Pushbacks and Delaware Appraisal Arbitrage

Jack B. Jacobs is a senior counsel at Sidley Austin LLP, and served on the Delaware Supreme Court from 2003 to 2014 and, prior to that, on the Delaware Court of Chancery since 1985. The views expressed in this post are those of the author and do not necessarily reflect the views of the firm. This post is part of the Delaware law series; links to other posts in the series are available here.

For over a decade hedge funds have utilized Delaware’s appraisal statute as a strategy to arbitrage either the statutory interest rate, or the possibility of a litigated capital gain, or both. Typically, hedge funds will buy into the stock of the target company after a merger is announced, and then litigate or settle the case at a premium above the deal price. Despite the protests of the corporate defense bar, the Delaware courts have held that this practice, whether or not desirable as a policy matter, is not legally prohibited.

Recently, however, two separate developments in Delaware signal a “pushback” designed to discourage this practice. The first development, which is legislative, is intended to reduce the economic incentive to engage in “interest rate arbitrage.” The second, which is a recent Delaware Court of Chancery appraisal decision, may have the effect (if not the intent) of reducing the number of appraisal proceedings brought to arbitrage the difference between the merger price and any (expected) higher appraisal award.

Amendments to the Delaware Appraisal Statute

Section 262 of the Delaware General Corporation Law (DGCL) confers appraisal rights upon a stockholder of record who (i) holds shares on the date an appraisal demand is made, (ii) continuously holds the shares through the effective date of the merger, (iii) submits a demand for appraisal meeting the requirements of the statute and (iv) has not voted in favor of the merger nor consented to the merger in writing. The Delaware House of Representatives already has, and the Senate soon will, approve amendments to the appraisal statute that would restrict a hedge fund’s ability to use appraisal for interest rate arbitrage.

The first amendment would eliminate de minimis appraisal cases by limiting the availability of appraisal to cases where a significant dollar amount is at stake. Specifically, it would provide that if the shares eligible for appraisal were listed, pre-merger, on a national securities exchange, the Court of Chancery shall dismiss the appraisal proceeding unless (i) the total number of shares entitled to appraisal exceeds 1% of the outstanding shares of the class or series eligible for appraisal, (ii) the value of the consideration provided in the merger for such total number of shares entitled to appraisal exceeds $1 million or (iii) the merger was approved pursuant to DGCL §253 or §267.

The second amendment would limit the post-merger surviving corporation’s exposure to liability for pre-judgment interest by enabling the corporation to voluntarily prepay, to each stockholder seeking appraisal, a cash amount up to the merger price. In that event, interest will cease to accrue upon the amount, and from the time, of the prepayment. This ability to reduce that exposure is significant because, over the past several years, the historically low interest rates have encouraged the filing of appraisals to arbitrage the interest rate differential, separate and apart from the prospect of achieving a litigated capital gain. Under the current appraisal statute, pre-judgment interest runs “from the effective date of the merger through the date of payment of the judgment…compounded quarterly and accru[ing] at 5% over the Federal Reserve discount rate (including any surcharge) as established from time to time during the period between the effective date of the merger and the date of payment of the judgment.” As a result, in past years the interest accrued on litigated appraisal awards has constituted a significant portion of the overall final judgment. Permitting voluntary prepayment will reduce the financial incentives for hedge funds to use appraisal for interest rate arbitrage.

The Dell Inc. Appraisal Decision Relating to Share Tracing

The second recent development may have the effect of reducing the total number of appraisal arbitrage cases altogether, whether filed for interest and/or capital gain arbitrage reasons. In early May 2016, the Court of Chancery decided In re Appraisal of Dell Inc., C.A. No. 9322-VCL (Del. Ch. May 11, 2016). The Court held that fourteen mutual funds sponsored by T. Rowe Price & Associates, or institutions that relied on T. Rowe to direct the voting of their Dell Inc. shares (the T. Rowe Petitioners), were not statutorily entitled to seek appraisal arising out of the 2013 merger of Dell Inc. into a buyout group comprising affiliates of Michael Dell and Silver Lake Management LLC. All told, over 31.8 million shares beneficially owned by the T. Rowe Petitioners, but held of record by Cede & Co., were statutorily disqualified, because those shares had mistakenly been voted in favor of the merger­ unbeknownst to the T. Rowe Petitioners and contrary to their actual voting instructions.

What is startling about this result is that prior Delaware case law, specifically, In re Appraisal of Transkaryotic Therapies, Inc. (Del. Ch. May 2, 2007) and its progeny, would have dictated a different outcome. Transkaryotic was an appraisal arbitrage case where a hedge fund purchased shares of the to-be-acquired company after the record date in order to seek appraisal for those shares. The surviving corporation moved to dismiss the appraisal claim on the grounds that the hedge fund could not trace its acquired shares to the record owner (Cede & Co.) or prove that those shares were not voted in favor of the merger, as required by the statute. The parties agreed that it was impossible for either side—the investors or the surviving corporation—to show how Cede actually voted those particular shares. The Court declined to impose a share-tracing requirement because doing so would effectively preclude any stockholder that held through Cede from seeking appraisal. Instead the Court held that in those circumstances, it would suffice if the appraisal petitioners can show that the aggregate number of shares held by Cede that were not voted in favor of the merger exceeded the aggregate number of shares for which appraisal was sought. Because those criteria were satisfied in that case, the Transkaryotic Court allowed the appraisal to proceed.

