An Ounce of Prevention: Managing the Increased Threat of Appraisal Proceedings Under Delaware Law
Except in the case of certain stock-for-stock mergers, stockholders of Delaware corporations that are acquired in merger transactions generally have a statutory right to a court appraisal of the value of their shares. Historically, this appraisal remedy has been pursued relatively infrequently, and significant disincentives to seeking an appraisal continue to exist. Nonetheless, acquirers should be cognizant of the risk that some target stockholders may be dissatisfied with the consideration offered in a merger and, consequently, may seek an appraisal of their shares. This risk may be heightened by various judicial decisions that have liberalized the valuation methodologies used, and the results obtained, in appraisal proceedings. Consequently, acquirers may want to take appropriate action to manage this risk to the extent practical in the circumstances presented.
Overview of DGCL Section 262
Section 262 of the Delaware General Corporation Law (the "DGCL") provides appraisal rights to the holders of record of shares of any corporation that is a party to a merger or consolidation, subject to specified exceptions and to compliance with specified procedural requirements.
Significant exceptions to the availability of appraisal rights include the denial of appraisal rights in respect of (i) shares of the corporation surviving the merger if the merger does not require the approval of the stockholders of such corporation and (ii) 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. These exceptions do not apply, however, if the holders of such shares are required to accept in the merger any consideration in exchange for such shares other than (i) shares of stock of the corporation surviving or resulting from the merger or consolidation, (ii) 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, (iii) cash in lieu of fractional shares, or (iv) any combination of the foregoing. In addition, these exceptions do not apply in respect of shares held by minority stockholders that are converted in a short-form merger.
Significant procedural requirements in connection with the perfection of appraisal rights include (i) continuous record ownership of the relevant shares from the date of the demand for appraisal through the effective date of the merger, (ii) not voting in favor of the merger or consenting to it in writing, (iii) delivery of a written demand for appraisal prior to the taking of the stockholder vote on the merger (or, in the case of a short-form merger or a merger approved by a written consent of stockholders, within 20 days of the mailing of a notice to stockholders informing them of the approval of the merger), (iv) filing of a petition with the Delaware Court of Chancery within 120 days after the effective date of the merger, and (v) service of a copy of such petition on the corporation surviving the merger.
Within 20 days of being served with a copy of the petition, the surviving corporation must file with the court a list containing the names and addresses of all stockholders 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 stockholders who have perfected their appraisal rights.
After determining the stockholders 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. The court will also determine the fair rate of simple or compound interest, if any, to be paid upon such fair value. Thereafter, the court will direct the surviving corporation to make payment of the applicable amounts to the stockholders entitled to it. The costs of the appraisal proceeding may be assessed by the court against the parties to it in such manner as the court deems equitable in the circumstances.
From and after the effective date of the merger, stockholders who have demanded appraisal rights are not entitled to vote their shares or to receive any dividends or other distributions (including the merger consideration) on account of these shares unless they properly withdraw their demand for appraisal. Following the filing of a petition, no stockholder may withdraw its demand without the court’s approval, which may be conditioned upon terms the court deems just.
Limiting the Exercise of Appraisal Rights
The use of the appraisal process to assert a serious challenge to the sufficiency of the consideration offered in a merger is relatively rare. According to an article by S. Travis Laster published in the April 2004 issue of Insights, only 33 Delaware cases dealing with appraisal challenges had been reported since 1983. Appraisal cases are rare because various factors ordinarily operate to result in stockholders receiving merger consideration that is fair, and because there are a number of practical disincentives to the pursuit of an appraisal remedy.
Except in the case of a short-form merger, mergers require the approval of the acquired corporation’s board of directors and stockholders. In most cases, the interests of these approving bodies are substantially aligned with those of the stockholders of the target corporation generally. In addition, the directors of the target corporation are required by their fiduciary duties to endeavor to act in the best interests of the corporation’s stockholders and, in circumstances involving a change in control of the target corporation, to seek to maximize the value received by the corporation’s stockholders. In circumstances in which directors of the target corporation who participate in the approval of the transaction or controlling stockholders who stand on both sides of the transaction have interests that differ materially from those of the corporation’s stockholders generally, the fiduciary duties of such directors or controlling stockholders require that they act in a manner that is entirely fair to all of the corporation’s stockholders, including with respect to the merger consideration offered to these stockholders.
