Contributions

Arbitraging Judicial Interpretation of the Delaware General Corporation Law

by Nathaniel Kiechel  1

Should investors be able to buy shares of a com­pa­ny tar­get­ed in a merg­er, to exploit a cen­tu­ry old pro­vi­sion in Delaware cor­po­rate law that enables them to object to the merg­er price and have a court deter­mine the “fair” (and hope­ful­ly, high­er) price? The Delaware Court of Chancery has held that “appraisal arbi­trageurs” – investors that buy into a merg­er in order to exer­cise appraisal rights – can be con­sid­ered dis­sent­ing minor­i­ty share­hold­ers capa­ble of demand­ing appraisal by a court for the fair val­ue of those shares, so long as cer­tain require­ments are met. 2 For exam­ple, in order to exer­cise appraisal, investors must sat­is­fy the “con­tin­u­ous hold­er” require­ment of Sec­tion 262 of the Delaware Gen­er­al Cor­po­ra­tion Law (“DGCL”), which demands that the exer­cis­er of appraisal rights hold the shares upon which appraisal is demand­ed, through the date of the merger’s con­sum­ma­tion.  How­ev­er, the under­ly­ing mechan­ics of share trad­ing have raised anoth­er com­plex legal ques­tion still in dispute.

Though shares of a com­pa­ny tar­get­ed in a merg­er are bought by appraisal arbi­trageurs as “ben­e­fi­cial own­ers,” they are kept on their behalf by cus­to­di­al invest­ment banks. How­ev­er, the shares them­selves are trad­ed on a com­plete­ly dif­fer­ent lev­el: that of the Deposi­tary Trust Com­pa­ny (DTC) par­tic­i­pants who, as “record hold­ers” of the shares, hold them in “street name.” For exam­ple, Cede & Com­pa­ny is by far the most promi­nent of these record hold­ers in Delaware, but the exis­tence of oth­ers cre­ates a tricky ques­tion in the appraisal arbi­trage process: are ben­e­fi­cial own­ers – here, the appraisal arbi­trageurs – pre­clud­ed from exer­cis­ing their appraisal rights under the con­tin­u­ous hold­er require­ment when the shares pur­chased by those ben­e­fi­cial own­ers are then re-titled in the “street name” of a dif­fer­ent DTC par­tic­i­pant – with­out the knowl­edge or con­sent of those ben­e­fi­cial own­ers – after an appraisal request is prop­er­ly filed, but before the merger’s consummation?

This Con­tri­bu­tion will argue that ben­e­fi­cial own­ers should be per­mit­ted to retain their right to the appraisal rem­e­dy, notwith­stand­ing tech­no­log­i­cal advances that have made it more like­ly their shares may be reti­tled in “street name,” with­out their consent.

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In In re Appraisal of Dell Inc., the Delaware Court of Chancery held that changes in the names of the record hold­ers pri­or to the merger’s con­sum­ma­tion should be assessed as changes in share own­er­ship for pur­pos­es of Sec­tion 262. 3 In the opin­ion, Vice Chan­cel­lor Laster pri­mar­i­ly relied on the fact that the court was bound by prece­dent inter­pret­ing Sec­tion 262 4, which he urged the Delaware Supreme Court to revise. 5 Appraisal arbi­trage investors there­by lost their appraisal rights, with Vice Chan­cel­lor Laster not­ing the arguably inequitable nature of the result. As Vice Chan­cel­lor Laster explained, 6 changes to the under­ly­ing mar­ket sys­tems through which shares are trad­ed can elu­ci­date the issue that gave rise to Dell. Shares of stock used to be – and some­times still are – rep­re­sent­ed by phys­i­cal cer­tifi­cates bear­ing the names of the ben­e­fi­cial own­ers. Trans­fer­ring own­er­ship was not dif­fi­cult under this sys­tem since, much like endors­ing a check, new own­ers could sim­ply cross out the names of old own­ers and write in their own. With the mas­sive increase in trad­ing vol­ume over the last cen­tu­ry, this sys­tem was logis­ti­cal­ly unwork­able for bro­ker­age firms and clear­ing hous­es. 7

