Law360, February 15, 2019 article: "Appraisal Arbitrage Dimmed By Delaware Rulings" [Analysis shows judicial reaction to appraisal adventurers has ended assurance of fair value realization]

Analysis shows judicial reaction to appraisal adventurers has ended assurance of fair value realization

Source: Law360, February 15, 2019 article

Analysis

Appraisal Arbitrage Dimmed By Delaware Rulings

Law360 (February 15, 2019, 4:07 PM EST) -- Appraisal arbitrage is falling out of style as the reality of recent Delaware rulings sets in, with a new study showing the number of mergers facing shareholder challenges over deal price dropped meaningfully for the second year in a row.

A study from Cornerstone Research released Wednesday evaluates how appraisal litigation has evolved since a 2007 opinion in In re: Appraisal of Transkaryotic Therapies Inc. laid the groundwork for an investment strategy known as appraisal arbitrage. The strategy sees shareholders — largely hedge funds and private equity firms — buy into target companies with the goal of gaining a higher deal price for their shares through the court.

The study found that the number of mergers facing appraisal actions fell to 22 in 2018, marking the second year of decline after peaking at 47 in 2016. That rapid slide coincided with a drop-off in the overall number of appraisal petitions filed. There were 26 appraisal petitions filed in 2018, down from 60 in 2017 and 76 in 2016, according to the report.

Two opinions from the Delaware Supreme Court weighing in on the private equity-backed buyouts of payday lender DFC Global Corp. and technology giant Dell Inc. are viewed as somewhat of a turning point for appraisal arbitrage because of the emphasis placed on deal price as a strong gauge of fair value.

“From my view, it’s because of the significant development in appraisal law in the last few years culminating in two Supreme Court cases, DFC and Dell, which effectively made clear that deal price may well be the best indicator of fair value in appropriate circumstances,” said Edward Micheletti, head of Skadden Arps Slate Meagher & Flom LLP’s Wilmington, Delaware litigation practice.

In the DFC case, the Delaware Supreme Court in August 2017 overturned the Chancery Court’s determination that the payday lender’s private equity buyer had underpaid by about $100 million of the $1.3 billion acquisition. The 87-page opinion penned by Chief Justice Leo E. Strine Jr. said that best evidence of fair value in the DFC case was indeed deal price, but declined to create a broad judicial rule that would apply deal price in an appraisal of an arm’s length transaction.

The Delaware Supreme Court in December 2017 also reversed a Chancery Court decision that had found that Dell’s $25 billion buyout was underpriced by roughly $7 billion. In an 84-page decision penned by Justice Karen L. Valihura, the justices remanded the case back to the Chancery Court, directing Vice Chancellor Laster to either appraise the transaction at its deal price with no further proceedings or choose “another route” based on the Delaware Supreme Court’s findings and explain his reasoning. The justices took particular issue with Vice Chancellor J. Travis Laster’s decision to give no weight to the deal price.

“Dell and DFC basically said that where you have an appraisal case following a competitive sales process, the transaction price should be given strong weight, and it should be the factor that is weighed most heavily in those cases,” said David Hennes, co-chair of Ropes & Gray LLP’s corporate and securities litigation practice.

There have also been a number of decisions in 2017 and 2018 that found the fair value to be below deal price, shaking shareholders’ confidence that they will be able to get more cash for their shares.

The rulings in appraisal cases of Clearwire Corp., PetSmart Inc., SWS Group Inc., Solera Holdings Inc., AOL Inc. and Aruba Network Inc. all drew rulings that pegged fair value below the deal price.

“The risk to petitioners is that now we are seeing results below the transaction price and, if that occurs, petitioners are going to take a loss on those investments,” Hennes said.

The structure of the sales process seems to be a key factor in the outcome of appraisal cases, the Cornerstone Research study found. According to the study, appraised transactions that included an auction process or a go-shop period saw the average premium to deal price land at 1 percent while appraised transactions without those factors where the acquirer was a related party saw an average premium of 47 percent awarded to the petitioners.

The study also found that of the 34 cases that went to trial between 2006 and 2018, 16 challenged transactions were appraised above the deal price while the other 18 came in at or below the deal price.

The highest premium — 158 percent — in the time frame was secured in 2016 by the shareholders who challenges the acquisition of INS Software Corp. And the biggest hit to premium — negative 57 percent — was seen in the challenge to Sprint’s acquisition of Clearwire following a bidding war.

While some of these closely watched cases have placed an emphasis on giving weight to deal price, that’s just one of a handful of methods that the Delaware courts use when tasked with determining the fair value of a company in an appraisal action.

In the 13 years covered by the Cornerstone Research study, the Delaware courts relied on a discounted cash flow analysis — a method of determining a company’s current value that incorporate future cash flows — 59 percent of the time and relied on deal price 38 percent of the time. The courts never based fair value on the value of comparable companies or precedent transactions during the time frame. And in 2018, for the first time, the Delaware Chancery Court in its appraisal of Aruba tied fair value to the company’s unaffected market price.

The Aruba case saw Vice Chancellor J. Travis Laster — the same justice who penned the Chancery Court’s Dell ruling — in February slash 30 percent from Hewlett-Packard Co.’s $2.8 billion takeover of Aruba when he used the target’s unaffected 30-day average market price to determine fair value.

In the 129-page opinion, Vice Chancellor Laster said that “forceful discussions” in the Dell and DFC opinions about reliance on valuations based on efficient capital markets justified giving market value substantial weight.

Delaware’s Supreme Court has yet to weigh in on the case.

--Additional reporting by Jeff Montgomery. Editing by Alanna Weissman.