Overview of a Two Part Series
Morgan Stanley and Citigroup entered into a joint venture (JV) dated as of May 31, 2009, with Morgan Stanley owning 51% and Citigroup owning the remaining 49% of the common member interests in Morgan Stanley Smith Barney Holdings LLC (“MSSBH”). The JV was evidenced by the Amended and Restated Limited Liability Company Agreement of MSSBH (“the LLC Agreement”). The LLC Agreement contained certain provisions providing for a series of options for Morgan Stanley to call (purchase) the 49% of the common membership interests owned by Citigroup.
Morgan Stanley issued a press release on May 31, 2012 (three years from the date of the LLC Agreement to the day) announcing its intent to exercise its option to call (purchase) an additional 14% of the common member interests from Citigroup in accordance with the terms of the LLC Agreement.
This post will describe the definition of the price (i.e., the amount that Morgan Stanley will have to pay to Citigroup) for transactions pursuant to the LLC Agreement as well the previously agreed upon process (in the LLC Agreement) for determining such price. The next post will then describe the actual process based on publicly available information. As usual, I will comment and relate this big-time buy-sell agreement to those found in companies that our attorney friends, accountants, financial planners and business appraisers more normally deal with.
I will be quoting from the Morgan Stanley Form 8-K and making comments, as appropriate.
As usual, there are some lessons to be learned from the “big boys.” And the big boys may have learned a lesson or two, as well.
The Price Morgan Stanley Will Pay Described
The price is described in the LLC Agreement beginning with the Definition of FMV. Presumably, FMV is some concept of fair market value, which is described in the ASA Business Valuation Standards as:
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Compare this definition of fair market value with that of “FMV” in the LLC Agreement, which is defined as the product of:
the aggregate common equity market value of MSSBH on the Notice Date as if, on the Notice Date, MSSBH had been converted into a domestic corporation or a new domestic corporation had been formed to own all the Membership Interests or assets of MSSBH (and assuming that the preferred membership interests of MSSBH had been converted to preferred stock of such corporation with the same amount of liquidation preference and having substantially the same terms as the preferred membership interests of MSSBH, subject to any modifications as may be mutually agreed by the MSSBH members in order to permit the exchange of preferred membership interests for preferred stock to be treated as a tax-free transaction for U.S. federal income tax purposes), and the common shares of such corporation (“the Publicly Traded JV Company”) were traded on the New York Stock Exchange or NASDAQ on a Fully Distributed Basis (as defined below);
and the percentage of outstanding Membership Interests subject to the Call Right.
It sounds like Morgan Stanley and Citigroup wanted any appraisers to treat MSSBH as a domestic, publicly traded corporation with its (hypothetical) shares being traded on the New York Stock Exchange (“NYSE”). And it appears that any preferred interests owned by the parties are not subject to any Call Right and remain in place following any transaction.
This is all well and good, but since the hypothetical shares of MSSBH are not actually traded on the NYSE, the parties wanted to provide any appraisers (described below) with certain instructions. We begin with the definition of Fully Distributing Basis, which:
means assuming 100% of the common shares of the Publicly Traded JV Company were publicly traded at such time and no one person or group of persons beneficially owned more than 1% of such shares.
This definition precludes any appraiser from making assumptions regarding control or other assumptions regarding the exercise of corporate power which might influence price. But we are not through with the definition of price. The next ponderous paragraph states that “Under the LLC Agreement, FMV will:” (with my numbering system replacing that in the LLC Agreement and with [my comments in brackets] and with any emphasis being mine) :
- not include any control premium [this reemphasizes the guidance in the definition of Fully Distributing Basis above]
- not include any discount due to the illiquid nature of the Membership Interests or any discount relating to the fact that MSSBH is not a public company [i.e., there will be no marketability discounts for lack of marketability, even though it has already been made clear that the hypothetical MSSBH is publicly traded on the NYSE. Someone just wanted to be sure that no one tried to insert a DLOM of any kind for any reason.]
