Post-merger appraisal rights[1] have attracted more than their fair share of controversy in recent years.  When activated, appraisal rights give the shareholders of a Delaware target corporation[2] the option to eschew the consideration of the proposed deal, pursuing instead a judicial determination of the “fair value” of their shares. By statutory requirement, this judicially-crafted valuation imposes no explicit burden of proof on the parties, and it must be based on all relevant factors (excluding buyer side synergies).

Although historically a sleepy corner of mergers and acquisitions litigation, appraisal proceedings have awoken dramatically in the last decade.  An important catalyst for this resurgence is the rise of “appraisal arbitrage,” whereby investors buy target-company shares shortly after a deal’s announcement principally (if not solely) to seek appraisal. This practice was greatly facilitated a decade ago by two landmark changes to Delaware appraisal law promulgated in rapid succession in mid-2007:

• First, Delaware amended §262(h) of the Delaware General Corporate Law to provide appraisal petitioners with compounded prejudgment interest pegged at the prevailing Federal Reserve discount rate, plus 5 percent. As a result, post-closing appraisal actions became attractive investment opportunities, promising returns that typically outflanked the risk-adjusted returns of similar investments (including even the surviving acquirer). [3]
• Second, in In re: Appraisal of Transkartoyic Therapies, Inc. (Del. Ch. CA 1554-CC), then-Chancellor William Chandler held that beneficial owners of target stock who purchase after the “record date” of the transaction are still eligible to assert appraisal rights. Moreover, the Court held, such dissenters are not required to prove how their newly acquired shares were voted. The opinion served largely to sanctify “claims trading” in appraisal, allowing investors to consolidate claims that would otherwise be distributed widely.

It is widely recognized that the two aforementioned reforms significantly raised the stakes (and available payoffs) from mounting a strategic appraisal action. Transkaryotic permitted petitioners to exploit scale economies in their appraisal actions, while the generous pre-judgment interest spread provided a safety net of sorts during the low interest rate environment of the last decade, allowing petitioners to come out ahead (on a risk-adjusted basis) even if the nominal appraisal valuation were to come in slightly below the deal price.

Some argue that appraisal arbitrage exacerbates the risk inherent already in appraisal proceedings, where judges notoriously struggle to decipher and adjudicate between highly technical and divergent valuation opinions offered by dueling litigant-retained experts.  The 2007 reforms, this argument goes, amplified this element of deal risk even further, causing acquirers either to shy away from appraisal-eligible acquisitions, or to discount their willingness to pay as a type of “hold-back” to self-insure against subsequent appraisal risk.  To the extent such claims are valid, they suggest that appraisal arbitrage may ultimately be undesirable for target shareholders: for if liberalization caused appraisal remedies to become too generous or unpredictable, the potential for deal chilling or price discounts could imply that the appraisal game is simply not worth the candle.

Our new paper, available here, seeks to evaluate the 2007 reforms in light of these criticisms, from both theoretical and empirical perspectives.  Theoretically, we extend an auction-design framework previously developed elsewhere by one of us[4] to generate predictions about the pricing and welfare effects of liberalized appraisal rules.  We show that the expected welfare of target shareholders will increase after liberalization only if the change also brings about higher premia in executed deals. Conversely, expected target shareholder welfare decreases in our auction framework if liberalization causes takeover premia to attenuate.  (We further demonstrate that that higher premia are both a “necessary and sufficient” condition for target-shareholder welfare improvement when courts under the status quo ante tend to comply with their mandate of withholding synergies as part of the appraisal proceeding.)

We then test these predictions empirically, using a “difference in differences” (DID) empirical design. Our study analyzes data on over 2,000 acquisitions of publicly traded Delaware targets between January 2003 and December 2016. A key axis of comparison concerns whether each deal was eligible for appraisal under Delaware law—a variable we hand-code—representing approximately two-thirds of our sample. Across the entire sample, we find that appraisal-eligible deals had higher average announcement premia over appraisal-ineligible deals (35 percent versus 24 percent).  Moreover, this difference—which persists qualitatively over the entire period—increases substantially in magnitude after the “treatment” represented by the 2007 reforms. We estimate a statistically and economically significant upward average treatment effect from the 2007 reforms in the range of between 9.7 and 14.1 percentage points (depending on the empirical model used). Our core results appear robust to several alternative specifications and the inclusion of a variety of controls, including target size, leverage, and ROA, as well as various macro-economic variables and buyer-type variables, as well as industry and quarter fixed effects.  At the same time, we find little evidence that the propensity of appraisal-eligible deals waned relative to ineligible deals after the 2007 reforms.

Taken together, our results are consistent with the claim that the 2007 reforms enhanced the credible threat of an appraisal action, effectively pushing the de facto “reserve price” in a company auction closer to its revenue maximizing point.  This finding—which is consistent with the results in at least one other contemporaneous study (using a different empirical design)[5]—holds relevance for courts, legislators, and policymakers who continue to grapple with whether appraisal (notwithstanding its various recognized imperfections) can have beneficial effects for Delaware target firms and their shareholders.

ENDNOTES

[1] Note that the appraisal remedy is only provided for eligible public-target transactions; in Delaware, this is generally limited to statutory mergers that (for public targets) involve either a mandatory cash component or a squeeze out of minority shareholders. Further, shareholders must “perfect” their eligibility in several ways in order to pursue the appraisal remedy.

[2] Note that all states have long provided a similar statutory option for some transactions; however, this study examines the appraisal remedy in the context of Delaware’s 2007 changes to the remedy.

[3] This right to statutory interest was recently reformed to permit the respondent to pre-pay its estimate of the appraisal value to the dissenters, excluding the prepaid amount from the accrual of prejudgment interest. See DGCL § 262(h), 2016 Delaware Laws Ch. 265 (H.B. 371).

[4] Choi, Albert H. and Talley, Eric L., Appraising the “Merger Price” Appraisal Rule (November 27, 2017). SSRN: https://ssrn.com/abstract=2888420.

[5] Boone, Audra L. and Broughman, Brian J. and Macias, Antonio J., Merger Negotiations in the Shadow of Judicial Appraisal (September 27, 2017). SSRN: https://ssrn.com/abstract=3039040.

This post comes to us from Scott Callahan at Rutgers Business School, Professor Darius Palia at Rutgers Business School and Columbia Law School, and Professor Eric Talley at Columbia Law School. It is based on their recent article, “Appraisal Arbitrage and Shareholder Value,” available here.