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Ramtron and Dell: Chancery Court Provides New Defenses Against Appraisal Arbitrageurs
Practical Law Legal Update w-000-4688 (Approx. 8 pages)
Ramtron and Dell: Chancery Court Provides New Defenses Against Appraisal Arbitrageurs
by Practical Law Corporate & Securities
| Published on 16 Jul 2015 • Delaware |
The Delaware Court of Chancery in LongPath Capital, LLC v. Ramtron International Corporation appraised the fair value of a petitioner's shares at the merger price less synergies. Separately, the court ruled in In re Appraisal of Dell Inc. that changes by custodial banks to the names of nominees listed on stock certificates disrupted the beneficial owners' continuous ownership of the shares and disqualified them from exercising appraisal rights.
In two recent decisions on appraisal actions, the Delaware Court of Chancery delivered opinions that provide new arguments for target companies defending against appraisal arbitrageurs. In LongPath Capital, LLC v. Ramtron International Corporation, the court ruled both to set aside the petitioner's discounted cash flow (DCF) analysis because of flaws in the underlying projections and to fully credit a merger price that was negotiated in a hostile takeover setting (C.A. No. 8094-VCP (Del. Ch. Jun. 30, 2015)). After subtracting the value of the merger's synergies from the deal price (and setting aside statutory interest), the decision had the effect of leaving the petitioner with less value per share than it would have received had it accepted the merger consideration at closing.
Less than two weeks later, the court ruled that under existing Delaware Supreme Court precedent, petitioners for appraisal had, through no fault of their own, lost their right to seek appraisal because of back-office procedures that had caused changes to the record ownership of their shares (In re Appraisal of Dell Inc., (Del. Ch. Jul. 13, 2015)). Unless overruled on appeal or through legislative action (as the court itself forcefully advocated for in dictum), the decision could provide a powerful new challenge to companies defending against appraisal actions.
LongPath v. Ramtron: Merger Price in Deal that Began as Hostile still Reliable
Background
The Ramtron decision concerned the acquisition of Ramtron International Corporation by Cypress Semiconductor Corporation pursuant to a merger agreement for a front-end tender offer that closed on November 20, 2012 (see the What's Market summary of the merger agreement). The petitioner, LongPath Capital, LLC, began acquiring shares of Ramtron in mid-October 2012, about a month after the announcement of the merger.
Unlike many other mergers that come before the Court of Chancery in appraisal actions and that result in a decision to rely on the deal price for the value of the shares, the Cypress/Ramtron transaction began as a hostile takeover attempt by Cypress. Cypress sent Ramtron a bear hug letter on June 12, 2012, offering to buy all of its shares for $2.48 per share. After Ramtron's board rejected the offer, Cypress initiated a hostile tender offer on June 21, 2012, at an increased price of $2.68 per share.
During the tender offer period, Ramtron authorized its financial advisor to market the company to other potential buyers and explore strategic alternatives. The advisor contacted 24 potential bidders and Ramtron signed nondisclosure agreements with six of them, but no firm bid ever materialized. Ramtron and Cypress eventually reached an agreement on a transaction price of $3.10 per share and signed a merger agreement to that effect on September 18, 2012. The final price represented a 71% premium over Ramtron's unaffected stock price of $1.81.
The petitioner LongPath acquired its shares after the announcement of the merger and demanded appraisal pursuant to Section 262 of the DGCL. LongPath's expert, relying on a combination of a DCF analysis and a comparable-transactions analysis, appraised the fair value of the shares at $4.96 per share. Ramtron contended that the merger price itself, less synergies, offered the most reliable measure of fair value. That methodology, as applied by Ramtron's expert, yielded a value of $2.76 per share.
Outcome
The court ruled that the DCF and comparable-transactions analyses were not reliable bases for determining the value of Ramtron's shares under the circumstances, while the negotiated merger price was a reliable indicator of value. The court did accept LongPath's estimate of the merger's synergies at three cents per share, rather than Ramtron's $0.34 per share estimate.
