Appraisal arbitrage and the future of public company M&A.

• Author: Korsmo, Charles R.
• Position: Mergers and aquisitions - Abstract through II. The Rise of Appraisal Arbitrage, p. 1551-1583

ABSTRACT

In this Article, we demonstrate that the stockholder's appraisal remedy--long-dismissed in corporate law scholarship as useless or worse--is in the middle of a renaissance in public company mergers. We argue that this surge in appraisal activity promises to benefit public shareholders in circumstances where they are most vulnerable.

We first show a sea change in the use of appraisal in Delaware. Relying on our hand-collected data, we document sharp recent increases in the incidence of appraisal petitions, in the size of the petitioners' holdings, and in the sophistication of the petitioners targeting public deals. These litigants appear to invest in target company stock after the announcement of the merger and with the intention of pursuing appraisal. In short, this is appraisal arbitrage. There is every reason to believe that appraisal now stands as the most potent legal challenge to opportunistic mergers.

We also present evidence showing that these appraisal petitions bear strong markers of litigation merit--they are, in other words, targeting the right deals. Nevertheless, defense lawyers have recently suggested that appraisal arbitrage constitutes some sort of "abuse" of the remedy and ought to be stopped. This nascent argument has matters precisely backwards.

This new world of appraisal should be welcomed and indeed encouraged. Our analysis reveals that appraisal arbitrage focuses private enforcement resources on the transactions that are most likely to deserve scrutiny, and the benefits of this kind of appraisal accrue to minority shareholders even when they do not themselves seek appraisal. In this way, the threat of appraisal helps to minimize agency costs in the takeover setting, thereby decreasing the ex ante cost of raising equity capital and improving allocative efficiency in public company mergers and acquisitions. We offer some modest reforms designed to enhance the operation of the appraisal remedy in Delaware.

TABLE OF CONTENTS INTRODUCTION I. THE ROLE OF APPRAISAL IN CORPORATE LAW A. The Statutory Design of Appraisal B. The Critique of Appraisal II. THE RISE OF APPRAISAL ARBITRAGE A. The Surge in Appraisal Activity B. The Sophistication of Appraisal Petitioners C. The Increasingly Competitive World of Appraisal Litigation D. What Explains the Rise in Appraisal Arbitrage? III. DOES APPRAISAL TARGET THE RIGHT TRANSACTIONS? A. The Unique Structure of Appraisal Litigation B. An Empirical Examination of the Merits of Appraisal Litigation 1. The Unimportance of Transaction Size 2. The Importance of the Merger Price IV. THE SOCIAL UTILITY OF THE APPRAISAL REMEDY AND APPRAISAL ARBITRAGE V. Potential Reforms A. Reforming Appraisal in Delaware B. Appraisal as a Model for Shareholder Litigation CONCLUSION INTRODUCTION

Stockholder appraisal is undergoing a profound transformation in Delaware. We demonstrate that appraisal activity has grown rapidly over the past three years, and this rise in appraisal litigation has been accompanied by the appearance of a new breed of appraisal arbitrageur. These developments--in stark contrast to other types of stockholder litigation--hold out great promise for stockholders and corporate law generally.

Stockholder appraisal is a unique remedy in corporate law: it allows the stockholder to forego the merger consideration and instead file a judicial proceeding to determine the "fair value" of the shares. (1) We have collected data on all appraisal cases in Delaware for the ten-year period from 2004 to 2013 and present the main results of our study in this Article. (2) Our Article is the first to provide a comprehensive examination of appraisal litigation. The lack of prior work no doubt stems from the prevailing academic view that appraisal "is seldom utilized" (3) and that the hurdles involved make it too cumbersome for stockholders to call upon profitably. (4) These dismissive attitudes towards appraisal are consistent with prior research finding that the appraisal remedy is not economically significant. (5)

With this Article, we show that this view is now badly out of date. Appraisal activity involving public companies is undergoing explosive growth in Delaware, driven by sophisticated parties who specialize in bringing appraisal claims. The value of claims in appraisal in 2013 was nearly $1.5 billion, a tenfold increase from 2004 and nearly one percent of the equity value of all merger activity in 2013. (6) Furthermore, the institutions bringing these claims are not the Potemkin "institutions" that often appear in securities or derivative litigation. (7) Appraisal claims are being brought by sophisticated entities that appear to have developed specialized investment strategies based on appraisal. This type of investing has come to be known as appraisal arbitrage and has utterly transformed what may once have been accurately characterized as a sleepy corporate law backwater.

