The use of a statutory appraisal proceeding as an investment strategy

December 2014 | SPOTLIGHT | MERGERS & ACQUISITIONS

There are many occasions when shareholders of a corporation are deprived of their ownership interest in that corporation against their will, either through merger, recapitalisation or as the result of some other corporate transaction. Even when shareholders do not believe that the transaction involves any illegal or improper actions on the part of management or the controlling shareholder, they may still be entitled to a premium over the deal price. Such a premium may be available through the use of a statutory appraisal proceeding.

Empirical evidence from appraisal cases over the last 20 years shows that awards of over 400 percent above the deal price are not uncommon and that the median premium exceeds 80 percent. In Delaware, by statute, interest awards are 5 percent above a federal funds rate for the period during which the proceeding was pending.

Right to appraisal and applicable procedures

Section 262 of the Delaware General Corporation Law (DGCL) governs the appraisal remedy for shareholders of Delaware companies and provides an appraisal right in a transaction where the shareholders receive cash in return for their shares, but not where a shareholder receives shares of another corporation. The right to pursue an appraisal is available to any stockholder of a Delaware corporation who: (i) holds shares of stock on the date a demand for appraisal is made; (ii) continuously holds such shares through the effective date of the merger or consolidation; (iii) has neither voted in favour of the merger or consolidation nor consented thereto in writing; and (iv) files a demand for appraisal with the corporation prior to the shareholder meeting where the transaction is to be voted upon. Where the above requirements under Section 262 are satisfied, the “dissenting stockholder has an absolute right to an appraisal”.

Once an appraisal action is commenced, there is no motion to dismiss. The filing of the petition and compliance with the requirements of Section 262 establish the existence of a claim. Because of the narrowly focused nature of the appraisal remedy, appraisal litigation is usually less time-consuming, expensive and onerous than litigation, where the primary goal is to determine whether a defendant did, or did not, commit an illegal or improper act. It is therefore often possible for an appraisal case to be tried within 12 to 24 months after the petition for appraisal is filed, as opposed to three to five years in other types of complex litigation.

Fair value

The Delaware Code requires that a shareholder be paid “fair value” for the shares subject to appraisal. Fair value requires that the corporation be valued as it is operating at the time of the transaction. The shareholder then receives its interest in the going concern entity as represented by its percentage shareholding (i.e., if it owns 10 percent of shares, it gets 10 percent of the value).

Fair value is not the market value of the shares – i.e., what they would fetch on the open market. The determination of fair value does not include any value that may be created as the result of the transaction that caused the appraisal, such as new management’s plans, for example. The appraisal is of the company exactly as it was being run as of the date of the transaction.

In valuing a company, there are a number of different methods that can be used. The various valuation methodologies include the discounted cash flow (DCF) methodology, the comparable companies methodology, and the comparable transactions methodology. Although the DCF methodology is often used by Delaware Courts, no one methodology is required and the goal is to use the methodology that best captures the going concern value of the entity being appraised.

It is important to note what an appraisal proceeding does not involve. It does not require allegations of wrongdoing on the part of the corporation or its executives or any claim that they breached a duty or somehow acted improperly. The only issue is the value of the shareholder’s stake in the corporation.

Post-record date purchases

In 2007, the Delaware Court of Chancery was asked to consider whether an investor who purchased shares after the record date, but prior to the merger vote, was eligible to seek appraisal on those shares. The question arose in connection with the 2005 acquisition of Transkaryotic Therapies, Inc. (TKT) by Shire Pharmaceuticals Group plc, in which certain shareholders sought appraisal on almost 11 million shares held “of record” by nominee Cede & Co. Approximately 8 million of those shares were purchased after the record date but before the shareholder vote on the merger. TKT petitioned the Court to exclude the 8 million post-record date shares from the appraisal action, contending that these beneficial owners could not prove whether their specific shares were not voted in favour of the merger and were not, therefore, entitled to appraisal under Section 262.

The Court rejected TKT’s argument, holding that, as long as the aggregate number of shares seeking appraisal is less than the aggregate number of shares for which the nominee voted against, abstained or did not vote in connection with the merger, appraisal rights may be asserted. The Court reasoned that: “as long as enough shares qualify for appraisal… then appraisal claims can go forward by beneficial owners who, not having personally instructed Cede on the vote, otherwise comply with the legal requirements”.

This opinion effectively opened the door for investors to leverage a post-record date appraisal investment strategy as a tool in their portfolio.

Conclusion

Investors should be fully aware of the possibility of an appraisal action in determining whether to vote for and ultimately accept the proceeds of any transaction in which they are being cashed out of their investment. Particularly in cases where there is an indicia of self-interest by parties to the transaction, there is a good prospect for a recovery that is in excess of the deal price. Such a recovery can be obtained more expeditiously and efficiently than other forms of litigation and without any accusation or determination of fault by the defendant company, its management or its controlling shareholders. Full awareness of the requirements and potential value of appraisal litigation should be a part of every investor’s process of evaluating potential cash-out transactions.

Geoffrey C. Jarvis is a director at Grant & Eisenhofer P.A. He can be contacted on +1 (302) 622 7040 or by email: gjarvis@gelaw.com.

Geoffrey C. Jarvis

Grant & Eisenhofer P.A.