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Appraisal Rights Litigation Blog

The Real Problem With Appraisal Arbitrage

Posted in Appraisal Arbitrage, Award Premium, Discounted Cash Flow Analysis, Fair Value, Merger Price, Perpetuity Growth Rate, Stock Market Price, Supply-side Discount Rate, WACC

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.