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 The strategy usually involves buying stock in a
Delaware-incorporated company that is being acquired and then filing
a claim that gets a judge to determine the fair price for the shares
in a process known as appraisal. The fund will argue in court that
the deal value was unfairly low and it should be paid a higher
price.
Since an annual interest rate of 5.75 percent currently accrues
while a case is pending, and a final judgment can take years, the
strategy generates a solid return even when the court rules the deal
price was fair.
But now the top corporate lawyers in Delaware, where about
two-thirds of Fortune 500 companies are chartered, are proposing an
amendment to the law aimed at removing the interest incentive if a
case is lost. The lawyers’ proposals have traditionally been
approved with little opposition by Delaware’s state legislature.
That hasn’t stopped the appraisal lawsuits from piling up. And there
are signs that given the low-return environment in financial
markets, more hedge funds and other investors may be filing
appraisal suits.
Between 2004 and 2010 only about 5 percent of the deals in which
Delaware chartered companies were eligible for such claims were the
subject of appraisal rights cases. By 2013 this had increased to 17
percent, according to the law firm Fried Frank.
LARGEST EVER
In recent days, funds affiliated with Third Point Reinsurance,
Farallon Capital Management and Muirfield Capital, among others,
have filed appraisal actions over the sale of pet products retailer
PetSmart Inc, which closed on March 11.
In all, the funds concerned hold about 10.5 million shares of
PetSmart, worth about $870 million, likely making it the largest
appraisal action ever, according to Minor Myers, a professor at
Brooklyn Law School.
Even if the court eventually determines that the $83 per share that
a consortium led by European private equity firm BC Partners paid
for PetSmart stock was fair, interest will accrue at more than $50
million per year while that decision is awaited, and will increase
as time goes on because the interest is compounded quarterly. In
addition, the court could determine the fair price should be much
higher, giving the funds a big potential payout.
The strategy does come with risks. Judges have ruled the fair price
was below the deal price in a small number of cases, and the hedge
funds have to pay for their lawyers and experts.
The appraisal strategy has been pioneered in recent years by Merion
Capital LP, a hedge fund founded by Andrew Barroway. The former
securities class action lawyer got his start building Schiffrin &
Barroway, now known as Kessler Topaz Meltzer & Check, into a major
player in federal securities fraud class actions.
Appraisal rights are not new. They originally emerged as protection
for minority investors as companies did away with universal
shareholder approval for certain corporate events.
Seeking an appraisal of a deal had previously mainly been used by
minority investors who felt they were squeezed out of a deal
decision by a controlling shareholder. However, in recent years the
claims have often come from hedge funds seeking juicy returns.
In a handful of cases in the past few years Delaware judges have
determined the fair price was much higher than the deal price. In
the sale of entertainment company The Orchard Enterprises, a
Delaware judge found the fair price was 127.8 percent above the
takeover price, according to a client memo from Fried Frank. The
interest during the two-year case tacked on another 36.1 percent to
returns.
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The proposal by the Delaware bar comes at a time when the state's
lawyers are seeking to preserve the state's leading role in
corporate litigation while responding to business demands to cut
meritless shareholder lawsuits.
More controversial proposals for changing Delaware corporate law
will be considered next month by the state's corporate lawyers. Some
are designed to prevent companies from adopting bylaws that force
their legal costs onto shareholders who sue and lose.
The committee proposing the appraisal arbitrage amendment is
reflective of many types of corporate law specialists, including
those who represent investors as well as lawyers for companies they
sue.
Some lawyers outside Delaware who represent companies have
criticized the appraisal proposal for not being tough enough on the
hedge funds.
Trevor Norwitz, a top deal lawyer at Wachtell, Lipton, Rosen & Katz,
which advised PetSmart, said Delaware law should require that only
investors who were shareholders before the deal announcement be
allowed to seek appraisal. Many funds seeking appraisal rulings
scoop up their stock after the shareholder vote on the deal but just
before it closes, which is a constant irritant to the company
defense lawyers who want proof of how the shares held by the hedge
funds were voted on the deal.
Norwitz wrote in a blog post that the bar's proposals do not go far
enough to discourage the hedge funds. As he sees it, there is a
danger that the buyers of companies will pay less to all
shareholders because they will have to find the funds to pay off the
hedge funds, who he referred to as “hold-up artists."
The Delaware bar committee that drafted the appraisal proposal said
in an explanatory paper that buyers can negotiate conditions that
would allow them to back out if a certain number of appraisals are
filed. The bar also said corporate deals involving proper steps,
such as testing the deal’s price by seeking other potential buyers,
are less likely to be the subject of appraisals.
In the PetSmart case, the funds asked the court to determine the
fair value of their stock and award them their costs associated with
the suit.
In a class action over the same deal, which was approved by about 75
percent of PetSmart shareholders, investors have said PetSmart was
worth more than $100 per share. At that price, the BC Partners
consortium could easily be on the hook for more than $200 million in
payments to the hedge funds, including interest.
A PetSmart spokesman declined to comment as did a lawyer for the
funds in the case.
(Reporting by Tom Hals in Wilmington, Delaware; Editing by Amy
Stevens and Martin Howell)
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