Professors Korsmo and Myers have once again lauded the benefits of appraisal litigation and chastised its critics for pressuring the Delaware bar council to reconsider its recent decision not to limit or eliminate appraisal arbitrage. In their latest piece, the authors reaffirm their findings that appraisal cases comprise that rare form of shareholder suit “where the merits actually matter.” They suggest that the emergence of appraisal arbitrage specialists should be “reassuring, not shocking” to the deal community, as it evidences “beneficial specialization” that allows shareholders unfamiliar with the appraisal process to cash out, sometimes at a premium to the merger price, without being forced to accept an undervalued deal or to prosecute appraisal rights for themselves.
As we’ve previously posted, the Corporation Council of the Delaware bar had taken up the question of whether to ban or curtail appraisal arbitrage, and more recently decided to take no such action after determining that the practice had no discernable negative effects on mergers and acquisitions and, if anything, continued to protect shareholder value. See our prior posts here and here. In addition, as we recently noted here, Chief Justice Strine of the Delaware Supreme Court tends to agree with that position and believes that the concern over appraisal arbitrage is overblown. As the Wall Street Journal reported this week, a group of law firms that typically represent parties to M&A deals strongly disagrees with the Council, and has sent a letter to the Council questioning its findings. The headline-grabbing quote from the letter — that appraisal arbitrage is both “unseemly” and “rampant” — challenges the Council’s determination that there has been no recent uptick in frivolous or speculative appraisal litigation. It is not apparent that the letter provides competing statistics to contest the Council’s findings, such as that in 2013, representative litigation occurred in more than 90% of public M&A, while only 17% of the appraisal-eligible transactions resulted in Delaware appraisal litigation. Rather, the letter seems grounded on a policy rationale that the appraisal statute was not intended to enable those who purchase shares after the public announcement of a deal, or at least those who bought after the record date for the vote, to seek appraisal. Given the Delaware courts’ finding to the contrary and their refusal to impose a share-tracing requirement that may impede appraisal rights of stockholders who purchased their shares after the vote, the letter-writers are taking their case to the legislature.
The current Delaware legislative session ends on June 30, so whatever changes, if any, are to be made to the appraisal remedy this year will need to take place before then. We’ll keep you posted.
Delaware judges, SEC leaders and lawyers from across the country convened in New Orleans last week for the 27th annual Tulane Corporate Law Institute, a two-day series of panels on March 19-20 analyzing Delaware corporate law and M&A deal making. Appraisal arbitrage garnered considerable attention as several panels discussed the practice as well as the proposed legislation by the Corporation Council of the Delaware bar, which avoided any proposals to eliminate or limit the practice. Several panelists were highly critical of the Delaware bar council for its refusal to curb appraisal arbitrage in any way, and expressed skepticism over the council’s findings that arbitrage did not stoke strike suits but instead advanced the statutory aim of investor protection. In response to such criticism, Chief Justice Strine of Delaware’s Supreme Court observed that the reaction by arbitrage critics is overblown, and that the arbitrage phenomenon may well die down over time because funds that recover the merger price alone will not recoup their litigation expenses. Accordingly, he predicted that the so-called event-driven funds pursuing appraisal arbitrage will be more selective in picking their spots and there may well be fewer of them down the road, and fewer such arbitrage plays, as a result.
On the related subject of interest — and the proposed legislation to allow acquiring companies to stop the statutory interest on at least a portion of the disputed amount by permitting them to prepay a cash amount, in whatever amount they may choose, on a non-recourse basis — Chief Justice Strine again chided the appraisal critics (who would prefer to see even further reductions to the interest component) by suggesting that the statutory interest award, even at 5% above the Federal Reserve discount rate, still does not compensate shareholders enough for being out of their money pending the appraisal litigation, especially in the past three years, during which time the statutory interest rate alone fell well below any credible market index. The Chief Justice also observed that the legislative proposal allowing a non-recourse prepayment could itself eliminate or reduce much of the interest arbitrage pursued by petitioners. Another panelist responded later in the day that the proposed prepayment legislation would not at all chill appraisal petitions, because the prepayment mechanism will only incentivize shareholders to redeploy their capital to pursue the next appraisal petition.
