Saturday, April 20, 2019
It’s no secret to anyone paying attention to Delaware law that the Aruba decisions – both at the Chancery and Supreme Court levels – involved some apparently personal clashes, which have already been the subject of speculation from several quarters, and I can only assume there is more analysis to come.
I was going to weigh in on that as well but upon further reflection, I decided that it’s … boring. And I’d rather talk about the substance of the law, because what we’re seeing here is the inevitable breakdown in appraisal actions given that no one knows why we even have them.
As a warning, I’ll say that reading over what I wrote on this, I realize it’s probably pretty impenetrable unless you already are versed in Delaware appraisal jurisprudence. I’ve previously posted about recent developments in Delaware appraisal litigation here, here, here, and here, so that might provide some background, but otherwise - you know, read at your own risk:
[More below the jump]
Historically, there was a very clear purpose for appraisal: it was intended as a mechanism of resolving disputes among shareholders with heterogeneous preferences as to the corporation’s future strategy. If the corporation sought to change its strategy with a merger or a new line of business, appraisal provided dissenting shareholders with an exit ramp. See, e.g., Peter V. Letsou, The Role of Appraisal in Corporate Law, 39 B.C. L. Rev. 1121 (1998). For that reason, appraisal is designed to give shareholders the value of their proportionate share in the existing enterprise, before any changes are made.
But the development of modern securities markets and securities regulation rendered these original purposes unnecessary. (Well, I argue in my article Shareholder Divorce Court that there is a role for appraisal to address heterogeneous preferences in the modern day, but that would require significant revision.) As a result, scholars began to defend the appraisal right as a mechanism of providing liquidity in the absence of a public market, or as a backstop to protect minority shareholders against conflict transactions (involving, for example, a controlling shareholder). See Mary Siegel, Back to the Future: Appraisal Rights in the Twenty-First Century, 32 Harv. J. on Legis. 79 (1995); Daniel R. Fischel, The Appraisal Remedy in Corporate Law, 8 Am. B. Found. Res. J. 875 (1983); Randall S. Thomas, Revising the Delaware Appraisal Statute, 3 Del. L. Rev. 1 (2000); Robert B. Thompson, Exit, Liquidity, and Majority Rule: Appraisal’s Role in Corporate Law, 84 Geo. L.J. 1 (1995).
The modern appraisal action, at least in Delaware, effectuates none of these purposes and all of them. It can’t just be about liquidity because it applies to publicly-traded stock, it can’t just be about conflict transactions because it’s available in nonconflict transactions – even if it’s more available in 90% controller squeezeouts – and the distinction Delaware draws between receipt of cash versus receipt of publicly traded stock is incoherent. See Charles Korsmo & Minor Myers, Reforming Modern Appraisal Litigation, 41 Del. J. Corp. L. 279 (2017). It’s a Frankenstein’s monster of different impulses that act at cross-purposes.
And everyone knows this, but there’s no reform because no one can agree on what appraisal is supposed to be (it’s like insider trading in that way – we all know the law makes no sense, but everyone has a different view of what it should be, and nothing changes).
With the rise of appraisal arbitrage, a number of scholars argued for its use as a substitute for, or supplement to, a broken system of fiduciary duty litigation. As Charles Korsmo and Minor Myers in particular have claimed, appraisal’s structure avoids some of the pathologies that infect traditional class claims. See, e.g., Minor Myers & Charles Korsmo, The Structure of Stockholder Litigation: When Do the Merits Matter?, 75 Ohio St. L.J. 829 (2014); see also Albert Choi & Eric Talley, Appraising the Merger Price Appraisal Rule, 34 J. L. Econ. & Org. 543 (2018); Scott Callahan, Darius Palia, & Eric Talley, Appraisal Arbitrage and Shareholder Value, 3 J. L. Fin. & Acctg 147 (2018).
