Chancery Court Permits Appraisal Arbitrage
A fairly new litigation development is the subject of two Delaware Court of Chancery decisions issued on the same day. Both In re Appraisal of Ancestry.com, Consol. C.A. No. 8173-VCG (Jan. 5, 2015), and Merion Capital v. BMC Software, C.A. No. 8900-VCG (Jan. 5, 2015), sustained the right of appraisal arbitrageurs to seek appraisal of the stockholdings following a cash-out merger. Had the court ruled differently, it might have severely limited such actions in Delaware.
Appraisal arbitrage has grown over the last several years to the point where the once-rare appraisal action has now become almost common. Somewhat oversimplified, appraisal arbitrage involves buying the stock of a company that has announced it is going to complete a merger that will entitle its stockholders to have the "fair value" of its stock determined by the Court of Chancery. Typically (but not always) that involves a going-private merger where stockholders are required to accept the cash price offered for their stock and cannot continue as stockholders of the merged entity. If those stockholders are dissatisfied with the price, they may demand appraisal of its fair value. The plaintiffs in appraisal arbitrage cases buy the company's stock after the merger is announced, with the expectation that they will win a higher price later by going through the appraisal process.
Until recently, few stockholders sought appraisal. The process involved expensive litigation with costly experts required to argue for a higher price. Moreover, appraisal actions are not risk-free. The Court of Chancery is not required to use the price offered in the merger as a floor and may decide—and sometimes has—the stock's fair value is less than the merger price. The risk of an adverse ruling is particularly strong when the merger price was set high to induce stockholder acceptance and avoidance of litigation. And while post-merger interest is due on the final court award, historically that was not enough to offset the costs involved in litigating.
That economic background changed, however, when interest rates fell to almost zero on most fixed-income investments. The Delaware appraisal statute provides that the "interest [on] ... the judgment shall be compounded quarterly and shall accrue at 5 percent over the Federal Reserve discount rate" from the "date of the merger." Thus, even when the discount rate is at zero, a 5 percent compounded rate is now very favorable. In addition, several studies have noted that most appraisal valuations of formerly publicly traded companies do exceed the merger price. That return plus the favorable interest has sparked appraisal litigation.
Of course, the stockholder still needs to pay his or her lawyers to litigate the appraisal action. To justify that expense, the plaintiff needs a lot of stock. After all, the appraisal award may be just a dollar or two higher than the merger price (or even less), and the appraisal case may cost a million dollars or more to litigate. Hence, at least a few million shares may be needed to warrant filing an appraisal suit. That is where appraisal arbitrage comes into play.
The Merion decision illustrates how appraisal arbitrage works. BMC, a large software company, entered into a going-private merger agreement May 6, 2013, under which BMC shareholders would receive $46.25 per share. Merion, a hedge fund, then decided that the fair value of BMC was much higher and began buying BMC shares. Eventually, Merion acquired 7.6 million BMC shares by July 17, 2013. As is typically done, Merion asked its broker to instruct the record owner, Cede & Co., to demand appraisal. When the broker refused, Merion scrambled to have its shares registered in its name. Merion later demanded appraisal and filed its petition Sept. 13, 2013, after the BMC stockholders had voted on the merger.
The Delaware appraisal statute conditions the right to appraisal on not voting the shares to be appraised in favor of the merger. Merion had become a record owner too late to show how the shares it purchased had voted while held up by their prior record owner. BMC argued that Merion was unable to prove those shares had not voted in favor of the merger and therefore Merion was not qualified to file an appraisal petition.
The court held that Merion was not required to prove its newly acquired shares had not voted for the merger. The key to the decision is that almost 50 million BMC shares had not voted to approve the merger and Merion only held 7.6 million shares. Hence, it was not possible that more shares were demanding appraisal than were qualified to do so.
The Ancestry.com decision is similar. There, Merion (yes, the same Merion) sought appraisal for shares of Ancestry.com that it had purchased after the record date to vote on the cash-out merger. Again, Merion could not prove that the sellers of the Ancestry.com shares it purchased had not voted for the merger. The prior record owner, Cede & Co., had held at least as many shares that did not vote for the merger as Merion sought to have appraised. The court held Merion could file its own petition for appraisal of those shares.
By upholding Merion's right to appraisal under these circumstances, the Court of Chancery has made it easier for investors to do appraisal arbitrage. But the court has not removed all risk in buying stock to have it appraised when the buyer cannot show how that stock voted on the merger. For example, a plaintiff who seeks appraisal for more shares than abstained or voted no on the merger may find itself in trouble. At least the right to have all the shares appraised will be in jeopardy. While both Merion and Ancestry.com argued that arbitrageurs should buy proxies to ensure a "no" vote, it is not clear that is practical. Hence, arbitrageurs need to be cautious in how and when they acquire stock for appraisal purposes.