The Vanderbilt Law Review published this note on Vice Chancellor Laster’s disqualification of stockholders in Dell who had inadvertently voted in favor of the merger, about which ruling we’ve posted before. This note breaks down that ruling and discusses the court’s strict requirements for appraisal procedure and its affirmation that share-tracing is not required of appraisal petitioners.
The New York Law Journal recently ran an article, Looking Beyond Delaware: Exercising Shareholder Appraisal Rights in N.Y. [via ALM], which analyzes the New York appraisal statute and observes that while appraisal litigation has remained underutilized outside of Delaware, it is possible that with the uptick in Delaware appraisal New York will see more appraisal litigation in its courts as well. As the article shows, the New York appraisal statute deviates from Delaware’s and provides appraisal rights even beyond merger transactions, extending to share exchanges and all-asset dispositions as well.
Cleary Gottlieb’s M&A blog’s recent post, Negotiating Appraisal Conditions in Public M&A Transactions, analyzes attempts — sometimes successful — by acquirors of Delaware public companies to include a closing condition in the merger agreement that would relieve the buyer from closing if a certain triggering percentage of appraisal rights are exercised. Their post discusses the negotiating and drafting of such thresholds and related provisions.
** The content of this post is contributed by Goodmans LLP of Toronto, Canada. We thank Sheldon Freeman of Goodmans for this contribution.
In Canada, as in the U.S., shareholders are becoming increasingly interested in the use of “appraisal arbitrage” strategies in the context of certain M&A transactions. While the circumstances and motivations for engaging in these strategies are quite similar on both sides of the border, there are numerous structural differences between Canadian and U.S. dissent and appraisal regimes that may affect the implementation of these strategies in Canada. Goodmans LLP, one of Canada’s leading business law firms, recently summarized these differences in “The Use of Appraisal Arbitrage Strategies in Canada in Light of Dell” and points out the key legal issues to consider when engaging in or defending against an exercise of dissent rights.
In response to the article on appraisal arbitrage by Gaurav Jetley and Xinyu Ji of the Analysis Group, about which we’ve posted before, Villanova Law Professor Richard A. Booth now argues in The Real Problem With Appraisal Arbitrage [via Social Science Research Network] that Jetley and Ji’s charge against the Delaware courts for overly indulging appraisal arbitrage is misdirected. According to Professor Booth, while Jetley and Ji believe that the Delaware courts incentivize arbitrageurs by using a discount rate lower than the rate typically applied by investment bankers, Professor Booth argues that the bigger and more significant problem is that the Delaware courts additionally reduce the discount rate in the terminal period. Nevertheless, after identifying what he believes is the Delaware courts’ truly faulty practice, Professor Booth offers up a full-throated defense of the appraisal remedy in general and arbitrage in particular.
Some Highlights of the Article
- Professor Booth believes that Jetley and Ji’s criticism of the Delaware courts’ use of the so-called supply-side discount rate, rather than the historical rate of return, is overblown. He agrees that the supply-side rate can inflate a valuation, but not by as great a magnitude as Jetley and Ji seem to believe.
- In rebutting the argument that so-called arbs “are not themselves long-term common stock investors and should not be so compensated for the time value of their money,” he observes that “they have bought the stock they hold from legacy investors and thus should be entitled to the same package of rights enjoyed by such investors.” If arbs’ rights were to be curtailed, that would cause stockholders who choose to sell out suffering an even bigger discount, which in turn would raise the price of deals for acquirors, because target stockholders “will be less confident that they will be paid based on the agreed amount when they want to be paid.” In this respect, arbitrage actually serves the acquirors well.
- Professor Booth critiques the presumption of fairness that some Delaware cases have accorded to the deal price:
- First, the deal price may often be too low, as deal price sometimes depends on the percentage of shares bought. Thus, dissenting stockholders may well be entitled to “higher and higher prices as the public float gets smaller and smaller,” which he finds consistent with the policy objective underlying appraisal: to compensate stockholders for being forced to sell out at a time and/or price not of their own choosing.
- Second, Professor Booth cautions against according too much weight to the premium paid over market price, as a depressed stock price will naturally warrant a higher premium; in that case the premium is simply “compensation for a discount built into the market price.”
