Shareholder Appraisal Rights: Delaware’s Flawed Market-Out Exception
Lynn Bai* and William A. Murphy*
State statutes give dissenting shareholders an appraisal right in some, but not all corporate mergers. With varying specifics, a widely adopted market-out exception denies appraisal if the shares are publicly traded. The rationale for market-out is that the public market offers a reliable valuation of the shares and a convenient exit to dissenting shareholders. A major criticism of market-out is that market prices may not reflect the full value of the shares due to information asymmetry in mergers involving conflicts of interests. Delaware’s market-out approach is drastically different from that adopted by the Model Business Corporation Act (MBCA), but both have a significant number of followers among US jurisdictions. This essay highlights the flaws in Delaware’s approach and shows that the MBCA provides better protection to dissenting shareholders. Fiduciary breach lawsuits are not adequate substitutes for appraisal due to procedural hurdles.
Introduction: The Market-Out Exception to Appraisal Rights
Historically, certain corporate transactions such as mergers and acquisitions required a unanimous approval by shareholders of the target company. The requirement effectively gave shareholders the power to veto highly valuable transactions.1Claire A. Hill, Brian JM Quinn & Steven Davidoff Solomon, Mergers & Acquisitions: Law, Theory, and Practice 63 (2d ed. 2019). Modern-day corporate statutes lower that requirement to an affirmative vote by a majority of shareholders.2See, e.g., Del. Code Ann. tit. 8, § 251(c) (2020). Merger terms are set by the management in negotiation with the acquiring company. The majority or supermajority approval means that the merger can consummate even if some shareholders disapprove of the transaction, most commonly because they believe the shares are undervalued or the compensation is in the form of illiquid securities that lack a ready market.
What are the options of the dissenting shareholders if they do not have enough shares to block the merger? They could submit to their fate and grudgingly accept the allegedly unfair terms, or they could seek an appraisal in court to determine a fair value for their shares and compel the acquiring company to pay this amount in cash (the most liquid form of compensation). Appraisal proceedings are costly to shareholders because of the need to retain lawyers and financial experts that will argue the merger compensation is unfairly low. The appraisal rights of shareholders of Delaware companies are governed by Section 262 of the Delaware General Corporation Law (DGCL).
Appraisal rights are not absolute. A market-out exception, now adopted in most jurisdictions, was first enacted by Delaware in 1967.3Gil Matthews, The “Market Exception” in Appraisal Statutes, Harv. L. Sch. F. on Corp. Governance (Mar. 30, 2020), https://corpgov.law.harvard.edu/2020/03/30/the-market-exception-in-appraisal-statues/#:~:text=First%2C%2011%20states%20have%20virtually,shareholders%20of%20publicly%20traded%20companies [perma.cc/TTH6-SW2D]. With varying specifics, the market-out exception denies appraisal rights to shareholders of public companies. Delaware, for example, does not extend appraisal rights to any class of stock listed on a national exchange or held of record by at least 2,000 shareholders.4Del. Code Ann. tit. 8, § 262(b)(1) (2020). When a stock is listed on a national exchange, appraisal is believed unnecessary because a fair, efficient, and liquid market already exists. Shareholders who are displeased with the merger compensation can sell their shares in the open market conveniently and receive fair market values without delay.5Hill et al., supra note 2, at 73; see also Jeff Goetz, A Dissent Dampened by Timing: How the Stock Market Exception Systematically Deprives Public Shareholders of Fair Value, 15 Fordham J. Corp. & Fin. L. 771, 777–79 (2010). The market-out exception is premised on the widely recognized efficient market hypothesis, which theorizes that stock prices in an open market reflect all publicly available information.6See Joel Seligman, Reappraising the Appraisal Remedy, 52 Geo. Wash. L. Rev. 829, 837 (1984). In addition, public companies are subject to the periodic reporting requirements of the Securities Exchange Act of 1934, making information about their operations and financial conditions are readily available.7Securities Exchange Act of 1934 § 13 (codified as amended at 15 U.S.C. § 78m). Reporting supposedly provides shareholders with the information needed to value their shares therefore removing the need for a court-determined fair value. Since private companies with 2,000 or more shareholders are subject to the same periodic reporting, their shareholders are also denied an appraisal right under Delaware’s market-out exception. Information asymmetry in nonreporting companies was a justification acknowledged by Delaware for appraisal. 8Earnest Folk, Folk’s Report On The Delaware General Corporation Law 199 (1964).
