Trevor Norwitz delivered the following remarks at the 2016 Delaware Business Law Forum, held in Wilmington, Delaware, during the week between Halloween and Election Day.
* * *
Is the Delaware appraisal rights remedy in need of repair? You may as well ask: is the American electoral system in need of repair?
In both cases the flaws are manifest and the scary results apparent. The difference is that the Delaware legislature can easily fix the General Corporation Law to eliminate the artificial and socially destructive phenomenon of appraisal arbitrage. This, of course, is the investing strategy in which an arbitrageur buys shares in a target company after the announcement of a deal specifically for the purpose of asserting appraisal rights. It is a recent development that has resulted directly from judicial interpretations of the outdated wording of section 262. Appraisal arbitrage leads to perverse incentives, unjust results, and a reduction in overall social benefit. Delaware lawmakers brought this Frankenstein creature into the world; they can and should take it out. (I hope you will forgive my gruesome metaphors and horror-flick references, but it is Halloween week, and we are still living through “The Nightmare on Pennsylvania Avenue.”)
Note that the question is not, “Is Section 262 good enough?” “Good enough” is not good enough for the State of Delaware. Delaware is the greatest jurisdiction for corporate law in the world—its sensible statutes; highly responsive legislators; sophisticated, fair-minded, and efficient judges; superb bar; and unparalleled deal- and case-flow all combine to make it the jurisdiction of choice for states in which to incorporate, conduct M&A deals, and litigate. That is good for Delaware. It is also good for business and for America. Delaware’s excellence in corporate law is part of America’s “secret sauce.”
In embracing appraisal arbitrage, however, Delaware distinguishes itself negatively, adding complexity and inequity to deal-making and threatening stockholder value in a wide range of transactions.
I am not arguing today for a total revamp of the appraisal rights remedy, such as the inclusion of a market out (which many other states recognize). I am not even arguing that the appropriate time for appraisal to attach should be the stockholder vote rather than the closing, or that stockholders should have to vote against a deal in order to assert appraisal rights. There are good arguments that can be made for those positions, and I believe those are conversations worth having over time. Today I am merely urging that the legislature should pluck the low-hanging fruit with alacrity. A modest amendment can eliminate the looming dark cloud of appraisal arbitrage. The need is clear and the fix is easy: dissenters’ rights should be for dissenters, not for speculators.
My learned opponent likely will say that this is all overblown, that Delaware’s judges are perfectly capable of making sense of the statute as it is and of dispensing justice to the parties before them, that the law was recently amended and should be given time to work before making more changes, and that appraisal arbitrage is actually beneficial.
These are inapt arguments. Of course Delaware’s judges are capable of dispensing justice, but they should not have to twist themselves into pretzels to deal with a poorly worded, outdated statute, creating artificial and perverse incentives in the process.
The fact that the statute was recently amended—seemingly as a compromise between the interests of the appraisal arbitrage community on the one hand, and those of Delaware corporations and their stakeholders on the other hand—is no reason not to fix the law. The interests of appraisal arbitrageurs should have no more weight in determining the appropriate legislative outcome to this question than the interests insider traders should have in determining what our insider trading laws should be.
I would like to be clear that I am not suggesting that appraisal arbitrageurs are evildoers who must be stopped. Well, they must be stopped, but that is because what they are doing is bad for Delaware corporations and stockholders and, ultimately, bad for Delaware and for America, not because they are bad people. They are merely doing what opportunistic investors are supposed to do, namely, find market inefficiencies, or gaps and loopholes in the law, and take advantage of them to divert wealth to themselves. I should not even call it an abuse. They are really just doing their civic duty by pointing out that our laws are broken and, as currently written, allow them to profit at everyone else’s expense. If they point this out to us and we do not fix it, then that is not their fault. Shame on us.
Why do I say that appraisal arbitrage leads to perverse incentives, unjust results, and a reduction in overall social benefit? Because it does. Let us go back to basics.
When you are buying a business, the most fundamental things you must know are what you are going to get and what you are going to pay for it. That is the essence of the deal—the quid and the quo. Buyers know they have to take some risks on the “get” side and go to great lengths and cost to minimize them, but at least they have some certainty as to what they will pay for the company they are buying, right? Unfortunately, in Delaware today that is not right.
