Courtesy of Ben Lucy
Appraisal is a statutory mechanism that allows dissenting shareholders of Delaware merger targets to petition the Court of Chancery for a judicial determination of the “fair value” of their shares. In the 2010s, appraisal rose from relative obscurity to the front lines of high-stakes commercial litigation and the front pages of the financial press. Billions of dollars hung in the balance as Delaware courts waded through an influx of appraisal litigation that coincided with their constriction of conventional avenues of merger dissent in the Trulia case and through the development of the Corwin doctrine. This time period also saw the birth of “appraisal arbitrage,” where sophisticated financial speculators purchase shares after a merger is announced with the intention of perfecting their appraisal rights, in the anticipation of receiving a premium to the deal price (plus generous statutory interest.)
Appraisal is a unique area of law in which judges perform tasks usually reserved for financial analysts. In an appraisal petition, the Court of Chancery must determine the target company’s value on its own. The appraisal statute, 8 Del. C. § 262, obtusely provides only that the court must determine the target company’s fair value “taking into account all relevant factors,” excluding any “value arising from the accomplishment or expectation of the merger.” The court must explain its valuation method “in a manner that is grounded in the record before it,” but it enjoys broad discretion to, for instance, award the deal price, adopt one party’s expert’s valuation model, or fashion its own. In Dell, the first of three prominent appraisal cases decided during this period, the Court of Chancery constructed its own discounted cash flow model and awarded petitioners an eye-popping 28% premium over the deal price.
With higher stakes came scholarly and judicial contention. Academics, practitioners, and courts disagreed considerably about which conception of appraisal fair value was most consistent with the purpose of the statute, Delaware case law, and the financial community’s consensus about company valuation in various M&A contexts.
Appraisal and the Efficient Capital Markets Hypothesis
The most interesting debate concerned the proper role of the efficient capital markets hypothesis (ECMH) in appraisal analysis. Its introduction into appraisal case law is consonant with Weinberger’s dictum that, when valuing companies, the Court of Chancery’s analysis should be grounded in “techniques or methods which are generally considered acceptable in the financial community.” However, given the relative dearth of Delaware cases that have even mentioned the ECMH, much less applied it, the concept has not enjoyed an easy assimilation into appraisal law. After all,the appraisal statute was born in the nineteenth century, and its early development occurred during a time when litigants were far more likely to contend over the fair value of livestock than of common stock. The first noteworthy appraisal case, Chicago Corp. v. Munds, featured a Depression-era Court of Chancery understandably expressing deep skepticism about the reliability of stock prices: “The experience of recent years,” the court wrote, “is enough to convince the most casual observer” that stock prices are often untrustworthy indicators of fundamental value.
Over eighty years later, the liquidity and efficiency of capital markets has increased dramatically. In 2017, the Delaware Supreme Court injected the ECMH into the appraisal lexicon in a momentous pair of cases, Dell and DFC. In both cases, the Court of Chancery identified transaction-specific facts that it believed undermined the reliability of both the deal price and the “fair value” claimed by each party’s experts. It had awarded appraisal petitioners substantial premiums over the deal price—approximately 7.5% in DFCand 28% in Dell. The Delaware Supreme Court reversed both decisions, dismissing numerous process deficiencies identified by the lower court. For instance, the Court of Chancery found that the Dell take-private was a conflict transaction in which conflicted financial advisors ran an ineffective market check. The Delaware Supreme Court stated that the Vice Chancellor’s resulting reticence to adopt the deal price “ignored the efficient market hypothesis long endorsed by this court.” It expressed the “semi-strong” form of the ECMH as follows: when the market for a company’s shares is efficient, the resulting price “reflects all publicly available information as a consensus, per-share valuation.”In both cases, the Delaware Supreme Court strongly implied that the petitioners should be awarded the deal price.
The high court’s full-throated endorsement of the ECMH quickly generated debate among practitioners and scholars. Among the most pressing questions was which market price is the best evidence of fair value. In Dell, the Delaware Supreme Court identified several factors that supported the proposition that the pre-leveraged buyout market for Dell’s stock was efficient, e.g., its high public float, extensive analyst coverage, and high weekly trading volume. Puzzlingly, it then all but directed the Court of Chancery to award the deal price on remand. (The parties later reached a settlement at the deal price.) Professors Charles Korsmo and Minor Myers identified this and other perplexities in the Dell and DFC decisions. The market for companies, they observed, is categorically different from the market for shares of stock. It is difficult to imagine any sales process for a company ever approaching the degree of efficiency (and thus fairness and reliability) of the market for a publicly traded company’s stock. In other words, there is an enormous logical gap in the Delaware Supreme Court’s reasoning: just because a company’ stock is fairly priced does not mean that the company itself will be fairly priced in a sales process that falls far short of the degree of efficiency associated with public capital markets.
