For an interesting overview of the appraisal process and a concise summary of the merits and risks associated with litigating appraisal rights, we recommend reviewing the article “Opportunistic Investing – the Case for Appraisal Rights” from Neuberger Berman’s Hedge Funds Solutions Group. In describing appraisal as a “niche, legally intensive strategy” with the “potential for providing compelling uncorrelated returns,” the authors provide some key data points on Delaware appraisal decisions’ premium over merger price. They identify appraisal, a “long-ignored part of corporate law,” as an “important weapon” for hedge funds in their “activist investment arsenal,” while cautioning investors to be selective in the deals they pursue.
In a new ruling in the DFC Global appraisal case, about which we’ve posted before, Chancellor Bouchard has now reconsidered his prior award of 7% over the merger price and increased his prior award by an extra 9 cents per share, translating to an additional $12 million in value above his prior ruling.
Both sides had asked the court to reconsider different aspects of its ruling, prompting the Chancellor raise the perpetuity growth rate in his DCF model from 3.1% to 4.0%. In reconsidering his ruling, the Chancellor held that he “failed to appreciate the extent to which DFC Global’s projected revenue and working capital need have a codependent relationship,” and that the high-level requirement for working capital necessarily corresponds to a high projected growth rate. In so ruling, the court had to overcome its initial theory that a company’s perpetual growth rate should never exceed the risk-free rate. The court came to realize that this proposition would be true only for companies that have reached a stable stage of development; where a company is expected to achieve fast-paced growth throughout the projection period, the court now agreed that the perpetuity growth rate should indeed be higher than the risk-free rate.
The court’s initial opinion rejected the stockholders’ use of a three-stage DCF model in favor of a two-stage model, but on reconsideration the court recognized that using the two-stage model required increasing the terminal growth rate to sufficiently take into account the company’s growth rate beyond the five-year projection period.
Finally, the court’s new ruling also unwound two adjustments to the company’s baseline projections that the court had inadvertently made in accepting the company’s DCF model wholesale.
Delaware Chancery has again awarded appraisal petitioners a significant bump above the merger price. In the ISN Software Corp. Appraisal Litigation, Vice Chancellor Glasscock was facing widely divergent valuation from the opposing experts, and relied exclusively on a discounted cash flow analysis as the most reliable indicator of fair value. The court’s per-share valuation award was more than 2.5 times the merger price.
ISN involved the valuation of a privately held software company founded in 2000 and specializing in assisting companies (largely in the oil and gas industry) to meet their governmental record keeping and compliance requirements. In the years leading up to the merger — which was completed on January 9, 2013, with the approval of ISN’s founder and majority shareholder — the company had experienced consistent and substantial growth. In setting the merger price, however, ISN did not engage a financial advisor or obtain a fairness opinion; rather, the company used a 2011 third-party valuation that ISN’s founder apparently adjusted based on his personal views of the company’s future prospects.
Particularly striking in this case was the sheer magnitude of the difference between the dissenters’ and ISN’s valuations, each of which was based largely on a DCF analysis with some weight given to other methodologies such as guideline public companies, comparable transactions, and direct capitalization of cash flow. The court found those other methodologies unreliable here. The petitioners’ valuation at $820 million was over eight times that of ISN’s valuation of $106 million (which was below the merger price’s implicit valuation of $137 million). The Court expressed some of the same skepticism that Delaware chancellors have historically shared regarding the reliability of competing experts in an adversarial litigation environment: “an optimist (a.k.a. someone other than a judge presiding in appraisal trials) might assume that experts hired to examine the same company, analyzing the same set of financial data, would reach similar results of present value based on discounted cash flow. . . . In a competition of experts to see which can generate the greatest judicial skepticism regarding valuation, however, this case, so far, takes the prize: one of the Petitioners’ experts opines that fair value is greater than eight times that implied by the DCF provided by the Respondent’s expert. Given such a divergence, the best scenario is that one expert, at the least, is wildly mistaken.”
The court performed its own independent DCF analysis using the ISN expert’s DCF model as a baseline with various adjustments. One difficulty in doing the DCF valuation was that the company did not regularly create long-term financial projections, requiring the experts to project future cash flows using various assumptions regarding growth and efficiency. Even though the court found that approach “inherently less reliable than using long-term management projections,” it found the expert projections reliable given ISN’s subscription-based business model, customer retention, and the inelastic demand for its product. Finding that “projections out more than a few years owe more to hope than reason,” the court found a standard five-year projection period appropriate.
