Appraisal Arbitrage – A Rising Star in the Activist Playbook

Shareholder activism gains momentum and publicity with each passing proxy season. Activist-focused funds increase capital and investor expectations, proxy contest tactics become more practiced and skillful, nominees for board positions are industry tailored and more sophisticated and social media increases the reach (and entertainment value) of activist communications. What comes next? Appraisal rights as arbitrage.

Appraisal rights are a state statutory remedy available to dissenting shareholders in extraordinary corporate transactions. The rules vary from state to state, but the most common scenario in which appraisal rights are used is a cash merger where objecting shareholders seek a court’s separate assessment of “fair value” for their shares. Under Delaware law, appraisal awards accrue statutory interest at the federal discount rate plus 5%, compounding quarterly from the transaction closing date until the award is paid. And, absent bad faith, the interest rate is paid regardless of the ultimate appraisal decision. In evaluating appraisal claims, Delaware courts also have wide latitude; they may consider “all relevant factors” in determining value, often relying on expert opinions and factoring in complex variables such as future projections, expected tax rates, equity risk premiums, control share premiums, and discount rates.

Historically, appraisal actions in connection with M&A transactions were uncommon, typically only filed by disgruntled shareholders. But, increasingly, activist funds are exercising statutory appraisal rights in public company transactions in order to maximize return—either by obtaining a court ruling that dissenting shareholders are entitled to additional consideration in excess of the deal price, by settling the claim, or by collecting the simple return generated by the statutory interest rate applicable to these claims.

Here is how the “arbitrage” works. Beginning in 2007, the Delaware Chancery Court’s Transkaryotic decision made it clear that any beneficial holder with shares held through Cede & Co. (also known as DTC, the clearing house for US stock) could seek appraisal rights regardless of when the shares were acquired, provided that the total number of dissenting shares was less than the total “street name” shares not voted or voted against the deal. Accordingly, investors can now determine, based on market reaction to a deal and applicable disclosure in proxy or similar materials, whether or not to “buy into” appraisal claims. In addition, the interest rate applicable to such claims, particularly in our current low interest rate environment, is a reliable offset to the risk and cost of an appraisal action. Notably, it also serves as an additional point of leverage in settlement discussions with target companies.

Going forward, appraisal rights will be a considerable factor in deal risk and related litigation. Data from Delaware’s Chancery Court reveals a clear trend—i.e. a significant increase in the number of appraisal actions filed. From 2009 to 2012, the number of filed claims was 16, 18, 20, and 21, respectively. That number jumped up to 35 in 2013. And so far in 2014, 20 appraisal claims have already been filed. Not only is the rate of claims on the rise, but so too is the use of their strategic force. For those who followed the recent Dell or Dole Foods management buyouts, the use of appraisal litigation (or at least its threat) was a major force in public resistance to the transactions and, potentially, a major windfall to the investors who exercised their right to have a court independently determine the value of their shares.

Appraisal rights are not an easy, quick or affordable remedy for all shareholders. Claims often take years to resolve and dissenting shareholders must pay their own fees while taking the risk of a court determined value (note that in some states, a court may actually determine fair value to be less than the deal price). Appraisal rights also ensure a level playing field for minority shareholders that may be harmed in an “insider” deal negotiated at a lower than “market” price. The market must now consider, however, if the advantage afforded to large (and possibly opportunistic) activist funds is fair or appropriate as compared to smaller holders with fewer resources.

All M&A practitioners are well advised to consider the impact of appraisal claims on public company transactions, particularly those, like management buyouts, that may be subject to heightened scrutiny regarding valuation. Both buyers and sellers are likely to focus on closing conditions tied to the number of shares subject to appraisal, a feature not common in today’s public deal agreements, as weighed against the potential hold-up value provided to activist funds looking to capitalize on arbitrage opportunities. It is also worth noting that many practitioners view this appraisal arbitrage as pure rent-seeking and, therefore, have initiated a call for legislation to limit the available statutory interest (particularly in cases where the appraisal value is set at or lower than the deal price) and/or to eliminate the ability to “buy into” an appraisal claim following announcement of the transaction.