The Long Rise and Quick Fall of Appraisal Arbitrage

Wei Jiang is the Arthur F. Burns Professor of Free and Competitive Enterprise at Columbia Business School; Tao Li is Assistant Professor of Finance at University of Florida Warrington College of Business; and Randall S. Thomas is John S. Beasley II Chair in Law and Business at Vanderbilt 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. 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 is a legislatively created right for shareholders to seek a judicial determination of the fair value of their shares that they choose not to surrender in a takeover or another change-of-control transaction. For many decades, appraisal was a little used, and even frequently maligned, corporate law remedy. Beginning at the turn of the 21st century, this all changed when a group of financial investors, especially some specialized hedge funds, began filing appraisal cases to garner high returns from litigation rather than seek remedy on their pre-existing investment. Appraisal arbitrage, as it became known, grew rapidly in popularity.

Appraisal arbitrage’s success soon attracted negative attention. In 2016, the Delaware legislature amended its appraisal statute to address two major criticisms of the existing system by eliminating small shareholders’ appraisal rights and by permitting companies to pre-pay merger consideration to appraisal petitioners to avoid paying interest at a lucrative rate – 5% above the federal discount rate. In 2017, the Delaware Supreme Court issued two important decisions on DFC Global and Dell, both assigning more weights to deal prices as the primary measure of fair value. Appraisal filings plummeted soon thereafter.

In this paper, The Long Rise and Quick Fall of Appraisal Arbitrage, we examine the up-to-date landscape of appraisal arbitrage since 2016, and compare the patterns to the era before. We begin with an overview, documenting the steady rise and rapid fall of appraisal arbitrage. Using hand collected data on all appraisal-eligible deals in Delaware that became effective over the time period 2000-2019, we show that appraisal arbitrage rose from a small handful of case filings (called appraisal petitions) in the early 2000’s to become commonplace in eligible merger transactions. In the early years, many of these filings were made by small shareholders, but by 2010 hedge fund investors dominated the ranks of appraisal petitioners, averaging about 85% of all filings during the 2015-2019 period. At its peak, during 2015-2017, appraisal arbitrageurs were challenging approximately 25% of all appraisal-eligible transactions, only for this to plummet in 2019 to roughly 5% of these deals.

The size of hedge fund arbitrageurs’ positions grew from $26.3 million during the period 2000-2014 to an average of $50 million per case in 2015-2019. We suggest that part of the reason for this increase was the impact of the Delaware legislation that reduced the number of cases filed by small shareholders. We also find that hedge funds were targeting bigger companies in the 2015-2019 period. Throughout this period, a small group of plaintiffs’ law firms disproportionately engaged in litigating these cases.

Appraisal arbitrage cases can be lengthy. While the time from the effective date of a merger to the filing of the first appraisal petition averages 73 days, the time to resolution is much longer. For example, the average time to reach settlement after the first petition is filed is 406 days and if there is a court decision the time from filing to that decision is on average 2.6 years. Importantly, during these long intervals pre-judgment interest, set at five percentage points above the risk-free rate, constitutes a significant part of the returns to appraisal arbitrageurs.

Hedge funds and other appraisal petitioners target low takeover premium transactions, with challenged deals offering on average 20% lower premiums than other appraisal-eligible deals without litigation. These deals are disproportionately minority shareholder squeezeouts or going private deals, both of which are widely perceived as most prone to abuse by acquirers. Not surprisingly, appraisal litigation in these types of deals tends to generate higher levels of financial returns to the hedge funds too. This suggests that appraisal arbitrage may serve to mitigate agency costs by providing recourse to shareholders who are vulnerable in potentially abusive deals.

In 2017, the Delaware Supreme Court decided the DFC Global and Dell cases, sending a clear message that in the future the lower court should rely more heavily on deal price, especially in arms-length deals, in assessing valuation. This philosophy was reinforced by a 2019 Delaware Supreme Court opinion in Aruba Networks. We show that these cases led to lower returns from appraisal arbitrage, mostly by significantly reducing valuation improvement from appraisals.

Using data for the period 2015-2019, we find that the average deal-level gross return during this period is 13.2%, far less than the 98.2% average gross returns during the 2000-2014 period that we study in an earlier study. For the more recent period, we break average gross returns into two parts for the cases that went to trial. First, we look at pre-judgment interest accrual and find that on average it generated total returns of 18.1% for appraisal petitioners. However, when we examine the judicial value improvement component, defined as the difference between the judicially determined fair price minus the deal price, we find that in 2015-2019 it averages a negative 5.3%. While both components are sharply lower than those found in earlier research for the pre-2015 era, the drop in judicial value improvement into the negative territory, is especially stark as it had been a positive 50.6% in the earlier period. We conclude that DFC Global, Dell and Aruba Networks were particularly important contributors to the fall of appraisal arbitrage.

The full paper is available for download here.

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