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Appraisal arbitrage and the future of public company M&A.

ABSTRACT

In this Article, we demonstrate that the stockholder's appraisal remedy--long-dismissed in corporate law scholarship as useless or worse--is in the middle of a renaissance in public company mergers. We argue that this surge in appraisal activity promises to benefit public shareholders in circumstances where they are most vulnerable.

We first show a sea change in the use of appraisal in Delaware. Relying on our hand-collected data, we document sharp recent increases in the incidence of appraisal petitions, in the size of the petitioners' holdings, and in the sophistication of the petitioners targeting public deals. These litigants appear to invest in target company stock after the announcement of the merger and with the intention of pursuing appraisal. In short, this is appraisal arbitrage. There is every reason to believe that appraisal now stands as the most potent legal challenge to opportunistic mergers.

We also present evidence showing that these appraisal petitions bear strong markers of litigation merit--they are, in other words, targeting the right deals. Nevertheless, defense lawyers have recently suggested that appraisal arbitrage constitutes some sort of "abuse" of the remedy and ought to be stopped. This nascent argument has matters precisely backwards.

This new world of appraisal should be welcomed and indeed encouraged. Our analysis reveals that appraisal arbitrage focuses private enforcement resources on the transactions that are most likely to deserve scrutiny, and the benefits of this kind of appraisal accrue to minority shareholders even when they do not themselves seek appraisal. In this way, the threat of appraisal helps to minimize agency costs in the takeover setting, thereby decreasing the ex ante cost of raising equity capital and improving allocative efficiency in public company mergers and acquisitions. We offer some modest reforms designed to enhance the operation of the appraisal remedy in Delaware.

TABLE OF CONTENTS

INTRODUCTION
I. THE ROLE OF APPRAISAL IN CORPORATE LAW
     A. The Statutory Design of Appraisal
     B. The Critique of Appraisal
II. THE RISE OF APPRAISAL ARBITRAGE
     A. The Surge in Appraisal Activity
     B. The Sophistication of Appraisal Petitioners
     C. The Increasingly Competitive World of Appraisal Litigation
     D. What Explains the Rise in Appraisal Arbitrage?
III. DOES APPRAISAL TARGET THE RIGHT TRANSACTIONS?
     A. The Unique Structure of Appraisal Litigation
     B. An Empirical Examination of the Merits of Appraisal
        Litigation
        1. The Unimportance of Transaction Size
        2. The Importance of the Merger Price
IV. THE SOCIAL UTILITY OF THE APPRAISAL REMEDY AND
    APPRAISAL ARBITRAGE
V. Potential Reforms
    A. Reforming Appraisal in Delaware
    B. Appraisal as a Model for Shareholder Litigation
CONCLUSION


INTRODUCTION

Stockholder appraisal is undergoing a profound transformation in Delaware. We demonstrate that appraisal activity has grown rapidly over the past three years, and this rise in appraisal litigation has been accompanied by the appearance of a new breed of appraisal arbitrageur. These developments--in stark contrast to other types of stockholder litigation--hold out great promise for stockholders and corporate law generally.

Stockholder appraisal is a unique remedy in corporate law: it allows the stockholder to forego the merger consideration and instead file a judicial proceeding to determine the "fair value" of the shares. (1) We have collected data on all appraisal cases in Delaware for the ten-year period from 2004 to 2013 and present the main results of our study in this Article. (2) Our Article is the first to provide a comprehensive examination of appraisal litigation. The lack of prior work no doubt stems from the prevailing academic view that appraisal "is seldom utilized" (3) and that the hurdles involved make it too cumbersome for stockholders to call upon profitably. (4) These dismissive attitudes towards appraisal are consistent with prior research finding that the appraisal remedy is not economically significant. (5)

With this Article, we show that this view is now badly out of date. Appraisal activity involving public companies is undergoing explosive growth in Delaware, driven by sophisticated parties who specialize in bringing appraisal claims. The value of claims in appraisal in 2013 was nearly $1.5 billion, a tenfold increase from 2004 and nearly one percent of the equity value of all merger activity in 2013. (6) Furthermore, the institutions bringing these claims are not the Potemkin "institutions" that often appear in securities or derivative litigation. (7) Appraisal claims are being brought by sophisticated entities that appear to have developed specialized investment strategies based on appraisal. This type of investing has come to be known as appraisal arbitrage and has utterly transformed what may once have been accurately characterized as a sleepy corporate law backwater.

While we can offer no perfect explanation for the rise in appraisal arbitrage, we can confidently dismiss two possible explanations that have been suggested. (8) The first ties the increase in appraisal to In re Appraisal of Transkaryotic Therapies, Inc., a 2007 Chancery Court decision. (9) Transkaryotic expanded the time frame for purchasing appraisal-eligible stock in advance of a stockholder vote to approve a merger. But the judicial ruling itself likely contributed little, if at all, to the rise in appraisal arbitrage. Transkaryotic only marginally expanded the time available to arbitrageurs for evaluating appraisal claims and, more importantly, only affected a subset of merger transactions. Thus, the larger trend is unlikely to be the result of the Transkaryotic holding. Likewise, a new statutory interest rate available to appraisal petitioners (the federal funds rate plus five percent) is unlikely to have been the catalyst for the appraisal boom. (10) Given the risks an appraisal petitioner must assume--an extended period of illiquidity with an unsecured claim against a surviving company that may be highly leveraged, plus the risk of the legal claim itself--the idea that interest rates are driving sophisticated parties to target appraisal is implausible.

