Appraising the “Merger Price” Appraisal Rule

Albert Choi is the Albert C. BeVier Research Professor of Law at the University of Virginia Law School; Eric Talley is the Isidor and Seville Sulzbacher Professor of Law at Columbia Law School. This post is based on their recent paper and is part of the Delaware law series; links to other posts in the series are available here.

In a new working paper, we consider the question of how best to measure “fair value” in a post-merger appraisal proceeding. Our inquiry spotlights an approach recently embraced by Delaware courts, which pegs fair value at the merger price itself (at least in certain situations). Using an economic framework that combines auction design, agency costs and shareholder voting, we assess how this “Merger Price” (MP) rule stacks up against alternative approaches (such as DCF) that are not benchmarked against the merger price.

Our analysis shows that as a general matter, the MP rule tends to depress both acquisition prices and target shareholders’ expected welfare relative to both an optimal appraisal rule and several other plausible alternatives. In fact, we demonstrate that the MP rule is strategically equivalent to nullifying the appraisal right altogether. Although the MP rule may be warranted in certain circumstances, our analysis suggests that such conditions are unlikely to be widespread, and—consequently—the rule should be employed with caution. Our framework also helps explain why a majority of litigated appraisal cases using conventional fair-value measures result in valuation assessments exceeding the deal price—an equilibrium phenomenon that stems from rational, strategic behavior (and not from an institutional deficiency, as some commentators have suggested). Finally, our analysis illuminates the strategic and efficiency implications of a variety of appraisal-related related phenomena, such as Delaware’s new “medium-form” merger statute, blow provisions, drag-alongs, and “naked no-vote” fees.

In mergers and acquisitions law, the appraisal right affords target-company shareholders an option of eschewing the terms of an acquisition in favor of receiving a judicially determined cash valuation for their shares. All states provide this statutory option in some form or another for many—but not all—transactions. In eligible cases, appraisal gives dissenting shareholders a potentially powerful tool to counter deal terms that they believe to be inadequate or under-compensatory. Although public company targets have historically faced appraisal actions only rarely, the procedure has grown significantly more popular and prevalent in recent years, driven substantially by sophisticated investors and hedge funds.

Appraisal proceedings are far less popular, by contrast, among judges who preside over them. Courts in appraisal cases face the vexing challenge of distilling mountains of financial and technical data into a single, equitable determination of “fair value.” The judge usually cannot dodge this responsibility on procedural grounds, cannot hand the job off to a jury, and cannot take refuge in traditional jurisprudential heuristics—such as evidentiary burdens of proof. Rather, the typical appraisal proceeding allocates no explicit burden of proof and requires the court to deliver a single number at the end of the process. Testimony in such proceedings adds little comfort, dominated by prolix technical reports from litigant-retained experts whose valuation opinions can diverge by as much as an order of magnitude. Especially for judges who are unfamiliar with the minutiae of asset pricing, fair valuation can be a formidable beast to wrangle.

In a series of recent appraisal cases, [1] the Delaware Chancery Court has deployed a jurisprudential verónica of sorts—summoning a doctrine that sidesteps this valuation challenge substantially (if not altogether). Specifically, the Court has proven increasingly willing to use the merger price itself as evidence (and sometimes the decisive piece of evidence) of fair value. To date, the “Merger Price” (MP) rule has not been utilized categorically, but instead seems confined largely to settings where the transaction “resulted from a competitive and fair auction, which followed a more-than-adequate sales process and involved broad dissemination of confidential information to a large number of prospective buyers.” Nevertheless, even in deals that engage a single bidder in bilateral negotiations, courts increasingly accord the merger price “substantial evidentiary weight” when the transaction “resulted from an arm’s-length process between two independent parties, and…no structural impediments existed that might materially distort—the crucible of objective market reality.” In fact, several advocates (and at least some academic commentators) have sought to impel the MP rule further in this direction, arguing that courts should defer “entirely” to the merger price when it is the product of a reasonable and disinterested process.

The concept underlying the MP rule is easy enough to articulate: it posits that “The Market” delivers the best indication of fair value, so long as the deal price is a product of reasonable arm’s-length negotiations. Put differently, the MP rule grows out of the (seemingly intuitive) economic intuition that a fully shopped deal provides adequate pricing protection to target shareholders, and that in such cases market price is a better bellwether of value than a judge’s often arbitrary, error-prone, and inaccurate accounting.

Sounds simple, right?

