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Appraisal Rights Litigation Blog

Can Drag-Along Provisions Be Used To Stifle Appraisal Rights?

Posted in Drag-Along Rights, Waiver of Appraisal Rights

The question of whether voting agreements, or so-called drag-along provisions, in stockholder agreements can be used to prevent a dissenter from exercising appraisal rights has not been tested in the courts.  Such clauses are often included in stockholders agreements to secure advance shareholder consent to such corporate actions as a sale of the company.  Prospective buyers tend to look favorably upon drag-along provisions because they offer the prospect of supportive votes favoring the acquisition, with the added hope that the drag-along rights may be sufficient to quash any appraisal rights that the shareholder might otherwise be inclined to exercise.

Interestingly, we are not aware of any case in Delaware or New York that has decided whether a drag-along clause can be enforced to effectively waive appraisal rights on the part of the shareholder being dragged along to consent to the deal.  Absent a specific waiver of appraisal rights, it is difficult to imagine that a chancery judge will be inclined to sweep them aside, and yet there is no guiding precedent to inform that decision.  Some academic commentary has speculated that common shareholders who have agreed to vote their shares as directed by drag-along provisions may lose their right to appraisal, which is generally available only to shareholders who vote against the transaction.  See Brian Broughman & Jesse M. Fried, Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups, 98 Cornell Law Review 1319, 1331, n. 50 (2013).  But again, no court has yet accepted or rejected this notion.  While courts are indeed inclined to appraise preferred stock as a matter of pure contract law  based on a clear and unambiguous provision in the company’s certificate of designation, it remains to be seen whether the courts will likewise deem a common stockholder to have waived her appraisal rights by virtue of a voting agreement or drag-along clause in a stockholder agreement, especially where that waiver has not been made explicitly in the contract itself.

Preferred Stock Has Appraisal Rights Too — Sort Of

Posted in Fair Value, Independent valuation, Preferred Stock, Waiver of Appraisal Rights

Like common stockholders, holders of preferred stock may exercise appraisal rights.  The extent of what those rights actually entail, however, may be far more limited than what common shareholders may experience.  As a general rule, preferred stock has the same appraisal rights as common stock, but “[u]nlike common stock, the value of preferred stock is determined solely from the contract rights conferred upon it in the certificate of designation.”  Shaftan v. Morgan Joseph Holdings, Inc., 57 A.3d 928, 942 (Del. Ch. 2012) (citing In re Appraisal of Metromedia International Group, Inc., 971 A.2d 893, 900 (Del. Ch. 2009)).

Delaware courts have consistently ruled that if the company’s certificate of designation is clear in providing just what the preferred stock is to receive upon a merger, then the certificate controls and effectively preempts the rights of the preferred stockholders to seek appraisal.  Thus, as Delaware Chancery has held, when the terms of preferred stock “clearly describe[d] an agreement between the [preferred stockholders] and the company regarding the consideration to be received” by the stockholders in the event of a specific type of merger, and that specific type of merger occurred, the stockholders were deemed to have waived their appraisal rights and were only entitled to the compensation provided for in the governing certificate.  Shaftan 57 A.3d at 928 (citing In re Appraisal of Ford Holdings, Inc. Preferred Stock, 698 A.2d 973, 978 (Del. Ch. 1997)).  Put another way, where the certificate of designation is clear in “contractually establish[ing] the metric for valuing the preferred shares in the event of a merger,” the court need not entertain competing valuation models and undertake the customary appraisal analysis; instead, the court simply views the valuation of the preferred stock “through the defining lens of its certificate of designation, unless the certificate is ambiguous or conflicts with positive law.”  Metromedia, 971 A.2d at 900.

In the case of unclear or indirect drafting in the certificate, the courts will not deprive stockholders of their statutory right to judicial appraisal of their preferred shares.

Appraisal Actions Are Increasingly Viewed as a Considered Investment Strategy

Posted in Number of appraisal rights filings

The forthcoming article on appraisal arbitration by Professors Korsmo and Myers is rich with data confirming the sophistication of the new breed of appraisal rights petitioners. (A previous post linked to graphs demonstrating the recent sharp increase in appraisal petitions and the spike in the dollars at play in appraisal cases.) We wanted to highlight some more of that data here.

Two metrics merit attention. The first is a graph representing the value of shares in Delaware appraisal actions held by “repeat players.” (view here) This shift from “one-off” filings by aggrieved shareholders to multiple petitions filed by single entities has been driven almost entirely by investment funds. Professors Korsmo and Myers hypothesize, and the data bears out, that these investors are increasingly looking to Delaware appraisal litigation as a considered investment strategy. Indeed, as the article states, “[t]he institutions that are beginning to specialize in appraisal . . . are among the most sophisticated financial entities in the United States.”

