Delaware Chancery Court Decision Demonstrates Continuing Risk to “Appraisal Arbitrage”
In a stark application of the adage that one should be careful what one wishes for—because one may get it—on May 30, Vice Chancellor Sam Glasscock III of the Delaware Chancery Court issued an opinion in In re Appraisal of SWS Group, Inc. (C.A. No. 10554-VCG), a stockholder lawsuit seeking appraisal for the shares of SWS Group, Inc. (SWS), a financially struggling bank and broker-dealer firm. The appraisal claim arose out of the merger of SWS with Hilltop Holdings Inc. (Hilltop) in January 2015. The court’s decision on the fair value of the SWS shares reduced the price paid to dissenting stockholders from the merger price of $6.92 per share, payable in a mixture of cash and stock, to $6.38, payable in cash. This decision, and the resulting 7.8 percent reduction in consideration, demonstrates the risks inherent in “appraisal arbitrage.”
Appraisal claims permit dissenting stockholders to pursue a claim for the fair value of their shares, based on the value of the corporation as a going concern, not as a merger target. Such claims have become increasingly popular in recent years, as investors use the appraisal process strategically to generate returns in the form of (1) potentially huge dividends if a court assigns a fair value in excess of the deal price and (2) interest on any gain from the appraisal at 5 percent plus the federal discount rate compounded monthly. This strategy, sometimes known as “appraisal arbitrage” and driven by the opportunity to generate above-market returns, has been more frequently employed in recent years.
The dissenting SWS stockholders argued that SWS was worth more than the $6.92 per-share price paid by Hilltop, emphasizing both SWS’s excess capital of nearly $194 million (ironically, created by Hilltop when it exercised SWS warrants in advance of the merger) and other offers received by SWS that were well above the Hilltop offer. Hilltop, now the controlling stockholder of SWS, argued that the focus on the excess capital created an inaccurate perception of SWS’ value, as the capital “created” by the exercise of the stock warrants did not actually provide any additional real money to SWS. As a result, SWS was worth only $5.71 per share under Hilltop’s analysis.
Recent decisions such as In re Appraisal of PetSmart Inc. and Merion Capital LP et al. v. Lender Processing Services Inc. serve to highlight one risk in appraisal proceedings: that a well-constructed auction process will lead to an efficient pricing outcome and to the court giving deference to the merger price. SWS Group highlights a different, but equally, significant risk. Vice Chancellor Glasscock declined to give deference to the merger price, saying that in this case, the merger process was unreliable. Instead, the court undertook its own analysis, ultimately siding largely with SWS, and determined SWS’s fair value was $6.38 per share, less than the per-share price paid by Hilltop and far below the per-share price sought by the dissenting stockholders. Vice Chancellor Glasscock noted that “when the merger price represents a transfer to the sellers of value arising solely from a merger, these additions to deal price are properly removed from the calculation of fair value.” In other words, mergers that present unique value to the parties involved due to synergies that are not available to the target on a stand-alone, going-concern basis are very risky transactions in which to engage in appraisal arbitrage. Once committed to an appraisal proceeding, a stockholder forgoes the ability to receive the merger consideration and instead is left with whatever value the court assigns to the dissenting stockholder’s shares. Particularly in synergies-driven mergers, this means that stockholders may receive less than the merger consideration, in addition to having to bear the cost of the appraisal proceeding.
SWS Group may be part of a legislative and judicial trend that may curb the use of appraisal rights. While it gets there by a different route, in that the court did not give deference to the merger price, the outcome of SWS Group is consistent with a developing line of Delaware cases, which have supported a merger price less synergies approach in appraisal cases. When coupled with legislative restrictions adopted in Delaware restricting their use to cases like PetSmart and Lender Processing Services, which also showed deference to the merger price, it may be that the hey-day of opportunistic appraisal proceeding has passed.