Appraisal is the New Fiduciary Duty

This week, the Delaware Supreme Court reversed and remanded Chancery’s appraisal determination in Dell et al. v. Magentar Global Event Driven Master Fund et al..  The decision amplified the Supreme Court’s earlier opinion in DFC Global Corp. v. Muirfield Value Partners, LP, et al..

In DFC, the Delaware Supreme Court held that courts entertaining appraisal claims should place heavy emphasis on the deal price, at least for arm's length negotiations with no apparent flaws.

Dell, however, was a slightly different animal.  Unlike DFC, it involved a management buy-out, which is a scenario rife with potential conflicts of interest.  It was precisely because of these conflicts that the Chancery court refused to accept the deal price, and instead used its own discounted cash flow analysis to determine that the stock was worth more.

On appeal, the Delaware Supreme Court reversed.  Though the Court acknowledged that there may be cause for concern in the MBO context, the Court concluded – based on Chancery’s own findings – that those concerns had been allayed in this particular case due to, among other things, an efficient market for the company’s stock, a robust sales process with full disclosure, and a CEO who was apparently willing to join with any potential buyer.

What was implicit in DFC – and what Dell makes explicit – is that in some ways, the Delaware Supreme Court is using appraisal to recapture ground it gave up in the context of fiduciary duty litigation.

As we all know, after Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015), a shareholder vote can cleanse a variety of management sins in the context of negotiating a sale of the company.  Though Corwin may have much to recommend it, the chief criticism is that management may be left with little incentive to conduct a robust sales process.  As management is presumably well aware, so long as there’s some kind of premium over market, stockholders may be feel pressured to accept a deal on the table rather than hold out hope that management, if rebuked by an unfavorable vote, will apply their full efforts towards obtaining a better price (especially given customary break up fees).  Corwin provides management with no incentives to do better than the minimum of what the stockholder vote will accept.

In DFC, the Delaware Supreme Court took the first steps toward filling that gap.  By holding that deal price should carry great weight in the appraisal context absent evidence of a dysfunctional sales process, the court provided new incentives for management to obtain the best possible price for stockholders.

What was implicit in DFC is explicit in Dell.  After explaining all the reasons why Dell’s sales process raised no red flags, and even counterbalanced the ordinary concerns that are raised in the MBO context, the court explained: “If the reward for adopting many mechanisms designed to minimize conflict and ensure stockholders obtain the highest possible value is to risk the court adding a premium to the deal price based on a DCF analysis, then the incentives to adopt best practices will be greatly reduced.”

Thus, the substitution of appraisal litigation for fiduciary litigation is near complete:  improving upon deal price in the context of appraisal may be impossible unless something went wrong in the sales process (at least for the sale of a public company without a controlling stockholder).  In this way, the Delaware Supreme Court ensures that there remain incentives for directors to use best practices when negotiating deals, while avoiding some of the pathologies that have infected fiduciary duty litigation.  See Charles Korsmo & Minor Myers, The Structure of Stockholder Litigation: When do the Merits Matter?, 75 Ohio St. L.J. 829 (2014).

The question remains, however, whether Delaware made the right call.  Commenters have argued that the threat of appraisal results in higher deal prices; those salutary effects may be mitigated under the new standards.  It is not clear how proficient courts are at detecting the kinds of subtle distortions in a sales process that might result from even mild degrees of director self-interest, lack of expertise, or distraction – indeed, commenters have argued that it is precisely because appraisal can avoid these inquiries that makes it such an effective remedy.