Chancery Court backs ‘appraisal arbitrage.’ Good for shareholders?

January 8, 2015

Companies involved in mergers and acquisitions lost a couple of big decisions Tuesday in Delaware Chancery Court, where Vice Chancellor Sam Glasscock assured the future of a burgeoning investment strategy known as “appraisal arbitrage.” But according to a forthcoming study – the first in-depth analysis of the recent explosion in post-merger suits over the fair market value of stock in M&A targets – appraisal arbitrage litigation is a boon to shareholders.

Here’s how it works. After a merger is announced, an investor buys shares of the company being acquired, betting that the merger price is too low. Unlike ordinary M&A arbitrageurs, who make their money if the target ends up attracting a better offer, appraisal arbitrageurs refuse to cash in their shares when a deal closes. Instead, they file a post-merger court petition that asks a judge to set a fair market price for their shares.

Post-merger appraisal litigation was once obscure but is now booming. It generated nearly $1.5 billion in claims in 2013, 10 times the value of claims in 2004, according to “Appraisal Arbitrage and the Future of Public Company M&A,” a soon-to-be published article in the Washington University Law Review by law professors Minor Myers of Brooklyn Law School and Charles Korsmo of Case Western Reserve.

It’s easy to understand why the whole idea of appraisal arbitrage – which is increasingly the province of deeply sophisticated and well-financed hedge funds, mutual funds and insurance companies – provokes spasms of fear and skepticism among promoters of the long-term-value theory of investing. Appraisal arbitrageurs buy shares not because they believe in a company and its board but because they specifically want to sue it. In fact, the most active of these arbitrage boutiques, Merion Capital, was founded by shareholder class action lawyer Andrew Barroway. Appraisal arbitrage has become a scary-enough corporate bogeyman that Lisa Rickard of the U.S. Chamber of Commerce’s Institute for Legal Reform invoked it alongside frivolous M&A derivative suits in a Nov. 14 Wall Street Journal op-ed advising Delaware to permit fee-shifting bylaws.

Defendants were hoping that the cases before Vice Chancellor Glasscock would make appraisal actions much harder to bring. As my Reuters colleague Tom Hals reported yesterday, Merion Capital bought shares in Ancestry.com and BMC Software after private equity funds agreed to buy the companies but before shareholders voted to approve the deals. (Additional appraisal arbitrageurs were involved in the Ancestry case but not the BMC litigation.) The funds nevertheless didn’t vote on the mergers because they weren’t shareholders as of the record date. They contended that to establish their standing to file post-merger appraisal petitions, they only had to show that they did not vote for the deals – not that the shares they now own were voted against the transactions. Ancestry.com and BMC, however, moved for summary judgment, arguing that the appraisal arbitrageurs only had standing if they could prove that the previous owners of their shares voted against the mergers.

If Glasscock had agreed with Ancestry.com and BMC, it would be virtually impossible for investors who bought shares on the open market to file appraisal petitions in Delaware (where most of the cases are brought). But he didn’t. He concluded in In re Ancestry.com and In re BMC that a beneficial shareholder must show only that it didn’t vote to approve the merger. (My thanks to Kyle Wagner Compton at The Chancery Daily for sharing the opinions.)

Glasscock’s Ancestry.com decision specifically noted the “vigorous debate” about whether appraisal arbitrage is “wholesome,” but the judge said appraisal rights are enshrined in Delaware law. “My function here is to ensure compliance with the statutory prerequisites,” he wrote.

So let’s raise the question Glasscock evades: Are appraisal actions good or bad for shareholders?

Professors Korsmo and Myers wholeheartedly endorse the cases as a vehicle for safeguarding shareholder rights – and their paper, which examined 129 Delaware appraisal cases filed between 2004 and 2013, is by far the most comprehensive analysis of the past decade of appraisal litigation. “Appraisal can protect minority holders against opportunism at the hands of controlling stockholders,” they wrote. “And in third-party transactions, appraisal can serve as a bulwark against sloth, negligence, or unconscious bias in the sales process.” When corporate boards know that an arbitrageur might bring an appraisal action, the professors argue, all shareholders are better off.

Korsmo and Myers argue that appraisal litigation is free of the incentives that may prompt plaintiffs’ lawyers to bring and quickly settle dubious M&A fiduciary duty cases. According to their analysis, appraisal arbitrageurs pick their battles carefully: They don’t file claims based on the size of the transaction, the professors found, but tend to challenge share valuations in deals that feature either low premiums or controlling shareholders.

Appraisal petitions are not class actions, and the biggest arbitrageurs – according to the law professors – appear to pay their lawyers by the hour rather than through contingency fees. That places control of the cases with shareholders, not their lawyer. “There’s someone real on the other side who is going to fight,” Brooklyn prof Myers told me in an interview Wednesday. It’s telling, he said, that appraisal cases – in which plaintiffs’ lawyers don’t have a motive to settle quickly – are vastly more likely to go to trial than M&A breach-of-duty class actions.

Myers also emphasized that appraisal arbitrageurs bear real downside risk: Because they’ve refused to participate in the merger, they’re stuck with whatever valuation the judge establishes for their shares. And sometimes they lose their bets that the court will find the merger was undervalued, Myers said.

In a 2007 appraisal, for instance, then Vice Chancellor Stephen Lamb, held that a fair market value for shares in the MONY Group was about $25 – $6 less per share than AXA Financial actually paid to acquire the insurance company. More recently, Vice Chancellor Donald Parsons ruled in a Merion appraisal case that shares in the biometrics company Cogent were worth only 75 cents apiece more than 3M had paid for them.

Myers and Korsmo concede that when a company is sold through a fair, free auction process, it doesn’t make sense for a judge to second-guess the outcome. They suggest reforming appraisal statutes to provide a safe harbor for corporations that can show they really tested the market for their shares.

But on the whole, they conclude, appraisal arbitrage “should be encouraged, rather than smothered in its crib.”

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