Appraisal is a remedy for shareholders who believe a merger is being consummated at below fair value. Appraisal is also a check on management and boards of directors – specifically, providing a ‘backcheck’ on whether the shareholder fiduciaries are achieving fair value for the company. Management buyouts are an acute case of mixed incentives for company insiders, and accordingly are a place where the appraisal remedy is particularly critical.

Enter a recent paper from the Journal of Financial Economics analyzing MBOs and freezeouts. Analyzing MBOs and other mergers from 1980 forward, the authors find evidence that MBOS and freezeout transactions are timed to take advantage of industry-wide under valuations. In other words – the insiders, with the most industry knowledge, are sometimes able to purchase companies on the cheap from existing shareholders when the overall industry is being undervalued by the market. This allows the buyer (management) to “capture the value” between the target’s value and the bid price in a time of industry undervaluation.

It is worth noting that the authors evidence applies to the “average” MBO – i.e., MBO’s in general – and not to any particular MBO. Management does not time its bid to industry undervaluation in every instance, or in any particular instance, but there is evidence that management does so across the aggregate of MBOs.

Data like this highlights the importance of the appraisal remedy. When MBOs are able to accrue value to the bidder, and not shareholders, shareholders need a remedy (like appraisal) to check the buyer (in this case – management’s!) gains. The data also highlights that appraisal may be particularly relevant in MBOs or other instances where the buyer has superior information to the market at large – something that was seen in Dell and other appraisal cases.

Valuation litigation plays out in a number of different business contexts. Readers of this blog will be well familiar with one of them: appraisal rights (a/k/a/ dissenters rights) actions brought when a public company is being acquired by another entity. But valuation disputes requiring the determination of fair value come up in many other contexts often not involving public companies, but instead private businesses. Recent discussion in the Delaware appraisal space focusing on Aruba, and its predecessor cases, discussing topics of market efficiency, “unaffected stock price”, whether the merger price is presumptively fair, etc. all presume an active, open, and at least on-first-glance well-functioning market for the stock of a company. But for private companies, there is usually no market to speak of, or, if there is one, defining it and understanding it is solely the province of economic and valuation experts. With no unaffected stock price, a ‘merger price’ almost always set by the dominant shareholder, and no real market check on value, there private valuation cases present an entirely different side to appraisal rights/dissenters rights.

This blog post details a New York dissolution proceeding where valuation was at issue. New York has a fair value statute, within its Business Corporation law, with respect to dissolution proceedings (§1118) which shares connection to New York’s appraisal rights section (§623). The post provides a blow-by-blow of a valuation dispute in New York, going through the case facts, the Net Asset Value (NAV) of the relevant entity, and then how NAV links to “fair value” (at least per the author). The post also has an extensive discussion of the application of discounts for lack of marketability (“DLOM”) in New York fair value proceedings. (For a discussion of DLOMs and DLOCs, see a guest post here.) Delaware-concerned readers may recall that Vice Chancellor Glasscock analyzed DLOMs in the case Wright v. Phillips, a deadlock case in Delaware. And we’ve written before how discounts in general come up in many fair value proceedings.

The blog post concerning New York goes through an analysis of why a DLOM (or other discounts) may not be appropriate in the dissolution case being analyzed, and notes that the opposing expert was setting out a 35% DLOM. Thus, the battlelines were set: 0% DLOM on one side; 35% DLOM on the other. Since the value at issue was in the millions, in turn, the DLOM level was worth millions (about ~$1.5MM after all was said and done according to the post).

According to the post, the matter eventually settled before trial, with a number reflecting an ‘in-between’ (though higher than 50%) of the 0% DLOM and 35% DLOM view.

The entire post is worth a read for its blow-by-blow of the valuation analysis and the underlying analysis. It bears repeating that appraisal disputes with private businesses involve an entire set of fair value considerations often different from the public-company-appraisal that captures headlines and academic attention.