The court awarded statutory interest and rejected ISN’s argument that “good cause” existed to deny at least one of the petitioners any interest. Finally, even though the court set forth in detail all the various adjustments it made to the ISN expert’s DCF model, he invited the parties to revisit the math, as “relying on the mathematical skill of this superannuated history major—even as assisted by an able judicial clerk—would be hubristic.”
Have the recent Delaware statutory amendments and major Dell decision threatened the appraisal arbitrage strategy? Business Law Prof Blog (via a guest post) acknowledges that while these two developments do not prevent appraisal arbitrage — indeed, the Delaware legislature rejected a proposal to crack down on arbitrage — they may be part of an overall trend against the strategy, and that those who want to pursue appraisal arbitrage should take action before potential other developments may limit it.
Appraisal arbitrage, as we’ve posted before, is a strategy whereby an investor buys shares of a company after announcement of a merger intending to exercise appraisal rights. Unlike historical holders, who may have purchased stock for amounts higher than the deal price, the arbitrageur is buying stock already priced with the deal in place, usually at a price much closer to the deal price. Whether the new Delaware rules will suppress appraisal filings has been a topic of significant debate – we’ve covered pieces about these topics before suggesting they may actually wind up inadvertently increasing appraisal claims.
The Business Law Prof Blog post points out that the fundamental premise of appraisal arbitrage involves the idea of “fungible bulk” – that any particular share of stock is part of the bulk of un-differentiable shares – so that barring a finding that the particular holder voted for the merger, the arbitrageur may seek appraisal so long as enough shares voted against the merger or abstained to “cover” the arbitrageur’s shares and render them eligible for appraisal.
Whether the recent statutory and legal developments actually signal a cautionary flag to arbitrageurs remains to be seen. The Delaware legislature will first need to be persuaded that its prior determination — that appraisal arbitrage is an accretive strategy that enhances shareholder value — was somehow incorrect.
A key aspect of the August 1 changes to Delaware appraisal law permits companies to unilaterally prepay some or all of the merger consideration, thereby stopping the interest accrual on such prepaid amounts. A recent article by Bloomberg discusses prepayment strategies under this new rule and echoes the point posted to this blog repeatedly: the new prepayment rule may have inadvertently fueled more appraisal litigation by “unlocking money for shareholder litigants.”
As discussed in the article, when deciding whether to prepay some or all of the merger price, the appraisal target may have to consider the risk of whether the amount of any prepayment reflects an indication of fair value, and whether prepayment will provide quick liquidity for investors who may have otherwise been deterred by the expense of pursing appraisal. Thus, while prepaying may save a company the statutory interest otherwise due on the prepaid amount, it may reduce any deterrent effect for investors who would otherwise have their capital locked up for the roughly two years that many appraisal cases last. For investors, the possibility of unilateral repayment is also a consideration in bringing, and valuing, the action. As Bloomberg observed, the prepayment option raises new, strategic considerations for both sides going forward.
As reported in The Hedge Fund Law Report‘s article, “Recent Legislative and Judicial Developments Fail to Diminish Appeal of Stockholder Appraisal Actions As Strategy for Hedge Fund Managers” [$$$], the recent statutory amendments have failed to diminish the appeal of stockholder appraisal actions as a strategy for hedge fund managers. According to this article, that news, combined with the recent Dell appraisal decision, confirms that this litigation-based investment strategy remains a suitable option for hedge fund managers.
Now that the amendments to the Delaware appraisal statute have been signed into law, the new provisions will apply to all M&A agreements entered into on or after August 1. Here is a link to the rule as revised, showing the new terms (only Sections 8-11 relate to appraisal). As we have posted previously, the statute, as amended, now (i) sets a floor for appraisal proceedings based on the quantum or dollar size of shareholdings and (ii) permits M&A targets to prepay dissenters in an amount of their choosing to halt the interest clock on the amount prepaid. As we’ve observed before, investors may welcome the opportunity to redeploy any such prepayments to the next appraisal case, thus indirectly solving the liquidity problem that has prevented some shareholders from exercising appraisal in the first place.
On July 8, the Delaware Court of Chancery issued its opinion in In re Appraisal of DFC Global Corp. A financial buyer, Lone Star Fund VIII, acquired DFC Corporation in June 2014 for $9.50 per share in an all-cash deal. Using a combination of a discounted cash flow analysis, comparable companies analysis, and the merger price, Chancellor Bouchard determined the fair value of DFC as a stand-alone entity at the time of closing to be $10.21 per share, or 7% above deal price, before adding statutory interest.
