Prepayment of Merger Consideration

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.

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.

Now that the amendments to the Delaware appraisal statute have been signed into law, the new provisions will apply to all M&A agreements entered into on or after August 1.  Here is a link to the rule as revised, showing the new terms (only Sections 8-11 relate to appraisal).  As we have posted previously, the statute, as amended, now (i) sets a floor for appraisal proceedings based on the quantum or dollar size of shareholdings and (ii) permits M&A targets to prepay dissenters in an amount of their choosing to halt the interest clock on the amount prepaid.  As we’ve observed before, investors may welcome the opportunity to redeploy any such prepayments to the next appraisal case, thus indirectly solving the liquidity problem that has prevented some shareholders from exercising appraisal in the first place.

As we’ve previously covered in this blog, the Delaware Legislature has proposed two changes to its appraisal statute in response to an increasing number of appraisal filings.  The first proposal, the De Minimis Exception, would require that anyone bringing an appraisal action have, at minimum, a $1 million stake in the company or 1 percent of its shares.  The second proposal, the Interest Reduction Amendment, would allow companies subject to appraisal actions to prepay any desired amount on the merger consideration.  This prepaid amount would count toward any final judgment rendered by the Court, and would not be subject to the prejudgment interest rate.

With these proposals in mind, academics Wei Jiang, Tai Li, Danqing Mei, and Randall Thomas have considered whether these proposed reforms will achieve their stated goals.  They provide a statistical analysis of the rise of appraisal actions in their article “Reforming the Delaware Appraisal Statute to Address Appraisal Arbitrage: Will It Be Successful?”  First, they find that, in recent years, hedge funds have dominated the appraisal arbitrage strategy, with the top seven hedge funds accounting for over 50 percent of the dollar volume of all appraisal petitions.  Second, most appraisal petitions target deals with potential conflicts of interest, such as going-private deals, minority squeeze-outs, and short-form mergers.  Each of these deals is associated with a 2-10 percent increase in the probability of an appraisal filing.  Low takeover premiums also generate a higher probability of appraisal petitions.

The authors find that the De Minimis Exception will likely lead to a 23 percent drop in the number of appraisal filings.  Although about 39 percent of appraisal petitions between 2000 and 2014 failed to meet the De Minimis Exception, about 16 percent of these petitions were short-form mergers, which would be excluded from this exception.  The authors contend that this 23 percent drop provides an accurate estimate of how many claims would be barred in the future if the De Minimis Exception were to pass.

The authors argue that the Interest Reduction Amendment would have a much larger impact on appraisal filings, though this blog recently covered an opposing view.  Interest accounted for about 60 percent of the returns in appraisal arbitrage trials between 2000 and 2014, and 11 percent of cases would have had negative raw returns were it not for the interest rate.  The authors conclude that the current interest rate likely stimulated 45 percent of all the appraisal petitions filed.  Based on this rationale, the prepayment amendment could significantly lower how much interest accrued, and in turn, theoretically lower the number of appraisal petitions filed as it would change the economic calculus of filing a petition.  However, as we’ve previously posted, the prepayment amendment may just as well increase the number of filings, since stockholders would have more liquidity and could redeploy the prepayment capital to their next appraisal case.

Whether the amendments will ultimately become law remains to be seen, as well as their ultimate effect on appraisal proceedings.

* The Appraisal Rights Litigation Blog thanks Trevor Halsey, a student at Brooklyn Law School and summer law clerk for Lowenstein Sandler for his substantial contribution to this post.

Today’s New York Times ran this piece analyzing the proposed Delaware amendments on appraisal proceedings, which we blogged about last weekThe New York Times shares our own observation that the proposed legislation’s provision allowing for prepayment by the M&A target could have the unintended effect of increasing appraisal filings: “Rather than discourage appraisal petitions, the elimination of interest accrual through prepayment may actually spur more appraisal actions because hedge funds would be paid sooner and be able to use that money to bring more appraisal actions.”