Appraisal Arbitrage Is in Trouble
When a public company is acquired in a merger, it will often be sued by shareholders. There are two reasons to sue. One reason is what is called "breach of fiduciary duty." The theory here is that the company's board or management or advisers did something bad that caused the deal price to be lower than it should have been: The board sold to its own chief executive officer at a sweetheart price, or the managers favored the private-equity buyer that offered them jobs over the strategic buyer that would fire them, or the company's investment banker was trying to win a mandate from the buyer to work on another deal. The M&A process is complicated and there are a lot of ways to get things wrong. On the other hand, the M&A process is pretty heavily lawyered and people have a lot of incentives not to get things wrong. But there are cases like this, and sometimes they succeed and result in big payouts for shareholders.
There used to be a lot more cases like this that didn't result in big payouts for shareholders: Lawyers would make some half-hearted claims about conflicts, and the company would settle quickly by agreeing to add a bit more disclosure in the proxy statement and pay a fee to the lawyers. It was a sort of "merger tax," and everyone thought it was terrible, and in recent years it has kind of gone away as courts in Delaware, where most U.S. public companies are incorporated, have become skeptical of these "disclosure-only" settlements.
The other reason to sue is what is called "appraisal." The theory here is just that the price in the deal was too low. Why was the price too low? Well, there could have been any of the problems -- conflicted boards, self-interested managers, disloyal advisers -- that would lead to a fiduciary-duty case. But there don't have to be. Delaware has a statute that says that a court can appraise the company's fair value (the pre-merger fair value, "exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation") and order the company to pay it to shareholders who sue for appraisal. Even if everyone does a good job and works honestly to get a fair deal for the company, a court can second-guess the price and, if it decides that price was too low, order the company to pay the difference.
This rule feels, to many people, weird and antiquated. Sure, back in the olden days when the Delaware General Corporation Law was written, nobody knew what a company was worth and so they'd go ask a judge to tell them. But in the 21st century, with deep liquid securities markets and the efficient markets hypothesis, it seems downright backwards to think that a judge's opinion of what a company is worth would be more valid than the market's. Wouldn't investors whose job it is to value companies, and whose own money is on the line, be better at valuing companies than a judge is?
In May 2015, Hewlett-Packard Company acquired Aruba Networks, Inc., for $24.67 per share. It was a pretty boring transaction. HP had no inside line at Aruba, Aruba's board wasn't beholden to HP, Aruba's advisers weren't in HP's pocket. (Sort of: Actually HP hated Aruba's advisers at Qatalyst Partners LP, who tried to repair their relationship by being nice to HP, but not in a way that prevented Aruba from getting a fair price.) You'd have a tough time making much of a fiduciary-duties case against this merger. But you could sue for appraisal, and some Aruba shareholders did. The merger consideration of $24.67 per share represented a big premium -- the Chancery Court found that "Aruba's thirty-day average unaffected market price was $17.13 per share" -- but there is evidence both that Aruba initially thought that a $30+ deal price would be fair, and that HP's own deal team came to a value (including synergies) of over $30 per share.
So some shareholders -- appraisal-arbitrage hedge funds -- sued for more money, and there was a trial in Delaware Chancery Court, and last week Delaware Vice Chancellor Travis Laster issued a 129-page opinion considering the competing valuation methods and testimony and deal history and so forth and deciding, look, never mind all of that, the fair price for Aruba was the price that Aruba traded at before the merger announcement. Aruba was a listed public company with a liquid market for its stock, it was covered by 33 research analysts, it filed regular reports with the SEC, and there was just generally no evidence that the public markets were unequipped to come up with a value for its stock. So Vice Chancellor Laster deferred to that value: As far as he was concerned, the market price of Aruba (before the deal leaked) was the best evidence of its value. The fact that the deal price was higher than the market price he attributed to merger-related factors: HP was paying up for synergies, and for "the value that the acquirer creates by reducing agency costs," which are not part of the standalone value of Aruba and which therefore shouldn't be paid to appraisal shareholders.
This was very bad for the shareholders who sued: Instead of getting the $24.67 deal price, they'll get just $17.13 (plus interest). In the merger, the theory goes, HP agreed to pay shareholders the value of Aruba ($17.13) plus the value of synergies and reducing-agency-costs, plus, if you like, a premium to reflect its own empire-building goals or overoptimism about synergies or whatever ($7.54). Because that's how negotiated transactions work. But appraisal just gives you the value of Aruba, which in Vice Chancellor Laster's math is just $17.13. So the appraisal shareholders get less than the shareholders who sold voluntarily in the merger, and will lose money on their trade.
But that's the least of their problems. The big problem is: Who would ever bring an appraisal action again? If Delaware courts will normally just defer to market prices -- and if most mergers are done at a premium -- then you should expect almost all appraisal actions to lead to valuations that are lower than the merger price. (This was not, historically, the case.) The recent flourishing of appraisal-arbitrage litigation may end. The Aruba plaintiffs have asked Laster to reconsider his ruling, which may be existential for them.
