Appraisal Arbitrage—A Rising Star in the Activist Playbook
Shareholder activism gains momentum and publicity with each passing proxy season. Activist-focused funds increase capital and investor expectations, proxy contest tactics become more practiced and skillful, nominees for board positions are industry tailored and more sophisticated and social media increases the reach (and entertainment value) of activist communications. What comes next? Appraisal rights as arbitrage.
Appraisal rights are a state statutory remedy available to dissenting shareholders in extraordinary corporate transactions. The rules vary from state to state, but the most common scenario in which appraisal rights are used is a cash merger where objecting shareholders seek a court's separate assessment of "fair value" for their shares. Under Delaware law, appraisal awards accrue statutory interest at the federal discount rate plus 5%, compounding quarterly from the transaction closing date until the award is paid. And, absent bad faith, the interest rate is paid regardless of the ultimate appraisal decision. In evaluating appraisal claims, Delaware courts also have wide latitude; they may consider "all relevant factors" in determining value, often relying on expert opinions and factoring in complex variables such as future projections, expected tax rates, equity risk premiums, control share premiums, and discount rates.
Historically, appraisal actions in connection with M&A transactions were uncommon, typically only filed by disgruntled shareholders. But, increasingly, activist funds are exercising statutory appraisal rights in public company transactions in order to maximize return—either by obtaining a court ruling that dissenting shareholders are entitled to additional consideration in excess of the deal price, by settling the claim, or by collecting the simple return generated by the statutory interest rate applicable to these claims.
Here is how the "arbitrage" works. Beginning in 2007, the Delaware Chancery Court's Transkaryotic decision made it clear that any beneficial holder with shares held through Cede & Co. (also known as DTC, the clearing house for US stock) could seek appraisal rights regardless of when the shares were acquired, provided that the total number of dissenting shares was less than the total "street name" shares not voted or voted against the deal. Accordingly, investors can now determine, based on market reaction to a deal and applicable disclosure in proxy or similar materials, whether or not to "buy into" appraisal claims. In addition, the interest rate applicable to such claims, particularly in our current low interest rate environment, is a reliable offset to the risk and cost of an appraisal action. Notably, it also serves as an additional point of leverage in settlement discussions with target companies.