On Monday, Law360 [$$] reported that the stockholders in the Clearwire appraisal action filed their opening brief in support of their appeal of the Chancery Court’s ruling, which found the fair value of Clearwire Corp. to be $2.13 per share, well below the $5 per share deal price paid by Sprint Nextel Corp. As reported in the article, on appeal, the stockholders argue that the “staggering discount” awarded by the Chancery Court is “virtually unprecedented.” We have previously posted on the Chancery decision here. We will continue to monitor the appeal and post on new developments as they arise.
As reported today in Law360 [$$], the Delaware Supreme Court heard argument yesterday on the chancery court’s ruling in the Dell appraisal case. The court did not render its decision and did not indicate when it would do so. We’ll continue to monitor the docket and post when the ruling comes down.
** Note: this law firm is one of the counsel of record in the Dell case.
As we previously posted, the Chancery Court appraised the fair value of Clearwire Corp. to be $2.13 per share, substantially below the $5 per share merger price paid by Sprint Nextel Corp in July 2013. This post will provide a more detailed breakdown of the ruling and the bases for Vice Chancellor Laster’s opinion.
In a March 2016 working paper, Corporate Darwinism: Disciplining Managers in a World With Weak Shareholder Litigation, Professors James D. Cox and Randall S. Thomas detail several recent legislative and judicial actions that potentially restrict the efficacy of shareholder acquisition-oriented class actions to control corporate managerial agency costs. The authors then discuss new corporate governance mechanisms that have naturally developed as alternative means to address managerial agency costs. One of these emerging mechanisms possibly as a response to judicial and legislative restrictions on shareholder litigation, is the appraisal proceeding. As readers of this blog are well aware, the resurgence of appraisal proceedings has also been fueled by the practice of appraisal arbitrage.
Does the resurgence of appraisal litigation provide an indirect check on corporate managerial or insider abuse? Professors Cox and Thomas are skeptical, citing several factors that may limit an expansion of appraisal litigation beyond its traditional role. However, they acknowledge that there are circumstances where appraisal litigation can potentially fill the managerial agency cost control void that other receding forms of shareholder litigation have created.
As the paper argues, at first glance, appraisal litigation appears to be a powerful tool for investors to monitor corporate management and control managerial agency costs. However, shareholders face certain disadvantages in an appraisal proceeding, including the completion of required, difficult procedural steps that must be followed precisely to maintain appraisal rights (highlighted by the recent Dell decision); the lack of a class action procedure that would allow joinder of all dissenting shareholders in order to more easily share litigation costs; and the narrow limits of appraisal as purely a valuation exercise that does not take aim at corporate misconduct.
After identifying these general obstacles to appraisal, the authors discuss more specific factors that arguably limit the efficacy of appraisal for remedying management abuse in all M&A transactions. Thus, appraisal is available as a remedy only in certain transactions (e.g., the market-out exception), and even among those transactions that qualify for appraisal, initiating appraisal litigation may often not be cost effective, especially for small shareholders. Also, deals can be structured to minimize or even avoid appraisal altogether.
Cox and Thomas also highlight circumstances where appraisal may well serve as a check on management power. First, appraisal can protect shareholders from being shortchanged in control shareholder squeezeouts. Because these transactions are not subject to a market check, appraisal gives shareholders a tool to ensure that the merger price reflects the fair value of the acquired shares. Leveraged buyouts that do not undergo market checks may also raise conflict of interest concerns, especially when the target’s executives may seek to keep their jobs and be hired by a private equity buyer to run the firm. In this scenario, appraisal arbitrage may ensure shareholders are not shortchanged in a sale of control. Shareholders facing these circumstances may benefit from appraisal.
Second, appraisal arbitrage, as repeatedly covered by this blog, is a viable appraisal tactic. As we’ve previously discussed, appraisal arbitrage has been facilitated by the Delaware Chancery Court decision of In re Appraisal Transkaryotic Therapies Inc., which held that shareholders who purchased their stock in the target company after the stockholders’ meeting, but before the stockholder vote, could seek appraisal despite not having the right to vote those shares at the meeting.
In their 2015 article Appraisal Arbitrage and the Future of Public Company M&A, Professors Korsmo and Myers argued that a robust appraisal remedy could work as a socially beneficial back-end check on insider abuse in merger transactions, but the authors appear skeptical that appraisal can fill this role due to limitations discussed here. These authors don’t take a normative position on appraisal arbitrage but simply query its efficacy as a control on managerial agency costs.
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The Appraisal Rights Litigation Blog thanks Charles York, a student at the University of Pennsylvania Law School and summer law clerk for Lowenstein Sandler, for his contribution to this post.
In this 2015 article from the Arizona Law Review, “Shareholder Litigation Without Class Actions,” Boston University Law School Professor David Webber imagines a “post-class-action landscape for shareholder litigation,” positing that the class action vehicle is becoming gutted by the courts and that mandatory arbitration provisions are undermining the class action device. In this so-called post-class-action environment, the author considers what devices shareholders would have at their disposal to protect themselves. He argues that “the decline of the transactional class action may be offset by, and may enhance, the rise of appraisal litigation, particularly of hedge fund participation in such litigation,” requiring a more active litigation strategy by fund managers than currently undertaken in furtherance of their fiduciary duties to their beneficiaries.