Vice Chancellor Laster previously decided the Dell appraisal case, which we talked about in 2016. That was a case involving a management buyout by a founder-CEO who had been accused of sandbagging the company's results to make it cheaper; Laster did not find any breach of fiduciary duty, but he did find enough breachish-of-fiduciaryish-dutyish things to make him doubt that the deal price was fair, and to award a higher valuation in appraisal. That decision had a big impact; it sent a message that Delaware courts would be happy to second-guess deal prices even when for deals where the companies work hard to manage conflicts of interest.
But then it was reversed on appeal in December, when the Delaware Supreme Court found that Vice Chancellor Laster was wrong to doubt the market's ability to value Dell efficiently. Laster took that reversal to heart. He is sometimes a bit catty about it, saying, for instance: "In this case, I regard the petitioners’ evidence of market mispricing as considerably weaker than what I abused my discretion by crediting in Dell." But he interprets the decision to mean that, in the ordinary case, with no evidence of fiduciary breaches or market breakdowns, courts should assume that markets are efficient and that market prices reflect values. So he does:
Considering these factors as a whole, the HP-Aruba merger looks like a run-of-the-mill, third-party deal. Nothing about it appears exploitive. Particularly given the inclusion of synergies, there is good reason to think that the deal price exceeded fair value and, if anything, should establish a ceiling for fair value.
If this decision holds up -- and again the plaintiffs have asked the judge to reconsider, and can still appeal -- then, combined with the demise of disclosure-only settlements, it will reflect a huge change in merger litigation. Not too long ago, the expectation was that every merger would be challenged in court. Lawyers could make a quick fee by demanding some additional disclosures; plaintiffs could get a higher price by producing a discounted cash flow valuation that showed a higher number than the negotiated merger price. Even in fairly ordinary deals there was a lot of opportunity for litigation and second-guessing.
In just a few years, that opportunity has mostly disappeared: Disclosure-only settlements are dead, and in a "run-of-the-mill, third-party deal," the deal price "should establish a ceiling for fair value" in appraisal. Now if you want to challenge a merger in Delaware, you can't just nitpick the disclosure or propose an alternative valuation. You need to have a serious argument that the deal was fundamentally flawed, that there was some deep conflict that prevented the board of the target from negotiating for a fair price. Otherwise, the courts have concluded, the regular merger process is the best way to get a fair merger price, and lawyers and courts should get out of the way. It is in some ways a rather hopeful conclusion: After decades of merger litigation, the merger process has been refined and perfected, and now it can for the most part run on its own.
Here is a business story that I really want to read:
XYZ Co. is well-known for its chill corporate culture. It is common for bosses to ask their teams to ship a new product within a week, and for the teams to say "man actually we have Warriors tickets that week how is next month for you?" Managers demand the possible and take no for an answer; they set easily achievable goals and then, when their subordinates fail to achieve those goals, they chuckle and say "ehh what are you gonna do."
The results are undeniable: Sales have grown at 500 percent a year for five years, XYZ is a leading technological innovator, and it is on its way to overtake Apple Inc. as the most valuable public company in the world.
I am not saying that those companies are out there. Though I hope they are? Don't you want to think that capitalism and success and a nice life are compatible? Wouldn't it be nice if people were pushing the envelope of technological innovation, you know, when they got around to it?
But instead there are basically two kinds of business story:
- XYZ Co. is well-known for its hard-charging corporate culture where managers demand the impossible and don't take no for an answer, and the result is wild success and regular appearances by the CEO on the cover of magazines as a corporate hero.
- XYZ Co. is well-known for its hard-charging corporate culture where managers demand the impossible and don't take no for an answer, and the result is misery, fraud, and regular appearances by the CEO on the cover of magazines as a cautionary tale.
I am sure that there are identifiable cultural differences that distinguish category 1 from category 2. (Maybe you have to demand the impossible politely to get your underlings to deliver it? Or you have to add "but don't do fraud!" at the end of every impossible demand?) But it is tempting to imagine that the outcome is random, that a hard-charging demand-the-impossible never-take-no-for-an-answer culture is just a way to achieve high variance in outcomes, and that the leaders who end up on the right tail of the distribution are praised for that culture while the ones who end up in the left tail are blamed for it. Even if it's the same culture.
Anyway here's a story about General Electric Co. and its former chief executive officer Jeffrey Immelt called "How Jeffrey Immelt's 'Success Theater' Masked the Rot at GE":
Mr. Immelt and his top deputies projected an optimism about GE’s business and its future that didn’t always match the reality of its operations or its markets, according to more than a dozen current and former executives, investors and people close to the company.
This culture of confidence trickled down the ranks and even affected how those gunning to succeed Mr. Immelt ran their business units, some of these people said, with consequences that included unreachable financial targets, mistimed bets on markets and sometimes poor decisions on how to deploy cash.
