Appraisal Practice Tips 1 Year After Prepayment Amendment
Effective Aug. 1 of last year, Delaware’s appraisal statute, Section 262 of the General Corporation Law of the State of Delaware (the DGCL), was amended in response to the recent rise of “appraisal arbitrage” to provide corporations acquired by merger or consolidation the option to prepay a sum of money to stockholders seeking appraisal and thereby limit the accrual of interest on the Court of Chancery’s fair-value award. One year later, we review the impact of this amendment on appraisal litigation, offer practice considerations with respect to making prepayment, and question whether prepayment is counterproductive to the legislative purpose of the statutory amendment — discouraging appraisal arbitrage, or at least limiting its adverse effects — and detrimental to the acquisitive companies, financial sponsors and long-term stockholders who are the ultimate payers of the deal tax extracted by arbitrageurs. Further to the last of those topics, we propose a potential alternative to prepayment that, although untested, could be used by a respondent in an appraisal proceeding to argue that no interest should accrue on any fair-value award in favor of arbitrageurs.
The Prepayment Amendment
A significant concern of transaction planners in recent years has been the above-market interest rate on fair-value awards in appraisal proceedings. During a time when market interest rates have been near historic lows, Section 262(h) of the DGCL prescribes a presumptive approach for the award of interest, providing that, “[u]nless the Court in its discretion determines otherwise for good cause shown,” interest is to be awarded at 5 percent over the Federal Reserve discount rate from the effective date of the merger through the date of payment of the judgment, compounded quarterly.
The 2016 amendment to Section 262(h) provides an option to a surviving corporation to prepay a sum of money to stockholders seeking appraisal, the amount of which may be determined in the sole discretion of the corporation, at any time prior to judgment, to avoid the need to pay subsequently accruing interest on the prepaid sum. Making or accepting prepayment does not give rise to any inference that the amount so prepaid is equal to, greater than or less than the fair value of the appraised shares. If any stockholder’s entitlement to appraisal is contested by the corporation in good faith, the corporation may make prepayment only to those stockholders whose entitlement to appraisal is uncontested.
Prepayment Considerations and Practice Tips
The prepayment option now provided under Section 262(h) enables a surviving corporation to limit the accrual of interest on an appraisal award, but many factors should be considered when determining whether, how and the extent to which a corporation should make a prepayment. These include, among other considerations, the following:
- Is There a Business Case for Prepayment? For smaller amounts, the use of the prepayment option as an interest-expense reduction tool usually makes sound financial sense. Where, however, the prepayment would represent a substantial sum of money for the company, the case for prepayment will depend on, among other things, the company’s balance sheet, its cost of debt, and whether the funds can be deployed for business initiatives yielding returns in excess of the statutory interest rate. Thus, for a corporation with slow (or negative) growth, excess cash, and/or a low cost of debt, there generally is a strong business case for making a prepayment to stop the accrual of above-market interest. The same might not be said, however, for a fast-growing company with many business opportunities offering attractive investment returns, and/or one without a strong cash position or with a high cost of debt.
- Will Prepayment Affect the Litigation? While no legal inference may be drawn from the prepayment as to whether the amount prepaid represents the fair value of the appraised shares, prepayment may affect the litigation in other ways. Prepaid monies could be used by an appraisal petitioner to finance the litigation. Depending on the circumstances, prepayment could make it easier or more difficult to settle the litigation. For serial acquirers, prepayment could come with the risk that the money will be used to fund an arbitrage investment in the next target of the acquirer, leading to yet more appraisal litigation.
- How Much to Prepay? The answer to this question involves a careful balance of the risk of overpayment, on the one hand, with the desire to take full advantage of the statutory amendment and stop the accrual of above-market interest, on the other hand. An approximate range of prepayment amounts could be from the unaffected market price of the stock prior to the announcement of the merger (or perhaps 50 percent of the deal price if a privately held company), at the low end, to slightly less than or equal to the deal price, on the high end. The amount might depend on, among other things, the fair value the respondent corporation hopes ultimately to prove and the perceived strength of its case.
Once a surviving corporation has decided to make prepayment to stop the accrual of interest and determined the amount it intends to prepay, the corporation must then undertake to effectuate the prepayment. In this regard, it is important to note that, although Section 262(h) now provides an acquired corporation the right to make prepayment, the statute provides no guide as to how to make such a prepayment. Given that the statutory amendment went into effect only one year ago, there is as yet no standard or customary practice for prepayment in appraisal proceedings. Rather, each appraisal prepayment of which the authors are aware has been undertaken by a bespoke method suited for the particular demands of the case and the needs of the litigants.