Today, if you are buying a Delaware corporation, you can participate in an auction admirably conducted by independent directors unquestionably satisfying their fiduciary duties, engage in tough negotiations with those independent directors, compete with other bidders, potentiallty get held up by activist “bumpitrageurs” and be forced to raise your price to get their support, then have the stockholders of the target company approve the transaction based on full and fair disclosure—by a majority of the minority if you are a controlling stockholder—and still run a significant risk of having to write a large check years later because an “expert” testifies based on a subjective discounted cash flow (DCF) analysis, or a petitioner points to your success in running the business since you bought it, that the price you paid did not reflect fair value for the company.
You paid a market-clearing price in a fair and open process, yet you face a claim that the price was not fair; the fair price—which no one offered to pay—was really 30, 40, or even 50 percent higher.
This is not just a theoretical risk. These are basically the core facts of the Dell appraisal decision handed down a few months ago, which I will talk a bit more about (and in which, in the interests of full disclosure, my firm represented Michael Dell). This risk is one that troubles buyers of Delaware companies (especially private equity firms), preventing them from paying the highest prices they can pay or causing them to structure deals in ways that are not optimal just to avoid the appraisal risk. This means that it is also a worry for Delaware companies looking to sell because they know that buyers cannot pay top dollar due to the asymmetrical appraisal risk: the buyer takes all the downside risk, but arbs get an option on the upside.
Buyers must take all known risks into account, and they know what likely lies ahead: aggressive activist investors who get multiple bites at the proverbial apple. After negotiating the deal with independent directors, the buyer is not only at risk of the “headless highwayman” who jumps out from behind the bushes and tries to force a price bump before the stockholder vote (remember, it is Halloween week), but now must also worry about being chased for years after the deal closes by “zombie stockholders” who were never real investors in the company in the first place. These arb-zombies invested in a litigation play, not in the company.
Buyers must protect themselves, and they will. Sometimes they can structure a deal specifically to avoid appraisal rights, even if it is not the most economically desirable or efficient manner in which it could be done. In one large, pending merger in which my firm is involved, the deal was originally going to include some cash consideration for stockholders who wanted cash, but that changed. I am not going to go beyond the public disclosure, but it is a matter of public record that originally this was proposed as a stock-and-cash deal with appraisal rights. There was discussion over an appraisal condition, and by the time the deal was announced, it was an all-stock deal with no appraisal rights. Companies should not have to factor in appraisal risk when determining the optimal deal structure. If buyers cannot avoid the risk structurally, they must deal with it some other way, typically by holding back some of the price they would have been willing to pay to all stockholders so that they can pay off the “highwaymen” and the “zombies.” Of course they are never going to admit to holding back, but as someone who sits in these meetings and strategizes with the decision-makers, I can assure you that what they are calling the “Dell-risk” is not lost on anyone. A sizable appraisal award could make the difference between a successful transaction and an unsuccessful one. In a leveraged deal, where the risks to the buyer are significant and the margin for miscalculation is razor thin, it can mean the difference between viability and insolvency.
The only argument anyone has offered to suggest that there is any social value to appraisal arbitrage at all is that it performs a “policing” or “monitoring” function in that it discourages abuse by controlling stockholders. That claim applies only to conflict transactions, or squeeze-outs. It has absolutely no force to the vast majority of arm’s-length deals, and even in conflict deals, that was never the purpose of appraisal. Delaware already has a mechanism for discouraging abuse by controlling stockholders called fiduciary duty litigation, and Delaware lawyers and judges are the olympians of that particular blood sport. If there is a view that the Delaware courts are incapable of enforcing fiduciary duties of controllers and directors, someone should try to make that case, and anyway the remedy would be to improve that mechanism if it is flawed. Allowing statutory appraisal rights to be abused as a back-door method of policing fiduciary duties not only leads to injustice, but also creates perverse incentives throughout the system.
