Appraisal Arbitrage Two Years after DFC and Dell
Posted on Jan 17, 2020In two 2017 decisions, DFC Global Corp. v. Muirfield Value Partners, L.P.[1] (“DFC”) and Dell, Inc v. Magnetar Global Event Driven Master Fund, Ltd.[2] (“Dell”), the Delaware Supreme Court loosely adopted the notion that the deal price of a merger resulting from a robust, arms-length bidding process is often the best indicator of fair value in appraisal actions.[3] This marked a major methodological shift in appraisal rights litigation; historically, the Chancery Court had opted to find the “intrinsic value” of a firm’s stock through a highly specific assessment of factual circumstances.[4] Thus far, application of the reasoning in DFC and Dell has largely yielded awards near or below deal value. The resulting decrease in the profitability of appraisal claims has called into question the longevity of the investment strategy called “appraisal arbitrage.”
Appraisal Right and the Rise of Appraisal ArbitrageursAn appraisal right is the right of a stockholder to ask for a judicial valuation of their shares. In Delaware, a dissenting stockholder must forgo the consideration they would be entitled to and instead request for the Chancery Court to make a fair valuation of their shares.[5] In addition to certain timing considerations, a party seeking appraisal action must not have voted for the merger,[6] and the compensation they received from the merger must not fall under the “market-out” exception.[7] Under said market-out exception, only shareholders who receive cash or shares of an illiquid stock as consideration for their position in the constituent firm may pursue appraisal action.
In 2011, this seldom-used remedy began experiencing an uptick in usage.[8] Sophisticated institutional investors, known as “appraisal arbitrageurs,” led the way, comprising the overwhelming majority of appraisal petitioners.[9] In appraisal arbitrage, an investor acquires a stake in a firm known to be a merger target, sometimes doing so even after a deal is announced. If and when the merger closes, the investor brings an appraisal claim in the hopes of being awarded a premium on the deal price. A party seeking an appraisal action is also entitled to interest on their original merger compensation accruing at a rate of 5% plus the Federal Reserve discount rate from the effective date of the merger through the date of payment of the judgment.[10] Even if the Chancery Court upholds the original deal price of a merger, an appraisal arbitrageur would still be entitled to a return on their original merger compensation, a fact which may make appraisal arbitrage more attractive for some investors.
DFC, Dell, and Fair ValueDelaware General Corporation Law section 262(h) provides that “the fair value of the shares” should be “exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation.”[11] In practice, the Chancery Court has used either a discounted cash flow analysis or a deal price minus synergies approach. Conducting a discounted cash flow analysis of a firm is a fact-specific undertaking, and its results can differ greatly depending on how one weighs the relevant factors.[12] Under the deal price minus synergies approach, one values, then deducts from the deal price, the premium at which the shares of the constituent firm were acquired. Acquiring firms nearly always pay a premium on the market value of target firms. Synergies, or the value created through merging the firms, partially explains why firms pay this increased price. Since fair value is to be exclusive of the value added by a merger, a court using the original deal price must deduct the estimated worth of the synergies created from the deal price to reach a more accurate valuation of the firm at the time it was acquired.
In DFC and Dell, the Supreme Court endorsed the use of the deal price minus synergies approach, which had previously been the less prevalent of the two methodologies.[13] Whereas the discounted cash flow analysis is (or may be) unbounded by the deal price, the deal price minus synergies approach essentially sets the deal price as the ceiling of fair valuation. The awards in recent Chancery Court cases from 2017 and 2018 illustrate that this preference for valuing claims based on deal price has significantly reduced appraisal awards.[14]
Aruba and Appraisal Arbitrage Going ForwardIn April 2019, in Verition Partners Master Fund Ltd. v. Aruba Networks, Inc. (“Aruba”), the Delaware Supreme Court reversed the Chancery Court’s holding that the unaffected market price of a publicly traded firm’s stock was the best indicator of its fair value.[15] In Aruba, the Supreme Court ordered that the Chancery Court increase its original award of $17.13 per share—the firm’s unaffected stock price—to $19.10 per share.[16] Though this valuation is still a discount from the original deal price of $24.67 per share, it is a far less substantial one than the Chancery Court reached using unaffected stock price.[17] Had this decision been upheld, it would have further depressed appraisal awards in actions dealing with publicly traded merger targets. Still, Aruba supports the trend that Delaware courts will, absent evidence of a lacking sales process, defer to deal price.
