Delaware Effort to Protect Shareholders May End Up Hurting Them

Deal Professor

By STEVEN DAVIDOFF SOLOMON   MAY 24, 2016

An overhaul in shareholder rights is coming as Delaware seeks to curtail a strategy that has grown popular with hedge funds. The question is whether shareholders or companies will benefit.

Right now, shareholders of a company that is the target of a corporate takeover can protest the price being paid by petitioning a court to appraise the value of their shares. The court will order the merged company to pay the shareholders fair value, which may be greater or less than the amount paid in the deal, plus any interest that accumulated during the court’s deliberation, which often takes years.

Appraisal rights originally came to be as a compromise. Mergers used to require the approval of 100 percent of shareholders. That gave power to shareholders who wanted to block deals by being holdouts. Appraisal rights were adopted to reduce the minimum deal approval threshold to a majority. That way, a shareholder could dissent from the takeover but not stop it.

The ability to exercise appraisal rights has always been convoluted and difficult, however. In Delaware, appraisal rights are usually available only if the deal price is paid in cash, not stock. This means there are ways to avoid setting off appraisal rights. Remember Bear Stearns’s acquisition by JPMorgan Chase in 2008? JPMorgan paid for the deal with stock instead of the measly cash amount it could have used, avoiding appraisal rights.

Exercising appraisal rights can also be risky for shareholders. If the court found that the acquirer had overpaid, the shareholder seeking the appraisal would receive less than other shareholders got in the deal. And lengthy court proceedings required costly experts to opine on the fairness of the price.

Because of these issues, shareholders seldom exercise appraisal rights.

That all changed after a case in Delaware eight years ago made it easier to exercise appraisal rights and incited a boom in appraisal arbitrage, a strategy in which a fund buys shares just before a merger closes in order to exercise the appraisal rights. Hedge funds like Merion Capital, Merlin Partners and Quadre Investments arose specializing in the strategy.

This was a problem for companies incorporated in Delaware, and thus the overhaul efforts began.

A proposal last year in Delaware limited appraisal rights to holders of $1 million or more of a company’s stock or 1 percent of the outstanding shares, whichever was less. Another proposal also took aim at the accumulated interest by allowing companies to prepay the acquisition amount and eliminate interest accrual.

These proposals died in the Legislature last year as a debate erupted over whether they went far enough or too far in limiting appraisal. They were revived this year, and they just passed the Delaware House of Representatives. They appear destined to become law.

The question is what effect these changes will have on appraisal rights. In a just-released study, four professors, including Wei Jiang at Columbia University and Randall Thomas at Vanderbilt University, looked at past appraisal actions to predict what would happen.

First, the authors found that hedge funds dominate appraisal cases. Actions by hedge funds make up three-quarters of the volume measured by dollars for appraisal actions in the last few years. Seven funds accounted for a majority of this volume.

Second, the study found that appraisal cases seem to serve some corrective function. Appraisal rights are exercised more often when there is a conflict with shareholders, as in a management buyout or private equity deal, or when there is a lower deal premium.

Finally, the professors found that if past filing patterns hold, the new appraisal rules would significantly restrict appraisal actions. The authors predict that the $1 million minimum will knock out a quarter of these actions. And allowing for an interest rate cutoff could eliminate another significant number of filings.

These changes are on top of a court crackdown that also limits investors seeking appraisals by setting the price paid by the acquirer as the amount to be awarded in an appraisal proceeding unless it can be shown that the sale process went awry.

The proposed changes may backfire, however. Rather than discourage appraisal petitions, the elimination of interest accrual through prepayment may actually spur more appraisal actions because hedge funds would be paid sooner and be able to use that money to bring more appraisal actions.

In addition, the $1 million minimum seemingly unfairly knocks out small shareholders but not professional hedge funds. There should be a remedy for a small shareholder who feels ill-treated.

Perhaps more important, legislators have not assessed whether the proposals uphold the intent of appraisal rights, which was to protect shareholders. In Delaware courts, it is hard to challenge a deal that was negotiated with good process. Appraisal rights could be the only remedy for shareholders in deals that did not have a great price. Absent the threat of appraisal proceedings, buyers and sellers might lose the incentive to pay a fair price, instead paying a price that was just high enough.

The overhaul also does not fix the problems with appraisal actions. They are still not available for stock deals, allowing companies to bypass this option easily. There will still be battles in court over the price of a deal in front of judges who are not trained in these issues. And these revisions may not even deter hedge funds from exercising appraisal rights, the ostensible impetus for these changes.

All of this speaks caution. After all, it seems funny that now that shareholders want to use appraisal rights, there is a push to try to end it. Does that seem right?

Deal Professor: Steven Davidoff Solomon is a professor of law at the University of California, Berkeley. His columns can be found at nytimes.com/dealbook.

A version of this article appears in print on May 25, 2016, on page B3 of the New York edition with the headline: Delaware Effort to Protect Shareholders May Hurt Them.

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