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February 24, 2015

Delaware Appraisal Actions Are Likely to Continue to Increase in Frequency Following Two Recent Delaware Chancery Court Decisions

There has been a significant increase in the incidence of appraisal actions in connection with public mergers since 2011.  According to one study, the percentage of petitions has increased from a historic average of around five percent for the period from 2004 through 2010, to over 15 percent in 2013.[1]  This has coincided with the formation of a number of funds that specialize in appraisal arbitrage, such as Merion Capital LP.  This trend is likely to continue, in the wake of two recent decisions, In re Appraisal, Inc.[2] ( and Merion Capital LP v.  BMC Software, Inc. (BMC Software),[3] which upheld the standing of appraisal arbitrageurs to bring appraisal actions with respect to shares purchased after the record date for the stockholder vote on the merger. Revalidates Holding of Transkaryotic That Share-Tracing Is Not Required in Appraisal Actions

The decision affirmed the continued validity of the holding in the 2007 decision In re:  Appraisal of Transkaryotic Therapies, Inc.[4] (Transkaryotic), notwithstanding a subsequent amendment to Delaware’s appraisal statute, Section 262 of the Delaware General Corporation Law (DGCL).  Appraisal rights under Section 262 are available to stockholders in certain types of long-form (i.e., where a stockholder vote is required) and short-form (i.e., where no stockholder vote is required) mergers.  In connection with a long-form merger, a stockholder of record must first make written demand to the corporation for appraisal before the stockholder vote on the merger.  A stockholder with standing can, within 120 days after the long-form merger, file an appraisal petition in the Court of Chancery.

As summarized by the court, to have standing pursuant to subsection (a) of Section  262, the stockholder seeking appraisal must show “that the record holder of the stock for which appraisal is sought (1) held those shares on the date it made a statutorily compliant demand for appraisal on the corporation, (2) continuously held those shares through the effective date of the merger; (3) has otherwise complied with subsection (d) [of Section 262] concerning the form and timeliness of the appraisal demand, and (4) has not voted in favor of . . . the merger with regard to those shares.”

The issue in Transkaryotic was whether a beneficial owner of shares, who acquires the shares after the record date for the stockholder vote on the merger, must prove that each of the shares for which it seeks appraisal was not voted in favor of the merger.  The Transkaryotic court held that there was no such share-tracing requirement.  It reasoned that only a record holder could demand and perfect appraisal rights under Section 262, thus the record holder’s actions, and not those of the beneficial owners, determine perfection of the right to seek appraisal.  Shares of public companies held on deposit with the Depository Trust Company (DTC), are registered in the name of DTC’s nominee, Cede & Co., which is the record holder of the shares.  The Transkaryotic court required a showing that the number of shares held by Cede & Co. that were voted against the merger, abstained or not voted, equaled or exceeded the number of shares subject to Cede & Co.’s appraisal petition.  According to the Transkaryotic court, “because the actions of the beneficial holders are irrelevant in appraisal matters, the inquiry ends here.”  The Transkaryotic decision thus permitted appraisal arbitrageurs to buy shares in street name after the record date for the stockholder vote on the merger, and include those shares in the appraisal petition.

At the time of the Transkaryotic decision, Section 262 required that the appraisal petition be filed in the name of the record holder of shares.  In 2007, shortly after the Transkaryotic decision, subsection (e) of Section 262 was amended to permit beneficial owners to file the appraisal petition in their own name.

In, one of the appraisal petitioners, Merion Capital LP (Merion), caused Cede & Co. to timely file an appraisal demand for shares purchased by Merion after the record date.[5] Merion then timely filed an appraisal petition in the Court of Chancery in accordance with amended Section 262(e).  The corporation, Inc.  (Ancestry), argued that the 2007 amendment required Merion to show that its shares were not voted in favor of the merger.  Ancestry argued that since Merion could not demonstrate that the owners of its shares on the record date did not vote in favor of the merger, it lacked standing to bring an appraisal action.  The court disagreed that the 2007 amendment introduced such a share-tracing requirement.

The court first reviewed the Transkaryotic decision, and then considered the relevant text of the 2007 amendment to subsection (e):

“Notwithstanding subsection (a) of this section, a person who is the beneficial owner of shares of such stock held either in a voting trust or by a nominee on behalf of such person may, in such person’s own name, file a petition or request from the corporation the statement [regarding other appraisal demands] described in this subsection.”

