APPRAISAL ARBITRAGE: IN CASE OF EMERGENCY, BREAK GLASS.

Author:Weldy, Malaina J.
 
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"But may not the existence of just such a[n] [appraisal] right--a switch which will be pulled only in case of emergency--be desirable [P]" (1)

INTRODUCTION

For most of its history, academics considered the statutory right to appraisal a sleepy, burdensome remedy with little to no economic value. (2) Yet as the contemporary uptick in appraisal filings and scholarship indicate, this once idle remedy has seen a rebirth in the past decade--to the consternation of many. (3) Indeed, appraisal in Delaware has shifted from a seldom used antidote to corporate law's majority rule to a new form of short-term investment strategy dubbed "appraisal arbitrage." (4) Appraisal arbitrage occurs when large investors, typically hedge funds, (5) purchase shares of a company after the announcement of a merger in order to contest the sufficiency of the deal price and hopefully get more consideration for their shares. (6) Under Delaware's appraisal statute, (7) any shareholder--even an abhorred appraisal arbitrageur--has an absolute right to appraisal in certain types of merger transactions, provided they meet the procedural requirements of the statute. (8)

Although appraisal petitions only represent about "one out of every twenty merger-related lawsuits," (9) the recent explosion of the remedy has drawn attention and criticism from all sides. Many scholars--and especially practitioners--contend appraisal arbitrage is "rent-seeking," (10) unnecessarily increases transaction costs, (11) and is generally of little to no social value. (12) Some even worry that it will eventually turn into a form of "nuisance litigation," if it is not that already. (13)

Yet the fundamental critique of appraisal arbitrage focuses not necessarily on the costs it imposes or the judicial resources it consumes, but rather on the misalignment between the strategy as currendy utilized and the historic purpose of the remedy--providing liquidity for shareholders who, without a veto right, are forced to receive an "illiquid instrument." (14) Indeed, appraisal arbitrageurs typically purchase their shares after the announcement of a merger, choosing to buy into the transaction rather than looking for an escape hatch out. (15) Although this is certainly not the way in which the statute was originally designed to be utilized, (16) this criticism largely overlooks one of the main goals of stockholder litigation: deterrence. (17) As most scholars agree that the more emergent purpose of the appraisal remedy is to protect minority shareholders from being compelled to accept less than the fair value of their shares, (18) having a large, sophisticated party in the wings who is able to bring suit absent a fair price is powerful. In this sense, what looks like opportunistic behavior by arbitrageurs might actually be socially desirable.

This Note argues two points, each fairly modest in ambition. First, it suggests that appraisal is a justified and desirable remedy, despite the undesirability of appraisal petitioners in recent years. In a world that loves to root for the underdog, no matter the circumstances, (19) arbitrageurs are the antithesis. Yet if we accept that today appraisal is at its core about deterrence and protecting minority shareholders, then it should not matter who is bringing the suit, so long as it is meritorious. (20) As there is evidence that appraisal arbitrage continues to benefit shareholders, especially ex ante, there is little reason for the Delaware legislature to adopt additional requirements meant to keep out the arbitrageurs who are bringing these cases.

Second, this Note argues that although Delaware's contemporary trend toward using merger price as the best evidence of fair value--in auction settings where there was publicly available information and arm's-length dealing--should, in conjunction with the 2016 amendments to the appraisal statute, eliminate many of the concerns about unmeritorious appraisal litigation, there are nevertheless potential issues with such a trend. Specifically, this Note argues that to the extent this trend indicates a greater skepticism of alternative valuation methods, even in suspect transactions, there is a risk that the court will too often simply return the merger price as fair value, disincentivizing even meritorious appraisal petitions and harming the deterrence value of the remedy. Accordingly, this Note suggests appointing a neutral expert to arbitrate valuation disputes (specifically when examining Discounted Cash Flow models), which could offer the court some much needed reliability and increase the likelihood that alternative valuation methods will be used instead of the merger price.

