The going-private frenzy, combined with the recent trend of including post-signing market check “go shop” provisions in merger agreements for unshopped deals, has led to increased shareholder activism among investors who are dissatisfied with the consideration being offered in mergers and other consolidations. Their “just say no” campaigns, whether through public statements or active solicitations, have met with mixed success, as shareholders will often take whatever premium is offered if a higher offer does not surface.
Increasingly, activist investors have turned to the appraisal remedy to seek redress. Recent case law supports the notion that the employment of appraisal rights by activist shareholders can be an effective mechanism for maximizing investment returns, as the Delaware courts have (1) awarded signifi cant premiums over the consideration offered in the subject transactions, (2) begun to accept with increased regularity a range of valuation methodologies and (3) recently clarifi ed that the acquisition of shares post-record date will not necessarily invalidate an appraisal demand with respect to those shares.
A recent example of a successful appraisal campaign waged by a hedge fund involves the going-private transaction by Innovative Communications Corp. of its majority-owned subsidiary, Emerging Communications Inc., where Greenlight Capital LLC was awarded a fair value decision of approximately 270% over the per share merger consideration of $10.25. Other examples include Gabelli Asset Management Inc.’s 2004 appraisal action against Carter Wallace Inc., in which the investment fi rm realized a more than 40% premium in a settlement with Carter-Wallace over its appraisal litigation1 and The Prescott Group LLC’s (“Prescott”) appraisal action against The Coleman Company Inc., where Prescott was awarded a 455% premium.2 Cases currently pending include the appraisal actions brought by Carl Icahn against Transkaryotic Therapies Inc. (“TKT”) and Westchester Capital Management Inc.’s appraisal action against Instinet Group Inc. Sometimes, the mere threat of invoking appraisal rights can lead an acquirer to increase the offer consideration, as witnessed by (1) Elkcorp’s recent decision to accept a $43.50 per share offer after Ramius Capital Group LLC threatened to invoke its appraisal rights when Elkcorp said it favored a lower bid,3 (2) Healthcor Management, LP’s threat to perfect its appraisal rights in the ICOS Corp. acquisition, leading the acquirer, Eli Lilly & Co., to increase the per share consideration from $32 to $344 and (3) Lawndale Capital Management LLC’s threat to invoke its appraisal rights against National Home Health Care Corp., if the $11.50 per share price offered by Angelo Gordon & Co., was not increased.5 Subsequently, Angelo Gordon & Co. increased its offer in the pending transaction to $12.50.
However, while a successful appraisal campaign can no doubt yield signifi cant benefi ts to the dissenting shareholder (which do not have to be shared with other shareholders), the pursuit of such a strategy is not without its share of risks and disincentives. Investors would be well-advised to thoroughly understand and appreciate the strict nature of the legal compliance necessary to comply with Delaware’s appraisal rights statute, the dynamics of the process to invoke appraisal rights and the attendant considerations that a typical appraisal proceeding dictates.
The appraisal right is, in many ways, a by-product of the corporation of yesteryear, when signifi cant corporate decisions, such as mergers, required the unanimous consent of a corporation’s shareholders.6 Such a burdensome requirement had the obvious effect of subjecting the will of the majority to that of the minority and allowed any one shareholder to effectively hold the corporation hostage.7 Ultimately, states acknowledged the problems inherent in such a construct and, accordingly, passed laws allowing for the less than unanimous approval of signifi cant corporate events.8 However, in order to protect minority shareholders who did not approve of corporate events, such as mergers, states began adopting laws that enabled dissenting shareholders to monetize their investment as a means of compensation for their loss of common law rights to veto such transactions.9
The Appraisal Process
The appraisal rights contained in Section 262 of the Delaware General Corporation Law (the “DGCL”) are available, subject to certain limited exceptions, to the record owners of shares of any corporation that is a constituent to a merger or consolidation. Typically, appraisal rights arise in the context of all cash and stock/ cash combination mergers.
