSA, in the form either of competitors to CTCA or the internal development by AIH of those services provided by CTCA, have been identified. Stephenson, as the majority shareholder of CTCA and the controlling shareholder of AIH, cannot reasonably be expected to abandon his significant investment in CTCA by depriving CTCA of its most important "customer." Hence, while the MSA could be terminated by either party upon notice within 90 days of the end of a contract term, no motivation for such action can be ascertained from the facts at hand Given the evidence existing at the time of the Merger Date, the only reasonable inference is that the MSA would continue indefinitely. Thus, the issue before me is not whether the MSA would continue beyond the Merger Date, but, more precisely, what are the projected terms, notably the percentage markup of the MSA.
I reject Lane's proposition that AIH could not terminate the MSA, or lacked the power to alter its terms, because of the implicit threat by CTCA to move the cancer treatment patients to the Tulsa facility. Lane's assertion presumes much about the "ownership" of the cancer treatment patients. Moreover, nothing in the record shows that the patients could be simply moved from Zion to Tulsa. However, while AIH could terminate the MSA, it could not do so immediately, having to abide by the termination provisions of the MSA and being constrained by the operational realities of finding an adequate replacement for CTCA.
At the heart of the dispute between the parties are differing views on the nature of the 20% markup under the MSA. Lane characterizes these payments as negotiated compensation for the provision of various services by CTCA to AIH. In contrast, CTCA portrays the 20% markup as a device by which AIH, the established entity, could deliver start-up funding for MMC and otherwise subsidize CTCA; in other words, the MSA served as a conduit for the capital necessary to build a national network of cancer treatment centers. I conclude that the 20% markup was not primarily consideration for services rendered by CTCA, but, instead, was a vehicle enabling AIH to funnel capital to CTCA to finance its eventual national expansion. The direct evidence in the record, in the form of statements contained in the April 1990 Memorandum, the representations made while seeking a line of credit from LaSalle National Bank, and the depiction of the 20% markup under the MSA as a subsidy for MMC in the initial projections for MMC, supports this characterization.
See April 1990 Memorandum, RX 34 at 2. In this memorandum, Stephenson wrote to Lane and the others that "AIH is the `cash cow' that makes possible its own survival and growth, and the opportunity presented to you vis a vis CTCA, et al. Unless we protect it, both AIH and CTCA development will be in jeopardy." Id. He further explained that "[i]t was understood that AIH would provide to CTCA a determinable amount of money to give CTCA a start. However, such investment would be first returned to [him] before profits of CTCA would be distributed under the proposed CTCA equity sharing arrangement. [He] did not intend a permanent assignment of a big portion of AIH cash flow, nor an indirect sharing of AIH profits triggered by said assignment." Id. at 4.
My decision that the parties chose, for whatever reason, to subsidize the national expansion of CTCA in the form of a 20% markup under the MSA is buttressed by the very structure of those Stephenson-controlled entities. CTCA's funding from the beginning came from AIH. No outside investors were brought into CTCA; the AIH "cash cow" was the only realistic source of financing the development of a national network of cancer treatment centers. Finally, that the 20% markup was a subsidy of CTCA's attempt at national expansion is confirmed by the fact that CTCA only charged MMC at-cost under the MMC Oral Contract. Thus, the structure of the relationships among AIH, CTCA and MMC corroborates the affirmative portrayals of the 20% markup as a method to subsidize the initial expansion of CTCA.
And, regardless of his proclaimed differences surrounding the initial financing of CTCA, even Lane admits that start-up funds for CTCA could be traced to profits derived from services provided to AIH. Tr. at 54 (Lane testified that his "task was to turn around the operation of [AIH] and to make it much more profitable and basically to use the monies generated by that success to fund the development of this national cancer center.").
