In an odd twist of fate, appraisal – a statutory remedy for aggrieved stockholders once described as “pointless” – is now the darling of activist shareholders and hedge funds alike. Statutory appraisal rights provide a limited, legislative remedy to stockholders who dissent from a merger or consolidation, claiming that the share price offered in the transaction was inadequate. Section 262 of the Delaware General Corporation Law (DGCL), which governs appraisal, provides that dissenting stockholders who perfect their appraisal rights are entitled to a judicial determination of the “fair value” of their shares. Simply put, “fair value” is the going-concern value of the target company immediately before the merger, but excluding any value relating to the merger, such as control premiums and synergies.
Statutory appraisal was an underutilized remedy prior to Chancellor William B. Chandler’s decision in In re Appraisal of Transkaryotic Therapies, Inc., 2007 WL 1378345 (Del. Ch. May 2, 2007), because transactions can often be structured to avoid appraisal rights altogether and, even if a transaction triggers an appraisal right, the expense and risk associated with appraisal often precludes all but the largest, most well-financed stockholders from pursuing it. In Transkaryotic, the court ruled that a beneficial owner who acquired shares after the record date but before the merger vote could seek appraisal of the shares without establishing that these newly acquired shares had not been voted in favor of the merger by the prior beneficial owner. Transkaryotic helped to facilitate a phenomenon now commonly referred to as appraisal arbitrage, a practice in which hedge funds and activist shareholders, among others, acquire shares of the target after the merger is announced with the hope of obtaining higher consideration in an appraisal. By 2011, the rate of appraisal petitions had doubled over the rate for the prior five-year period. The rate continued to increase in 2013 and 2014. The uptick in appraisal litigation has generated several interesting decisions from the Delaware courts as well as proposed amendments to the appraisal statute.
Huff Fund Investment Partnership v. CKx, Inc., 2013 WL 5878807 (Del. Ch. Nov. 1, 2013), aff’d, 2015 WL 631586 (Del. Feb. 12, 2015), involved the appraisal of a company holding the rights to certain entertainment assets. The company’s most lucrative asset was its right to license the American Idol franchise under an exclusive and perpetually renewable license with Fox Entertainment. At the time of the merger, the company was in the process of negotiating a renewed license with Fox for American Idol. Thus, the future value of the company’s primary revenue stream was uncertain. Management had, however, prepared projections that it described as its “best estimate” of a forward five year projection and “potentially achievable”; those projections were provided to potential bidders and used in presentations to the company’s lenders for purposes of assessing the company’s credit risk. Both sides utilized discounted cash flow (DCF) valuations. Petitioners relied upon the contemporaneous management projections. Respondent’s expert adjusted the management projections downward. Vice Chancellor Glasscock found that management’s projections were not reliable because of the uncertainty of the company’s revenues from American Idol due to the pending negotiations with Fox. The Court of Chancery also rejected the parties’ respective comparable companies and comparable transactions analyses finding that the companies and transactions used were not sufficiently comparable. In the absence of (1) reliable projections to use in a DCF analysis and (2) comparable companies or transactions to guide a comparable companies or comparable transactions analysis, the court concluded that the negotiated deal price was the most reliable evidence of the value of the company and appraised the company at the deal price, because the sales process was “thorough, effective, and free from any specter of self-interest or disloyalty.” Huff, which was affirmed without opinion by the Delaware Supreme Court recently, marked the high water line in the use of the merger price to determine appraised value for a little over a year.
In re Appraisal of Ancestry.com, Inc., 2015 WL 399726 (Del. Ch. Jan. 30, 2015), involved the appraisal of the online family history resource. The company’s management did not prepare management projections in the ordinary course of business, but did prepare projections that were approved by the board and presented to bidders in connection with the sale process (the “Bidder Projections”). Management described the Bidder Projections as “optimistic” and “aggressive.” Management also prepared more conservative projections after bidders and the company’s financial advisor commented that the assumptions were optimistic and aggressive (the “Revised Projections”). Both parties relied exclusively on DCF valuations and eschewed comparable companies and comparable transactions analyses. Petitioners’ expert developed a set of blended projections that weighted the Bidder Projections and the Revised Projections equally. Respondent’s expert relied exclusively on the more conservative Revised Projections. Vice Chancellor Glasscock (the same member of the Court who decided Huff) found that both sets of projections were “imperfect”: management did not prepare projections in the regular course of business; the Bidder Projections were aggressive to bolster a potential sale; and the Revised Projections were prepared to support a fairness opinion, at a time that management was contemplating large rollovers of their own stock, and the CEO was preparing private “hacks” showing a higher growth rate for his rollover interest. The court also found that both experts tailored their DCF analyses in a “results-oriented” manner. After conducting his own DCF valuation that resulted in a valuation very close to the merger price, Vice Chancellor Glasscock found that the “relatively untainted” auction was unlikely to have left significant value unaccounted for and, because it was a non-strategic acquisition, he could not identify any synergies that were likely to push the purchase price above fair value. Thus, even with projections available to conduct a DCF valuation, Vice Chancellor Glasscock (again) concluded that the merger consideration was better evidence of fair value.
