Today’s Hedge Fund Law Report ran an article about the appraisal remedy, its positive results and its distinctiveness from traditional stockholder litigation. That article, “Stockholder Appraisal Actions Present an Attractive Litigation-Based Strategy for Hedge Fund Managers,” also discusses the proposed legislative amendments, judicial limitations and potential opportunities that we’ve posted on before.
We have blogged before (see here) about a then-forthcoming law review article by Professors Charles Korsmo (Associate Professor at Brooklyn Law School) and Minor Myers (Associate Professor at Brooklyn Law School) analyzing the value-creation resulting from the increased use of appraisal arbitrage. The authors’ paper has now been published in the final 2015 issue of the Washington University law review: http://openscholarship.wustl.edu/law_lawreview/vol92/iss6/7/
While there have been some revisions to the final version, their underlying data points, arising from their study of all Delaware appraisal cases for the ten-year period from 2004 to 2013, remain intact.
In this working paper (available via SSRN), “Influencing Control: Jawboning in Risk Arbitrage,” authors Jiang, Li, and Mei consider the use of appraisal strategies, among others, by the so-called “activist” investor. In studying instances of appraisal arbitrage, among other activist strategies, the authors conclude that activist investors can utilize a variety of tools – including appraisal – to realize abnormal returns on M&A transactions.
In particular, Table 7 of the attached article (pages 50-51) presents the results of their analysis of such abnormal returns. The sample used in this study included only 14 mergers with appraisal actions, but their findings on “appraisal returns” are interesting: “The average (median) appraisal return is 15.6% (19.6%). The average (median) length between deal completion and the appraisal decision is 1,043.1 (1,106) calendar days,” or just over three years (footnote 14). In addition, Appendix A analyzes the Golden Telecom decision as an illustrative case in their study, in which the appraisal strategy experienced an annualized return of 15%.
As a result of the recent increase in the Federal Reserve discount rate, statutory interest in appraisal cases is now up to 6%, compounding quarterly. The discount rate had been 0.75% from February 19, 2010 through December 17, 2015, at which time it was increased to 1%. As the appraisal statute sets interest at 5% over the Federal Reserve discount rate, the recent .25% increase pushes the appraisal interest rate up from 5.75% to 6%.
In last month’s decision in Houseman v. Sagerman, Vice Chancellor Glasscock addressed the common law analogue to Delaware’s appraisal rights statute – the remedy of “quasi-appraisal” for a breach of fiduciary duty. In the November 19 opinion, the court described a long litigation history stemming from the merger of Universata, Inc., into an LLC purchaser. The Housemans, shareholders of Universata, did not in the first instance exercise statutory appraisal rights, choosing instead to sue a putative purchaser of their shares under a “put contract” in Minnesota. The Minnesota state court dismissed that breach of contract action in 2012. More than two years after the close of the Universata merger, the Housemans filed a complaint in Delaware Chancery alleging breach of fiduciary duty in the sale process. Of interest to us was the Court’s discussion of the Housemans’ claim for quasi-appraisal. Vice Chancellor Glasscock observed that quasi-appraisal was not a cause of action at all, but was rather a remedy available to shareholders upon a finding of a breach of fiduciary duty. The Vice Chancellor acknowledged that there could be confusion as to what, exactly, quasi-appraisal was, but made clear that it is ultimately a remedy whereby the court awards shareholders damages “based on the going-concern value of their previously owned stock” upon an appropriate finding of liability. For background on the quasi-appraisal remedy in stockholder litigation in general, see this article from the HLS Forum on Corporate Governance and Financial Regulation.
Notwithstanding the ostensive viability of their claim, the Housemans would not receive quasi-appraisal – not because it was not a cause of action, but because of the doctrine of laches, an equitable doctrine similar to a statute of limitations that bars a cause of action when there is prejudicial delay in bringing it. In the Houseman case, the plaintiffs waited 27 months to bring a breach of fiduciary duty claim (and thus seek quasi-appraisal), choosing to litigate the Minnesota breach of contract issues in the first instance. The Court thus granted summary judgment to defendants on the breach of fiduciary claim, and in doing so barred the quasi-appraisal remedy, as the claim was simply brought too late.
