Delaware Open MRI Radiology Associates, P.A. v. Kessler
2006 Del. Ch. LEXIS 84, 2006 WL 4764042, 898 A.2d 290 (2006)
Rule of Law:
In a squeeze-out merger by a controlling shareholder, the controlling shareholder bears the burden of proving entire fairness, which includes demonstrating both fair dealing and fair price. Fair value for appraisal and entire fairness purposes must include the value of all non-speculative future business opportunities known or susceptible of proof at the merger date and must properly account for the benefits of an S-corporation tax status, as well as ensure self-dealing transactions are at a fair market rate.
Facts:
- Eight radiologists formed Delaware Open MRI Radiology Associates, P.A. ("Delaware Radiology") to own MRI centers and capture additional revenues from MRI scans.
- The radiologists' underlying radiology practice split, forming two groups: the "Broder Group" (five stockholders, 62.5% ownership) and the "Kessler Group" (three stockholders, 37.5% ownership).
- Delaware Radiology and Dr. Steven Edell formed a joint venture, opening Delaware Open MRI, L.L.C. ("Delaware I") in Newark, DE in 1998 (70% Delaware Radiology, 30% Edell) and Delaware Open MRI II, L.L.C. ("Delaware II") in Wilmington, DE in 1999 (60% Delaware Radiology, 40% Edell).
- Initially, Delaware Radiology passed its 15% reading fees from MRI centers to Fox Chase (the Broder Group's practice) for the actual reading services, with all eight original Delaware Radiology shareholders benefiting.
- The Kessler Group left Fox Chase in June 1999 to form their own practice, Bucks County Radiology Associates, P.C., disrupting the equitable distribution of reading fees.
- The Broder Group, controlling Delaware Radiology, progressively reduced the Kessler Group's share of MRI reads from two-thirds to one-sixth, and eventually to zero by December 2002.
- In August 2002, the Kessler Group announced it would compete with the Broder Group for the Jeanes Hospital contract, which Fox Chase (Broder Group) subsequently lost to the Kessler Group in October 2002.
- The Broder Group, as the sole directors of Delaware Radiology by November 2002, retroactively increased Tri-State's (a Broder Group entity) management fee to 2% and increased reading fees for Delaware I to 17.5% in March 2003.
- The Broder Group formulated plans for opening Delaware Open MRI III, L.L.C. ("Delaware III") in Middletown, DE and Delaware Open MRI IV, L.L.C. ("Delaware IV") in Dover, DE, and began discussions for Delaware Open MRI V, L.L.C. ("Delaware V") in Seaford, DE, all before the merger date.
Procedural Posture:
- On January 9, 2004, the members of the Kessler Group submitted written demands for appraisal of their shares pursuant to 8 Del. C. § 262.
- On January 20, 2004, a squeeze-out merger was effected, with Delaware Open Acquisition, P.A. (Broder Group's acquisition vehicle) merging with Delaware Open MRI Radiology Associates, P.A., with Delaware Open MRI Radiology Associates, P.A. as the surviving corporation.
- In February 2004, Delaware Open MRI Radiology Associates, P.A., as the surviving corporation, filed a lawsuit in the Delaware Court of Chancery (trial court) to determine the value of shares held by the Kessler Group (appraisal action).
- In June 2004, the Kessler Group filed a complaint in the Delaware Court of Chancery (trial court) against the members of the Broder Group and Delaware Open Acquisition, P.A., alleging breach of fiduciary duties for effecting the merger in an unfair manner.
- The Delaware Court of Chancery consolidated the appraisal action and the entire fairness action for resolution.
Premium Content
Subscribe to Lexplug to view the complete brief
You're viewing a preview with Rule of Law, Facts, and Procedural Posture
Issue:
Does the merger price for a squeeze-out merger by a controlling shareholder constitute fair value when it fails to include the value of the corporation's non-speculative future business expansion plans, incorrectly assesses the corporation's S-corporation tax status, and includes self-dealing transaction expenses that are above market rates?
Opinions:
Majority - Strine, Vice Chancellor
No, the merger price of $16,228.55 per share was not fair because it failed to account for the value of Delaware Radiology's non-speculative future expansion plans, the reading fees paid to the Broder Group were above market rates, and the increase in management fees to Tri-State was unfair. The court found that the plans for Delaware III and IV were "operative reality" as of the merger date, with leases signed or finalized and financing sought, and therefore should have been included in the valuation under `Technicolor` and `Weinberger` precedent. Even Delaware V, though more inchoate, was part of an obvious statewide expansion strategy and thus held some value that should have been recognized. The Broder Group's refusal to include these values in the merger price was unfair and resulted in undervaluation. The court determined that the Broder Group's decision to allocate all read work to its entity (Fox Chase) at a 15-17.5% rate without a market check was a breach of fiduciary duty. The court found a fair market rate, based on Medicare reimbursement rates, to be 13.7% and included the difference as an "unfair profit" diverted from Delaware Radiology, citing `Telxon Corp. v. Meyerson` for the principle that self-compensation must be fair to the corporation. While the initial 1% management fee to Tri-State was fair and approved by the Kessler Group, the subsequent unilateral increase to 2% after the Kessler Group was removed from the board was an interested transaction not ratified by disinterested parties, and its fairness was not proven; thus, the court reduced it to 1%. However, the increase in Dr. Edell's fees to 7.5% was deemed fair given his valuable marketing services and importance to the MRI Centers' success. The court also addressed the S-corporation tax status, rejecting both experts' approaches of full C-corp tax or no tax. It held that an S-corporation's favorable tax status (avoiding double taxation) produces a material increase in economic value for stockholders and should be recognized in valuation. The court calculated an "equivalent, hypothetical 'pre-dividend' S corporation tax rate" of 29.4% to accurately capture this benefit, preventing both overstatement and understatement of value, consistent with `In re Radiology Assocs.` and U.S. Tax Court decisions. The court largely adopted Mitchell's (Kessler Group's expert) discounted cash flow (DCF) analysis as more reliable, making adjustments for its findings on expansion plans, reading fees, management fees, and S-corporation tax status. The court awarded $33,232.26 per share, totaling $4,984,838.71 to the Kessler Group, with pre- and post-judgment interest at 6.9% compounded monthly.
Analysis:
This case provides a significant precedent for valuing privately held S-corporations in Delaware squeeze-out mergers, clarifying the treatment of their unique tax status. It reinforces the duty of controlling shareholders to prove "entire fairness" in conflicted transactions, particularly regarding the price, and emphasizes that fair value must encompass all non-speculative business opportunities and market-rate self-dealing. The ruling highlights the court's active role in scrutinizing expert valuations and making independent determinations to protect minority shareholders, especially concerning future growth prospects and potential corporate opportunity claims. This decision makes it harder for controlling shareholders to time mergers to exclude minority shareholders from anticipated gains from a company's established growth strategy.