Here’s why: the great advantage of appraisal suits from the claimants’ point of view is that they do not have to prove or even allege any wrong-doing by the board, controlling stockholder, or anyone else; they must only convince a judge (years after the deal) that the fair value of the shares at closing was greater than the deal price. What this means is that, if the board or controller can be shown to have acted improperly (i.e., to have breached their fiduciary duties), then all stockholders share in any recovery. If the board and controllers cannot be said to have done anything wrong—as was the case in Dell—only the opportunistic “hold-outs” benefit from any award. That is not right. If stockholders were, in fact, harmed by a bad process, and that can be shown, they should all be made whole. In addition, it creates perverse incentives, not only on the part of the arbitrageurs (who know that buyers will hold back value from stockholders at large to satisfy their more aggressive claims), but also on the part of buyers themselves (who, frankly, know that there are far fewer holdouts seeking appraisal than there are stockholders).
So how did we get into this scary movie? (I am not sure whether you would call it “American Werewolf in Wilmington” or “Rocky Horror Appraisal Show.”) Not surprisingly, through a series of unrelated, mostly well-intentioned acts that had unintended consequences.
Appraisal rights themselves are not the problem. They have been part of Delaware law longer than any of us have been alive. Delaware companies never had to worry about them too much. They were not pursued very often and only resulted in large awards in egregious circumstances where there was real abuse of an insider position (e.g., Emerging Communications).
Section 262, added to the General Corporation Law in 1967, provides that a stockholder of a corporation engaging in certain fundamental transactions may, so long as their shares are not voted in favor of the transaction and certain other formalities are followed, ask the Court of Chancery to appraise the fair value of their shares. The legislative history of this provision is clear that this was intended to compensate minority stockholders who dissented from a fundamental transaction like a merger for the loss of their right to veto it. That appraisal rights were intended as a remedy for dissenting stockholders has been explicitly recognized by Delaware courts for decades (see, e.g., Weinberger, Technicolor and Transkaryotic).
Over the years, the appraisal remedy evolved: Weinberger opened up the range of permissible valuation techniques, whereas a series of later cases (see, e.g., MG Bancorp and Cox Radio) established DCF as the strongly favored valuation technique for establishing going-concern value. Golden Telecom posited that the Court of Chancery may not simply defer to the merger price full stop, but had to undertake an independent appraisal.
A key development was the dematerialization of shares. Unlike in 1967 when section 262 was enacted, we live in a world where almost all public company shares are held through depositaries in undifferentiated fungible bulk, as Chancellor Chandler so poetically put it. The question arose as to what should happen when a stockholder who bought shares in the market was not able to establish the statutory precondition to asserting appraisal rights, that the shares were not voted in favor of the transaction—that they were really dissenting shares. Almost 10 years ago, in Transkaryotic, the Court of Chancery held, regrettably, that the literal language of section 262 did not require that appraisal seekers must actually demonstrate that their shares were not voted in favor of the transaction. It is sufficient that enough shares were not voted in favor by the depositary for it to be mathematically possible. At the end of his decision, Chancellor Chandler noted the concern that his decision would “pervert the goals of the appraisal statute by allowing it to be used as an investment tool for arbitrageurs as opposed to a statutory safety net for objecting stockholders.” However, relief, he wrote, “more properly lies with the legislature.”
In effect this was a double invitation: to the arbitrageurs to “pervert the goals of the appraisal statute by allowing it to be used as an investment tool” and to the legislature to stop them. Sadly, only one of those invitations has thus far been taken up.
Even though Transkaryotic noted, like many cases before it, that appraisal rights were created as a remedy for “dissenting stockholders,” the interpretation it adopted allowed one to seek appraisal of shares one owns or later buys without being a dissenting stockholder as to those shares.
Transkaryotic laid the groundwork for a new industry—appraisal arbitrage—which was pioneered in part by members of the Delaware plaintiff’s bar who saw the lucrative potential in this legislative misalignment. Funds were raised specifically for the purpose of targeting this strategy, and a few years ago the all-out assault was launched, with a host of appraisal claims brought by speculators who were not real stockholders of the target companies. Among the first deals targeted were the buyouts of Ancestry.com, Ramtron, and BMC software. (In the interests of full disclosure, my firm represented Ancestry.com.)
