Hedge funds hot "appraisal" strategy for deals may become a lot less appealing

BY TOM HALS

Thu Mar 19, 2015 6:25am EDT

(Reuters) - An increasingly popular legal strategy that allows hedge funds to make potentially lucrative bets on takeover deals, and get a return even if they lose, may be about to become much less attractive.

    The strategy usually involves buying stock in a Delaware-incorporated company that is being acquired and then filing a claim that gets a judge to determine the fair price for the shares in a process known as appraisal. The fund will argue in court that the deal value was unfairly low and it should be paid a higher price.

    Since an annual interest rate of 5.75 percent currently accrues while a case is pending, and a final judgment can take years, the strategy generates a solid return even when the court rules the deal price was fair.

    But now the top corporate lawyers in Delaware, where about two-thirds of Fortune 500 companies are chartered, are proposing an amendment to the law aimed at removing the interest incentive if a case is lost. The lawyers’ proposals have traditionally been approved with little opposition by Delaware’s state legislature.

    That hasn’t stopped the appraisal lawsuits from piling up.  And there are signs that given the low-return environment in financial markets, more hedge funds and other investors may be filing appraisal suits. 

Between 2004 and 2010 only about 5 percent of the deals in which Delaware chartered companies were eligible for such claims were the subject of appraisal rights cases. By 2013 this had increased to 17 percent, according to the law firm Fried Frank.

LARGEST EVER

    In recent days, funds affiliated with Third Point Reinsurance, Farallon Capital Management and Muirfield Capital, among others, have filed appraisal actions over the sale of  pet products retailer PetSmart Inc, which closed on March 11.

    In all, the funds concerned hold about 10.5 million shares of PetSmart, worth about $870 million, likely making it the largest appraisal action ever, according to Minor Myers, a professor at Brooklyn Law School.

    Even if the court eventually determines that the $83 per share that a consortium led by European private equity firm BC Partners paid for PetSmart stock was fair, interest will accrue at more than $50 million per year while that decision is awaited, and will increase as time goes on because the interest is compounded quarterly. In addition, the court could determine the fair price should be much higher, giving the funds a big potential payout.

The strategy does come with risks. Judges have ruled the fair price was below the deal price in a small number of cases, and the hedge funds have to pay for their lawyers and experts.

    The appraisal strategy has been pioneered in recent years by Merion Capital LP, a hedge fund founded by Andrew Barroway. The former securities class action lawyer got his start building Schiffrin & Barroway, now known as Kessler Topaz Meltzer & Check, into a major player in federal securities fraud class actions.

    Appraisal rights are not new. They originally emerged as protection for minority investors as companies did away with universal shareholder approval for certain corporate events.

    Seeking an appraisal of a deal had previously mainly been used by minority investors who felt they were squeezed out of a deal decision by a controlling shareholder. However, in recent years the claims have often come from hedge funds seeking juicy returns.    

    In a handful of cases in the past few years Delaware judges have determined the fair price was much higher than the deal price. In the sale of entertainment company The Orchard Enterprises, a Delaware judge found the fair price was 127.8 percent above the takeover price, according to a client memo from Fried Frank. The interest during the two-year case tacked on another 36.1 percent to returns.

    The proposal by the Delaware bar comes at a time when the state's lawyers are seeking to preserve the state's leading role in corporate litigation while responding to business demands to cut meritless shareholder lawsuits.

    More controversial proposals for changing Delaware corporate law will be considered next month by the state's corporate lawyers. Some are designed to prevent companies from adopting bylaws that force their legal costs onto shareholders who sue and lose.

   The committee proposing the appraisal arbitrage amendment is reflective of many types of corporate law specialists, including  those who represent investors as well as lawyers for companies they sue.

    Some lawyers outside Delaware who represent companies have criticized the appraisal proposal for not being tough enough on the hedge funds.

    Trevor Norwitz, a top deal lawyer at Wachtell, Lipton, Rosen & Katz, which advised PetSmart, said Delaware law should require that only investors who were shareholders before the deal announcement be allowed to seek appraisal. Many funds seeking appraisal rulings scoop up their stock after the shareholder vote on the deal but just before it closes, which is a constant irritant to the company defense lawyers who want proof of how the shares held by the hedge funds were voted on the deal.

   Norwitz wrote in a blog post that the bar's proposals do not go far enough to discourage the hedge funds. As he sees it, there is a danger that the buyers of companies will pay less to all shareholders because they will have to find the funds to pay off the hedge funds, who he referred to as “hold-up artists." 

    The Delaware bar committee that drafted the appraisal proposal said in an explanatory paper that buyers can negotiate conditions that would allow them to back out if a certain number of appraisals are filed. The bar also said corporate deals involving proper steps, such as testing the deal’s price by seeking other potential buyers, are less likely to be the subject of appraisals.

    In the PetSmart case, the funds asked the court to determine the fair value of their stock and award them their costs associated with the suit.

    In a class action over the same deal, which was approved by about 75 percent of PetSmart shareholders, investors have said PetSmart was worth more than $100 per share. At that price, the BC Partners consortium could easily be on the hook for more than $200 million in payments to the hedge funds, including interest. 

    A PetSmart spokesman declined to comment as did a lawyer for the funds in the case.

(Reporting by Tom Hals in Wilmington, Delaware; Editing by Amy Stevens and Martin Howell)