Delaware’s law of appraisal rights has been in an uproar since hedge fund arbitrageurs showed up in the Chancery Court fifteen or so years ago as appraisal petitioners. The shock led to minor changes in the statute and extensive changes in the caselaw. Responsive commentaries continue to appear with regularity. Professor Robert Miller takes a fresh look at the situation in Stock Market Value and Deal Value in Appraisal Proceedings. His paper is well worth a look.
I need to back up those fifteen years in order to frame the paper. Appraisal arbitrage really changed the game. All of a sudden a notoriously plaintiff-unfriendly legal remedy became a play space for Wall Street smart money looking for Alpha. The arbs worked the system by cooking up persuasive discounted cash flow (DCF) valuations that came in above the merger price. Shareholder advocates saw much to like in this development. The Delaware bar and judiciary, along with most of the rest of the establishment, saw things differently. The bar pushed through some minor revisions of the statute through the legislature, but those were not enough to stop the show.
It was left to the bench to shut down the arbs. It rose to the occasion. In a series of decisions—Dell, DFC, Aruba Networks, Jarden, and Stillwater—Delaware’s Chancery and Supreme Courts rewrote the playbook for the legal determination of “fair value.” Since the 1983 decision of Weinberger v. UOP, fair value had been the preserve of financial experts presenting state of the art analyses employing DCF, comparable companies, and comparable mergers methodologies. The recent cases leave the door open for such presentations. Their innovation lies in the introduction of two new alternative routes to a fair value result—the merger price (minus synergies) and the pre-merger market price. The decisional pattern makes it clear that the merger price (minus synergies) is preferred to the old analyses, even as the cases also make it clear that approaches to fair value are to be made on all the facts of the particular case. The status of market price is less clear, but it now certainly has a place on appraisal’s methodological menu.
Merger price (minus synergies) and market price hold out two great advantages. First, they are transactionally-based rather than hypothetical. They as such warm law and economics hearts—Jonathan Macey and Joshua Mitts have taken the occasion to strike a blow for the Efficient Market Hypothesis and make the case for elevating market price over merger price. Second, whether the court goes for merger price (minus synergies) or pre-merger market price, it pulls the rug out from under appraisal arbitrageurs. Why incur litigation costs to come home with merger price minus synergies? You can get a higher figure (merger price with synergies) by doing nothing. Worse, why run the risk of getting pre-merger market price—a sucker payoff that cuts off all access to the merger premium? The answer is that you don’t run the risk. Appraisal arbitrage is now dead as a door nail.
But where does this leave “fair value” as a matter of legal theory? The pre-arbitrage law review literature speaks emphatically on this topic. Per articles by Bill Carney, Rich Booth and Michael Wachter and Larry Hamermesh, the appraisal petitioner is entitled to a pro rata share of the pre-merger going concern value of the company as opposed to a pro rata share of the company’s value in a third-party sale. Taking this principle to the new world in which the judge chooses between merger price (minus synergies) and pre-merger market price, market price emerges as the choice, as Macey and Mitts have made abundantly clear.
Let us now turn to Professor Miller. He gives us the background with dispatch and then turns to the merger price/market price binary. The search, he reminds us, is in part for a credible figure susceptible of clear proof. Unfortunately, both figures present evidentiary problems despite their hard origins in actual transactions. Merger price presupposes a fact-intensive, Revlon-type showing of a solid sale process. Although this inquiry is factual and the applicable standard is open-ended, fair value is not the issue. The fair value problem arises when the quasi-Revlon test is passed and the synergies to be deducted from the merger price (as required by Delaware section 262) must be calculated. Unfortunately, the synergies are unlikely to show up clearly. Recourse must be made to guesstimates based on expert testimony, which is just the territory the new regime tries to avoid entering. There is also a threshold test respecting market price—a deep, “efficient” market must be shown affirmatively. Once efficiency is established the question is whether the pre-merger price failed to reflect undisclosed material information, information that might well have influenced the negotiated price. Miller holds the plausible view that this often will be the case, again leaving us in an evidentiary morass.
Miller then takes up the old recurring question: Is the appraisal petitioner entitled to a cut of the merger premium? He addresses the question with a broad review of the economics of merger premiums. The discussion shows that the literature’s consensus view—that the premium follows from an allocation of expected synergies and gains from agency cost reduction—does not exhaust the field of possibilities. For example, some bidders (particularly strategic bidders) just overpay. Moreover, in any given merger, there will be deal-specific mix of contributing factors. What then is legal theory, which needs a straightforward set of descriptive assumptions, to do?
Professor Miller turns to the downward sloping demand theory of merger pricing. Under this, different shareholders value the company differently, with the lowest valuing holders selling into the pre-merger stock market and with higher valuing holders holding out for their higher reservation prices. The acquirer pays a premium because it must go up the demand curve, offering a sufficiently high price to garner the support of a majority of the shares. By hypothesis, the appraisal dissenter comes from the minority of holders with higher-still valuations.
As Professor Miller notes, the downward sloping demand explanation is simple, complete, and intuitive. Its even there in the law review literature, the subject of distinguished papers by Lynn Stout and Rich Booth, published in 1990 and 1991, respectively. Why then does it have the status of a discarded minority view? As Professor Miller shows us, it is quite consistent with the law of one price. But it also is inconsistent with orthodox financial economic theory, which holds that security pricing has a flat demand curve. Stocks and bonds are not consumed, like widgets. They provide payment streams that finance the consumption of widgets and other goods and services. Demand for money is constant—people always want it. When a stock goes down it is not because demand for the money on offer has decreased, it is because less future money is now projected or the same monetary projection has become a riskier proposition. Portfolio theory backs up this insight with its showing that rational investors will hold stocks in a single optimal market portfolio, addressing their variant tastes for risk as they interpolate risk-free treasuries into the investment mix.
Professor Miller confronts this problem, showing us that downward sloping demand can be interpolated consistently with cutting edge financial economic thinking. In so doing, he draws on the growing corpus of heterogeneous expectation models of stock pricing. The cites are apt. Supply and demand are now factors on the table in the advanced financial economics of stock market pricing.
Professor Miller’s paper is important because it cuts sharply against a consensus view, offering a clear-cut, theoretically-backed alternative that implies higher payouts to appraisal petitioners. It will not by itself displace the consensus. But it destabilizes the consensus, depriving it of the illusion of full-dress support in high church financial economic theory. The appraisal world emerges a more complicated place than ever, and that’s a good thing.
Professor Miller, by the way, is an excellent writer. He is above all else succinct. He accomplishes this presentation in just under seventeen law review pages. I couldn’t have done it in fifty. Of course, I would have added some stuff in those extra thirty-three pages. But not all that much.