A little known court ruling in Delaware from 2007 has had some big consequences. While it has provided some benefits for investors, it also results in the inefficient use of resources, increased costs for mergers and acquisitions, and arbitrage. After examining the source of these effects, it may be possible to reduce the costs while keeping the benefits.
The case, which found that a shareholder could vote on a proposed deal if they held stock on the date of the vote, as opposed to the date of record (when the offer was made). This has allowed hedge funds and activist investors to take positions in a target companies after a deal price has been announced, then vote stop the deal in order to determine a fair price through what is called an appraisal. This has resulted in what is known as appraisal arbitrage. While this plan can backfire if the judgement decreases the price, professional investors are in as good a position as anyone to decide whether a price is too low, and there is an additional incentive that mediates the cost of the appraisal and the possibility off loos. However this outcome is actually quite rare: 80% succeed in getting a higher price.
Hedge funds argue that investors can actually be made better off by these deals because it allows bad deals that would have otherwise gone through to be recognized by professionals and provides an avenue to rectify the situation (with interest!). Recent examples in the news demonstrate this. The threat of appraisal by Carl Ichan didn’t prevent Dell from going private, but it did secure a higher price per share for investors. Currently, Dole is in court over its acquisition last year being too low, and Darden Restaurants is currently dealing with Starboard Value LP, a hedge fund who wants to stop the sale of its Red Lobster Chain of restaurants.
While such actions by activist investors and hedge funds have made investors better off in the past, it’s called arbitrage for a reason. Once the case arrives in court, the price is arrived at via the discounted cash flow method. According to David A. Katz, a partner at Wachtell, Lipton, Rosen, and Katz, “Discounted cash flow analyses, however, often produce values in excess of what a buyer would be willing to pay or the value of the company’s stock in the public trading markets.” In addition to the inflated measure of value the company has to pay 5.75% interest on the judgment, even if the original price is found to be fair. This amounts to a practically risk free profit if the deal was even close to fair to begin with.
Appraisal arbitrage can be seen as less an economic issue and more of a legal anomaly. To fix this problem, while preserving the economic benefit for consumers, the court should allow for the use of whatever valuation method is most appropriate to the company in question. Most importantly, it must reduce the interest rate that it pays on the judgments to be pegged to treasuries to end the arbitrage opportunity. In this way, activists and funds will intercede only when investors need them most.