For obvious reasons, it is advisable to execute a written agreement with the appraisal claimant to document the prepayment transaction, which may involve the payment of tens of millions or even hundreds of millions of dollars. Not only will such an agreement memorialize the terms and conditions of prepayment, but it will provide assurances to any relevant third-party agents, such as paying and transfer agents, some of whom have expressed concerns regarding prepayment mechanics in appraisal proceedings.
The following are a few of the key provisions in a written prepayment agreement:
- Representations and Warranties as to the Proper Recipient of the Prepayment. The language of the statutory amendment appears to contemplate that prepayment would be made to the stockholder of record, which is consistent with the manner in which merger consideration typically is paid; however, Cede & Co. (the record holder for most shares of publicly traded Delaware corporations) has indicated that any prepayment should be made not to it but rather directly to the beneficial owner of the appraised stock. In addition to the ambiguity in the statute, appraisal petitioners or claimants potentially can dispose of, pledge or assign their interests in the appraised shares. By documenting the prepayment in a written agreement, a surviving corporation can obtain representations and warranties from the petitioner or other appraisal claimant that it is the proper party entitled to prepayment and that it has not assigned or otherwise encumbered its stock. Similarly, it may make sense in certain cases for a respondent corporation to move the Court of Chancery pursuant to Section 262(g) to require the appraisal claimants to submit their stock certificates for notation thereon of the pendency of the appraisal proceedings, to eliminate any uncertainty as to the proper recipient of the prepayment funds.
- Deduction From Future Appraisal Award of Prepayment Amount. The statutory amendment provides a surviving corporation the right to make prepayment and addresses the resulting effect on the accrual of interest, but it does not expressly provide that the prepayment amount will be deducted from any future payment of the merger consideration or a fair-value award determined by the Court of Chancery. While this surely is implicit from the statutory amendment and its legislative history, and the Court of Chancery, as a court of equity, would be loath to permit an unjust double recovery, it remains advisable for a respondent corporation to obtain from the appraisal claimant an explicit forfeiture of the prepayment amount from any appraisal award.
- Right to Recoupment of Overpayment if Fair Value is Less Than Prepayment Amount. The statute as amended does not expressly provide for return of any prepaid funds if the Court of Chancery’s fair value determination is lower than the prepaid amount. A written agreement, however, can provide for the recoupment of overpaid amounts. Appraisal petitioners have been willing to agree to such a clawback provision, perhaps because it may mean, for instance, that the corporation will make a larger prepayment. Prior stipulated orders agreed upon by appraisal litigants and approved by the court have included a recoupment right.
Impact on Appraisal Litigation to Date
One year has passed since the prepayment amendment took effect, but its efficacy in reducing appraisal litigation or otherwise easing the costs on acquirers associated with appraisal arbitrage largely remains to be seen. Insufficient post-amendment data exists to draw any firm conclusions regarding its effect on appraisal activity but, in the year following the Aug. 1, 2016, effective date of the amendment, appraisal filings have continued to increase. Since Aug. 1 of last year, 74 appraisal petitions have been filed in the Court of Chancery, challenging 39 different transactions. Below is a chart comparing these figures to those from the same period over previous years:
|Period||Appraisal Petitions Filed||Year-Over-Year Change||Deals Challenged||Year-Over-Year Change|
|Aug. 1, 2016-July 20, 2017||74||+40 percent||39||-10 percent|
|Aug. 1, 2015-July 31, 2016||53||+10 percent||43||+65 percent|
|Aug. 1, 2014-July 31, 2015||48||+2 percent||26||-19 percent|
|Aug. 1, 2013-July 31, 2014||47||+88 percent||32||+39 percent|
|Aug. 1, 2012-July 31, 2013||25||--||23||--|
A comparison of appraisal petitions filed in the first half of 2017 to the first halves of prior years shows:
|Period||Appraisal Petitions Filed||Year-Over-Year Change||Deals Challenged||Year-Over-Year Change|
|Jan. 1, 2017-June 30, 2017||35||+3 percent||18||-33 percent|
|Jan. 1, 2016-June 30, 2016||34||+3 percent||27||+42 percent|
|Jan. 1, 2015-June 30, 2015||33||+22 percent||19||+19 percent|
|Jan. 1, 2014-June 30, 2014||27||+80 percent||16||+23 percent|
|Jan. 1, 2013-June 30, 2013||15||--||13||--|
No matter the comparison period, the volume of appraisal actions continues to grow, notwithstanding the prepayment amendment. And, while the number of unique transactions subject to appraisal proceedings has declined compared to prior periods, that surely is due to the decline in merger and acquisition activity generally in 2017. Consequently, while the full impact of the prepayment option still remains to be seen, it is clear that the prepayment option has not deterred appraisal arbitrage to date. To the contrary, that appraisal litigation continues its upward trend despite the recent overall decline in M&A activity may suggest that, as discussed below, the prospect of prepayment is contributing to its continued rise.