Whatever its cause, the surge in appraisal litigation implicates a host of important public policy questions. The increased activity coincides with a rise in stockholder fiduciary litigation generally. (11) By many accounts, that fiduciary litigation is a hotbed of nuisance claims of dubious social value. (12) Accordingly, it is natural to fear that the increase in appraisal arbitrage is an ominous development. Appraisal litigation, however, is structured in a way that renders the risks of meritless, attorney-driven litigation remote.

In particular, two unique features distinguish appraisal. (13) First, appraisal claims can be purchased: a stockholder need not own the stock on the date the challenged merger is announced. (14) This feature stands in contrast to a standard stockholder claim, where the only stockholders who may press a claim are those who owned the stock at the time of the alleged wrong. (15) Second, there is no conventional class action: a stockholder is only eligible to file an appraisal petition if she affirmatively opts-in by meeting certain procedural requirements. (16) The result is a form of aggregate litigation where the aggregation is performed, and the litigation controlled, by the actual plaintiff--the appraisal arbitrageur--rather than the plaintiffs' attorney. Indeed, some of the largest appraisal petitioners appear to shun contingency arrangements altogether and instead pay their attorneys by the hour. In addition, the narrow focus of an appraisal claim and the possibility a court will determine fair value to be below the merger price render the risks and costs of litigation far more symmetric than in other forms of shareholder suit, further reducing the potential for nuisance claims.

We test these propositions empirically and show that appraisal suits indeed bear multiple indicia of litigation merit. (17) The analysis presented below reveals that appraisal petitioners target transactions with lower deal premia and also going-private transactions, where minority shareholders are most likely to face expropriation. By contrast, the size of the transaction--believed to correlate more with the size of the potential nuisance settlement and long the chief determinant of fiduciary litigation--does not appear to matter at all for appraisal petitioners. (18) We present summary results on these points here and report these findings more fully in a companion paper. (19)

In light of these empirical findings, we argue here that the rise of appraisal arbitrage is, on balance, a beneficial development. (20) Much as the market for corporate control generates a disciplining effect on management, a robust market for appraisal arbitrage could serve as an effective back-end check on expropriation from stockholders in merger transactions. The implications in related-party mergers are plain: appraisal can protect minority holders against opportunism at the hands of controlling stockholders. And in third-party transactions, appraisal can serve as a bulwark against sloth, negligence, or unconscious bias in the sales process. For appraisal to perform such a role, however, a deep and active appraisal arbitrage market is necessary. (21) By buying up large positions after the announcement of a transaction, arbitrageurs can overcome the collective action problems that would otherwise render appraisal ineffective. At bottom, appraisal arbitrage solves the same collective action problems that class action and other aggregate litigation seeks to solve, but without generating a serious agency problem in the process.

A highly developed appraisal arbitrage market would aid minority shareholders--even those not equipped to pursue appraisal themselves--by deterring abusive mergers and by causing shares traded postannouncement to be bid up to the expected value of an appraisal claim. (22) Such a result would benefit not only minority shareholders, but also--in the long run--controlling shareholders, entrepreneurs, and the economy at large. If appraisal arbitrage reduces the risk of expropriation faced by minority shareholders, it will increase the value of minority stakes and thus reduce the costs of capital for companies and increase the allocative efficiency of capital markets as a whole. (23)

In spite of our empirical findings that appraisal activity is associated with merit, and the benefits we argue will be generated by increased appraisal arbitrage, defendants have already begun to argue that appraisal arbitrage constitutes an abuse of the appraisal process. (24) This may be, in part, an attempt to re-litigate the point in Transkaryotic and foreclose any shares acquired after the voting record date from seeking appraisal. More generally, this may be the opening salvo in an attempt to curtail appraisal rights by altering the substantive standard in appraisal proceedings. We believe that either would be a regrettable misstep for Delaware law. One of the great virtues of appraisal litigation is that its substantive standard defies manipulation and cannot be evaded or altered by purely procedural means such as the formation of a committee or inclusion of a particular voting provision in a merger agreement. (25) We show here that the choice to initiate appraisal proceedings appears strongly focused on litigation merit. It would be a cruel irony if appraisal litigation--where the evidence suggests that the merits matter--were to be "reformed" by importing features of fiduciary merger litigation, where the evidence suggests the legal merits are functionally irrelevant. (26) Indeed, the more promising direction of reform is the reverse: borrowing features from appraisal and applying them to other forms of shareholder litigation. We offer some tentative thoughts on potential reforms along these lines. (27)