Not so fast. Our working paper demonstrates that the intuition underlying the MP rule—while sound in certain respects—is less general and more fragile than it first appears. Specifically, we show that the rule is defensible on economic grounds only in relatively narrow set of circumstances that can be demanding, in practice, to meet; and in any event, such circumstances are difficult to diagnose without the court going much of the way to value the firm using more conventional measures. Consequently, if the primary benefit of the MP approach is judicial cost savings, the approach may frequently be self-defeating.

Our argument begins by highlighting a critical flaw in the economic logic that purports to undergird the MP rule: the presumption that “The Market” operates separately and independently from the underlying legal environment. On first principles alone, this presumption is generally false; market outcomes and laws governing markets are fundamentally intertwined. Markets—and particularly robust markets—reflect participants’ expectations about the future, related to earnings, costs, new business opportunities, and the like. But healthy markets also reflect participants’ expectations about the very legal environment in which markets operate. Change that legal environment, and expectations will change; change expectations, and market prices soon follow. It is a fundamental economic misconception, therefore, to presume that a market price—even one produced by a seemingly robust market—is an autonomous oracle of worth, untethered to expectations related to (and affected by) law.

While the interdependency of market price and legal environment is known to implicate many fields of practice, it carries particular bite in the appraisal context: for a court’s approach to assessing fair value in appraisal affects not only what dissenting shareholders receive ex post, but also how the merger is priced and approved (or not) ex ante. Indeed, the outside option of seeking post-merger appraisal alters shareholders’ receptivity to an announced deal, effectively committing them to a “reserve price” of sorts for the sale, at an amount tied to the anticipated appraisal remedy. Under plausible conditions, this de facto reserve price can protect shareholders’ interests better than either a shareholder approval requirement, or reliance on management’s incentives to design a profit maximizing auction. Sophisticated buyers, moreover, anticipate this effect, and may well modify their bids in response, adjusting them upward to meet (or get close to) the appraisal reserve price, secure shareholder approval, and preempt widespread appraisal litigation. To the extent that appraisal value is pegged against independent factors (and not the merger price), a plausibly designed appraisal remedy can enhance value for all shareholders—even those who do not seek appraisal.

Under the MP rule, by contrast, this reserve-price effect collapses under its own weight. Indeed, the MP rule dictates that the value of shareholders’ appraisal right floats up and down mechanically with the winning bid, regardless of the bid’s evident adequacy under objective measures. Opting for appraisal, therefore, can never yield a dissenter any upside over the terms of the merger (and may introduce a downside in the form of legal costs). Consequently, prospective buyers need not fear that the winning bid will prove inadequate relative to the outside option of appraisal: for the winning bid is the outside option. Put simply, the MP rule functionally nullifies the appraisal right, and whatever value enhancing implications the reserve-price effect portends. So long as there exists some plausible alternative appraisal remedy that enhances shareholders’ welfare ex ante—even if modestly—the MP rule cannot be optimal.

To demonstrate our claims, we analyze a canonical auction framework from game theory, involving a group of arm’s-length buyers who may bid on a target firm. Our framework incorporates several features that are specific to the corporate acquisition process, including agency costs associated with the deal team’s auction-design incentives, a shareholder voting requirement to close a signed deal, and a post-transaction appraisal remedy for dissenters. Using this framework, we compare equilibria under what we call “conventional” appraisal valuation approaches (where information unrelated to the winning bid is used to benchmark fair value) [2] to the MP rule (where appraisal value is pegged at the winning bid). Holding the number of bidders fixed, we show that the MP rule never generates a higher price than plausible conventional approaches, and more typically leads to a strictly lower price. Our results, moreover, extend beyond mere price, holding implications for expected shareholder welfare too: whenever any plausible conventional approach to valuation enhances ex ante shareholder value relative to no appraisal rights, the MP approach must necessarily be inferior. Although we identify some circumstances where the MP rule could conceivably be one of several optimal alternatives, these conditions appear difficult to satisfy in practice. Our analysis therefore counsels that the MP rule should be deployed—if at all—with caution.

Beyond this core contribution, our inquiry sheds light on a variety of debates among commentators and academics related to appraisal. Most notably, our model predicts that under a conventional appraisal rule, shareholders will—in equilibrium—seek appraisal only rarely, and typically only for mergers that offer relatively meager premiums. Moreover, in those instances where appraisal is sought, fair-value assessments will tend overwhelmingly to be skewed well above the deal price. Each of these predictions appears to have solid empirical support. Nevertheless, proponents of the MP rule frequently point to the upwards skew of appraisal awards over deal price as evidence of dysfunction in the process. Our analysis parts company with that conclusion: the upward skew we predict is nothing more than an artifact of rational, strategic decision making. When target shareholders expect the appraisal valuation to be lower than the merger consideration, they will simply decline to seek appraisal (even if they oppose the acquisition). We would therefore expect to see a qualitatively similar upward skew on appraisal awards regardless of whether the fair-value measure was set too high, too low, or just right by objective measures.