And when these appraisal arbitrage cases hit the Delaware Supreme Court, that court – almost – seemed to agree. Specifically, DFC Glob. Corp. v. Muirfield Value Partners, L.P., 172 A.3d 346 (Del. 2017) and Dell Inc. v. Magnetar Glob. Event Masterfund, Ltd., 177 A.3d 1 (Del. 2017), took steps to move appraisal law more toward traditional fiduciary law.
Most obviously, although appraisal is usually described as an attempt to value the company “as a going concern, rather than its value to a third party as an acquisition,” In re Petsmart, 2017 WL 2303599 (Del. Ch. May 26, 2017), DFC took a new tack, stressing that the purpose of an appraisal action is to “make sure that [dissenters] receive fair compensation for their shares in the sense that it reflects what they deserve to receive based on what would fairly be given to them in an arm’s-length transaction.” In fact, the DFC decision actually seemed to express some doubt about the exclusion of synergies from the appraisal valuation, noting that it is not a compelled reading of the statute, and repeatedly stressing that Delaware precedent only “seemed” to exclude synergies.
This is important, because if you view appraisal as a backstop to fiduciary litigation – namely, as a mechanism for ensuring that target boards fight for the highest price possible – then of course you don’t want to exclude synergies; you want target boards to win a share of them.
That impression was further confirmed by both Dell and DFC’s emphasis on the importance of deal process. Use of a reasonable negotiating process, the decisions stressed, would ensure that the deal price was the best evidence of target value. But good deal processes are characterized by the target’s attempts to extract maximum value – including synergy value. So if appraisal value is measured by how well target boards accomplish this task, appraisal must be about efforts to win the highest price for shareholders – which includes sharing in synergies – and not about the going concern value of the target.
In fact, Dell actually stated that “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.” In other words, appraisal’s function is to incentivize directors to maximize target shareholder welfare.
But if the Delaware Supreme Court seemed, in these decisions, to endorse scholars’ view that appraisal could substitute for fiduciary litigation, it did not fully satisfy anyone, mostly because those scholars who endorse appraisal as a fiduciary-duty substitute also endorse its exclusive focus on price, without reference to process. It was the focus on process, in part, that was mucking everything up, and that Delaware just imported back into the litigation. See Minor Myers & Charles Korsmo, The Structure of Stockholder Litigation: When Do the Merits Matter?, 75 Ohio St. L.J. 829 (2014); Charles Korsmo & Minor Myers, The Flawed Corporate Finance of Dell and DFC Global, forthcoming Emory L.J.
Plus, there was another problem with reading Dell and DFC as I have just described them: their truly baffling discussion of market efficiency. Both cases included extensive endorsement of the efficient markets hypothesis, stressing that multiple market actors bidding for the same asset were more likely to reach an accurate valuation than a single person’s estimate. As DFC put it, “Precisely because DFC’s shares were widely traded on a public market based upon a rich information base, the ‘fair value of the stockholder’s shares of stock’ held by minority stockholders like the petitioners, would, to an economist, likely be best reflected by the prices at which their shares were trading as of the merger.”; see also DFC (“Indeed, the relationship between market valuation and fundamental valuation has been strong historically.”); Dell, (“the evidence suggests that the market for Dell’s shares was actually efficient and, therefore, likely a possible proxy for fair value.”).
Which is why VC Laster’s Aruba opinion, equating going concern value with market value, was completely reasonable. Implications of Dell and DFC notwithstanding, appraisal is theoretically about value of what was taken from shareholders, without reference to merger-related synergies. In that context, both decisions’ extensive endorsements of the efficient markets hypothesis would seem to suggest that, absent other evidence, market price is the best evidence of going concern value.
But if that’s right, it means that appraisal should not be viewed as a substitute for fiduciary duty litigation. Most acquisitions of public companies are accomplished at a price above market value; if market value is the appropriate measure, then no matter how dysfunctional the negotiation process, appraisal will not win the petitioner any gains and thus cannot discipline recalcitrant directors.
This does not mean appraisal has no purpose; instead, appraisal’s purpose would be to provide a fair “exit” in the absence of a public market. Which is exactly how it works in many states other than Delaware (they do exist).