This is not to suggest that the appraisal remedy, as currently constituted, could not be improved. Indeed, the basic premise of appraisal--that a judicial proceeding can provide a more reliable valuation of stock than some market process--fails in predicable circumstances. In our view, a genuine market test of the target company will necessarily provide a superior valuation of the stockholders' interest, and in such circumstances an appraisal proceeding can only cause mischief. For this reason, we would support the development of a safe harbor to eliminate appraisal where the transaction has undergone a true auction. A target could affirmatively seek the protection of the safe harbor only by subjecting itself to a genuine market test, not merely by engaging in a procedural kabuki dance that happens to satisfy Revlon. (28) Our second reform proposal focuses on decoupling appraisal rights from the form of merger consideration. Delaware currently limits the availability of appraisal to mergers where the consideration takes certain forms--primarily cash or non-public shares. We argue that the form of merger consideration should be irrelevant to eligibility for appraisal. The adequacy of the consideration paid in a merger does not, at the end of the day, depend on the form of that consideration. Our two reform proposals together would improve the functioning of appraisal arbitrage as a mechanism of corporate governance.

This Article proceeds as follows. Part I provides a brief summary of the structure of appraisal litigation and prior scholarly perspectives. Part II presents the results of our empirical investigation of appraisal activity, showing since 2011 a large increase in activity and the emergence of appraisal arbitrageurs. Part III demonstrates that the merits appear to matter in the decision to file appraisal petitions. Part IV argues that, in light of these empirical findings, appraisal arbitrage has the potential to play a beneficial role in corporate governance. Part V suggests reforms for appraisal and for fiduciary litigation.

I. THE ROLE OF APPRAISAL IN CORPORATE LAW

Appraisal allows a stockholder to dissent from a merger and forego the merger consideration in favor of filing a judicial proceeding that will determine the "fair value" of the stock cancelled in the merger. (29) This Part describes the design of modern appraisal statutes in Delaware and elsewhere and also outlines the overwhelmingly pessimistic view of appraisal in prior legal scholarship.

A. The Statutory Design of Appraisal

The origin of the modern appraisal action can be traced back to basic changes in American corporate law at the beginning of the twentieth century. (30) Older corporate codes required the unanimous consent of all shareholders before a merger or other fundamental change. (31) The holdout problem--a single shareholder could stand in the way of any significant transaction--became severe as companies increasingly tapped public equity markets. (32) In response, states amended their corporate codes to eliminate the requirement of unanimity and replace it with a majority-voting rule. (33) This change stripped minority shareholders of protection against majority expropriation, and the appraisal remedy emerged as something of a replacement. (34) Appraisal affords minority shareholders who object to a fundamental transaction the opportunity to exit from the enterprise on terms set by a judge instead of majority shareholders. (35)

The availability of appraisal rights varies from jurisdiction to jurisdiction. In MBCA states, appraisal rights are available in a wide array of circumstances, including a merger, a sale of assets, or an amendment to the certificate of incorporation. (36) In Delaware, by contrast, only mergers give rise to appraisal rights. (37) For public companies, the form of consideration also affects eligibility for appraisal. The remedy is available if cash is the merger consideration but not if shareholders receive stock in the surviving entity or in another widely traded entity--the so-called "market out" exception. (38) Even when a transaction gives rise to appraisal rights, stockholders must affirmatively comply with a number of requirements to be eligible to pursue the remedy. For example, the stockholder must not vote in favor of the merger, (39) must deliver to the company a written demand of appraisal rights, (40) and must file a petition in the Court of Chancery within (120) days of the merger's effective date. (41)

B. The Critique of Appraisal

Appraisal has long been regarded in the corporate law literature as an almost useless remedy. Scholarly commentators throughout the 1960s and 1970s heaped scorn on it. Bayless Manning issued perhaps the most well-known indictment in a 1962 Yale Law Journal piece, describing appraisal as "of virtually no economic advantage to the usual shareholder except in highly specialized situations." (42) Similarly, Victor Brudney and Marvin Chirelstein called it a "last-ditch check on management improvidence," (43) and Melvin A. Eisenberg described it as a "remedy of desperation." (44) Part of the reason these commentators found appraisal so pointless is that transactions can often be structured to avoid it. At a Delaware firm, for example, a sale of all assets would have the same economic effect as a merger but, unlike a merger, would not give rise to appraisal rights.

Academic commentary continues to take a sweepingly dismissive view of appraisal. (45) The modern critique faults appraisal because, as one Delaware court noted, it is "chock-full of disadvantages for shareholders." (46) These disadvantages tend to fall into three categories:

(1) the procedural burdens of preserving and asserting an appraisal remedy; (2) the inability to proceed as a class and shift attorneys' fees to shareholders as a whole or to defendants; and (3) the narrow and inflexible nature of the remedy available. Taken together, these disadvantages have led many scholars to believe that appraisal will almost never prove useful.

