As has been widely noted, the number of post-merger appraisal petitions in Delaware has increased significantly in recent years, due primarily to the rise of appraisal arbitrage as a weapon of shareholder activists seeking alternative methods of influence and value creation in the M&A sphere. The phenomenon of appraisal arbitrage is to a great extent a product of the frequency with which the Delaware Chancery Court has appraised dissenting shares at “fair values” that are higher (often, far higher) than the merger consideration in the transactions from which the shareholders are dissenting. Our analysis of the post-trial appraisal decisions issued in Delaware since 2010 indicates that the court’s appraisal determinations have exceeded the merger price in all but two cases—with the appraisal determinations representing premiums over the merger price ranging from 8.5% to 149% (with an average of 61%).

There has been understandable concern. Practitioners and academics have commented on the uncertainty created for deals from an unknowable and potentially significant post-closing appraisal liability, and have questioned the logic underlying the court’s almost invariable determination that the “going concern” value of a target company just prior to a merger was significantly higher than the merger price. Because the Delaware appraisal statute prescribes that the “fair value” of dissenting shares for appraisal purposes must be based on the going concern value of the company just prior to the merger, but excluding any value relating to the merger (such as merger synergies and a control premium)—and because a merger price is essentially the going concern value of a target company plus expected merger synergies and a control premium—as a matter of simple logic, going concern value should generally be well below the merger price, not far above it.

Why do the court’s appraisal awards exceed the merger price so often and by so much? And who is affected?

Based on our analysis of the Delaware appraisal decisions since 2010, we have concluded as follows:

»  First, the extent of the problem has been overstated. Appraisal cases, while more prevalent than ever, still are not common. Moreover, appraisal cases are largely self-selecting for transactions in which the apparent facts provide a basis for believing that the merger price seriously undervalues the target company.

»  Second, rather than indicating an illogical or highly uncertain approach by the court, the actual results of the appraisal cases (as opposed to the court’s expressed jurisprudence) indicate a deep—and rational—skepticism by the court, not of merger prices generally but of merger prices in “interested” transactions (that is, mergers involving a controlling stockholder, parent-subsidiary, or management buyout) that did not include a meaningful market check as part of the sale process.

»  Third, the court’s virtually exclusive reliance in appraisal cases on the discounted cash flow (DCF) valuation methodology—an analysis that is subject to significant uncertainty, particularly in terms of the discount rate used (which involves a high degree of subjectivity and as to which even a small change will produce a significant impact on the result)—readily permits higher valuations in connection with interested transactions that do not include a market check.

»  Finally, notwithstanding the court’s continuing reference to the irrelevance of the merger price in appraisal proceedings, it would appear that the merger price would always be relevant as a benchmark in determining going concern value and that its use would not be inconsistent with the prescriptions of the appraisal statute. Moreover, consideration of the merger price, rather than its irrelevance, would appear to reflect the reality of what the court has done in appraisal cases (albeit contrary to what it has said in appraisal decisions).

The extent of the problem has been overstated.

It should be noted that, despite the significant increase in the filing of appraisal petitions over the last several years, the large majority of appraisal-eligible transactions still do not attract appraisal petitions. In 2013, appraisal petitions were filed in 17% of appraisal-eligible transactions. By contrast, almost all strategic transactions now attract breach of fiduciary duty litigation. Moreover, most appraisal petitions are withdrawn or the cases settled (although often for significant sums). Thus, there have been only nine Delaware post-trial appraisal decisions since the beginning of 2010.

In addition, appraisal cases are largely self-selecting for transactions in which the merger price does not fairly value the company. Because appraisal proceedings are complicated, lengthy, expensive and risky, and because the expenses are shared by the dissenting stockholders (and cannot be shifted to all shareholders as a group or to the target company), generally appraisal cases that are brought and decided are those in which, from the apparent facts, there is a likelihood that the merger price does not fairly value the company. For example, Andrew Barroway, founder and CEO of Merion Investment Management, one of the most prolific of the hedge funds dedicated to filing appraisal petitions, has said that Merion looks for deals that appear to be undervalued by at least 30% and focuses on management-led buyouts. “The vast majority of deals are fair. We’re looking for the outliers,” he has said. In effect, virtually every appraisal decision relates to a transaction that is an outlier.

The actual results of the appraisal cases indicate a deep—and rational—skepticism by the court, not of merger prices generally, but of merger prices in “interested” transactions that did not include a market check.

Rather than indicating an illogical or highly uncertain approach by the court, the actual results of the appraisal cases (while belying the jurisprudence and the court’s assertions in its opinions) indicate a deep and rational skepticism by the court of merger prices in “interested” transactions that do not include a market check—as well as skepticism about the range of fairness established by the target company’s investment bankers in connection with their fairness opinions and the financial analyses of the target company’s experts in the appraisal proceedings in these transactions. While the court espouses the traditional Delaware jurisprudence that holds that the merger price and sale process are irrelevant to an appraisal determination of going concern value, the pattern of the court’s appraisal determinations appears to reflect an elemental distrust by the court of the fairness of the merger price in the case of interested transactions where there has not been a market check. The data is consistent in supporting the inverse conclusion as well—that, in the context of a transaction with a meaningful market check, the court will tend to rely on the merger price as a significant factor in determining going concern value.