The factors described above ordinarily would be expected to result in the stockholders of target corporations receiving fair value for their shares, or at least sufficient value to render the exercise of appraisal rights unattractive. In practice, appraisal rights tend to be exercised most frequently in the context of acquisitions by controlling stockholders of the minority interests in a corporation, presumably because the potential for overreaching tends to be greatest in this context.
Even in circumstances in which legitimate issues regarding the sufficiency of the consideration offered in a merger may exist, there are a number of factors that tend to make appraisal an unattractive remedy. Among other considerations are the following:
- A dissenting stockholder’s failure to comply with relatively complex requirements will result in a forfeiture of its appraisal rights.
- A dissenting stockholder will not receive any value from the merger or otherwise on account of its shares until the appraisal process, which may take several years, has been completed.
- A dissenting stockholder must initially (and, in most cases, ultimately) bear the costs of its legal counsel and valuation experts, subject to any apportionment of costs among dissenters that a court may implement in its discretion.
- The outcome of the court’s appraisal is subject to substantial uncertainties, and the appraised value payable to the dissenting stockholder may be less than the consideration offered to stockholders in the merger.
- The amount of interest, if any, awarded on the appraised value payable to the dissenting stockholder is subject to substantial uncertainties.
Taken together, the factors described above suggest that an appraisal remedy is likely to be viable only if a stockholder (i) has a substantial investment at stake, (ii) is reasonably confident that the appraisal process will result in a valuation substantially in excess of the consideration offered in the merger, (iii) has sufficient liquidity to pay the costs of proceeding in advance of receiving any consideration on account of its shares, and (iv) meticulously complies with all relevant procedural requirements.
Evolution of the Appraisal Process
General. Section 262 provides for an appraisal by the Court of Chancery. If neither of the parties to an appraisal proceeding establishes its proposed valuation by a preponderance of the evidence, the court will make its own determination of value. In so doing, the court is free to accept or reject, in whole or in part, the valuations and methodologies proposed by either or both of the parties.
The Delaware courts have held that a dissenting stockholder is entitled to receive a proportionate share of the fair value of the target corporation as a going concern. Consequently, the Delaware courts value shares in an appraisal proceeding by first valuing the target corporation as a whole and then assigning a pro rata share of that value to the dissenting stockholder. Significantly, this approach does not allow for the application of a "minority discount" in valuing a dissenting stockholder’s shares.
Prior to Weinberger v. UOP, 457 A.2d 701 (Del. 1983), the Delaware courts employed the so-called "Delaware block" valuation methodology to arrive at a value for the corporation as a whole. This methodology, which involved the assignments of weights to various elements of value (e.g., assets, earnings, market price, etc.) and the summation of the resulting values, often produced values lower than those that would be expected to result from negotiations between a willing buyer and seller. In Weinberger, the court rejected this practice, holding that a proper valuation approach "must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court." The Weinberger court also held that the valuation should include elements of future value that are known or susceptible to proof, excluding only speculative elements.
The more liberal approach to valuation mandated by the Weinberger court has led the Delaware courts to consider a much broader array of factors in determining the fair value of a target corporation’s stock. While the additional factors being considered may not necessarily lead to increased valuations, the results are substantially less predictable than those obtained using the Delaware block methodology.
Valuation Methodologies. Since Weinberger, the discounted cash flow ("DCF") valuation methodology has become the primary valuation tool used by Delaware courts in appraisal proceedings. Under this methodology, the target’s equity value is derived from projecting the target’s future cash flows and discounting them to their present value. The assumptions built into a particular DCF model, which ultimately drive the resulting valuation, can require complex analysis of the target corporation’s business and prospects and are often the subject of much debate. Consequently, appraisals using the DCF methodology have become a "battle of experts," in which each side presents competing models based on different assumptions. In the end, the use of competing DCF models can result in highly unpredictable judicial determinations of the value of the target. For example, in Taylor v. Am. Specialty Retail Group, Inc., No. Civ. A. 19239, 2003 WL 21753752 (Del. Ch. July 25, 2003), the court appraised the value of the petitioner’s stock at $9,079.43 per share after considering valuations of $2,200.00 per share and $14,666.67 produced by the parties’ competing DCF valuation models.