Appraisal rights will be denied with respect to (1) shares of the corporation surviving the merger if the merger does not require the approval of the shareholders of such corporation and (2) in what has been commonly referred to as the “market-out exception,” shares of any class or series that is listed on any national security exchange, quoted on the NASDAQ national market system, or held of record by more than 2,000 holders.10 However, appraisal rights will be restored if the consideration to be received is comprised of anything but:
- shares of stock of the corporation surviving or resulting from the merger or consolidation,
- shares of stock of any other corporation that will be listed on a national securities exchange, quoted on the NASDAQ national market system, or held of record by more than 2,000 holders,
- cash in lieu of fractional shares, or
- any combination of the foregoing.11
The subject corporation must deliver notice to its shareholders advising them of the availability of appraisal rights and the methods to perfect such rights, which notice, in the event of a long-form merger, must be delivered at least 20 days prior to the shareholder meeting convened for the purpose of approving the business combination.12 But perfecting appraisal rights is not always a simple task, since its requirements consist of:
- continuous record ownership through the effective date of the merger,
- not voting in favor of, or consenting to, the transaction,
- delivery to the corporation by the dissenting shareholders of a written appraisal demand prior to the shareholder meeting on the merger,13
- fi ling of a petition with the Delaware Court of Chancery within 120 days after the effective date of the merger, and
- service of a copy of such petition on the corporation surviving the merger.14
Appraisal rights will be denied for failure to meet any deadline or to strictly comply with the statute.15 Moreover, it is the dissenting shareholder that bears the burden of proof that he or she has complied with the requirements imposed by Section 262 of the DGCL.16 Perhaps most importantly, it should be noted that appraisal rights are only available to shareholders of record and not benefi cial owners of shares and any demand that is inconsistent in its description of the record owner will likely be denied.17 This point is particularly relevant to activist investors, since benefi cial owners, whose shares are held in the name of brokers or fi duciaries, are not shareholders of record; therefore, technically, they are not entitled to appraisal rights.18
Activist fund investors who wish to pursue the appraisal remedy should confi rm through their brokers that, in fact, the registered owner (typically the custodian or the custodian’s master custodian, i.e., the Depository Trust Company (“DTC”) or its nominees, Cede & Co. (“Cede”)) send the appraisal demand and fi le any subsequent petitions, since the latter and not the former are the true record owners for purposes of Section 262 of the DGCL.19 In addition, given the growing tendency of investors to use such synthetic instruments as total return swaps, prepaid variable forwards, options, warrants and other similar derivative securities, such positions must be unwound and shares must be held in kind in order for an investor to employ its appraisal rights. Similarly, stock lent out on margin should be returned prior to the shareholder meeting in order to (1) ensure that such shares will not be voted for the merger by the borrower of such securities and (2) satisfy the continuous holding requirement imposed by Section 262(a) of the DGCL. Ideally, investors should insist on removing such rights from their prime brokerage agreements to protect against these and other related risks.
The appraisal demand, among other things, provides the subject corporation with the percentage of shareholders seeking appraisal, which is especially crucial for mergers conditioned on the percentage of dissenting shareholders not exceeding a specifi ed threshold. This data forms the basis from which the constituent corporations can evaluate not only deal certainty but real economic risk, should the merger proceed,20 sometimes leading the acquirer to increase the offer price in an effort to mitigate the appraisal threat. In fact, some hedge funds employ arbitrage strategies premised solely on this dynamic or as part of a broader strategy to exploit what they see as value differential in a given transaction context. However, it should be noted that the acquirer may always waive the appraisal condition and close the merger over the appraisal claims. Indeed, Shire Pharmaceuticals Group plc (“Shire”) exercised precisely that option when a reported 34.6%21 of the outstanding TKT shareholders perfected their appraisal demands in the face of a condition in the merger agreement placing a cap on dissenters at 15%.22 Shire is now faced with having to deal with Icahn and others in court, where the value of the merger consideration will be tested.
The “continuous holding” requirement is intended to deny appraisal rights to a party who was a shareholder of record as of the demand date and as of the effective date of the merger but not in between, by virtue of selling shares during the window period.23 Accordingly, a shareholder will be estopped from pursuing its appraisal remedy where it can be demonstrated that such shareholder sold or bought shares between the demand date and the consummation of the merger.24 However, as clarifi ed by the Delaware Court of Chancery’s ruling in the recent entitlement challenge involving Ichan’s appraisal demand against TKT, assuming satisfaction with all other relevant conditions, a shareholder will not forfeit the right to an appraisal remedy merely by purchasing shares after the record date set for approving the merger.25 This decision alone may impact the level of appraisal demands brought by activist holders, particularly those who buy shares after a transaction is announced.
