Appraisal Triggers: Can They Really Take a Deal off the Table?

Friday, March 31st, 2017 at 11:36 am, by James Kim

Recent cases in the Delaware Chancery Courts have made bringing appraisal actions more attractive. In fact, certain funds have found the remedy very profitable and specialize in purchasing shares and seeking appraisal. But why are appraisal rights, an old concept, resurging as a valuable discussion topic in drafting a merger agreement; moreover, why can it actually be a highly negotiated condition?

Appraisal Cap

An appraisal cap is a condition negotiated in a merger agreement that allows a purchaser to walk away from the deal if more than a certain percentage of the shares are brought forward in appraisal actions. This “trigger” is commonly 5 percent, 10 percent, or 15 percent.

Clearly a seller does not want an appraisal cap, or at worst, wants to negotiate a high appraisal cap. The target does not want the deal taken off the table simply because of the attractiveness of appraisal actions. On the buyer’s side, a high amount of shares coming forward means the acquisition will cost more than anticipated because of the cost of the litigation and the difference per share in what the court determines as the fair value and the deal price for every share. In the appraisal case of Dell (Del. Ch. 2016) the appraisal claims added over $150 million to the acquisition cost.  Some appraisal actions are to be expected, but if the firm is leveraging debt to begin with to purchase the target, a large appraisal action can be disastrous and destroy any equity.  

In this chart analyzing large public company transactions provided from Law360, the percentage of companies reached an all time high in 2006, steadily decreased until 2012, and has begun to resurge. This historical trend peaks in the heyday of private equity firms; this makes sense when one considers that private equity firms are highly leveraged, meaning if there is a large appraisal action and the corporation must pay out for these actions, it could destroy any profit to be had in the deal. When dealing with a strategic buyer in the target’s industry that might not be using as much debt to finance the acquisition, the appraisal actions will not affect them in the same way.

However, regardless of the nature of the acquirer, the importance of appraisal caps may become more important because of several cases which make appraisal actions more attractive. The Chancery Court has changed the landscape in a few ways by signaling that MBOs and LBOs might be scrutinized more, that the courts will not trace shares, and that the Chancellors are increasingly suspicious of the deal price as the fair value of the share and will conduct their own methodologies.

The tl;dr of In re Appraisal of Dell is that Vice Chancellor Laster may have been suspicious of the deal price for a variety of reasons but especially because it was a management buyout (MBO), which operates like a leveraged buy out (LBO), except that the management is involved in the acquisition by having a stake in the acquiring company. This skin in the came could be an incentive to acquire the target for a lower price.

The 10,000 ft overview of another issue in the appraisal of Dell is that because of a series of cases before Dell, the courts will not make appraisal arbitrageurs prove that their shares were voted in a certain way. That is not to say that they won’t accept the evidence if it is already there, though. T. Rowe Price accidentally voted yes on a proxy instruction that was discoverable in litigation and therefore disqualified them from appraisal rights for lack of standing.  

Lastly, Bouchard in DFC Global departed from common practice and conducted a thorough examination of each input from both sides to determine which DCF was more accurate and what a fair price would or should be. He decided that instead of relying on what the market paid in an arm’s length auction, he would weight three different metrics equally – DCF, comparable company analysis, and deal price.

The more discerning look into MBOs and LBOs, the lack of a share tracing requirement unless there is affirmative proof available (sorry T. Rowe Price) and the 1/3-1/3-1/3 plan to make sure the prices aren’t too damn low may make it more desirable for appraisal suits to be brought because the courts seems to be shifting. There is more variance in how each chancellor is going to approach these appraisal suits, given there is no longer established precedent. Couple this with the fact that there is a statutorily mandated interest rate during the pendency of the suit and that this amount is 5% higher than the current Federal Reserve Discount Rate (which has now just risen to 1.5%) and you get some strong incentives.

Regulation – De minimis requirement and Prepayment of Interest Accrual

There has been some legislative response to the prevalence of appraisal actions though. The two notable changes come from House Bill 371, which amends the DGCL in a variety of ways. The portion we care about deals with amending § 262 by adding a De Minimis requirement – the Court of Chancery shall dismiss any appraisal proceedings unless

  • 1) The total number of shares entitled to appraisal exceeds 1% of the outstanding shares of the class or series eligible for appraisal
  • (2) The value of the consideration provided in the merger or consolidation for such total number of shares exceeds $1 million, or
  • (3) The merger was approved pursuant to § 253 or § 267 of this title, i.e., short-form mergers.

The second change will allow the surviving corporation to prepay any stockholders entitled to appraisal to avoid the accrual of the interest (6.5% for those of you counting at home). This limits the free interest that made these appraisal arbitrage actions so lucrative.

Conclusion

Clearly there are still incentives for appraisal arbitrage (called bumpitrarge in the biz) actions, but there are also some legislative measures taken to limit predatory or even wasteful/frivolous behavior. I think on balance, appraisal arbitrage hasn’t significantly changed.

I think appraisal arbitrageurs are ultimately useful, just like vulture funds, but are susceptible to abuse. This new legislation limits some of the attractiveness of the suits because it has the de minimis requirement and allows the corporation to avoid the accrual of interest which really was a free lunch. However, limiting appraisal actions further would be a disservice because these appraisal actions are effective market checks.

These suits ensure that corporations are paying a fair price for shares, and just like vulture funds that can act as watchdogs over debt holders, these “bumpitrageurs” canvas the market to make sure that corporations are paying the appropriate amount to its shareholders and in doing so, may collect a handsome bounty for themselves. The actual act of paying these bumpitrageurs is harmful to the company because it increases the cost of the deal; this, coupled with an appraisal trigger, is an incentive for the company to actually bargain for a fair price. If it fails to bargain properly, the company might lose the deal altogether because if more than 5, 10, or 15 percent of the shares bring appraisal actions, the merger agreement will be terminable. The logic is simple – if 15% of your shares are seeking appraisal, then perhaps the acquirer underpaid. If there are very few appraisal actions, then the market has probably accepted the value of the deal and it was a fair price, especially given that there is no longer free interest.

If you make the trigger too low, you probably discourage appraisal actions because no one, even an arbitrageur, wants the deal to go sour but you risk deal certainty if a large shareholder does bring suit. If you keep the trigger high, you are encouraging people to bring suit but do manage to have greater deal certainty.

Overall, I think these new cases and the new legislation will not really shake the world of appraisal arbitrage, but the ground is less settled and therefore the suits are less predictable.