Appraisal Arbitrage—Is There a Delaware Advantage?

Posted by Gaurav Jetley and Xinyu Ji, Analysis Group, Inc., on Monday, July 27, 2015

Market observers have devoted a fair amount of attention to possible reasons underlying the recent increase in appraisal rights actions filed in the Delaware Chancery Court. A number of commentators have connected such an increase to recent rulings reaffirming appraisal rights of shares bought by appraisal arbitrageurs after the record date of the relevant transactions. Other reasons posited for the current increase in appraisal activity include the relatively high interest rate on the appraisal award and a belief that the Delaware Chancery Court may feel more comfortable finding fair values in excess of, rather than below, the transaction price.

In our paper Appraisal Arbitrage—Is There a Delaware Advantage?, we examine the extent to which economic incentives may have improved for appraisal arbitrageurs in recent years, which may help explain the increase in appraisal activity. We investigate three specific issues.

First, we examine the economic implications of permitting appraisal rights to shares that were purchased after the record date. The ability to delay the investment allows appraisal arbitrageurs to get a better sense of the value of the target, while at the same time helping reduce their exposure to the risk of deal failure. Figure 1 shows the typical time line of a friendly all-cash deal. As shown in the figure, in general, there are over two months between the record date and the deal closing. Postponing the share purchase to after the record date enables arbitrageurs to take advantage of information that may not have been available as of the record date. Casual observation of the financial markets suggests that a lot can change over a two-month period. Postponing the investment decision to as near the deal closing as possible also helps arbitrageurs minimize or eliminate deal risk (i.e., the risk that the deal will not close). Thus, allowing appraisal arbitrageurs to delay their investment in target company stocks by about two months is akin to giving them a valuable option, which helps arbitrageurs both increase return and lower risk.

Figure 1: Timeline of a Typical Deal Process

Second, recent rulings in appraisal matters have signaled a preference by the Delaware Chancery Court for the discounted cash flow (“DCF”) valuation method in determining the fair value of the target stock. We examine the extent to which the Chancery Court’s preferences, with respect to certain inputs to the DCF method, may be affecting economic incentives for appraisal arbitrageurs. We find that recent rulings in appraisal proceedings suggest that the Court prefers to use the supply-side equity risk premium (“ERP”) in computing the target firm’s cost of equity. While using the supply-side ERP is consistent with the view generally accepted by academic researchers that, going forward, the ERP is likely to be lower than was observed in the past, it may be inconsistent with the common practice of investment bankers advising M&A deals. Figure 2 compares ERPs reported in a sample of target company proxy filings to contemporaneous supply-side ERP measures. It shows that nearly two-thirds of the time, target financial advisors adopted a higher ERP. This finding implies that appraisal arbitrageurs may be able to take advantage of the wedge between the valuation inputs commonly used by investment bankers providing fairness opinions to parties in M&A transactions and those preferred by the Court.

Figure 2: ERP Inputs Used by Target Financial Advisors vs. Supply-Side ERPs in Selected Transactions

In addition, Delaware’s appraisal statute requires the court to determine a point estimate, rather than a range, of the fair value of the target company. Thus, transactions consummated at a price that is on the lower end of the DCF value range established by the target’s financial advisors might be more attractive to appraisal arbitrageurs, because arbitrageurs could start by showing that the fair value of the target is at least equal to the mid-point of the target financial advisor’s DCF value range. Figure 3 compares the transaction price in a sample of M&A deals during the 2010-2014 period to the DCF valuation range established by the target’s financial advisors. It shows that over one third of the deals were consummated at a price below the midpoint of the DCF range. This fact alone does not mean that the Delaware appraisal statute gives appraisal arbitrageurs any particular advantage. However, a combination of various factors, including Delaware’s preference for the supply-side equity risk premium, the statutory requirement for determining a point estimate of value, and the Court’s historical reluctance to give the actual transaction price much weight under an appraisal proceeding, does present a favorable environment for appraisal arbitrageurs.

Figure 3: Deal Prices Relative to DCF Price Ranges Established by Target Financial Advisors

Finally, we benchmark the Delaware statutory rate on the appraisal award to yields on the U.S. Treasury Bonds as well as corporate bonds with maturity and credit risk that correspond to risk of appraisal (three-year with credit ratings of “BB” or higher). Figure 4 shows that the statutory rate, set at the Federal Reserve Discount Rate plus 5%, is higher than the benchmark yields. Thus, the Delaware statutory rate compensates appraisal petitioners for significantly more than the time value in question, and in instances where the credit rating of the surviving entity after an M&A deal is at least “BB,” the statutory rate more than compensates petitioners for a bond-like claim. While it is debatable whether the extent to which an arbitrageur’s decision to seek appraisal is driven by the statutory rate, our findings are consistent with the notion that the relatively high current statutory rate does improve the economics for arbitrageurs.

Figure 4: Benchmarking the Delaware Statutory Rate Against Selected Benchmark Interest Rates, 2010 to 2014

A few policy implications flow from our results: First, from an economic perspective, it seems reasonable to limit a dissenting shareholder’s appraisal rights to only the shares held as of the record date. Setting the cut-off at the record date, instead of at an earlier time, such as the deal announcement date, allows an appraisal arbitrageur time to evaluate whether to purchase a target company’s stock for purposes of bringing an appraisal claim later. At the same time, denying appraisal rights to shares acquired after the record date helps reduce the value transfer (i.e., the value of the delay option) from the acquirer/target to appraisal arbitrageurs.

Second, with respect to the potential wedge between the Court’s preference and investment bankers’ common practices for certain valuation inputs, we do not suggest that the Court should simply adopt investment bankers’ valuation assumptions, as doing so would defeat the purpose of an appraisal action. However, our findings do indicate that the Court may want to be mindful of certain systematic differences in valuation inputs which could create profiteering opportunities for those seeking appraisal. Conversely, investment bankers and deal lawyers should also be sensitive to these systematic differences, and should at least be aware of the potential implication of continuing to adopt certain valuation assumptions. With respect to the Court’s practice of giving little weight to the merger price in determining fair value, we suggest that, in the absence of a finding of a flawed sales process, it might be useful for the Court to keep the actual transaction price in mind when appraising the fair value of a publicly traded target company. Furthermore, even in instances where the sales process is less than ideal, it may still be useful to subject the DCF value of a publicly traded target to some form of a market check.

Finally, our benchmarking analysis of the Delaware statutory interest rate indicates that it may be useful to contemplate a change in either the interest rate itself or the amount on which the interest rate is paid (or both). We recognize that it may not be possible to set an interest rate based on the characteristics of a target or an acquirer without increasing the scope of issues that are likely to be litigated in an appraisal proceeding. Given this consideration, it may be more practical to adopt a change that limits the amount on which the interest rate is paid. On that regard, the recent proposal by the Council of the Delaware Bar Association’s Corporation Law Section to limit the amount of interest paid by appraisal respondents—by allowing them to pay appraisal claimants a sum of money at the beginning of the appraisal action—seems like a practical way to address concerns regarding the statutory rate. However, at the same time, such a practice might further encourage appraisal arbitrage, because paying appraisal claimants a portion of the target’s fair value up front effectively supplies capital to claimants to pre-fund their appraisal pursuits.

The full paper is available for download here.