OPINION | MONEY STUFF

Should Courts Care Who Wins in a Merger?

By Matt Levine

February‎ ‎27‎, ‎2018‎ ‎10‎:‎07‎‎ ‎AM

Appraisal.

We talked last week about appraisal arbitrage, the strategy in which hedge funds buy stock in companies that have announced mergers, vote against the mergers, and then sue in Delaware court to get a court to give them the fair value of their stock. Often, in the not-too-distant past, the court calculated a fair value that was a lot higher than the deal price, and so this strategy could be very profitable. But then Delaware Vice Chancellor Travis Laster issued a shocking shrug of an opinion in the appraisal litigation over Hewlett-Packard Co.'s acquisition of Aruba Networks Inc., figuring that the stock market knew how to value Aruba, and that it had valued Aruba at $17.13 per share, so he was going to use that value as the amount to award in the appraisal. That was the value that the stock market gave to Aruba before the deal, meaning that the appraisal arbitrage funds will get paid much less than the $24.67 deal price. The logic of the opinion is that any premium that HP paid beyond the stock's trading price must have had to do with something that HP brought to the table -- synergies, "reducing agency costs" -- and so wasn't part of Aruba's stand-alone value; that stand-alone value was best estimated by its trading price.

It is a shocking injection of efficient-markets-hypothesis fundamentalism into a process that is, after all, entirely about distrust of market efficiency: If markets were efficient then you'd never need appraisal. It's so strange that no one quite believes it, and several people who follow appraisal closely have suggested to me a sort of Straussian reading of Laster's opinion: Last year the Delaware Supreme Court reversed his decision awarding more money to appraisal plaintiffs in the Dell Inc. buyout, finding that he had relied too much on his own discounted-cash-flow math and not enough on the evidence of the market, and that the conflicts of interest he found in the Dell buyout were not enough to sway the price. His Aruba opinion is so extreme a swing the other way -- relying solely on the evidence, not even of the takeover market, but of the stock market, and finding conflicts of interest only to ignore them because they didn't affect Aruba's stand-alone value -- that it almost seems like his goal in this opinion might be to embarrass the Supreme Court into reversing him again and admitting that markets aren't that efficient.

I am not used to the idea of reading judicial decisions as sarcasm, but maybe that's how you should take this one. Still I ... think he is ... kind of right? When a public company buys another public company for cash in an arm's-length deal, with no disclosure or liquidity or conflict-of-interest problems, it does sort of seem like the unaffected stock price of the target is the best starting point for its appraised value. You'd expect at least a lot of the premium in the deal to come from synergies -- from the fact that the two companies can cut costs or cross-sell when they're combined into one -- which are not part of the appraised value. Of course some companies are worth more than their stock price and others are worth less, but in general the stock price is a better indicator of value than some after-the-fact discounted cash flow models built by a judge in Delaware, particularly if those DCF models always result in a higher valuation.

But if this really is the rule then of course there will be many fewer appraisal lawsuits: Hedge funds used to figure their worst likely case in appraisal litigation was to get the deal price (plus above-market interest), while their best case was to get some extra money, so it was a popular strategy. Now the worst case -- and maybe the most likely case! -- is to get much less than the deal price. At least in arm's-length public-company mergers, you'd expect fewer appraisal lawsuits.

If you think -- as many people do -- that appraisal lawsuits are an effective check on underpriced acquisitions, that they keep buyers honest and force them to pay fair premiums to avoid being hit with big appraisal awards, then you might think this is bad. Without the threat of appraisal litigation, buyers won't feel the need to pay up as much, and deal premiums will drop.

This will be bad for shareholders in merger targets: They want big premiums, and without the threat of appraisal litigation they will get smaller premiums. On the other hand, it will be good for shareholders of the acquiring companies, who won't have to pay as much to get deals done. 

Here is my speculative reading of Aruba: This is the decision you would expect in a world of diversified index and quasi-index investors. If everyone owns all the companies, then who cares what the deal premium is? Who cares how the value of synergies is allocated between buyer shareholders and target shareholders? If they are the same shareholders then the point is to create the synergies, to do the deals; the shareholders care about growing the size of the pie, not fighting over its allocation.

A lot of thinking, and law, in corporate America comes from a time when shareholders weren't expected to be all that diversified. You bought Amalgamated Widgets stock, and you wanted Amalgamated to do well. You didn't care about Consolidated Thingamajigs; if anything, you wanted them to fail so that Amalgamated could expand its market share. And if Consolidated mounted a takeover bid for Amalgamated, you'd want Amalgamated to demand the highest possible premium for your shares: If there are going to be synergies from combining the two companies, you wanted to get paid for them, rather than just letting them accrue to Consolidated shareholders.

But now everyone owns both stocks and much of that imperative has just gone away. We talk a lot around here about the notion that the rise of large diversified institutional investors might reduce competition, because if every company in an industry is owned by the same shareholders then they have less reason to try to take market share from each other. Nobody quite believes in the mechanism by which this would happen. But it's easier to picture in the mergers-and-acquisitions context. Consolidated mounts a bid for Amalgamated, Amalgamated's managers put up a big fight and make a lot of noise about how the bid undervalues their company, and their large overlapping shareholder base quietly says: Look, there is value to be had -- in synergies, in pure market-dominating bigness -- in combining these companies, so let's just have it. Don't worry about whether it accrues mostly to target shareholders or acquirer shareholders, because they are the same shareholders.

In that world you would expect the courts to eventually shrug and say, you know what, in arm's-length deals between public companies, we're just going to effectively get rid of appraisal rights. The way to protect the value of your shares in public-company mergers is not appraisal; it's diversification. (This does not work as well in private-equity deals, of course, but it's fine for public-to-public mergers.)

Obviously you don't have to like this! The people who think that common ownership reduces competition think that competition is good and that common ownership is suspect. They should also worry if common ownership makes mergers easier. And Matthew Schoenfeld wrote about appraisal litigation (before Aruba):

But I think if you look narrowly at the purposes of corporate law, it makes a kind of sense. Corporate managers are supposed to serve the interests of their shareholders. The approaches, and thus the interests, of those shareholders have changed. You'd expect corporate behavior, and corporate law, to change with them.

♦ ♦ ♦

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:

Brooke Sample at bsample1@bloomberg.net

©2018 Bloomberg L.P. All Rights Reserved