In sum, the Chief Justice closed his discussion by stating that appraisal rights enhance shareholder value and play a systemic role in promoting fair treatment. Indeed, as he explained, unlike fiduciary duty actions, appraisal rights cases do not yield “disclosure only” settlements (which the courts tend to frown upon), and they are not pursued on a class basis and settled for “garbage.” Thus, he concluded that the state of appraisal rights is not in crisis, and when the new proposals and the current case law play out, the incentives will require that only serious cases be brought.
We posted earlier this week regarding a white paper written by the Council of the Corporation Law Section of the Delaware state bar, which was issued alongside the Council’s proposed amendments to Delaware’s appraisal statute. The Council had considered amendments to address the practice of appraisal arbitrage, but ultimately did not make any recommendations to eliminate or limit that practice. One reason the Council decided not to act to curtail appraisal arbitrage is that it perceived certain concerns expressed over the negative effects of arbitrage to be overblown, as the Council reviewed data from studies of appraisal arbitrage that did not indicate a material uptick in speculative or frivolous appraisal litigation. The following additional findings from the white paper further explain why the Council has suggested that the Delaware legislature not hinder appraisal arbitrage:
- Default fiduciary duties may not suffice to ensure that merger prices reflect the fair value of a target company’s shares, especially in deals such as buyouts by a controlling stockholder and other transactions that are not subject to a market check. In light of the fact that appraisal is a necessary remedy to protect shareholders, it would be much less effective if the appraisal statute were amended to curtail the ability to transfer that right. The law generally looks favorably on the assignment of financial claims, and there is no principled basis to depart from that position in the appraisal context.
- Appraisal actions tend to target two species of deals: conflict transactions and those involving questionable pricing. In both of these instances, which in the Council’s words have “a greater potential for unfairness,” the appraisal award is often a premium (significant, in many cases) to the merger price.
- “Appraisal cases attacking the merger consideration in non-conflict transactions are fewer in number and often result in appraisal results below or near the merger consideration.”
- “To the extent that the buyer in a merger has concern about an increased number of merger claimants and the overall cost of the transaction, the buyer can negotiate an appraisal-out condition (e.g., a right not to close the merger if more than a specified percentage of shareholders dissent and demand appraisal). The fact that such appraisal-out conditions remain fairly rare suggests that the availability of appraisal arbitrage is not a significant factor in the market.”
At least one commentator who represented the respondent in the Ancestry.com case and who had (unsuccessfully) requested the Chancery Court to disallow arbitrage in that case has been extremely critical of the Council’s determination not to limit appraisal arbitrage. We will continue to monitor developments in the state legislature and report on the assembly’s reaction to the Council’s proposal.
We posted last week about new legislative amendments to the appraisal remedy proposed by the Council of the Corporation Law Section of the Delaware state bar association, an influential group of Delaware lawyers. The amendments were accompanied by an explanatory white paper explaining the rationale behind those recommendations that the Council made, and of note, those it did not make. In particular, the Council did not advance a proposal to limit or eliminate outright appraisal arbitrage. We have posted previously about so-called appraisal arbitrage, in which professional investors purchase shares ‒ with attendant appraisal rights ‒ after the terms of a merger are announced but before the deal closes. See here, here, and here.
By way of background, the Council had created a subcommittee in February 2014 to consider the desirability of amendments to the appraisal statute. As the Council’s report explained, the very creation of the subcommittee arose in part because of the increasing use of appraisal arbitrage and resultant commentary as to whether arbitrage was consistent with the intended purpose of the appraisal statute. As the Council further reported, several considerations led the subcommittee to recommend, and the Council to conclude, that the appraisal statute should not limit appraisal rights to shares held before the public announcement of a proposed transaction. In specific, the Council found that appraisal arbitrage is not contrary to the “balance” envisioned by the Delaware appraisal remedy, which the Council identified to be “the ability of corporations to engage in desirable value enhancing transactions and the ability of dissenting stockholders to receive fair value for their holdings.” One of the primary factors behind this finding was the Council’s determination that appraisal arbitrage ‒ and appraisal litigation more generally ‒ does not encourage frivolous litigation. As the Council found: “Unlike the case of representative litigation, which occurs in more than 90% of the public mergers and consolidations, only 17% of the appraisal eligible transactions during 2013 resulted in appraisal litigation in Delaware.”
