The following post comes to us from Charles Korsmo, Assistant Professor at Case Western Reserve University School of Law, and Minor Myers, Assistant Professor at Brooklyn Law School. It is based on their recent paper entitled “Appraisal Arbitrage and the Future of Public Company M&A” and is available here.
Stockholder appraisal has been thrust into the spotlight by two high-profile and very large appraisal actions in Delaware involving the Dell and Dole going-private transactions. As we show in our forthcoming article, “Appraisal Arbitrage and the Future of Public Company M&A,” these two cases are part of a larger trend of explosive growth in appraisal. Furthermore, the parties driving this growth are a new group of sophisticated investors who specialize in pursuing appraisal claims. In short, we are in the midst of the rise of appraisal arbitrage, and in our article we argue that this is a development Delaware should encourage. An active phalanx of appraisal petitioners can benefit shareholders in circumstances where they are most vulnerable—and without any of the well-known pathologies associated with other types of stockholder litigation.
Appraisal allows a dissenting stockholder to forego the merger consideration and instead file a judicial proceeding to determine the “fair value” of the shares. Our article offers the first comprehensive look at appraisal activity in Delaware. Across various measures of appraisal activity, we document sharp increases in the last three years. While stockholders filed an average of approximately 10 appraisal petitions per year from 2004 through 2010, an average of more than 20 petitions were filed each year from 2011 through 2013, with nearly 30 petitions filed in 2013 alone. This surge in appraisal activity does not merely reflect an increase in merger activity. Approximately 5% of appraisal-eligible transactions attracted appraisal litigation from 2004 through 2010. The appraisal rate more than doubled in 2011 and has continued to increase since then. By 2013, more than 15% of appraisal-eligible transactions attracted an appraisal petition. The value of claims in appraisal in 2013 was nearly $1.5 billion, a tenfold increase from 2004 and nearly 1% of the equity value of all merger activity in 2013.
In addition to the increasing volume of appraisal activity—measured both in the number of petitions and the dollar values at stake—the profile of the public company appraisal petitioner has changed sharply since 2010. Petitioners have become increasingly specialized and sophisticated, with repeat petitioners dominating appraisal activity. Before 2010, resort to appraisal was almost exclusively a one-off exercise for aggrieved minority stockholders. But since 2010 repeat petitioners dominate, with more than 80% of appraisal proceedings involving at least one repeat petitioner.
These repeat petitioners typically make the decision to invest after a merger deal has already been announced, with the express purpose of seeking appraisal—a practice we describe as “appraisal arbitrage.” Among this new breed of appraisal arbitrageurs are large, sophisticated hedge funds including Magnetar Capital and Verition Fund, a Greenwich-based fund managed by former principals at Amaranth Advisors. The largest repeat petitioner is Merion Capital, with over $700 million invested in appraisal claims. The fund is headed by a successful plaintiffs’ attorney from Philadelphia and has reportedly sought to raise $1 billion for a dedicated appraisal fund.
The causes of this rise in appraisal are unclear, but we can confidently dismiss two potential explanations. The first points to the method of calculating interest on appraisal claims. Delaware offers a statutory rate of interest equal to the federal funds rate plus 5%, high enough to be unusually attractive in an era of historically low interest rates. Given, however, the risks an appraisal petitioner must assume—an extended period of illiquidity with an unsecured claim against a surviving company that may be highly leveraged, plus the risk of the legal claim itself—the idea that interest rates are driving sophisticated parties to target appraisal is implausible.
The second explanation ties the increase in appraisal to In re Transkaryotic, a 2007 Chancery Court decision. Transkaryotic expanded the time frame for purchasing appraisal-eligible stock in advance of a stockholder vote to approve a merger. But the judicial ruling itself likely contributed little, if at all, to the rise in appraisal arbitrage. Transkaryotic only marginally expanded the time available to arbitrageurs for evaluating appraisal claims and, more importantly, only affected a subset of merger transactions triggering appraisal—those requiring shareholder votes. The surge in activity has, however, been stronger in mergers involving tender offers, where Transkaryotic can have had had no effect, than in deals calling for a stockholder vote. Thus, the larger trend is unlikely to be the result of the Transkaryotic holding. Indeed, the economic result in the Transkaryotic litigation, rather than the consequences of the court ruling, is more likely to have played a role in the increased interest in appraisal. The parties ultimately settled the claims for a 35% premium over the merger consideration.
Given the increasing incidence of appraisal litigation and the escalating dollar amounts at stake, examining the policy implications of appraisal becomes a matter of some urgency. At least superficially, there is some reason to fear that appraisal—as a species of shareholder litigation—will share some of the well-known pathologies of other types of shareholder litigation. In particular, most forms of shareholder litigation generate a serious agency problem between the stockholders, as nominal plaintiffs, and the plaintiffs’ attorneys. The structure of appraisal litigation, however, is such that serious agency problems are unlikely. There are no class claims in appraisal. Each petitioner must affirmatively opt in by dissenting and seeking appraisal. Further, the sole issue at stake in an appraisal action is the fair value of the plaintiff’s shares. The single-issue nature of the claim precludes collusive “disclosure only” settlement and reduces the nuisance value of a claim by narrowing the scope of the issues subject to discovery and resolution at trial. In addition, the fact that an appraisal petitioner must forego the merger consideration and the risk that the court may ultimately declare fair value to be less than the merger consideration equalizes the risk faced by the parties. This further reduces the in terrorem value of litigation.
Indeed, our analysis reveals that appraisal suits—in contrast to fiduciary suits challenging the same universe of transactions—bear multiple indicia of litigation merits, targeting transactions with lower deal premia and also going-private transactions, where minority shareholders are most likely to face expropriation. Appraisal petitioners, in other words, are focusing on the right deals.
In light of these empirical findings, we argue that the rise of appraisal arbitrage is, on balance, a beneficial development. Much as the market for corporate control generates a disciplining effect on management, a robust market for appraisal arbitrage could serve as an effective back-end check on expropriation from stockholders in merger transactions. Appraisal can protect minority holders against opportunism at the hands of controlling stockholders, and in third-party transactions appraisal can serve as a bulwark against sloth, negligence, or unconscious bias in the sales process. For appraisal to perform such a role, however, a deep and active appraisal arbitrage market is necessary. By buying up large positions after the announcement of a transaction, arbitrageurs can overcome the collective action problems that would otherwise render appraisal ineffective. A highly-developed appraisal arbitrage market would aid minority shareholders—even those not equipped to pursue appraisal themselves—by deterring abusive mergers and by causing shares traded post-announcement to be bid up to the expected value of an appraisal claim.