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.
* * * *
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.
In a highly anticipated appraisal decision, Vice Chancellor Laster today valued Dell’s common stock at $17.62 per share, reflecting a 28% premium above the $13.75 merger price that was paid to Dell shareholders on October 29, 2013. The court further ordered that interest shall accrue on this amount at the statutory rate of interest (5% over the Federal Reserve discount rate), compounding quarterly, from the merger date until the date of payment.
Today’s New York Times ran this piece analyzing the proposed Delaware amendments on appraisal proceedings, which we blogged about last week. The New York Times shares our own observation that the proposed legislation’s provision allowing for prepayment by the M&A target could have the unintended effect of increasing appraisal filings: “Rather than discourage appraisal petitions, the elimination of interest accrual through prepayment may actually spur more appraisal actions because hedge funds would be paid sooner and be able to use that money to bring more appraisal actions.”
Proposed changes to the Delaware appraisal statute have cleared Delaware’s House of Representatives without dissent, and now move on to the state Senate. The new legislation, which we blogged about in March, sets a floor for the number of shares and value of suit necessary to bring an appraisal action. It also permits M&A targets to prepay merger consideration to dissenting shareholders to avoid interest accruing on the prepaid amounts. We note that the target’s ability to prepay some or all of the merger consideration could have the unintended effect of increasing the number of appraisal filings by ameliorating an investor’s illiquidity problem in prosecuting an appraisal action. Investors may now be enabled to redeploy their otherwise trapped capital in a new appraisal case; while investors would obviously lose their statutory interest on the prepaid amount, that might be a trade-off they can live with.
On May 11, Vice Chancellor Laster issued an opinion in the Dell case denying the T. Rowe Price lead petitioner’s entitlement to proceed with its appraisal case on the grounds that it (inadvertently) voted in favor of the merger, when it should have abstained or voted against. The ruling did not address the underlying valuation issue, which is still outstanding.
The highlights of this ruling:
- The record evidence shows that T. Rowe instructed Cede via its custodian to vote in favor of the merger; the arguments that those instructions were mistaken and unintended are irrelevant.
- The Transkaryotic, BMC Software and com line of cases allowing appraisal arbitrage is irrelevant, as those cases involved an absence of proof regarding how the petitioners’ shares were voted; here there is record evidence of how those shares voted. It is not enough to rely on Cede having generally voted enough shares against the merger as was true in the Transkaryotic cases. To read more from previous posts on this topic, click here and here.
- Also irrelevant was the apparent confusion caused by the proxy statement that was issued after the shareholder meeting was rescheduled, telling shareholders that that there was no need to re-vote if they had previously voted (and here, T. Rowe had previously voted “Against”).
- The court was unapologetic and unequivocal in reaching this decision. This is unlike the court’s July 2015 opinion which dismissed approximately 1 million petitioning shares based on the violation of the continuous holder requirement, in which the chancery court so much as asked the Supreme Court to reverse that decision. That decision arose from certain petitioners’ custodians having directed Cede to re-certificate the shares in the names of their own nominees rather than that of Cede.
- Rowe was given the merger price, without interest (the merger closed in October 2013).
The so-called market-out exception precludes appraisal where the target’s stock trades in a highly liquid market. In other words, appraisal is normally available to shareholders except, as the rationale goes, where the M&A target’s stock trades in such a liquid, highly efficient market that its stock price naturally reflects its fair value, and any M&A transaction offering a premium to that market price thus provides shareholders even greater, above-market value that would render an appraisal challenge superfluous. Or, at least, so the theory goes.