We will post some additional highlights from the Council’s report later this week.
As we have posted previously, whether a voting agreement, or so-called drag-along provision, can be successfully enforced to prevent common stockholders from seeking appraisal is an open question in the Delaware courts. And so it remains, even in the wake of Halpin v. Riverstone National, Inc., (Del. Ch. Feb. 26, 2015), in which the Court of Chancery faced the question of whether common shareholders can be charged with having waived their statutory appraisal rights in advance of the transaction under a drag-along provision. The drag-along provision at issue did not actually include a waiver of appraisal rights, and instead required the minority stockholders to vote in favor of a change-in-control transaction upon advance notice of the transaction. While in theory an agreement that forces a shareholder to vote in favor of a deal arguably leads to a waiver of appraisal rights insofar as such an agreement eliminates a stockholder’s opportunity to provide the requisite dissent from the proposed merger, it is also true that in order to be effective such an agreement would have to be in place prior to any vote on the transaction. In Halpin, the company did not invoke the drag-along provision until after the merger vote, so the Court avoided deciding the question of whether a waiver took place and instead held that as a matter of contract the minority stockholders were free to seek statutory appraisal of their shares. The minority shareholders obviously could not be forced to consent to a deal that had already occurred.
The Court did assume, without deciding the issue, that as a theoretical matter holders of common stock could indeed waive their appraisal rights by contract in advance of a transaction. But that assumption is simply that, an assumption, which as a legal matter was not decided and remains an open question of law. The Court also noted that, unlike common stockholders, it is well-established Delaware law that preferred stockholders may waive their appraisal rights. Indeed, we have previously posted here about the important differences between the appraisal rights of preferred and common stockholders, and Chancery once again acknowledged the unique nature of the preferreds’ appraisal rights.
The Corporation Council of the Delaware bar released proposed amendments to Delaware’s General Corporation Law last week. Among the various proposals, ranging from fee-shift provisions to forum-selection clauses in corporate bylaws, the committee proposed two changes to Delaware’s statutory appraisal remedy: first, to bar appraisals by shareholders holding 1% or less of the outstanding stock of a public company if the value of their shares is $1 million or less as based on the merger price; and second, to allow acquiring companies to stop the statutory interest on at least a portion of the disputed amount by permitting them to prepay a cash amount, in whatever amount they may choose. The proposed amendments to the appraisal statute are here, and the Corporate Council’s white paper explaining the amendments is here.
The legislature has not yet approved or even considered these proposals; we’ll post about any developments in that regard. In the meantime, the first such proposal will not likely have much of a practical impact, as there are not too many petitions, if any, brought by stockholders with such a small position. After all, a holder of a $1 million stake would not have sufficient economic incentive to bring an appraisal petition in the first place, given the expert and other litigation costs incurred in pursuing such a claim. It presents a limitation on such a rare class of cases so that the proposal will have precious little consequence. But that does not mean the legislature will readily take up the measure. There may be a concern among some legislators that once an effort is underway to eliminate “small” claims, future proposed amendments could take aim at cutting off larger claims. As to the second proposed amendment, the option of allowing respondent companies to make cash prepayments might have interesting results; it could encourage companies to prepay significant amounts, even up to the full merger price, just to stop the interest clock, which in turn could actually encourage more appraisal claims by inviting challenges from otherwise-reluctant stockholders concerned about having their capital locked up during the pendency of the appraisal proceeding.
Significantly, the proposals do not include an amendment to eliminate or limit appraisal arbitrage; we’ll post more about that issue in the coming days.