The court noted that the General Assembly decided to allow beneficial owners to file an appraisal petition, but did not otherwise amend Section 262 to allow beneficial owners to perfect appraisal rights by not voting in favor and making a timely demand.  Those requirements continued to only apply to record holders.  In addition, the General Assembly did not amend the statute to address the Transkaryotic court’s holding that a record holder need only show that the number of shares it did not vote in favor of the merger equals or exceeds the number for which it perfected appraisal.

The court held that Section 262 as amended was unambiguous, and continued to focus on the actions of the stockholder of record and not the shares.  The court found that Cede & Co. made demand as required by Section 262(a).  Cede & Co. had at least as many shares not voted in favor of the merger as the number for which demand was made.  The court held that based on the plain language of Section 262, Merion Capital had standing to pursue appraisal.  In response to Ancestry’s argument that not imposing a share-tracing requirement could result in “over-appraisal,” i.e., having more appraisal shares than the number of shares not voted in favor of the merger, the court held that this issue was merely a theoretical concern for the legislature to resolve.  There was nothing in the 2007 amendments to suggest that the legislature intended to “require beneficial owners who made post record-date purchases to show that their specific shares were not voted in favor of the merger, in contradiction to the approach taken in Transkaryotic.”

BMC Software Court Holds No Share-Tracing for Shares Held of Record

The issue in BMC Software was whether Section 262 imposed a share-tracing requirement with respect to shares acquired after the record date and held of record (as opposed to in street name).  The court held that it did not.  In BMC Software, Merion and an affiliated fund (for simplicity, collectively referred to as “Merion”) purchased shares of BMC Software, Inc. (“BMC”) after the record date for BMC’s merger.  When Merion directed its broker to pass along a demand request to Cede & Co., the broker refused.  As a result, Merion caused the shares to be withdrawn from the DTC system and Merion became the shareholder of record.  Merion then delivered an appraisal demand to BMC before the special meeting date, and filed an appraisal petition in the Court of Chancery after the merger within the 120 days deadline.  BMC argued that Merion, as the record holder, had the burden of proving that each appraisal share was not voted by any previous owned in favor of the merger.

The court reviewed the standing requirements in Section 262(a) and noted that, as explained in Transkaryotic, the appraisal requirements are directed to the stockholder of record and not the shares for which appraisal is sought.  The focus in Transkaryotic was on whether Cede & Co. “had sufficient shares it had not voted in favor of the merger to satisfy the demand, not whether those specific shares were shares [Cede & Co.] had voted in favor of the merger.”  The court noted that there is no “explicit requirement that the stockholder seeking appraisal prove that the specific shares it seeks to have appraised were not voted in favor of the merger.”  The court concluded that had “the General Assembly intended the statute to include a share-tracing requirement . . . it would have explicitly written that requirement into the provision governing standing . . .”

Decisions Favor Appraisal Arbitrage Funds

The two decisions were victories for Merion Capital LP, an appraisal arbitrage fund.  Appraisal arbitrage involves the acquisition of shares following an announced merger with the intent to exercise appraisal rights.  The arbitrageur’s goal is to obtain a price per share in the appraisal proceeding that exceeds the merger price per share.  Pursuant to Section 262(h), the arbitrageur is also entitled to receive interest on the award amount from the effective date of the merger through the date of payment of the judgment.[6]  The two decisions provide appraisal arbitrageurs with more time to study a transaction before purchasing shares.  Assuming a straightforward cash merger with no significant regulatory issues, the record date is typically about 6 weeks after signing and announcement, and the meeting date is about 5 weeks after the record date.  Thus, the decisions permit merger arbitrageurs to purchase shares during the 11 week period after deal announcement, instead of just the 6 week period between deal announcement and the record date.  Appraisal arbitrageurs also benefit from being able to review the definitive proxy statement before purchasing shares.

As noted above, there has been a significant increase in the percentage of appraisal petitions in transactions for which appraisal rights are available since 2011.  Many commentators have asserted that the Transkaryotic decision is one of the causes of the increase in appraisal arbitrage.  Legal commentators also point to the high statutory interest rate on appraisal awards as likely to incentivize appraisal claims, particularly in the current low interest rate environment.[7]  Whatever the cause,[8] it is clear that the recent decisions will not dampen, and may augment, the current high rate of appraisal petitions.

How Should Companies Deal With the Increase in Appraisal Actions?