- take into account trading values of comparable companies (A) the prospects of MSSBH [how any appraiser could fail to consider the prospects of MSSBH or any company being valued is beyond me], (B) the value of the estimated future earnings of MSSBH [so the appraisers are required to use the discounted cash flow or future earnings method], (C) the size of MSSBH [with more than 16,000 brokers, it is a pretty good-sized business], (D) the public market trading values of comparable companies [so the instructions require the use of the guideline public company method], (E) the business mix of MSSBH relative to comparable companies [appraisers, be sure that the "comparable" companies are comparable!], and (F) such other factors as the Appraisers (as defined below) deem relevant
- be based on (A) the valuation of MSSBH and its subsidiaries taken as a whole [appraisers, value MSSBH and not something else?], (B) an assumption that MSSBH will remain independent and have the continued ownership of its subsidiaries [no sneaking in a control premium Appraisers, get it?] and (C) an assumption that the then existing contractual relationships among Morgan Stanley, Citigroup and MSSBH and their respective controlled affiliates shall remain in full force and effect and continue in accordance with their terms (other than certain transaction documents that terminate in accordance with their terms) [This reminds me of a buy-sell agreement dispute where an investment banker from then Salomon Brothers was appraising for his "buying" client. He wanted to argue that his client would cease supplying the joint venture and its value was therefore diminished by the operation of the buy-sell agreement! It didn't work.]
- take into account whether or not any items are non-recurring and [this virtually universal appraisal practice is made specifically clear.]
- assume that all funding contribution obligations and obligations to make any delayed contributions of certain businesses to MSSBH have been satisfied or made and all delayed distributions of certain businesses from MSSBH to Morgan Stanley and Citigroup have been effected. FMV will also take into account the tax attributes of the Publicly Traded JV Company, including an assumption that the Publicly Traded JV Company had received the benefit of a tax basis step-up for income tax purposes(if then available under applicable law) arising by reason of the purchase of (A) Citigroup’s entire Membership Interest in MSSBH (i.e., a 49% percentage interest) at FMV as of the Notice Date and (b) all preferred membership interests of MSSBH then held by Citigroup and/or its affiliates at their liquidation preference. [From the financial press, there was a substantial disagreement regarding tax treatment in the valuation process]As of March 31, 2012, there was an aggregate face amount of approximately $7.5 billion of preferred membership interests of MSSBH outstanding, of which approximately $5.5 billion was held by Morgan Stanley and $2 billion was held by Citigroup. The determination of FMV will assume only a single level of corporate income tax imposed on the Publicly Traded JV Company
Lawyers and perhaps some consulting investment bankers must have worked hard on this, trying as best they could to define away all possible sources of potential future dispute.
Interestingly, while the LLC Agreement prohibits the application of a control premium, it does not prohibit (nor does it mention) the use of multiples from guideline transactions involving the sale of comparable companies. This could have been a back-door way for someone to attempt to sneak in an implicit control premium without ever mentioning the word. I don’t know if this happened or not. The point is, the longer and more refined the list of instructions becomes in a buy-sell agreement, almost the easier for an advocative appraiser to slip in methods or techniques inconsistent with the instructions.
If I had to summarize the Definition of FMV from the LLC Agreement, it would appear that the parties were attempting to agree on a value that I would describe as “fair market value at the marketable minority level of value.” Defining FMV in this fashion might have been clearer than all of the convoluted instructions to the appraisers. Or, having provided specific instructions, the LLC Agreement could have concluded by noting that “the above instructions are tantamount to defining FMV as being determined at the marketable minority level of value, including all the institutional-specific assumptions provided.” But they didn’t ask me.
The “words on the pages” of the LLC Agreement are the only words that matter once a buy-sell agreement has been triggered, including the triggering of the Call Right in the LLC Agreement by Morgan Stanley.
The Valuation Process Described
With everything crystal clear about price and the definition of FMV, we proceed to the valuation process described in the LLC Agreement, which provides a specific process for determining FMV as follows:
Two Appraisers Start the Valuation Process
Without attempting to quote directly, we can summarize the the valuation process first, as beginning with two appraisers and then becoming a three appraiser process. The first two appraisers are selected and operate as described.
- Within 10 days, each of Morgan Stanley and Citigroup “will engage one investment bank or financial advisory firm of national standing and with experience in the valuation of securities of financial services for purposes of estimating FMV.” Each is an “Appraiser” per the LLC Agreement. The parties are respectively responsible for the fees of their selected Appraisers.
- This next aspect is quite interesting and insures great potential for disagreement (i.e., advocacy) between the Appraisers. “Either or both of the first two Appraisers may be an affiliate of the party engaging such an Appraiser.” Morgan Stanley selected Morgan Stanley Investment Banking as its appraiser and Citigroup selected Citigroup Global Markets, Inc.
