Hedge Funds Can Still Manipulate Corporate Law
- by Maurice M. Lefkort
Arcane rules called “appraisal rights” were designed over 100 years ago to provide a safety valve of fairness. Today, however, these rules are being manipulated by sophisticated market players to reap above-market, low-risk returns in a practice known as “Appraisal Arbitrage.” Constrained by those arcane rules, the Delaware Supreme Court in mid-January upheld that practice. Allowing this practice to continue will come at the expense of the stockholders who are not manipulating these rules, and at the efficiency of the mergers and acquisitions marketplace.
To understand Appraisal Arbitrage, a little background is needed in two arcane areas, the first is modern custody practice, and the second is appraisal rights.
Modern Custody Practice
Individuals and institutions that refer to themselves as “stockholders” usually aren’t. A person or institution that buys 100 shares of Acme Corp. and holds them in a brokerage account doesn’t really own any stock. On the books and records of Acme Corp., the vast majority of shares of Acme are owned by a depositary. The depositary is the true stockholder and is referred to as the record owner.
When a market participant buys 100 shares through its broker, no stock changes hands; instead, two things happen. First, on the books of the depositary, the seller’s broker’s account is reduced by 100 shares and the buyer’s broker’s account is increased by 100 shares. Second, on the books of the buyer’s broker, the buyer is credited with 100 shares. While the buyer may be the beneficial owner of the stock, the legal rights of the buyer are against the broker and are referred to as a “securities entitlement.” When the shares of Acme Corp. are voted, the record owner does the voting, but at the direction of the beneficial owner.
The differences between the record owner and the beneficial owner is important to understanding appraisal rights.
In a merger, two corporations merge, and the stockholders of each receive cash, stock or other property. When corporate law was first developed, beneficial owners were also record owners, and mergers required the consent of all stockholders. That gave small stockholders the ability to “hold up” a merger. As a result, corporate law evolved to the point where approval of a merger required the vote of a specified majority of the stockholders. To protect the minority that did not vote in favor of the deal, a final safety valve of fairness was implemented. Those stockholders that did not vote in favor of the deal were given the right to go to court to have the value of their stock judicially determined and to have that judicially determined value paid to them in cash. Those rights are referred to as “appraisal rights.” At least one commentator has observed that, since 2010, the Delaware Chancery Court’s appraisal decisions have exceeded the merger price in all but two cases.” Since that comment, on January 30, 2015, there was a highly publicized decision in the Ancestry.com appraisal action, in which the Delaware court found the appraisal price to be equal to the merger price. So, make it “all but three.”
A stockholder that exercises appraisal rights has to wait for the judicial determination of a fair price before receiving payment. Thus, to put that stockholder on an even footing with those who accept the merger consideration, most appraisal statutes require the corporation to pay a statutory rate of interest from the date of the transaction to the date of the payment of the appraised value. In Delaware that rate is 5 percent above the federal discount rate. As the federal discount rate is 0.75 percent as of this writing, a party exercising appraisal rights will receive 5.75 percent return on the amount ultimately awarded by a court.
Appraisal Arbitrage exploits the failure of the statutes governing appraisal rights to keep up with modern custody practice. Appraisal rights were designed to protect stockholders in a merger that they felt offered them too low a price. In Appraisal Arbitrage, an investor buys into a deal for the purpose of exercising appraisal rights. The Appraisal Arbitrageur waits until a deal is almost closed, which is often after the stockholder vote, and then buys stock on the market at what is likely less than the deal price, becoming the beneficial owner, but not the record owner. When the deal closes the arbitrageur exercises appraisal rights based on two factors: (a) the appraised value, in all likelihood, will be greater than the deal value, especially if it is a deal subject to heightened scrutiny, such as a “squeeze-out” by a controlling stockholder; and (b) the arbitrageur will receive 5 percent over the Fed discount rate (currently 5.75 percent) interest on its appraised value.
These factors mean that even when the Appraisal Arbitrageurs lose, they win. In the Ancestry.com decision on January 30, which is widely seen as a “loss” by Appraisal Arbitrageurs, the Appraisal Arbitrageurs still received the deal price, which was likely more than their purchase price, and 5.75 percent on the entire amount, less the cost of the appraisal action.
But wait. To exercise appraisal rights, the record owner of the stock had to not have voted in favor of the deal. How can the arbitrageur show that to be the case? That is precisely the question addressed by the Delaware Supreme Court in January. In two cases decided the same day, the Delaware Supreme Court interpreted the appraisal rights statute to mean that so long as the record owner represented more shares not voting in favor of a merger than the number of shares for which the Appraisal Arbitrageur was exercising his or her appraisal rights, then the exercise of the appraisal rights was valid. The court held that there was no requirement that the arbitrageur show that the particular shares that he or she acquired did not vote in favor of the merger.
Why should you care if hedge fund managers are making money in Appraisal Arbitrage?
There are two reasons. The first is that you may want to invest with them (this posting is not investment advice). The second is that the practice of Appraisal Arbitrage is reducing the efficiency of the market. Here’s why:
- Assume Engulf & Devour is willing to buy Acme for an aggregate price of P, and Acme has S shares outstanding—then the “efficient” deal price per share would be P/S
- Now Engulf & Devour has to worry about Appraisal Arbitrageurs. It doesn’t know how many people will not vote in favor of the deal creating “room” for arbitrage, and it also has to worry about how the appraisal proceeding will come out. As a result they decide to reserve an amount equal to AA for that uncertainty.
- Engulf & Devour now pays (P-AA)/S per share for Acme.
- The average shareholder loses out on AA/S per share, and maybe the Appraisal Arbitrageurs get more or less than AA.
In either case, average shareholders have paid the price of the Appraisal Arbitrageurs even if they don’t strike in the particular deal, a far from efficient outcome. Lest you think this is theoretical, I have seen more than one deal where this is the case.
You the stockholder can help this situation by voting that proxy card you receive in the mail. If you vote in favor of a merger, there are less unvoted shares for the Appraisal Arbitrageur to exploit. Ultimately, it is up to the state legislatures to fix this problem.
Update: Maurice Lefkort reports on Feb. 13, 2015, about another loss (sort of) for Appraisal Arbitrageurs:
On February 12, I posted about the practice of Appraisal Arbitrageurs, and how their “no lose” strategy was disrupting market efficiency (see above). On the same day, the Delaware Supreme Court upheld a ruling by the Delaware Chancery Court in an Appraisal Arbitrage case. In the original case, the Chancery Court found that the the “appraised value” of stock in an arms-length merger was equal to the deal price. (See here: http://courts.delaware.gov/opinions/List.aspx?ag=Supreme Court&typ=Civil).
While yesterday’s ruling can be seen as a loss for the Appraisal Arbitrageur, as I demonstrated in my original post, the “loss” means that the Appraisal Arbitrageurs will only earn: (1) the gain on the difference between the purchase price of the stock and the deal price, and (2) 5.75 percent annual return on the deal price, less the cost of the appraisal action.
I only wish that my losses were so profitable!
Fundamentally, this ruling does not address the issues with Appraisal Arbitrage; it just demonstrates the heads the Arbitrageur wins, tails the market loses nature of the practice.
Editor’s note: This blog post is intended as general information on the law and legal developments, and is not legal advice as to any particular situation. Under New York ethical rules, please note that this post may constitute “ATTORNEY ADVERTISING.”