Last week the Delaware Supreme Court’s en banc hearing in the CKx case resulted in a simple affirmance, without opinion, of the Chancery Court’s 2013 decision that the merger price in this particular case was the best proxy for the fair value of petitioners’ stock. In CKx, the Chancery Court had rejected the valuation methodologies presented by both sides and yet also failed to consider any other valuation approach, pointing instead to the price paid by the acquirer as the most reliable indicator of fair value given its finding that the merger price was the product of a fulsome and robust auction process. The Supreme Court also rejected the company’s request to set fair value below the merger price after taking out supposed synergistic gains that the acquirer had planned to capture from the merger entity (to which post-merger synergies dissenting stockholders are not entitled by statute). Likewise, the Supreme Court rejected the company’s cross-appeal challenging the full award of statutory interest at 5.75%, affirming Chancery’s ruling that it had no authority under the appraisal statute to permit the respondent to compel the petitioners to accept a partial pre-payment of the award that would cut off the accrual of interest.
As reported by Reuters, if you read the Supreme Court order in CKx as setting the market price as a floor in appraisal litigation, rather than a ceiling, and after taking the statutory interest award into account, the decision may ultimately incentivize appraisal arbitrage for big investors.
**Note: this law firm is of counsel to the appellant-petitioner shareholders in CKx.
We posted last month about the Delaware Chancery Court’s ruling in Ancestry.com, in which it upheld the growing practice of appraisal arbitrage. The Chancery Court has now rendered its valuation decision in that case, finding the merger price itself to be the most fair measure of stockholder value on a going concern basis. As Reuters has reported, the court also declined to find fair value below the deal price. To the extent that the court relied on merger price for its valuation, it is reminiscent of the same judge’s decision in the CKx case, which is currently scheduled for en banc review next week in the Delaware Supreme Court (as we have previously posted). But unlike the court’s approach in CKx, in Ancestry.com the court undertook a DCF analysis based on the parties’ competing valuations. The court’s own DCF analysis yielded a value 21 cents short of the $32 merger price, but given its uncertainty over the projections, the court said it was uncomfortable insisting that a buyer who actually put its own money at risk nevertheless overpaid. The court refused to second-guess the market price, especially given what it found to be a robust sales process.
The court expressed skepticism over the reliability of any after-the-fact valuation analyses, suggesting that valuation experts are more in the business of reverse engineering to arrive at their pre-selected values than in presenting the court with truly objective values. To underscore the point, the court cited one side’s expert who saw it as his job to “torture the numbers until they confess[ed].” The other side’s expert likewise suggested that if he had reached a valuation that widely departed from the merger price, he would have had to find a way to reconcile those numbers, or, as the court put it, he would have “tailored his analysis to fit the merger price.” One option the court did not address is having the court itself engage a non-party independent valuation expert to report its own analysis directly to the court, which the Chancery Court has done in the past.
With respect to the particular DCF issues the court addressed, the court focused on certain components in the calculation of terminal value that have not traditionally been addressed in court opinions, including how to determine the “plowback” ratio — the percentage of future profits that the company would have to “plowback” into capital expenditures to remain competitive over the long term — and whether to “normalize” EBIT margin. Both of these adjustments can temper the valuation-enhancing effect of a high terminal growth rate. Another interesting issue raised by this case is whether and, how to account for stock-based compensation (SBC) in a DCF, which is especially significant for Internet-based companies in particular, as they tend to have large SBC components to their employee compensation programs. Here, the court concluded that SBC had to be taken into account, and it did so in a way that reduced its valuation.
Finally, the court lamented that appraisal actions are unique in that each party bears the burden of proof, such that if neither party meets its burden, the burden instead falls on the court. But this observation effectively repeats the long-standing principle that courts in appraisal cases are required to perform an independent analysis. In that regard, it will be interesting to see how the Supreme Court reacts next week to this judge’s prior opinion in CKx and whether the court sufficiently discharged its duty to perform an independent valuation when it deferred to the merger price as the only reliable indicator of value after having rejected the valuation methods proposed by the parties, unlike its approach in Ancestry.com.
We recently posted about the two related January 5, 2015 arbitrage decisions, in which the Delaware Chancery Court refused to impose share-tracing requirements or other obligations on beneficial stockholders and reaffirmed that only record owners bear the burden to no-vote their shares and otherwise perfect their appraisal rights. This week the lawyers defending Ancestry.com, whose arguments were rejected by the Court, have posted this blog calling for legislative reform of the appraisal rights statute to remedy what they perceive to be a “troubling expansion” of stockholder appraisal rights.