- Each Appraiser is instructed to determine FMV in “good faith” and to provide estimates in accordance with the Definition of FMV we just described and within 45 days.
- Finally, if the higher of the two estimates of FMV (Citigroup is selling. Care to guess which one was higher?) is more than 110% of the lower, the final determination of FMV will be the average of the conclusions of the first two Appraisers. In the next post we will learn just how much more than 110% the higher can be over the lower.
The Third Appraiser
If the first two Appraisers’ conclusions are more than 110% apart (higher to lower), then the first two Appraisers are required to select a third Appraiser who is independent of all parties. There is a further process for selecting a third Appraiser if the first two Appraisers cannot agree. Since that didn’t happen here, we’ll save a few words. Fees of the third Appraisers are shared equally by Morgan Stanley and Citigroup. The third Appraiser is to be selected by the 60th day following the Notice Date.
Once selected (it was Perella Weinberg Partners), the third Appraiser is to render its estimate within an additional 30 days. An interesting restriction is placed on the third Appraiser, indicating “the estimate of the third appraiser must be equal to one of, or be within the range between, the estimates of the first two Appraisers.”
It is always the role of the third Appraisers to, hopefully, resolve the valuation process. How that resolution occurs, however, is up to the parties. The third appraiser’s conclusion can, for example, be binding in and of itself. Alternatively, the third conclusion can be averaged with the closest conclusion of the first two. Other resolving processes can be described. The LLC provides an interesting twist on the resolution process:
If the FMV estimated by the third Appraiser is in the middle third of the range of the FMVs estimated by the other two Appraisers, the FMV of the third Appraiser will be the final FMV. If the FMV estimated by the third Appraiser is in the top third of the range, the final FMV will be the average of the FMV estimated by the third Appraiser and the higher FMV of the first two Appraisers. If the FMV estimated by the third Appraiser is in the bottom third of the range, the final FMV will be the average of the FMV estimated by the third Appraiser and the lower FMV of the first two Appraisers.
This clause provide for potential enormous movement of the concluded FMV based on very small differences in the third Appraiser’s conclusion. Assume for a moment that the lower appraisal of FMV is at $3 billion and the higher estimate is at $12 billion. The bottom third is defined by the range of $3 billion to $6 billion.
- Assume that the third Appraiser concludes that FMV is $5.9 billion. The average of $5.9 billion and $3 billion is $4.45 billion.
- Assume that the third Appraiser concludes that FMV is $6.1 billion, this conclusion is within the middle third range and would be binding.
- A $200 million ($0.2 billion) swing in the third Appraiser’s estimate, say from $6.1 billion (within the middle third range and therefore binding) to $5.9 billion, would cause an averaging with the $3.0 billion low result. The price would fall from $6.1 billion to $4.45 billion, which would be a swing in favor of the purchaser of $1.55 billion, and a reduction of some 27% in proceeds to the seller. The buy-sell agreement in the LLC Agreement would provide a mirror swing for conclusions around $9 million, which is the boundary between the middle third and the top third.
We will see how it all worked out in the next post, which will look at the dynamics of the process.
Several comments were made along the way. As we conclude this discussion of the definition of price and the overview of the valuation process for a whopping buy-sell agreement, let me make the following observations.
- The parties went to great lengths to define FMV. However, the length of the definition likely introduced as many areas for potential dispute between advocative appraisers as it eliminated. As noted above, the more intensively parties try to define value or price, the easier, in some respects, it is to find an exception to the “rules” laid out in an agreement.
- This process was set up to be advocative. Morgan Stanley hired its investment banking arm. Citigroup hired its brokerage and securities arm.
- There is pressure for the third Appraiser to reach a conclusion within the middle third range between the FMV estimates of the first two Appraisers. The investment banker reaching a conclusion creating a swing like described above might be unpopular with a powerful enemy, and perhaps popular and with a powerful friend at the same time.
- The process described in the LLC Agreement is a three appraiser agreement where the third Appraiser is the Determiner, as described in my book, Buy-Sell Agreements for Closely Held and Family Business Owners.
- When this process was initiated on May 31, 2012 by Morgan Stanley, it was bound to be public and potentially embarrassing for one or both of the parties. With captive Appraisers allowed and selected, the process was bound to create a third Appraiser requirement. The confusion created by the minute descriptions in the definition of FMV provided almost certain room for varying interpretations by the two captive appraisers.