Maybe Publius was right: relying on merger price to determine fair value in Delaware appraisal cases.

• Jurisdiction: United States
• Date: 01 December 2016
• Author: Meyer, Daniel E.

Introduction I. Overview of Appraisal Rights II. The Growth of Appraisal Arbitrage A. Factors Influencing the Rise of Appraisal Arbitrage Claims B. Backlash Against the Practice of Appraisal Arbitrage III. Delaware's Approach to Valuation in Appraisal Cases A. Calculating "Fair Value" B. Calculating Synergies IV. Appraisal Arbitrage, Merger Price, and Delaware Precedent A. Background of LongPath B. Holding and Reasoning of Longpath C. Dell and DFC Global V. A (Long)Path Forward Conclusion "Every thing is worth what its purchaser will pay for it."

--Publius Syrus (1)

INTRODUCTION

In less than a decade, the annual value of appraisal claims in Delaware has increased tenfold over historical levels. (2) The driving force behind this growth has been the emergence of an investment strategy known as appraisal arbitrage. (3) Appraisal arbitrageurs buy a target company's shares after the announcement of a merger, oppose the transaction, and then make--or threaten to make--an appraisal claim in order to capture a value greater than the merger price. (4) Because of the development and growth of this investment strategy, the "appraisal remedy has been transformed from a forgettable attribute of stock ownership" into a viable mechanism for challenging opportunistic mergers. (5) Thus, absent further legislative reform or a shift in the Delaware Court of Chancery's approach to appraisal, the appraisal remedy stands to remain an important part of the framework for ensuring corporate accountability going forward.

Much noise has been made concerning the development of "buying into" a lawsuit. On the one hand, some scholars have embraced appraisal arbitrage, viewing its development as a net positive. (6) They argue that decisions to initiate appraisal proceedings are correlated to litigation merit and can serve as a safeguard against poor sales processes. (7) Nonrobust sales processes, including those that lack a market auction, may not result in the highest price possible, and indeed, the transactions targeted for appraisal proceedings tend to have unusually low premia. (8) As such, appraisal suits may actually be initiated when target shareholders are receiving too little consideration for their shares. On the other hand, deal lawyers unsurprisingly have been vocal critics of this practice. (9) They argue that the mere threat of appraisal litigation stands to reduce the number of beneficial deals that are closed and to block shareholders from capturing higher value in transactions that are actually consummated. (10) Under this view, the possibility of appraisal litigation causes potential acquirers to offer lower bids and require restrictive closing conditions in order to account for potential litigation costs and the uncertain outcome of an appraisal proceeding, leading to deal failures and lower purchase prices. (11)

Both sides of this debate have called on the Delaware legislature to reform its appraisal statute. (12) Scholars who approve of the appraisal remedy have suggested a number of amendments that would expand and, in their view, improve the appraisal process. (13) Deal lawyers, conversely, have advocated for the Delaware legislature to restrict appraisal rights by denying them to shareholders who purchase shares after the record date for the merger vote. (14) Currently, the relevant date for entitlement to appraisal rights is the closing date of the transaction. Transactional advisors claim that reforming that date will prevent appraisal arbitrageurs from having the option to wait and then "buy into" a lawsuit if there are developments between the record date and the closing date that arbitrageurs believe would increase a court's determination of the fair value of their shares. (15)

Delaware's Corporation Law Council (the Council), the body responsible for suggesting amendments to the corporate code to the Delaware legislature, (16) heard these cries for reform and proposed two amendments to the appraisal statute in the spring of 2015. (17) First, the Council suggested a de minimis requirement in order to eliminate nuisance suits. Under that proposal, shareholders seeking appraisal would have to collectively hold at least one percent of total shares outstanding or one million dollars' worth of shares. (18) Second, the Council proposed a provision intended to offset the potential economic incentive created by the interest owed to successful appraisal plaintiffs. Specifically, the amendment sought to allow the acquiring company "at any time before the court enters judgment in an appraisal action, ... [to] pay to each stockholder seeking appraisal rights an amount of cash, with interest continuing to accrue only on the amount that is the difference between that cash payment and the court's ultimate award." (19) The Delaware legislature did not adopt these amendments in 2015. (20) The Council then issued substantially the same suggestions in the spring of 2016, only adding that the de minimis requirement should not apply to parent/subsidiary mergers approved under section 253 or 267 of the Delaware General Corporation Law (DGCL). (21) The legislature responded by approving the addition of these amendments on June 8, 2016. (22)

