August 2016 Amendments

A new piece by Skadden focuses on some old, and some new factors regarding prepayment. Since the 2016 appraisal amendments, respondents in an appraisal proceeding have had the right to ‘prepay’ some or all of the merger consideration.  The mechanics of this are basic, but deserve a moment of explanation.  In appraisal proceedings, unlike in many other lawsuits, the petitioner/plaintiff already owns something of value (stock) at the start of the proceeding – the Court’s job is to determine how much money that stock is worth.  At the end of the proceeding, which is potentially years away from the start, the petitioner is due interest on the funds they were denied during the pendency of the lawsuit – i.e., the value of their stock as determined by the Court.  As an example: if a merger occurred for $10 a share (merger price), and a shareholder demanded appraisal for 10 shares, it may be 2 years before the Court determines that the “fair value” of those shares was actually $15 a share.  The shareholder has lost 2 years of use of $150 of value, and thus is due interest on that.  Even if the Court found that the merger price was fair value, the shareholder still has lost 2 years of use of $100 – and interest would attach to the $100.

Now, enter prepayment.  It is doubtful, if not impossible, that any appraisal proceeding would ever reveal a value of 0 for the appraising shares – so a company will always owe some interest on some portion of the consideration. In order to allow a company to reduce its interest risk, while also providing the shareholder use of their value, in 2016 the Delaware legislature allowed companies to prepay some (or all) of the consideration, and thereby cutoff the interest clock on the portion they prepaid.  Multiple companies have taken this route in their appraisal proceedings.

Last year, we covered how prepayment had been progressing after a year, and how the reality compared to suggested prepayment factors and strategies considered in the runup to the 2016 change in law. As we near the two year mark, others have continued to cover the factors for and against prepayment.  Skadden’s new piece points out that the federal reserve (which sets the ‘base’ interest rate on which the appraisal-related interest rate is determined) has been increasing rates over time.  This augurs for prepayment as the interest exposure goes up as the base rate goes up. Skadden also points out that prepayment can ‘break up’ the need for capital to pay off the appraisal consideration  – as opposed to a company having to come up with the entirety of the appraisal consideration at the end of the case, when business conditions, interest rates, or other financial considerations may be different.

Each case will no doubt be different, and no one size fits all strategy of prepayment will apply.

Law360 [$$] recently carried an analysis by a trio of Delaware attorneys regarding the impact of 2016’s prepayment amendment to Delaware appraisal law.  Part of the August 2016 amendments allowed M&A targets to prepay dissenting shareholders an amount of their choosing, thereby stopping the accrual of interest on that portion of the merger price/amount at issue.  At the time of the amendments, there was meaningful debate whether the new rules – including the prepayment option – would curtail appraisal filings, with some commentators suggesting that they may in fact increase appraisal filings, focusing on the prepayment option.

This more recent analysis considers the last year of appraisal, and while the authors note that a year of data is insufficient to “draw any firm conclusions,” their analysis shows that “in the year following the Aug. 1, 2016, effective date of the amendment, appraisal filings have continued to increase.”  Echoing the pre-amendment analysis that the amendments may increase appraisal activity, the authors make note of the fact that as “appraisal litigation continues its upward trend despite the recent overall decline in M&A activity, this trend may suggest that, as discussed below, the prospect of prepayment is contributing to its continued rise.”

As previous analysis discussed, while prepayment may save on interest for a respondent company subject to appraisal, it otherwise frees up capital for investors to redeploy elsewhere – instead of having that capital ‘locked up’ in the appraisal action. Prepayment introduces additional strategic considerations in appraisal for both investors and respondent companies.

Cooley LLP highlights that increased appraisals are being factored into mergers.  Following up on a previous piece, Cooley LLP notes that appraisal costs can be large, referencing the over $50 million added to the merger price in Dell, and further comments on the rise of appraisal claims, which Cooley calculates as a 267% increase from 2012 to 2016.   We’ve posted previously on the uptick in appraisal filings, and how the August 2016 amendments may further increase filings, as well as what this means for investors interested in the strategy.

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.