Appraisal - Arbs and top-up options

Last week following the decision in In re Cogent, I moved on.  I mean, why not, right?  The court passed on the deal and it can now proceed to close.  Well, not everybody is like me.  Who is like a dog with a bone?  Appraisal arbs, that's who.  Take a look at this press release from Koyote Trading to Cogent shareholders. (The Deal Prof noticed this, too.)  In it they write the following: 

“We are pleased that 3M acquired a 52% stake in Cogent last week principally through the acquisition of a 38.8% stake owned by the CEO Mr. Ming Hsieh. However, as we and other owners of Cogent have been saying for some time, the $10.50 valuation is clearly inadequate by any number of metrics,” stated Zachary Prensky, co-manager of the Special Situations desk at Koyote. As stated by 3M in a press release dated Friday, October 8^th, 2010, less than 15% of the outstanding publically-owned common stock of Cogent was tendered to 3M. ...

We applaud 3M’s long term commitment to a business that we are excited about. But the price offered is inadequate to 48% of Cogent shareholders that declined to participate in 3M’s tender. With the senior management and Board of Cogent committed to the $10.50 valuation, we have no choice but to explore the possible formation of a committee of shareholders to negotiate directly with 3M for a fair and adequate price for our stake. If 3M works with us, we believe we can find a middle ground that rewards minority shareholders for their long-term support of Cogent’s business plan,” added Mr. Prensky.

So, do they really think that the Cogent board will sit down and negotiate a higher price when a court has already given its blessing to the merger agreement?  I doubt it.   No, what they are probably up it is organizing a committee to pursue appraisal.  Meet the appraisal arbs.  A memo from Latham & Watkins issued way back in 2007 outlines the strategy. 

[T]he Delaware Chancery Court issued its opinion in the Transkaryotic appraisal proceedings. The issue was whether some 10 million Transkaryotic shares acquired afterthe record date largely by hedge funds and arbitragers were entitled to appraisal even though the beneficial owners could not demonstrate that the particular shares had, in fact, either been voted against the merger transaction or had not voted at all—a statutory prerequisite for assertingappraisal rights.

The effect is to create a post-deal announcement market for target shares.  Arbs who believe that there might be some real value in an appraisal proceeding can bid the price up and pursue and action - the reasonable costs of which may be borne by the surviving company.   Looks like Koyote is thinking of something along these lines with respect to Cogent.  Of course, the thing about an appraisal proceeding - it's a battle of experts and in the end the court determines the fair value of the shares - excluding any value created by the announced transaction.  That's a little like when a student comes back to me asking for their exam to be re-graded.  If you're lucky, it might go up.  Then again, it could go down.

On a related matter, there is an open issue with top-up options and appraisal that will receive more attention as deal-makers continue their push toward ever lower and lower triggers for the top-up option.  That issue has to do with the dilutive effect of the top-up on shares that may seek appraisal.  If Cede tells us anything, it's that a court will analyze the top-up as an integrated part of the entire transaction.  That could be troublesome if a diluted appraisal arb challenges a top-up option as part of an appraisal action.

This issue was a live one in Cogent.  The plaintiffs made the following argument: 

The last argument Plaintiffs make regarding the Top-Up Option is that the appraisal rights of Cogent stockholders will be adversely affected by the potential issuance of 139 million additional shares.  They claim that the value of current stockholder’s shares may be significantly reduced as a result of the dilutive effect of a substantial increase in shares outstanding and the “questionable value” of the promissory note.  Plaintiffs argue that the Top-Up Option will result in the issuance of numerous shares at less than their fair value. As a result, when the Company’s assets are valued in a subsequent appraisal proceeding following the execution of the Top-Up Option, the resulting valuation will be less than it would have been before the Option’s exercise.

It looks like deal lawyers saw this coming, so the Cogent merger agreement included a protective provision as part of the top-up:

Plaintiffs admit that Defendants have attempted to mitigate any potential devaluation that might occur by agreeing, in § 2.2(c) of the Merger Agreement, that “the fair value of the Appraisal Shares shall be determined in accordance with DGCL § 262 without regard to the Top-Up Option, the Top-Up Option Shares or any promissory note delivered by the Merger Sub.”  Plaintiffs question, however, the ability of this provision to protect the stockholders because, they argue, a private contract cannot alter the statutory fair value or limit what the Court of Chancery can consider in an appraisal.(66) Because DGCL § 262’s fair value standard requires that appraisal be based on all relevant factors, Plaintiffs contend the Merger Agreement cannot preclude a court from taking into account the total number of outstanding shares, including those distributed upon the exercise of the Top-Up Option.  In addition, they argue that even if the parties contractually could provide such protection to the stockholders, § 2.2 of the Merger Agreement fails to accomplish that purpose because the Merger Agreement does not designate stockholders as third-party beneficiaries with enforceable rights.

 While the issue of whether DGCL § 262 allows merger parties to define the conditions under which appraisal will take place has not been decided conclusively, there are indications from the Court of Chancery that it is permissible.(67) The analysis in the cited decisions indicates there is a strong argument in favor of the parties’ ability to stipulate to certain conditions under which an appraisal will be conducted—certainly to the extent that it would benefit dissenting stockholders and not be inconsistent with the purpose of the statute. In this case, I find that § 2.2(c) of the Merger Agreement, which states that “the fair value of theAppraisal Shares shall be determined in accordance with Section 262 without regard to the Top-Up Option . . . or any promissory note,” is sufficient to overcome Plaintiffs’ professed concerns about protecting the Company’s stockholders from the potential dilutive effects of the Top-Up Option.  Accordingly, I find that Plaintiffs have not shown that they are likely to succeed on the merits of their claims based on the Top-Up Option.

When the top-up option was simply a cleaning up device to help tidy up a tender, I suspect that few merger agreements included protective provisions as part of the top-up.  If we are moving toward lower and lower top-up triggers, then this kind of protective provision will become required, lest a challenge get some traction in the courts.

-bjmq