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

Author:Korsmo, Charles R.
Position:Mergers and acquisitions - III. Does Appraisal Target the Right Transactions? through Conclusion, with footnotes and appendices, p. 1583-1615

    Given the increasing incidence of appraisal litigation, and the sharply increasing amounts at stake, examining the policy implications of appraisal becomes a matter of some urgency. This Part and the next begin this examination. We hypothesize that the structure of appraisal litigation--which provides strong incentives for stockholders but not their attorneys--ought to lead to litigation that bears markers of litigation merit. In our empirical analysis, we find strong evidence in favor of this hypothesis. Appraisal petitioners target deals where the merger premium is low and where controlling stockholders are taking the company private.

    1. The Unique Structure of Appraisal Litigation

      At least superficially, there is some reason to fear that appraisal litigation--as a species of shareholder litigation--will share some of the well-known pathologies of shareholder litigation. In other types of shareholder litigation--like derivative suits or class actions alleging violations of fiduciary duties in mergers--the actual plaintiff is largely irrelevant. The plaintiffs' attorneys face all of the meaningful incentives in such litigation, (115) and the agency problem between the attorneys and the class of shareholders can oftentimes be severe. (116) Plaintiffs in shareholder litigation generally have only nominal control over their attorneys, (117) and the attorneys typically have de facto control over all litigation decisions, including the decision to settle and the terms on which the settlement will take place. The danger, then, is that attorneys will (1) bring non-meritorious claims in hopes of settling quickly for a generous award of fees--essentially a nuisance payment--and (2) settle meritorious claims for less than the discounted settlement value because they can be bought off by the defendants in settlement. Both outcomes are bad for shareholders, and potentially for allocative efficiency. As a result, a large literature exists questioning the extent to which the merits matter in shareholder actions. (118)

      Most recently and most relevantly, we performed a study assessing the merits of fiduciary duty class actions challenging merger transactions. (119) In a merger transaction, the chief concern to shareholders will generally be the amount of the merger consideration. (120) If the merits mattered in merger litigation, we would expect there to be an inverse relationship between the size of the merger premium and the likelihood of a class action being filed. (121) In fact, we found that there was only a very weak correlation between the merger premium (122) and the likelihood of a fiduciary duty class action. (123) Instead, the strongest predictor of a fiduciary duty class action was the deal size, (124) suggesting that plaintiffs' attorneys are primarily seeking to maximize the nuisance value of suits by going after deep pockets and large transactions. (125)

      If a similar dynamic were at work in appraisal litigation--which, of course, also targets merger transactions--the increase in appraisal activity would be cause for alarm. The structure of appraisal litigation, however, is such that this is far less likely than for other forms of shareholder litigation. Two features distinguish appraisal. First, as detailed above, there are no class claims in appraisal. (126) This means that an attorney cannot make an arrangement with a small shareholder (one who owns a single share, at the extreme) and seek to represent the entire class of shareholders. (127) It also means that the potential recovery is limited by the size of the plaintiff's holdings. In addition, the presence of a genuine plaintiff with a meaningful economic stake makes a collusive settlement between the petitioner's attorney and the defendant corporation impossible. (128) Second, Delaware's appraisal statute does not provide for the allocation of plaintiffs' attorneys' fees to the defendant. As a result, the attorney's only route to a fee is, again, through an actual plaintiff. (129)

      Furthermore, the sole issue at stake in an appraisal action is the fair value of the plaintiffs shares. This distinction is crucial for at least two reasons. First, the single-issue nature of the claim precludes the typical shareholder litigation phenomenon of collusive "disclosure only" settlements whereby the defendants pay a sizeable cash fee to the plaintiffs' attorneys, while providing only non-monetary window dressing to the shareholders themselves. (130) An appraisal case can only settle for cash. Second, the narrow focus of appraisal litigation reduces the nuisance value of an appraisal petition. Nuisance suits may be profitable whenever defendants are risk-averse or face asymmetric litigation costs. (131) While calculating fair value is far from easy, the single-issue nature of the claim renders the proceeding relatively straightforward, and the scope of discovery is limited to materials bearing on the company's value. To be sure, where one party seeks to use the merger price itself as evidence of fair value, somewhat more sweeping discovery into the process that led to that price may be necessary. But compared to other forms of shareholder litigation, the proceeding is relatively simple and thus inexpensive, reducing the nuisance value of a claim. (132)