So Laster’s interpretation was not unreasonable.
But in reversing him, the Delaware Supreme Court has signaled that this is not where it wants to go – it wants appraisal to serve some other purpose. We just don’t know what that is.
The first thing to note is that the Delaware Supreme Court’s Aruba decision seriously walks back Dell and DFC. Whereas DFC emphasized that appraisal is about giving the petitioner what s/he would have received in an arm’s length sale – which itself was a break from prior law – Aruba swings the pendulum back to the more traditionalist view:
[T]he Court of Chancery’s task in an appraisal case is to value what has been taken from the shareholder: viz. his proportionate interest in a going concern. That is, the court must value the company as an operating entity . . . but without regard to post-merger events or other possible business combinations. [Section] 262 command[s] that the court determine fair value “exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation,” which this Court has interpreted as ruling out consideration of not just the gains that the particular merger will produce, but also the gains that might be obtained from any other merger. As a result, fair value is more properly described as the value of the company to the stockholder as a going concern, rather than its value to a third party as an acquisition.
That quote alone suggests appraisal should not be about testing the propriety of the deal process, because deal process is about identifying the “value to a third party as an acquisition.”
Next, the Aruba Court makes a valiant effort to reconcile Dell and DFC’s discussions of market efficiency with previous Delaware precedent. On this point, the Aruba Court states:
[O]ur courts have for years applied corporate finance principles such as the capital asset pricing model to value companies in appraisal proceedings in ways that depend on market efficiency. The reliable application of valuation methods used in appraisal proceedings, such as DCF and comparable companies analysis, often depends on market data and the efficiency of the markets from which that data is derived. For example, it is difficult to come up with a reliable beta if the subject company’s shares do not trade in an efficient market, and the reliability of a comparable companies or transactions analysis depends on the underlying efficiency of the markets from which the multiples used in the analysis are derived.
Even before this Court’s seminal opinion in Weinberger, the old Delaware “block” method used market prices in one of its three prongs. In forsaking the Delaware block method as a rigid basis to determine fair value, Weinberger did not hold that market value was no longer relevant; in fact, Weinberger explicitly condoned its use. Extending this basic point, DFC and Dell merely recognized that a buyer in possession of material nonpublic information about the seller is in a strong position (and is uniquely incentivized) to properly value the seller when agreeing to buy the company at a particular deal price, and that view of value should be given considerable weight by the Court of Chancery absent deficiencies in the deal process.
Likewise, assuming an efficient market, the unaffected market price and that price as adjusted upward by a competitive bidding process leading to a sale of the entire company was likely to be strong evidence of fair value….
[T]o the extent the Court of Chancery read DFC and Dell as reaffirming the traditional Delaware view, which is accepted in corporate finance, that the price a stock trades at in an efficient market is an important indicator of its economic value that should be given weight, it was correct....
I’ll just say that in my view, prior to Dell and DFC, Delaware kind of stood out for its failure to endorse the concept of efficient markets – which was exactly Laster’s point (see his Aruba decision at fn 305). So the Delaware Supreme Court’s retcon here does not strike me as entirely convincing.
In any event, in what seems to be quite a break from Dell and DFC, the Aruba decision explains all the reasons why courts cannot rely on market price in appraisal actions. Namely, markets are not fundamental-value efficient, and parties engaged in private negotiations have better information and incentives than market traders. As the Court explains:
Dell and DFC did not imply that the market price of a stock was necessarily the best estimate of the stock’s so-called fundamental value at any particular time. Rather, they did recognize that when a market was informationally efficient in the sense that “the market’s digestion and assessment of all publicly available information concerning [the Company] [is] quickly impounded into the Company’s stock price,” the market price is likely to be more informative of fundamental value. In fact, Dell’s references to market efficiency focused on informational efficiency—the idea that markets quickly reflect publicly available information and can be a proxy for fair value—not the idea that an informationally efficient market price invariably reflects the company’s fair value in an appraisal or fundamental value in economic terms....