- Finally, it is inherent in the concept of nearly any acquisition that a buyer is only willing to pay some lesser price than full fair value, in order to extract the expected value to be gained by redeploying the target company to its highest and best use; to that extent, he suggests, “deal price should always be a bit lower than going concern value [emphasis added],” prompting stockholders to hold out.
- Given these factors, he finds that appraisal performs the valuable function of testing deal price against investor expectation based on CAPM. He believes that appraisal thus helps drive price toward fairness, as a robust appraisal remedy will induce bidders to pay a fair price up front. His critique of the court’s further reduction of the discount rate in the terminal period is intended to improve the appraisal process, not undermine it; he encourages the courts to embrace his reforms rather than “hide behind the aw-shucks notion that law-trained judges are ill-suited to address” questions of valuation, finance, and investment banking.
In summary, the author concludes that appraisal arbitrage has gotten a “bad rap” and that appraisal itself works best if arbitrage is made possible; he fears that absent arbitrage, buyers may rely on the hope that potential dissenters will simply decline to exercise any appraisal rights, allowing the bidder to get away with paying a reduced price.
For an interesting overview of the appraisal process and a concise summary of the merits and risks associated with litigating appraisal rights, we recommend reviewing the article “Opportunistic Investing – the Case for Appraisal Rights” from Neuberger Berman’s Hedge Funds Solutions Group. In describing appraisal as a “niche, legally intensive strategy” with the “potential for providing compelling uncorrelated returns,” the authors provide some key data points on Delaware appraisal decisions’ premium over merger price. They identify appraisal, a “long-ignored part of corporate law,” as an “important weapon” for hedge funds in their “activist investment arsenal,” while cautioning investors to be selective in the deals they pursue.
In a new ruling in the DFC Global appraisal case, about which we’ve posted before, Chancellor Bouchard has now reconsidered his prior award of 7% over the merger price and increased his prior award by an extra 9 cents per share, translating to an additional $12 million in value above his prior ruling.
Both sides had asked the court to reconsider different aspects of its ruling, prompting the Chancellor raise the perpetuity growth rate in his DCF model from 3.1% to 4.0%. In reconsidering his ruling, the Chancellor held that he “failed to appreciate the extent to which DFC Global’s projected revenue and working capital need have a codependent relationship,” and that the high-level requirement for working capital necessarily corresponds to a high projected growth rate. In so ruling, the court had to overcome its initial theory that a company’s perpetual growth rate should never exceed the risk-free rate. The court came to realize that this proposition would be true only for companies that have reached a stable stage of development; where a company is expected to achieve fast-paced growth throughout the projection period, the court now agreed that the perpetuity growth rate should indeed be higher than the risk-free rate.
The court’s initial opinion rejected the stockholders’ use of a three-stage DCF model in favor of a two-stage model, but on reconsideration the court recognized that using the two-stage model required increasing the terminal growth rate to sufficiently take into account the company’s growth rate beyond the five-year projection period.
Finally, the court’s new ruling also unwound two adjustments to the company’s baseline projections that the court had inadvertently made in accepting the company’s DCF model wholesale.
Delaware Chancery has again awarded appraisal petitioners a significant bump above the merger price. In the ISN Software Corp. Appraisal Litigation, Vice Chancellor Glasscock was facing widely divergent valuation from the opposing experts, and relied exclusively on a discounted cash flow analysis as the most reliable indicator of fair value. The court’s per-share valuation award was more than 2.5 times the merger price.
ISN involved the valuation of a privately held software company founded in 2000 and specializing in assisting companies (largely in the oil and gas industry) to meet their governmental record keeping and compliance requirements. In the years leading up to the merger — which was completed on January 9, 2013, with the approval of ISN’s founder and majority shareholder — the company had experienced consistent and substantial growth. In setting the merger price, however, ISN did not engage a financial advisor or obtain a fairness opinion; rather, the company used a 2011 third-party valuation that ISN’s founder apparently adjusted based on his personal views of the company’s future prospects.
