Continuous Holder Requirement

Does appraisal arbitrage create costly uncertainty for a putative corporate buyer?  In The Cost of Appraisal Rights: How to Restore Certainty in Delaware Mergers, 52 Ga. L. Rev. 651 (Winter 2018), the author argues that the well-established ability to alienate voting interest from equity interest with common stock opened the door to appraisal arbitrage – and that either a legislative, or a market plumbing solution, could ameliorate corporate buyers risks when entering into a merger.  We’ve covered before how deal lawyers and others must factor in the possibility of appraisal when looking at a transaction (perhaps even more so when a transaction involves insiders, has a poor process, or otherwise does not comply with shareholder-protective standards) – here, the author proposes solutions.

First, a legislative change to the appraisal holding requirement is proposed: require appraisal seeking shares to be continuously held from the record date.  Second, structurally, move the securities recording system from one of fungible bulk to actual share tracing through a system of centralized recording.  (Note: We’ve written before about how blockchain solutions, which can be centralized or decentralized, could affect appraisal).

To briefly recap and oversimplify what these changes seek to ‘solve’:  The vast majority of stock in the United States is held in “fungible bulk” by the Deposit Trust Clearing Corporation (DTCC).  Fungible bulk means that one share cannot be differentiated from another share.  If a company issued 1,000 shares of stock – any given one of those thousands shares is ‘fungible’ with any other given share – and they are held by DTCC in ‘bulk’ – meaning not assigned to a specific (even individual) beneficial owner, but rather in bulk lots assigned to certain nominees, brokers, etc.

Setting aside the wisdom (or lack thereof) of this system, the result is that it is a metaphysical impossibility, generally, to show that any particular share of stock voted for or against a merger (or abstained).  The result is that a share purchased after the record date may well be one of the (again, this is metaphysical – the shares cannot be differentiated) shares that voted against the merger (or abstained), and thus, it carries appraisal rights.  This becomes an issue only if more shares seek appraisal than could have possibly voted against the merger or abstained.

The author’s changes here would certainly restrict appraisal arbitrage; as we’ve discussed before, structural solutions that allow for actual share tracing could make for all kinds of changes to corporate governance and shareholder rights (including appraisal).  Delaware courts — as well as the legislature — have rejected efforts to import a share-tracing requirement in Delaware appraisal.

The ABA Business Law Section, Spring Meeting, shared this presentation, laying out some useful information regarding the Depository Trust & Clearing Corporation. The material is of particular relevance to those interested in appraisal rights; the continuous holder requirement – which requires appraisal seekers to have continuously held their stock from the time of making their appraisal demand through the deal closing – requires a petitioner to overcome procedural hurdles in order to exercise appraisal and make sure their claim is not subject to challenge. This presentation gives an overview of some of the recent case law, including the Dell matter, for those interested in the nuts and bolts of exercising appraisal rights.

Blockchain: The idea of distributed ledger technology – usually associated with “cryptocurrency” like bitcoin – may be coming to the world of appraisal rights in the near future. As reported by Bloomberg BNA, Delaware’s legislature is considering facilitating the use of blockchain technology with respect to share ownership. As recent cases have shown, pursuit of appraisal rights is critically related to an understanding of the actual system of share ownership involving the Depository Trust & Clearing Corporation and intermediaries in the U.S., a process that, for the appraisal claimant, can be fraught with peril. Blockchain is one potential solution to simplify the record keeping of who owns what shares and how they own them. The relevant proposed legislation is available here.

The Chancery Court granted summary judgment in favor of Dell against a number of stockholders who duly noticed their appraisal demands but whose stock certificates had been retitled before the effective date of the merger to their own custodians’ nominees. As is typical for an appraisal challenge, DTC certificated the dissenting stockholders’ shares into the name of its nominee, Cede. But the beneficial owners’ custodians then took the added step of directing DTC to retitle the shares to the name of their own nominees, which change took place prior to the consummation of the merger. The court ruled that this ostensive break in record ownership violated the continuous holder requirement and thus disqualified those beneficial owners from proceeding with their appraisal case.

This ruling dismisses almost a million shares from the Dell appraisal case. Shares that were certificated in the name of Cede, without a further name change, are unaffected by this decision and the rest of the claims remain pending before the court. The ruling only affects those holders whose custodians changed the designee out of Cede’s name and into their own nominees’ names. Interestingly, the court found it irrelevant that the funds themselves were unaware of the retitling of their shares, a process which is undertaken by the custodian without the beneficial owner’s knowledge or consent. Thus, Vice Chancellor Laster found that once a shareholder chooses to hold its shares through intermediaries, it assumes the risk that the intermediaries might take an action against its interests.

Vice Chancellor Laster makes very clear that he felt constrained by Delaware case law to reach this result and that “were it up to me,” a better interpretation of the term “stockholder of record” in the appraisal statute would include the DTC participant list (i.e., the brokers and custodians, not just Cede). Under federal law, Cede is not the record holder, the DTC participants are deemed to be the holders, and the Vice Chancellor would have followed federal law if he did not think that Delaware law so clearly deems only Cede to be the owner of record. In fact, he directed much of his opinion to the Supreme Court itself and seems to want to be reversed. The legislature could conceivably take action first, and contemplating that very possibility, the Vice Chancellor also stated that he did not want to be overridden by the legislature and that there should not be a legislative cure to an issue of statutory construction.

The opinion provides a very detailed account of the process by which shares are held in fungible bulk and then re-certificated by DTC, and how Congress directed the SEC to immobilize share certificates through a depository system in response to the unworkable situation that had arisen under the former paper trading framework. The decision also lays out a comprehensive history of the record holder requirement, from 1899 to the present, in the course of which the court touched on appraisal arbitrage: on the one hand, the court said that including the DTC participants would bring greater clarity to the question of how particular stockholders may have voted. But at the same time, the Vice Chancellor made very clear that he did not thereby intend to undercut the practice of appraisal arbitrage, and as a policy matter he did not understand why critics of appraisal arbitrage oppose the transfer of appraisal rights when the commercial marketplace generally favors the transfer of property, including something as likely to result in an assignment of a litigation claim as a defaulted loan.