DCF Analysis Undermined by Unreliable Management Projections
The court discussed in detail its many reasons for affording no weight to LongPath's expert's DCF analysis. As discussed in Practice Note, Appraisal Rights: Discounted Cash Flow Analysis, a necessary condition for the court to rely on the DCF method (as it typically does) is that the projections that underpin the analysis were prepared by management in the ordinary course of business. However, projections are not entitled to the same deference if, for example, the projections were created in anticipation of litigation, such as an appraisal proceeding, or if the projections were made for some benefit outside the ordinary course of business.
In Ramtron, the court described several shortcomings with the projections relied on by LongPath, including that they:
- Were prepared by a new management team that had been with the company for less than a year.
- Were prepared in anticipation of future disputes and of shopping the company to potential white knights (moreover, a separate set of projections were prepared for the company's lenders).
- Covered a significantly longer period of time than previous forecasts.
- Predicted growth out of line with historical trends and generally failed a "reality check" for valuing Ramtron's business.
Comparable Transactions Analysis Rejected for Small Sample Size
The court also rejected LongPath's comparable-transactions analysis, which relied on only two similar transactions. As discussed in Practice Note, Appraisal Rights: Comparable Transactions Analysis, the court has in the past rejected a comparable-transactions analysis because it was based on a set of five transactions (In re John Q. Hammons Inc. S'holder Litig., , at *5 (Del. Ch. Jan. 14, 2011)). The Ramtron court cited Hammons in rejecting an analysis based on an even smaller sample size.
Merger Price Deemed Reliable
As discussed in Practice Note, Appraisal Rights: Merger Price, the Court of Chancery has had several opportunities in recent months to clarify its approach to using the merger price as an indicator of fair value. The court has explained that while it cannot favor merger price over any other analysis, it does not have to ignore the merger price altogether. This principle has led the court to conclude that it can rely on the merger price as an indicator of value when:
- All the traditional valuation methodologies have shortcomings that make them unreliable.
- The merger price was generated at arms' length in an auction process.
LongPath argued that the merger price should not be relied on in this case, both because Cypress was the only bidder for the company and because the negotiations started out as hostile. The court rejected both these arguments.
To the argument that the auction has to have been a multi-bidder process in order to be considered to have generated a fair value, the court remarked that it was not aware of any precedent holding to that effect.
The court was also not bothered by the fact that the negotiations began as a hostile takeover attempt. The court was satisfied that the process by which Ramtron was marketed to potential buyers was "thorough, effective, and free from any specter of self-interest or disloyalty." The court emphasized that Ramtron could, and repeatedly did, reject Cypress' overtures, and simultaneously actively solicited every buyer it believed could be interested in a transaction. While LongPath contended that the lack of other bidders indicated a flawed process, the court saw the lack of other bids as an indication of Ramtron's operational difficulties, but not as shortcomings in the merger process. The court also saw no evidence that Cypress' hostile bid had prevented other parties from making a bid, considering that six potential bidders had signed NDAs with Ramtron.
Synergies
Having determined that the merger price should be weighed at 100% in determining the value of Ramtron's shares, the court proceeded to evaluate the Cypress-specific synergies that needed to be subtracted from that value. The court concluded that LongPath's estimate of synergies was more appropriate than Ramtron's, as Ramtron's $0.34 per share estimate implicitly ascribed more than 10% of the value of the deal to synergies alone.
Practical Implications
The Ramtron decision is the Court of Chancery's fourth since 2013 to reject traditional valuation methodologies in favor of placing total weight on the merger price. For target companies, the decision provides an outline of defenses that they can use when defending appraisal actions. For one, the decision expands on the factors that may cause the court to discredit management's projections and with them the petitioner's DCF analysis. Secondly, the decision establishes that the negotiated deal price can be relied on fully to evaluate the company's shares, even if the price resulted from negotiations with a single, initially hostile bidder.