Particularly striking in this case was the sheer magnitude of the difference between the dissenters’ and ISN’s valuations, each of which was based largely on a DCF analysis with some weight given to other methodologies such as guideline public companies, comparable transactions, and direct capitalization of cash flow. The court found those other methodologies unreliable here. The petitioners’ valuation at $820 million was over eight times that of ISN’s valuation of $106 million (which was below the merger price’s implicit valuation of $137 million). The Court expressed some of the same skepticism that Delaware chancellors have historically shared regarding the reliability of competing experts in an adversarial litigation environment: “an optimist (a.k.a. someone other than a judge presiding in appraisal trials) might assume that experts hired to examine the same company, analyzing the same set of financial data, would reach similar results of present value based on discounted cash flow. . . . In a competition of experts to see which can generate the greatest judicial skepticism regarding valuation, however, this case, so far, takes the prize: one of the Petitioners’ experts opines that fair value is greater than eight times that implied by the DCF provided by the Respondent’s expert. Given such a divergence, the best scenario is that one expert, at the least, is wildly mistaken.”
The court performed its own independent DCF analysis using the ISN expert’s DCF model as a baseline with various adjustments. One difficulty in doing the DCF valuation was that the company did not regularly create long-term financial projections, requiring the experts to project future cash flows using various assumptions regarding growth and efficiency. Even though the court found that approach “inherently less reliable than using long-term management projections,” it found the expert projections reliable given ISN’s subscription-based business model, customer retention, and the inelastic demand for its product. Finding that “projections out more than a few years owe more to hope than reason,” the court found a standard five-year projection period appropriate.
The court awarded statutory interest and rejected ISN’s argument that “good cause” existed to deny at least one of the petitioners any interest. Finally, even though the court set forth in detail all the various adjustments it made to the ISN expert’s DCF model, he invited the parties to revisit the math, as “relying on the mathematical skill of this superannuated history major—even as assisted by an able judicial clerk—would be hubristic.”
Have the recent Delaware statutory amendments and major Dell decision threatened the appraisal arbitrage strategy? Business Law Prof Blog (via a guest post) acknowledges that while these two developments do not prevent appraisal arbitrage — indeed, the Delaware legislature rejected a proposal to crack down on arbitrage — they may be part of an overall trend against the strategy, and that those who want to pursue appraisal arbitrage should take action before potential other developments may limit it.
Appraisal arbitrage, as we’ve posted before, is a strategy whereby an investor buys shares of a company after announcement of a merger intending to exercise appraisal rights. Unlike historical holders, who may have purchased stock for amounts higher than the deal price, the arbitrageur is buying stock already priced with the deal in place, usually at a price much closer to the deal price. Whether the new Delaware rules will suppress appraisal filings has been a topic of significant debate – we’ve covered pieces about these topics before suggesting they may actually wind up inadvertently increasing appraisal claims.
The Business Law Prof Blog post points out that the fundamental premise of appraisal arbitrage involves the idea of “fungible bulk” – that any particular share of stock is part of the bulk of un-differentiable shares – so that barring a finding that the particular holder voted for the merger, the arbitrageur may seek appraisal so long as enough shares voted against the merger or abstained to “cover” the arbitrageur’s shares and render them eligible for appraisal.
Whether the recent statutory and legal developments actually signal a cautionary flag to arbitrageurs remains to be seen. The Delaware legislature will first need to be persuaded that its prior determination — that appraisal arbitrage is an accretive strategy that enhances shareholder value — was somehow incorrect.
A key aspect of the August 1 changes to Delaware appraisal law permits companies to unilaterally prepay some or all of the merger consideration, thereby stopping the interest accrual on such prepaid amounts. A recent article by Bloomberg discusses prepayment strategies under this new rule and echoes the point posted to this blog repeatedly: the new prepayment rule may have inadvertently fueled more appraisal litigation by “unlocking money for shareholder litigants.”
As discussed in the article, when deciding whether to prepay some or all of the merger price, the appraisal target may have to consider the risk of whether the amount of any prepayment reflects an indication of fair value, and whether prepayment will provide quick liquidity for investors who may have otherwise been deterred by the expense of pursing appraisal. Thus, while prepaying may save a company the statutory interest otherwise due on the prepaid amount, it may reduce any deterrent effect for investors who would otherwise have their capital locked up for the roughly two years that many appraisal cases last. For investors, the possibility of unilateral repayment is also a consideration in bringing, and valuing, the action. As Bloomberg observed, the prepayment option raises new, strategic considerations for both sides going forward.