In the cases we have reviewed (from 2010 to date), the appraisal determinations representing the highest premiums over the merger price were all in “interested” transactions, and in none of those transactions was there a meaningful market check as part of the sale process. The premiums over the merger price in these interested transaction cases ranged from 19.5% to 148.8% (averaging 80.5%). By contrast, in the four cases that involved “disinterested” transactions (i.e., third party mergers), two of the appraisal determinations were at a premium above the merger price, but at lower premiums than in the interested cases—8.5% and 15.6%, respectively; one of the determinations was equal to the merger price (where there was a full market check with competing bidders in an open auction); and one was below the merger price, reflecting a 14.4% discount to the merger price. One may predict that for the cases that fall between these extremes—that is, interested transactions with meaningful market checks and disinterested transactions without full market checks—the court is likely to be guided, in the former cases, by the extent to which it has confidence that the market check was sufficient to overcome the skepticism engendered by the interested nature of the transaction and, in the latter cases, by the extent to which the disinterested arm’s length nature of the transaction may overcome the skepticism arising from the absence of a meaningful market check.

The court’s reliance on the DCF valuation methodology readily permits higher valuations in interested transactions without a market check.

Pursuant to the Delaware appraisal statute, the court may use any financial analyses that are generally accepted by the financial community to determine going concern value. In appraisal proceedings, both parties’ financial experts generally submit discounted cash flow (DCF) analyses, sometimes along with comparable company or comparable transaction analyses. The court has almost invariably used a DCF analysis, alone, to determine going concern value.

Notably, determination of what discount rate to use in a DCF analysis is highly subjective. In addition, even a slight change in the discount rate used will have a significant impact on the result. Thus, a dissenting stockholder who can convince the court to lower the discount rate used by the company in its DCF analysis stands to achieve an appraisal determination that is significantly higher than the merger price. A look at the Sunbelt Beverage appraisal case is instructive.

The price paid in the Sunbelt merger was $45.83 per share. Both parties’ experts in the appraisal proceeding agreed that the DCF methodology should be used; agreed to use management’s projections in the analysis; agreed on the basic discount rate to be used; agreed that a small-company risk premium should be applied to increase the discount rate; and agreed that the small-company risk premium should be derived from the Ibbotson risk premium table. The only areas of disagreement between the experts with respect to the DCF analysis related to two factors that affected the discount rate—first, whether the company’s market capitalization placed it in the 9^th or the 10^th decile of companies in the Ibbotson table; and, second, whether a company-specific risk premium should also be applied to the discount rate.

The DCF analysis by the company’s expert (which used the small company premium applicable to companies in the 10^th decile of the table—5.78%; and which also applied a company-specific risk premium of 3%) yielded a fair value of $36.30 per share. The DCF analysis by the petitioner’s expert (which used the premium applicable to companies that were close to the line between the 9^th and 10^th decile in the table—3.47%; and did not apply a company-specific premium) resulted in a fair value of $114.04. The critical difference between the two analyses, which led to these vastly different amounts, was simply the relatively small effect of the two different risk premiums on the discount rate. The court accepted the petitioner’s expert’s view on these two factors and determined fair value to be $114.04 (significantly above the respondent’s determination of $36.30 and the merger price of $45.83).

Consideration of the merger price, rather than its irrelevance, would appear to reflect the reality of what the court has done in appraisal cases (albeit contrary to what it has said), and would appear to be not inconsistent with the prescriptions of the appraisal statute.

As noted, it appears that the court harbors a deep skepticism that the merger price in an interested transaction without a meaningful market check will fairly value a company. This conclusion is not self-evident, as the court goes to considerable length in its appraisal opinions to assert that any consideration of the merger price is not appropriate in an appraisal case. However, based on an analysis of the actual results of the cases, as discussed above, there is an almost complete correlation between the extent to which the sale process lends confidence to the merger price as not undervaluing the company, on the one hand, and the amount by which the court’s appraisal determination exceeds the merger price, on the other hand.

In our view, the statutory language does not command disregard of the merger price in an appraisal proceeding. In fact, the statute’s direction to the court that, in determining going concern value, it must consider “all relevant factors” may be seen as expressly permitting (if not even possibly requiring) that the merger price be considered as one, among other, relevant factors. In CKx, the sole case (since the seminal Golden Telecom decision) in which the court expressly relied on the merger price to determine going concern value, Vice Chancellor Glasscock expressed his view that the court’s rejection of consideration of the merger price in Golden Telecom was only a rejection of an automatic presumption in favor of the merger price as itself establishing going concern value. Consideration of the merger price as one relevant factor—or even, as Glasscock found it to be in CKx, the most relevant factor—would not be inconsistent with that holding, he reasoned.

Conclusion

Despite the court’s record in consistently determining appraisal awards that significantly exceed the merger price, for a disinterested transaction with a meaningful market check, there should be little concern. For an interested transaction without a market check, there will be a meaningful risk of an appraisal award above the merger price. For the transactions that fall between these two extremes, appraisal risk should approximate the extent to which the transaction is interested or disinterested and has or has not included a meaningful market check.

Accordingly, parties to transactions, when considering merger price and sale process issues, will want to factor into that calculus the risk associated with appraisal. Target company stockholders, when deciding whether or not to seek appraisal, will want to consider the nature of the transaction and the reasonableness of the price and process—including the range of fairness determined by the target company’s investment bankers in connection with their fairness opinion, the investment bankers’ underlying financial analyses (in particular, the DCF analysis) supporting their range of fairness, the nature and extent of the market check in the sale process, the presence of any other features lending credibility to the merger price (such as a majority-of-the-minority stockholder vote requirement), and the reaction of the market and analysts.

Despite much ado about the court’s appraisal decisions, it appears that the court’s results have a reasonable foundation, although the court’s process is opaque. In addition, it appears that, for at least certain types of transactions, the court’s results are reasonably predictable—the court is unlikely to make an appraisal determination that significantly exceeds the merger price in a transaction that has been subjected to a meaningful market check.

[for large image of chart, click here]