The Delaware courts sometimes employ other valuation methodologies, including methodologies that value the target corporation’s stock on the basis of attributes of purportedly comparable companies, including multiples obtained by dividing the market capitalization or acquisition prices of these other companies by specified financial metrics of other such companies (e.g., sales; net income; earnings before income taxes, depreciation, and amortization; net income before taxes; etc.). One or a combination of these valuation methodologies may be used by a court in combination with, or in lieu of, the DCF valuation methodology. Because Section 262 does not mandate any specific valuation method, and because Weinberger permits the consideration of virtually any reasonable method presented, no party to an appraisal action can ever be sure of what method or methods the court will use or what valuation the court will ultimately determine.
Elements of Future Value. Following Weinberger, Delaware courts also began including other elements of future value in their valuation processes, so long as these elements were not "speculative." As illustrated by the following cases, the consideration of these additional elements has led to further uncertainty as to the results of appraisal actions.
In 1983, MacAndrew & Forbes Group, Inc. ("MAF") sought to acquire Technicolor, Inc. ("Technicolor") through a tender offer, followed by a short-form merger. MAF gained control of a majority of Technicolor’s stock in the tender offer and immediately instituted a breakup plan. The short-form merger that followed cashed out the remaining minority interest at the tender offer price, and certain stockholders demanded an appraisal of their shares. A critical factor in the initial valuation determined by the court was that MAF had instituted a breakup plan for Technicolor prior to completion of the short-form merger. The court (in Cede & Co. v. Technicolor, Inc., 684 A.2d 289 (Del. 1996)) held that the breakup plan could be used to calculate the value of the Technicolor stock. The defendants argued that the benefits derived from the acquisition and the resulting breakup plan should not be included in the valuation because they were dependent upon the accomplishment of the merger. The court rejected this argument, holding that the statutory exclusion of value arising from the accomplishment or expectation of the merger is very narrow and is designed to exclude only speculative elements of any value to be derived from the completion of the transaction. After numerous appeals and remands, the Cede litigation was finally resolved in 2005, with the final value of the dissenters’ shares determined to be approximately 24 percent higher than the tender offer price.
In ONTI, Inc. v. Integra Bank, 751 A.2d 904 (Del. Ch. 1999), minority stockholders of OTI, Inc. ("OTI") were cashed out for approximately $6 million in a short-form merger of OTI with and into the New Treatment Companies. Douglas Colkitt controlled 60 percent of OTI at the time of the merger. After the first merger, the New Treatment Companies were merged into Colkitt Oncology Group, a company completely owned by Colkitt. Colkitt Oncology Group then merged with EquiVision, Inc., a publicly traded company of which Colkitt owned 30 percent. The plaintiffs presented valuation models that took into account the value the subsequent mergers added to premerger OTI. This methodology arrived at a value for the cashed-out stock of almost $94 million. The defendants urged the court to exclude this methodology on the basis that the valuation should be determined for premerger OTI on a "going concern basis, not including speculative hopes for future synergies." Citing Cede, the court held that the plaintiff’s proposed valuation must be considered and eventually awarded the minority stockholders approximately $16 million.
Control Premiums. Considerable confusion exists in Delaware case law as to whether the appraised value of the target corporation should include any adjustment to add a control premium or to eliminate a minority discount. This confusion appears to have resulted, at least in part, from the failure of courts to analyze whether a particular valuation methodology employed gives effect to an inherent control premium or an inherent minority discount.
