Wednesday, August 17, 2016
If it is true that “a good thing cannot last forever,” the recent turn of events concerning appraisal arbitrage in Delaware may be a proof point. A line of cases coming out of the Delaware Court of Chancery, namely In re Appraisal of Transkaryotic Therapies, Inc., No. CIV.A. 1554-CC (Del. Ch. May 2, 2007), In re Ancestry.Com, Inc., No. CV 8173-VCG (Del. Ch. Jan. 5, 2015), and Merion Capital LP v. BMC Software, Inc., No. CV 8900-VCG (Del. Ch. Jan. 5, 2015), have made one point clear: courts impose no affirmative evidence that each specific share of stock was not voted in favor of the merger—a “share-tracing” requirement. Despite this “green light” for hedge funds engaging in appraisal arbitrage, the latest case law and legislation identify some new limitations.
What Is Appraisal Arbitrage?
Under § 262 of the Delaware General Corporation Law (DGCL), a shareholder in a corporation (usually privately-held) that disagrees with a proposed plan of merger can seek appraisal from the Court of Chancery for the fair value of their shares after approval of the merger by a majority of shareholders. The appraisal-seeking shareholder, however, must not have voted in favor of the merger. Section 262, nevertheless, has been used mainly by hedge funds in a popular practice called appraisal arbitrage, the purchasing of shares in a corporation after announcement of a merger for the sole purpose of bringing an appraisal suit against the corporation. Investors do this in hopes that the court determines a fair value of the shares that is a higher price than the merger price for shares.
In Using the Absurdity Principle & Other Strategies Against Appraisal Arbitrage by Hedge Funds, I outline how this practice is problematic for merging corporations. Not only can appraisal demands lead to 200–300% premiums for investors, assets in leveraged buyouts already tied up in financing the merger create an even heavier strain on liquidating assets for cash to fund appraisal demands. Additionally, if such restraints are too burdensome due to an unusually high demand of appraisal by arbitrageurs seeking investment returns, the merger can be completely terminated under “appraisal conditions”—a contractual countermeasure giving potential buyers a way out of the merger if a threshold percentage of shares seeking appraisal rights is exceeded. The article also identifies some creative solutions that can be effected by the judiciary or parties to and affected by a merger in absence of judicial and legislative action, and it evaluates the consequences of unobstructed appraisal arbitrage.
The Issue Is the “Fungible Bulk” of Modern Trading Practices
In the leading case, Transkaryotic, counsel for a defending corporation argued that compliance with § 262 required shareholders seeking appraisal prove that each of its specific shares was not voted in favor of the merger. The court pushed back against this share-tracing requirement and held that a plain language interpretation of § 262 requires no showing that specific shares were not voted in favor of the merger, but only requires that the current holder did not vote the shares in favor of the merger. The court noted that even if it imposed such a requirement, neither party could meet it because of the way modern trading practices occur.
Because the transfer of physical securities in the traditional certificate-based system became a complicated, labor-intensive process on Wall Street in the 1960s and 1970s, the United States adopted a policy of immobilization of share certificates through a depository system. Within this system, most shares in corporations are now held in “street name,” through participants with accounts at the Depository Trust Company (DTC). Cede & Co. is the record holder name and custodian of shares through the DTC, and it holds shares in a “fungible bulk”—all shares are in Cede’s name and without any subdivision into separate accounts of the participants’ customers. However, DTC tracks the number of shares that each participant holds using an electronic book entry system. In practice, regarding how participants vote shares for or against a merger, DTC transfers Cede’s state law voting authority to the DTC participants by executing an omnibus proxy in their favor. Participants vote proxies based on instructions from their customers. Additionally, customers via their participants can cause Cede to demand appraisal for shares.
As pointed out in Transkaryotic, holding shares in a fungible bulk makes it impossible for appraisal petitioners (customers) to show how the specific shares they came to hold were voted in a merger. For this and other reasons, the court in Transkaryotic held that § 262 focuses on the record holder’s actions (Cede), and Cede need only show that it held an aggregate quantity of shares in its fungible bulk not voted in favor of the merger equal to or greater than the quantity of shares sought for appraisal.
Dell Overcomes the “Fungible Bulk” Issue
In In re Appraisal of Dell Inc., C.A. No. 9322-VCL (Del. Ch. May 11, 2016), the argument and circumstances were different. This time, due to a complicated series of events, a DTC participant mistakenly received instructions to vote Dell shares in favor of the merger from shareholders that had actually sent instructions to vote against the merger and that would later seek appraisal. Armed with evidence that a DTC participant instructed Cede to vote in favor of a merger and then instructed Cede to demand appraisal for the same shares, Dell’s argument was that the court should not simply look to Cede’s aggregate voting totals as it has done in previous cases. Doing so would permit an investor to submit instructions that shares be voted in favor of a merger and still pursue appraisal rights for those shares. The court sided with Dell and barred appraisal.
New Limiting Legislation
Effective August 1, 2016, §§ 262(g) and 262(h) of the DGCL limit appraisal demands and awards. The first amendment, with respect to publicly traded companies, essentially sets a minimum for the number of shares that may be appraised unless the merger is a parent/subsidiary merger approved under § 253 or § 267. The second amendment limits the interest accrued on appraisal awards. If a corporation pays a “pre-appraisal” amount to a shareholder seeking appraisal, the interest only accrues on any excess of the appraisal award over the already paid amount and on any interest accrued, unless such interest is paid at the time the pre-appraisal payment is made.
In the end, the Dell decision and amendments only limit and do not prevent appraisal arbitrage. However, they could be the first of many steps toward ultimate preclusion of this practice. Thus, the arbitrage green light has turned to cautionary orange and investors wanting to act should do so before it turns red.
This post is written by Georgia State College of Law recent graduate, Pierce G. Hand, IV. For this contribution, Pierce adapted (and updated) an article he wrote on the topic last year, and for which he was recognized.