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.

In response to the article on appraisal arbitrage by Gaurav Jetley and Xinyu Ji of the Analysis Group, about which we’ve posted before, Villanova Law Professor Richard A. Booth now argues in  The Real Problem With Appraisal Arbitrage [via Social Science Research Network] that Jetley and Ji’s charge against the Delaware courts for overly indulging appraisal arbitrage is misdirected.  According to Professor Booth, while Jetley and Ji believe that the Delaware courts incentivize arbitrageurs by using a discount rate lower than the rate typically applied by investment bankers, Professor Booth argues that the bigger and more significant problem is that the Delaware courts additionally reduce the discount rate in the terminal period.  Nevertheless, after identifying what he believes is the Delaware courts’ truly faulty practice, Professor Booth offers up a full-throated defense of the appraisal remedy in general and arbitrage in particular.

Some Highlights of the Article

  • Professor Booth believes that Jetley and Ji’s criticism of the Delaware courts’ use of the so-called supply-side discount rate, rather than the historical rate of return, is overblown.  He agrees that the supply-side rate can inflate a valuation, but not by as great a magnitude as Jetley and Ji seem to believe.
  • In rebutting the argument that so-called arbs “are not themselves long-term common stock investors and should not be so compensated for the time value of their money,” he observes that “they have bought the stock they hold from legacy investors and thus should be entitled to the same package of rights enjoyed by such investors.”  If arbs’ rights were to be curtailed, that would cause stockholders who choose to sell out suffering an even bigger discount, which in turn would raise the price of deals for acquirors, because target stockholders “will be less confident that they will be paid based on the agreed amount when they want to be paid.”  In this respect, arbitrage actually serves the acquirors well.
  • Professor Booth critiques the presumption of fairness that some Delaware cases have accorded to the deal price:
    • First, the deal price may often be too low, as deal price sometimes depends on the percentage of shares bought.  Thus, dissenting stockholders may well be entitled to “higher and higher prices as the public float gets smaller and smaller,” which he finds consistent with the policy objective underlying appraisal: to compensate stockholders for being forced to sell out at a time and/or price not of their own choosing.
    • Second, Professor Booth cautions against according too much weight to the premium paid over market price, as a depressed stock price will naturally warrant a higher premium; in that case the premium is simply “compensation for a discount built into the market price.”
    • Finally, it is inherent in the concept of nearly any acquisition that a buyer is only willing to pay some lesser price than full fair value, in order to extract the expected value to be gained by redeploying the target company to its highest and best use; to that extent, he suggests, “deal price should always be a bit lower than going concern value [emphasis added],” prompting stockholders to hold out.
  • Given these factors, he finds that appraisal performs the valuable function of testing deal price against investor expectation based on CAPM.  He believes that appraisal thus helps drive price toward fairness, as a robust appraisal remedy will induce bidders to pay a fair price up front.  His critique of the court’s further reduction of the discount rate in the terminal period is intended to improve the appraisal process, not undermine it; he encourages the courts to embrace his reforms rather than “hide behind the aw-shucks notion that law-trained judges are ill-suited to address” questions of valuation, finance, and investment banking.

In summary, the author concludes that appraisal arbitrage has gotten a “bad rap” and that appraisal itself works best if arbitrage is made possible; he fears that absent arbitrage, buyers may rely on the hope that potential dissenters will simply decline to exercise any appraisal rights, allowing the bidder to get away with paying a reduced price.

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).

As one Delaware judge put it long ago, the Delaware courts conducting an appraisal proceeding have long ago “rejected placing absolute confidence in the market price for a share of stock.” Kleinwort Benson Ltd. v. Silgan Corp., No. 11107, 1995 Del. Ch. LEXIS 75 (Del. Ch. June 15, 1995) (Chandler, V.C.). For one thing, a publicly traded stock price is solely a measure of the value of a minority position and market price therefore reflects only the value of a single share. Delaware courts thus adjust the market value to compensate for that so-called inherent minority discount.

Furthermore, even if a court wanted to look at a company’s most recent stock price preceding the merger date as a factor in determining enterprise value, that price may already be impacted by short-term news and noise. Indeed, short-term economic and political realities — such as short-term unemployment rates, lending rates and monetary policy — may have an outsized impact on the stock market while having no necessary correlation to the underlying fundamentals of a company or its industry. That markets overreact is implied in the so-called “bounce back” period used to calculate damages under the Private Securities Litigation Reform Act, which determines damages by using the mean trading price during the 90-day period following the dissemination of corrective information rather than the trading price on just the first day.

But even beyond these considerations, the Delaware courts have identified as recently as last week another factor making a public stock price far less reliable in the valuation exercise; namely, the downward pressure a stock price will experience over time as a result of a prolonged sale process. Where a company is on the sales block for an extended time, even the mean stock price measured over a prolonged period of time will not provide the court with sufficient insight into the company’s long-term growth potential to provide a basis for the valuation exercise to be built upon. Thus, evidence that the “stock price may have undervalued the company due to the company’s inability to make acquisitions while it was up for sale” led one court to recently reject the stock’s trading price as an indicator of fair value. Huff Fund Investment Partnership d/b/a Musashi II Ltd. v. CKx, Inc., Case No. 6844-VCG (Nov. 1, 2013).

A stockholder pursuing appraisal rights is entitled to the present value of the long-term going concern value of her stock, often with the expectation that holding onto that stock over the long term is likely to realize more value than what can be achieved in a near-term sale in the existing economic environment. Courts are therefore careful to rise above immediate or even long-term market conditions and are predisposed to give little weight to the stock trading price as a proxy for whatever longer-term value that stock might represent. This is especially so where there is no reliable evidence that the stock trades in an efficient market that would permit a court to even consider whether the stock price is reflective of fair value. Moreover, in any event, Delaware law requires courts to undertake an independent evaluation of the stock’s fair value at the time of a transaction, and courts therefore cannot place too much weight on trading price as a substitute for engaging in their own independent analysis of fair value.