Delaware Courts Pause on the Deal Price Do-Over

FEB. 19, 2015

The latest hedge fund strategy to seek higher returns has hit speed bumps courtesy of the Delaware courts in a recent case involving Ancestry.com.

The strategy involves exercising what are known as appraisal rights, or dissenters’ rights, which allows shareholders of an acquired company to go to court to seek more cash if they think the takeover price was too low.

Until recently, appraisal rights were seldom exercised. To pursue a claim, a shareholder must hire lawyers and experts and sue in court. This can be expensive and time-consuming. The results are also uncertain because a court may award less than the amount offered in the takeover. Most shareholders don’t want to take the time, expense or risk.

Enter the hedge funds, vehicles created to take on risky strategies. They have adopted appraisal rights as the latest strategy in their pursuit of ever higher returns.

Over the last few years, hedge funds like Merion Capital, with almost $1 billion in assets under management, have emerged to pursue appraisal rights in takeovers. These specialized funds have emboldened other shareholders like T. Rowe Price, which exercised appraisal rights in the Dell deal. The result has been that appraisal rights actions rose tenfold from 2004 to 2013, according to a paper by Minor Myers and Charles Korsmo.

This may be a good development. Appraisal rights could serve as a real check on companies. With a real plaintiff, motivated to make money, appraisal rights actions may be the mechanism that prevents an underpriced takeover from taking place. Of course, companies fear that this will result in an excessive amount of costly appraisal actions without merit.

The surge in appraisal rights cases and the arguments from advocates and opponents have been dumped into the laps of the courts in Delaware, where most companies are incorporated and these actions mostly take place.

Delaware judges are beginning to sort this issue out.

The first big question was whether hedge funds could even exercise appraisal rights. Stockholders usually hold their shares through brokers and are only beneficial owners. The shares themselves are actually owned by the broker or more likely on behalf of the broker and shareholders by Cede & Company, an outfit deep in the plumbing of the stock markets that holds most shares.

This creates an issue because in order to exercise appraisal rights, shareholders are required to not vote for the transaction. However, a hedge fund may simply not know how their shares were actually voted because they are not the owner of record and may have acquired their shares after they were voted in favor of the takeover.

This is what happened in the recent proceedings concerning the buyout of Ancestry.com by a consortium led by the private equity firm Permira. The hedge funds Merion Capital, Merlin Partners and Ancora Merger Arbitrage Fund exercised appraisal rights for the 1.4 million shares the funds owned at the time of the takeover.

Ancestry filed a motion to disqualify Merion from seeking appraisal rights, arguing that because Merion bought its stock after the record date of the shareholder vote on the deal, it had to show the previous owners of the shares did not vote in favor of the merger as well. Merion admitted in a deposition that it did not know how the shares were voted.

A victory for the company would have knocked out many pending appraisal claims because it would be impossible for hedge funds to trace back and find out how shares acquired after the record date were voted. But the court rejected that argument, ruling that it is the vote of the record holder that matters. In this case, because Cede & Company had either not voted or voted against the transaction at least the number of shares that Merion owned, Merion was covered. Even if the focus were on the beneficial owner rather that the record owner, the judge ruled, Merion did not vote in favor of the merger and thus would qualify to seek appraisal rights.

Despite Merion's win, Ancestry.com eventually prevailed a few weeks later when the court decided that the hedge funds were entitled to the original sale price.

Appraisal rights battles are frustrating for judges. They typically involve a battle of experts as each side puts forth a valuation expert to calculate the fair value of the shares. You can guess where each side comes out. The plaintiffs argue that the takeover price was too low, and the company argues that shareholders were, if anything, paid too much. In the Ancestry.com case, the hedge funds’ expert asserted that the fair value of the shares was as high as $47. The company’s expert countered that it was $30.63. The sale price was $32.

Anyone who practices valuation can understand the wide divergence. It is often more art than science. The inputs for any valuation depend on future projections that can change depending on the forecaster. In addition, valuation involves techniques and inputs that are at the substantial discretion of whoever is doing the valuation.

The judge in the Ancestry.com proceedings, Vice Chancellor Sam Glasscock III, noted this, stating that he was being asked to “make difficult factual determinations” that were not within his expertise. Putting together the two expert reports, he calculated a value of $30.33 to $33.24.

He also threw up his hands, stating that this was like “eating chicken gizzards: plenty of chewing but mighty little swallowing.” He then ruled that given the differences and the fact, there was a “reasonable” sale process with an auction, the best price was the one negotiated.

This result illustrates the problem with appraisal rights actions. The Delaware judges, faced with a deluge of these petitions, will push back. Reinforcing this point, the Delaware Supreme Court affirmed a decision last week in an appraisal rights proceeding involving the buyout of CKX by Apollo Global Management. In that case, Judge Glasscock ruled [note: the link in the New York Times website is for a different court opinion; the Ckx opinion addressed by the author is here] in the that the price was appropriate because the takeover was negotiated at arm’s length and therefore was a good indicator of fair value, even though CKX accepted a bid of $5.50 a share that was 10 cents a share lower than one from another private equity firm. CKX cited troubles with the higher offer's financing.

Although these decisions will knock out many appraisal cases where there appears to be a negotiated price, it will not end the appraisal rights strategy. Big cases like Dole, which involves a management buyout and questionable process, are still pending. The hedge funds will simply shift their focus to these types of cases.

Moreover, litigating an appraisal rights case is costly, and many funds are willing to settle for only a few extra million dollars. This will also keep driving this strategy.

Then there is the “heads I win, tails you lose” aspect of these cases that the law firm Wachtell Lipton has written about, arguing that appraisal rights need to be limited. However, the Delaware courts seem reluctant to ever award less than the takeover price. In addition, dissenting shareholders receive a statutory interest rate of 5.75 percent on their money while the case is litigated, no matter the price determined by the court.

Despite the minimum guaranteed upside and the essential protection on the downside, these cases will still give pause to hedge funds. The ability to score quick settlements still remains, but at the end of the day, a 5.75 percent return is not going to cut it for a hedge fund, even in a zero-interest rate environment.

In other words, the pursuit of appraisal rights seems to be turning out like merger litigation generally – good in some cases but probably not in others and in all instances something the companies wish they didn't have to deal with.

Steven Davidoff Solomon, a professor of law at the University of California, Berkeley, is the author of “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion.” Email: dealprof@nytimes.com | Twitter: @StevenDavidoff

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