For public company shareholders, a cashout merger offer (even one at a too-low price) tells you that someone wants your shares and intends to pay you cash for them. And, at least in US actions, it is the rare public-company focused appraisal case that concerns collections. Indeed, if an acquirer is paying cash for a public company, the idea of collections barely registers.

But, one bears reminding, appraisal actions are not a special breed of lawsuit where payment is somehow guaranteed. Enter In re Lee, 898 F.3d 768 (7th Cir. 2018), where we find a federal appeals court dealing with appraisal remedy related collections.

How Lee got from an Indiana appraisal case to the 7th Circuit is a tortured route, but the core facts of relevance are straightforward: a minority investor obtained a judgment under Indiana’s appraisal remedy against a corporation. The controlling majority shareholder filed for bankruptcy (and because all bankruptcy is in federal court – the federal court angle). Post-merger, the controlling shareholder “gutted” the merged company, leaving it with nothing to satisfy the appraisal judgement. The aggrieved minority shareholder sought to access the controlling shareholders personal assets. The District Court agreed with this; and the 7th Circuit affirmed. (For a more robust discussion of non-appraisal aspects of In re Lee, see this article.)

Focusing on the appraisal angle, this case highlights a couple points. Appraisal remains a potential remedy for minority shareholder oppression. While this blog, and many Delaware appraisal cases, cover billion dollar companies targeting other billion dollar companies, appraisal is not limited to such cases. An aggrieved shareholder of a small company, including a family company, may indeed have appraisal rights (depending on their jurisdiction and the facts of the case). And finally, in many instances appraisal remains part of a larger litigation environment. In other contexts (here, the bankruptcy limited the minority shareholders options), other potential litigation approaches may have possible – whether fraudulent conveyance lawsuits, or using information gleaned via appraisal in another action.

Lee, and cases like it are a useful reminder: While appraisal may be a somewhat unique remedy, it is still litigation. Appraisal can still face litigation risks (like collections), and it can be part of a larger litigation strategy than just ‘bring an appraisal.’

We’ve covered the Mobile Posse case before, specifically, how it shows the importance of getting the basics right regarding appraisal notices. The Delaware Litigation blog provides more on Mobile Posse, including a recap of whether a post-suit “do over” is available:

“The company sought a “do-over” or a mulligan for its statutory errors, because it purported to send proper notices required by DGCL Section 262–only after suit was filed. Three problems with that approach are that: (i) Such a “replicated remedy proposal” had never before been blessed by a Delaware court; (ii) Even the supplemental notice proposed was itself wrong (in part because it quoted the statute of another statute); and (iii) trying to make a “supplemental notice” sent after the lawsuit was filed does not always make it part of the pleadings, although as noted above–in some circumstances–based on the opinion in this case, it is now possible to do so. See Slip op. at 13.”

At core, the various aspects of this case highlight that – especially for corporate lawyers preparing the transaction – getting the appraisal notice right up front is critical. Failing to do so can subject the company to liability, and you may not get a mulligan.

The State Board of Administration of Florida’s proxy guidelines join a number of others in suggesting that investors vote FOR appraisal rights when available. For institutional investors, appraisal rights are a critical shareholder protection, especially in instances where the merger process raises questions or where market dislocation results in a value gap between merger and closing. It makes sense that major institutional investors and proxy services continue to suggest voting for appraisal rights.

Legal news site Law360 ran this analysis [$$$] of Aruba, focusing on whether the decision should be seen as a fight between valuation methodologies, or between two courts trying to fulfill their respective roles. The Chancery Court, left to apply the Delaware Supreme Court’s precedent to complex fact situations and manage cases from their infancy through decision, may be struggling with the Dell and DFC decisions. The Supreme Court, perhaps reconsidering some of the positions it held as law in Dell and DFC, is left to ‘police’ the lower court as that court struggles to apply sometimes conflicting rules and views.