Part I of this Note introduces the appraisal remedy, outlining its history, purpose, and modern justifications. It also details the procedural process for bringing an appraisal claim. Part II examines the rise of appraisal in its current arbitrage form, delving into the various reasons set forth to explain its rise, as well as how the recent amendments to the Delaware appraisal statute have addressed these issues. This Part also analyzes Delaware's recent merger price "presumption" trend. Part III puts forth several arguments in light of this trend, with the intent that such arguments will both justify and protect the remedy's deterrence value. This is followed by a brief conclusion.

  1. APPRAISAL IN DELAWARE: A HISTORICAL OVERVIEW

    This Part provides a brief overview of appraisal rights and the appraisal process in order to offer the reader a foundation for understanding the current appraisal debate. Although much could be said about the appraisal remedy from a historical standpoint, (21) this Note seeks to address appraisal as it is currently utilized given that the remedy's trajectory has changed drastically over time. This Part lays the groundwork for several justifications and defenses of the appraisal remedy, which will become relevant to the arguments in Part III.

    1. The Role and History of Appraisal

      Historically, merger approval required the unanimous consent of all stockholders. (22) The rationale for unanimity was that purchasing stock in a firm gave you a contract right, and thus the stockholder's approval was necessary before you could divest him of that right. (23) Unanimity, however, allowed just a single shareholder to prevent a majority-approved merger from going forward, creating a holdup problem for corporations across the United States. (24) Yet as Professors James Cox and Thomas Hazen note, "[b]ecause of the importance of contract and property rights, courts [initially] held grave doubts regarding the constitutionality of permitting corporate actions over the protest of any single shareholder." (25) Indeed, the skepticism of corporate consolidations and mergers was reflected in an opera at the time, which had the line: "Is it worse to rob a bank than merge a bank?" (26) Nevertheless, as the holdout problem persisted, the courts' concern quickly gave way to practicality. Pennsylvania was the first state to provide an appraisal remedy to a minority, dissenting shareholder in a merger, (27) and other states eventually followed suit. (28) Delaware, the state around which most of corporate law centers, enacted its appraisal statute in 1899. (29)

      The original purpose of appraisal was "to compensate stockholders for the loss of veto power and to give dissenters the right to exit the corporation and recover the cash value of their shares," which is commonly referred to as the liquidity rationale. (30) Absent a veto right, a shareholder could, as illustrated by Professor Bayless Manning, own a horse and suddenly find that after the merger, he owned a cow instead. (31) The perceived injustice of this reality was informed by an early suspicion and distaste for corporate combinations in general, strengthening the need for some sort of remedy to let the shareholder out of the transaction in the absence of veto power. (32) Thus, to compensate shareholders for this perceived injustice and to provide liquidity, appraisal offered shareholders a choice: accept the deal--a cow for a horse--or dissent and seek appraisal. (33)

    2. The Modern Justifications of Appraisal

      The liquidity rationale, although still at play today, is largely secondary in significance to a more pressing concern: the need to protect minority shareholders from majority abuse, especially in transactions involving a perceived conflict of interest or the potential for self-dealing. (34) Appraisal petitions today tend to be used to dissent from transactions with "lower deal premia," as well as going-private transactions, which are precisely the ones most likely to take advantage of minority shareholders. (35)

      A classic example of the type of merger in which concern for minority shareholders abounds (and one of the types of mergers granted appraisal rights in Delaware's appraisal statute), (36) is the short-form merger. A short-form merger occurs "when a subsidiary merges into a parent that already owns most of the subsidiary's shares," (37) usually around ninety percent. (38) In such a scenario, there is a risk that the parent company will offer the subsidiary's shareholders a price for their shares that is less than fair value, because the transaction does not require a shareholder vote (39) (meaning there is less incentive to pay a competitive price). However, in such a scenario, the availability of the appraisal remedy serves as an ex ante threat to those companies who would consider offering a low price, (40) and an ex post remedy for shareholders who feel they have not received a fair one. (41) Thus, appraisal can serve as a defense against "sloth, negligence, or unconscious bias in the sales process." (42)

      Admittedly, fiduciary duty litigation is also meant in part to protect minority shareholders, albeit against particular directors personally rather than the company as a whole. (43) However, the appraisal remedy in recent years has been...

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