The Model Business Corporation Act (MBCA) includes a market-out provision that offers considerably more protection to shareholders. The MBCA only denies appraisal rights for shares that are traded in an organized market, have at least a $20 million market capitalization, and have at least 2,000 record shareholders.9Model Bus. Corp. Act § 13.02 (Am. Bar Ass’n, amended 2021). The MBCA upholds shareholders’ appraisal rights if the company is a private company, regardless of how many shareholders the company has.
The presumption that the market price reflects the true value of shares has been challenged where a conflict of interest exists. For example, prior to a management-led buyout, management may elect to downplay financial projections or delay valuable investments until after the deal is effective, suppressing the share value. Although insider trading restrictions prevent the most egregious forms of this kind of opportunism, management may be able to take advantage of smaller pieces of nonpublic information. These pieces of information do not individually meet the test for materiality, but collectively give the management greater insight than the public minority shareholders about the intrinsic value of the company. Management can maximize the effect of information asymmetries by executing a freeze-out at a time it perceives the market price is less than the company’s true value. Academic research has found a correlation between management-led buyouts and measures that reduce the apparent performance of a company during periods before the announcement of the buyout.10In re Dole Food Co., Inc. Stockholder Litig., No. CV 8703-VCL, 2015 WL 5052214, at *26 n.13 (Del. Ch. Aug. 27, 2015); see also Guhan Subramanian, Deal Process Design in Management Buyouts, 130 Harv. L. Rev. 590, 618 (2016).
Three Categories of the Market-Out Exception
States’ various market-out provisions can be divided into three categories. Eleven states completely deny appraisal rights to shareholders of public companies, ignoring the concern about inadequate market prices in interested transactions.11Matthews, supra note 4. Fourteen states follow the MBCA; accordingly they permit appraisal where shareholders receive anything other than cash or stocks of public corporations to compensate for the illiquidity. Appraisal is likewise permitted in interested transactions, regardless of the merger consideration.12Id. Interested transactions are those involving anyone who owns 20% or more of voting shares, has the power to elect 25% or more of directors to the board, or is a senior director or executive of the company or its affiliates.13Model Bus. Corp. Act § 13.01 (Am. Bar Ass’n, amended 2021). The MBCA’s provision on interested transactions acknowledges that these deals may be subject to influences where a corporation’s management, controlling shareholders or directors have conflicting interests that could, if not dealt with appropriately, adversely affect the consideration. Thirteen states, including Delaware, deny appraisal to shareholders that receive shares of a public company in a stock-for-stock transaction, but allow appraisal rights if such holders receive cash or debt.14Matthews, supra note 4; e.g., Del. Code Ann. tit. 8, § 262(b) (2020).
Delaware’s Failure to Address Concerns of Inadequate Market Prices
Delaware’s approach is perplexing. Restoring appraisal for shareholders of public companies when they receive cash, but not shares, does not fully address the primary challenge to the market-out exception, i.e., inadequate market prices due to information asymmetry in interested transactions. The following example illustrates the problem:
Jerry owns 1 million shares of ABC Corp., whose shares are publicly traded on the New York Stock Exchange for $20 per share. The company’s controlling shareholder is XYZ Corp., which is also a public company whose shares are trading at $24 per share. XYZ nominates the majority of ABC’s board of directors. XYZ proposes to acquire the shares from Jerry and other minority shareholders at the price of $24 per share. Although this price is at a 20% premium to ABC’s current market price, it is much lower than the $30 per share value immediately before ABC’s board gave a pessimistic projection of the company’s growth potential about a month ago. Jerry suspects that the ABC board deliberately painted a gloomy picture to suppress the market price before the buyout. If his suspicion is correct, Jerry is under-compensated by $6 per share, regardless of the form of the buyout compensation: If the buyout is paid in cash, Jerry is paid only $24 million instead of $30 million; if the buyout is through a 1-1 share exchange, Jerry receives only 1 million XYZ shares instead of 1.25 million. However, Delaware grants appraisal if Jerry receives cash and denies appraisal if Jerry receives shares.
