The Real Problem with Appraisal Arbitrage
Richard A. Booth, 72(2): 325-352 (Spring 2017)
In the controversial practice of appraisal arbitrage, activist investors buy up the shares of a corporation to be acquired by merger in order to assert appraisal rights challenging the price of the deal. The practice is controversial because the appraisal remedy is widely seen as intended to protect existing stockholders who are (or will be) forced to sell their shares in the merger. But the real puzzle is why appraisal arbitrage is profitable, given that an appraisal proceeding’s goal is to determine the fair price of target shares using the same techniques of valuation used by financial professionals who advise the parties to such deals. Thus, commentators have argued that the profit derives from (1) a free option to assert appraisal rights at any time until target shares are canceled, (2) the award of prejudgment interest at a too-generous rate, and (3) the use of a too-low supply-side discount rate in the valuation of shares. As this article shows, none of these explanations has merit, but the third may be on the right track in that it has become almost standard practice among appraisal courts to reduce the discount rate for the so-called terminal period beyond five years into the future by the projected rate of inflation plus general economic growth. The fallacy in doing so is that the discount rate implicit in market prices already incorporates these factors because investors demand and expect returns commensurate therewith. Although it may be appropriate to adjust the terminal period discount rate for company-specific growth funded by the plowback of returns at a rate implicit in projected terminal period cash flow, assuming that growth will simply happen in lockstep with the economy as a whole would be incorrect. Thus, awards that are skewed to the high side by erroneous valuation practices likely encourage appraisal arbitrage.
Finding the Right Balance in Appraisal Litigation: Deal Price, Deal Process, and Synergies
Lawrence A. Hamermesh and Michael L. Wachter, 73(4) 961-1010 (Fall 2018)
This article examines the evolution of Delaware appraisal litigation and concludes that recent precedents have created a satisfactory framework in which the remedy is most effective in the case of transactions where there is the greatest reason to question the efficacy of the market for corporate control, and vice versa. We suggest that, in effect, the developing framework invites the courts to accept the deal price as the proper measure of fair value, not because of any presumption that would operate in the absence of proof, but where the proponent of the transaction affirmatively demonstrates that the transaction would survive judicial review under the enhanced scrutiny standard applicable to fiduciary duty-based challenges to sales of corporate control. We also suggest, however, that the courts and expert witnesses should and are likely to refine the manner in which elements of value (synergies) should, as a matter of well-established law, be deducted from the deal price to arrive at an appropriate estimate of fair value.
Give Me Back My Money: A Proposed Amendment to Delaware’s Prepayment System in Statutory Appraisal Cases
R. Garrett Rice, 73(4) 1051-1092 (Fall 2018)
In 2016, the Delaware General Assembly amended section 262 of the Delaware General Corporation Law to provide surviving corporations with the option to prepay stockholders in appraisal cases. Specifically, the amendment gives a surviving corporation the option to pay, in advance of a trial, to determine the stock’s fair value, whatever amount per share that it chooses. Doing so cuts off the statutory interest on the prepaid amount, which theoretically should disincentivize investors from filing appraisal petitions solely to turn a profit from the statutory interest rate—a strategy known as “interest-rate arbitrage.” But in amending the statute, the General Assembly did not specify whether the petitioning stockholders must return to the corporation any amount by which the prepayment exceeds the court’s determination of fair value. The resulting ambiguity has not only caused uncertainty among litigants and costly motion practice in the Delaware Court of Chancery—a consequence, ironically, that the legislative amendment was aimed at avoiding—but has also diminished the amendment’s effect on curbing interest-rate arbitrage and, more generally, appraisal arbitrage. This article explores the history behind the prepayment amendment, including the evolution of Delaware’s appraisal statute and two Court of Chancery cases in which the Court foresaw the need for an effective prepayment system. This article also examines the legislative history of the 2016 amendment and other scholars’ suggestions for dealing with the statutory ambiguity. Finally, the article offers a new model for legislative reform, one that retains section 262’s core and advances the policy objectives that underlie Delaware’s appraisal system.
Appraisal Rights and Economic Growth
Richard A. Booth, 73(4) 1011-1030 (Fall 2018)
In disputes relating to valuation where there is reason to doubt the fairness of deal price, the courts prefer the discounted cash flow (DCF) method and the capital asset pricing model (CAPM). Under this approach the standard practice is to calculate value year-by-year for the coming five years (the projection period), to use projected average cash flow to calculate value for the period thereafter (the terminal period), and to sum the two. Because cash flow differs from GAAP earnings primarily by netting out funds reinvested in the firm (plowback), future returns can be expected to grow. Thus, one must adjust for expected growth during the terminal period, which is typically accomplished by reducing the discount rate by the projected inflation rate plus the GDP growth rate, because a firm must keep up with inflation (lest the firm disappear over time) and because economic growth comes from returns generated by business. But if plowback generates return at the same rate ordinarily required of the firm, growth in value will be equal to plowback. Thus, it would be simpler to use projected GAAP earnings as the measure of return for the terminal period without any adjustment to the discount rate. To use cash flow together with an adjusted discount rate is akin to making Maraschino cherries—which are first soaked in lye to remove color and flavor and then soaked in food coloring and sugar to put it back. The question is whether long-term growth in firm value is limited to growth from plowback. There is good reason to think that it is so limited because opportunities to generate above normal returns (economic rents) are likely to dissipate because of competition. Still, it is possible that firms do grow by more than can be explained by plowback. But data are to the contrary. Since 1930, S&P 500 growth can be fully explained by plowback (GAAP earnings less dividends) together with likely reinvestment by investors. Although plowback during this period has been just enough to match inflation, remaining growth in stock prices is slightly less than would be expected by dividend reinvestment, which is consistent with diversion of some portion of dividends to consumption. The data since 2000 are somewhat different in that plowback has been less than inflation, but stock prices have nonetheless increased consistent with reinvestment. The bottom line is that real stock prices seem to grow at a rate slightly more than the real GDP growth rate but a bit less than the plowback rate plus the likely reinvestment rate. It follows that there is no reason for stockholders to expect growth at any greater rate and thus no need for courts to struggle with estimating growth rates: By using projected GAAP earnings as the measure of average long-term return, the courts can use an unadjusted discount rate to calculate terminal value.
Asking the Right Question: The Statutory Right of Appraisal and Efficient Markets
Jonathan Macey and Joshua Mitts, 74(4): 1015-1064
In this article, we make several contributions to the literature on appraisal rights and similar cases in which courts assign values to a company’s shares in the litigation context. First, we applaud the recent trend in Delaware cases to consider the market prices of the stock of the company being valued if that stock trades in an efficient market, and we defend this market-oriented methodology against claims that recent discoveries in behavioral finance indicate that share prices are unreliable due to various cognitive biases. Next, we propose that the framework and methodology for utilizing market prices be clarified. We maintain that courts should look at the market price of the securities of a target company whose shares are being valued, unadjusted for the news of the merger, rather than at the deal price that was reached by the parties in the transaction.