Eight years after Transkaryotic, two Court of Chancery decisions adopted that same approach. (Merion Capital LP v. BMC Software, Inc. (Jan. 5, 2015) and In re Appraisal of Ancestry.com, Inc. (Jan. 5, 2015). That led to an apparent consensus within the corporate law community that it was now settled law that, where the number of shares held by the record holder (Cede) and not voted for the merger exceeds the number of shares for which appraisal is sought, the shares held by an appraisal claimant who held through (and whose stock was voted by) Cede are presumed not to have been voted in favor of the merger.

To the extent there was such a consensus, it was not shared by Dell Inc. and its attorneys, who had developed specific evidence that the shares traceable to the T. Rowe Petitioners had, in fact, been voted in favor of the merger. In these circumstances (Dell Inc. argued), the Transkaryotic “no share-tracing” rule did not apply and, as a result, the T. Rowe Petitioners’ shares were statutorily disqualified from seeking appraisal. Vice Chancellor Laster credited that argument and distinguished Transkaryotic and its progeny. His analysis in the Dell Inc. opinion has important implications for the M&A bar.

The Facts

The pivotal fact that drove both the analysis and the result in the Dell Inc. appraisal decision was that there was specific reliable evidence that Cede had, in fact, voted the specific shares that were traceable to the T. Rowe Petitioners in favor of the merger. More broadly, the case demonstrated that there is a reliable pathway that enables appraisal petitioners and the surviving corporation to determine, at an early stage, how the omnibus record owner (Cede) voted the specific shares for which appraisal is being sought.

First, the shares beneficially owned by the T. Rowe Petitioners were held by State Street Bank & Trust Company as custodian. For Delaware law purposes, the record holder was Depository Trust Company, which held the shares in the name of its nominee, Cede & Co., which thereby had the legal right to vote the shares and demand appraisal. However, through a daisy chain of authorizations, voting authority for the T. Rowe Petitioners’ shares ultimately came to rest with Broadridge Financial Solutions, Inc. The T. Rowe Petitioners opposed the merger but, due to a computer system glitch, Broadridge received faulty instructions and submitted proxies voting the T. Rowe Petitioners’ shares in favor of the merger. The result was to disqualify all those shares from seeking appraisal.

Second, contrary to the evidentiary vacuum that existed in the Transkaryotic line of appraisal arbitrage cases, in this case Dell Inc. was able to trace the specific shares owned by the T. Rowe Petitioners and determine how they were voted. By using Broadridge internal control numbers that corresponded to the T. Rowe Petitioners’ accounts and related ballot control numbers for each position, Dell Inc. was able to determine that all of the positions in question had been voted for the merger. Based on this factual record, the Court found that “Dell has proven by a preponderance of the evidence that the T. Rowe Petitioners’ shares were voted “FOR” the Merger.”

Prior Case Law

This quite different factual record required the Court to decide whether Transkaryotic was still sound Delaware law in a case involving specific proof that the contested shares had been voted in favor of the merger. After re-examining the relevant case law starting from the 1960’s, the Court concluded that the prior cases, fairly read, did require an appraisal petitioner to prove that its specific shares seeking appraisal had not been voted in favor of the merger. Against that landscape, Transkaryotic and its progeny were outliers which the Court found distinguishable, because all parties in those cases agreed that it was impossible to prove how the specific Cede-held shares had been voted. In Dell Inc., however, that showing could be-and was-made. In the Court’s words:

The evidence showing how Cede voted particular blocks of shares provides a basis for distinguishing the Appraisal Arbitrage Decisions. Under those opinions, an appraisal petitioner that held in street name can establish a prima facie case that the…requirement [to prove that the shares were not voted for the merger] was met by showing that there were sufficient shares at Cede that were not voted in favor of the merger to cover the appraisal class…If there is no other evidence, then as in the Appraisal Arbitrage Decisions, the prima facie showing is dispositive.

The analysis, however, need not stop there. Once the appraisal petitioner has made out a prima facie case, the burden shifts to the corporation to show that Cede actually voted the shares for which the petitioner seeks appraisal in favor of the merger. The corporation can do this by pointing to documents that are publicly available, such as a Form N-PX. Or the corporation can introduce evidence from Broadridge, ISS, and other providers of voting services, such as internal control numbers and voting authentication records. If [that] evidence is not sufficient to demonstrate that Cede actually voted the shares for which the petitioner seeks appraisal in favor of the merger, then the petitioner can continue to maintain the appraisal action. But if the corporation demonstrates that Cede actually voted the shares for which the petitioner seeks appraisal in favor of the merger, then…the petitioner cannot…seek appraisal for those shares.

The Implications

Hedge funds contemplating a purchase of a block of stock in a to-be-acquired company will now face the risk that the post-merger surviving corporation will be able to ascertain whether, in fact, the purchased shares seeking appraisal were voted in favor of the merger and rebut any such presumption. Accordingly, the risk of purchasing shares without knowing in advance whether appraisal will be available for those shares may discourage that appraisal arbitrage strategy.

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