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.

The so-called market-out exception precludes appraisal where the target’s stock trades in a highly liquid market.  In other words, appraisal is normally available to shareholders except, as the rationale goes, where the M&A target’s stock trades in such a liquid, highly efficient market that its stock price naturally reflects its fair value, and any M&A transaction offering a premium to that market price thus provides shareholders even greater, above-market value that would render an appraisal challenge superfluous.  Or, at least, so the theory goes.

Delaware’s appraisal statute incorporates the market-out exception, precluding appraisal rights where the target’s stock is either “(i) listed on a national securities exchange or (ii) held of record by more than 2,000 holders.”  DGCL § 262(b)(1).  But the Delaware statute doesn’t stop there, and this is where it parts ways with many other states:  it then carves out from the market-out exception circumstances where the target’s stock is being acquired for cash, in whole or in part.  As a result of this exception to the exception, Delaware’s market-out exception has far fewer teeth than do those of jurisdictions that adopted the market-out exception outright, without exception.  Thus, based on the theory underlying the statute, and notwithstanding the purported liquidity and efficiency of the stock markets in which most public M&A targets are traded, Delaware allows stockholders of its corporations to assert appraisal rights rather than assume that the market price inevitably captures the maximum value of their shares.

Many other states, such as Arizona, have adopted the market-out exception as is, without any carve-outs.  Indeed, back in February, when it was announced that the Apollo Education Group (“APOL”), which is incorporated in Arizona, had agreed to be acquired by a consortium of investors including The Vistria Group, affiliates of Apollo Global Management, and the Najafi Companies for $9.50 per share in cash, many investors immediately took to social media and other informal outlets to consider mounting an appraisal case against APOL.  However, such plans were just as immediately halted as they ran into Arizona’s market-out exception. AZ ST. § 10-1302(D).  Unlike Delaware, Arizona does not allow any exceptions to the exception, and a target such as APOL that trades on a sufficiently large stock exchange is shielded from appraisal.

Massachusetts, in contrast, has not adopted the market-out exception, but appraisal rights in that state are limited to transactions presenting potential conflicts of interest.  Thus, when EMC agreed to be acquired by Dell in late 2015, stockholders who believed they faced an uphill battle of demonstrating conflict of interest were likewise stymied from pursuing appraisal.  MA GL § 13.02(a)(1)(B).

The bottom line: Investors cannot presume that all jurisdictions providing for appraisal rights afford stockholders similar rights in their statutes.  Before investing the time and diligence in evaluating a target’s acquisition price, shareholders must fully inform themselves of the applicable state statute as well as its exceptions (and any carve-outs to those exceptions).

A frequently asked question involves the availability of appraisal rights when investors are being offered only stock in the acquiring corporation in exchange for their shares.

The answer is typically no.  The Delaware appraisal statute provides that appraisal rights are available in a wide range of statutorily permitted mergers.  8 Del. C. § 262(b).  However, in what is commonly referred to as the “market-out exception,” the statute further provides that appraisal rights are not available for stock that is “either (i) listed on a national securities exchange or (ii) held of record by more than 2,000 holders.”  8 Del. C. § 262(b)(1).  Of course, if this is where the story ended, the market-out exception would render appraisal rights unavailable in most cases.  But the Delaware legislature created another exception in the appraisal statute, which Delaware courts have labeled the “exception to the exception.”  The exception to the exception states that the market-out exception does not apply when the shareholders of the target corporation are required to accept consideration for their shares that is not (a) shares of stock in the surviving corporation, (b) shares of stock in any other corporation that are either listed on a national securities exchange or held of record by more than 2,000 holders, or (c) cash in lieu of fractional shares described in (a) or (b).  8 Del. C. § 262(b)(2).  Thus, the statute provides that when the holders of a nationally listed or widely held stock are offered cash consideration for their shares (other than cash in lieu of fractional shares), appraisal rights exist, but when they are offered only the stock of the acquirer or other nationally listed or widely held stock, there are no appraisal rights.

In Louisiana Municipal Police Employees’ Retirement System v. Crawford, 918 A.2d 1172 (Del. Ch. 2007), the Delaware Chancery Court addressed the interesting question of whether appraisal rights exist when the shareholders of the target company are offered only stock of the acquiring company, but the acquiring company also causes the target’s board to declare a special dividend immediately prior to the merger.  The acquiring company argued that appraisal rights were not available because the merger was technically an all-stock deal and the special dividend was not part of the merger consideration being offered by the acquirer.  The Chancery Court rejected that argument, however, finding that it elevated form over substance.  The payment of the special dividend was dependent on the shareholders of the target approving the merger.  Thus, the Court found, “[w]hen merger consideration includes partial cash and stock payments, shareholders are entitled to appraisal rights.  So long as payment of the special dividend remains conditioned upon shareholder approval of the merger, [shareholders of the target corporation] should not be denied their appraisal rights simply because their directors are willing to collude with a favored bidder to ‘launder’ a cash payment.”

In another interesting application of the appraisal statute, Krieger v. Wesco Financial Corp., 30 A.3d 54 (Del. Ch. 2011), the Chancery Court addressed whether appraisal rights exist when shareholders are given the option of receiving either cash or stock.  Shareholders who failed to make an election would receive cash.  The Chancery Court held that appraisal rights were not available in that instance because the shareholders had the option to elect to receive stock.  Even though they might ultimately receive cash, they were not required to accept cash.

Accordingly, whether or not an ostensibly all-stock deal is appraisal eligible requires an examination of all the forms of consideration being offered in the merger and any election features available to stockholders.