The Aruba Case
Next came the Aruba appraisal case. In it, the Court of Chancery meticulously mined the Delaware Supreme Court’s Dell and DFC opinions, the corporate finance literature, and a voluminous factual record to arrive at an alarming appraisal fair value determination: the fair price of Aruba’s stock, it reasoned, was equal to its unaffected thirty-day average trading price. The court considered various valuation alternatives and concluded that, on the record before it, each of them was likely to be tainted by human error. Quoting the Delaware Supreme Court in DFC, the Court of Chancery wrote: “Rather than representing my own fallible determination, [the unaffected trading price] distills ‘the collective judgment of the many based on all the publicly available information about a given company and the value of its shares.’” To put it mildly, Arubathrew the confusion identified by Professors Korsmo and Myers into sharp relief. How should counsel, financial advisers, and deal participants understand the ECMH now?
The case also invited the Delaware Supreme Court to weigh in on an issue it had not addressed since it revised its appraisal jurisprudence to incorporate the ECMH: should “agency cost reductions,” the value a buyer creates by replacing ineffective management with superior administrators, be excluded from appraisal awards? The Court of Chancery relied upon this idea in its opinion as part of the justification for awarding the unaffected trading price. Delaware courts have consistently described appraisal fair value in terms of going concern value, and they have long agreed that merger synergies are not a component of appraisal fair value—even though they often award petitioners the deal price, which one would ordinarily presume includes some synergy value. The concept that installing superior managers will increase the expected cash flows to a company’s stockholders is certainly acceptable in the financial community, and it is uncontroversial that agency cost reductions are a motivation for many mergers. In my view, agency cost reductions also rather obviously constitute “value arising from the accomplishment or expectation of the merger.” By raising the agency costs issue in its opinion, the Court of Chancery set the stage for a widely-anticipated appellate opinion.
If the Aruba decision had been upheld, it would have spelled the end for appraisal. Virtually every non-distressed deal involving a public company takes place at a premium to the market price. If the best price dissenting stockholders could hope for was the company’s unaffected trading price, then no rational stockholder would ever bring an appraisal petition.
Unsurprisingly, the Delaware Supreme Court reversed. It argued vigorously that its Dell and DFC decisions did not compel such an extreme result. The high court discarded the Court of Chancery’s “inapt theory that it needed to make an additional deduction from the deal price for unspecified ‘reduced agency costs,’” suggesting that the buyer’s synergies estimate likely included the entirety of the value it anticipated in excess of the target’s trading price. It directed the lower court to award petitioners the deal price, less synergies.
In an apparent response to Korsmo and Myers’s commentary, the Delaware Supreme Court denied that its Dell and DFC holdings implied “that the market price of a stock was necessarily the best estimate of the stock’s so-called fundamental value at any particular time.” Instead, the court wrote, those decisions “recognize[d] that when a market was informationally efficient . . . the market price is likely to be more informative of fundamental value.” More informative than what? The deal price? If consideration of the ECMH is normatively a component of appraisal analysis, this rehashing of Dell and DFC simply regenerates the confusion that produced the Court of Chancery’s Aruba opinion to begin with.
Against this backdrop, I attempt to harmonize the Delaware Supreme Court’s embrace of the ECMH with the orphaned issue of how to treat agency cost reductions in the following section.
Toward a Revised Appraisal Fair Value Framework
In a forthcoming student Note, Defining Appraisal Fair Value, I suggest an alternative adjudicatory framework for appraisal petitions that promotes the core goals of Delaware corporate law, particularly those of facilitating capital formation and incentivizing efficient transactions. It is also consistent with the Delaware Supreme Court’s characterization of the ECMH and the language of the appraisal statute. I propose a simple model for understanding the components of merger deal prices. I then ask of each component, “Is this a part of appraisal fair value?” Finally, I suggest a method for analyzing appraisal cases that will encourage fair and efficient transactions and serve judicial economy.
The proposed model recognizes four components of merger prices: (1) the target’s unaffected market capitalization; (2) merger synergies; (3) agency cost reductions; and (4) the value, if any, of nonpublic information about the target. If the ECMH obtains, the target’s unaffected trading price sets an intuitive baseline for the value of stock. Merger synergies are definitionally created by the transaction itself, so they must be excluded. Reduced agency costs are another source of value that derives from the merger itself, so this, too, should be excluded. Material nonpublic information, by contrast—that is, information that has determinate positive or negative implications for company value—where it exists, should be included in appraisal awards.
The Court of Chancery was correct to excise the value of reduced agency costs from its estimation of the fair value of Aruba’s stock. In a nutshell, stockholders buy in to a company as it currently exists, with its current management and capital structure. If the value of reduced agency costs is included in appraisal awards, then stockholders who bought in at a “minority” price will be cashed out at a “majority” price, the higher price a buyer pays to acquire a controlling block of stock. I am unable to see how this could ever be a desirable result, and it actually strikes me as unfair to the acquirer’s shareholders. And although capable arguments have been made on both sides of this debate, the Delaware Supreme Court’s rulings in Dell, DFC and Aruba do not resemble any of them. If the Delaware Supreme Court meant that Delaware law considers agency cost reductions should simply be seen as a subset of synergies, that is sensible enough. Since synergies are already excluded, if agency cost reductions are synergies, then the high court reaches the same conclusion as I do. But here is the mystery: recall that the Delaware Supreme Court directed that petitioners be awarded the deal-price-less-synergies number. That number was higher than Aruba’s unaffected trading price! The unaffected trading price was $17.13 per share, and the deal-price-less-synergies figure was $19.10 per share (an 11.5% premium). If all agency cost reductions are a component of synergies, what can explain this gap? I cannot find an answer, and it strikes me that the law should have one.