Enter the fed­er­al gov­ern­ment, which instruct­ed the SEC to cre­ate the Deposi­tary Trust Com­pa­ny (“DTC”) sys­tem in 1975.  Under this sys­tem, changes in “ben­e­fi­cial own­er­ship” – those who bear the val­ue of share own­er­ship, such as, in this case, a hedge fund – are rec­og­nized at the bro­ker­age hous­es and cus­to­di­al banks. Phys­i­cal stock cer­tifi­cates are held at these bro­ker-deal­er banks (e.g., JP Mor­gan), bear­ing the names of DTC par­tic­i­pants (e.g., Cede) who, as “record hold­ers,” hold the stock on behalf of the ben­e­fi­cial own­er.  In order to deal with coun­ter­par­ty risk, inter­nal com­pli­ance require­ments by the cus­to­di­al invest­ment banks some­times demand that these banks only hold shares in the names of those DTC par­tic­i­pants with which the banks are affil­i­at­ed (for exam­ple, a DTC par­tic­i­pant affil­i­at­ed with J.P. Mor­gan). When the shares are thus reti­tled in the names of those affil­i­at­ed DTC par­tic­i­pants, this reti­tling can amount to a change in record own­er­ship, and per Delaware law as it cur­rent­ly stands after Dell, ben­e­fi­cial own­ers like appraisal arbi­trage hedge funds may lose their rights to demand appraisal.

As a result, Sec­tion 262 of the DGCL defines “stock­hold­er” as a “hold­er of record” in a cor­po­ra­tion. 8 How­ev­er, and as the court grap­pled with in Dell, this def­i­n­i­tion has become cir­cu­lar giv­en pri­or case law: 9 there remains a ques­tion of which “record” must be scru­ti­nized to assess whether a par­ty appears on it and is thus a stock­hold­er. In Dell, the ben­e­fi­cial own­ers – here, the appraisal arbi­trageur hedge funds – argued that, for pur­pos­es of Delaware’s afore­men­tioned con­tin­u­ous hold­er require­ment, the cus­to­di­al banks should be rec­og­nized as “record hold­ers.” While the stock cer­tifi­cates were reti­tled in the names of a new DTC, the iden­ti­ties of the cus­to­di­al banks remained the same: thus, if the cus­to­di­al banks were rec­og­nized as record hold­ers, the appraisal arbi­trageurs would have sat­is­fied the con­tin­u­ous hold­er require­ment, there­fore allow­ing them to exer­cise appraisal rights.

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Such an inter­pre­ta­tion of the mean­ing of “stock­hold­er” would accord with fed­er­al secu­ri­ties laws, which defines “record hold­er” as “any bro­ker, deal­er, vot­ing trustee, bank, asso­ci­a­tion or oth­er enti­ty that exer­cis­es fidu­cia­ry pow­ers which holds secu­ri­ties of record in nom­i­nee name or oth­er­wise or as a par­tic­i­pant in a clear­ing agency.” 10And, an “enti­ty that exer­cis­es fidu­cia­ry pow­ers” means “any enti­ty that holds secu­ri­ties in nom­i­nee name or oth­er­wise on behalf of a ben­e­fi­cial own­er but does not include a clear­ing agency reg­is­tered pur­suant to sec­tion 17A of the Act or a bro­ker or a deal­er.” 11 Read­ing these two def­i­n­i­tions togeth­er, it is clear that the fed­er­al sys­tem “looks through” 12 the DTC lev­el of own­er­ship, and includes cus­to­di­al banks as poten­tial record hold­ers in a cor­po­ra­tion. The court in Dell not­ed that, because the fed­er­al gov­ern­ment first imple­ment­ed the DTC sys­tem now used in Delaware and nation­wide, the term “record hold­er” should be con­strued uni­form­ly, ulti­mate­ly defer­ring that respon­si­bil­i­ty to the Delaware Supreme Court so to  rede­fine the term for pur­pos­es of the DGCL. 13 This was the cor­rect approach, as it log­i­cal­ly molds the appraisal rem­e­dy to the mod­ern real­i­ty of share trading.

