Finding the Right Balance in Appraisal Litigation: Deal Price, Deal Process, and Synergies

Lawrence A. Hamermesh is Executive Director of the University of Pennsylvania Law School Institute for Law and Economics and Professor Emeritus at Widener University Delaware Law School. Michael L. Wachter is the William B. and Mary Barb Johnson Professor of Law and Economics at the University of Pennsylvania Law School, and is Co-Director of its Institute for Law and Economics. 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.

This paper examines the evolution of Delaware appraisal litigation and concludes that recent precedents have created a satisfactory framework in which the remedy is most effective in the case of transactions where there is the greatest reason to question the efficacy of the market for corporate control, and vice versa. The article suggests that, in effect, the developing framework (including the December 14, 2017 Delaware Supreme Court opinion in the Dell appraisal case, which was issued after the current draft of the article was completed) invites the courts to accept the deal price as the proper measure of fair value, not because of any presumption that would operate in the absence of proof, but where the proponent of the transaction affirmatively demonstrates that the transaction would survive judicial review under the enhanced scrutiny standard applicable to fiduciary duty-based challenges to sales of corporate control. The article also suggests, however, that the courts and expert witnesses should and are likely to refine the manner in which elements of value (synergies) should, as a matter of well established law, be deducted from the deal price to arrive at an appropriate estimate of fair value.

Facilitated largely by “appraisal arbitrage”—the practice of purchasing shares of stock after announcement of a merger, with a view to exercising the statutory right to an award of “fair value” in lieu of the merger price—the once-discredited appraisal remedy has become a significant phenomenon in shareholder litigation. That development has generated competing claims that appraisal arbitrage should be prohibited because it unduly deters bids, or should be encouraged as an incentive to bidders to pay fair value. Increased use of the appraisal remedy has also engendered a parallel debate about the role of the merger price in determining fair value: one school of thought posits that the merger price (or deal price) should presumptively be taken to reflect fair value; the opposing school holds that such a “market price rule” harms target company stockholders and should be rejected.

The article submits that the divergence between the competing perspectives about use of the deal price to measure fair value is overstated, and that the Delaware courts are developing a middle ground point of view with respect to these parallel debates. On one hand, the courts have continued to affirm that the practice of appraisal arbitrage is legally permissible under the governing statutory framework, and the Delaware legislature has done nothing to undermine that view. The article suggests that this state of affairs is justified by evidence that appraisal litigation targets conflict transactions and transactions with relatively low premiums, and that appraisal arbitrage confers at least some benefits on stockholders who sell when appraisal arbitrageurs are acquiring stock. On the other hand, the courts’ increasing reliance on the deal price to measure fair value has undoubtedly circumscribed the incentive to engage in appraisal arbitrage, at least in cases in which such reliance is most likely to occur.

The authors support this emerging middle ground point of view, and suggest two significant refinements that would clarify the operation of the appraisal remedy. First, they suggest that the Delaware courts’ treatment of the use of the deal price to determine fair value does and should mirror the treatment of shareholder class action fiduciary duty litigation. In the case of a sale of corporate control, in which the Delaware statute affords appraisal rights, the governing standard of judicial review as described by the Delaware Supreme Court in Paramount v. QVC requires “enhanced scrutiny” to determine the reasonableness of the sale process. That same form of judicial review could usefully be applied to determine when the deal price should be used to measure fair value: where the proponents of the deal satisfy that form of review, such use of the deal price is appropriate; and where they don’t, it’s not (although where the proponent of the transaction fails to establish the reasonableness of the sale process, it may still be appropriate for the court to take the deal price into account in some manner, such as a corroborative check on the results of other valuation techniques.)

Second, the authors further suggest that reliance on the deal price, without further inquiry, inappropriately creates a no-lose proposition for appraisal arbitrage. It also fails to give effect to well-settled judicial interpretation of the appraisal statute, under which elements of value reflected in the deal price must be deducted to arrive at fair value if they involve value (synergies) that can be achieved only as a result of the merger. Case law and finance literature are sparse, however, in their treatment and quantification of an appropriate deduction for synergies, and we suggest that law and finance practitioners and the Delaware courts are likely to devote increased attention to these matters, as deal price comes to play a more regular role in the establishment of fair value. The article discusses how synergies should be identified for purposes of any deduction from the deal price, and suggests that a form of discounted cash flow model for estimating total merger synergies is likely to provide an important tool in appraisal litigation. Finally, the article encourages further examination of the important question of how to estimate how synergies are allocated between acquirers and target stockholders.

The complete paper is available for download here.

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