Our framework additionally illuminates the strategic and efficiency implications of several institutional devices that go beyond the MP rule, but which fundamentally bear on appraisal. For example, a popular deal structure for public-company targets in Delaware—and one where appraisal is usually available—involves a two-step acquisition that begins with a negotiated tender offer, followed immediately by an involuntary “squeeze out” merger of non-tendering shareholders at the same price. Historically, the second-step squeeze out functionally required at least 90-percent of target’s shareholders to have tendered in the first stage. In 2013, however, Delaware amended its statutes to allow an alternative form of two-step merger, wherein the first step need only secure a bare 50-percent threshold before the squeeze out can commence. A central result of our analysis is that the MP rule can be optimal when the merger is conditioned on a strong super-majority approval of shareholders. This insight suggests that courts might similarly condition their valuation approach on the shareholder mandate sought. Traditional two-step, short-form deals requiring 90-percent support might receive the MP rule, while “medium-form” deals requiring a mere 50-percent might fall under more conventional approaches (such as DCF).

Moreover, our analysis facilitates the evaluation of several appraisal-related contractual provisions. For example, “drag-along” terms oblige shareholders to vote in favor of a merger when a sufficient fraction of shareholders favors the acquisition. “Naked no vote” terms require the target to pay a termination fee to the buyer should the deal be vetoed by shareholders. “Blow” provisions condition the buyer’s duty to close a merger on a maximal threshold of shareholders seeking appraisal (frequently in the 10-20 percent range). Our analysis suggests that drag-alongs and naked no-vote provisions tend to dampen deal prices and target shareholder welfare, negating many of the beneficial attributes of appraisal. Blow provisions, in contrast, have more complex effects: Although a blow clearly rations appraisal’s benefits to a select few target shareholders, it simultaneously establishes an implicit supermajority condition for the deal’s consummation. As noted above, such supermajority conditions can often accomplish the same purpose as an optimal appraisal rule, pushing merger prices and shareholder welfare upwards. (In fact, the MP rule might even be optimal in the presence of an effective blow.)

There are several important caveats to our core argument that warrant explicit mention. First, although the price- and welfare-dampening attributes of the MP rule hold for auctions of any size, the quantitative magnitudes of these effects attenuate as the number of bidders grows. That is, the MP rule visits progressively smaller discounts on target share value as the bidder population expands. Consequently, when the number of bidders is endogenous to the seller’s efforts to shop the deal, the appraisal rule can represent a compelling incentive device. For example, if the MP rule were available only after large and robust auctions, the seller’s deal team may have a much stronger incentive to design an effective auction process. In such settings, shareholder welfare may well be higher when (a) numerous bidders participate but the MP rule nullifies appraisal rights, than when (b) relatively fewer bidders bid in the shadow of a bona fide appraisal right. Thus, were the MP rule strictly limited to “many-bidder” settings, its downside would be relatively modest (and its upside intriguing).

Second, as noted above, a standard knock against conventional valuation measures (such as DCF) is that they are prone to measurement error when utilized by judges who are not financial experts. Our analysis allows for this possibility. In fact, virtually all our arguments remain intact even when appraisal proceedings are subject to potentially severe judicial inaccuracy, so long as courts remain unbiased overall—that is, if the distribution of appraisal valuations remains stable and roughly predictable (even if subject to uncertainty in each individual case). The reason is simple: Much of the reserve-price benefit of appraisal inures to shareholders by enhancing buyers’ willingness to pay higher premiums ex ante, so as to win affirmative votes and avoid appraisal. In the presence of judicial error, both the buyer’s and the prospective dissenters’ calculi change, replacing a predictable appraisal value with its expected value. But so long as error-prone courts remain unbiased overall, the substitution of expected values will have only marginal effects, and bidding and dissenting behaviors will remain largely unchanged. [3]

