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By Ivet Bell
This article, written by Ivet Bell, is a winning entry in the 2016 Bloomberg Law Write-On Competition for law students. Ivet is a J.D. candidate at Columbia Law School 2016 and a graduate magna cum laude in Economics from Harvard College 2013. She serves as the Editor-in-Chief of the Journal of Law and Social Problems and, after law school, will join the offices of Sidley Austin LLP in New York.
The recent emergence and growth of appraisal arbitrage as a litigation investment strategy has sounded alarms around a historically dormant area of public company M&A law and practice. Although the regulatory response has generally been slow to awaken, hotly-contested appraisal actions have focused the attention of Delaware courts on a key public M&A litigation question: how to determine the “fair value” of target shares. Five important appraisal decisions in 2015 show that Delaware courts will in some contexts begin to rely on transaction price rather than on typical valuation methodologies emphasized in the past, such as discounted cash flow (DCF) or comparable company analyses.
This article will help parties and advisers in public company M&A assess the appraisal litigation risk and cost that different deals bear as a result of a new approach that Delaware courts will apply to determine fair value. For litigants bringing or defending appraisal actions, this article will highlight courts' increasing concern with the malleability of valuation methodologies and will consider the future of appraisal arbitrage in light of recent developments.
“Appraisal arbitrage” is an investment strategy in which hedge funds purchase shares of a target company after the announcement of a cash-out merger with the intention of asserting statutory appraisal rights under 8 Del. C. §262. In the subsequent appraisal action, the court considers the petitioner's claim that the transaction price was below the “fair value” of the target shares. If the court determines that the target was undervalued, the amount awarded above the transaction price represents the return on the petitioner's investment.
Appraisal arbitrage is a no-risk and potentially high-return strategy in the current low interest rate environment. A statutorily defined prejudgment interest of 5 percent accrues on the total amount claimed while litigation is pending, so a hedge fund can earn a sizeable return even if the claim is meritless. More importantly, in the overwhelming majority of cases Delaware courts have pinned fair value substantially above the merger transaction price. In this context, concerns over appraisal arbitrage risk have heightened the importance of attorney guidance during the deal process (01 CGR 151, 7/6/15) (18 MALR 926, 6/22/15) (104 BBR 1141, 6/16/15) (13 CARE 1260, 6/12/15) (111 Banking Daily, 6/10/15) (111 DER 111, 6/10/15).
To reach a fair value determination, courts rely on a variety of valuation methodologies, among which DCF analysis is predominant and comparable or transactions analyses are common. Valuation is no exact science—even small variations in the methodologies or the underlying inputs can yield widely divergent results. Yet the courts' ultimate valuation decisions are critical determinants of M&A deal risks and costs.
As appraisal valuation decisions approach the transaction price, the appraisal arbitrage incentive decreases. Yet when appraisal arbitrage gathered speed a few years ago, Delaware courts firmly refused to adopt any measure of presumptive deference to merger price in appraisal proceedings. Golden Telecom Inc. v. Global GT LP, 11 A.3d 214 (Del. 2010). Reliance on merger price was thought to go against the point of appraisal itself: how can courts evaluate the fairness of the merger price by presuming it was fair? Nonetheless, in 2015 the Delaware Supreme Court affirmed a single decision which had carved out a limited exception. In Huff investment Partnership v. CKx (Del. Ch. Nov. 1, 2013) aff'd (Del. Feb. 12, 2015), the court held that the valuation could rely on merger price (1) if the target underwent an effective market check and (2) the financial inputs on which other valuation methodologies depend are unreliable (30 CCW 59, 2/25/15) (18 MALR 281, 2/23/15) (13 CARE 382, 2/20/15). Based on this approach, the court deferred to merger price in In re Ancestry.com Inc., No. 8173-VCG, 2015 BL 23048 (Del. Ch. Jan. 30, 2015), a case in which Vice Chancellor Sam Glasscock III emphasized that law-trained bench judges are not adequately prepared to use their own valuations and should not rely on parties' valuations in appraisal cases (13 CARE 85, 1/9/15). The exception quickly saw large application in 2015.
In Merlin v. Autoinfo, No. 8509-VCN, 2015 BL 127097 (Del. Ch. Apr. 30, 2015), the target was a small, publicly traded transportation provider which underwent a months-long sale process which involved pitches to 164 potential acquirers and the evaluation of a number of bids (15 EXER 223, 5/18/15) (47 SRLR 955, 5/11/15) (18 MALR 699, 5/11/15) (13 CARE 952, 5/8/15) (30 CCW 138, 5/6/15) (86 SLD, 5/5/15). The highest bidder valued the company at $1.26 a share, but later brought its offer down to $1.05 because of issues that came to light during due diligence. Petitioners in the case asserted a price of $2.60 per share, reached by valuation primarily based on management projections. The court found the projections unreliable because the management team had no experience preparing such projections, had received instruction to make the valuation “optimistic,” and had admitted to doubting the accuracy of its assumptions. The court also found suggested comparable companies analyses unconvincing, because the companies were different in size and risk profile.