The broad­er ques­tion impli­cat­ed by this prob­lem is the extent to which appraisal arbi­trage is a desir­able method of invest­ing. On the one hand, the arbi­trage process, by incen­tiviz­ing com­pa­nies tar­get­ed for merg­ers or acqui­si­tions to ensure their stock­hold­ers are receiv­ing the high­est pos­si­ble price for their shares, adds to mar­ket effi­cien­cy. How­ev­er,  the judi­cial process of appraisal is not akin to a prop­er­ty right, but was instead intend­ed orig­i­nal­ly as a lim­it­ed rem­e­dy in sit­u­a­tions very unlike the cur­rent ones. Now, hedge funds can employ mas­sive resources to con­duct due dili­gence on their chances of suc­cess­ful­ly pur­su­ing a high­er price through appraisal. More­over, such funds often seek the returns gen­er­at­ed from Delaware’s com­par­a­tive­ly high statu­to­ry inter­est rate: 5% over the Fed­er­al Reserve dis­count rate. 14 Delaware courts may order that suc­cess­ful plain­tiffs be award­ed the amount of the judg­ment they seek, plus the inter­est accrued at this high rate since a pri­or date deter­mined by the court (such as that on which the merg­er was con­sum­mat­ed, at the price deter­mined by the court to have been unfair).  Because that Delaware courts may award suc­cess­ful appraisal plain­tiffs with fore­gone inter­est, this favor­able inter­est rate may be the true source of the return that hedge funds seek through appraisal arbi­trage. If so, this prac­tice may jus­ti­fi­ably gar­ner the atten­tion of the Delaware leg­is­la­tors, who might char­ac­ter­ize this prac­tice as an exploita­tion of a judi­cial­ly enforced statu­to­ry inter­est rate. In turn, those leg­is­la­tors might be act to dis­in­cen­tivize investors from treat­ing civ­il suits as prof­it-bear­ing assets in and of themselves.

In sum, Dell demon­strat­ed how hedge funds uti­lize every oppor­tu­ni­ty to seek returns for their clients. Though these oppor­tu­ni­ties might exploit what some would call a “loop­hole,” the invest­ment activ­i­ties of appraisal arbi­trageurs should alert law­mak­ers to the anti­quat­ed def­i­n­i­tions that, in the con­text of the mod­ern finan­cial mar­kets, no longer serve their intend­ed purposes.

Notes:

  1. The fol­low­ing arti­cle reflects my expe­ri­ence in the 2016 28th Annu­al Ruby R. Vale Inter­school Moot Court Com­pe­ti­tion, at Widen­er Uni­ver­si­ty Delaware Law School. Issue II of the prob­lem was based on the sit­u­a­tion pre­sent­ed by In re Appraisal of Dell, Inc., No. 9322-VCL, 2015 Del. Ch. LEXIS 184 (rev’d July 30, 2015) (Laster, V.C.) The Court of Chancery was asked to deter­mine whether appel­lants, a group of hedge funds prac­tic­ing appraisal arbi­trage, had sat­is­fied the con­tin­u­ous hold­er require­ment of §262 of the Delaware Gen­er­al Cor­po­ra­tion Law, allow­ing them to seek judi­cial appraisal for the fair val­ue of their shares which were bought out in a going-pri­vate trans­ac­tion. The hedge funds’ shares had been reti­tled in “street name” on the Deposi­tary Trust Com­pa­ny lev­el, after the date of a prop­er­ly per­fect­ed appraisal claim, but before the effec­tive date of the merg­er.
  2. In re Appraisal of Tran­skary­ot­ic Ther­a­pies, No. 1554-CC, 2007 Del. Ch. LEXIS 57, at *6 (Del. Ch. 2007).
  3. In re Appraisal of Dell, Inc., No. 9322-VCL, 2015 Del. Ch. LEXIS 184 (2015).
  4. Tran­skary­ot­ic, 2007 Del. Ch. LEXIS 57, at *3.
  5. Dell, 2015 Del. Ch. LEXIS 184, at *7.
  6. Id., at *9 – 18.
  7. Id., at *11, (cit­ing Suellen M. Wolfe, Escheat and the Chal­lenge of Appor­tion­ment: A Bright Line Test To Slice A Shad­ow, 27 Ariz. St. L.J. 173, 178–88 (1995)).
  8. Id., at *24 (cit­ing 8 Del. C. § 262(a)).
  9. Id., at *25, (cit­ing Engel v. Mag­navox Co., 1976 Del. Ch. LEXIS 165, 1976 WL 1705, at *1 (Del. Ch. Apr. 21, 1976)).
  10. 17 C.F.R. § 240.14c‑1(i).
  11. Id. § 240.14c‑1©.
  12. Dell, 2015 Del. Ch. LEXIS 184, at *8.
  13. Id., at *37.
  14. 6 Del. C. § 2301.