In addition to Icahn, hedge funds including Millenco LLP, Porter Orlin LLC, Atticus Capital LP, Sigma Capital Associates LLC, CR Intrinsic Investments LLC and Viking Global Equities LP fi led petitions asking the court to establish the fair value of their holdings in TKT, which they believed was far in excess of the $37 per share acquisition price offered by Shire. Although the petitioners only owned approximately 2.9 million shares as of the record date, they began to accumulate a position which, together with shares previously benefi cially owned by them, totaled approximately 11 million shares in the aggregate. As a result, if the court rules in the petitioners’ favor, the TKT appraisal proceeding could result in Shire writing a substantial additional check.26 In fact, according to its most recent 10-Q, Shire has established a specifi c reserve in the amount of $38.6 million merely for the provision of interest that may be awarded by the Delaware Chancery Court in the appraisal proceeding.
Cede, as nominee for DTC, was the record owner of all the shares throughout the period. In fact, Cede was the record owner of approximately 30 million TKT shares, of which only 13 million were voted for the merger. Despite well settled case law supporting the notion that an entity that is a record holder but not the benefi cial owner of shares “can vote certain of those shares against a merger, and others in favor, and seek appraisal as to the dissenting shares,”27 TKT asserted in its entitlement challenge that the court must look through the record owner and force the petitioners to prove that the shares over which they sought appraisal were not voted for the merger by the previous benefi cial owner. The court denied TKT’s contention and reaffi rmed the notion that appraisal rights are only available to record owners who have “an absolute right to proceed under Section 262 once the record holder complies with its requirements.”28 Furthermore, in answering the question, “Must a benefi cial shareholder, who purchased shares after the record date but before the merger vote, prove, by documentation, that each newly acquired share (i.e., after the record date) is a share not voted in favor of the merger by the previous benefi cial shareholder?,” the court responded with a clear negative.29 In fact, the court even conceded that its ruling may encourage arbitrageurs to seek appraisal rights by “free-riding on Cede’s votes” but left the responsibility of addressing that potential problem with the legislature.30 Particularly, the ruling has the potential effect of enabling activist investors to review the defi nitive proxy disclosure which details important aspects of the transaction including process and valuation but may not be available until after the record date has been set, and thereby assess the transaction’s “appraisal profi le” and make their investment after the meeting’s record date has been established. So long as the total number of dissenting shares does not exceed the total number of shares that have abstained or voted no on the merger, and assuming the investor has otherwise perfected his appraisal demand, such investor’s post-record date acquired dissenting shares should, as per the TKT ruling, qualify for appraisal.
Before fi ling a petition for appraisal with the Court of Chancery, a shareholder should exercise its right pursuant to Section 262(e) of the DGCL to request a statement from the corporation setting forth the aggregate number of shares not voted in favor of the merger and for which demands for appraisal have been received together with the aggregate number of holders of such shares, which the corporation must respond to in relatively short order. This statement enables the shareholder to conduct a cost/benefi t analysis in determining whether it should pursue its appraisal demand, since the corporation’s response will indicate how many people might be expected to share the costs of the proceeding.
If, after examining the statement of shares or for any other reason, the shareholder does not desire to complete the process, he may withdraw his appraisal demand with respect to some or all of his shares,31 at any time up until 60 days after the effective date of the merger without consent and accept the terms of the merger.32 After the 60-day period, the appraisal right vests, and a shareholder may withdraw an appraisal demand only with the written consent of the corporation, and if a petition has been fi led permission of the court is also required.33
After deciding to proceed, a dissenting shareholder must (unless the corporation has previously done so) fi le a petition for appraisal with the Court of Chancery demanding a determination of the value of the shares of all shareholders entitled to appraisal within 120 days after the effective date of the merger.34 Within 20 days of being served with a copy of the petition, the surviving corporation must fi le with the court a list containing the names and addresses of all shareholders who have demanded payment of fair value for their shares and with whom agreements as to such value have not been reached. Thereafter, the court will hold a hearing on the petition and determine the shareholders who have perfected their appraisal rights.35
After determining the shareholders entitled to an appraisal, the court will appraise the shares, determining their fair value exclusive of any element of value arising from the accomplishment or expectation of the merger,36 as discussed in the next section. The court will also determine the fair rate of simple or compound interest, calculated from the merger’s effective date to the payment date,37 if any, to be paid upon such fair value.38
Thereafter, the court will direct the surviving corporation to make payment of the applicable amounts to the shareholders entitled to such payment. The costs of the appraisal proceeding may be assessed by the court against the parties in such manner as the court deems equitable in the circumstances.39 However, as noted earlier, upon application to the court, a shareholder may request that the court order that all or a portion of the expenses incurred by any one shareholder be shared pro rata among all dissenting shareholders.40
A note of caution is warranted. Appraisal proceedings require patience. A typical appraisal proceeding involves cumbersome discovery, expert witnesses and trial resulting in a process that could take at least two to three years.41 Delays and appeals are not uncommon and can stretch the proceeding out further, with some proceedings lasting as long as 10 to 15 years.42 As discussed, although the court is usually willing to grant interest, the amount of the award is uncertain and nevertheless will probably not approximate the return an investor could realize on other investments. Some have argued that given the time delay, although most appraisal demands result in a fair value determination in excess of the offered consideration in the merger, annual returns to the petitioner often top out at 10%.43 Coupled with this fact is the signifi cant level of expense required to pursue an appraisal remedy, which can cost approximately $1-2 million over a three-year period.44 The majority of these costs are comprised of legal and expert witness fees, which generally may not be shifted to the surviving corporation. Although the ability to allocate a portion of the expenses incurred by a petitioner shareholder among all petitioners may temper the expense burden, this factor, together with the nature of illiquidity the appraisal process entails, must be considered before embarking on such a campaign.
