Hedge Funds | Deal Professor

Fine Legal Point Poses Challenge to Appraisal Rights

  May 30, 2014 2:59 pm

The hedge fund Merion Capital might have hit a roadblock in its multimillion-dollar appraisal proceedings involving the $1.6 billion buyout of Ancestry.com. And it’s a roadblock that just might slow the trend toward exercising appraisal rights.

Appraisal rights allow shareholders in an acquisition to ask a court to assess the value of their shares. The idea is that if the buyer underpaid for the stock, shareholders have a remedy — namely going to court and having a judge determine the right price for the shares.

While appraisal seems like an effective remedy, shareholders have been reluctant to exercise this right because the process can take years, shareholders have to pay legal fees and many state courts, including Delaware’s, can actually award less than the amount paid in the merger.

Enter the hedge funds. Merion is the largest of a number of funds that are now exercising appraisal rights as a business strategy. Merion has reportedly raised more than $1 billion and to date has exercised appraisal rights in nine different actions, including takeovers involving Dole Foods, BMC Software and Airvana.

These funds have led to an upsurge in appraisal rights. According to a paper by two law professors, Minor Myers of Brooklyn Law School and Charles Korsmo of Case Western Reserve Law School, the value of appraisal claims was $1.5 billion last year, a tenfold increase from 2004.

In the case of Ancestry.com, which was bought by an investor group led by the European private equity firm Permira, Merion bought 1.225 million shares of its stock at the $32 cash buyout price, worth about $39 million.

Merion is pursuing appraisal rights to obtain a higher dollar figure. It seems to be a strategy perfect for a hedge fund that is run by experienced lawyers and is designed to take risks.

However, perfection may have run into reality in the Ancestry.com proceedings, which are taking place in a Delaware court. The combination of hedge funds and appraisal rights is new, and that means that the law governing it is still in flux.

Ancestry is opposing the appraisal rights petition, arguing that the price paid was fair value. Ordinarily this would lead to a trial where the court would determine who was correct. Courts have tended in the past to favor the party seeking appraisal, a fact that is underpinning Merion’s strategy.

But Ancestry filed a brief two weeks ago on a novel legal point that may wipe out Merion’s case not only in its proceeding but possibly in others as well.

The issue is that in order to exercise appraisal rights in Delaware, a stockholder must not have “voted in favor” of the transaction. This makes sense, because if you are asking the court to give you more money in a takeover, then you should at least show you opposed the deal at the price you think is too low.

It sounds like a simple rule, but it is complicated.

First, there is the issue that most shareholders don’t hold their shares directly in a company. They are merely beneficial owners. Actual record ownership of the shares is held through brokers and then through the share ownership company Cede & Company. Cede votes its shares as all the shareholders direct, but Cede votes these shares in the aggregate and does not allocate shares to each owner. Consequently, it is impossible for a beneficial owner to assert how their shares were voted and to know whether the appraisal requirement to not vote for the deal is met.

Second, for each shareholder vote there is a record date. The record date marks the date when shareholders are counted as eligible to vote. But shareholders can buy shares after that date and exercise appraisal rights. However, such a shareholder never votes on the transaction. Instead, the previous owners who held the shares on the record date may vote their shares for the deal. In this case, what happens if the previous owners voted for the transaction or their votes are unknown?

It is this second problem that Merion faces. Merion bought all of its shares after the record date for the shareholder vote on the transaction.

In depositions by Ancestry’s counsel, Samuel Johnson, a portfolio manager at Merion said that he did not know how Merion’s shares were voted because they were bought after the record date.

This would seem to doom Merion’s claim. But not entirely. In the case of Transkaryotic Therapies Inc., the court addressed the issue of whether a beneficial holder of shares who acquired shares after the record date was required to show that the previous owner did not vote for the transaction. In that case, the stockholders demanding appraisal had held their shares beneficially with Cede as the record-holder. The court held that in such a case, only the record-holder — Cede — had to show that there was not an affirmative vote. Because Cede had voted sufficient shares as record-holder against the transaction, the appraisal petition was sufficient.

This case made sense because the Delaware statute at the time permitted only a record-holder of stock to exercise appraisal rights. Cede also appears unable to retrace its shares and show how they were voted for its beneficial shareholders. If the court in Transkaryotic had required this, many shareholders would effectively lose their appraisal rights.

Merion will no doubt argue this case applies here because it held its shares beneficially and not as record owners.

In the wake of Transkaryotic, however, the Delaware appraisal statute was amended to allow shareholders who own stock beneficially to exercise appraisal rights.

Ancestry’s counsel is now arguing that this amendment requires that a beneficial owner show it did not vote in favor of the transaction. In its filing to the Delaware court, Ancestry stated that a “beneficial owner may now bring an appraisal action in its own name, without relying on Cede (or some other nominee) to vindicate its rights indirectly.” The beneficial holder thus now “assumes the statutory obligation to show that the shares it seeks to have appraised were not voted in favor of the merger.”

The case is not completely in favor of Ancestry, though. The section of the appraisal rights statute Ancestry is citing requires that the beneficial owner exercising appraisal rights set forth a statement of “the aggregate number of shares not voted in favor of the merger or consolidation.” But the amended statute does not state whether these shares are required to have not been voted for the transaction. Moreover, the statute itself when it refers to a shareholder defines it as a shareholder of record, meaning that the basis for Transkaryotic appears to remain despite this amendment.

In its petition seeking appraisal, Merion said it had not voted in favor of the transaction. When asked at deposition about this, Mr. Johnson said that it was “boilerplate” and that Merion did not know how its shares were voted. In other words, Merion is relying squarely on the Transkaryotic opinion to win.

The question now is whether court views on appraisal rights are changing now that their exercise is more frequent.

Even if Merion wins, it might only be kicking the can down the road. In the appraisal proceedings for Dole, another action Merion is participating in, more shares are exercising appraisal rights than those that voted against the deal or abstained. This means that there are definitely stockholders exercising appraisal rights who hold shares that voted yes.

It all means peril not just for hedge funds but for companies as they wait for the law to catch up and see whether their business strategies work. It’s a risky strategy, but then again that is what hedge funds specialize in.

Steven M. Davidoff, a professor at the Michael E. Moritz College of Law at Ohio State University, is the author of “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion.” E-mail: dealprof@nytimes.com | Twitter: @StevenDavidoff

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