It’s now accepted wisdom that virtually all public company mergers and acquisitions will be challenged with at least one lawsuit — over 95 percent of them are. A less well-publicized form of challenge — and one that is both fascinating and perplexing for those interested in securities litigation — is the unique creature of Delaware law known as the appraisal proceeding. Under Delaware General Corporation Law §262, shareholders dissenting from a merger on grounds that the share price they’ll receive is inadequate “shall be entitled to an appraisal by the Court of Chancery of the fair value of the stockholder’s shares of stock.” If the court finds that the deal price is lower than fair market value, the acquiring corporation must pay the difference to the dissenting shareholders, plus interest. The court may also award their attorneys’ and experts’ fees, which can be significant. This process has created a cottage industry of “appraisal arbitrage,” in which hedge funds purchase shares in hopes of securing a higher price for those shares through appraisal. Fortunately, D&O insurance might be available to cover the acquired company’s defense and other costs.
An insurance company’s duty is to pay defense costs under D&O insurance is generally triggered by allegations of “wrongful acts” committed by the insured individual directors and officers or the company. Because a typical appraisal petition alleges the per-share acquisition price of the target company’s stock and other basic facts relating to the merger, many in the D&O insurance “community” have viewed appraisal proceedings incorrectly as a simple exercise in economics, not an allegation of “wrongful acts.”
This cramped approach ignores the reality of appraisal proceedings today, which tend to focus on the adequacy of the process by which the purchase price was determined. A board may have fulfilled its fiduciary duties, but still have failed to meet the requirements of a fair process implicit in Section 262. Numerous recent decisions make this point. As the Chancery Court said in In re Appraisal of Dell Inc.: “[A] sale process might pass muster for the purposes of a breach of fiduciary claim and yet still generate a sub-optimal process for purposes of an appraisal.” In reviewing this process, the Chancery Court may examine whether there was meaningful competition among bidders, whether the seller offered adequate and reliable information, whether there was evidence of collusion or favoritism towards certain bidders, whether the seller sought topping bids during a go-shop period, and whether the board obtained an independent third-party valuation, among other factors.
While the claimant’s burden of proof in establishing liability under Section 262 is relatively low, so is the standard for meeting the typical D&O policy’s requirement of an alleged “wrongful act.” The definition of “wrongful act” commonly encompasses “any actual or alleged breach of duty, neglect, error, misstatement, misleading statement, [or] omission” — in short, almost any corporate act or omission. As a result, a board’s alleged “omission” in failing to follow an adequate sales process may be considered a wrongful act under a D&O policy’s broad definition of that term.
In many cases, the claimants may couple their appraisal claim with a breach of fiduciary duty claim, asserting improper self-dealing or other misconduct by a target company’s directors and officers. Such allegations are well within the scope of the Chancery Court’s Section 262 mandate, which is to consider “all relevant factors” in reviewing the sale process and determining the “true” pre-merger value of the company. Appraisal proceedings may also give rise to separate breach of fiduciary duty and/or securities litigation. The fact that appraisal proceedings generally delve into the adequacy of the sales process and other “relevant factors” provides a strong basis for coverage under D&O policies.
Another nuance to the trigger of coverage issue is whether an appraisal action is considered a claim against a board of directors, or a claim against the corporate entity. As noted, inherent in appraisal proceedings today are implicit allegations of wrongful acts committed by the company’s board. Allegations against individual directors and officers for wrongful acts typically trigger “Side B” coverage — D&O coverage for amounts that the company must pay to indemnify those individuals. The named defendant in appraisal proceedings is generally the company, not the board. However, even if viewed as a claim against the entity, an appraisal action may trigger “Side C” coverage — public company D&O coverage which is typically limited to “securities claims.”
While an appraisal proceeding relates to securities by definition, it does not require allegations of securities law violations. D&O insurers may seek to avoid “Side C” coverage of appraisal proceedings for that reason. But in some policies, the definition of “securities claim” does not require that a claim specifically allege the violation of federal or state securities laws. And courts have recently expanded the scope of what constitutes a “securities claim” under D&O policies. A recent Delaware Superior Court decision held that a lawsuit that did not contain direct allegations of securities violations was still a “securities claim” because the plaintiffs’ allegations related to issues inherent in laws regulating securities transactions. Under such a broad construction, allegations in appraisal actions that the insured failed to implement an adequate process to obtain the optimum purchase price may well trigger Side C “securities claim” coverage.
There is even more support for coverage for appraisal proceedings in the “inadequate consideration” or “price adjustment” exclusion to the definition of “loss” found in most D&O policies — sometimes referred to as a “bump-up” exclusion. Under this exclusion, covered “loss” does not include the additional merger consideration that any party may be ordered to pay as a result of a claim alleging that the price paid for the company’s stock is inadequate. Sound familiar? What is important is that defense costs are usually expressly carved out of this exclusion. This indicates that insurers intend to cover defense costs for exactly those kinds of claims — claims that appear in appraisal actions. So the “bump-up” exclusion and its carve-back for defense costs appear to provide strong support for coverage of defendants’ appraisal action defense costs under standard D&O policies. If the court awards the appraisal claimants’ often significant attorneys’ and experts’ fees, those may also be covered even in the absence of indemnity coverage.
Practical Tips for Policyholders
Every Delaware-incorporated policyholder engaged in merger negotiations and at risk of an appraisal challenge should take the following steps:
- Promptly notify your D&O carrier of an appraisal demand made under Section 262. Be sure to include any facts or circumstances that may be raised in the appraisal proceeding concerning the process for deriving the purchase price, assumptions used, or other such matters that may arise in the proceeding. This will set the table for a dialogue about coverage for the eventual appraisal litigation.
- Consult with your broker about coverage limits and constraints on defense coverage.
- Seek consent from your insurers for the law firm engaged in the appraisal proceeding, along with economic and forensic accounting experts.
- Consult competent coverage counsel to explore all possibilities for coverage given the particularities of policy language and the facts surrounding the merger.
This article also was posted on the Harvard Law School Forum on Corporate Governance and Financial Regulation on August 17, 2017.