While we can offer no perfect explanation for the rise in appraisal arbitrage, we can confidently dismiss two possible explanations that have been suggested. (8) The first ties the increase in appraisal to In re Appraisal of Transkaryotic Therapies, Inc., a 2007 Chancery Court decision. (9) Transkaryotic expanded the time frame for purchasing appraisal-eligible stock in advance of a stockholder vote to approve a merger. But the judicial ruling itself likely contributed little, if at all, to the rise in appraisal arbitrage. Transkaryotic only marginally expanded the time available to arbitrageurs for evaluating appraisal claims and, more importantly, only affected a subset of merger transactions. Thus, the larger trend is unlikely to be the result of the Transkaryotic holding. Likewise, a new statutory interest rate available to appraisal petitioners (the federal funds rate plus five percent) is unlikely to have been the catalyst for the appraisal boom. (10) Given the risks an appraisal petitioner must assume--an extended period of illiquidity with an unsecured claim against a surviving company that may be highly leveraged, plus the risk of the legal claim itself--the idea that interest rates are driving sophisticated parties to target appraisal is implausible.

Whatever its cause, the surge in appraisal litigation implicates a host of important public policy questions. The increased activity coincides with a rise in stockholder fiduciary litigation generally. (11) By many accounts, that fiduciary litigation is a hotbed of nuisance claims of dubious social value. (12) Accordingly, it is natural to fear that the increase in appraisal arbitrage is an ominous development. Appraisal litigation, however, is structured in a way that renders the risks of meritless, attorney-driven litigation remote.

In particular, two unique features distinguish appraisal. (13) First, appraisal claims can be purchased: a stockholder need not own the stock on the date the challenged merger is announced. (14) This feature stands in contrast to a standard stockholder claim, where the only stockholders who may press a claim are those who owned the stock at the time of the alleged wrong. (15) Second, there is no conventional class action: a stockholder is only eligible to file an appraisal petition if she affirmatively opts-in by meeting certain procedural requirements. (16) The result is a form of aggregate litigation where the aggregation is performed, and the litigation controlled, by the actual plaintiff--the appraisal arbitrageur--rather than the plaintiffs' attorney. Indeed, some of the largest appraisal petitioners appear to shun contingency arrangements altogether and instead pay their attorneys by the hour. In addition, the narrow focus of an appraisal claim and the possibility a court will determine fair value to be below the merger price render the risks and costs of litigation far more symmetric than in other forms of shareholder suit, further reducing the potential for nuisance claims.

We test these propositions empirically and show that appraisal suits indeed bear multiple indicia of litigation merit. (17) The analysis presented below reveals that appraisal petitioners target transactions with lower deal premia and also going-private transactions, where minority shareholders are most likely to face expropriation. By contrast, the size of the transaction--believed to correlate more with the size of the potential nuisance settlement and long the chief determinant of fiduciary litigation--does not appear to matter at all for appraisal petitioners. (18) We present summary results on these points here and report these findings more fully in a companion paper. (19)

In light of these empirical findings, we argue here that the rise of appraisal arbitrage is, on balance, a beneficial development. (20) Much as the market for corporate control generates a disciplining effect on management, a robust market for appraisal arbitrage could serve as an effective back-end check on expropriation from stockholders in merger transactions. The implications in related-party mergers are plain: appraisal can protect minority holders against opportunism at the hands of controlling stockholders. And in third-party transactions, appraisal can serve as a bulwark against sloth, negligence, or unconscious bias in the sales process. For appraisal to perform such a role, however, a deep and active appraisal arbitrage market is necessary. (21) By buying up large positions after the announcement of a transaction, arbitrageurs can overcome the collective action problems that would otherwise render appraisal ineffective. At bottom, appraisal arbitrage solves the same collective action problems that class action and other aggregate litigation seeks to solve, but without generating a serious agency problem in the process.

A highly developed appraisal arbitrage market would aid minority shareholders--even those not equipped to pursue appraisal themselves--by deterring abusive mergers and by causing shares traded postannouncement...