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.
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.
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.
- 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. ↩
- In re Appraisal of Transkaryotic Therapies, No. 1554-CC, 2007 Del. Ch. LEXIS 57, at *6 (Del. Ch. 2007). ↩
- In re Appraisal of Dell, Inc., No. 9322-VCL, 2015 Del. Ch. LEXIS 184 (2015). ↩
- Transkaryotic, 2007 Del. Ch. LEXIS 57, at *3. ↩
- Dell, 2015 Del. Ch. LEXIS 184, at *7. ↩
- Id., at *9 – 18. ↩
- 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)). ↩
- Id., at *24 (citing 8 Del. C. § 262(a)). ↩
- Id., at *25, (citing Engel v. Magnavox Co., 1976 Del. Ch. LEXIS 165, 1976 WL 1705, at *1 (Del. Ch. Apr. 21, 1976)). ↩
- 17 C.F.R. § 240.14c‑1(i). ↩
- Id. § 240.14c‑1(c). ↩
- Dell, 2015 Del. Ch. LEXIS 184, at *8. ↩
- Id., at *37. ↩
- 6 Del. C. § 2301. ↩