The literature is replete with references to the supposedly Byzantine procedure for asserting one's appraisal rights. Leading casebooks refer to appraisal as "a cumbersome remedy," (47) and one that requires shareholders of Delaware corporations to navigate a "complicated maze ... to successfully assert appraisal rights." (48) Others have suggested that "[a]ppraisal litigation is complicated and expensive" and that "many shareholders find it difficult to meet the complicated procedural requirements and deadlines of the appraisal remedy." (49) On top of the supposed complexity, a shareholder bringing an appraisal action in Delaware is required to forego the merger consideration, and thus may not finance the litigation out of the merger proceeds, such that they "may receive no return on their investment for prolonged periods of time." (50) Indeed, courts in appraisal actions can, and occasionally do, (51) determine fair value of the plaintiffs shares to be less than the merger consideration. (52) In contrast, fiduciary duty class action plaintiffs have typically already received the merger consideration and face no financial downside, giving fiduciary litigation an option value that is absent in appraisal actions. (53)

Perhaps the main reason given for the supposed impotence of the appraisal remedy is the inability to proceed as a class. (54) While shareholders not desiring to be represented in a typical stockholder class action must try to opt-out, (55) shareholders seeking judicial appraisal must "opt-in." (56) Moreover, because dissenting shareholders must vote against the merger and give notice of intent to pursue appraisal, the process of opting-in must actually begin long before the appraisal petition is filed. (57) As Ronald Gilson and Jeffrey Gordon note, this procedural difference between opt-out fiduciary litigation and opt-in appraisal litigation is "ultimately of enormous substantive consequence." (58)

Given the superficial similarity of the issues and remedies involved in a fiduciary duty proceeding and in an appraisal action, the availability of class treatment in the former potentially makes it far more attractive, at least in theory. (59) The major benefit of class treatment to the plaintiff (or her attorney) is that it allows litigation costs to be spread over the potentially much larger class of aggrieved minority shareholders. (60) Some commentators also suggest that the unavailability of attorney fee-shifting in most Delaware appraisal actions further increases the relative costs of appraisal litigation to the plaintiff. (61) Fee shifting, however, may be less economically significant than it appears at first glance. Even where fee shifting is available, any fees must come out of what the defendant would otherwise be prepared to offer to settle the case. In most cases, it will make little economic difference whether the defendant pays the plaintiffs' attorneys--in which case the defendant will be willing to pay less to settle the case--or if the plaintiff pays--in which case it will come out of the settlement. In either situation, the plaintiff ends up bearing most or all of the economic cost. The more significant difference between a fiduciary class action and an appraisal action stems not from the unavailability of fee shifting, but rather that a larger class leads to a larger plaintiff group and greater leverage to extract a settlement. Plaintiffs' attorneys in fiduciary class actions can bear the up-front costs of bringing a claim, (62) secure in the knowledge that they will be able to settle the claim for at least nuisance value.

Appraisal is potentially even less attractive in view of the narrow scope of the remedy available. Plaintiffs in appraisal actions are limited to receiving fair value for their shares. (63) Typically, of course, that is precisely the remedy the shareholder wants. Nonetheless, this limited remedy has a tactical drawback compared to the otherwise similar fiduciary duty class action. (64) The threat of injunction or rescission--even where it is not really what the stockholder is after--can significantly increase the settlement leverage of a plaintiff in a fiduciary duty class action. (65)

With these disadvantages in mind, it is easy to see why so many commentators have come to the conclusion that plaintiffs will rarely, if ever, choose to pursue an appraisal action instead of a fiduciary duty class action. All of the "incentive[s] for plaintiffs [are] to reject the technically easier option of an appraisal action for the more onerous burden of proving a fiduciary breach." (66) With a fiduciary class action almost always available to challenge suspect transactions, (67) one might simply conclude that appraisal is unnecessary and can safely be abandoned.

Several commentators, however, have suggested that appraisal should be reformed, rather than consigned to the scrap heap. (68) Naturally enough, suggestions for reform center on making the appraisal action look more like the typical fiduciary duty class action. (69) Most prominently, a number of scholars have suggested extending opt-out class treatment to appraisal actions. (70)

Modifying appraisal to allow opt-out class treatment would, however, potentially have substantial downsides, in addition to any upside gained. Class treatment would almost certainly expand the practical availability of appraisal and could theoretically help address any under-deterrence problem. But it would also introduce the same agency-cost dynamics that have traditionally bedeviled shareholder litigation. As we explain, the very feature of appraisal action that attracts the most criticism--the unavailability of class treatment--also has the great virtue of largely eliminating the kinds of agency problems that can lead to abusive and wasteful shareholder litigation. (71) Furthermore, the new phenomenon of appraisal arbitrage has the potential to solve the same collective action problems addressed by aggregate litigation, while avoiding the agency problems that plague class actions.