Vice Chancellor Glasscock, in his first decision in Ancestry (that case has become known as Ancestry I), followed Transkaryotic and allowed the arbitrageurs to pursue their claims. He repeated Chancellor Chandler’s admonition that, if the legislative intent behind appraisal rights was not met by the words of the statute, then it was for the legislature, not the judiciary, to fix. Unfortunately, that has still not happened, and that is why we are having this debate.
After Ancestry I, a great hue and cry was heard across corporate America. Many people in business, legal practice, and academia (myself included) wrote to warn of the danger of appraisal arbitrage and implore the Delaware legislature to fix the statute. The problems were well-documented, including subversion of the legislative purpose, the uncertainty and deal risk created by buyers’ not knowing what they will have to pay, and the risk that they would hold back consideration to pay off arbitrageurs or seek to insert appraisal conditions in deals, which create dangerous uncertainty for both sides, but especially for sellers.
These problem were then exacerbated by the very high statutory interest rate that, in this current low-interest-rate environment, created an irresistible “heads I win; tails I win a bit less” dynamic. When the current statutory interest rate was adopted about 10 years ago, it was double the federal discount rate; now it is six times the federal discount rate.
Plaintiff’s lawyers were, to a large degree, driving the appraisal arbitrage gravy train, using slick marketing presentations to show hedge funds how to profit from appraisal arbitrage. Billions of dollars in hedge fund money were now targeting this unintended little aberration in the law.
The appraisal arbitrage claims kept coming—Dole, Petsmart, Safeway, Zale, and on and on. By one account, appraisal actions were filed in about a quarter of all Delaware transactions eligible for appraisal, making up a substantial part of the Delaware Court of Chancery docket. Add to the parade of horribles the wasting of judicial resources and the diversion of judicial brainpower to the intricacies and rabbit-holes of DCF analyses.
After all the fuss over Ancestry I, the Delaware Corporation Law Council proposed a partial measure to ameliorate the problem. I assume everyone here knows that this proposal was to exclude small, de minimis nuisance claims and to allow companies facing appraisal suits to make partial payments to the appraisal claimants, thereby cutting off the compounding above-market interest as to the amount paid. This proposal was criticized as inadequate by some (including yours truly), but it became embroiled with the fee-shifting tempest in a teapot, and the Delaware legislature did not take it up in 2015.
Then last year, we went into a period of a few months when the Court of Chancery was issuing its valuation determinations in a number of appraisal cases, and these decisions—Ancestry II, Autoinfo, Ramtron, and BMC II—suggested that, so long as a proper sale process was followed, the court would show a high degree of deference to the negotiated deal price. This “judicial solution” made people feel a lot better. The critics of the council’s proposal were mollified by the comforting notion that, even if the statute still facilitated appraisal arbitrage, the judges would step in to ensure that the rights were not abused. In that environment, the council repeated its anti-nuisance and partial-payment recommendations in 2016, and these changes were adopted by the legislature, taking effect this past August.
The recent revisions to section 262 are not very controversial as far as they go, but they do not go nearly far enough. This is because, at best, they may reduce but do not eliminate the artificial incentive to arbitrage appraisal rights. They may actually encourage appraisal arbitrage because they create a path for up-front funding for the litigation costs. Appraisal arbitrageurs will get most of their capital back, be able to pay their lawyers, and still be able to roll the dice for the upside. In Atlantic City they call this “playing with the House’s money.” It is early days, but so far in most cases, companies facing arbitrageur claims have chosen not to pre-fund their attackers, and the changes do not appear to have affected the tide of appraisal claims much.
At the time, however, with this legislative tweak and the Court of Chancery emphasizing the gravitational force of negotiated deal prices so long as a proper sale process was followed, a warm and fuzzy feeling set in among the M&A community. People stopped worrying and quit whining. (The noise level went from Texas Chainsaw Massacre to Silence of the Lambs.) It felt safe to go back into the water. Then came Dell. That decision made a lot of us feel like those holidaymakers on the beach at Amity Island.
