Rise in “Dissenting Shareholder” Merger Conditions

ATTORNEY: ANNA KARIN F. MANALAYSAY
POMERANTZ MONITOR, MARCH/APRIL 2014 

The increasing frequency of appraisal proceedings has led directly to a significant change in Delaware law and practice, most notably to the increasing use of dissenting-shareholder conditions in merger agreements. These provisions allow an acquirer to back away from the merger if holders of more than a specified percentage of outstanding shares exercise their appraisal rights. Without this condition, the acquirer would have to go through with the merger even if there are a large number of dissenting shares, thereby running the risk of having to pay a lot more than what it had bargained for. In Delaware, valuation of the target company’s stock in an appraisal proceeding requires a court to “determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger” but taking into account “all relevant factors.” 

Historically, the appraisal remedy has been pursued infrequently because the appraisal process is complex and potentially risky for the dissenting shareholder. Shareholders seeking appraisal must be prepared to invest considerable time and expense in pursuing their rights. Even when the process goes quickly, dissenters face the risk that the court will undervalue the company and their shares. Dissenters must initially bear all their litigation expenses and do not receive payment until finally ordered by the court, and then only receive reimbursement depending on the number of other dissenters, each of whom must pay his or her share of the costs. Absent a group of dissenters who can share costs and (most importantly) legal and expert witness fees, the cost of an appraisal is prohibitively expensive except for holders with large stakes. 

Despite these obstacles, the appraisal remedy is becoming more and more popular, at least in Delaware. One reason is that appraisal valuations have exceeded the merger price in approximately 85% of cases litigated to decision. Another is that even if the court’s valuation is lower than the merger price, dissenters can still come out ahead because these awards include interest at a rate of 5% above the Federal Reserve discount rate. According to recent academic studies, last year the value of appraisal claims was $1.5 billion, a ten-fold increase in the past ten years; and more than 15 percent of takeovers in 2003 led to appraisal actions by dissenters. Recent changes to Delaware law encourage the appraisal remedy by allowing shareholders to exercise their appraisal rights even prior to the consummation of the merger, at the conclusion of the first step in the transaction. Mergers often are completed in two steps. In step one, the acquirer launches a tender or exchange offer for any and all outstanding shares. Upon the close of that transaction, the acquirer then scoops up any shares not tendered in the offer by way of a second-step merger. 

A “short-form” merger does not require stockholder approval of the second-step merger, but can be used only if the acquirer buys at least 90 percent of the target’s stock after the step one. If the acquirer gets less than 90 percent, it has to use a “long-form” merger, which requires it to mail a proxy statement to all remaining shareholders and hold a stockholder meeting to approve the merger. Delaware recently enacted a new law that permits parties entering merger agreements after August 1, 2013, to agree to eliminate the need for a stockholder vote for a second-step merger if certain conditions are met, including receiving tenders of at least 50% of the shares. At the same time, Delaware amended its appraisal statute to provide that in connection with a merger under the new law a corporation can send the required notice of the availability of appraisal rights to its stockholders prior to the closing of the offer, and can require them to decide immediately whether to exercise their appraisal rights. In response to these changes, Delaware corporations have begun notifying their stockholders that all demands for appraisal must be made no later than when the first-step offer is consummated. 

The significance of these changes is that acquirers will now know, before they buy a single share of the target, how many shareholders are going to exercise their appraisal rights. This development, in turn, makes it possible for an acquirer to include a dissenting-shareholders condition to its obligation to consummate even step one of the deal, which, is, effectively, a condition to doing the entire deal. 

With the rising popularity of appraisal litigation and recent changes to the DGCL, a dissenting-shareholders condition will likely become a common feature in merger agreements.