In LongPath Capital LLC v. Ramtron Int'l Corp., No. 8094-VCP, 2015 BL 208944 (Del. Ch. June 30, 2015), the target was subject to a hostile bid and sought other buyers (18 MALR 1008, 7/13/15) (30 CCW 205, 7/8/15) (47 SRLR 1354, 7/6/15) (13 CARE 1512, 7/3/15) (See previous story, 07/02/15) (127 SLD, 7/2/15). Finding none, it agreed to sell itself at $3.10 per share. The petitioners offered expert DCF analysis based on management projections that suggested a price of $4.96 per share. The court found the projections unreliable because they were prepared for the purpose of offering the company to white knights, were inconsistent with historical trends, and were prepared by a management team that joined the company just months before. Beyond finding fault with the projections themselves, the court expressed a strong view that expert-crafted, litigation-driven valuations are generally strongly biased. The court ultimately found that fair value was slightly below the merger price.
In Merion Capital LP v. BMC Software, No. 8900-VCG, 2015 BL 346010 (Del. Ch. Oct. 21, 2015), the target initiated two separate sales processes and considered several bids before it sold itself to a consortium of private equity firms at $46.25 per share (30 CCW 324, 10/28/15) (18 MALR 1562, 10/26/15) (53 CARE 53, 10/23/15). The merger agreement allowed for a month-long “go shop” period. Petitioners claimed a fair value of $67.08 per share, relying on a DCF model. The court adjusted the assumptions in the DCF models applied by both petitioners and the company, and found a $48 price. The court second-guessed its own valuation, however, because it thought the management projections it used were historically problematic and had doubts about the assumed discount rate and expected growth rate. Even after having adjusted the inputs to make them reasonable and conducting its own analysis, the court ultimately deferred to the merger price.
Appraisal arbitrage has added a significant potential cost to M&A deals. Acquirers can price this based on the risk of litigation and the risk of a high fair-value outcome. The Delaware courts changed the expected value of this calculus in 2015. A court can now rely on transaction price where two conditions are present: first, the target underwent an effective market check and second, the inputs for valuation methodologies are unreliable.
Acquirers pursuing a target that has not been subject to a rigorous sale process or market check are substantially more exposed to the unpredictable outcomes of typical valuation methodologies than acquirers pursuing well-shopped targets. Additionally, acquirers of well-shopped companies are now unlikely to face litigation at all. Arbitrageurs will likely redirect their focus to targets where the expected return of asserting appraisal rights is higher.
With respect to the second requirement, courts may quickly point out the unreliability of inputs if they are evaluating a well-shopped target and have the option of deferring to merger price. The opinions in the cases show that courts are increasingly wary of client bias in expert, litigation-driven valuations. Courts are likely to probe management valuations for over-optimism. Courts may also second-guess whether a bench judge is well-equipped to make valuation decisions, as in Ramtron, and may second-guess their assessments even after adjusting the inputs offered by parties for reasonableness, as in BMC Software. A court may find, as in Ramtron, that a valuation significantly higher than the deal price would indicate a “significant market failure,” and one would not expect such a market failure unless there were significant flaws in the sale process. Yet where the valuation approximates the deal price, as in BMC Software, the court may find the lack of difference to be just as good of a reason to defer to the merger price.
Although the unreliability of valuation inputs is unlikely to be as significant as the presence of an effective market check in determining whether the court will defer to merger price, M&A dealmakers can approximate the risks of no deferral by evaluating the reasonableness of target management's projections for the company. Factors of special relevance to the reliability of such projections include the deviation of the estimates from historical trends, the level of experience management has had with the company, and the context in which the projections were prepared if outside the ordinary course of business.
Increased reliance on merger price by the Delaware courts is unlikely to stem the tide of appraisal arbitration. The statutory interest rate alone incentivizes arbitrageurs to try their chances in court, especially since rapid changes to today's low interest rate environment seem unlikely. Appraisal arbitrageurs continue to benefit from courts' unwillingness to adopt share tracing requirements. In 2015, the Delaware State Bar considered statutory amendments that would have slowed appraisal arbitrage (18 MALR 446, 3/23/15) (13 CARE 582, 3/20/15) (30 CCW 84, 3/18/15) (50 DER EE-17, 3/16/15), but these were never introduced into the Legislature.
On April 5, 2016, the Delaware State Bar's Corporation Law Section approved these amendments again (19 MALR 553, 4/11/16) (67 CARE, 4/7/16). The first of the proposed amendments would deny appraisal remedy for de minimis claims on shares of publicly listed companies. The second would permit companies to pay a cash amount to dissenting shareholders before an appraisal proceeding ends, such that the statutory interest would only accrue on the unpaid portion of the ultimate appraisal award. If adopted, the proposed changes will certainly decrease the incentive to bring appraisal claims. The proposed changes will have to be introduced to and adopted by the Delaware General Assembly to become law.
In the meantime, the new transaction price deference approach will immunize arm's-length deals from the variability of outcomes in appraisal litigation and will decrease the expected return on many potential appraisal actions. Dealmakers and advisers can more easily recognize appraisal litigation risk and cost by assessing the faults in the sale process or management's projections. Importantly, parties can anticipate that courts will have a more market-reliant approach to fair-price valuation generally as abuses of the inherent subjectivity of valuation methodologies become increasingly obvious.
For the second year in a row, we invited law students from schools around the country to submit original articles, the best of which would be published in selected Bloomberg BNA Law Reports. Entries were evaluated by our editorial team based on accuracy, depth of analysis, writing style and usefulness to our audience. The winning articles will appear during the month of April in 10 Bloomberg BNA publications and on Bloomberg Law.
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