How to squelch appraisal arbitrage, Minnesota style

December 17, 2015

(Reuters) – The beauty of a burgeoning litigation investment strategy known as appraisal arbitrage is that speculators can make money even if they lose in court. Appraisal actions, brought by shareholders who believe buyout prices are too low, ask courts to set a fair value for share prices. If the courts decide the fair value is more than the buyout price, the protesting shareholder is entitled to the higher price, plus interest.

That seems straightforward enough, but in the era of low interest rates, the statutory 5.75 interest rate in Delaware, where the majority of appraisal actions are litigated, is a profit motive. In Delaware’s appraisal system, the dissenting shareholder’s whole stake is at issue in the litigation. So even if Chancery Court judges ultimately conclude the takeover price was fair – which has been the outcome in a few high-profile appraisal actions this year – arbitrageurs are entitled to statutory interest on the entire value of their holding in the corporation.

Unlike Delaware shareholders who just took the buyout price for their shares at the time of the takeover, appraisal arbitrageurs who have failed to prove the takeover price wasn’t fair get to collect the buyout price – plus 5.75 percent annual interest for however many years the litigation was under way. Their only downside risk is legal fees and the lost opportunity to invest the contested money elsewhere, but in an October 2015 paper, “Appraisal Arbitrage: Is there a Delaware Advantage?,” two economics consultants from the Analysis Group concluded that Delaware’s interest rate “more than compensates appraisal petitioners” for the time value of their money.

Earlier this year, the Delaware bar’s corporate law section proposed a change in Delaware’s appraisal system to reduce the arbitrage incentive. Under the bar group’s proposal, corporations would pre-pay appraisal plaintiffs the buyout price for their shares. That way, if the court concluded the merger price was fair, corporations would owe the appraisal plaintiff nothing. And even if the appraisal arbitrageur won a ruling that shares were worth more than the buyout price, the corporation would owe interest only on the difference.

Delaware’s legislature, as the Lowenstein Sandler Appraisal Rights Litigation Blog has reported, did not end up enacting the bar group’s proposal. But if lawmakers decide to reconsider it, they might want to take into account what happened in Minnesota when Caribou Coffee shareholder Richard Fearon brought an appraisal action challenging the buyout price JAB Holding Company offered for the company.

Fearon, his wife and his investment company, Accretive Capital Partners owned more than 850,000 shares of Caribou, a Minnesota-incorporated company that owned and licensed hundreds of coffeehouses across the country, with a concentration in Minnesota. In December 2012, the company agreed to be acquired by JAB – an private investment group that has been snapping up companies in the U.S. coffee business – for $16 per share.

That was a 29 percent premium on Caribou’s share price, but Fearon believed it wasn’t a fair value for the stock. He notified Caribou of his dissent.

Here’s where the appraisal system in Minnesota parts ways with Delaware’s system. Under Minnesota law, the target corporation pays dissenting shareholders what it considers a fair price for their shares. The money at stake in appraisal actions is just the differential between the company’s assessment of fair value and the dissenting shareholder’s calculation.

Caribou contended there were procedural problems with Fearon’s dissent so it agreed to pay him only $15.03 for his shares, nearly a dollar less than other shareholders received in the JAB buyout. By bringing an appraisal action, in other words, Fearon put about $850,000 at risk, plus legal fees for his counsel at Lindquist & Vennum.

Fearon’s potential upside was still considerable. As Judge Ronald Abrams of Minneapolis state court explained in a Dec. 15 ruling (here and here, in two parts), Fearon’s expert opined that the Caribou shares were actually worth $22. If Judge Abrams agreed with that valuation, Fearon would have been entitled to about $6 million, plus 4 percent statutory interest. But because Caribou had already paid him more than $13 million to acquire the shares, he would not be due interest on his entire investment in Caribou.

As it turned out, Fearon was due nothing at all. After a five-day trial featuring former top Caribou executives and experts from both sides, Judge Abrams agreed with Caribou’s lawyers at Skadden Arps Slate Meagher & Flom and Briggs & Morgan that the company had paid Fearon a fair price for his stake. The judge actually concluded that the $15.03 per share Fearon received was more than fair: He valued the shares at $14.45, based on Minnesota’s preferred method of discounted cash flow analysis to calculate fair value.

Caribou can’t recover the extra 58 cents per share it paid Fearon for his shares. But he’s out the $850,000 difference between the $15.03 per share he received and the $16 per share other Caribou investors were paid.

Granted, a case in Minnesota isn’t going to dissuade appraisal arbitrageurs in Delaware, where appraisal actions against Delaware corporations take place. (Fearon also isn’t a professional appraisal arbitrageur, like some hedge funds that bring Delaware actions.) Minnesota appraisal cases are outliers. But after the Caribou litigation, shareholders in Minnesota corporations are on notice that they might actually lose money in a challenge to a buyout offer.

If Delaware wants to dissuade appraisal arbitrage, that’s a good place to start.

I left a message for Fearon counsel Terrence Fleming but didn’t hear back.

For more of my posts, please go to WestlawNext Practitioner Insights

Follow me on Twitter

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/