Another data point demonstrates that these sophisticated entities are filing their petitions much more quickly. (view here) Under Delaware law, shareholders dissenting from a merger have 120 days after the effective date to bring their appraisal petition. The professors suggest that prior to 2010, petitioners generally took that entire period to negotiate a settlement before filing. From 2011 onward, however, the professors believe that dissenting shareholders appear to be foregoing this initial round of settlement discussions and filing their appraisal petitions immediately. Another interpretation of this data is that this increase in the pace of filings may result from the fact that historically stockholders often gave pre-closing notice to the target of their intent to exercise appraisal rights simply as a means to preserve their optionality and buy time to consider a challenge. Now, however, as funds and other dissenters have become more deliberate in their strategy to follow through with an appraisal proceeding, they don’t need extended time to consider their options and thus tend to file a petition more promptly post-closing to follow through with their predetermined litigation plan.

Why Do Delaware Appraisal Awards Typically Exceed Merger Price?

Posted in Arbitrage, Discounted Cash Flow Analysis, Fair Value, Merger Price, Number of appraisal rights filings

We thought readers would be interested in this recent article by Fried Frank, Why Delaware Appraisal Awards Exceed the Merger Price, providing an analysis of why the Delaware appraisal decisions since 2010 have produced valuation awards that are often significantly higher than the merger consideration.  We do not necessarily endorse the assertions and conclusions in this article but wanted to share their perspective on this phenomenon.

Spike in Appraisal Rights Cases Graphically Illustrated

Posted in Dollar amount of appraisal rights filings, Number of appraisal rights filings

Among the compelling metrics compiled by Professors Korsmo and Myers in their article on appraisal rights that has been approvingly cited by the Delaware Court of Chancery, they have highlighted two key trends which, taken together, demonstrate the sophistication of the investors now driving what appears to be a pronounced spike in appraisal rights cases. Thus, the first graph (view here) shows the sharp increase in the number of petitions filed over the past decade, and the second graph (view here) shows the sheer size of the dollar amounts at stake.

Valuation Basics: Equity Risk Premium and Beta

Posted in Beta, Discounted Cash Flow Analysis, Fair Value, Risk Premium, Valuation Expert, WACC

Prior posts in our “Valuation Basics” series have examined the various components of the cost of equity capital under the Capital Asset Pricing Model (“CAPM”). In this post we continue our discussion of those components, focusing on the equity risk premium and its modifying coefficient, the beta.

The CAPM has become the Delaware Court of Chancery’s preferred method for calculating a company’s cost of equity (i.e., the rate of return an investor would demand in order to purchase the company’s stock). A company’s cost of equity under the CAPM is generally the sum of (1) a risk-free rate, plus (2) the equity risk premium adjusted by a beta, plus (3) a size risk premium.

The “equity risk premium” is the difference between the risk-free rate and the expected return from the market. That is, the equity risk premium predicts how a stock index will perform compared to a risk-free investment, such as a treasury bond. Because not all stocks listed on a particular index perform alike, an appraiser valuing a specific company typically adjusts the equity risk premium by a volatility metric called a “beta.” A company with a beta of 1.0 will have an equity risk premium in line with the market. A company with a beta higher than 1.0 will be more volatile than the market, and a company with a beta of less than 1.0 will be less volatile than the market.

Calculating the Equity Risk Premium

The Ibbotson SBBI Valuation Yearbook provides two methods for calculating the equity risk premium: historic and supply-side. The historic equity risk premium looks at stock market returns against risk-free returns dating back to 1926. The supply-side equity risk premium modifies the historic equity risk premium by adjusting the historic equity risk premium for any inflation included in the price-to-earnings ratio. The supply-side method thus produces a slightly lower equity risk premium than the historic method.

Although the historic equity risk premium is the more traditional method, in its recent appraisal opinions the Delaware Court of Chancery has embraced the supply-side equity risk premium as the prevailing methodology. In Global GT LP v. Golden Telecom, Inc., for example, the court adopted the supply-side method over the historic method because the weight of authority supported a rate of return that was closer to the supply-side equity risk premium.

Calculating Beta

Small variances in beta can lead to large discrepancies in the overall valuation of a company. For example, suppose an appraiser determines that, as of the merger date, the equity risk premium for Company X was 6%. A beta of 1.5 would increase that number to 9%. A beta of 0.5 would decrease that number to 3%. Assuming Company X had very little debt, this could lead to an almost 6% swing in the weighted average cost of capital. Not surprisingly, therefore, beta calculations are frequently contested in appraisal actions.

