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E-MailBrian Broughman is Professor of Law at Indiana University. This post relates to an Amicus Brief submitted by Law and Finance Professors, led by Professor Broughman, in the case of Verition Partners v. Aruba Networks, available here. This post is part of the Delaware law series; links to other posts in the series are available here.
In Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., the Delaware Court of Chancery appraised the “fair value” of Aruba’s shares as their average market price during the 30 days prior to the announcement of Aruba’s merger with HP. The Court’s fair-value determination was not only 31% below the merger price, but also below the fair-value estimate of defendant’s own expert. Aruba appears to be the first Delaware decision to “hold that the unaffected market price was the best evidence of fair value and award that figure.” Not surprisingly, the decision attracted considerable attention (including here, here, here, here, and here on this blog). The case is now on appeal before the Delaware Supreme Court.
We filed an amicus brief in connection with the appeal. The brief makes two simple points. First, even if a target’s stock traded in an efficient market, its pre-announcement market price will often be an unreliable measure of fair value at the close of the merger. Second, the available evidence suggests that Delaware stockholders have benefitted from the protection provided by fair-value appraisal, and consequently could be hurt if Aruba’s approach is sustained and appraisal valuations collapse down to unaffected market price.
Use of the Efficient Market Hypothesis in Appraisal
While there remains academic disagreement on market efficiency, the amicus brief assumes—for the sake of argument—that Aruba’s stock traded in a semi-strong form efficient market. Even conceding this point, in the M&A setting the pre-announcement market price is often an unreliable measure of fair value.
First, market prices only reflect information that is publicly available at the time. In M&A deals, however, target firms routinely share nonpublic information with the bidder under confidentiality agreements. In the Aruba-HP deal, for example, HP knew that Aruba was about to report stronger than expected quarterly results. The deal was negotiated and priced while such information remained non-public. Moreover, existence of a potential merger was strategically leaked to the public prior to the disclosure of Aruba’s quarterly results, making it impossible to infer much from the pre-announcement stock price. This setting is not unique to Aruba-HP, as there are often strategic reasons for keeping information—especially positive information—private until after a merger is announced.
Second, the pre-announcement trading price does not account for information that is revealed or events that take place between the announcement date and the closing date—the valuation date required by the appraisal statute. Events that occur in the weeks or months between announcement and closing, whether they are macroeconomic developments, industry-specific developments, or firm-specific events, will necessarily not be reflected in the pre-announcement trading price.
Third, market prices reflect the value that a marginal investor assigns to the cash-flow rights associated with a single share of stock. By contrast, Delaware law requires courts to value the target firm as a going concern, and then assign each dissenter its pro-rata interest. Because the market price is discounted to reflect a lack of control, multiplying the number of shares outstanding by the market price will typically yield a low valuation for the target firm as a whole.
Empirical Studies Related to Appraisal
The amicus brief also summarizes some recent empirical studies related to appraisal. Some commentators have expressed concern that appraisal litigation may be frivolous, or worse that it may cause lower upfront acquisition prices as bidders keep dry powder in reserve to pay dissenting stockholder post-closing.
Current research, however, suggests that such concerns are misplaced. For example, multiple studies find that transactions where there is more reason to doubt the adequacy of the price—either because of conflicts of interest or because the target received an abnormally small premium relative to a matched control group—are more likely to receive an appraisal challenge.
Moreover, there is no evidence that threat of appraisal causes bidders to offer a lower upfront price. Two recent studies—Callahan, Palia, & Talley (2018) (hereafter CPT) and Boone, Broughman, and Macias (2018) (hereafter BBM)—investigate this claim, exploring the impact of changes in the appraisal remedy on ex ante deal terms. Using different time periods and a different sample of deals, both studies, nonetheless, find that events which increase the strength of the appraisal remedy are associated with a statistically significant increase in deal premia and abnormal returns for target shareholders in subsequent acquisitions. These findings suggest that a robust appraisal regime provides a credible “reserve price” below which a sale cannot occur, and that shareholders benefit from this protection. As noted by CPT, “target-company shareholders likely benefited ex ante from liberalized appraisal, regardless of whether they subsequently sought appraisal or not.”
Finally, BBM explore the impact on governance terms and on deal process:
our analysis suggests that bidders protect themselves against threat of appraisal, not through contractual terms that would allow the bidder to walk away from the deal (e.g. appraisal out clause), but rather by increasing their upfront bid and improving the price-setting process (e.g. formal auctions).
This emphasizes that appraisal can have desirable ex ante effects on how acquisitions are negotiated and ultimately allows target firms to obtain a better price. Taken together, this evidence suggests that Delaware stockholders may be harmed if Aruba’s approach to estimating fair value using unaffected market price becomes widely adopted.
A full copy of the Amicus brief is available for download here.