The official commentary and legislative history of the DGCL fail to provide any justification for this differential treatment. Even if share exchanges allow the target company’s shareholders to maintain an interest in the combined entity after the merger, that continued interest does not justify unfair compensations that reduce their ownership in the new enterprise. Moreover, if the goal of appraisal is to give dissenting shareholders a fair value in cash — so they are not forced to take the shares of the surviving or another entity — then Delaware seems backwards. In a clear contrast to Delaware’s baffling inversion, the MBCA permits appraisal when shareholders receive anything other than cash or publicly traded stocks. Thereby catering to shareholders’ need for liquidity when merger considerations include shares that do not have a ready market.
How Should Delaware Change?
Delaware could potentially follow the other eleven states by eliminating the confusing exceptions to market-out contained in DGCL 262(b)(2) entirely thus denying appraisal whenever the shares are publicly traded. A major flaw of this simplistic approach is that it ignores the overarching concern of inadequate market prices when the merger involves conflicts of interests. Proponents of this approach would argue that shareholders of Delaware companies are already safeguarded from such conflicts of interests through the Delaware courts’ imposition of higher fiduciary duties and heightened judicial reviews over managerial conducts. Pragmatically, that argument is unconvincing.
Revlon duties imposed by the Delaware court on directors of for-sale companies require them to seek the highest available value;15Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 184 (Del. 1986). arguably, any latent value of the company would be revealed through due diligence by third-party bidders. However, the bidding process is costly in both financial and human capital. It typically involves conducting a lengthy due diligence of the target company, retaining legal counsel to identify contractual, regulatory, and tax issues, and paying financial advisors to value the target company’s assets and shares. Third parties are reluctant to incur the high cost if the possibility of winning the deal with a fair bid is small, which is likely if the original bid comes from insiders of the target company. The management’s access to inside information creates a winner’s curse; if a third-party can outbid insiders who have superior knowledge of the target company’s true value, it is probably overpaying. The deterrence effect is exacerbated where a deal includes a right of first refusal that gives insiders the right to match any third-party bid. If insiders match, the third-party loses the deal and wastes all costs incurred in the pursuit; if insiders decline to match, the third-party bid is likely too high. Third-parties’ reluctance to jump insiders’ bid has been predicted in financial theories,16Paul Klemperer, Auctions with Almost Common Values: The ‘Wallet Game’ and Its Applications, 42 Eur. Econ. Rev. 757, 758 (1998). corroborated by empirical evidence,17J. Russel Denton, Stacked Deck: Go-Shops and Auction Theory, 60 Stan. L. Rev. 1529, 1547 (2008) (nearly all management buyouts reported in MergerMetrics received no jump bids from third-party financial bidders during the examined period). and noted in legal scholarship.18Id. at 1536 (“Because of the high probability that they will be victims of the winner’s curse if they win the auction, weak [uninformed] bidders may not be willing to participate at all in an ascending common-value auction with asymmetric information. If weak bidders do not enter the auction, then stronger [informed] bidders have an incentive to bid even less since no one else is going to enter auction to steal their surplus, lowering the seller’s expected revenue.”); see also Subramanian, supra note 11, at 615 (“This information-asymmetry problem between management and potential third-party bidders creates an unlevel playing field in an MBO process. Without an edge, third parties will be rationally deterred from bidding in order to avoid the winner’s curse.”).
Directors have a fiduciary duty to act in the best interest of shareholders. Shareholders maintain their standing to sue for any fiduciary breach that is related to the merger even though they stop being shareholders after the merger is consummated.19Lewis v. Anderson, 477 A.2d 1040, 1046 (Del. 1984). Where the merger involves a potential conflict of interest, and an absence of procedural safeguards such as the approval by both an independent special committee and the majority of disinterested shareholders, directors must satisfy the entire fairness test that includes fair price and fair dealing.20Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983). Although the fair price standard serves a similar purpose to appraisal, shareholders must overcome the double hurdle of heightened pleading requirements and difficult gathering of corporate information. For example, to bring an action under Revlon, plaintiffs must plead in sufficient specificity thereby making it reasonably conceivable that directors ignored their Revlon duties.21Houseman v. Sagerman, No. CIV.A. 8897-VCG, 2014 WL 1478511, at *7 (Del. Ch. Apr. 16, 2014). Minority investors often lack the information to plead those facts. If a shareholder wants to inspect corporate books to find the necessary facts, they must provide a “credible basis” that permits an inference of mismanagement; mere suspicion of wrongdoing is insufficient.22Seinfield v. Verizon Commc’ns, Inc., 909 A.2d 117, 118 (Del. 2006). Accordingly, Delaware requires shareholders to show specific facts to plead the directors’ breach, while requiring evidence of the breach to reach those facts. This circular relationship means that a fiduciary breach claim is often beyond the reach of dissenting shareholders. Thus, granting shareholders appraisal rights in interested transactions (as the MBCA already does) when the market price may be artificially suppressed by management or controlling shareholders helps minority shareholders get fair compensation for their investments without the inhibitive procedural hurdles.