Although the historical market beta of a publicly traded company can be calculated by examining the covariance between the stock’s historical performance and that of the S&P 500, this method is often unreliable when calculating the beta of smaller public companies, where the stock may not trade in an efficient market. An alternative method for calculating beta is to use the published betas of guideline companies to select a beta for the subject company. Because the guideline companies have their own unique capital structures, however, the appraiser must “unlever” the guideline betas to remove the impact that the guideline company’s debt has on its beta. An unlevered beta is calculated using the following equation:

where LB is the levered beta of the guideline company; T is the tax rate of the guideline company; D is the percentage of the guideline company’s capital structure that is debt; and E is the percentage of the guideline company’s capital structure that is equity.

After selecting an appropriate unlevered beta for the subject company based on the unlevered betas of the guideline companies, the appraiser must “relever” the selected beta based on the capital structure of the subject company, using the following equation:

UB*[1 + (1 – T)*(D/E)]

where UB is the selected unlevered beta for the subject company; T is the tax rate of the subject company; D is the percentage of the subject company’s capital structure that is debt; and E is the percentage of the subject company’s capital structure that is equity. This levered beta is then applied to the equity risk premium as part of the calculation of the subject company’s cost of equity capital. This is a generally accepted method for calculating beta under the CAPM, although it is not the only method.

 

Court Reaffirms Independence and Importance of Appraisal Rights Remedy

Posted in Distinct from Fiduciary Duty Claims, No Proof of Wrongdoing Needed

Last week, the Delaware Court of Chancery issued an opinion in In re Orchard Enterprises, Inc. Shareholder Litigation (Del. Ch. Aug 22, 2014) concerning an application for attorneys’ fees (we have previously posted about a significant 2012 decision in that same case by former Chancellor Strine). We found the court’s latest decision noteworthy for two reasons. First, the court reaffirmed the principle that an appraisal action brought by an individual shareholder seeking a judicial determination of the fair value of its stock as of the merger date is an entirely separate animal from a shareholder class action in which the plaintiffs allege director misconduct in connection with the price or process leading up to the transaction. Second, the court cited approvingly an upcoming law review article that highlights statistically the benefits of the appraisal process.

In 2010, The Orchard Enterprises, Inc., was acquired by its controlling shareholder for $2.05 per share in cash. Following the merger, several shareholders pursued an appraisal action, which resulted in a judicial determination that the fair value of Orchard was $4.67 per share. After the appraisal action concluded, another shareholder who had not exercised his appraisal rights brought a class action against the board for breach of fiduciary duty. The class action settled before trial. Counsel for the appraisal shareholders objected to the settlement, arguing that they should be reimbursed from the class action settlement for the fees they incurred in the appraisal action because their efforts contributed to the settlement of the class action. Vice Chancellor Laster acknowledged that the appraisal shareholders “raised the bar” for the company by demonstrating that the fair value of Orchard stock was more than double the merger consideration. However, the court ruled that appraisal counsel was not entitled to reimbursement for its fees because the appraisal action was brought on behalf of individual shareholders, not on behalf of all of Orchard’s shareholders.

In a prior post, we observed how former Chancellor Strine (now Chief Justice of the Delaware Supreme Court) repeatedly took the time to clarify the important but often overlooked distinction between fiduciary duty claims and appraisal rights actions. Vice Chancellor Laster has now followed suit in Orchard when he declined to apportion part of the class action settlement to pay the attorneys’ fees incurred by the successful appraisal petitioners. According to the Vice Chancellor, as unsecured creditors who elected not to accept the merger consideration, appraisal petitioners may have interests that conflict with shareholders pursuing breach of fiduciary duty claims after selling their shares in the merger. Moreover, unlike class plaintiffs (who frequently own only a small stake in the company), appraisal petitioners typically have significant holdings that they believe have been undervalued, so they do not need to be offered an additional incentive (such as the reimbursement of attorneys’ fees) in order for them to seek court intervention.

We also recently blogged about a forthcoming law review article by Professors Charles Korsmo and Minor Myers of Brooklyn Law School, which is expected to be published in the Washington University Law Review in 2015. In that article, the authors laud the appraisal process because it ultimately provides an efficient means for benefiting minority shareholders and reducing the cost of raising equity capital. In the new Orchard decision, Vice Chancellor Laster cited this article and expressly recognized that the effect of an appraisal rights petition “may well be a net positive” because the process “reduces agency costs when compared to traditional class actions and results in a more efficient corporation law.” This is a highly significant reaffirmation of the unique and valuable role that appraisal actions will continue to play in enhancing shareholder value.

