August 2016

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 strategyBusiness 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.

As reported in The Hedge Fund Law Report‘s article, “Recent Legislative and Judicial Developments Fail to Diminish Appeal of Stockholder Appraisal Actions As Strategy for Hedge Fund Managers” [$$$], the recent statutory amendments have failed to diminish the appeal of stockholder appraisal actions as a strategy for hedge fund managers.  According to this article, that news, combined with the recent Dell appraisal decision, confirms that this litigation-based investment strategy remains a suitable option for hedge fund managers.