**Update on January 21, 2016: the Westlaw Journal has now covered the same case discussed in this post: Houseman et al. v. Sagerman et al., 31 Westlaw Journal Delaware Corporation Law Update 3 (2016).
As reported in Law360, Dole shareholders have settled their class action arising from the Company’s 2013 take-private deal for a $114 million payout. In August 2015, the Delaware Chancery Court had awarded Dole shareholders $148 million, in a combined appraisal and entire fairness action. The settlement thus disposes of the Dole shareholders’ appraisal case as well as the shareholder class claims.
In a related story, Law360 has also reported that two California investment funds filed a complaint in Delaware federal court on Wednesday accusing Dole executives of a fraud designed to drive down the company’s price before the 2013 take-private deal, similar to the class claims that were settled earlier this week.
The July 2015 article “Appraisal Arbitrage – Is there a Delaware Advantage?” by Gaurav Jetley and Xinyu Ji of the Analysis Group analyzes the extent to which economic incentives have improved for appraisal arbitrageurs in recent years, which the authors believe helps explain the “observed increase” in appraisal activity. The article concludes that appraisal arbitrageurs enjoy an economic benefit by delaying their investment until after the record date, as they are privy to better information about the target’s value while minimizing their exposure to the risk of deal failure. The study also finds that the Delaware Chancery Court utilizes a lower equity risk premium than do the financial advisors handling the deal itself, resulting in another benefit to arbitrageurs (and, one would think, historical holders as well). Finally, the authors conclude that the statutory interest rate more than compensates appraisal petitioners for the time value of money.
Based on these findings, the authors propose several policy recommendations, including (i) a limitation on the arbitrage strategy by reducing stockholders’ ability to seek appraisal for shares acquired after the record date, and (ii) enactment of the proposal by the Council of the Delaware Bar Association’s Corporation Law Section (which the Delaware legislature has not enacted) to allow appraisal respondents to prepay claimants some portion of the merger consideration in order to limit the interest accruing during the pendency of the case. On this latter point, the authors likewise acknowledge that allowing such prepayment is tantamount to funding claimants’ appraisal actions, thus potentially spurring on funds to increase their arbitrage strategy as they can redeploy such prepaid capital to the next case.
In this 2015 article from the Arizona Law Review, “Shareholder Litigation Without Class Actions,” Boston University Law School Professor David Webber imagines a “post-class-action landscape for shareholder litigation,” positing that the class action vehicle is becoming gutted by the courts and that mandatory arbitration provisions are undermining the class action device. In this so-called post-class-action environment, the author considers what devices shareholders would have at their disposal to protect themselves. He argues that “the decline of the transactional class action may be offset by, and may enhance, the rise of appraisal litigation, particularly of hedge fund participation in such litigation,” requiring a more active litigation strategy by fund managers than currently undertaken in furtherance of their fiduciary duties to their beneficiaries.
The article provides an interesting thought experiment and suggests that appraisal is a unique and narrow remedy that is highly individualized, as the right only accrues to the “no” voter and the resultant settlement or trial award does not benefit nonparticipating investors, unlike a class action. For instance, unlike the typical fiduciary duty class action accompanying M&A deals, there are no additional disclosures to other shareholders. In addition, as Professor Webber states on page 242, “[i]n the deal context, mandatory arbitration would make it impossible for plaintiffs to enjoin a shareholder meeting, which is the source of much of plaintiffs’ settlement leverage. This could then shift the focus of institutional investors to appraisal proceedings. Lately, such proceedings have attracted increased attention from investors, and the loss of a meaningful remedy under Revlon might force more institutions to seek out appraisal remedies, particularly in cases where institutional lead plaintiffs have had success in litigating transactional class actions in the past.”
In sum, if mandatory arbitration prohibits the injunction possibility, the institutional investor may be left solely with its appraisal rights. And in an interesting twist, the author suggests that if appraisal rights are circumscribed by the legislature, the dissenter is in effect left with no choice but to pursue the strike-suit strategy, which in turn may be further limited by an arbitration provision. In other words, if appraisal is the stockholder’s last hope, it should be left undisturbed and remain a robust tool.
