► Holding: In praise of merger appraisals

Singing appraisals

23 February 2017 By Reynolds Holding

Holdout shareholders deserve praise for their appraisals. Dissenters to payday lender DFC Global’s $1.3 billion sale three years ago persuaded a Delaware judge that they received about 8 percent less than fair value for their stock. The company appealed, citing a judge’s computational error as proof that courts shouldn’t second-guess deal prices. It’s now up to the state’s Supreme Court to uphold a process that keeps merging companies honest.

So-called appraisal rights – a century-old fixture of Delaware law – allow shareholders who didn’t vote for a cash merger to ask a judge for a sweeter deal. Last July, Chancellor Andre Bouchard ruled that DFC investors should have received $10.21 a share rather than the $9.50 that private equity firm Lone Star paid.

Bouchard acknowledged that the arm’s-length sale to a third-party buyer after a two-year process gave the merger price credibility. Even so, Lone Star’s focus on its internal rate of return and its view that DFC was on the verge of an upswing meant the amount was below fair value. The judge calculated a new number by giving equal weight to the deal price, the company’s discounted cash flow and the median value of comparable companies.

DFC spotted a mistake that inflated Bouchard’s cash-flow calculation. When the judge redid the numbers, however, he also increased the company’s assumed growth rate from 3.1 percent to 4 percent, leading to an even higher fair value of $10.30 a share.

Understandably miffed, DFC appealed to the Delaware Supreme Court, calling the case “the perfect illustration of the arbitrariness and imprecision” involved in appraisal actions. The best fix, argued the company, was to defer to the price “proven by a real-world, arm’s-length, conflict-free transaction.”

It’s a fair point. In fact, several recent cases – including one last year involving title insurer Fidelity National Financial’s $2.9 billion purchase of Lender Processing Services – ended with the merger price prevailing. It’s not hard to imagine the Supreme Court adopting a narrow rule requiring deference to that price in strictly arm’s-length transactions.

That would probably be a mistake, however. Appraisal was designed to protect minority shareholders who prefer to keep their stock from being unfairly exploited by a majority intent on cashing them out – sort of like a right to eminent domain. It also gives bidders an incentive to offer the best deal possible and minimize the number of dissenters.

What’s more, even an arm’s-length transaction with no conflicts of interest can undervalue a target. Common deal protections are one culprit. No-shop provisions block sellers from seeking a higher price, and matching rights that give buyers the option to meet or beat an offer discourage other bidders. “Crown jewel” lockups, which hand over valuable assets even if a transaction falls through, can be an impediment that courts often discourage, though they have turned up in deals like Intercontinental Exchange’s $8.2 billion acquisition of NYSE Euronext. Breakup fees also can thwart better offers.

The absence of corporate bidders, whose long-term focus may justify a premium price, also may cause problems. Private-equity firms like Lone Star need hefty rates of return over relatively few years and can borrow only limited amounts, all factors that can depress a bid. The tortuous process of taking computer company Dell private in 2013 met resistance largely for those reasons. Delaware Vice Chancellor Travis Laster noted how fairly the $25 billion transaction had been conducted before awarding dissenting stockholders $17.62 a share last year instead of the $13.75 that Michael Dell and Silver Lake Partners had paid.

Even shareholder approval doesn’t ensure top dollar. Institutional investors may accept less if it produces a timely gain or offsets a loss for quarterly reporting purposes. And fair value at signing may be anything but if the company is worth substantially more at closing, the date relevant to the appraisal calculation.

Nuisance lawsuits are the bane of M&A, but appraisal actions offer little reason to worry. They’re costly and carry the risk that shareholders will end up with the merger price – or less. That’s why they generally target only suspect deals.

Companies subject to appraisal lawsuits are, for example, sold for substantially lower premiums than other firms, researchers at Oregon State and San Diego State universities found. Every 10 percentage-point reduction in a deal premium increases the chances of an appraisal case by about 0.72 percent, according to a study from Columbia and Vanderbilt universities. The lawsuits are also notably successful, with Delaware judges awarding holdout investors between 8.5 percent and 149 percent above the merger price in seven of the nine cases decided between 2010 and 2015, according to New York law firm Fried Frank.

The process can be imprecise and maybe even arbitrary, but on balance it’s a useful check on unfair transactions. It ensures that America’s most financially literate – though imperfect – court will review how companies sell themselves, how their advisers behave and how their boards reach decisions. That’s reason enough for the Delaware Supreme Court to keep its judgment in favor of appraisals.

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