Law360, New York (August 07, 2014, 10:36 AM ET) -- Delaware appraisal actions are on the rise, primarily due to the new and expanding phenomenon of “appraisal arbitrage” — in which shareholder activists and hedge funds acquire target shares after a merger is announced and focus on asserting appraisal claims as a kind of investment in and of themselves.

From 2004 through 2010, the number of appraisal petitions filed in Delaware rose and fell roughly in parallel with the overall level of merger activity, with appraisal rights being asserted in about 5 percent of the transactions for which they were available. In 2011, however, the rate of petitions more than doubled (to 10 percent) and it has continued to increase. In 2013, 28 appraisal petitions were filed in Delaware, representing about 17 percent of appraisal-eligible transactions.

In 2014, so far, more than 20 appraisal claims already have been filed in Delaware. The amounts at stake in appraisal actions have increased as well, with the value of dissenting shares in 2013 ($1.5 billion) being 10 times the value of dissenting shares in 2004, and more than five times the value of dissenting shares over their highest point in the last five years. Of the eight appraisal proceedings between 2004 and 2013 that involved more than $100 million worth of dissenting shares, four of them occurred in 2013. (This data is derived from a report by law professors Charles R. Korsmo and Minor Myers.)

In our review of Delaware post-trial appraisal decisions from 2010 to June 2014 (see chart below), we found that the court’s determination of fair value was higher than the merger price in seven of the nine cases. The highest premium represented by the appraisal award over the merger price was 148.8 percent — without even considering the award of statutory interest (which, in that case, represented an additional premium of 213.8 percent above the merger price). There was only one case in which the appraisal award was lower than the merger price (representing a 14.4 percent discount to the merger price); and only one case in which the appraisal award was the same as the merger price.

In the five cases that the court viewed as “interested transactions” (i.e., controlling stockholder or parent-subsidiary mergers), the appraisal award was significantly above the merger price — with premiums of 19.5 percent, 19.8 percent, 86.6 percent, 127.8 percent and 148.8 percent, respectively. Taking into account the statutory interest awards in these cases, there was an additional premium of approximately 14.7 percent, 26.9 percent, 24.7 percent, 36.1 percent and 213.8 percent, respectively.

While the extent of the market checks and protections afforded to the disinterested shareholders in these transactions varied, the range was from none to relatively weak. Notably, the two highest fair-value premiums (148.8 percent and 86.6 percent — we have excluded the 127.8 percent premium because it was based almost entirely on an issue relating to interpretation of preferred stock terms and so is not relevant in this context) were awarded in the only two cases in which there were no market checks or minority protections whatsoever.

For example, the backdrop to the case with the highest premium was an arbitration panel determination that the only reason for the merger was to eliminate the petitioner as the sole remaining minority shareholder — “without notice and without legal justification ... [and through the controlling stockholder’s use of] strong-arm tactics.”

By contrast, in the four transactions viewed by the court as “disinterested” (i.e., third party arm’s-length transactions), the fair value determination was higher than the merger price in only two of them. Further, these premiums, 8.5 percent and 15.6 percent, were considerably lower than the premiums in the interested transactions.

Critically, notwithstanding the notable increase in appraisal activity, it is still only a fairly low percentage of all appraisal eligible transactions (17 percent in 2013) that currently attract appraisal petitions. (By contrast, almost all strategic transactions now attract litigation with breach of fiduciary duty claims.) Moreover, while the only consideration in an appraisal proceeding is the determination of fair value (and wrongdoing by the target board or flaws in the sale process are legally irrelevant for these purposes), the transactions that attract appraisal petitions generally involve some basis for a belief that the deal price significantly undervalues the company — that is, controlling stockholder transactions, management buyouts, or other transactions for which there did not appear to be a meaningful market check or significant minority shareholder protections as part of the sale process.

This Quarter’s Delaware Appraisal Cases

Court Declines to Use Merger Price as a Basis for Determining Fair Value: Laidler v. Hesco (May 12; June 25)

Vice Chancellor Sam Glasscock declined to use the merger price as a basis for determining “fair value” in an appraisal proceeding. Glasscock had recently decided, in Huff v. CKx (November 2013), in a departure from recent Delaware court practice, to use the merger price as the basis for determining appraised fair value. In Hesco, Glassock distinguished CKx, emphasizing that the CKx transaction had been fully arm’s length, there was a competitive auction, and the court had determined that no other financial analysis to determine fair value was available because of the high degree of unreliability of management’s projections.