For appraisal arbitrageurs, the Ramtron decision represents another warning that a payoff for appraisal is not easily won. This is particularly so when the court not only finds that the merger price was the best evidence of value, but then subtracts an amount representing merger synergies from that price.
To succeed at convincing the court that a price paid for a company at a premium to the company's market value was unfair, a petitioner will likely have to uncover some significant shortcoming in the auction process akin to the sort of factual finding that provides the basis for a breach of fiduciary duty claim. Short of that, the safest bet for arbitrageurs is to focus on corporations that have been acquired in controlling-stockholder transactions, where the merger price is deemed unreliable as a matter of common law.
In re Appraisal of Dell: Custodial Banks' Changes to Stock Certificates Broke Continuous Ownership
Background
The issue in Dell turned on the somewhat obscure technicalities of DTC record-ownership of shares of publicly traded companies, helpfully described in detail in the court's decision.
The Dell going-private transaction is summarized in What's Market, Michael Dell and Silver Lake Partners/Dell Inc. Merger Agreement Summary. After the announcement of the merger, five funds acquired share in Dell for the sake of exercising appraisal rights. (One of those funds is affiliated with investment firm T. Rowe Price. In a parallel and higher profile dispute over the appraisal of Dell, T. Rowe Price is contending that it should be entitled to appraisal rights for its shares, even though it mistakenly transmitted an instruction to DTC to vote in favor of the transaction. That issue is separate from the July 13 decision on the five funds' 922,975 shares of Dell.)
As is settled under current Delaware common law, a petitioner can acquire the shares for which it demands appraisal after the announcement of the merger, because the record ownership of those shares will not have changed. This is a result of the "share immobilization" system that the SEC adopted in the early 1970s. Through that system, shares of publicly traded companies are not certificated on paper and certificates are not exchanged with every purchase and sale of shares. Instead, all record ownership of publicly traded shares stays with DTC.
Owing to the share immobilization system, arbitrageurs can buy shares after the announcement of a merger and become entitled to appraisal for them, because record ownership does not change with the purchase. This satisfies the continuous-ownership requirement of the Delaware appraisal statute. The only caveat is that a sufficient number of shares owned beneficially by anyone vote against the merger so as to cover those shares for which any beneficial owner demands appraisal.
When the SEC instituted the policy of share immobilization, it placed the depository institution "at the bottom of the ownership chain," as the court put it. As it happened, DTC became the only domestic depository, and over 800 custodial banks and brokers became participating members with DTC.
In the ordinary course, stockholders entrust custody of shares they own to a custodial bank or broker, which then deposits the shares with DTC. DTC, in turn, appoints a nominee, Cede & Co., as the record holder, which makes Cede the record holder on the books and records of the issuer. DTC holds shares on custodial banks' and brokers' behalf in fungible bulk, all issued in the name of Cede, not in the name of DTC's participants. DTC uses an electronic book entry system to track the number of shares of stock that each participant holds.
Despite this electronic system, when situations arise in which DTC needs to tie specific shares to specific beneficial owners, it resorts to paper. One of those situations is when a beneficial owner causes Cede to demand appraisal. When that happens, DTC removes the shares covered by the demand from the fungible bulk tracked in the electronic book entry system. DTC does this by causing the issuer's transfer agent to issue a paper stock certificate for the number of shares held by the beneficial owner. The paper certificate is issued in Cede's name, so the same record holder continues to hold the shares for purposes of the continuous-ownership requirement.
However, DTC prefers not to act as a custodian of paper stock certificates. It therefore gives its custodial bank and broker participants one of two choices:
- Pay DTC to hold those certificates in a vault.
- Take physical custody of the certificates themselves and hold them in their own vault.
The difficulty arises, as it did in Dell, when a custodial bank or broker chooses to take custody of the certificates itself, but only (for its own reasons having to do with insurance or internal recordkeeping) if the certificates are issued in its own nominee's name and not Cede. In Dell, the five funds' two custodial banks would not hold paper certificates unless the shares were titled in the names of their own nominees. The custodial banks therefore instructed Cede to authorize the shares to be re-titled in the names of their nominees, which Cede did. Unfortunately for the funds, this change in the name of the nominee broke the chain of continuous record ownership.
