Opinion On Wall Street

Delaware hedge fund tussle puts efficient market hypothesis in spotlight

Issue at heart of hedge fund battle over Hewlett-Packard takeover

Sujeet Indap

Sujeet Indap in New York  [March 1, 2019]

It would be no surprise if Delaware judges are tired of inputting data into complex spreadsheets.

Sophisticated hedge funds are turning in ever greater numbers to Delaware’s courts to deploy “appraisal rights”, a once obscure legal remedy that gives shareholders of companies incorporated in the east coast state the right to challenge the price of a mergers and acquisition transaction. Given the majority of US companies are incorporated in Delaware, the state’s judiciary has been busy.

In a handful of cases, Delaware judges have agreed with dissenting shareholders that a company was not sold at fair value. The judgments have triggered windfalls for a breed of specialist hedge funds engaging in what is known as “appraisal arbitrage”, with more than $1bn flowing to them.

The trend has seen judges hold an increasing number of trials over disputed M&A valuations, sending those draped in black robes on a crash course in equity betas, market risk premiums and other textbook esoterica. One judge in a high-profile valuation ruling made a maths error that required a correction. Another pointed out in a ruling that the necessary financial “formulas did not spring from the mind of this judge, softened as it has been by a liberal arts education”.

But this burst of number-crunching by Delaware’s judiciary may soon become nothing more than an historical oddity. On March 27 the Delaware Supreme Court is set to deliberate on a case in which the hedge fund Verition Partners is appealing a ruling by a Delaware lower court judge on Hewlett-Packard’s $3bn acquisition of Aruba Corp in 2015. The judge, vice-chancellor Travis Laster, shocked observers by ruling that the fair value for Aruba was just $17.13 a share, less than the $24.67 a share Hewlett-Packard had agreed to pay.

Even more startling was how the judge reached his valuation. Eschewing a traditional calculations-laden discounted cash flow model, he simply relied on the famed efficient market hypothesis, which would contend that the price at which Aruba’s shares were trading at before the takeover refected the company’s fundamental value. If Delaware’s Supreme Court afrms the lower court’s faith in efcient markets it would be a landmark moment. But the raging controversy over appraisal rights has already demonstrated the perils of having to impose science — even a theory with little maths required — on an exercise, corporate valuation, that is largely art.

Hedge funds’ appetite for using legal appraisals to challenge M&A deals hasn’t simply been about the chance of a big pay-off. It’s also been seen as a largely risk-free strategy.

Just like the student who never expects a lower grade if they ask for their exam to be remarked, those funds disrupting takeovers largely disregarded the possibility that a judge would say a company had overpaid.

At the same time, in cases where judges have ruled that the agreed takeover price was a fair one, awkward compromises are required. The Delaware statute calls for the company’s standalone, “going-concern” value to be determined, excluding any potential benefits, or synergies, stemming from the acquisition. But a deal price is typically struck at large premium to pay for such synergies, raising questions over how exactly to judge fair value.

Just before the case of Aruba, whose sale process Verition claims was tainted, the Delaware Supreme Court acknowledged this when reviewing the appraisals of two other companies, Dell and DFC Global. In each case, the lower Delaware court awarded hedge funds significant premiums to the original deal price.

However, the Supreme Court overturned the decisions, endorsing the deal price standard for fair value. And in the written opinions in the cases, it arguably laid the groundwork for a new efficient markets standard that will be under the microscope later this month.

In its decision in the case of Dell, the Supreme Court ruling said the efficient markets hypothesis “is generally a more reliable assessment of fair value than the view of a single analyst, especially an expert witness who caters her valuation to the litigation imperatives of a well-heeled client”. The witnesses in question are the top-end, mercenary economists each side in appraisal cases hire to produce the valuation they need.

With that green light, vice-chancellor Laster ruled Aruba’s fair value was simply its 30-day moving average before the deal being announced.

Yet if efficient markets theory is now suddenly the new standard for appraisal cases, a new legal morass will open. Market structure experts will testify about stock liquidity and debate the vagaries of “fundamental” efciency versus “informational” efficiency.

While the controversy over appraisals comes just as Delaware has become less friendly towards shareholder lawsuits of all types, one hedge fund investor predicts the Supreme Court will deliver an ambiguous ruling in the Aruba case. That will be welcomed by the state’s lawyers who want a healthy volume of cases. “It does no good for Delaware to have no litigation,” he said.

Judges may need to hold of uninstalling Microsoft Excel just yet.