In this Comment, I argue that further calls for reform to the appraisal remedy should be aimed at the Delaware Court of Chancery. The purpose of this Comment is not to express a normative judgment about the overall desirability of appraisal arbitrage; rather, I propose a shift away from the Chancery Court's oft-favored valuation technique, discounted cash flow (DCF) analysis, (23) in appraisal cases arising out of certain third-party, or arm's-length, transactions. The Chancery Court should instead rely on merger price as the best estimate of the "fair value" (24) of an appraisal petitioner's shares when (1) the inputs required for a DCF analysis are unreliable and (2) there has been a genuine market test.

Reliance on the merger price under these conditions would allay concerns on both sides of the debate. For proponents of appraisal arbitrage, this valuation approach does not impinge on shareholders' ability to resort to the appraisal remedy by restricting their deadline to the record date. Additionally, the Chancery Court's embrace of merger price would incentivize additional disclosure by target companies in order to demonstrate that the sale process was fulsome. (25) For opponents of appraisal arbitrage, when there has been a genuine market test and a DCF analysis is unreliable, the use of merger price punishes appraisal petitioners when their claims are unwarranted (i.e., purely speculative investments aimed at low-premium transactions). Appraisal arbitrageurs cannot profit from "buying into" a lawsuit when the merger price is used as fair value; they must bear litigation expenses and additionally may face a "synergy deduction," as appraisal claimants cannot capture any value arising from the expectation of the merger. (26) Thus, this approach to valuation would only encourage claims where there is real reason to believe that the price achieved in the merger was not "fair"--namely, in controlling shareholder and parent/subsidiary mergers--and would remove some uncertainty from third-party mergers (the transactions that are the primary focus of M&A lawyers).

Following a description of the history and purpose of the appraisal statute and the mechanics of an appraisal suit in Part I, Part II of this Comment provides an overview of the recent emergence and growth of appraisal claims and discusses factors that may have contributed to this increase. While none of these factors alone seems to explain the rise in appraisal claims, when taken together, they indicate that unless there are further legislative or judicial restrictions, appraisal arbitrageurs will persist in employing the remedy in order to check--or profit from--third-party mergers. Part III addresses the Chancery Court's historical approach to determining fair value, as well as its increasing willingness to use merger price as the best evidence of fair value. (27) This Part also discusses the need to calculate synergies if merger price is to be used to find fair value, given that section 262(h) of the DGCL requires fair value to be determined exclusive of any value arising from the merger. (28) Although a legal framework for this calculation is not well-established, it is a feasible calculation for parties and the court to make. Part IV discusses the Chancery Court's decision in LongPath Capital, LLC v. Ramtron International Corp., (29) a case in which appraisal arbitrage and the court's use of merger price to determine fair value dovetail. Longpath exemplifies not only a situation where the use of DCF analysis is inappropriate, but also illustrates the need to develop a robust analytical framework for valuing synergies. This Part also addresses the Chancery Court's recent appraisal decisions in In re Appraisal of Dell Inc. (30) and In re Appraisal of DFC Global Corp., (31) in which the court did not rely exclusively on merger price, and explains why these decisions are not inconsistent with this Comment's ultimate argument. Finally, in Part V, I propose a framework for when the Chancery Court should rely on merger price as the best evidence of fair value in appraisal proceedings, namely, when there has been a genuine market test and the inputs for a DCF analysis are unreliable.

1. OVERVIEW OF APPRAISAL RIGHTS

   Shareholders' statutory right to appraisal grew out of the shift away from the traditional requirement that shareholders unanimously consent in order to proceed with a merger or other fundamental corporate change. (32) Although the unanimity requirement afforded great protection to individual shareholders, it also gave rise to a holdout problem, as an equity holder with just one share could block the entire transaction. (33) To cure this issue, states amended their corporate statutes to replace the unanimity...