As the diverse reactions to Aruba consider, no doubt scholars will analyze the decision (and decisions still to come) as part of both the evolution of appraisal law, but also in how lower courts and higher courts interact.

It looks that way, according to this analysis on the CLS BlueSky Blog. From the authors:

  • “… investors pay close attention to how stock-based deals affect the acquirer’s short-term earnings per share (EPS). Merger announcements are regularly accompanied by discussions of whether the deal will be accretive or dilutive for the acquirer’s EPS, and if immediately dilutive, how quickly the deal would turn accretive. Finance theory, however, does not imply any particular benefit of an EPS-accretive deal (in which the post-merger EPS is higher than the acquirer’s pre-merger EPS), focusing instead on whether the deal creates value.”
  • “… post-merger EPS is mainly determined by the stand-alone EPS of the acquirer and target, the incremental earnings from deal synergies, and the number of shares issued by the acquirer to finance the deal.”

The evidence the authors analyze suggests deals are structured to avoid EPS dilution and that deals which would be dilutive under an all-stock purchase are then done in cash. In short: “cash and mixed deals replace stock deals when the latter become dilutive.

Even assuming a deal is good for both acquirer and target objectively, it remains a question what portion of the deal synergies (or, more simply, value) will accrue to the acquirer versus the target. The evidence adduced by these authors is not good for the target: the target is giving up premium to have the acquirer avoid EPS dilution. The authors explain: “For deals with a range of feasible exchange ratios that allow for a premium and accretive EPS, a smooth distribution of bargaining power between acquirer and target would suggest that, for pure stock deals, the exchange ratio would also be smoothly distributed. In contract, what we find is that there is a clustering of deals just below the dilutive exchange ratio. This result suggests that the target is giving up part of the premium to enable the acquirer to avoid EPS dilution.

How is this relevant to appraisal? As readers of this blog may know, all-stock deals are not appraisal eligible (at least in Delaware), whereas stock+cash deals are appraisal eligible. This may be one factor that contributes to the “costs” which, per the author’s evidence “prevent small amounts of cash from being used to mitigate the minor EPS dilution.” In addition, the evidence suggests that target management may be willing to part with premium to assist the acquirer get the deal done – ultimately shortchanging their shareholders.

Does the valuation method parties pursue, and that a Court uses, matter to the ultimate valuation of a firm? This recent paper studying data from Finnish appraisal of private terms over a 16 year period suggests that the choice of methodology does matter.

For readers of this blog, or those who know of appraisal predominantly through the Delaware-dominated and – more relevant here – public company dominated area, this conclusion may seem obvious. Of course valuation methodology matters to valuation!  Important to recognize is that appraisal is not solely (or even mostly) a concern for shareholders in large, publicly traded companies with likely liquid public markets for their securities. Instead, appraisal is often the remedy of the minority shareholder in a private firm; the oppressed shareholder or the person being squeezed out of an enterprise. Unlike with some large public company transactions, the “merger price” in such instances is almost definitively not set by an arm’s length transaction, and the ‘merger’ itself often involves the irreducible conflict of management being on both sides of the transaction.

These cases are further complicated by the fact that because no public market exists for the individual shares of the business (and setting aside whether a market may exist for the business as a whole), and thus the valuation question is far more tabula rasa (blank slate) for an appraiser of a private company. The Finland evidence suggests that in such instances, the choice of valuation method is a significant determinant on how the valuation comes out.

More generally, this is evidence against the “rationality” perspective and for the “measurement” perspective – per the authors “The ‘rationality’ perspective believes that the choice of a valuation method does not affect the outcome. That is, the valuation estimate incorporates all the available information pertaining to the valuation, and the chosen valuation method is rationally adjusted if needed. Conversely, the ‘measurement’ perspective argues that the chosen method determines which information and adjustments are incorporated into the valuation estimate. In other words, the limitations and biases inherent in valuation methods manifest themselves in valuation estimates.”