A singular feature of appraisal litigation--and one essential to the rise of appraisal arbitrage--is that standing to bring an appraisal petition is not limited to investors who held stock at the time of the announcement. In securities and derivative litigation, standing to bring the claims is limited by the so-called contemporaneous ownership requirement. (72) This means that investors who acquire the stock after the alleged wrong may not bring suit to remedy it. Appraisal is different in an important way: an investor who acquires the stock after the announcement of the merger may still pursue appraisal. The cutoff for acquiring stock with appraisal rights depends on the structure of the transaction, (73) but investors generally have long enough to examine proxy statements, tender offer statements, or other informational material before deciding whether to acquire stock with appraisal rights. This means that an investor can accumulate a large stake in a company after the announcement of a merger and still pursue appraisal rights in court. (74)

II. THE RISE OF APPRAISAL ARBITRAGE

Prior examinations of appraisal have largely taken place in an empirical vacuum. To remedy this, we have collected all appraisal petitions filed in the Delaware Court of Chancery for the ten-year period from the start of 2004 through the end of 2013. In addition, by examining public filings we have collected information on the dissenters and their claims. (75) The focus of our analysis is on appraisal petitions filed against public companies. (76) We use this data set to provide the first full picture of modern appraisal activity. (77)

Our data reveal Delaware is in the midst of a sea change in appraisal litigation. While appraisal may once have been a quiet corner of corporate law, it is now an area of active litigation undergoing a period of explosive growth. Furthermore, the parties driving that growth are a new group of sophisticated investors who appear to specialize in pursuing appraisal claims. (78) In short, we have documented the rise of appraisal arbitrage.

A. The Surge in Appraisal Activity

A basic result of our investigation is that appraisal activity involving public companies increased substantially starting in 2011, as measured both by the number of petitions filed and the value of the dissenting shares.

The most basic way to measure appraisal activity is by the raw counts of petitions filed. During our ten-year period of study, 129 appraisal petitions were filed in Delaware involving counseled petitioners. (79) Figure 1 shows the number of petitions filed per year.

Figure 1 shows the effective year of the underlying transaction, rather than the filing year of the petition. (80) The reason for focusing on the transaction year is that a petitioner has 120 days following the effective date to file a petition, and the effective date better captures the timing from the perspective of the appraisal investor, who will have already begun the process of dissenting at that point. The basic change in appraisal activity is evident from Figure 1. The level of appraisal activity in 2011 and 2012 was matched earlier only in 2007, and activity in 2013 has only increased. This represents a lower bound of appraisal activity in Delaware because some claims by dissenting shareholders are resolved before the petition is ever filed. (81)

The recent change in appraisal activity becomes even more apparent when we compare appraisal claims to the number of appraisal-eligible mergers. From 2004 through 2010, the number of appraisal petitions moved roughly in tandem with the general level of merger activity, rising through 2007 and thereafter falling along with the number of mergers after the financial crisis. A more or less constant percentage of mergers attracted appraisal claims in this period. This pattern changed sharply, however, beginning in 2011. Despite a lower level of overall merger activity, the number of petitions filed in 2011 and 2012 matched the number filed at the peak of the pre-financial crisis merger wave, and the number of petitions in 2013 is larger still. This change in the pattern of appraisal litigation comes into sharper relief in Figure 2, which presents appraisal petitions as percentage of appraisal-eligible mergers.

Approximately five percent of appraisal-eligible transactions attracted at least one appraisal petition from 2004 through 2010. The appraisal rate more than doubled in 2011 and has continued to increase since then. By 2013, more than fifteen percent of transactions attracted an appraisal petition.

The raw numbers or percentage of deals facing appraisal petitions, however, tell us little about the economic significance of appraisal litigation. Using the merger price and the number of dissenting shares, we can calculate the amount of foregone merger consideration in each appraisal dispute, obtaining at least a rough measure of the economic value at stake in the case.

The values at stake in appraisal proceedings have also increased sharply in recent years. The 129 petitions we observed involved 106 separate transactions over our study period. The mean value of the foregone merger consideration in an appraisal dispute over the entire period was $30 million and does not appear to have followed any strong trend over time. When combined with the increase in the number of petitions over time, however, the total dollar amount at stake in appraisal proceedings in each year shows a large increase in recent years, particularly the most recent year. Figure 3 shows the value of the dissenting shares in Delaware appraisal petitions for each year of our study period.

The amount of money involved in 2013 is nearly three times the amount involved in any prior year and ten times the 2004 amount. To some extent, this effect is driven by outliers. The largest appraisal case over our study period is Dell, a 2013 transaction where $654 million worth of shares dissented. The second largest is Transkaryotic Therapies ("Transkaryotic"), a 2005 transaction where $520 million worth of shares sought appraisal. (82) But in some ways, excluding these two very large cases only makes the new trend clearer. Without Transkaryotic, the values at stake in appraisal never exceeded $300 million in any given year; while in 2013 the values at stake approach one billion dollars even excluding Dell. Most tellingly, over the ten-year period, only eight appraisal cases have involved more than $100 million, and four of them were in 2013.