There's a little chart of the stock price under Immelt (down) and under his lionized predecessor Jack Welch (up). Did the culture change that much? "GE itself has never been a culture where people can say, ‘I can’t,’" says a consultant. But sometimes they could, and that culture was good, and sometimes they couldn't and it was bad.
In 2012, a generation ago in cryptocurrency terms, Jon Montroll "launched BitFunder as an online 'bitcoin fund raiser and trader.'" Here is how it worked:
Through BitFunder’s platform, registered users of BitFunder (“Users”) could create, offer, buy and sell shares in various enterprises (referred to as “Assets” and “Asset Shares” on the BitFunder website). The Assets listed on the platform primarily were virtual currency-related businesses, such as virtual currency mining operations. Shares in respective Assets were offered and sold by certain Users (referred to as “Asset Issuer[s]” on the BitFunder website) to other Users on the platform in “initial offerings.” Many of the offerings promised and paid dividends (referred to as “dividend paying asset share[s]” on the BitFunder website). Users also were permitted to buy and sell these virtual shares in secondary market transactions on the platform at increased prices. Bitcoin was the only form of payment used and accepted by Users on the platform.
Does that sound familiar? The things were called "Assets" instead of "tokens," "initial offerings" instead of "initial coin offerings," but those are cosmetic differences. BitFunder was an early platform for people to conduct ICOs, and to trade the shares -- tokens, whatever -- that they acquired in those ICOs at ever-increasing prices.
The quotes above are of course from a Securities and Exchange Commission complaint against Montroll and BitFunder, which alleges that they "operated BitFunder as an unregistered online securities exchange and defrauded exchange users by misappropriating their bitcoins and failing to disclose a cyberattack on BitFunder’s system that resulted in the theft of more than 6,000 bitcoins." Obviously you should not misappropriate Bitcoins or neglect to tell your customers that you've been hacked, but those are sort of trivial points. Just don't do that.
The real point of this enforcement action is the "unregistered online securities exchange" bit. "BitFunder," alleges the SEC, "without being registered as a national securities exchange or exempted from such registration, directly or indirectly, by the use of the means and instrumentalities of interstate commerce or of the mails, acted as an exchange and effected transactions in securities and/or reported such transactions," which violates Section 5 of the Securities Exchange Act of 1934. If you want to run a platform for buying and selling securities, you need to register as a national securities exchange, or qualify for an exemption. (There is a notable exemption for dark pools run by registered broker-dealers, but those have to comply with other rules -- and be registered as broker-dealers.)
If you want to run a platform for buying and selling cryptocurrencies ... look, I don't know, so far you seem to be able to do that without much SEC oversight, though I would not go so far as to give you legal advice about it. (Maybe you should get a New York BitLicense?) But Bitcoin is, let's say, not a security, and so a Bitcoin trading platform is not a securities exchange. The problem comes when you run a platform for buying and selling cryptocurrencies that also supports trading for, you know, KodakCoins or Munchee tokens or any of the hundreds of other blockchain-based tokens that are sold by companies to fund the development of their platforms and that are bought by investors for investment purposes. Those tokens are obviously securities, and the SEC has said as much, and if you offer a platform for trading them, then you are obviously an unregistered securities exchange, and now the SEC has said as much. Those platforms are on notice now. The fact that the securities are called "tokens" and they trade on the blockchain and you have to buy them with Bitcoin or Ether does not change the analysis.
Here is an extremely pleasing story from Sarah Kessler at Quartz about how Amazon's warehouses are organized: randomly. When things arrive at the warehouse, an employee puts them "wherever he finds open space," scanning barcodes on the shelf and the product so that a computer can keep track of what is where. You don't sort, you index:
The reason it makes sense to group these random products together has everything to do with technology: the speed and frequency with which customers order online, and the tools that Amazon has developed to keep track of every item in its vast warehouses.
First, random storage makes finding the toothpaste faster in an era of on-demand efficiency. If there were a dedicated “toothpaste shelf” and someone ordered toothpaste, a “picker”—how Amazon refers to employees who gather items—would need to travel there, whether he were 10 feet or 100 yards away from that location. But if the warehouse stores toothpaste in 50 different locations, there’s a much better chance that there’s a tube close to some picker. There’s also a greater chance that the second item the customer ordered is also nearby.
It also saves space: "Reserving empty space on the 'toothpaste shelf' while waiting for the next shipment of toothpaste would mean its warehouses would need to be even bigger. It’s more efficient to use any free shelf space available."
I sometimes make fun of tech companies for confusing their computer systems with the physical world. "The world exists," I once wrote, "and it is messier than your protocols want it to be." But Amazon realized that in some senses computers are messier than we usually allow the physical world to be: You can just put data anywhere in a computer; you access it by knowing where it is rather than by putting it all in order in prearranged boxes. It applied the same principle to its warehouses, and it worked.
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