The hottest litigation in Delaware Chancery Court, after the court’s notorious crackdown on unwarranted challenges to M&A transactions, is appraisal arbitrage. These cases, as I’ll explain, have been a relatively low-risk bet for shareholders and plaintiffs’ lawyers, whose limited downside exposure has been offset by occasional jackpot rulings from Chancery judges. But after an opinion Monday from Vice-Chancellor Samuel Glasscock in In re Appraisal of SWS Group, appraisal arbitrageurs may have to recalibrate their odds.
Glasscock ruled that the fair value of SWS shares at the time the bank holding company was bought out by Hilltop Holdings was $6.32 – 8.7 percent less than the merger price of $6.92. The merger took place in January 2015. So the SWS shareholders who refused to cash in their shares and opted to litigate are now slated to receive less than they would have gotten in the merger – minus whatever they spent in legal fees and the lost opportunity to invest their money in a more profitable endeavor than this case.
Vice-Chancellor Glasscock’s opinion marks the first time in the modern era of appraisal litigation that the court has determined shares to have been worth significantly less than the merger price, according to a client alert by Wachtell Lipton Rosen & Katz, which represents SWS in the appraisal action. The decision, Wachtell said, shows that the merger price is not necessarily a floor for fair value, despite a string of recent Chancery Court appraisal decisions that have held merger price to be the best indicator of fair value in a well-run sale process. (The most recent of those decisions, In re Appraisal of Petsmart, came last week from none other than Vice-Chancellor Glasscock in another Wachtell case.)
To understand why it’s significant that Chancery has now said holdout shareholders may be entitled to less than the merger price, you have to know a bit about appraisal actions. Delaware corporate law gives shareholders who are dissatisfied with a merger offer the right to refuse to participate in the merger and instead to ask Chancery Court judges to determine the fair value of their shares in an appraisal action. At the end of the case, holdout investors are awarded the court-determined fair value, plus statutory interest. Theoretically, as Brooklyn Law professor Minor Myers explained to me a couple of years ago, appraisal actions empower shareholders to hold corporations accountable for tainted deals.
But several years ago, super-sophisticated investors realized that Delaware’s statutory interest rate (the Federal Reserve discount rate plus 5 percent) significantly changed the calculus for appraisal actions. Remember, investors are entitled to statutory interest on the fair value of their shares. So even if the court determines shares are worth only what the company agreed to accept from its merger partner, appraisal action plaintiffs get that amount plus at least 5 percent interest. If the merger price is a floor valuation, appraisal actions are a low-risk venture, especially when a guaranteed 5-percent interest rate is a decent return.
That realization led to the practice known as appraisal arbitrage, in which hedge funds actually bought shares of companies that had announced mergers with the specific intention of bringing appraisal actions after the mergers closed. Companies hate these cases, in which renegade shareholders bring in experts who contend the negotiated merger price was way too low. (I should point out that the Delaware legislature has acted to limit the impact of statutory interest rates in appraisal actions by allowing companies to pay renegade shareholders at any time in the case, stopping interest rates from accruing on whatever they’ve already paid. That law did not take effect in time to apply in the SWS litigation.)
Chancery Court judges have engaged in considerable hand-wringing over the years about whether they’re properly trained to pick through competing economic models to figure out a fair share price. Their default, as I mentioned, has been to evaluate the merger process. If they determine the process is robust and untainted by conflicts, they’ve generally held the merger price represents a fair value for shares. Chancery judges retain discretion to hold otherwise, though next week, the Delaware Supreme Court will hear arguments in an appraisal appeal that presents the question of whether Chancery judges should be required to defer to the market price.
The unusual twist in the SWS case is that neither side argued that the sale price was the best indicator of fair value. The renegade shareholders, represented by Prickett Jones & Elliott and Heyman Enerio Gattuso & Hirzel, said the merger was tainted because of SWS’s relationship with Hilltop, which previously lent the company $100 million and held a seat on the SWS board. Shareholders alleged SWS was actually worth 50 percent more than Hilltop paid, or $9.61 per share. SWS, by contrast, argued that Hilltop paid more than fair value for SWS because it believed the deal made strategic sense. The company’s expert said the fair value of SWS shares was $5.17, well below the $6.92 Hilltop paid in cash and stock.
After a four-day trial last September, Vice-Chancellor Glasscock agreed with shareholders on flaws in the sale process. (He spends dozens of pages describing the companies and negotiations but I’ll spare you the details.) But that was the end of the good news for shareholders because he accepted SWS's arguments that Hilltop’s price reflected anticipated synergies. When the Vice-Chancellor ran the numbers in his discounted cash flow model, he came up with $6.32, not nearly as low a value as SWS had urged upon him, but materially less than the actual merger price.
The big question is whether the Vice-Chancellor intended his SWS opinion to send a message to appraisal arbitrageurs. Remember, when Chancery Court decided to end the era of disclosure-only settlements in M&A shareholder suits, the judges as a group began issuing skeptical decisions about such settlements, culminating, of course, in Chancellor Andre Bouchard’s 2016 opinion in In re Trulia. Appraisal litigation seems to have supplanted M&A shareholder suits as the object of corporate ire in Delaware courts. Vice-Chancellor Glasscock’s SWS decision may be the beginning of Chancery’s pushback in these cases.
I left a phone message for investor lawyer Marcus Montejo but didn’t hear back.