Perhaps the most remarkable thing about appraisal activity during the new 2011 to 2013 era is that, unlike 2007 and 2008, the increase in numbers and economic significance of appraisal does not coincide with an increase in merger activity. In other words, the rise in appraisal activity since 2011 appears to reflect a secular increase in interest in appraisal, rather than a mere cyclical phenomenon tied to the conditions of the merger market. For each year in our study period, we tallied the equity value of all appraisal-eligible transactions and then computed the percentage of value that sought appraisal. In 2013, 0.92% of the equity value dissented, nearly three times higher than any prior year. Indeed, the percentage of dissenting equity value was never higher than 0.10% in any prior year except 2005, the year of Transkaryotic. (83)

B. The Sophistication of Appraisal Petitioners

In addition to the increasing volume of appraisal activity--measured both in number of petitions and the dollar values at stake--the profile of the public company appraisal petitioner has changed sharply in the recent period. In particular, petitioners have become increasingly specialized and sophisticated over our time period, with repeat petitioners increasingly dominating appraisal activity. Since 2011, more than eighty percent of appraisal proceedings have involved a repeat petitioner--that is, a petitioner who filed more than one appraisal petition across our study period. Three constellations of related funds appear more than ten times each. Perhaps the most striking result of our investigation is the increase in the economic significance of repeat players in appraisal. Figure 4 shows the value of shares per year in appraisal held by repeat petitioners.

The rise in repeat petitioner value beginning in 2010 is immediately apparent. Before 2010, appraisal appears to have been largely a one-off exercise for aggrieved stockholders. Repeat petitioners played a small role, and there is little evidence that funds were seeking appraisal as part of a considered investment strategy. Starting in 2010, however, and accelerating through 2013, the repeat petitioner dominates. Indeed, every appraisal case filed in 2013 involved at least one repeat petitioner.

By virtue of the unique standing requirements in appraisal, (84) these specialized appraisal petitioners are typically able to invest in the target company after the announcement of the transaction they challenge. The decision to invest, then, is based on a calculation that the amount they will be able to recover in an appraisal proceeding in Delaware--via trial or settlement--will exceed the merger price by enough to offer an attractive return. This practice can be fairly characterized as appraisal arbitrage--by analogy to traditional merger arbitrage (85)--and those who practice it may be termed appraisal arbitrageurs. (86) Table 1 presents summary statistics for repeat dissenters. The first column reports the total value of stock the fund or group of funds has dissented on in our study period; the second column reports the number of transactions in which the fund has publicly dissented; the third column reports the mean value of the petitioner group filing the case. The second column reports the mean value of all dissenters in the case (including those who did not file petitions), which compared to the third column reveals whether the fund tends to operate by itself or often ends up in cases with other dissenters.

Unlike in fiduciary litigation--where "professional plaintiffs" tend to be small shareholders with close ties to plaintiffs' firms--the repeat appraisal petitioners, especially at the top end of the field, appear to be sophisticated parties specializing in appraisal. For example, the largest repeat petitioner is Merion Capital, with over $700 million invested in appraisal claims. Merion has been involved in seven cases since 2010, with increasingly large amounts at stake. The fund is based in Pennsylvania and headed by Andrew Barroway, a successful plaintiffs' lawyer from Philadelphia. It made its first public appraisal investment in 2010, with $8.5 million at stake. After a number of appraisal petitions averaging around $50 million in value at stake during 2012 and 2013, Merion reportedly raised a targeted amount of $1 billion for a dedicated appraisal fund in 2013. (87) During 2013, it filed two appraisal petitions with an average value at stake of $177 million.

Another large and recent repeat petitioner is Verition Fund, a Greenwich-based fund that has been involved in four cases, all in 2013, with an average of $25 million at stake. Verition is managed by Nicholas Maounis, who formerly headed Greenwich-based Amaranth Advisors. (88) Other recent entrants are Fortress Investment Group, a large publicly traded hedge fund, and Hudson Bay Capital Management, both of which filed large appraisal petitions in 2013. Similarly, major mutual funds and insurance companies--two types of institutions that have entirely avoided standard stockholder litigation--have recently filed appraisal petitions. (89) Much is often made of the involvement of institutional investors (or the lack thereof) in corporate governance. (90) All too often in corporate litigation, the so-called "institutions" are akin to the Bailiffs' Retirement Fund of Chippewa Falls, while sophisticated financial players remain on the sidelines. (91) The institutions that are beginning to specialize in appraisal, by contrast, are among the most sophisticated financial entities in the United States.

Beyond the bulge bracket appraisal petitioners are a handful of specialized smaller funds that have been quite active. Some join larger petitioner groups, perhaps to capture economies in pursuing the case. A larger group may make the threat to go to trial more credible, increasing the bargaining position of all dissenters. Two features of the Delaware appraisal statute make this strategy possible. First, after the merger closes, a dissenter stockholder is entitled under Section 262(e) to demand a statement of the aggregate number of shares demanding appraisal from the surviving company. (92) A dissenter might seek this information to confirm the existence of other dissenters who, for example, can help spread the costs of prosecuting the appraisal case. If the dissenter does not like the results of the information supplied by the company, it has a statutory right to withdraw its dissent and accept the merger consideration. (93)

C. The Increasingly Competitive World of Appraisal Litigation

The manner in which appraisal litigation proceeds also appears to be changing in ways that may indicate increasing competition among appraisal petitioners. Dissenting shareholders have 120 days following the merger's effective date to file a petition in court demanding the judicial appraisal. (94) That 120-day period can often be a time for negotiation, and the parties may settle their dispute before ever filing a claim. Figure 5 shows a kernel density plot (95) of filing times from the effective date of the merger for two appraisal petitions challenging two sets of mergers: (1) those from 2004 through 2010, shown in black and (2) those from 2011 through 2013, shown in gray.