The merger in Hesco, however — where the 90 percent parent “itself decided the price” to pay to the sole remaining minority shareholder of its subsidiary in a short-form merger — was “nothing like” the arm’s-length competitive auction process pursuant to which the merger price was determined (and then approved by a minority shareholder vote) in CKx.

With the facts of the CKx transaction at one extreme with respect to process protections and those of Hesco at the other extreme, it remains unclear whether, and to what extent, the court will be inclined to use a merger price as the basis for appraised fair value in the context of an arm’s-length transaction where other financial analyses are available (or, where they are not available and there has been a market check but the market check was less than perfect).

Also of interest, in Hesco, the court adopted, for the first time, a direct capitalization of cash flow (DCCF) methodology for determining fair value (rather than the discounted cash flow (DCF) method usually used by the court). Both parties’ experts had agreed that DCCF was the most appropriate methodology in this case because of management never having made cash flow projections in the ordinary course of its business, together with the uncertain nature of the company’s future revenue (due to its standing to lose the patent on its primary product and the unusual nature of its business in which its primary product is purchased only in anticipation of or after major natural disasters).

DCCF differs from DCF in that DCF projects cash flows over a horizon period and estimates a terminal value at which cash flows can be valued in perpetuity, and then discounts to present value those cash flows over multiple periods, while DCCF estimates a normalized level of cash flows in perpetuity and divides those cash flows by a capitalization rate to estimate the present value of the business. In Hesco, the merger price offered to the dissenting shareholder had been $207 per share; petitioner’s and respondent’s experts, both using the DCCF methodology, had determined fair values of $515 and $250, respectively; and the court determined fair value to be $387.

Voting Issues Cloud Appraisal Rights: Merion Capital/Ancestry.com and Merion Capital/Dole Food (Both Proceedings are Pending)

Merion Capital, a hedge fund that focuses on appraisal arbitrage, is seeking appraisal of the Ancestry.com shares it purchased after Ancestry.com was acquired by an investor group led by private equity firm Permira, and the Dole Food shares it acquired just before the Dole management buyout. An issue in both proceedings is that it is only shares that do not vote for a merger that are entitled to appraisal.

It can be difficult to establish how shares have been voted in two situations: first, if the shares are held in street name, in which case they are voted in the aggregate by the depositary (albeit in accordance with instructions from the beneficial owners), and second, if the shares are acquired after the record date for the merger and so were voted by the previous owner.

The Delaware Supreme Court, in its 2007 Transkaryotic decision, established that, as shares held in street name are voted in the aggregate without attribution to the beneficial owners, street shares would be entitled to appraisal rights so long as the total number of street shares seeking appraisal did not exceed the total number of shares that the depositary voted against the merger.

In Ancestry, Merion acquired the shares after the record date for the merger and did not know how they had been voted. As the shares are held in street name, Merion has assumed that Transkaryotic would apply. Ancestry has argued, however, in a brief filed in May, that, since the law changed after Transkaryotic to permit beneficial holders (and not just record holders) to assert appraisal rights, the beneficial owner (and not only the record holder) now has the statutory obligation to show how its shares were voted.

The issue that has arisen in the Dole proceeding is that more shares are seeking appraisal than have voted against the merger.

It is not known how the court will view these issues. Their resolution may significantly affect shareholders’ ability to seek appraisal — especially activist shareholders and hedge funds that engage in appraisal arbitrage (and so often buy shares after the record date).

—By Abigail Pickering Bomba, Steven Epstein, Arthur Fleischer Jr., Peter S. Golden, David Hennes, Renard Miller, Philip Richter, Robert C. Schwenkel, David N. Shine, Peter Simmons, John E. Sorkin and Gail Weinstein, Fried Frank Harris Shriver & Jacobson LLP

Abigail Pickering Bomba, Steven Epstein, Peter Golden, David Hennes, Philip Richter, Robert Schwenkel, David Shine, Peter Simmons and John Sorkin are partners in Fried Frank's New York office.

Arthur Fleischer and Gail Weinstein are senior counsel in New York.

Renard Miller is an associate in the firm's Washington, D.C., office.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.