Material nonpublic information (MNPI) is value-relevant company information that is not publicly available. MNPI can be positive or negative. Under the ECMH, market prices do not incorporate MNPI. And yet this information is by definition relevant to the company’s going concern value. If we understand the corporate form to invite stockholders to take the risk of investing in companies about which they have imperfect information, then it follows that they are entitled to the returns associated with that risk. For example, if a biotechnology company has developed the cure for a widespread and deadly virus, and it is acquired by another company before that information has been made public, then its stockholders would justifiably feel cheated. Since prospective buyers receive MNPI about target companies during the diligence phase of M&A transactions, courts should foreclose the possibility of stockholder exploitation in such situations by explicitly incorporating nonpublic value into appraisal analysis.
With these observations in hand, it remains to operationalize the model. With the ECMH in mind, I suggest that, where the target company’s stock trades in an efficient market, the court should presume that the unaffected trading price is the best evidence of fair value. The presumption can be overcome by proof that undisclosed material information prevented the market from properly valuing the target company. I suggest that evidence of a competitive, transparent sales process should mitigate some degree of judicial suspicion about MNPI suppression, because buyers will (hopefully) bid away the value of the information asymmetry they enjoy vis-à-vis the broader marketplace. If the petitioner sufficiently demonstrates MNPI suppression, the court can proceed as it long has—by making the best determination of fair value it can from the evidence presented to it.
Efficient mergers are desirable, and the law should encourage them. Adopting this framework will incentivize efficient transactions by enabling merger buyers to retain the value they create in the form of synergies and agency cost reductions. It will also increase certainty among participants in the market for corporate control by characterizing with particularity the conditions under which deal prices will be subject to judicial second-guessing. M&A participants rightly shudder at the idea of a court deciding how much a company is worth, and this framework provides guidance about how to avoid it: run a fair, transparent transaction, ideally with a competitive sales process. The proposed method will have no impact on the cost of equity capital, because in the real world investors generally buy stock expecting to bear the agency cost risk associated with the company’s existing management. They are simply not entitled to the value created by replacing that management. But if they do want to be cashed out at a “majority” rate, they can easily accomplish that by simply not bringing an appraisal petition. Finally, the proposed framework serves judicial economy. Litigants will raise MNPI issues at the pleading stage, allowing the court to quickly judge the likelihood that more intense scrutiny is warranted. Frivolous appraisal claims will be discouraged; unless there is a legitimate process adequacy concern that implicates MNPI, appraisal petitioners can expect to receive a price lower than the deal price.
If, as Professors Korsmo and Myers have written, appraisal is the “last judicial sentry on watch” following Delaware’s more hostile treatment of traditional merger challenges, then a clearer articulation of how the law understands appraisal fair value is desirable. The framework I have proposed preserves the benefits of the Delaware Supreme Court’s adoption of the ECMH while dispelling the confusion it has caused. It is grounded in the reliability of market prices, departing from them only where considerations of process adequacy (or in the extreme, fraud) demand it. If, for example, the target’s board sleepwalks its way through a sales process in which the CEO failed to disclose an egregious conflict of interest (as was the case in Aruba), the existence of the conflict is MNPI, and the court should undertake a more exacting review of the transaction. This preserves the possibility that an appraisal award can exceed the deal price, so appraisal retains its teeth.
Appraisal will still stand as a vital deterrent against process failures and minoritystockholder exploitation. The sentry will remain on watch, but its energies will be focused only upon those cases where scrutiny is most likely to be warranted.
 See In re Trulia, Inc. S’holder Litig.,129 A.3d 884, 898–99 (Del. Ch. 2016) (explaining that, for a disclosure-only settlement in a merger challenge lawsuit to gain approval by the court, the additional disclosures obtained by the plaintiff must be “plainly material”).
 See Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304, 305–06 (Del. 2015). In post-closing breach-of-fiduciary duty merger litigation where the entire fairness standard of review does not apply, the merger will be subject to the court’s most relaxed standard of review, the business judgment rule, if it “has been approved by a fully informed, uncoerced majority of the disinterested stockholders.” Id. See also Steven M. Haas, The Corwin Effect: Stockholder Approval of M&A Transactions, Harv. L. Sch. F. Corp. Governance (Feb. 21, 2017) (After Corwin, “[t]he business judgment rule appears to be irrebuttable following a fully informed and uncoerced stockholder vote.”).