Stockholder appraisal rights are established by statute. The eligibility of particular transactions for the appraisal remedy and the procedures employed vary – sometimes significantly -- from state to state. Most discussion of appraisal rights occurs in the context of Delaware law. More than half of U.S. publicly-traded companies and fully 64 percent of the Fortune 500 are incorporated in Delaware and, as a result, Delaware’s legal framework for appraisal actions is more fully developed and is utilized more frequently than other jurisdictions.
What Are Appraisal Rights and Appraisal Actions?
In instances where a company is facing a merger, the stockholders of that company may have various rights regarding the value of their shares. In the most egregious situations, where the board and/or management has acted wholly improperly, they may sue for a breach of fiduciary duty. Such cases, however, can be long and complex and require a substantial showing of wrong-doing by the responsible individuals. In situations where the conduct is less egregious, where for instance, shareholders believe that the merger price does not reflect the company’s true value, but the conduct by managers does not rise to the level of a fiduciary duty violation, they may have the option to request that the court make an appraisal of the company’s shares. The court would then hold a proceeding to determine the “fair value” of the corporation’s shares – which would be awarded to the shareholders who sought appraisal. These rights are commonly referred to as “dissenting stockholder rights,” or simply “dissenter’s rights.”
In these types of cases, called “appraisal actions,” the stockholder does not automatically receive the consideration associated with the merger. Instead, the stockholder will often receive what the court determines to be the fair value of the shares, plus interest from the merger date. In some instances, this amount can be less than the merger price.
Unlike fiduciary merger cases, stockholders in an appraisal action do not need to prove a breach of corporate fiduciary duties. Instead, traditional appraisal actions addressed:
- Whether the stockholder has met the statutory procedures for asserting appraisal rights
- Evidence presented by corporate valuation experts regarding the fair value of the company
Increasingly, however, in recent years, a number of decisions from the Delaware Chancery Court have found that the deal price represents the fair value of the corporation subject to appraisal in situations where the court has concluded that there was an adequate process – and particularly a process that involves the to-be-acquired company being marketed to a broad selection of potential acquirers. See, e.g., In re PetSmart, Inc. 2017 WL 2303599 at n.333 (Del. Ch. May 26, 2017) (citing cases). Thus, having counsel analyze the deal process has become an important aspect of determining whether a particular transaction is a good appraisal candidate, and offering evidence on the flaws in that process (even if not sufficient to create a fiduciary duty violation) has become an important part of litigating such cases.
While awarding fair value and interest (fed funds + 5% in Delaware) is required in an appraisal award, appraisal-seeking stockholders are not entitled to receive awards that cover attorney fees, expert expenses, and litigation costs. Thus, when seeking an appraisal, the stockholder must consider whether it is economically feasible to pursue such an action, given the risks regarding fair value calculation as well as litigation expenses.
Determining Fair Value
The trial judge’s role in an appraisal proceeding is to independently determine fair value after taking into account all relevant factors. In some cases, as noted above, the court may determine that the merger price is the best indication of fair value. However, other valuation methods may be employed, such as asset-based methods, cash flow methods, hybrid/formula methods, comparable market data models, and various other formulas.
In particular, application of a discounted cash flow (DCF) valuation method has been common in appraisal lawsuits. DCF methods utilize future free cash flow projections and discount them to arrive at estimates for the present value. This can sometimes result in values well above the deal price and current trading prices for a stock, particularly where a company has strong growth prospects.
Recent Appraisal Cases
The Delaware Court of Chancery issued one of the most high-profile appraisal opinions in recent times in In re Appraisal of PetSmart Inc. As noted above, it is the most recent in a line of cases where the Court of Chancery concluded that the deal price was the best evidence of fair value. It is significant, however, because it was the largest appraisal proceeding (in terms of the dollar value of shares subject to appraisal) ever brought in Delaware and many of the traditional valuation methods showed a fair value well in excess of the deal price.
In their presentation to the Court, petitioners’ utilized a discounted cash flow evaluation of PetSmart based upon management projections. This is the method generally preferred by the Court. The Court, however, concluded that the projections were unreliable, finding that they were too optimistic regarding the company's future. The Court also found that the projections contained other “telltale indicators of unreliability.” In addition, it was found that the projections were made for the purpose of the sales process, and not in the ordinary course.
Underpinning the Court’s conclusion (and likely its statements about the projections) was its finding that the merger price was “the product of not only a fair sales process, but also of a well-functioning market.” In the case of PetSmart, there had been a robust sales process with multiple parties bidding until a winner was selected. Overall, the fair value determined by the Court was $4.5 billion less than what the petitioners claimed was the fair value.
Several days following the PetSmart decision, the Delaware Chancery Court issued a ruling in In re Appraisal of SWS Group. In contrast to the PetSmart case, Vice Chancellor Glasscock concluded that the deal price was unreliable evidence of fair value, but then concluded that fair value was less than the deal price. Here, the Court relied on a DCF analysis to determine the fair value of SWS at approximately 8% less than the merger price.
Glasscock stated that certain limitations “unique to SWS” made application of the merger price “not the most reliable indicia of fair value.” Some of these limitations included the company’s relatively small size, as well as its lack of scale. The Court also cited a “problematic sale process” as contributing to the inaccuracy of the deal price as a measure of fair value.
Chancellor Glasscock then conducted a DCF analysis was based on management projections (petitioner had advocated for the use of certain projections created by the acquirer). He also employed several assumptions about growth and other relevant metrics that differed significantly from those advocated by petitioners (and in line with the company’s valuation model). This resulted in a fair value below the deal price. In effect, Vice-Chancellor found that the acquirer had overpaid for the company.
The PetSmart decision demonstrates that the deal price may be considered reliable evidence of a company’s fair value, particularly where a competitive and robust sales process is in place. This is somewhat of a departure from Delaware Chancery Court rulings that have previously treated deal price as a poor indicator of fair value.
In contrast, the SWS opinion involved a flawed transaction process that did not produce reliable evidence of fair value. The case also highlights the potential risk for those bringing appraisal suits that fair value determinations in an appraisal proceeding may result in figures below the deal price.
Issues such as appraisal rights and determinations of share values in an appraisal action can involve many complex concepts that are subject to various interpretations. Recent rulings by the Delaware Chancery Court demonstrate how important surrounding factors are when it comes to issuing a ruling on fair value. If you have any questions or concerns involving appraisal rights, contact us at Kessler Topaz. Our team of attorneys has experience advising on appraisal actions, traditional class actions, direct actions, arbitrations, and various other types of proceedings.
For additional information and in-depth analysis on appraisal actions, view our Primer on Shareholder Litigation.