The Delaware appraisal statute requires that shareholders receive fair value for their shares, based on the shareholders’ proportionate interest in the going concern value (not the fair market value) of the target corporation as of the merger’s closing date.45 While appraisal determinations often result in awards in excess of the consideration offered in the subject transaction, courts can, and indeed have, determined fair value in amounts lower than the offered consideration.46
However, fair-value determinations have become an unpredictable exercise, with courts utilizing several different approaches, sometimes independent of each other and other times on a blended basis. Prior to the decision in Weinberger v. UOP, Inc.47 (considered the leading case on appraisal proceedings), the Delaware courts only used the Delaware Block Method of valuation, which values a going concern based on a weighted average of asset value, market value and capitalized earnings. The court applies the weight based on the signifi cance of each relevant metric to the subject corporation; however, when employing this method the earnings metric is typically given the most weight.48 The Weinberger court held that the Delaware Block Method was not to be the exclusive method in assessing fair value and that “a more liberal approach must include proof of value by any techniques or methods which are generally considered acceptable in the fi nancial community and otherwise admissible in court.”49
In valuing a business, Delaware courts can take into account any element of future value that are susceptible of proof, including market value, asset value, dividends, earning prospects, the nature of the enterprise, externalities that might have depressed the current market, cyclical earnings, and whether management timed the merger in anticipation of a positive development.50 The appraisal process in certain circumstances, therefore, may neutralize any attempted timing advantage sought by the acquirer based on a cyclical period of shallow earnings or unfavorable market conditions.51 Appraisal valuation techniques cannot include synergies or other benefi ts derived from the merger or other factors which are speculative in nature, the rationale being that the dissenting shareholder is entitled to his pro rata portion of the going concern value of the subject corporation as in effect prior to the merger. Therefore, similarly, a minority discount cannot be assessed against the fair value of the appraisal shares.52 However, since the fair value determination is measured at a point in time immediately prior to the effectiveness of the merger, and not on the date the merger agreement was signed or the merger was approved by stockholders, any increase in value in the enterprise fl ows to the benefi t of the stockholder.53 Since Weinberger, Delaware courts have come to favor the Discounted Cash Flow (“DCF”) model of valuation,54 where the value of an asset is found to be the present value of the discounted stream of future free cash fl ows that the asset can generate. The DCF model relies on cash fl ow projections, terminal value and a specifi ed discount rate. In assessing the future cash fl ows, the Delaware courts tend to use managements’ projections, although each party may use their own estimates so long as they are relevant. Applying management’s projections can often benefi t the dissenter, as those projections may be more positive than those of an acquirer. Nevertheless, competing DCF valuations often lead to a high degree of unpredictability in the process overall. Typically, a fi ve-year period is applied, although the measurement period could be shorter or longer based on the particular circumstances. The discount rate is computed based on the entity’s weighted average cost of capital, where its cost of equity is derived using the capital asset pricing model and its cost of debt is such entity’s historical cost of debt fi nancing.