While observing “merger price in an arm’s-length transaction that was subjected to a robust market check is a strong indication of fair value,” the Court also cautioned that merger price “is reliable only when the market conditions leading to the transaction are conducive to achieving a fair price.” Concluding that deference to merger price would be improper, the Court highlighted that “[t]he transaction here was negotiated and consummated during a period of significant company turmoil and regulatory uncertainty” arising from possible regulatory changes affecting payday lenders, such as DFC, in the countries in which they operate. These potential regulatory changes could have had the negative effect of rendering DFC’s business not viable or the positive effect of reducing DFC’s competition in certain markets. As a result of this uncertainty, DFC repeatedly lowered guidance throughout the sales process and potential bidders were deterred. Indeed, Lone Star itself cited the uncertainty surrounding DFC as a reason it perceived value in acquiring the DFC. Because of these regulatory uncertainties and their impact on management’s forecasts, the Court gave equal weight to its DCF analysis, the comparable companies analysis, and the merger price.
The Court’s opinion is also notable for its extensive discussion of the relevant beta to apply. Specifically, the Court declined to rely upon Barra beta, a proprietary model designed to measure a firm’s sensitivity to changes in the industry or the market. While not rejecting the use of Barra beta wholesale, the Court reiterated that in order to rely upon it, the expert applying the model must be able to re-create its findings and explain its predictive effectiveness, something DFC’s expert was found unable to do. The Court also reiterated its preference for a beta that applies a measurement period of five years rather than two years unless “a fundamental change in business operations occurs.”
Finally, the Court rejected Petitioners’ expert’s use of a 3-stage DCF model. As the Court recognized, “that the growth rate drops off somewhat sharply from the projection period to the terminal period is not ideal but not necessarily problematic.” The Court was particularly reluctant to perform a 3-stage DCF that extrapolated from forecasts it found to be flawed given the regulatory uncertainty. Accordingly, the Court performed a 2-stage DCF, the analysis of which is regularly cited in Owen v. Cannon, a case on which we’ve blogged on previously.
Ultimately, dissenters are receiving $10.21 per share, along with interest accruing from the June 13, 2014, closing at the statutory rate of 5% over the Federal Reserve discount rate, compounded quarterly. A back-of-the-envelope calculation suggests that, as of this posting, the appraisal award thus rises to approximately $11.50 total, or approximately 21% over the merger price, once interest is factored in.
In a March 2016 working paper, Corporate Darwinism: Disciplining Managers in a World With Weak Shareholder Litigation, Professors James D. Cox and Randall S. Thomas detail several recent legislative and judicial actions that potentially restrict the efficacy of shareholder acquisition-oriented class actions to control corporate managerial agency costs. The authors then discuss new corporate governance mechanisms that have naturally developed as alternative means to address managerial agency costs. One of these emerging mechanisms possibly as a response to judicial and legislative restrictions on shareholder litigation, is the appraisal proceeding. As readers of this blog are well aware, the resurgence of appraisal proceedings has also been fueled by the practice of appraisal arbitrage.
Does the resurgence of appraisal litigation provide an indirect check on corporate managerial or insider abuse? Professors Cox and Thomas are skeptical, citing several factors that may limit an expansion of appraisal litigation beyond its traditional role. However, they acknowledge that there are circumstances where appraisal litigation can potentially fill the managerial agency cost control void that other receding forms of shareholder litigation have created.
As the paper argues, at first glance, appraisal litigation appears to be a powerful tool for investors to monitor corporate management and control managerial agency costs. However, shareholders face certain disadvantages in an appraisal proceeding, including the completion of required, difficult procedural steps that must be followed precisely to maintain appraisal rights (highlighted by the recent Dell decision); the lack of a class action procedure that would allow joinder of all dissenting shareholders in order to more easily share litigation costs; and the narrow limits of appraisal as purely a valuation exercise that does not take aim at corporate misconduct.
After identifying these general obstacles to appraisal, the authors discuss more specific factors that arguably limit the efficacy of appraisal for remedying management abuse in all M&A transactions. Thus, appraisal is available as a remedy only in certain transactions (e.g., the market-out exception), and even among those transactions that qualify for appraisal, initiating appraisal litigation may often not be cost effective, especially for small shareholders. Also, deals can be structured to minimize or even avoid appraisal altogether.
