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.
A new piece by Reuters Breakingviews, M&A at Last Finds a Way for Lawsuits to Pay, covers last week’s rulings on appraisal arbitrage by the Chancery Court in Ancestry.com and BMC (which we posted about last week), and also observes generally that appraisal actions are “surprisingly successful” and are thus witnessing a surge in filings over the past few years. The author finds appraisal cases to be “the rare litigation strategy that can benefit investors more than their lawyers.” The article also briefly discusses the upcoming en banc hearing by the Delaware Supreme Court scheduled for February 2015, in the appeal of the appraisal of CKx shares, which we’ve addressed in a prior post.
In conjunction with this article, the author discussed his research and findings about the success of appraisal actions in a short Reuters Breakingviews video, “A New Way to Make M&A Hay.”
In two separate rulings on January 5, 2015 — In re Appraisal of Ancestry.com., Inc., and Merion Capital LP v. BMC Software, Inc., both by Vice Chancellor Glasscock — the Delaware Chancery Court reaffirmed the legitimacy of the appraisal arbitrage strategy and refused to impose share-tracing requirements or other obligations on the beneficial stockholder, continuing to require only of the record owner that it perfect appraisal rights by not voting in favor of the deal and making a timely demand for appraisal. News of these rulings has already been widely reported, including by Reuters and The Wall Street Journal.
We’ve posted before about arbitrage opportunities in appraisal rights and the increased utilization of this strategy by professional investors. Indeed, we had been awaiting the Chancery Court’s ruling in Ancestry.com, as it presented the first opportunity since the Delaware appraisal statute was amended in 2007 to decide whether the Court’s prior ruling in Transkaryotic would remain good law in light of that amendment.
Both new cases address the practice of so-called appraisal arbitrage, in which an investor buys the target company’s stock after a merger announcement. In the Ancestry.com case, the Court rejected the company’s argument that given the 2007 amendment to the appraisal statute — by which Delaware’s legislature expressly permitted beneficial owners to file appraisal petitions directly on their own behalf — the beneficial owner should be required to show that its predecessors did not vote in favor of the merger, and if it cannot do so, it lacks standing. The Court held that under a plain reading of the statute, it remains the record holder alone who must have no-voted the shares for which it seeks appraisal; the statute does not impose any requirement on a stockholder to demonstrate that previous owners also refrained from voting in favor. In other words, the Court affirmed Chancellor Chandler’s previous ruling in Transkaryotic that the actions of the beneficial holders are irrelevant in appraisal actions, and the Court thus refused to adopt the company’s proposed share-tracing requirement. As a matter of procedure, the Court denied the company’s motion for summary judgment on this issue; the appraisal decision itself has not yet been made and will issue separately.
The ruling in Ancestry.com is thus the first decision to uphold appraisal arbitrage after the 2007 statutory amendment was made; Transkaryotic, which first permitted arbitrage, was decided in 2007 prior to the amendment. The ruling in Transkaryotic was based in large part on Chancellor Chandler’s accounting for the fact that in a typical situation the owner of stock certificates, such as Cede & Co. — which is usually the nominal owner of shares that are on deposit with the Depository Trust Company — holds their shares in an undifferentiated manner in “fungible bulk,” and so no shareholder has ownership rights to any particular share of stock. Vice Chancellor Glasscock’s new ruling continued to recognize that reality and found nothing in the 2007 amendment to Section 262 to suggest that the Delaware legislature intended to require beneficial owners who made post-record-date purchases to show that their specific shares were not voted in favor of the merger. In fact, the Court found Ancestry.com’s proposed requirement to contradict and be invalidated by the Court’s prior approach in Transkaryotic.
The action in Merion Capital v. BMC Software was brought by Merion Capital, a self-described “event-driven investment” fund that specializes in appraisal arbitrage. The stockholder in that case faced a unique problem because Cede refused to make its appraisal demand on its behalf, so Merion was forced to have its holdings in BMC stock withdrawn from the “fungible mass” at DTC/Cede and registered directly with BMC’s transfer agent, Computershare. Merion thus sought to become its own record holder as well, and the Court found that it succeeded in doing so and properly made demand. BMC challenged Merion’s standing by saying Merion needed to prove that each share it seeks to have appraised was not voted by any previous owner in favor of the merger. The Court rejected BMC’s challenge and found that Merion succeeded in showing that it had not voted the shares in favor of the merger; as it did with Ancestry.com and Transkaryotic, the Court held that nothing in the statute requires a stockholder to prove that the specific shares it seeks to appraise were not voted in favor of the merger.
These rulings clearly reaffirm the validity of appraisal arbitrage, at least as a legal matter. Of course, as a practical matter, that strategy remains subject to the very real risk that the number of shares presented for appraisal actually outnumbers the number of no-voted shares eligible for appraisal, causing the appraisal action to be oversubscribed. The Court refused to make any pronouncement on how it might rule in such an overappraised situation, since it was not presented with those facts in either of these two cases.
The Delaware Supreme Court has scheduled the case of Huff Fund Investment Partnership v. CKx Inc. for en banc review in February 2015.
The Chancery Court rejected the valuation methods proposed by the parties and deferred to the merger price as the only reliable indicator of value. The Chancery Court likewise rejected the shareholders’ argument for an upward adjustment to the merger price as well as the company’s argument for a downward adjustment.
On appeal, the parties are asking the Supreme Court to consider whether the Chancery Court erred by:
- deferring exclusively to the merger price, in lieu of performing any valuation analysis, to determine the stock’s fair value.
- rejecting both of the DCF valuations presented by the shareholders as well as the company.
- rejecting the shareholders’ other valuation methodologies; namely, their expert’s (a) guideline publicly-traded companies analysis and (b) precedent transactions valuation.
- refusing to attribute any value to a corporate acquisition that materialized after the merger price was agreed upon but prior to the time the merger was consummated.
- refusing to decrease the merger price by certain claimed synergies and other cost-savings that the acquirer expected to achieve.
- refusing to allow the company to make a partial payment to the shareholders to stop the running of statutory interest prior to the entry of final judgment.
The Supreme Court seldom reviews appraisal cases en banc. In fact, the seminal cases of Weinberger v. UOP, Inc. (1983) and M.G. Bancorporation, Inc. v. Le Beau (1999) are the only other en banc appraisal cases of which we are aware.
**Note: this law firm is of counsel to the appellant-petitioner shareholders in CKx.
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.
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.
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.
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.
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.
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.
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.