One may argue that appraisal rights ought to be restricted rather than broadened because it incentivizes appraisal arbitrage. Arbitrage occurs when opportunistic investors (mostly hedge funds) acquire the target company’s shares before shareholders vote on the merger just so they could seek appraisal. Arbitrage is motivated by two sources of returns: One, the target company’s shares are under-compensated and thus the appraised value is likely higher; two, arbitrageurs seek to benefit from the lucrative statutory interest rate – 5% above the Federal Reserve discount rate — that applies to the appraised value for the duration of the appraisal proceeding. 23Del. Code Ann. tit. 8, § 262(h) (2020). Research has shown that on average it takes 406 days from filing the first appraisal petition to reach a settlement, and 2.6 years from filing to attain a judicial decision.24Wei Jiang, Tao Li & Randall S. Thomas, The Long Rise and Quick Fall of Appraisal Arbitrage, Harv. L. Sch. F. on Corp. Governance (Mar. 17, 2020), https://corpgov.law.harvard.edu/2020/03/17/the-long-rise-and-quick-fall-of-appraisal-arbitrage/ [perma.cc/B2VU-TEV9] The attractive interest rate for such long intervals offers a good return to arbitrageurs. Arbitrageurs are said to extract value from other shareholders because they force merger companies to create a reserve for appraisal liabilities and reduce the merger price to offset the cost.25Maurice M. Lefkort, Hedge Funds Can Still Manipulate Corporate Law, Wharton Mag. (Feb. 12, 2015), https://magazine.wharton.upenn.edu/digital/hedge-funds-can-still-manipulate-stock-market-rule/ [perma.cc/J84H-GR64].
To the extent that arbitrage is caused by an undervaluation of the target company’s shares, it discourages unfair transactions and aids smaller shareholders who lack resources to seek an appraisal on their own. Research shows that arbitrageurs have targeted mergers that offered an average of 20% lower premium than other deals.26Jiang et al., supra note 25. As for the interest rate arbitrage, the Delaware legislature amended DGCL §262(h) in 2016 to allow merger companies to pre-pay dissenting shareholders any amount in cash while the appraisal is pending. 27Del. Code Ann. tit. 8, § 262(h) (2020). This reduces arbitrageurs’ returns by preventing interest from accruing on the pre-paid amount. The Delaware Supreme Court further attacked appraisal arbitrage through its 2017 decisions in DFC Global28DFC Global Co. v. Muirfield Value Partners, L.P., 172 A.3d 346 (Del. 2017). and Dell.29Dell, Inc. v. Magnetar Glob. Event Driven Master Fund LTD, 177 A.3d 1 (Del. 2017), where it showed a willingness to assign more weight to merger prices determined through competitive bidding and arms-length negotiations. These legislative and judicial measures have caused appraisal arbitrage to dwindle from 25% of transactions in 2017 to 5% in 2019.30Jiang et al., supra note 25.
In sum, Delaware’s market-out exception and its “exceptions to the market-out exception” appear flawed in logic and fail to address conflicts of interests which render market prices inadequate value indicators. Mergers by share exchanges may leave shareholders unfairly compensated and without recourse at court through appraisal. In comparison, the MBCA’s approach provides a better liquidity to shareholders and better safeguards their interests when the market is susceptible to the management’s chicanery.
* Lynn Bai is Professor of Law at University of Cincinnati College of Law; William A. Murphy is a J.D. candidate (2023) at the University of Cincinnati College of Law.