And to the extent that the Court of Chancery also read DFC and Dell as reaffirming the view that when that market price is further informed by the efforts of arm’s length buyers of the entire company to learn more through due diligence, involving confidential non-public information, and with the keener incentives of someone considering taking the non-diversifiable risk of buying the entire entity, the price that results from that process is even more likely to be indicative of so-called fundamental value, it was correct.
Here,. … HP had more incentive to study Aruba closely than ordinary traders in small blocks of Aruba shares, and also had material, nonpublic information that, by definition, could not have been baked into the public trading price….
Ultimately, the Aruba court endorses the deal-price-minus-synergies approach for valuing the target as a going concern, on the theory that the deal price is the best evidence of what someone would pay if they have access to private information, but that price involves synergies, to which the target is not entitled, so they should be deducted.
The problem is, this standard (1) gets further away from DFC’s description of appraisal as providing sellers with “what … would fairly be given to them in an arm’s-length transaction,” and (2) introduces the very uncertainty and judge-imposed economic evaluation that Dell and DFC seemed to want to avoid. (As Brian Quinn put it, “People understand that ‘deal price minus synergies’ is mumbo-jumbo, right? It’s just a guess. It’s not scientific.”)
But the worst thing about this standard is it how pointless it is. An analysis that defers to deal price so long as the process is “Dell compliant” at least has a purpose, namely, as a backdoor mechanism of policing compliance with fiduciary duties. An analysis that looks solely at market price (absent reason to think market price is unreliable) moves appraisal into the box of providing liquidity, which is a reasonable place for it to be.
But a deal-price-minus-synergies test serves no purpose at all. It doesn’t have anything to do with liquidity, and it doesn’t protect against flawed processes, since a court will probably find enough synergies to suggest that the flawed process still resulted in some add above standalone value.
That fact is especially evident in Aruba, where VC Laster documented numerous dysfunctions in the deal process, including conflicted incentives of Aruba’s bankers and its CEO, but concluded they were not relevant to his valuation because market price represented standalone value:
If this were a case where the market price was depressed or unreliable, then perhaps a detailed inquiry into issues like competition or negotiation might become important in assessing whether the deal process achieved fair value. In a scenario where the underlying market price is reliable, competition and negotiation become secondary. Under those circumstances, an arm’s- length deal at a premium over the market price is non-exploitive. By definition, it gives stockholders “what would fairly be given to them in an arm’s-length transaction.”
On this, I’ll also note this quote from Laster’s Aruba opinion, which business profs everywhere should add to their discussions of Revlon and/or Barlow:
Aruba ... focus[ed] at trial on an email exchange ... that discussed why the merger benefitted Aruba’s customers and employees, including its salesforce in the field. Aruba argued that this email showed that the HP deal was a good one. Whether the deal was good for these corporate constituencies is a different question than whether it provided fair value for stockholders. What the email did show is that [Aruba] pursued the HP deal (at least in part) because of loyalties to constituencies beyond the stockholders. In the grander scheme of life, I find that commendable. For the narrow purpose of Delaware corporate law, those competing loyalties are factors that a court has to weigh.
On appeal, the Supreme Court rejected the market price measure of going concern value, but still found the process problems irrelevant given the synergies inherent in the deal. Thus, though it awarded a price above market, it still gave petitioners an award below deal price to account for those synergies, without so much as a nod to the pervasive conflicts of interest identified by Laster. The Court also implied (without squarely holding) that reductions in agency costs as a result of going private “count” as a synergy to be deducted, so that appraisal awards even in cases involving financial buyers - who typically work with management and thus are especially likely to exploit conflicts - will come in below deal price. In so doing, the Court undermined whatever value appraisal might have in backstopping directors’ fiduciary duties.
So in the post-Aruba world, appraisal can’t protect against dysfunctional dealmaking, it’s not designed to provide stockholders with liquidity, and it remains just as uncertain, just as pointless, as it ever was, but now with - less arbitrage, I guess?