 

Forthcoming Law Review Article Lauds Value Creation Resulting from Surge in Appraisal Activity Due to Increased Use of Arbitrage

Posted in Arbitrage, Merger vote, Record date

In a forthcoming law review article expected to be published in 2015 in the Washington University Law Review, “Appraisal Arbitrage and the Future of Public Company M&A,” Charles Korsmo (Associate Professor at Brooklyn Law School) and Minor Myers (Associate Professor at Brooklyn Law School) report their findings showing a large uptick in the number of appraisal petitions being filed, as well as a marked increase in the size of the petitioners’ holdings and an increased level of sophistication among the filers themselves. The authors observe an increased use of arbitrage by which petitioners appear to invest in the target after the M&A deal is announced (for more about arbitrage, see our prior post here). While the authors note that the defense community has decried appraisal arbitrage as an abusive exercise of appraisal rights that ought to be suppressed, the authors argue that this criticism has it precisely backward and that the “new world of appraisal” should be welcomed and encouraged, as it ultimately provides an efficient means for benefiting minority shareholders and actually reducing the cost of raising equity capital.

Among the highly telling data points that Professors Korsmo and Myers collected for their analysis, they found that the value of claims in appraisal in 2013 was nearly $1.5 billion, a tenfold increase from 2004 and nearly 1% of the equity value of all merger activity in 2013. They attribute this surge in appraisal claims to the increased use of appraisal arbitrage in a manner that is transforming what this blog has repeatedly described as an underutilized shareholder remedy into a specialized investment strategy.

 

Are There Arbitrage Opportunities With Appraisal Rights?

Posted in Arbitrage, Merger vote, Notice of Demand for Appraisal, Record date

An interesting question first addressed many years ago has just resurfaced: can a shareholder seek appraisal rights for shares it acquires after the merger is announced and even after the record date that is set for voting on whether to approve the proposed M&A transaction? Historically the Delaware court said yes, subject to certain other conditions being met, but that may not be the last word on the subject. The New York Times recently blogged about a new case currently before the Delaware courts arising from the buyout of Ancestry.com, showing that this issue is timely again.

First, some background: in 2007, the Delaware Chancery Court opened the door to arbitrage possibilities by its ruling in the appraisal rights case of Transkaryotic Therapies, Inc. In that proceeding, the court permitted a shareholder to exercise appraisal rights for shares acquired after the record date but before the merger vote, provided that the record holder had timely notified the issuer, pre-vote, of a sufficient number of “no” votes or abstentions to cover the number of newly acquired shares being put up for appraisal. The court recognized that owners of stock certificates, such as Cede & Co. — which is typically the nominal owner of shares that are on deposit with the Depository Trust Company, hold their shares in an undifferentiated manner in “fungible bulk,” and so no shareholder has ownership rights to any particular share of stock. Accordingly, there is no voting history attached to any particular share of stock or beneficial owner; all that matters is that the record holder vote no or abstain with respect to a sufficient number of shares to cover the newly acquired shares for which a petitioner wants to seek appraisal.

There are limits as to how late a stockholder may acquire shares for purposes of appraisal; naturally, shares bought after the merger vote, even if acquired before the merger consummation or closing date, won’t count toward appraisal, as they are acquired too late and without sufficient notice to the company.

To illustrate the point, let’s assume that a shareholder currently owns five shares in XYZ Company and an announcement is made on June 10 that ABC Company will be acquiring XYZ. XYZ will be conducting a shareholder meeting regarding the proposed merger on July 1, based on a record date of June 20. Now let’s assume that after the deal is announced and before the July 1 shareholder meeting, our shareholder directs Cede to provide notice to XYZ Company that she will be dissenting with respect to her five shares. Cede then follows those instructions, as well as the directions it receives from all the other beneficial owners for whom it holds shares, and Cede goes ahead and provides notice to the company for all the “no” votes that it has been directed to give. Let’s further assume the total of “no” votes is 100, and in addition to those votes, there are 50 abstentions, so the total number of shares “eligible” for an appraisal demand is 150.

If our shareholder later buys five more shares after the June 20 record date but prior to the July 1 merger vote, she can still seek appraisal for her new total of 10 shares out of the 150 eligible shares for which Cede has given notice. If, however, other dissenting beneficial owners for whom Cede also holds have tendered 145 shares for appraisal, then our shareholder can seek appraisal for only five of her shares, not for the other five in excess of the 150 total eligible shares.