Appraisal arbitrage can be viewed as another deal tax, akin to the deal tax imposed by fiduciary duty strike suits.  Issuers need to retain a valuation expert, and there is limited ability for issuers to dispose of cases prior to trial, given the absence of a motion to dismiss process.  So what can issuers do?  Running a good deal process appears to help.  In a January 30, 2015 decision in the Ancestry appraisal action (“Ancestry II”), the court gave substantial weight to the merger price in the appraisal proceeding.[9] The court in Ancestry II expressly noted that “where ‘the transaction giving rise to the appraisal resulted from an arm’s length process between two independent parties, and . . . no structural impediments existed that might materially distort ‘the crucible of objective market reality,’ a reviewing court should give substantial evidentiary weight to the merger price as an indicator of fair value.’”[10] The form of transaction is also relevant.  For example, long-form stock mergers involving public acquirers and targets do not trigger appraisal rights under Section 262.  Cash election mergers generally do, unless stockholders are not required to accept consideration other than publicly available stock.[11] Short form mergers under DGCL Sections 251(h) and 253 also trigger appraisal rights.

There is also the possibility that the Delaware legislature could act.  The and BMC Software decisions make clear that any introduction of a share-tracing requirement will have to come from the legislature.  As noted above in note 8, it is unclear how much of an impact that would have on the frequency of appraisal claims.  A more significant deterrent might be for the legislature to prohibit the exercise of appraisal claims by a stockholder who has not held the stock for a requisite period of time prior to the shareholder vote, e.g., since the deal announcement date.  This could eliminate the ability of appraisal arbitrageurs to buy into appraisal positions after the deal announcement, which would shut down the appraisal arbitrage industry, at least as it currently exists.  The legislature could also decrease the statutory presumptive interest rate applicable to appraisal awards and thus reduce one of the economic incentives to pursue appraisal arbitrage.

Another possibility that could reduce the risks of appraisal claims, from the corporation’s perspective, would be to create a statutory presumption that the merger price represents fair value in arms’ length transactions.  The Ancestry II decision makes clear that the appraisal process is inherently difficult for the Court of Chancery because Section 262 purports to allocate the burden of proof to both parties.  Thus, “in reality, the burden falls on the judge to determine fair value, using ‘all relevant factors.’” The role of the judge could be made easier, and the uncertainties in the appraisal process reduced, through creation of a statutory rule that the corporation has the burden of showing that the transaction was negotiated on an arms’ length basis and the corporation’s board was reasonably informed as to the corporation’s value.  The burden would then switch to the petitioner to show that the merger price did not represent fair value.

It is unclear whether and how the Delaware legislature will act.  It is also unclear how widespread appraisal petitions will become, whether due to the formation of new appraisal arbitrage funds or otherwise.  However, the current incidence of appraisal actions is sufficiently high that deal parties should keep appraisal claims firmly on their radar screens in deal planning.

[1]           See Myers & Korsmo, Appraisal Arbitrage and the Future of Public Company M&A.

[2]           C.A. No. 8173-VCG (Del. Ch. Jan. 5, 2015).

[3]           C.A. No. 8900-VCG (Del. Ch. Jan. 5, 2015).

[4]           2007 WL 1378345 (Del. Ch. 2007).

[5]           The 2007 amendment did not change the requirement that the demand notice be given by the holder of record.

[6]           Section 262(h) provides:  “Unless the Court in its discretion determines otherwise for good cause shown, interest from the effective date of the merger through the date of payment of the judgment shall be compounded quarterly and shall accrue at 5 percent over the Federal Reserve discount rate. ..”

[7]           To illustrate, the current federal funds rate is around 0.1 percent. Thus the statutory interest rate applicable to appraisal awards is approximately 5.1 percent. This is very high compared, for example, to the rate on 30 year treasuries, which is approximately 2.7 percent. This high rate of interest compared to market rates creates an incentive to invest in appraisal actions.

[8]           The Myers & Korsmo Study disputes this, given both that Transkaryotic was decided 4 years before the spike in appraisal actions began, and the increase in appraisal in long-form mergers is not as pronounced as the increase in appraisal actions in short-form mergers, for which Transkaryotic is irrelevant.

[9]           In re Appraisal, Inc., Civil Action No. 8173-VCG (Del. Ch. Jan. 30, 2015).

[10]          Ancestry II (quoting Highfields Capital, Ltd. v. AXA Fin., Inc., 939 A.2d 34, 42 (Del. Ch. 2007)).

[11]          See Krieger v. Wesco Financial Corp., 30 A.3d 54 (Del. Ch. 2011).