Let us briefly recall the salient facts in Dell, as recounted in the court’s opinion. Dell Inc. was in deep trouble, facing declining prospects and a “changing ecosystem.” One analyst cited by the court called the company a “sinking ship.” Its stock was plummeting, its market share was declining, and its projections kept dropping lower and lower. Blue-chip private equity parties were dropping out of the process like Republican presidential candidates. KKR said it could not get its arms around the risk to the PC business; TPG said the cash flows were too uncertain and unpredictable to establish a business case.
The independent special committee of the Dell board ran an exemplary sales process. They negotiated hard and they achieved the best price that was available in the market. After the deal’s announcement, they engaged a second bank to run a full-go shop, which reached out to 60 new parties. Blackstone took a whiff and passed; there was only one guy who actually made a proposal: Carl Icahn. Talk about the mouse going to the cat for love. Icahn did not want to buy Dell, of course, but rather was merely playing his favorite game of “bumpitrage” and succeeded in extracting a price bump as tribute for his support of the deal.
The entire process followed in this case was pristine. Vice Chancellor Laster so held, noting expressly that, “this court could not hold that the directors breached their fiduciary duties or that there could be any basis for liability.” Indeed, the Vice Chancellor praised the manner in which the members of the special committee, acting for the sellers, conducted themselves, as he did Michael Dell, the controlling stockholder who was the largest member of the buyout group. Nevertheless, he found that the fair value of Dell was almost one-third higher than that hotly negotiated, stockholder-approved price that had even won Arbzilla’s approval.
In his decision, the Vice Chancellor effectively acknowledged that the fair value he decided on was not attainable in the circumstances in which the Dell special committee found themselves. It was not available in the market. There were no strategic buyers (as the Dell board and its advisers had correctly determined). All of the private equity firms who bid based their offers, as private equity firms do, on what they could afford to pay to receive the rate of return they required to justify the investment and the risk of taking on huge debt. Nevertheless, he determined that the fair value for statutory appraisal purposes was 28 percent higher than the established fair market value.
Was a great injustice done in Dell? Of course not. Only a small percentage of the overall shares had perfected their appraisal rights. The arbitrageurs who held them were very happy. With the benefit of almost three years of hindsight, one could see that Michael Dell and his co-purchasers at Silver Lake were doing rather well on the acquisition. Their bet was working out. So this might appear to be one of those win-win/no-loser situations, right? Not right. The losers are the stockholders of Delaware corporations in future transactions because decisions like this create a disincentive for buyers to pay top dollar out of a rational fear that a court will later require them to pay some theoretical “fair value” that the market itself would not support.
The appraisal process has largely become a battle of DCF experts-for-hire offering “chasmically” diverging opinions on the same sets of facts. As Chancellor Bouchard recently wrote (quoting Justice Jacobs in part): “The advantage of an arm’s-length transaction price as a reliable indicator of fair value is that it is ‘forged in the crucible of objective market reality (as distinguished from the unavoidably subjective thought process of a valuation expert) . . . .’”
The Dell case was not a mere aberration. Shortly after Dell, there was another case concerning the appraisal of DFC Global in which the Chancery Court awarded the appraisal plaintiffs a fair-value award of 7.5 percent above the negotiated deal price, despite the fact that the deal was the product of a robust two-year, arms-length sale process.
These were two very different cases, and 7.5 percent is a lot less than 28 percent, but to some ears, DFC Global amplified the alarm bells that Dell had sounded, alerting purchasers that they still must contend with appraisal risk.
In DFC Global, the company’s board also faced extremely difficult circumstances. As the Chancellor noted, “at the time of its sale, DFC was navigating turbulent regulatory waters that imposed considerable uncertainty on the company’s future profitability, and even its viability . . . the potential outcome could have been dire, leaving DFC unable to operate its fundamental businesses. . . .” In these dire straits, the DFC Global board made the decision that it was best to sell the company and let the buyer bear those risks. So the board ran an exhaustive process to successfully secure for stockholders the best price the market would deliver. Nevertheless, the Chancellor agreed with the appraisal plaintiffs that the company was sold “at a discount to its fair value during a period of regulatory uncertainly that temporarily depressed the market value of the company” and awarded them a price increase (admittedly not as much as they had hoped).