The black line suggests that petitioners commonly took the entire 120 days to negotiate over their disputes before filing in the 2004 through 2010 period. The gray line shows the lag between the merger and the filing from 2011 through 2013, and reveals that parties are filing their petitions much faster, more often not bothering to go through an initial round of settlement discussions before filing. We can only speculate on the causes of this, but one explanation may indeed be increasing competition among shareholders dissenting on the same transaction. One of the advantages of filing is that it compels the surviving company to identify publicly all other shareholders who have preserved the right to seek appraisal. (96) Doing so may make it harder for other dissenting shareholders to strike a separate bargain without including the filing shareholder. Filing faster may also provide an advantage in selecting lead counsel and managing the claims. The new filing pattern may also indicate that petitioners do not believe that claims are likely to settle without substantial litigation activity, and they may be anxious to proceed to discovery. In any event, we tentatively interpret this shift as a sign that appraisal arbitrage is becoming more competitive.

D. What Explains the Rise in Appraisal Arbitrage?

We lack a compelling explanation for the rise in appraisal arbitrage identified here. We can, however, confidently dismiss two theories that have sometimes been offered by defense-side lawyers to explain this increase.

The first theory that has often been floated is that a 2007 Chancery decision called In re Appraisal of Transkaryotic Therapies (97) opened the floodgates for appraisal litigation. (98) The Transkaryotic opinion arose from an extremely large appraisal proceeding involving nearly half a billion dollars in foregone merger consideration. (99) Many of the shareholders seeking appraisal had acquired their stock after the record date for voting in the merger, but before the actual vote on the merger. (100) The court held that holders of shares acquired during that period were eligible to pursue appraisal, despite the inability of the petitioners to show how the shares had been voted, so long as the total number of shares seeking appraisal did not exceed the total number of "no" votes plus abstentions. (101) According to defense attorneys, appraisal arbitrageurs "are taking advantage of the flexibility of Transkaryotic," (102)

The trouble with this explanation is that the Transkaryotic holding--in addition to coming out nearly four years before the recent surge in appraisal activity--created only a marginal increase in the window of time during which would-be appraisal petitioners may buy stock. Weeks or months typically pass between the announcement of a transaction and the record date, and stock acquired in that period has always been available for appraisal. A company's preliminary proxy statement, of course, may disclose new information that would make an appraisal claim more attractive, and the Transkaryotic ruling allows potential investors more time to consider the proxy contents. By the same token, the Transkaryotic ruling also ensures that companies cannot set the record date opportunistically to preclude appraisal claims. The more fundamental problem with relying on the Transkaryotic decision to explain the rise in appraisal claims is that Transkaryotic is only relevant in a transaction structure that contemplates a shareholder vote, and many do not. In a tender offer followed by a Section 251(h) merger, a short-form merger, or a merger approved by written consent of a majority of holders, no shareholder vote is required and thus the Transkaryotic ruling can have had no impact. These types of transactions constitute a substantial portion of M&A activity, and an even larger proportion of appraisal targets.

To investigate the possible role of Transkaryotic, we separated out transactions that were affected by the ruling and those that were not, and examined the change in appraisal litigation for each group. Our data show that the rise in appraisal activity appears strongest outside of the transaction structure affected by Transkaryotic. The Chancery Court issued the Transkaryotic decision in the summer of 2008. During the period from 2004 to 2007, stockholders filed appraisal petitions in approximately 5% of transactions structured as a tender offer and approximately 5% of those structured as a standard merger with a shareholder vote subject to the Transkaryotic rule. If the Transkaryotic ruling mattered, we would expect to see that transactions affected by the ruling would be more likely to involve an appraisal petition. We find the opposite. In the post-Transkaryotic era, from 2009 to 2013, stockholders dissented in approximately 9% of transactions subject to Transkaryotic. By contrast, in tender offer deals--which were entirely unaffected by the ruling in Transkaryotic--the appraisal rate was 13%. These numbers suggest that whatever legal changes were wrought by the Transkaryotic decision do not appear to have moved the needle on appraisal activity.

