Is Appraisal Arbitrage Past Its Prime?
Once again, some corporate lawyers are complaining that the Delaware courts are too good to stockholders or, more often, plaintiffs’ lawyers. In the more recent past, those complaints focused on merger litigation that led to disclosure-only settlements. Now the outcry is over so-called appraisal arbitrage. But, just as the Delaware courts eventually curbed disclosure-only settlements in merger litigation, the more recent appraisal decisions are making appraisal litigation much less attractive. In just five days, two Court of Chancery decisions dealt major setbacks to appraisal arbitrage.
To set those decisions in context, it helps to first briefly review the contours of appraisal litigation. Since 2007, Delaware law provides a statutory interest rate for appraisal awards of five percent over the Federal Discount Rate. As interest rates subsequently declined, even just a five percent rate was an attractive investment return. At least partly for that reason, there was a sharp increase in appraisal litigation over the last few years.
Adding to the attraction of appraisal litigation, some large awards in excess of the merger price also encouraged investors to buy a target company’s stock after a merger announcement for the express purpose of filing for appraisal. This rise in appraisal arbitrage was denounced on many grounds. In 2016, Delaware reacted by amending the appraisal statute to not permit appraisal for de minimis claims and to permit a cutoff of interest by paying petitioners some or all of the amount in dispute before judgment was entered.
Nonetheless, appraisal litigation remained both costly in fees and expenses, and also risky in outcome. In almost every appraisal case, the petitioners would offer a well-qualified expert who based on a discounted cash flow analysis testified the fair value of the target corporation was well above the deal price. While petitioners did not always get all they wanted, in a large majority of cases the appraisal award was more than the deal price, giving a good profit to any arbitrageur.
The criticism of that result reached its zenith after the decision in In re Appraisal of Dell, Inc., 2016 WL 3186538 (Del. Ch. May 31, 2016). Dell awarded petitioners $17.62 per share, a 28% significant increase over the $13.36 per share deal price. Moreover, Dell also found that the merger price was the product of a fair process with a vigorous market check. How, then, the critics howled, would the fair value be more than what the market would pay? The Dell decision is now on appeal.
In terms of the future of appraisal litigation, Dell may still prove to be unique, regardless of the outcome in its appeal. For there are several post-Dell decisions that now make appraisal litigation less attractive. As these decisions illustrate, when the Court of Chancery has reason to doubt that a discounted cash flow analysis is properly supported, the deal price will be given great weight. See, e.g., Merion Capital LP v. Lender Processing Services, Inc., 2016 WL 7324770 (Del. Ch. December 16, 2016) and In re Appraisal of PetSmart, Inc., 2017 WL 2303599 (Del. Ch. May 26, 2017).
With that background, the decision in In re Appraisal of SWS Group, Inc., C.A. 10554-VCG (Del. Ch. May 30, 2017) is worth a look. For the SWS decision did use a discounted cash flow analysis, but still concluded that the fair value of SWS stock was significantly below the deal price. As a result, the Petitioners in SWS lost money if they purchased their SWS stock at the merger price and incurred substantial litigation expenses in doing so. How, then, could that have happened?
There are several keys to the result in SWS. To begin with, all DCF analysis started with projections of cash flows and then adjust those projections, applying a terminal growth rate and a discount rate. For the reasons stated in the opinion, the Court eventually calculated a DCF analysis that came out lower than the merger price. Hence, the first point of SWS is that there is always risk in a battle of experts. Petitioners can lose that battle.
Second, the court was unimpressed by the deal price. SWS was an attractive target because an acquiror could achieve substantial cost savings in SWS banking business that would lead to higher profits than SWS could achieve on its own. Those “synergy values” were considered to be possible only through the merger with a similar business. But as the Delaware appraisal statute precludes including “any element of value arising from the accomplishment or expectation of the merger”, those synergy values in the deal price were not counted in deciding SWS’s fair value.
It is this last lesson from SWS that may prove most important. Almost any merger with a strategic buyer will possibly have synergies for the combined entity. If those benefits arising from the merger are always to be excluded, then the deal price may actually set as a cap on value and the final judgement will likely be less than the deal price. In short, SWS signals a danger for appraisal arbitrageurs in synergies-driven mergers.
This does not necessarily follow. What constitutes a synergy-driven merger is not always clear under Delaware law. It may well be that even if a company lacks the ability to realize all the value of its assets by itself, that value is still there. To let the buyer take all the synergies in such a case by excluding that value from the appraisal award does not seem fair. We will see if SWS leads to that result and what will be its impact on appraisal.