The article provides an interesting thought experiment and suggests that appraisal is a unique and narrow remedy that is highly individualized, as the right only accrues to the “no” voter and the resultant settlement or trial award does not benefit nonparticipating investors, unlike a class action. For instance, unlike the typical fiduciary duty class action accompanying M&A deals, there are no additional disclosures to other shareholders. In addition, as Professor Webber states on page 242, “[i]n the deal context, mandatory arbitration would make it impossible for plaintiffs to enjoin a shareholder meeting, which is the source of much of plaintiffs’ settlement leverage. This could then shift the focus of institutional investors to appraisal proceedings. Lately, such proceedings have attracted increased attention from investors, and the loss of a meaningful remedy under Revlon might force more institutions to seek out appraisal remedies, particularly in cases where institutional lead plaintiffs have had success in litigating transactional class actions in the past.”
In sum, if mandatory arbitration prohibits the injunction possibility, the institutional investor may be left solely with its appraisal rights. And in an interesting twist, the author suggests that if appraisal rights are circumscribed by the legislature, the dissenter is in effect left with no choice but to pursue the strike-suit strategy, which in turn may be further limited by an arbitration provision. In other words, if appraisal is the stockholder’s last hope, it should be left undisturbed and remain a robust tool.
The Delaware Chancery Court’s recent opinion in Owen v. Cannon has garnered little notice or press coverage, but deserves attention not only because the hybrid fiduciary duty-appraisal decision is Chancellor Bouchard’s first foray into the appraisal space, but because it reinforces some basic appraisal tenets and yet also bucks what some have called a recent trend of merger price rulings.
The transaction arose from the interactions of the company’s three main principals: Nate Owen, the founder and president of the firm at the center of the lawsuit, Energy Services Group; his brother Bryn, who worked at ESG directly under Nate; and Lynn Cannon, who put up the capital for the Company. Bryn and Cannon eventually forced Nate out of his job as president (with Cannon being his replacement), and cashed out in a short-form merger Nate’s significant minority stake in ESG for just under $20/share. After applying a discounted cash flow analysis, and no other valuation methods, Chancellor Bouchard awarded Nate approximately $42 million for his 1.32 million shares of ESG, or just under $32/share. The Chancellor’s $12/share premium is a departure from a recent slate of appraisal actions, including Ramtron and Ancestry.com, in which the Court of Chancery has rejected income- or market-based valuation methodologies while looking simply to the merger price as fair value.
In his lengthy opinion, Chancellor Bouchard reaffirms a number of bedrock principles of the appraisal analysis:
- The primacy of the DCF. According to Chancellor Bouchard, the discounted cash flow valuation methodology is the preferred manner in which to determine fair value because “it is the [valuation] approach that merits the greatest confidence within the financial community.” Chancellor Bouchard’s view on the use of transaction price as proof of fair value was not tested in Owen, as both valuation experts in the case used a DCF exclusively and the Chancellor thus had no occasion to opine on the merits of merger price or any other metric to determine fair value.
- Reliable management projections can be dispositive. Of course, a DCF is only as good as its inputs. Much of the Chancellor’s exhaustive 80-page opinion was dedicated to whether or not he could rely on management projections created by Cannon in 2013 in connection with Nate’s buy-out. Chancellor Bouchard determined that he could, in large part because Cannon created the projections when he was already trying to force Nate out of the company (meaning that the projections already had conservative assumptions baked in), and ESG submitted the projections to Citizens Bank to obtain a $25 million revolver (meaning that it would be a federal crime if the projections were false). In contrast, the Chancellor applied well-settled Delaware law in rejecting defendants’ expert’s post hoc, litigation-driven projections in their entirety.
- Tax treatment can mean real money. ESG was a subchapter S corporation, meaning that (unlike in a subchapter C corporation) ESG’s income was only taxed once, at the stockholder’s income rate. Because Delaware law requires a shareholder in an appraisal to be paid “for that which has been taken from him,” and a “critical component” of what was taken from Nate was the “tax advantage” of owning shares in a subchapter S corporation, Chancellor Bouchard adopted Nate’s argument that the Court’s DCF should be tax affected to take into account ESG’s subchapter S status. Under the hypothetical posed by the Chancellor in Owen, S Corp tax treatment means a nearly $14 boon to an investor for every $100 of income.