      The litigation risk faced by the parties is also far more symmetric in appraisal litigation than in other forms of shareholder litigation. Aggregate shareholder litigation creates the possibility of catastrophic damages or an injunction. Damages in appraisal are limited to the fair value of the actual petitioner's shares. Moreover, the petitioner has real skin in the game, as well. Not only may filing a petition entail substantial upfront cost, courts in appraisal actions can--and occasionally do (133)--determine the fair value of the plaintiffs shares to be less than the merger consideration. (134) In contrast, fiduciary duty class action plaintiffs have typically already received the merger consideration and face no financial downside, giving fiduciary litigation a costless option value that is absent in appraisal actions. (135)

      Furthermore, the distorting effects of insurance play less of a role in appraisal. For most types of shareholder litigation, the potential for a nuisance settlement is heightened by the ubiquity of liability insurance for directors and officers. Such insurance policies will pay some or all of the costs of a settlement, so long as the defendants are not found culpable at trial. (136) As a result, defendants face a strong incentive to settle weak claims rather than run a small risk of personal liability. In an appraisal proceeding, any recovery simply comes from the acquirer, and the culpability and personal liability of the target company's board are not at issue.

      In sum, the agency problem--ubiquitous in aggregate shareholder litigation--is absent from appraisal litigation, and the parties to an appraisal proceeding face far more symmetric costs and risks from litigation, greatly reducing the in terrorem value of nuisance suits. There is thus strong reason to believe that appraisal litigation will be more meritorious, on average, than other forms of shareholder litigation. (137)

    2. An Empirical Examination of the Merits of Appraisal Litigation

      In evaluating whether the merits matter, we seek to determine how mergers are selected for appraisal litigation. Are plaintiffs targeting deals where there is reason to believe the merger consideration was inadequate? Or are they simply seeking deep pockets that may be willing to settle

      for nuisance value? Davidoff and Cain, for example, find that nearly 95% of all mergers with a deal size greater than $100 million result in some form of shareholder litigation. (138)

      If this dynamic were also at work in appraisal actions, we would expect to see large merger transactions to be disproportionately targeted for appraisal petitions, and for the adequacy of the merger price to have little or no predictive power. (139) Until recently, an empirical investigation of this question has been impossible, due to a lack of data on the characteristics of appraisal litigation. (140) Using our hand-collected data set, (141) however, it is possible to examine the selection of merger transactions by appraisal petitioners.

      Out of 1168 appraisal-eligible transactions for which litigation data was available, 683 attracted at least one fiduciary class action. (142) By contrast, only 87 transactions involved a counseled appraisal petition, with an additional seven transactions attracting only pro se petitions. (143) Table 2 presents the general pattern of litigation.

      A major difficulty in determining whether the merits matter in much shareholder litigation--involving issues of scienter and breach of fiduciary duty, for example--is that the merits are generally not easy to evaluate. The only issue in an appraisal action, however, is the fair value of the plaintiffs' shares, and the sole remedy is accordingly very straightforward--cash in exchange for the shares. (144) As we have argued elsewhere, (145) per share cash recovery is likely to be the only truly meaningful relief--and thus the best measure of the merits--even in non-appraisal merger litigation. This simplicity offers a rare opportunity to assess the merits of a claim. The merits of appraisal actions are easy to perceive. (146)

      In evaluating how appraisal petitioners select disputes for litigation, we examined two principal metrics. The first represents the size of the transaction, (147) which we do not consider directly relevant to the merits. The second represents the adequacy of the merger consideration, which is relevant to the merits. We examine these two metrics below. A large merger premium should suggest a weak appraisal claim and a small merger premium should suggest a strong merger claim, all else being equal. By contrast, we would expect there to...

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