Chancery Dings Appraisals, But Deal Makers Still Vulnerable

By Karlee Weinmann

Law360, New York (February 02, 2015, 6:46 PM ET) -- The Delaware Chancery Court firmed up its stance on fast-rising appraisal arbitrage claims, particularly those targeting public company transactions, in a Friday decision that pricks the enthusiasm for the controversial actions but offers deal makers little protection against them.

In his decision, Vice Chancellor Sam Glasscock III found Permira Advisers LLC paid a fair price when it bought Ancestry.com Inc. for $1.6 billion, or $32 per share, in 2012. A group of hedge funds, including appraisal arbitrage veterans Merion Capital LP and Merlin Partners LP, had argued the company's true value hit as high as $47 per share.

After reviewing intricate valuation algorithms and expert testimony from both sides, the judge found the company's analysis more persuasive. An outgrowth of earlier rulings, the decision didn't shock the marketplace, reaffirming the appraisal arbitrage process can freely proceed in Delaware.

Still, it added another small but much-anticipated wrinkle to an investment strategy still taking shape as its popularity ticks up.

"It really doesn't change what the courts are doing substantively," said Gail Weinstein, senior counsel at Fried Frank Harris Shriver & Jacobson LLP. "But by providing some more clarity as to what they're doing, it should help appraisal arbitrageurs by driving them to arbitrage the deals most likely to result to appraisal awards significantly above the merger price."

Appraisal arbitrage claims sprout when investors vote against a proposed transaction, then ask a judge to reassess the target company's stock value after a trial. Hedge funds generally jump-start the process by purchasing shares after a deal announcement, then mount their push for a heftier payout.

It's a risky tactic with no guaranteed payoff, but a sharp rise in shareholder activism put momentum behind the strategy in recent years. In 2011, the rate of appraisal petitions more than doubled over the previous year, cropping up in 10 percent of eligible transactions. By 2013, that number swelled to 17 percent, according to data gathered by Fried Frank.

Though the cases still aren't common, a series of substantial payouts fueled the upward trend again last year. But while Delaware litigators expect appraisal arbitrage to stay in the spotlight, a growing body of guidance from the state's revered judiciary — including Friday's decision — will keep the burgeoning interest in check.

For one, Ancestry.com exposes the contours around when appraisal arbitrage generally works and when it doesn't. The courts have largely meted out the biggest appraisal awards in conflicted transactions — for example, take-privates where the buyer already owns stock in the company. Appraisal payouts in those deals can reach multiples of the initial takeover bid.

But public company appraisal cases tell a vastly different story, said John Reed, who heads the Wilmington litigation group at DLA Piper and served as lead counsel in one of the rare public-company successes, when the Chancery tacked nearly $1 billion onto Golden Telecom Inc.'s price.

The Ancestry.com buyout was the product of third-party, arm's-length negotiations with a private equity firm. In siding with the company and using the company-approved merger consideration as a key piece of its analysis, the Chancery showcased the risk of losing out on big-ticket appraisal claims targeting nonconflicted deals.

"I would think that based on the record now developing, you would see a slowdown and see investors being a bit more selective in the cases they pursue," Reed said. "Unless investors simply want to negotiate very quickly for a slight increase in the merger consideration measured by defense cost savings, it's hard to image that things are going to continue at the same pace."

In addition, the latest ruling amplifies the risk shouldered by those seeking huge payouts when the court's framework for deciding on a fair price is relatively fluid.

The Chancery's look at Ancestry.com leaned on the original merger price to determine a fair value, as it has in a smattering of other deals. In other cases, though, judges have cast aside merger price, relying instead on the more complex — and more subjective — discounted cash flow metric.

Even with uncertainty hanging over certain aspects of the appraisal process, some deal watchers caution that the latest guidance helps repeat arbitrageurs sketch out a better-defined blueprint for claims. In turn, that could provide an enticing platform for others, particularly when Delaware statutes provide a distinct upside.

Under state law, appraisal awards accrue backdated interest at an annual rate of 5.75 percent, win or lose — a counter to the financial risks of bringing a claim. The broad upswing in appraisal actions roughly aligns with a general drop in interest rates that began in 2010.

Advocates for reform say Delaware's Legislature should tweak the state's interest rule and consider putting limits on when investors pursuing appraisal claims can buy into a company. As it stands, the playing field isn't level and generally leaves targeted companies with two costly options: settle, or face a lengthy courtroom fight.

"Changing the standing requirement to file an appraisal claim to require a shareholder to have held shares before the announcement of a merger would be more equitable," said Scott Luftglass, counsel in the litigation department at Davis Polk & Wardwell LLP. "Lowering the statutory interest rate — or making it more commensurate with prevailing market conditions — likewise would be a welcome change."

But a push from the state capitol to lower interest rates won't wipe out arbitrage actions lodged by the fiercest and best-established players in the market, including hedge funds and private equity firms that over the past few years have embraced a more active role in their investments.

"The institutional investors are really trying to put their money where they're going to get a real bonanza of a return, and they're not looking to the interest rate to do that," Weinstein said. "They're looking to an appraisal award premium above the merger price to do that."

Still, such a move would nurture a shift already under way toward a marketplace that tilts toward season arbitrageurs like Merion Capital and Merlin Partners, the best-known names behind the Ancestry.com campaign. It's an evolution that's also propelled in part by developments from the judiciary, including the Friday's guidance.

"The decisions will help drive the arbitrage to the deals where it actually makes sense for it to be," Weinstein said. "The court will become more predictable."

--Additional reporting by Matt Chiappardi. Editing by Katherine Rautenberg and Philip Shea.

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