Vice Chancellor Glasscock issued his valuation decision this week in the BMC Software case, which we have previously blogged about concerning its threshold ruling rejecting any share-tracing requirements and thus allowing appraisal arbitrageurs to proceed with a valuation case. As we have previously reported, Merion Capital was seeking a 45% premium to the merger price, while BMC Software argued that the fair value was actually far below the merger price.
Merger Price Reflected Fair Value in This Deal
In rendering his decision, the Vice Chancellor once again looked to merger price as a measure of fair value, as he did in the Ancestry.com decision. Perhaps most interesting was his discussion of synergies toward the end of the opinion, in which he hypothesized that if Company B, holding a patent on the bow, found it advantageous to acquire Company A, a manufacturer of arrows, “synergies could result from the combination that would not have composed part of the going concern or the market value of Company A, pre-merger,” in which case Company B might value Company A more highly than the market ordinarily would. In this situation the court would be required to deduct any such synergistic value from the merger price. However, in this particular case, the acquisition was not strategic but financial, and while Respondent pointed to tax savings and other cost savings that it claims it would have realized as a private entity, the court refused to discount the merger price for any synergies.
The court further noted that receiving fair value is not necessarily the same as going concern value, and that any tax or other take-private savings may not be subject to exclusion from the awarded price as synergistic, but those savings could indeed be excludable from the going-concern value. The evidence in this case did not demonstrate any specific dollar-per-share value attributable to such savings, so the court refused to so discount the merger price. In a footnote, Vice Chancellor Glasscock said that the requirement to reduce from fair value any “non-speculative increases in value requiring a change in corporate form” was an “artifact of the policy decision to engraft ‘going concern’ valuation onto the explicit language of the appraisal statute itself,” citing Union Illinois.
The court also rejected Respondent’s request to deduct synergies based on take-private cost savings because they required a 23% internal rate of return in their business model to justify the acquisition, which raised the question of “whether the synergies present in a going-private sale represent a true premium to the alternatives of selling to a public company or remaining independent.” Thus, it was unclear whether any alleged going-private savings outweighed the buyer’s rate of return that was required “to justify the leverage presumably used to generate those savings.”
The Court’s DCF Exceeded Merger Price
The parties relied exclusively on their own DCF models, finding a comparable companies or precedent transactions analysis unreliable. Likewise, the court did its own DCF analysis and came up with a $48 per share price, exceeding the $46.25 merger price that it ultimately found to be fair value. The Vice Chancellor said that he was reluctant to use his own valuation and instead deferred to merger price, given the optimism inherent in the management projections; the raging debate within the academic community over the proper equity-risk premium to apply (thus undermining the reliability of his discount rate); and the difficulties in predicting the accurate terminal growth rate, which could be anywhere in between the floor of inflation and GDP (here, the court had picked the midpoint of those two measures in setting its own terminal rate). In this respect, the court’s DCF valuation, which exceeded merger price, was different from that in Ancestry.com, where the court’s own DCF came up just short of the merger price.
In examining the merger process itself, the court found the process to be robust insofar as there were two auctions conducted for several months each, and there were a total of five financial sponsors and eight strategic entities considering the acquisition. There was a go-shop clause, as a result of which the company contacted sixteen bidders — seven financial and nine strategic — which resulted in no alternative offers. And finally, in an arguable blurring of the line between fiduciary duty actions and appraisal rights (a subject on which we’ve posted several times before), the court explicitly looked to the settlement of the class action fiduciary duty litigation as an indication that the process was found to be free of any irregularities or fiduciary duty violations. In particular, the court found significant that the company’s activist investor, Elliot Associates, who had pressured the company to sell, was also forced to conclude that the auction itself was “a fair process.”
Other DCF Valuation Metrics
As to some of the basic valuation metrics (which were used to calculate the court’s own DCF that it ultimately refused to utilize in favor of the merger price):
- The court adopted a supply-side equity risk premium, finding that it had already been done in Golden Telecom and Orchard Enterprises and is thus indicative of the “Court’s practice of the recent past.” The court found a preference for using forward-looking data as opposed to the historical or the supply-side approach, notwithstanding the continuing debate within academe concerning the more reliable method.
