Delaware's appraisal arbitrage problem, at a peak
Buy in after the deal, dissent, petition, and collect statutory interest while Chancery works through its backlog
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hedge fund buys target shares after a merger is announced, votes them against the deal, and files a petition asking the Delaware Court of Chancery to decide what the shares were really worth. While the court decides, the unpaid merger consideration accrues interest at five points over the Federal Reserve discount rate. That is the trade, and in 2016 it is the loudest argument in Delaware corporate law.
The mechanic has been on the books for decades. What changed, roughly starting in 2012 and 2013, is that a small group of funds began treating the appraisal section of the DGCL as a yield product rather than a minority-shareholder remedy. The Court of Chancery's docket reflects that shift. So does the tone at this spring's corporate-law conferences.
How the trade actually runs
Appraisal is a statutory dissent right. If a public company is acquired for cash, a stockholder who does not vote for the merger and who follows the statute's procedural choreography — a written demand before the vote, abstention, a timely petition after closing — can ask Chancery to determine the "fair value" of the shares as of the moment before the merger. The court then enters a judgment for that number, whatever it is, and orders the surviving company to pay.
Two features make this more than a protest vote. The first is that fair value is a judicial finding, not a negotiated price, and it is not bounded by the deal consideration. A court may conclude the shares were worth less than the merger price, in which case the petitioner is stuck with a worse outcome and the legal bill. But a court may also conclude the shares were worth more, sometimes meaningfully more, and in a competitive auction with a squeeze-out at the end that outcome is not rare.
The second feature is the interest rate. The statute accrues interest on the amount ultimately awarded, from the effective date of the merger until payment, compounded quarterly, at five percentage points above the Federal Reserve discount rate. In an environment where the discount rate has sat near the floor for years, that produces an all-in coupon well north of what a liquid credit portfolio can earn with similar duration. The interest runs whether the court ends up above, at, or below the deal price. A petitioner who breaks even on valuation still collects the yield for the time the case was pending.
Put those two features next to a Chancery docket that, on big appraisal matters, now runs eighteen months to two years between petition and post-trial opinion, and the trade writes itself. A fund can buy after the announcement, when the arbitrage spread is thin, hold through a close it voted against, and book a return that does not depend on the direction of the market or the quality of its merger-break analysis.
Why it became arbitrage
None of the elements were secret. The statute is old. The interest formula was set, in its current form, in 2007. What made 2012 through 2015 different was a combination of inputs.
Private-equity take-privates and sponsor-backed squeeze-outs produced a run of deals in which the process record was thin enough that "fair value" was plausibly above the merger price. Several post-trial opinions during this period found upward adjustments in that direction, which repriced the tail risk for the buy side. Low rates made the statutory coupon unusually attractive on a relative basis. And the courts had not yet resolved whether a fund that bought shares after the record date — shares whose previous holder had not dissented — was even allowed to petition. In 2015, in a decision involving the Ancestry.com merger, the Chancery Court came down on the side that permitted that buying pattern, which removed the last structural obstacle.
By the time of the 2015 proxy season, dedicated appraisal strategies had tens of billions of dollars behind them, measured by the market capitalization of target shares tendered into petitions. A handful of funds accounted for the majority of the dollar volume. Some were single-strategy vehicles that did nothing else.
The effect on the Delaware bar was twofold. Transactional lawyers began pricing appraisal risk into deal terms, which pushed up break fees, reverse break fees, and the legal budgets for acquirer diligence. Chancery judges, for their part, started writing opinions whose second halves read like monetary-policy commentary, because in a real sense the statute had handed them one.
What Delaware has tried to do
The legislature moved first. The 2015 amendments to the appraisal section, effective for mergers with agreements executed on or after August 1, 2016, do two things that matter for the arbitrage thesis.
The first is a de minimis screen for public-company deals. The surviving corporation can seek dismissal if the petitioning shares represent neither more than one percent of the outstanding class nor more than roughly one million dollars in merger consideration at the deal price. The screen is designed to cut off the smallest strike suits, not the large coordinated petitions, and the funds running the strategy in size will not be affected by it.
The second is the interest provision, and this is the one the bar has been debating. The amendment lets the surviving company prepay a portion of the merger consideration to the petitioners at any point after the close. Interest then accrues only on the unpaid balance above the prepayment. In theory, a well-advised acquirer can mail a check for something close to the deal price the day after closing, leaving the statutory coupon running only on the delta between the deal price and whatever fair-value number a court eventually lands on. That collapses the yield trade, at least for deals where the acquirer has the cash and the willingness to write it.
Chancery has also done its own work inside the doctrine. A series of opinions during 2015 and early 2016 reinforced that in an arm's-length transaction with a robust sale process and no structural conflict, merger price is strong evidence of fair value, and in some cases dispositive. The Dell and DFC Global matters, both of which went to trial last year and are awaiting post-trial decision, will test how far that line extends when the sale process is not textbook. The outcome of those cases, whatever the number, will reset the implied volatility of the appraisal book.
What is not yet clear
Several questions are open as of this spring. Whether the prepayment mechanic will actually be used widely, or whether acquirers will treat it as a defensive tool only in the few cases where the petition volume is large enough to matter, is an empirical question that will answer itself over the next year. Whether the Supreme Court of Delaware, on appeal from whichever Dell or DFC Global outcome gets appealed, will codify a stronger presumption around merger price is the doctrinal question the deal bar is watching. Whether the funds running this strategy rotate into a different post-closing remedy if the yield disappears — disclosure claims, fiduciary suits against the financial advisor, the residue of aiding-and-abetting theory that survived the recent disclosure-only settlement crackdown — is the structural question.
None of these resolve before the 2016 proxy season closes. For the people who actually form Delaware entities on behalf of clients, the short-term implication is narrower: if you are papering a take-private or a cash-out merger in the second half of this year, your acquirer counsel will ask about the prepayment mechanic, and your deal model needs a line for it. If you are not asked, ask anyway. The statute changed, the arbitrage did not change yet, and the gap between the two is where money will move.