Reforming the Delaware Law to Address Appraisal Arbitrage

Wei Jiang is Arthur F. Burns Professor of Free and Competitive Enterprise at Columbia Business School. This post is based on an article authored by Professor Jiang; Tao Li, Assistant Professor of Finance at Warwick Business School; Danqing Mei, Ph.D. candidate in Finance at Columbia Business School; and Randall S. Thomas, John S. Beasley II Professor of Law and Business at Vanderbilt Law School and Owen Graduate School of Management. This post is part of the Delaware law series; links to other posts in the series are available here.

The number of appraisal petitions has increased from a trickle of cases in early 2000s to over 20 a year in recent years, or close to one-quarter of all transactions where appraisal is possible, or appraisal eligible deals. After years of being infrequently deployed and largely overshadowed by shareholder class actions in Delaware and other states, the contours of the appraisal remedy are suddenly front page news as some Wall Street law firms seek to cut back on appraisal arbitrage filings. These firms are petitioning the Council of the Corporate Law Section of the Delaware State Bar Association (the “Council”) and the Delaware legislature to raise the bar for shareholders eligibility to file appraisal petitions and to make its terms less attractive in an effort to curb what they perceive to be a new form of strike suit. Echoing this view, Delaware Vice Chancellor Sam Glasscock III commented in Merion Capital v. BMC Software, Inc. (2015) that dissenters of valuation were “arbitrageurs who bought, not into an ongoing concern, but instead into this lawsuit.” Shareholder advocates, on the other hand, are arguing in favor of expanding the appraisal remedy in order to fill perceived gaps in investor protection that are alleged to have surfaced as Delaware and other states have cut back on judicial protections for minority shareholders in change-of-control transactions.

After weighing the arguments made by both sides, the Council has proposed two important reforms in 2015: a required minimum required stake of $1 million or 1% of the stock of the company for which the petitioner is seeking appraisal (the “De Minimis Exception”), and reductions to the statutory pre-judgment interest rate paid on the amount awarded in an appraisal proceeding (the “Interest Reduction Amendment”). Our article, Reforming the Delaware Appraisal Statute to Address Appraisal Arbitrage: Will It Be Successful?, which was recently made publicly available on SSRN, examines the empirical underpinnings of these proposed reforms to inform the ongoing debate about reforming the Delaware appraisal statute. This first large-sample empirical analysis of appraisal arbitrage is based on a manually collected comprehensive sample of all appraisal eligible deals and appraisal petitions from 2000 to 2014.

First, hedge funds dominate the appraisal arbitrage strategy, accounting for three-quarters of the dollar volume involved in all appraisal petitions in recent years. The top seven hedge funds file petitions accounting for over 50% of the dollar volume and the top seven law firms representing them are named in about 50% of all the cases. Petitioners’ stake size is highly variable, with a median of $1.9 million, although about 32% of the cases involve stakes that are both below $1 million and 1% of the stock of the company.

Second, appraisal petitions target deals that have potential conflicts of interest. Going private deals, minority squeezeouts, short-form mergers (and other second-step transactions) after tender offers are each associated with a significant 2–10 percentage point increase in probability of an appraisal filing, a substantive magnitude given the all-sample average probability of 6.9%. Relatedly, low takeover premiums are an invitation to appraisal arbitrageurs, other things equal: for every 10 percentage point decrease in the deal premium, the probability of an appraisal increases by 63–72 basis points.

Next, the study provides direct evidence to assess the potential impact of the De Minimis Exception. Using the $1 million and 1% of outstanding stock as the cutoff for “large-stake” petitions, we project that the number of appraisal petitions will drop by about one quarter if that reform is enacted, assuming that the in-sample relation between deal/firm characteristics and the filing of appraisal petitions remains constant. However, the same restriction will not affect shareholders’ motives for seeking appraisal because the underlying motives bear a stronger statistical relation to large-stake petitions than to small-stake ones.

Moreover, confirming the common wisdom, we find that most (80.1%) of the petitioners settle. Notably, the petitioner stake size is the single most powerful predictor of whether a petition will go to trial: the probability increases by 14.7 percentage points if the petitioner’s stake exceeds $10 million. Interestingly, a low cutoff at $1 million, as suggested by the De Minimis Exception, would have no impact on the likelihood of a case going to trial. Instead, a cutoff closer to $5 million would be necessary to make a significant impact.

As to the Interest Rate Reduction, our study affirms the widely held belief that a significant part of the increase in appraisal petitions has been driven by the lucrative yields provided on the awards in these cases. For every percentage point increase in the yield that arbitrageurs obtain in excess to their alternative risk free investment (e.g., treasury bills with comparable duration), the probability of an appraisal filing increases by about 1.3 percentage points. This implies that the 5% statutory rate above the risk free rate, on its own, has triggered 6.5 percentage points of additional appraisal filings among all eligible M&A deals, or almost 45% of the actual appraisal petitions filed. Such a finding strongly supports the Interest Reduction Amendment as a way of discouraging interest rate driven appraisal cases.

Finally, we note that the Council’s decision not to propose legislative overruling of the Transkaryotic decision, perhaps because of the Delaware Chancery Court’s statements that they will defer to the deal price in M&A transactions negotiated in arm’s length transactions, appears prudent. Larger shareholders that file appraisal petitions are generally motivated to do so because of perceived conflicts of interest, and these transactions are the least likely to be negotiated at arm’s length. If the appraisal remedy is designed to address “unfair” prices in M&A transactions, then the Delaware appraisal statute will still be available in those circumstances.

The full article is available for download here.

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