Delaware’s appraisal statute incorporates the market-out exception, precluding appraisal rights where the target’s stock is either “(i) listed on a national securities exchange or (ii) held of record by more than 2,000 holders.” DGCL § 262(b)(1). But the Delaware statute doesn’t stop there, and this is where it parts ways with many other states: it then carves out from the market-out exception circumstances where the target’s stock is being acquired for cash, in whole or in part. As a result of this exception to the exception, Delaware’s market-out exception has far fewer teeth than do those of jurisdictions that adopted the market-out exception outright, without exception. Thus, based on the theory underlying the statute, and notwithstanding the purported liquidity and efficiency of the stock markets in which most public M&A targets are traded, Delaware allows stockholders of its corporations to assert appraisal rights rather than assume that the market price inevitably captures the maximum value of their shares.
Many other states, such as Arizona, have adopted the market-out exception as is, without any carve-outs. Indeed, back in February, when it was announced that the Apollo Education Group (“APOL”), which is incorporated in Arizona, had agreed to be acquired by a consortium of investors including The Vistria Group, affiliates of Apollo Global Management, and the Najafi Companies for $9.50 per share in cash, many investors immediately took to social media and other informal outlets to consider mounting an appraisal case against APOL. However, such plans were just as immediately halted as they ran into Arizona’s market-out exception. AZ ST. § 10-1302(D). Unlike Delaware, Arizona does not allow any exceptions to the exception, and a target such as APOL that trades on a sufficiently large stock exchange is shielded from appraisal.
Massachusetts, in contrast, has not adopted the market-out exception, but appraisal rights in that state are limited to transactions presenting potential conflicts of interest. Thus, when EMC agreed to be acquired by Dell in late 2015, stockholders who believed they faced an uphill battle of demonstrating conflict of interest were likewise stymied from pursuing appraisal. MA GL § 13.02(a)(1)(B).
The bottom line: Investors cannot presume that all jurisdictions providing for appraisal rights afford stockholders similar rights in their statutes. Before investing the time and diligence in evaluating a target’s acquisition price, shareholders must fully inform themselves of the applicable state statute as well as its exceptions (and any carve-outs to those exceptions).
A number of amendments to Delaware’s appraisal statute have once again been proposed by the Corporate Council of the Corporation Law Section of the Delaware State Bar Association, the committee that customarily recommends legislative action to Delaware’s state lawmaking body. If certain proposed changes to the Delaware General Corporation Law (“DGCL”) are approved by the Corporation Law Section, they will be introduced to the Delaware General Assembly.
The proposed legislative changes – available here – are intended to (i) set a floor for the number and value of shares asserting appraisal and (ii) permit M&A targets to prepay some or all of the merger consideration to dissenters to avoid the accrual of interest on such prepaid amounts.
- Threshold for Appraisal
Under the proposed amendments, the Court of Chancery shall dismiss an appraisal proceeding for a public company, unless (1) the total number of shares entitled to appraisal exceeds 1% of the outstanding shares of the class or series eligible for appraisal, (2) the value of the merger consideration for such dissenting shares exceeds $1 million, or (3) the merger was a short-form merger pursuant to § 253 or § 267 of the DGCL.
To be clear, the legislature has not yet approved or even considered these proposals; we’ll post about any future developments in that regard. Since most appraisal cases already exceed such levels, we don’t anticipate that the thresholds set forth in items (1) and (2) will have a terribly profound impact; indeed, the cost of mounting an appraisal action naturally dissuades small stockholders from doing so.
- Prepayment Option
The proposed legislation also permits the surviving company to make a cash payment to dissenters in an amount of its choosing, with interest accruing only on the difference between the amount so paid and the fair value of the shares as determined by the Chancery Court (as well as any interest that had previously accrued on the paid amount as of the effective date of the merger).
Interestingly, while this second proposal would encourage appraisal respondents to prepay significant amounts to stop the interest clock, investors might utilize the opportunity to redeploy such returned capital to their next appraisal case, thus having the unintended effect of increasing the number of appraisal petitions.
It is worth noting that the draft legislation does not include any specific proposals to eliminate or limit appraisal arbitrage. The proposed legislation includes several provisions unrelated to appraisal that are not addressed here.
If ultimately adopted by the Delaware legislature, the legislation would become effective in respect of merger agreements entered into on August 1, 2016, and thereafter.