Will Aruba Finish Off Appraisal Arbitrage and End Windfalls for Deal Dissenters? We Hope So

William J. Carney is Charles Howard Candler Professor of Law Emeritus at Emory University School of Law and Keith Sharfman is Professor at St. John’s University School of Law. This post is based on their article, recently published in the Delaware Journal of Corporate Law.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.

The corporate law world has been abuzz of late about the commendable effort by Delaware’s courts to scale back “appraisal arbitrage”: a trading strategy predicated on deal dissenters receiving via appraisal litigation more for their shares than the deal prices from which they dissent. For years, parties engaging in appraisal arbitrage enjoyed the opportunity to initiate essentially risk free appraisal litigation with substantial upside potential, because it was assumed by courts and litigants that “fair value” entitled dissenters to at least the price of the deal they were rejecting and potentially more. But happily, this misunderstanding and misapplication of the law of appraisal now appears finally to have reached its end.

The Delaware Supreme Court struck two blows against appraisal arbitrage in 2017 in its DFC Global and Dell decisions, which both held that the Court of Chancery should not award fair value in excess of the deal price absent compelling evidence that the deal price is not a reliable indicator of fair value. Such evidence is inherently lacking when a sale is conducted at arms’ length, without conflicts, in a robust competitive process.

The Court of Chancery Court then struck yet a further blow in 2018 in its appraisal decision in Verition Partners Master Fund, Ltd. v. Aruba Networks, Inc., which awarded deal dissenters even *less* than the deal price. Relying on a previously underenforced provision of Delaware’s appraisal statute, Section 262(h), which excludes from fair value any value that is uniquely associated with the deal from which appraisal-seeking shareholders dissent, the Court of Chancery awarded to the dissenters as fair value only their shares’ public trading price prior to the deal’s announcement. This decision is now under appeal in the Delaware Supreme Court, which has scheduled oral argument for this coming March 27th.

We recently published an article in the Delaware Journal of Corporate Law taking note of these salutary developments in Delaware’s law of appraisal. William J. Carney & Keith Sharfman, The Death of Appraisal Arbitrage: Ending Windfalls for Deal Dissenters, 43 Del. J. Corp. L. 63 (2018). There, we discuss the historical development of and economic rationales for excluding deal value from fair value in appraisal litigation.

Our article’s core insight, which we have also emphasized in our amicus brief in Aruba, is that in the absence of evident conflicts or fraud, market pricing when available is always a more reliable way for courts to value a company than is reliance upon expert estimates self-servingly offered by competing valuation litigants. If the many scientific achievements of financial economists over the past half century have taught us anything, it is that unbiased market values untainted by conflict or fraud are more accurate than the valuation estimates of even unbiased experts. The proposition that markets efficiently price securities—the so-called Efficient Capital Markets Hypothesis (“ECMH”)—has been confirmed by empirical research time and again, culminating in 2013 with the award of the Nobel Prize in Economics to the University of Chicago’s Eugene Fama for his monumental research in this area.

Accepting the ECMH implies that when there is no evidence of conflict or fraud affecting the deal price, the deal price should be an upper bound on any appraisal award, as DFC and Dell essentially hold. And it further implies that, when publicly available, the market price of a target firm’s shares prior to a deal’s announcement—the value of the shares “unaffected” by the deal—is the most reliable and appropriate measurement of fair value, as held in Aruba.

The Delaware Supreme Court explicitly recognized the validity and truth of the ECMH in DFC. And it will have an opportunity to do so again in Aruba, which we hope it will.

Other distinguished corporate law and economics scholars agree with us about the application of the ECMH to appraisal awards. (See, for instance, the recent paper by Professors Jonathan Macey (Yale) and Joshua Mitts (Columbia) available here.) But there are also some scholars who disagree with us.

Relying on empirical research by Professors Eric Talley (Columbia) and Albert Choi (Virginia), a group of distinguished scholars has argued as Amici in Aruba that a more robust appraisal remedy benefits shareholders because it enables them to receive a higher price for their shares. This presents an important challenge to the view we espouse, that markets are wiser than experts and that appraisal awards should not exceed the “unaffected” market price.

Our response to this challenge, both in our article and in our brief in Aruba, is twofold. First, we note that allowing dissenting shareholders to use the appraisal remedy to extract more deal value from the buyer than the deal price offered them consensually violates Section 262(h) of the appraisal statute, which excludes deal value from the fair value calculus. Second and more fundamentally, we observe that even if it is true that some shareholders would benefit from a more robust appraisal remedy, others would undoubtedly be harmed—namely, the shareholders of firms for which offers would be chilled or reduced by a more robust appraisal remedy. The opposing Amici professors argue that there is no evidence that a more generous appraisal remedy would chill deal flow. Our response is that there is no evidence that an enhanced appraisal remedy would *not* reduce deal flow and much in the basic economic theory of demand (when prices go up, less quantity is purchased) suggesting that increasing the cost of corporate acquisitions would indeed reduce deal flow. Economic research by Andrei Shleifer (Harvard) has demonstrated empirically that the theory of demand applies to individual stocks just as it does to other things of value. We see no reason for the law of demand not to apply equally to M&A activity at the firm level.

We look forward to seeing how the Delaware Supreme Court will rule in Aruba. And we hope that it will avail itself of this important opportunity to affirm market values and discourage a trading practice that is harmful to shareholders.

The complete article is available for download here.

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