- The court reaffirmed that inflation is generally the floor for a terminal value, and here, since there was no evidence to suggest that the growth rate should be limited to inflation, the court ultimately chose a growth rate at the midpoint of inflation and GDP, which was 3.25%.
- The court found it appropriate to include a reasonable offset for the tax associated with repatriating offshore cash, rejecting Petitioner’s argument that the company’s plan to keep that money offshore indefinitely should translate to no offset at all. We have seen this same point argued (and now pending before the court) in the Dell appraisal case as well.
- As is true of many tech companies, BMC had a sizable stock-based compensation (SBC) policy, which the court found was required to be accounted for, and further found reasonable to treat as an expense, particularly because this practice was expected to continue into the future. The court thus agreed with Respondent’s expert, who treated SBC as a cash expense, as opposed to Petitioner’s expert, who didn’t account for future SBC at all.
While the court seemed to take a jab at Petitioner for being “arbitrageurs who bought, not into an ongoing concern, but instead into this lawsuit,” nothing in this opinion referred back to or otherwise altered its prior ruling allowing appraisal arbitrage to proceed unfettered by a constraint such as the share-tracing requirement that BMC had asked the court to impose.
A frequently asked question involves the availability of appraisal rights when investors are being offered only stock in the acquiring corporation in exchange for their shares.
The answer is typically no. The Delaware appraisal statute provides that appraisal rights are available in a wide range of statutorily permitted mergers. 8 Del. C. § 262(b). However, in what is commonly referred to as the “market-out exception,” the statute further provides that appraisal rights are not available for stock that is “either (i) listed on a national securities exchange or (ii) held of record by more than 2,000 holders.” 8 Del. C. § 262(b)(1). Of course, if this is where the story ended, the market-out exception would render appraisal rights unavailable in most cases. But the Delaware legislature created another exception in the appraisal statute, which Delaware courts have labeled the “exception to the exception.” The exception to the exception states that the market-out exception does not apply when the shareholders of the target corporation are required to accept consideration for their shares that is not (a) shares of stock in the surviving corporation, (b) shares of stock in any other corporation that are either listed on a national securities exchange or held of record by more than 2,000 holders, or (c) cash in lieu of fractional shares described in (a) or (b). 8 Del. C. § 262(b)(2). Thus, the statute provides that when the holders of a nationally listed or widely held stock are offered cash consideration for their shares (other than cash in lieu of fractional shares), appraisal rights exist, but when they are offered only the stock of the acquirer or other nationally listed or widely held stock, there are no appraisal rights.
In Louisiana Municipal Police Employees’ Retirement System v. Crawford, 918 A.2d 1172 (Del. Ch. 2007), the Delaware Chancery Court addressed the interesting question of whether appraisal rights exist when the shareholders of the target company are offered only stock of the acquiring company, but the acquiring company also causes the target’s board to declare a special dividend immediately prior to the merger. The acquiring company argued that appraisal rights were not available because the merger was technically an all-stock deal and the special dividend was not part of the merger consideration being offered by the acquirer. The Chancery Court rejected that argument, however, finding that it elevated form over substance. The payment of the special dividend was dependent on the shareholders of the target approving the merger. Thus, the Court found, “[w]hen merger consideration includes partial cash and stock payments, shareholders are entitled to appraisal rights. So long as payment of the special dividend remains conditioned upon shareholder approval of the merger, [shareholders of the target corporation] should not be denied their appraisal rights simply because their directors are willing to collude with a favored bidder to ‘launder’ a cash payment.”
In another interesting application of the appraisal statute, Krieger v. Wesco Financial Corp., 30 A.3d 54 (Del. Ch. 2011), the Chancery Court addressed whether appraisal rights exist when shareholders are given the option of receiving either cash or stock. Shareholders who failed to make an election would receive cash. The Chancery Court held that appraisal rights were not available in that instance because the shareholders had the option to elect to receive stock. Even though they might ultimately receive cash, they were not required to accept cash.
Accordingly, whether or not an ostensibly all-stock deal is appraisal eligible requires an examination of all the forms of consideration being offered in the merger and any election features available to stockholders.