CLS BlueSky Blog has published a post discussing the current state of Delaware appraisal law and fitting appraisal developments into the broader context of M&A rules and corporate governance. The post covers recent appraisal decisions, with the authors concluding that: “in our view, generally, the court is more likely to continue to reach above-the-deal-price results in non-arm’s-length merger cases (such as controller transactions, squeeze-outs, and certain MBOs-unless the transaction complies with the MFW prerequisites), and may also do so in arm’s-length merger cases involving a seriously flawed sale process.” This view fits with the trend of academics and attorneys focusing on both the sales process and then the valuation as part of appraisal. The authors also cover the 2018 proposed amendments, which we discussed here.
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 week. The 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.”
Proposed changes to the Delaware appraisal statute have cleared Delaware’s House of Representatives without dissent, and now move on to the state Senate. The new legislation, which we blogged about in March, sets a floor for the number of shares and value of suit necessary to bring an appraisal action. It also permits M&A targets to prepay merger consideration to dissenting shareholders to avoid interest accruing on the prepaid amounts. We note that the target’s ability to prepay some or all of the merger consideration could have the unintended effect of increasing the number of appraisal filings by ameliorating an investor’s illiquidity problem in prosecuting an appraisal action. Investors may now be enabled to redeploy their otherwise trapped capital in a new appraisal case; while investors would obviously lose their statutory interest on the prepaid amount, that might be a trade-off they can live with.
A number of amendments to Delaware’s appraisal statute have once again been proposed by the Corporate Council of the Corporation Law Section of the Delaware State Bar Association, the committee that customarily recommends legislative action to Delaware’s state lawmaking body. If certain proposed changes to the Delaware General Corporation Law (“DGCL”) are approved by the Corporation Law Section, they will be introduced to the Delaware General Assembly.
The proposed legislative changes – available here – are intended to (i) set a floor for the number and value of shares asserting appraisal and (ii) permit M&A targets to prepay some or all of the merger consideration to dissenters to avoid the accrual of interest on such prepaid amounts.
- Threshold for Appraisal
Under the proposed amendments, the Court of Chancery shall dismiss an appraisal proceeding for a public company, unless (1) the total number of shares entitled to appraisal exceeds 1% of the outstanding shares of the class or series eligible for appraisal, (2) the value of the merger consideration for such dissenting shares exceeds $1 million, or (3) the merger was a short-form merger pursuant to § 253 or § 267 of the DGCL.
To be clear, the legislature has not yet approved or even considered these proposals; we’ll post about any future developments in that regard. Since most appraisal cases already exceed such levels, we don’t anticipate that the thresholds set forth in items (1) and (2) will have a terribly profound impact; indeed, the cost of mounting an appraisal action naturally dissuades small stockholders from doing so.
- Prepayment Option
The proposed legislation also permits the surviving company to make a cash payment to dissenters in an amount of its choosing, with interest accruing only on the difference between the amount so paid and the fair value of the shares as determined by the Chancery Court (as well as any interest that had previously accrued on the paid amount as of the effective date of the merger).
Interestingly, while this second proposal would encourage appraisal respondents to prepay significant amounts to stop the interest clock, investors might utilize the opportunity to redeploy such returned capital to their next appraisal case, thus having the unintended effect of increasing the number of appraisal petitions.
It is worth noting that the draft legislation does not include any specific proposals to eliminate or limit appraisal arbitrage. The proposed legislation includes several provisions unrelated to appraisal that are not addressed here.
If ultimately adopted by the Delaware legislature, the legislation would become effective in respect of merger agreements entered into on August 1, 2016, and thereafter.
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.
On May 12, 2014, the Delaware Court of Chancery issued its latest appraisal opinion, Laidler v. Hesco Bastion Environmental, Inc., addressing, among other things, the limitations on the use of merger price in an appraisal proceeding.
The petition for appraisal was brought by a former employee of Hesco Bastion USA, Inc. (“Hesco”), which manufactured and sold “Concertainer units” – deployable barriers designed to protect against flooding – in the United States. On January 26, 2012, Hesco was merged into its majority shareholder, the respondent, pursuant to a short-form merger. Immediately prior to the merger, the respondent held 90% of the outstanding equity of Hesco, and the petitioner held 10%. The petitioner refused to accept the $207.50 per share cash consideration offered by the respondent, and instead exercised appraisal rights.
Vice Chancellor Glasscock concluded that the fair value of the petitioner’s shares was $364.24 per share, a 75% increase over the merger consideration. In reaching his conclusion, the Vice Chancellor rejected the respondent’s position that the Court should consider the merger price as persuasive evidence of fair value because it was the result of an arm’s-length negotiation between the controlling shareholder and an independent director. The Court found that it was not an arm’s-length transaction subject to a full market check, but rather a short-form merger consummated by a controlling shareholder who set the merger price. “Under our case law,” the Court stated, “a statutory appraisal is the sole remedy to which the Petitioner is entitled, and to defer to an interested controlling shareholder’s determination of fair value in a transaction such as this would render that remedy illusory.”
Vice Chancellor Glasscock used a direct capitalization of cash flows (“DCCF”) valuation method to determine the fair value of the petitioner’s shares. The Vice Chancellor did not perform a traditional discounted cash flow (“DCF”) analysis because Hesco had not created management projections in its ordinary course of business. The Court relied on the DCCF analysis – which was the sole method applied by the petitioner’s valuation expert and one of the methods applied by the respondent’s valuation expert – determining a normalized figure for annual cash flows in perpetuity and then dividing those cash flows by a capitalization rate. To determine the company’s normalized annual cash flows, the Court averaged the company’s cash flows from the three years preceding the merger. To determine the capitalization rate, the Court subtracted the company’s long-term growth rate (4%) from its weighted average cost of capital (“WACC”) (21.83%). This appears to be the only Delaware case in which the Court based 100% of its valuation on a DCCF analysis.
The Court’s acceptance and application of a DCCF analysis may be significant. The DCCF analysis provides the Court with a methodology for valuing a company where there are no reliable management projections from which to craft a DCF analysis, and where the company is not sufficiently comparable to other companies for the Court to conduct a comparable companies or precedent transactions analysis. Rather than using the merger price as evidence of going concern value, the Court capitalized historical normalized cash flows in perpetuity to independently value the company as a going concern.
The Court’s acceptance of the buildup model to calculate the company’s WACC is also notable. What is the buildup model? The buildup model is similar to the Capital Asset Pricing Model (“CAPM”), except that it adjusts for industry risk by adding an industry-specific equity risk premium rather than using a beta, and also adds a company-specific equity risk premium. In In re Orchard Enterprises, Inc., (Del. Ch. July 18, 2012), then-Chancellor Strine was highly critical of the buildup model, finding that it was not “well accepted by mainstream corporate finance theory” because “its components involve a great deal of subjectivity.” Nevertheless, both parties’ experts used the buildup model in Laidler. The opinion in Laidler, therefore, should not be read as a signal that the Court of Chancery has abandoned the CAPM in favor of the buildup model.