Delaware case law is clear that the value of a dissenting stockholder’s shares is not to be reduced to impose a minority discount reflecting the lack of the stockholders’ control over the corporation. Indeed, this appears to be the rationale for valuing the target corporation as a whole and allocating a proportionate share of that value to the shares of the dissenting stockholder. At the same time, Delaware courts have suggested, without explanation, that the value of the corporation as a whole, and as a going concern, should not include a control premium of the type that might be realized in a sale of the corporation.
The DCF methodology values a corporation on the basis of its projected future cash flows, which are independent of the manner in which control of the target corporation is allocated. Consequently, no adjustment to eliminate a minority discount from a DCF-based valuation is necessary or appropriate. Indeed, it might be argued that a DCF-based valuation inherently reflects a control premium that should be eliminated. On the other hand, if a valuation methodology based upon market trading prices of shares of a comparable company is employed, it is arguable that such reference share prices inherently reflect a minority discount that should be eliminated in valuing the target corporation. Conversely, if a valuation methodology based on the acquisition price of a comparable company is employed, it is arguable that such reference price inherently reflects a control premium that should be eliminated in valuing the target corporation. Unfortunately, the Delaware courts have been inconsistent in their treatment of these concepts, thereby further impairing the predictability of outcomes in appraisal proceedings.
Interest Awards. Section 262 authorizes the court to add simple or compounded interest to the appraised value payable to a dissenting stockholder. The purpose of an interest award is both to require the acquirer to disgorge any benefit it received from its temporary retention of the value of the dissenting stockholder’s shares and to compensate the dissenting stockholder for the delay in receiving such value. In light of the dual purpose of an interest award, the court may consider both the acquirer’s actual cost of borrowing and the notional return that could have been achieved by the prudent investment of funds in an amount equal to the appraised value of the dissenting stockholder’s shares.
If neither of the parties to an appraisal proceeding establishes its proposed award of interest by a preponderance of the evidence, the court will make its own determination with respect to it. In some cases, the court simply awarded the legal rate of interest, or the Federal Reserve discount rate plus 5 percent. In other cases, the court has awarded interest equal to the average of the acquirer’s cost of borrowing and the so-called "prudent investor" rate.
Delaware courts have the discretion to determine whether to award simple or compound interest. Throughout most of Delaware’s appraisal history, courts have awarded simple interest. More recently, however, Delaware courts have been more generous in awarding compound interest. Factors considered by the courts in making these determinations include the amount of the appraised value of the relevant shares and the amount of time that has elapsed since the completion of the merger.
Effects of the Evolution. Since the Weinberger decision, courts have exercised greater discretion in determining what valuation methods to use and in assigning weights to individual methods when multiple methods are used in combination. As a result, appraisal outcomes have become increasingly uncertain. Some cases result in appraised values at or below the merger consideration. More frequently, appraisal proceedings have resulted in values significantly higher than the merger consideration. Of the 33 reported cases noted in Laster’s article, the mean adjudicated premiums were 449.14 percent over the merger consideration, with a median premium of 82.1 percent. Because the appraisal remedy tends to be pursued in only the most egregious circumstances, these statistics do not imply that merger transactions generally involve consideration that is less than fair. Nevertheless, the statistics suggest that, in at least some instances, the appraisal risks for acquirers can be substantial.
Managing Appraisal Risks
Except in the case of a short-form merger, meticulous attention by the target corporation’s directors to their fiduciary duties should ordinarily prevent the corporation from being acquired at a price that is less than fair value. Accordingly, an acquirer should seek, with the assistance of its legal and financial advisors, visibility into the target’s information gathering and analytical and deliberative processes and the manner in which they are documented in order to ensure that a defensible record is produced. In addition, an acquirer should be sensitive to the potential consequences of overreaching in the context of deal protection measures such as exclusivity and no-shop provisions and termination fees (none of which should be problematic unless, in the circumstances presented, they are unduly preclusive of alternative transactions or are otherwise unreasonable).