Vice Chancellor Glasscock’s reliance on merger price in Huff and Ancestry.com has garnered a great deal of attention. However, more than a decade earlier, then-Vice Chancellor Strine relied on merger price in The Union Illinois 1995 Investment L.P. v. Union Financial Group, Ltd., 847 A.2d 340, 357 (Del. Ch. 2003), reasoning that merger price less synergies was the “most reliable evidence of fair value” following a reliable, untainted sales process. “This real-world market check is overridingly important evidence of value,” where, as here, it was not “a squeeze-out merger.” Notwithstanding, the Court of Chancery conducted a DCF analysis as a check on the merger price, using management’s projections and more generous assumptions than it felt was warranted. That DCF analysis reflected a per share value of the company that was lower than the merger price less synergies. Nevertheless, the court gave full weight to the merger price as the best indication of fair value, and awarded the merger price less synergies to the petitioners.
Some commentators have cheered Vice Chancellor Glasscock’s reliance on merger price as an indicator of fair value in Huff and Ancestry.com as a potential check on the recent growth of appraisal arbitrage. That praise misses the mark, however. Neither Huff and Ancestry.com nor Union should be read as creating a presumption in favor of merger price simply because there was an untainted auction. Even in an untainted auction, poor timing of the transaction and other market forces could result in a merger price that does not reflect the fair value of the company as a going concern. Recall that in both Union and Ancestry.com the Court of Chancery conducted a DCF analysis as a check on the merger price. Thus, merger price should be, and is, only one of several factors a trial court may consider in appraisal litigation. Management projections are another. And, as for those commentators hoping for the early demise of appraisal arbitrage, who better to test the fairness of the merger price than large, well-heeled stockholders who are capable of bearing the well-known risks and significant costs associated with appraisal?
Indeed, in connection with the proposal of two amendments to Section 262 of the DGCL, the Council of the Corporation Law Section of the Delaware State Bar Association (the “Corporate Council”), which is responsible for recommending amendments to the DGCL, determined that appraisal arbitrage does not upset the balance between corporations’ ability to engage in value-enhancing transactions and stockholders’ rights to dissent and seek appraisal. The proposed amendment to 262(g) seeks to lessen, if not eliminate, nuisance-type appraisal proceedings by permitting the court to dismiss an appraisal proceeding unless “(1) the total number of shares entitled to appraisal exceeds 1% of the outstanding shares of the class or series entitled to appraisal, (2) the value of the consideration provided in the merger or consolidation for such total number of shares exceeds $1 million, or (3) the merger was approved pursuant to § 253 or § 276” of the DGCL. The proposed amendment to Section 262(g) applies only to shares for which appraisal is sought that were listed on a national securities exchange. Of course, such issues are generally not in play in the context of appraisal arbitrage.
The proposed amendment to Section 262(h) would permit corporations to limit the accrual of interest on appraisal awards by allowing a corporation to pay a sum of money (of its choosing) to the appraisal petitioners in advance. Interest at the statutory rate of 5 percent over the Federal Reserve discount rate would only accrue on a judicial award that exceeds the amount the corporation paid to the appraisal petitioners in advance. Some commentators have urged the Corporate Council to go further and reduce the statutory interest rate available under Section 262, arguing that it provides a relatively high rate of return as compared to the current government yields and money markets and, thus, encourages appraisal arbitrage. That concern appears to be overstated, given that hedge funds engaged in appraisal arbitrage typically achieve a rate of return in excess of the legal rate. The call to reduce the statutory rate of interest also ignores the fact that appraisal petitioners have been cashed out of their chosen investment and now bear the unsecured credit risk associated with an appraisal proceeding. Interestingly, the proposal to limit the accrual of interest awarded to appraisal petitioners by an upfront payment may have unintended consequences: it may encourage more “appraisal arbitrage” by freeing up funds for redeployment in the next deal.
Delaware’s appraisal law will continue to evolve at a measured pace in response to changes in the marketplace, as it should. And though Union, Huff, and Ancestry.com highlight the risk that appraisal petitioners face, even when there are contemporaneous management projections that may justify a higher DCF valuation, the fact remains that merger price is only one of several factors the court may consider to ascertain fair value under Section 262, and even then, it should do so only in exceptional circumstances.