The Chancellor expressed that “[t]he merger price in an arm’s-length transaction that was subjected to a robust market check is a strong indication of fair value in an appraisal proceeding as a general matter, but the market price is informative of fair value only when it is the product of not only a fair sale process, but also of a well-functioning market.” In that case, he found, “the transaction . . . was negotiated and consummated during a period of significant company turmoil and regulatory uncertainty, calling into question the reliability of the transaction price as well as management’s financial projections.” These are carefully calibrated words, but not every lawyer reads every word.
So long as appraisal arbitrage is allowed, appraisal claims likely will be brought in certain situations, for example where DCF models suggest theoretical valuations higher than the deal price, or when the deal is struck at a time of great uncertainty. This litigation will be much more extensive and serious than traditional appraisal litigation because it will not be brought by real dissenting stockholders who are unhappy with the price, but by professional opportunists who are well-funded and who have organized themselves specifically to game the system and take advantage of this legislative quirk.
These decisions not only have troubling policy implications, but they also raise doctrinal questions. The law defers to the decisions of loyal and well-informed directors. That is especially true under the new MFW “unified standard” where the combination of effective independent director negotiation and minority stockholder approval leads to business judgment review of board action. It is difficult to see these determinations—that the fair value of these companies was higher than the board achieved or could possibly have achieved in the circumstances—as anything other than second-guessing the decisions of the board in each case that it was the right time to sell the company. The Dell and DFC Global boards decided to accept a premium to the trading value—the best price they could get—and to allow someone else to take the risk (the risk of righting the “sinking ship” in Dell’s case, or of regulatory Armageddon in DFC Global’s case). Rather than deferring to their loyal and well-informed decisions, the court said they sold too cheap. There is an inconsistency there, and it is not eliminated by the fact that the immediate consequences of this judicial second-guessing are borne not by the directors themselves, but by the buyers because the buyers simply will pass those costs on.
Some of the problem is inherent in the appraisal rights concept itself and in the wording of the statute. The judge’s statutory obligation is to determine de novo the target company’s fair value as of the closing date, which might be many months after a sale process has established the company’s fair market value. A company’s fair value is not necessarily the same as its fair market value, especially if the two determinations are separated in time. The temporal aspect is baked into the appraisal statute, and with the appraisal arbitrageurs attacking deals that can make it very hard to sell companies in certain circumstances, such as during regulatory turmoil or if they have a significant FDA approval pending. The legislature might consider revising the statute to have the appraisal valuation speak as of the date the stockholders make their decision to sell, as some jurisdictions do, but I am not promoting that amendment today.
Most appraisal fights are not driven by the timing differential, but by the difference between fair value and fair market value. This means the litigation battleground centers on valuation metrics, the intricacies of DCF modeling, projections, discount rates, terminal multiples, and dueling valuation experts. It is the Wharton version of Alien vs. Predator, and it is up to the courts to decide how deeply they want to get dragged into that quicksand, or whether the “value that is forged in the crucible of objective market reality” is close enough in most cases.
The modest changes I am urging would not completely eliminate the risk of timing or valuation arbitrage, but it would greatly alleviate the magnitude of the problem by limiting appraisal rights to those whom the law is supposed to protect. What the legislature should do is amend section 262 of the Delaware General Corporation Law to specify that only shareholders on the record date who can demonstrate that their shares were not voted in favor of the transaction are eligible for appraisal.
If that simple change were made, the number of appraisal cases, the dollars involved, and the risks to corporations doing business in Delaware will go down dramatically, with no loss of protection for the dissenting stockholders the law was aimed to protect. In fact, any “policing” value added by the fact that appraisal claims are easier to win than fiduciary claims would still exist; it would simply benefit the people it was always supposed to benefit, namely, dissenting stockholders rather than enriching opportunistic, quick-buck artists.
The Delaware Supreme Court might get the opportunity to weigh in on these questions, in Dell or in other cases in the pipeline, but there is no reason to ask the Supreme Court to fix what the legislature could with the stroke of a pen. The Delaware legislature must be The Exorcist.