The Transkaryotic opinion back in 2007 was issued by the Delaware Chancery Court, and the rule in this case has not yet been affirmed or otherwise opined on by the Delaware Supreme Court; it is indeed the standing principle today but could become more controversial and may well be revisited if it reaches the Supreme Court and they see things differently. And now that Ancestry.com seems to be taking a run at challenging the Transkaryotic ruling, based in part on a change in the appraisal statute since the time that that case was decided, the Delaware courts may take up this issue again. We’ll watch this case as it proceeds and post any new developments here.

 

Chancery Court Rejects Use of Merger Price in Appraisal Action and Accepts Experts’ Direct Capitalization of Cash Flows Valuation Method; Court Also Accepts Experts’ Use of Buildup Model

Posted in Buildup Model, Direct Capitalization of Cash Flows, Discounted Cash Flow Analysis, Fair Value, Independent valuation, Merger Price, Short-Form Merger, WACC

On May 12, 2014, the Delaware Court of Chancery issued its latest appraisal opinion, Laidler v. Hesco Bastion Environmental, Inc., addressing, among other things, the limitations on the use of merger price in an appraisal proceeding.

The petition for appraisal was brought by a former employee of Hesco Bastion USA, Inc. (“Hesco”), which manufactured and sold “Concertainer units” – deployable barriers designed to protect against flooding – in the United States. On January 26, 2012, Hesco was merged into its majority shareholder, the respondent, pursuant to a short-form merger. Immediately prior to the merger, the respondent held 90% of the outstanding equity of Hesco, and the petitioner held 10%. The petitioner refused to accept the $207.50 per share cash consideration offered by the respondent, and instead exercised appraisal rights.

Vice Chancellor Glasscock concluded that the fair value of the petitioner’s shares was $364.24 per share, a 75% increase over the merger consideration. In reaching his conclusion, the Vice Chancellor rejected the respondent’s position that the Court should consider the merger price as persuasive evidence of fair value because it was the result of an arm’s-length negotiation between the controlling shareholder and an independent director. The Court found that it was not an arm’s-length transaction subject to a full market check, but rather a short-form merger consummated by a controlling shareholder who set the merger price. “Under our case law,” the Court stated, “a statutory appraisal is the sole remedy to which the Petitioner is entitled, and to defer to an interested controlling shareholder’s determination of fair value in a transaction such as this would render that remedy illusory.”

Vice Chancellor Glasscock used a direct capitalization of cash flows (“DCCF”) valuation method to determine the fair value of the petitioner’s shares. The Vice Chancellor did not perform a traditional discounted cash flow (“DCF”) analysis because Hesco had not created management projections in its ordinary course of business. The Court relied on the DCCF analysis – which was the sole method applied by the petitioner’s valuation expert and one of the methods applied by the respondent’s valuation expert – determining a normalized figure for annual cash flows in perpetuity and then dividing those cash flows by a capitalization rate. To determine the company’s normalized annual cash flows, the Court averaged the company’s cash flows from the three years preceding the merger. To determine the capitalization rate, the Court subtracted the company’s long-term growth rate (4%) from its weighted average cost of capital (“WACC”) (21.83%). This appears to be the only Delaware case in which the Court based 100% of its valuation on a DCCF analysis.

The Court’s acceptance and application of a DCCF analysis may be significant. The DCCF analysis provides the Court with a methodology for valuing a company where there are no reliable management projections from which to craft a DCF analysis, and where the company is not sufficiently comparable to other companies for the Court to conduct a comparable companies or precedent transactions analysis. Rather than using the merger price as evidence of going concern value, the Court capitalized historical normalized cash flows in perpetuity to independently value the company as a going concern.

The Court’s acceptance of the buildup model to calculate the company’s WACC is also notable. What is the buildup model? The buildup model is similar to the Capital Asset Pricing Model (“CAPM”), except that it adjusts for industry risk by adding an industry-specific equity risk premium rather than using a beta, and also adds a company-specific equity risk premium. In In re Orchard Enterprises, Inc., (Del. Ch. July 18, 2012), then-Chancellor Strine was highly critical of the buildup model, finding that it was not “well accepted by mainstream corporate finance theory” because “its components involve a great deal of subjectivity.” Nevertheless, both parties’ experts used the buildup model in Laidler. The opinion in Laidler, therefore, should not be read as a signal that the Court of Chancery has abandoned the CAPM in favor of the buildup model.