While DCF is perhaps the predominant valuation technique in appraisal proceedings, by no means does it enjoy exclusivity. The courts have employed comparable company and transaction analyses, earnings and asset value tests, and market benchmarks. In fact, some recent case law on the topic suggests that courts are now more willing to apply other techniques. For instance, in the Union Illinois case, the court took comfort in the fairness surrounding the sale process and concluded that the merger price resulted from an effective marketing campaign and auction. Therefore, it used that price as the benchmark and proceeded to determine whether any additional value could be attributed to the shares between the signing date and closing date of the transaction, and in fact none was found. Interestingly, the court tested its determination against the DCF approach and found that, in applying the latter, a value lower than the merger price would result, given the fact that post-merger synergies would have to be stripped out of that valuation. In fact, the actual appraisal award was approximately 7% lower than the merger price, not taking into account the contingent rights associated therewith.55
Other recent appraisal proceedings have utilized comparable company and comparable transaction analyses.56 The comparable company method involves analyzing publicly traded industry competitors and comparing their per share prices as a multiple of relevant economic indicators, such as revenues, EBITDA or EBIT, and then applying those multiples to the subject company. The comparable transaction method does not employ performance ratios as a multiple of market price but instead compares comparable transaction prices to such ratios.
Of interest will be whether the courts will assign any value to offers made during go-shop periods that are in excess of the merger consideration ultimately accepted by the target’s board. For instance, with respect to the potential takeover of Topps Inc. by Michael Eisner, despite the existence of a go-shop provision in the merger agreement which yielded an offer that was $1.00 more than the consideration offered by Eisner, the Topps’ board rejected this subsequent higher offer and proceeded to do business with Eisner.57 Other examples of such board action include the takeover deals for EGL Inc. and Genesis Healthcare Corp.58 Activist investors, disappointed with these types of board decisions, may decide to avail themselves of the appraisal process and use these higher offers as support for higher valuations.
Complicating matters further, the courts seem to be inconsistent in the treatment of control premiums, minority discounts and other similar factors as they relate to such market based approaches. Unlike the DCF approach, which is entirely free from such vagaries, other market-based approaches, some argue, have the potential to embed within them either minority discounts or control premiums. For instance, some commentators assert that inherent in a comparable company analysis is a minority discount, since the resulting determination is based on the market price of comparable companies. As with the comparable company method, some point out the diffi culty with the comparable transaction approach, noting that it implies a control premium and the analysis is based on transaction prices that assume such premiums.
Nevertheless, some have demonstrated that an analysis of appraisal awards granted over the past 20 years imply median premiums in excess of 80%, interest awards of over 9% and some awards of over 400% above the merger price.59 A review of selected appraisal cases within the past fi ve years indicate that premiums within the range of 200–300% are not uncommon.60
Is Appraisal Advisable to Activist Investors?
The appraisal process is administratively complex and potentially risky for the dissenting shareholder. Shareholders seeking appraisal must be prepared to invest considerable time and expense in pursuing their rights under the Delaware statute. Even when the process proceeds expeditiously, shareholders face the risk that the court will undervalue the company and their shares. Dissenters must initially bear all their litigation expenses and do not receive payment until fi nally ordered by the court, and then only receive reimbursement depending on the number of other dissenters, each of whom must pay their share of the costs. Dissenters’ expenses, such as attorney and expert fees, can only be charged against the value of the appraised shares and cannot be recovered from the corporation. Even though ultimately divided up amongst dissenters, in the event that an appraisal proceeding devolves into a battle of experts, the fees dissenters must absorb can become signifi cant. The valuation process carried out by the Court of Chancery is also subject to substantial uncertainty. A shareholder seeking appraisal runs the risk that the appraised value received is less than the consideration offered to shareholders in the merger. Additionally, the amount of interest, if any, awarded on the appraised value is subject to substantial uncertainties.
These factors may serve as practical disincentives for activist investors to pursue appraisal rights. Perhaps these disincentives account for the fact that, as one commentator notes, only 33 Delaware cases dealing with appraisal challenges had been reported between 1983 and 2004.61
However, and particularly where the facts demonstrate that a less-than-robust sales process took place or where evidence of non-arm’s length terms can be proven to exist, an appraisal proceeding can result in a substantial recovery to the dissenting activist investor who has the patience and fortitude to see the process through to its ultimate conclusion. These circumstances typically exist in squeeze-out mergers by controlling shareholders, transactions where management shareholders are on both sides, short form mergers where shareholder approval is not required by the DGCL, and unshopped or lightlyshopped deals. The TKT ruling provides the activist investor with added comfort of diligencing his target after the record date has been set in order to make a more informed investment decision to seek or increase his appraisal demand. In these situations, where the facts can demonstrate the absence of fair dealing or fair value, the dissenting investor can profi t and the recent trends in the Delaware Chancery Court are in the shareholder’s favor.