- Absent identifiable risk of insolvency, inflation is the floor for a terminal growth rate, with a premium to inflation being appropriate for profitable companies. The DCF’s terminal growth rate — which is intended to capture a firm’s future growth rate while still recognizing that firms cannot over time grow materially in excess of the economy’s real growth — is a critical DCF input. (We described one way to calculate terminal growth here, in an earlier post in our “Valuation Basics Series”). Applying Delaware precedent, Chancellor Bouchard determined that it was appropriate to set the terminal growth rate at 3%, a “modest” 100 basis points premium over the Fed’s projected 2% inflation rate. According to the Chancellor (quoting a 2010 Delaware Supreme Court decision), “the rate of inflation is the floor for a terminal value estimate for a solidly profitable company that does not have an identifiable risk of insolvency.” Chancellor Bouchard, however, rejected Nate’s suggested 5% terminal growth rate (above nominal GDP growth) as too high for ESG, a company facing increasing competitive pressures whose years of rapid growth may have been behind it.
The Chancellor also found breaches of fiduciary duties, generally agreeing that, by Nate’s description, the merger was conducted in a “boom, done, Blitzkrieg style,” with Nate having been given notice (by sheriff’s service) on Friday, May 3, 2013 of a Monday, May 6, 2013 special meeting of shareholders to vote on the merger. This was especially egregious as ESG had never before held a formal board meeting until Cannon and Bryn orchestrated two such last-minute meetings, the first one being to terminate Nate’s employment with ESG (which meeting Nate found out about while tending to a health issue for his wife). The May 6 meeting was conducted despite Nate’s request for an adjournment, and the meeting was overseen by an armed guard who stood “at the door with a gun at his hip.” Nevertheless, the damages award for the fiduciary duty claims equaled those decided by Chancellor Bouchard’s appraisal ruling.
As reported in the Wall Street Journal, several investments funds who had exercised appraisal rights in connection with Albertsons’ acquisition of Safeway Inc. have now settled their appraisal case for a 26% premium over the merger price within just half a year after the deal closed. The settlement, at $44 per share, netted $127 million more to the settling funds than the merger price of $34.92 would have given them. While the deal resolves the claims of most dissenting stockholders, two other funds holding 3.7 million shares remain in the appraisal case, and the fiduciary duty class actions against Safeway remain pending as well.
Last week, the Delaware Court of Chancery issued an opinion in In re Orchard Enterprises, Inc. Shareholder Litigation (Del. Ch. Aug 22, 2014) concerning an application for attorneys’ fees (we have previously posted about a significant 2012 decision in that same case by former Chancellor Strine). We found the court’s latest decision noteworthy for two reasons. First, the court reaffirmed the principle that an appraisal action brought by an individual shareholder seeking a judicial determination of the fair value of its stock as of the merger date is an entirely separate animal from a shareholder class action in which the plaintiffs allege director misconduct in connection with the price or process leading up to the transaction. Second, the court cited approvingly an upcoming law review article that highlights statistically the benefits of the appraisal process.
In 2010, The Orchard Enterprises, Inc., was acquired by its controlling shareholder for $2.05 per share in cash. Following the merger, several shareholders pursued an appraisal action, which resulted in a judicial determination that the fair value of Orchard was $4.67 per share. After the appraisal action concluded, another shareholder who had not exercised his appraisal rights brought a class action against the board for breach of fiduciary duty. The class action settled before trial. Counsel for the appraisal shareholders objected to the settlement, arguing that they should be reimbursed from the class action settlement for the fees they incurred in the appraisal action because their efforts contributed to the settlement of the class action. Vice Chancellor Laster acknowledged that the appraisal shareholders “raised the bar” for the company by demonstrating that the fair value of Orchard stock was more than double the merger consideration. However, the court ruled that appraisal counsel was not entitled to reimbursement for its fees because the appraisal action was brought on behalf of individual shareholders, not on behalf of all of Orchard’s shareholders.
In a prior post, we observed how former Chancellor Strine (now Chief Justice of the Delaware Supreme Court) repeatedly took the time to clarify the important but often overlooked distinction between fiduciary duty claims and appraisal rights actions. Vice Chancellor Laster has now followed suit in Orchard when he declined to apportion part of the class action settlement to pay the attorneys’ fees incurred by the successful appraisal petitioners. According to the Vice Chancellor, as unsecured creditors who elected not to accept the merger consideration, appraisal petitioners may have interests that conflict with shareholders pursuing breach of fiduciary duty claims after selling their shares in the merger. Moreover, unlike class plaintiffs (who frequently own only a small stake in the company), appraisal petitioners typically have significant holdings that they believe have been undervalued, so they do not need to be offered an additional incentive (such as the reimbursement of attorneys’ fees) in order for them to seek court intervention.
We also recently blogged about a forthcoming law review article by Professors Charles Korsmo and Minor Myers of Brooklyn Law School, which is expected to be published in the Washington University Law Review in 2015. In that article, the authors laud the appraisal process because it ultimately provides an efficient means for benefiting minority shareholders and reducing the cost of raising equity capital. In the new Orchard decision, Vice Chancellor Laster cited this article and expressly recognized that the effect of an appraisal rights petition “may well be a net positive” because the process “reduces agency costs when compared to traditional class actions and results in a more efficient corporation law.” This is a highly significant reaffirmation of the unique and valuable role that appraisal actions will continue to play in enhancing shareholder value.