Outcome
The Court of Chancery ruled that the change in nominees from Cede to the custodial banks' own nominees caused a change in record ownership. The court arrived at this decision somewhat ruefully, which it made no attempt to hide. It was undisputed in Dell that the petitioners had no involvement in any of the certification or transfers, and that they were the beneficial owners of the shares in question throughout the process. The court strongly recommended that the Delaware Supreme Court look through the nominee names on physical stock certificates to the custodial banks and brokers to determine that the funds still held rights to appraisal. However, under current precedent, the court felt bound to rule that the funds had lost their rights to appraisal because of the re-titling of record ownership.
The court's ruling comes on page 22 of a 53-page memorandum opinion. The remainder of the opinion contains Vice Chancellor Laster's recommendation in dictum that the Supreme Court rule that the custodial banks and brokers who appear on the DTC participant list be considered stockholders of record for purposes of Delaware law. To that end, the opinion also contains Vice Chancellor Laster's detailed defense of his view that the judiciary is better placed to make that change to Delaware law, contra the Delaware Supreme Court's view expressed in Crown EMAK Partners, LLC v. Kurz, 992 A.2d 377, 398 (Del. 2010) (a decision that overruled Vice Chancellor Laster's opinion in Kurz v. Holbrook, 989 A.2d 140 (Del. Ch. 2010)). Practical Law subscribers are encouraged to read that section of the opinion at their leisure.
Practical Implications
Assuming the decision is appealed, the Delaware Supreme Court may yet rule in accordance with the recommendation detailed by the Court of Chancery. Until that time, the immediate impact of Dell is that companies defending appraisal actions may challenge petitioners' rights to appraisal on grounds that the stockholders' custodial banks or brokers broke the chain of record ownership by re-titling stock certificates.
On the flip side, all dissenting stockholders involved in appraisal proceedings (whether or not they are appraisal arbitrageurs) should investigate whether their petitions may be subject to challenge on those grounds.
Custodial banks themselves should also consider revisiting their policies, if they have not already, to avoid another incident that causes their customers to lose their appraisal rights. This can be accomplished either by modifying their policies on holding stock certificates issued to Cede, or by paying for a vault at DTC where certificates issued to Cede can be held.
The Future of Appraisal Arbitrage
Between the decisions in Dell and Ramtron, companies defending their deals against appraisal arbitrageurs have new pathways to winning either dismissal altogether or a decision that awards the merger price.
The court's position in Dell that the Supreme Court should look through superficial record ownership could be read as a blow against the very legality of appraisal arbitrage, because appraisal arbitrage depends on maintaining the legal formality that record ownership does not change when beneficial ownership does. However, this interpretation is a step too far. The court did not advocate for the Supreme Court to rule that changes in beneficial ownership break the chain of ownership for purposes of the appraisal statute. Its recommendation was more modest, that the concept of record ownership be expanded to include the custodial bankers and brokers who participate in the DTC system.
The court itself added its view that it does not find the practice of appraisal arbitrage offensive (as some do). The court compared the right to seek appraisal, which attaches to shares, to the right to enforce a loan through litigation. In the court's view, the two are the same, and there is no inherent reason why the ability to pass on a claim that attaches to equity rights should be objectionable if the ability to pass on a claim that attaches to debt is not. In either situation, property rights, even intangible property rights, are allowed to flow to the highest bidder, which is generally thought of as a positive for growing societal wealth.
If appraisal arbitrage is here to stay, counsel advising on public mergers should be familiar with the process for perfecting appraisal rights and the valuation techniques favored by the Delaware Court of Chancery. These areas, including the many recent Chancery decisions on valuation, are described in detail in Practice Note, Appraisal Rights.