August 2013

Institutional investors should be keenly aware of their returns during the pendency of an appraisal proceeding, since such costs may go a long way toward reimbursing the investor for the cost of such a proceeding. Under Delaware law, a shareholder who seeks to appraise the value of its shares is generally entitled to “interest from the effective date of the merger to the date of payment of the judgment . . . compounded quarterly . . . at 5% above the Federal Reserve discount rate . . . .” 8 Del. C. § 262(h). At current interest rates, this translates into approximately 5.8% interest on the unpaid merger consideration per year. Given that appraisal proceedings normally last approximately two years, it provides a floor of almost 12% of the merger consideration to help cover the costs of experts and attorney’s fees in the appraisal proceeding.

Although the Delaware statute provides a formula for interest, it also allows the amount to be changed in the court’s discretion for “good cause.” Given the statute’s apparent delegation of authority to the trial court, there are several very good reasons to argue for more interest. Indeed, under the old version of Delaware’s interest statute, parties made a number of arguments for why the interest rate should be something above the market rate. First, for example, consider that Delaware law imposes the merger payment obligation on the “surviving corporation.” In cases where an acquisition has improved the creditworthiness of the company, the credit risk of non-payment may arguably decline. However, many acquisitions are leveraged buy-outs and may be financed through high-yield debt instruments. In these circumstances, the surviving corporation has become much more leveraged and there is a market measure of the credit risk associated with the company — namely, the coupon on its high-yield debt. Since payment of the merger consideration is in fact an unsecured debt, one could argue that the yield on the surviving corporation’s unsecured bonds is the better measure. In most cases, that rate will substantially succeed the statutory interest rate.

Alternatively, one could argue that the consequences of not receiving the merger consideration at the time of the merger should be compensated with an equity return. Under this approach, one would argue that the shareholder should be compensated with the return that an equity investor would require to invest in the company. In other words, the investor has been forced to “forgo” an equity investment in a company of similar risk. One proxy for the “equity return” can be found in the discounted cash flow analysis frequently used by Delaware Courts in appraisal proceedings. In determining the discount rate, courts routinely calculate the “cost of equity capital” that investors require to invest in a company of the size and risk of the target. Again, the equity return on invested capital will likely be substantially higher than the statutory interest rate.

Finally, during a period of rising equity markets, a broad equity index — such as the S&P 500 — can be used as a measure for the forgone opportunity of an equity investment. Under this theory, the investor exercising appraisal rights would argue that if it had received the merger consideration at the time of the merger, it would have invested those proceeds into a general equity investment the return on which can be measured by the return on the S&P 500 or other index during the applicable time. Again, in some instances this will result in returns in excess of statutory interest.

Whether or not these arguments remain viable under the “good cause” provision of the current statute has yet to be tested. No party has pressed these kinds of arguments yet to our knowledge. Although professional investors should avoid needless disputes over interest owed in appraisal proceedings, the arguments outlined above could well constitute “good cause” sufficient to enhance the overall returns in appraisal proceedings and help professional investors defray the legal cost of expert fees associated with pursuing appraisal rights actions.

 

A mining company is acquired and a shareholder who preferred the company’s long-term prospects to its short-term sale price exercises its appraisal rights. Fast forward to the appraisal exercise in court: the company’s primary asset to be valued is a gold mine that the company had acquired pre-merger but only first began to actively extract ore from post-merger. In assessing the mine’s fair value as of the merger date, is the court confined to examine only pre-merger projections or can it resort to post-merger evidence of actual results?

When a court sets out to determine just what a company’s “fair value” is as of the time of the merger, the judge generally avoids relying on transactions or events that occur after the merger takes place. While at first blush the rule barring post-merger evidence seems to deprive the court of all available evidence — sometimes the ostensively best evidence of just how accurate the pre-merger expectations were — the wisdom of the rule cannot be overstated.

In an appraisal proceeding, the Court of Chancery shall appraise “the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger . . . .” 8 Del. C. § 262(h). The underlying assumption in an appraisal proceeding is that the dissenting shareholder would be willing to maintain his equity position in the company had the merger not occurred. To fully compensate the stockholder for having his shares taken away from him involuntarily, those shares are to be valued as his proportionate interest in the company as a going concern. Likewise, fair value is to be determined as of the effective date of the merger, so post-merger evidence — that is, what actually happens after the closing — is irrelevant to the valuation exercise.

As a result, the Delaware courts generally base their appraisals on projections prepared by company management before the merger. The other side of this coin is that courts are highly skeptical of companies that try to disclaim their own pre-merger projections through their valuation experts. Delaware courts thus reject hindsight-driven, after-the-fact views of the company’s pre-merger prospects:

Contemporary pre-merger management projections are particularly useful in the appraisal context because management projections, by definition, are not tainted by post-merger hindsight and are usually created by an impartial body. In stark contrast, post hoc, litigation-driven forecasts have an “untenably high” probability of containing “hindsight bias and other cognitive distortions.”

Prescott Group Small Cap, L.P. v. Coleman Co., Inc., 2004 WL 2059515, at *21 (Del. Ch. 2004). Delaware courts thus prohibit a merged company from using post-merger data to undermine pre-merger projections, as “any other result would condone allowing a company’s management or board of directors to disavow their own data in order to justify a lower valuation in an appraisal proceeding.” Gray v. Cytokine Pharmasciences, Inc., 2002 WL 853549, at *8 (De. Ch. 2002). While on rare occasions a court might consider post-merger evidence for the limited purpose of validating what was known or knowable and susceptible of proof as of the time of the merger, that exception reinforces the rule that post-merger evidence generally may not be used to adjust or change pre-merger data.

So in our mining company example, the value of that gold mine is to be determined based only on facts known or knowable as of the merger date; what happens after then is immaterial to the appraisal action. After the acquisition is consummated, there could be a huge spike or a sudden drop in the price of gold; mining technology could improve, or miners could go on a prolonged strike, but none of these post-merger events is permitted to override the purity of the valuation of the shares as of the date that they were forcibly removed from the shareholder’s hands: the shareholder is not required to share in the company’s unanticipated future loss just as he is not permitted to enjoy participation in an unexpected future gain.

Such a rule preserves the integrity of the valuation exercise, however removed from actual post-merger reality. After all, the policy underlying appraisal rights recognizes that the shareholder would continue to hold stock in the company absent the merger; once the shareholder is thus deprived by merger of the chance to share in the company’s future risks and rewards, he is to be effectively appraised and cashed out on a going concern basis, as of the merger date, without regard to how those future risks and rewards actually turn out.

As more fully explained in a Law360 article by the same authors of this Blog, just last month the Delaware Chancery Court squarely rejected any suggestion that the merger price paid for a company is a proxy for the fair value of its stockholders’ shares. Consistent with two landmark Delaware rulings of the past few years — Golden Telecom, Inc. v. Global GT LP and In re Orchard Enterprises, Inc. — the Chancery Court answered any open question as to whether a court would attach presumptive weight to the merger price with a resounding “no.” In so ruling, the Chancery Court found the actual merger price paid by the acquirer to be “largely irrelevant” in determining the fair value of the company’s shares.