Asking the Right Question: The Statutory Right of Appraisal and Efficient Markets

Jonathan R. Macey is the Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale University and Joshua Mitts is Associate Professor of Law at Columbia Law School. This post is based on a recent paper by Professor Macey and Professor Mitts. Related research from the Program on Corporate Governance includes Using the Deal Price for Determining “Fair Value” in Appraisal Proceedings (discussed on the Forum here) and Appraisal After Dell, both by Guhan Subramanian.

Appraisal proceedings drag financial economics from the classroom into the courtroom. In Delaware, by statute, shareholders are “entitled to an appraisal by the Court of Chancery of the fair value” of their shares. Del. Code. Ann. tit. 8, § 262 (a) (2018). In that proceeding, courts are required to take into account “all relevant factors.” Id. § 262 (h) (2018); Golden Telecom, Inc. v. Glob. GT LP, 11 A.3d 214 (Del. 2010). By law, courts will look at “accepted financial principles relevant to determining the value of corporations and their stock” when engaged in the exercise of determining fair value. DFC Glob. Corp. v. Muirfield Value Partners, L.P., 172 A.3d 346, 349 (Del. 2017). Under this standard, sometimes a single market valuation metric such as the deal price or the pre-bid market price will provide the most reliable evidence of fair value. In such cases, “giving weight to another factor will do nothing but distort that best estimate. In other cases, ‘it may be necessary to consider two or more factors.’” Blueblade Capital Opportunities LLC v. Norcraft Companies, Inc., 2018 WL 3602940, at *2 (Del. Ch. July 27, 2018).

Our paper, available for download on SSRN, considers the proper role of the Efficient Capital Markets Hypothesis (ECMH) in Delaware appraisal litigation. Recently courts in Delaware explicitly have embraced the Efficient Capital Markets Hypothesis and correctly have observed that it is superior to discounted cash flow (DCF) analysis as a means for determining fair value in appraisal proceedings. We make three contributions to the literature.

First, we describe the ECMH and explain the relationship between markets that are efficient in an information sense and markets that are fundamentally efficient. Observing that informational efficiency and fundamental efficiency are not the same thing, we acknowledge that the share price of a company’s stock, even when informationally efficient, occasionally may diverge from the stock’s fundamentally efficient price. We point out that this occurs infrequently. Specifically, it occurs only when there is material nonpublic information that is not impounded in a company’s share prices. In such cases, courts should still utilize share price when determining fair value in appraisal proceedings, but adjust the share price up or down to reflect any material nonpublic information that is later revealed.

Second, we consider recent challenges to the ECMH and observe that, notwithstanding certain theoretical shortcomings in the hypothesis, Delaware Courts are correct in affording primacy to the ECMH in valuation cases. In particular, we note that, whatever its shortcomings, methodologies embracing the ECMH are vastly superior to alternative, subjective valuation methodologies such as discounted cash flow analysis. Here we confront the argument that the use of share prices in valuation proceedings should be confined to transactions that involve arm-length bargaining between the acquirer and the target, and are not tainted by conflicts of interest.

For example, in a recent appraisal case, the Delaware Court of Chancery declined to use the merger price or any other market price in determining the fair value of the target corporation on the grounds that “significant flaws in the process leading to the Merger … undermine the reliability of the Merger Price as an indicator of [the] fair value” of the target company. Norcraft at *2. We point out that, while the deal price of a company’s securities might be tainted by flaws in the process leading to a merger, any such flaws in the deal price do not affect the unaffected, pre-bid market price of the target firm’s shares. As such, market prices still should be utilized as a basis for valuation even in cases in which the deal process is flawed.

Further, we observe that, even when the deal process is flawed, the deal price provides useful information that should not be ignored because it is well-recognized that all of the alternative valuation methodologies also are flawed. As such, failure to take the deal price into account succumbs to what economists have described as the “Nirvana fallacy.” The Nirvana fallacy shows that policymakers should not reject a particular policy option merely on the grounds that the policy option is flawed, or that it compares unfavorably to some unarticulated, idealized real-world alternative. Put in its most simple terms, those who succumb to the Nirvana fallacy believe that the grass is always greener on the other side.

In the context of appraisal rights, the Nirvana fallacy manifests itself in the assumption that an alternative valuation method such as a discounted cash flow analysis is always superior to the deal price in a merger transaction in which the deal process is flawed. This is incorrect. Even here the process through which a deal price is determined was flawed, the deal price may provide the best information about the value of a company’s shares where the alternative valuation methodologies are even more flawed.

Similarly, we take issue with the principle espoused in Delaware appraisal cases that the stock price of the target company should be completely ignored in appraisal proceedings where the target company’s shares trade in an inefficient market. This reasoning also succumbs to the Nirvana fallacy. Even if the target’s stock price is not fully efficient in the semi-strong sense, it may yield information that is of use to a court because it contains valuable, unbiased information about value. This is particularly true in light of the flaws of alternative valuation methods.

In the third section of this Article, we compare two market prices for a company’s shares: the deal price and the unaffected, pre-bid market price. We show that the unaffected, pre-bid market price is the superior benchmark for determining value, but that the deal price can be an appropriate reference point where the market price varies from the fundamental value of the company due to material, nonpublic information being impounded in the share price.

Finally, we observe that until now it has not been possible to utilize market prices of any kind unless the shares of the target company trade in an efficient market. We further contribute to the literature on appraisal by showing that, regardless of whether the target company’s shares trade in an efficient market, where the acquirer is a public company whose shares traded in an efficient market it often will be possible to use market prices to determine whether fair value has been paid for the target by looking at the way that the share price of the acquirer firm reacts to the announcement of the bid. In particular, if the value of the acquirer declines when a deal is announced, then the bidder may have overpaid, suggesting that target company shareholders received more than fair value for their shares. In contrast, where the value of the bidder goes up by a statistically significant amount, after making the appropriate adjustments to account for synergies and agency-cost reduction, the bidder may have underpaid, and courts should be concerned that the target company’s shares were underpriced.

The complete paper is available here.

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