Finally, our paper focuses on an economic analysis of appraisal, assessing how different valuation approaches fare in enhancing target shareholder welfare (or in some cases, social efficiency). For this approach to have practical traction, it must also presuppose both (a) that economic considerations “matter” for appraisal jurisprudence, and (b) that the judicial outcome is not over-determined by other factors (such as statutory inflexibility, rigid precedent, or historical path dependence). As to the former presupposition, no one today seriously challenges the utility of economic considerations in clarifying unsettled issues of corporate law (even if disagreement remains about what other considerations deserve equal billing). Indeed, many commentators argue that appraisal law in particular should embrace the tenets of financial economics as a central normative commitment. As to the second presupposition, it seems unlikely that non-economic factors pre-ordain the outcome of most modern appraisal cases. Although appraisal statutes certainly contain some hard-and-fast imperatives, they are conspicuous both in what they leave unattended (e.g., how to compute fair value) and in their famously tortured linguistic indeterminacy. [4] The common-law interpretations that have sprung up around appraisal rights, moreover, appear analogously pliant. In the last half century alone, courts have invented (and then reinvented) major components of appraisal time and again, seemingly undaunted by inelastic precedent or statutory compulsion. These dalliances include—inter alia—articulating what set of approaches are permissible for fair valuation, what do and do not constitute deal synergies in an appraisal, whether to adjust fair value for implicit minority discounts, whether mixed cash and stock deals trigger appraisal rights, whether beneficial owners purchasing after the record date are eligible to seek appraisal, and whether such late-purchasing owners must demonstrate that their specific shares were not voted in favor of the merger. Even the underlying policy rationale for appraisal appears to be a contingent product of uncertain provenance and peripatetic evolution—one that appears to be unfolding even still. [5]

If the recent upsurge in appraisal actions represents a transformation of doctrine that invites us collectively to re-imagine its normative commitments (as several commentators now assert), then bona fide economic considerations deserve to be present in the room where it happens.

The full paper is available for download here.

Endnotes

1See, e.g., Merion Capital v. Lender Processing Services, C.A. No. 9320-VCL (Del. Ch. Dec. 16, 2016); Dunmire v. Farmers & Merchants Bancorp, C.A. No. 10589-CB (Del. Ch. 2016); Merion Capital v. BMC Software, C.A. No. 8900-VCG (2015); Huff Fund Inv. P’ship v. CKx, Inc., 2013 WL 5878807 (Del. Ch. Nov. 1, 2013); In re Appraisal of Ancestry.com, 2015 WL 399726 (Del. Ch. Jan. 30, 2015); LongPath Capital LLC v. Ramtron International Corp., C.A. No. 8094-VCP (Del. Ch. June 30, 2015); Merlin Partners LP v. AutoInfo Inc., C.A. No. 8509-VCN (Del. Ch. Apr. 30, 2015); The Union Illinois 1995 Investment Limited Partnership v. Union Financial Group, Ltd., 847 A.2d 340 (Del. Ch. 2004).(go back)

2Discounted Cash Flow (DCF) analysis is the predominant conventional approach today, but the class of conventional methods includes all other methods that are independent of Merger Price, such as comparable companies/transactions approaches, and even the old Delaware “block” method for valuation.(go back)

3Although the argument in the text presumes risk neutrality of the buyer and target shareholders, risk aversion can cause our results to grow even stronger. See our working paper for details.(go back)

4For instance, the “market-out” exception to appraisal—and the various exceptions to the exception—under DGCL § 262(b) are widely considered to be a poster child for philological nihilism. Accord Thompson, Robert B. “Exit, Liquidity, and Majority Rule: Appraisal’s Role in Corporate Law.” Georgetown L. J. 84:1-54, 30 (1995) (characterizing § 262(b) as embodying “the kind of double negative that should make any legislator’s grammar teacher cringe”).(go back)

5It is commonly asserted that appraisal statutes were originally intended as liquidity-preserving substitutes for shareholder veto rights upon the elimination of unanimity voting rules for acquisitions in the early 1900s. See, e.g., Thompson, supra, at 3-4 (1995). The “fit” between the timing of appraisal’s introduction and the elimination of unanimity mandates, however, casts significant doubt on that common narrative. See id. at 14-15. Moreover, the significant heterogeneity in statutes—both across jurisdictions and over time—appears inconsistent with a single, monolithic, consensus purpose. Levmore, Saul & Hideki Kanda, “The Appraisal Remedy and the Goals of Corporate Law.” UCLA Law Review 32:429-73, 431-2 (1985). Regardless of appraisal’s original intent, most believe that the liquidity preservation goal eventually faded, emancipating appraisal to be deployed for other (heterogeneous) aims. Thompson, for example, reports 11 years’ worth of appraisal action data (1984-1994) reflecting a large set of circumstances, ranging from close corporations (13.1%) to public-company minority freeze-outs (35.7%) to cash acquisitions of widely-held public targets (25.0%). Thompson, supra, at 27.(go back)

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