The Free Capital Problem With Prepayment
The immediate interest-reducing benefit a respondent corporation can derive from prepayment is obvious and may very well override other considerations but, as suggested above, prepayment might also work against the legislative intent of the statutory amendment that authorizes it. To the extent a respondent corporation takes advantage of the amended statute, prepayment provides the appraisal arbitrageur with capital that would otherwise be tied up in the litigation and thus unproductive and at risk. The appraisal arbitrageur surely will put the prepaid funds to productive use elsewhere and may even invest them in its next appraisal arbitrage play, leading to yet more appraisal litigation — a disappointing outcome for companies and financial sponsors that routinely engage in corporate acquisitions. In all events, through receipt of a prepayment and deployment of those funds in other endeavors, the appraisal arbitrageur is able to increase its investment returns, hedge against risk, and reduce the impact of an adverse fair-value award in the appraisal proceeding in which prepayment was made. Indeed, prepayment makes an appraisal arbitrage investment more auspicious by enabling an arbitrageur to retain all of the potential upside of the litigation (i.e., a fair-value award in excess of the merger price) with little potential downside remaining because its capital (or much of it) has been returned (even with a contractual recoupment provision).
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It remains too early to tell just how the prepayment option will affect appraisal arbitrage in general, but one can reasonably conclude that prepayment might serve to encourage, rather than discourage, the practice. Certainly, the number of new appraisal claims brought since the statutory amendment went into effect does not suggest a different conclusion. As many commentators predicted at the time the 2016 statutory amendments were adopted, the likely outcome is that prepayment will help to curb only the weaker claims, including primarily those brought solely for “interest arbitrage.” The larger appraisal actions, where arbitrageurs have staked significant positions in a target company’s shares, and where their investment is motivated by the potential of an award significantly in excess of the merger price, are unlikely to diminish and could instead increase if respondent corporations begin to prepay as a matter of course.
Accordingly, transaction planners are seeking alternative means to attempt to staunch the wave of appraisal arbitrage. The list of these possible alternatives is lengthy, and we propose one addition consistent with the topic of this article — a bylaw adopted by a board of directors in the context of a sale of the company aimed at barring statutory interest on a fair-value award in an appraisal proceeding brought by an arbitrageur.
Whether implemented while undertaking an auction, during sale negotiations with a prospective acquirer, or at the time of execution of the merger agreement, such a bylaw potentially would reduce the transaction’s appeal to arbitrageurs and could be used by a target company board as a bargaining chip to extract additional merger consideration from an acquirer. While the validity and enforceability of such a bylaw surely would face challenge by appraisal arbitrageurs and ultimately be judged by the Delaware courts, such a bylaw arguably would be valid under Section 109(b) of the DGCL, which authorizes bylaws to “contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.”
Bylaws only are invalid under this statutory provision if they do not relate to any of these subjects, and a bylaw precluding an arbitrageur’s recovery of statutory interest in an appraisal proceeding appears to relate to “the rights of [a target company’s] stockholders [qua stockholders].” Nor does it appear that such a bylaw would run afoul of the DGCL, as Section 262(h) contemplates appraisal proceedings in which statutory interest will not be awarded by the court, expressly providing that the court may, in its discretion, determine not to award statutory interest for good cause shown. A bylaw precluding statutory interest for appraisal arbitrageurs, who did not own their stock prior to the announcement of the merger agreement and who acquired their stock notwithstanding notice of the bylaw, arguably would be “good cause” for the court not to award interest because such a bylaw constitutes part of the binding contract among the directors, officers and stockholders of the corporation and represents the target company board’s good-faith business judgment to prefer the company’s then-existing stockholders over opportunists who were not a part of the corporate enterprise and simply seek to extract a deal tax.
In sum, while prepayment likely does not deter (and may ultimately even encourage) appraisal arbitrage, it remains a useful and, therefore, attractive tool for individual companies to reduce the expense of appraisal litigation. Given the issues discussed above, however, repeat acquirers sensitive to the general state of appraisal litigation may be inclined to attempt alternative methods to reduce the interest expense on a fair-value award in a manner that does not provide free capital to their recurring arbitrageur adversaries. Time will tell if corporate counsel are able to devise effective deterrents for appraisal arbitrage. In the meantime, appraisal litigation continues to increase and acquirers and their counsel ought to understand the issues regarding whether and how to effect interest-reducing prepayments.
This article was originally published in the July 31, 2017 issue of Law360.