The disclosure document provided to the target corporation’s stockholders in order to solicit their approval of the merger or to inform them of their appraisal rights should fully apprise them of relevant facts that support the fairness of the merger consideration. Relevant matters in this regard might include, among other matters, historical operating results and future prospects, competitive and other risks, levels of liquidity and capital resources, internal and external indicia of value, efforts to explore strategic alternatives and the results thereof, opportunities for interested parties to submit competing acquisition proposals, and fairness opinions obtained from financial advisors and supporting analyses. As long as the disclosure does not misstate material facts or omit facts necessary to make the statements therein not misleading, informing stockholders of facts supporting the putative fairness of the merger consideration is entirely consistent with helping stockholders to make well-informed decisions.
If one or more stockholders nonetheless make a demand for appraisal, additional communications regarding the reasons why the transaction parties believe that the merger consideration is fair, and why the pursuit of an appraisal may be costly, time-consuming, and counterproductive, may result in the withdrawal of the demand. Communications of this type tend to be particularly effective where the demanding stockholder has a relatively modest investment and may not fully appreciate the factors supporting the fairness of the merger consideration and the costs and risks associated with the pursuit of an appraisal.
In addition to the foregoing, certain structural mechanisms may provide a degree of protection to acquirers from the potential consequences of stockholder demands for appraisal. These mechanisms include, among others, conditioning the acquirer’s obligation to consummate the transaction on the absence of demands for appraisal in respect of a specified maximum number of shares and, if the target corporation is closely held, requiring nondissenting stockholders to indemnify the acquirer from the consequences of appraisals demanded by their dissenting cohorts. It may also be desirable to obtain commitments from target stockholders to vote in favor of the proposed transaction (thereby effectively waiving their appraisal rights), although such arrangements may need to be limited to directors, officers, and substantial stockholders of the target corporation due to securities law concerns. Finally, it may be desirable for the acquirer to seek to purchase shares in advance of the merger in transactions that do not give rise to appraisal rights, such as tender offers, market purchases, and privately negotiated transactions. Or, less commonly, it may be possible to effect the acquisition by means of a transaction, such as an asset purchase, that does not give rise to appraisal rights.
Acquirers should also be aware that the development and implementation prior to the completion of the acquisition of the plans to enhance post-acquisition value may result in a greater appraised value for any dissenting stockholders. However, as is the case in considering any of the foregoing or other means of managing appraisal risks, it is necessary to analyze carefully all of the related pros and cons.
For the most part, the appraisal remedy provided by Section 262 of the DGCL continues to be used only sparingly. Other safeguards result in the fair pricing of most acquisition transactions, and the costs and risk-adjusted rewards associated with the appraisal remedy tend to make it unattractive in many situations where the sufficiency of the merger consideration may be questionable. In short, pursuit of the appraisal remedy is likely to be viable only where a stockholder or group of stockholders acting in concert have both a substantial investment at stake and a reasonably high degree of confidence that a court will arrive at an appraised value that is substantially higher than the merger consideration.
Factors that have contributed to the recent rise in appraisal actions include more accommodating judicial attitudes toward dissenters and the valuation theories and evidence that they proffer, and the concentration of the shares of many companies in the hands of large institutional investors. The former of these factors increases the risk that a court appraisal will substantially exceed the merger consideration, while the latter increases the risk that enough value will be at stake to motivate one or more stockholders to incur the costs associated with pursuing an appraisal.
Consequently, at least in some circumstances, the availability of appraisal rights may pose a significant risk to the acquirer. Acquirers should therefore evaluate the appraisal-related risks presented by any particular transaction and carefully consider strategies designed to minimize the likelihood of a successful appraisal action.
Mark E. Betzen
Mark, a partner in the Dallas Office, has more than 20 years of experience in assisting principals and other participants in a wide variety of sophisticated corporate, securities, and business transactions. He has extensive experience in mergers, acquisitions, and dispositions involving publicly traded and closely held companies and in equity and debt financing transactions. Mark co-heads the Mergers & Acquisitions Practice in the Firm’s Dallas Office.
Matthew R. Shurte
Matt is an associate in the Columbus Office. His practice primarily involves mergers and acquisitions, financing transactions, and general business counseling. He also has experience in securities offerings and compliance, shareholder disputes, corporate governance matters, and real estate transactions.