Though deference to deal price has negatively impacted appraisal arbitrage, the strategy may still have a role in the future. Proponents suggest that appraisal arbitrageurs aid minority shareholders by deterring self-dealing mergers, lowering the chance of expropriation of minority shareholders and thereby increasing the value of minority shares.[18] Notably, this advancement is made with the caveat that such benefits result only in situations where a “genuine market test” cannot provide the best valuation.[19] Under this view, arbitrageurs can provide the most economic benefit by targeting cases in which the bid the price is not the result of a competitive market. According to DFC and Dell, this is precisely the kind of case that merits use of a discounted cash flow analysis, and that way of analysis is more likely to result in substantial above-deal premiums.[20] As more case law in the vein of DFC, Dell, and Aruba comes out and delimits what the Chancery Court considers to be a deficient market/bidding process, arbitrageurs should be able to better predict which mergers are worth their time and which are not. While appraisal arbitrage is unlikely to return to the level of prominence it once had, it can likely serve as an alternative to shareholder derivative suits; unlike derivative suits, appraisal actions do not require plaintiffs to overcome the business judgment rule, but they can similarly be used to address corporate wrongdoing and yield profits for minority shareholders while doing so.
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[1] DFC Glob. Corp. v. Murifield Value Partners, L.P, 172 A.3d 346 (Del. 2017).
[2] Dell, Inc v. Magnetar Glob. Event Driven Master Fund, Ltd., 177 A.3d 1 (Del. 2017).
[3] In DFC, the Supreme Court wrote “there is no presumption in favor of deal price. DFC Glob. Corp, 172 A.3d at 349. However, subsequent decisions show that the Chancery Court must have a good reason for departing from deal price.
[4] William J Carney & Keith Sharfman, The Death of Appraisal Arbitrage: Ending Windfalls for Deal Dissenters, 43 Del. J. Corp. L. 61, 80 (2018).
[5] Del. Code Ann. tit. 8, §262(a) (West 2019).
[6] Id.
[7] Id. § 262(b)(1)(2).
[8] In 2011, there were nineteen appraisal petitions filed in the Chancery Court. By 2016, there were seventy-six petitions. David F. Marcus et al., Cornerstone Research, Appraisal Litigation in Delaware: Trends in Petitions and Opinions 2006-2018, at 4 (2019), https://www.cornerstone.com/publications/reports/appraisal-litigation-delaware-2006-2018.
[9] Id. at 5 (“The top 10 petitioners accounted for more than half (254) of the 433 appraisal petitions filed between 2006 and 2018.”).
[10] Del. Code Ann. tit. 8, §262(h) (West 2019).
[11] Del. Code Ann. tit. 8, §262(h) (West 2019).
[12] In Chancery Court appraisal cases from 2006–2018, both respondents and petitioners relied on a discounted cash flow analysis over 90% of the time. Over that same period, petitioners proposed an average award of 74% above the original deal price, while respondents recommended awards 17% below the original deal price. Marcus, supra note 8, at 9.
[13] Id. at 10.
[14] Between 2017 and 2018, eight appraisal cases went to the Chancery Court; seven of these cases returned a value at or below deal price. In the preceding eleven years, eleven out of twenty-six cases had returned such a verdict. Between 2006 and 2018, on average the Chancery Court awarded an 18% premium on deal price. In 2017 and 2018 however, the average premium awarded was negative. Id. at 8.
[15] Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., 210 A.3d 128 (Del. 2019).
[16] Id. at 130.
[17] Id.
[18] Charles Korsmo & Minor Myers, Appraisal Arbitrage and the Future of Public Company M&A, 92 Wash. U. L. Rev. 1551, 1556 (2015).
[19] Id. at 1557
[20] Marcus, supra note 8, at 9.