Cox and Thomas also highlight circumstances where appraisal may well serve as a check on management power. First, appraisal can protect shareholders from being shortchanged in control shareholder squeezeouts. Because these transactions are not subject to a market check, appraisal gives shareholders a tool to ensure that the merger price reflects the fair value of the acquired shares. Leveraged buyouts that do not undergo market checks may also raise conflict of interest concerns, especially when the target’s executives may seek to keep their jobs and be hired by a private equity buyer to run the firm. In this scenario, appraisal arbitrage may ensure shareholders are not shortchanged in a sale of control. Shareholders facing these circumstances may benefit from appraisal.
Second, appraisal arbitrage, as repeatedly covered by this blog, is a viable appraisal tactic. As we’ve previously discussed, appraisal arbitrage has been facilitated by the Delaware Chancery Court decision of In re Appraisal Transkaryotic Therapies Inc., which held that shareholders who purchased their stock in the target company after the stockholders’ meeting, but before the stockholder vote, could seek appraisal despite not having the right to vote those shares at the meeting.
In their 2015 article Appraisal Arbitrage and the Future of Public Company M&A, Professors Korsmo and Myers argued that a robust appraisal remedy could work as a socially beneficial back-end check on insider abuse in merger transactions, but the authors appear skeptical that appraisal can fill this role due to limitations discussed here. These authors don’t take a normative position on appraisal arbitrage but simply query its efficacy as a control on managerial agency costs.
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The Appraisal Rights Litigation Blog thanks Charles York, a student at the University of Pennsylvania Law School and summer law clerk for Lowenstein Sandler, for his contribution to this post.
As we’ve previously covered in this blog, the Delaware Legislature has proposed two changes to its appraisal statute in response to an increasing number of appraisal filings. The first proposal, the De Minimis Exception, would require that anyone bringing an appraisal action have, at minimum, a $1 million stake in the company or 1 percent of its shares. The second proposal, the Interest Reduction Amendment, would allow companies subject to appraisal actions to prepay any desired amount on the merger consideration. This prepaid amount would count toward any final judgment rendered by the Court, and would not be subject to the prejudgment interest rate.
With these proposals in mind, academics Wei Jiang, Tai Li, Danqing Mei, and Randall Thomas have considered whether these proposed reforms will achieve their stated goals. They provide a statistical analysis of the rise of appraisal actions in their article “Reforming the Delaware Appraisal Statute to Address Appraisal Arbitrage: Will It Be Successful?” First, they find that, in recent years, hedge funds have dominated the appraisal arbitrage strategy, with the top seven hedge funds accounting for over 50 percent of the dollar volume of all appraisal petitions. Second, most appraisal petitions target deals with potential conflicts of interest, such as going-private deals, minority squeeze-outs, and short-form mergers. Each of these deals is associated with a 2-10 percent increase in the probability of an appraisal filing. Low takeover premiums also generate a higher probability of appraisal petitions.
The authors find that the De Minimis Exception will likely lead to a 23 percent drop in the number of appraisal filings. Although about 39 percent of appraisal petitions between 2000 and 2014 failed to meet the De Minimis Exception, about 16 percent of these petitions were short-form mergers, which would be excluded from this exception. The authors contend that this 23 percent drop provides an accurate estimate of how many claims would be barred in the future if the De Minimis Exception were to pass.
The authors argue that the Interest Reduction Amendment would have a much larger impact on appraisal filings, though this blog recently covered an opposing view. Interest accounted for about 60 percent of the returns in appraisal arbitrage trials between 2000 and 2014, and 11 percent of cases would have had negative raw returns were it not for the interest rate. The authors conclude that the current interest rate likely stimulated 45 percent of all the appraisal petitions filed. Based on this rationale, the prepayment amendment could significantly lower how much interest accrued, and in turn, theoretically lower the number of appraisal petitions filed as it would change the economic calculus of filing a petition. However, as we’ve previously posted, the prepayment amendment may just as well increase the number of filings, since stockholders would have more liquidity and could redeploy the prepayment capital to their next appraisal case.
Whether the amendments will ultimately become law remains to be seen, as well as their ultimate effect on appraisal proceedings.
* The Appraisal Rights Litigation Blog thanks Trevor Halsey, a student at Brooklyn Law School and summer law clerk for Lowenstein Sandler for his substantial contribution to this post.