The second explanation sometimes offered is centered on the interest rates available to appraisal petitioners. Appraisal petitioners are entitled to interest on amounts recovered in their petitions from the effective date of the merger. Delaware amended its appraisal statute in 2007 (103) to set the interest rate equal to the federal funds rate plus five percent, compounded quarterly. (104) Some lawyers have suggested that in an era of historically low interest rates, the interest rate available to appraisal petitioners has attracted investors to appraisal. (105) The apparent theory is that an investor could park money in an appraisal claim, and even if the court found the merger price to represent fair value, the investor would receive an attractive return. Vice Chancellor Glasscock, too, has voiced a "concern about whether the interest rate that the Legislature has set encourages these types of appraisal cases." (106)

In our view, the statutory interest rate cannot account for the rise in appraisal activity. As an initial matter, the timing does not line up: interest rates dropped precipitously in 2009, two years before the sharp rise in appraisal activity. More fundamentally, it is unlikely that a five percent premium over the federal funds rate would represent an attractive return under the circumstances, given the substantial risks associated with an appraisal proceeding. Appraisal petitioners function as unsecured creditors of the surviving company, holding a claim of uncertain value to be determined by litigation. While the statutory rate no doubt is better than what petitioners could get in a money market account, it likely undercompensates them for the risk of their position. The appraisal interest rate surely defrays some of the risk, particularly compared to other conventional measures of interest in legal scenarios. But petitioners are exposed not only to the credit risk of the surviving company, but also to the financial risk associated with the trial. Petitioners are only entitled to demand an award of interest if they take their claims all the way to trial, which typically takes well over a year and carries with it the risk that the appraised value could be less than the foregone merger consideration. The idea that sophisticated investors are pouring hundreds of millions of dollars into risky appraisal proceedings to chase above-market interest rates simply is not credible.

Yet another potential explanation for the rise of appraisal litigation is that it is simply part of the roughly contemporaneous trend in merger litigation. As others have shown, fiduciary class actions challenging mergers have recently become ubiquitous, touching over 90% of transactions above $100 million. (107) Our own data on fiduciary challenges to mergers--which cover only appraisal-eligible transactions--confirm this same phenomenon. In 2004, 36% of transactions attracted a fiduciary challenge; by 2013, 90% of transactions did. Figure 6 shows the trend in fiduciary litigation from 2004 to 2013 in gray and plotted on the left axis, and it shows the trend in appraisal litigation over the same period in black and plotted on the right axis.

Fiduciary litigation rose sharply in 2009, and since 2010, stockholders have challenged more than eighty-five percent of transactions. The rise in appraisal litigation did not start until 2011, two years after the litigation rate rose in fiduciary litigation. It certainly could be the case that there is some connection between the rise in the two types of litigation, given that they both involve legal action relating to mergers. Beyond these superficial similarities, however, there is no reason to conclude any connection between the two types of litigation. The parties who appear to be driving appraisal arbitrage--the sophisticated investors we described above--have little connection to fiduciary litigation and historically have had no interest in it. There are thus no grounds to suspect that the rise in appraisal activity has anything to do with the rise of fiduciary litigation.

In the end, we can identify no single causative factor to account for the rise in appraisal arbitrage. We suspect that it may simply be a case of a few investors who, somewhat by accident, found themselves considering appraisal as a method for salvaging an investment following a bad merger, became intrigued by the opportunity, and explored it further. As word spread of their success, others mimicked the strategy. Indeed, the Transkaryotic transaction itself--and not the judicial opinion that grew out of it--may have functioned as a catalyst for interest in appraisal. Among the class of dissenting shareholders in Transkaryotic were some of the most sophisticated entities on Wall Street, including various Carl Icahn affiliates, SAC Capital Advisors, and Millennium Management. (108) Transkaryotic was acquired by Shire Pic for $37 per share. (109) Appraisal cases that settle are not made public because unlike standard shareholder litigation they do not bind non-signatories. (110) But Shire is a public company and had to disclose developments in the litigation in its periodic SEC reports. Shire announced the settlement of the Transkaryotic claims in November 2008, (111) and it disclosed that the settlement "paid the same price of $37 per share originally offered to all TKT shareholders at the time of the July 2005 merger, plus interest." (112) This account of the Transkaryotic settlement frequently appears in subsequent retellings of the case. (113)

This description of the settlement, however, obscures its significance. First of all, paying interest in a settlement is puzzling: a settling acquirer is under no obligation to include interest in the settlement, and, in any event, this case was filed before Delaware adopted the statutory interest rate discussed above. Moreover, from the petitioners' perspective, the label attached to the settlement funds is unimportant--a dollar is a dollar, whether it is part of the "settlement price" or the "interest" on the settlement price. Shire only disclosed the aggregate interest award, (114) but by dividing this amount by the number of shares seeking appraisal it is possible to determine the per share figure for the entire settlement: precisely $50 per share. Thus, the amount of the "interest" award appears to have been reverse-engineered to achieve a pre-determined (and favorable) per-share settlement price. The net result was that the petitioners recovered a thirty-five percent premium on what would remain the largest appraisal claim in history until the Dell case in 2013. The successful result in Transkaryotic, though it was partially concealed, might in fact be a major part of what has sparked interest in appraisal.
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Title Annotation:mergers and aquisitions; Abstract through II. The Rise of Appraisal Arbitrage, p. 1551-1583
Author:Korsmo, Charles R.; Myers, Minor
Publication:Washington University Law Review
Date:Sep 1, 2015
Words:7679
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