The perception that the 20% markup was to serve as seed money for the expansion of CTCA has an important ramification. By its nature, start-up (or venture capital) funding is frequently limited in duration, with the specific purpose of providing a cash infusion into a newly formed entity in order to enable it to reach some level of financial and operating independence. Thus, the April 1990 Memorandum noted that "[i]t was understood that AIH would provide to CTCA a determinable amount of money to give CTCA a start. . . . I [Stephenson] did not intend a permanent assignment of a big portion of AIH cash flow, nor an indirect sharing of AIH profits triggered by said assignment." Furthermore, with the realization that the 20% markup under the MSA was primarily a method to channel capital from AIH to CTCA, the debate of the parties as to whether a 20% return was reasonable becomes less important. What must be determined is the likelihood of continued payment in light of its purpose in initially funding the creation of a national network of cancer treatment centers. In any event, it is clear that the 20% markup, although continuing for some time after the Merger Date, was not to be paid permanently.
RX 34 at 4. Lane argues that he understood, at the time of first receiving the April 1990 Memorandum, that the funds referred to by Stephenson did not include the "management fee" comprised of the 20% markup under the MSA, but were separate, capital contributions to have been made by Stephenson. However, given that CTCA had been operating for nearly one year with no such contributions having been made by Stephenson, and that the only funds provided to CTCA during that period were under the MSA, I find Lane's belief unreasonable.
Cimasi contended that the "subsidization" he acknowledged in his testimony as being under the MSA referred to the bonus provision in the MSA. Tr. at 406. I note though that no monies were shown to have been paid pursuant to the bonus provision. Also, I note that, while the 20% markup may not have been the most efficient vehicle to subsidize CTCA, a bonus on that markup would have injected another layer of uncertainty.
I note though that I find Baehr the more persuasive of the conflicting expert witnesses as to the reasonableness of compensating CTCA for services provided by a 20% markup over costs. In part, my opinion is formed from the inability of Cimasi to point to specific instances of a comparably sized fee. See Tr. at 443. The perception that 20% is an unreasonable amount for CTCA to be compensated for its services only reinforces my belief that such payments are best viewed as a financing vehicle, instead of a negotiated level of compensation.
Lane insists that, because no affirmative steps were taken to terminate the MSA or alter its terms, the Court should assume that the status quo under the MSA would continue indefinitely. The absence of such evidence, however, fails to overcome the evidence demonstrating the nature of 20% markup under the MSA, and the consequences that likely flow from it.
I am satisfied it is reasonable to project that the 20% markup would continue through the third year after the Merger. Such a time frame for the 20% markup would be consistent with its purpose of enabling the next stage of growth in a national network of cancer treatment centers. Moreover, a three-year timeframe would allow more than adequate time for Gagliardi to demonstrate that expansion was possible by reversing the deterioration of MMC. Additionally, I am satisfied that, although not a definitive constraint, within three years significant burdens would be imposed upon AIH to justify the continued payment of the 20% markup under the MSA by the rigors of the already commenced bond financing. AIH, the foundation of the CTCA and MMC enterprises, needed to revamp the AIH facility in order to retain its operating licenses in Illinois. To this end, CTCA and the City of Zion had already entered into negotiations at the time of the Merger to accomplish this undertaking. The arrangements for bond financing with the City of Zion, while not by their very terms comprising a definitive limitation on funding of the related entities, would to some degree constrain the ability of AIH to subsidize CTCA's growth due to operational realities in making scheduled payments. Therefore, I conclude that the 20% markup under the MSA would continue for a period of three years beyond the Merger Date, after which, with its mission of "giv[ing] CTCA a start," fulfilled, the level of remuneration provided for under the MSA would be revised downward. The question, thus, becomes: what markup can reasonably be forecast based on the information known as of the Merger Date? Baehr's projection of 10% as a going rate is not unreasonable. The markup, however, would not be completely based upon external market forces.
To guess as to the precise terms and restraints that might be imposed upon AIH by the hypothetical bond agreements, upon a record lacking factual details, when the parties were still negotiating those covenants, would be to engage in the kind of speculation deemed impermissible by Weinberger and its progeny. See supra note 90 and accompanying text. It is both sufficient and necessary for these purposes to recognize that the AIH expansion would inevitably put pressure of AIH to reduce the markup/subsidy paid to CTCA.