Rogue Missives Friday, April 25, 1997

With countless industries rushing toward consolidation, it's likely that most investors will find themselves holding an ownership stake in a merger target at some point. But once the market reacts to news of the merger, a shareholder might find that the proposed stock swap approved by her company's board of directors doesn't look so attractive anymore.

Even if the market remains sanguine about the deal, there's often something decidedly unappealing about swapping shares of a company growing by, say, 50% a year for a stake in a much larger entity clocking in at a ho-hum growth rate of just 15%. Even in the best cases, an investor may feel that the premium offered by the acquiring company is insufficient.

State corporate charters, however, do provide disgruntled investors with legal recourse. Dissenting shareholders can vote against the merger and file to exercise their right of appraisal. Ultimately, this process involves asking a court to determine the fair value of a company's stock. It also allows an investor to receive cash for her shares rather than stock in the acquiring company.

Appraisal rights came about as a judicial remedy to compensate for the extraordinary weakening of the rights of minority shareholders over the years. Throughout much of the nineteenth century, shareholders of public corporations were understood as having a binding contract with a company that ensured the firm would continue its business practices as it had in the past. Minority stockholders thus had an inviolable right to block fundamental corporate changes, such as the sale of a corporation's assets for securities in another company. This mandate of unanimous consent had its disadvantages, since it meant that a single stockholder could impede even a beneficial corporate change.

Starting in the late 1880s, the courts created a number of exceptions to unanimous consent. This process of ceding greater control to majority shareholders accelerated through the early years of this century, as states such as New Jersey and Delaware raced to liberalize their rules of incorporation in order to attract U.S. companies and thus increase state tax revenues. This "race to the bottom" in the area of state charters changed the nature of public corporations by stripping state business charters of the language that made corporations answerable to public goals and some wide-ranging government restrictions. In other words, the rights of minority stockholders were watered down at the same time that corporations generally became more autonomous.

Scholars of the issue, then, say that the contractual nature of stock ownership shifted from one driven by the "property rule" to one built on the "liability rule." In the earlier era, a minority stockholder could force the majority shareholders either to buy out the dissident owner at a negotiated price or rethink their plans. In cases where unanimous consent was not required, however, companies could now go ahead with a majority-approved business change. Dissenting shareholders were allowed recourse only after the fact, and only if they were willing to go to court to seek damages for the breach of contract.

A shareholder's right of appraisal, then, grew out of specific court decisions and was gradually codified by states as part of their corporate charter rules. It's a right that affords minimum protection to minority shareholders in an era when corporate statutes generally require only a simple majority vote on issues that call for shareholder approval. And while Delaware law generally provides the right of appraisal only in the case of mergers, many states permit it in other matters (such as the sale of all of a company's assets) that require the vote of shareholders. On the other hand, appraisal rights are generally not available in the case of a cash tender offer.

William J. Carney is a law professor at Emory University who has written about this history behind the right of appraisal. He's also chair of the state bar committee responsible for writing Georgia's corporate code. According to Carney, the process involved in exercising one's appraisal rights is relatively straightforward though lengthy.

"There's a back and forth notice process in most states," he said. First, about a month before the meeting during which shareholders must vote on a proposed merger, a company sends out a proxy statement for approval of the merger, including written notification of the right of appraisal. Carney said that in Georgia, for instance, a company must furnish shareholders with a copy of the statute that sets out a shareholder's rights. A shareholder who doesn't like the deal has to notify the company in advance of the meeting that he intends to dissent. Then he has to vote against the transaction. If the deal is approved, the company then must send out a notice to shareholders indicating that dissidents have 30 days, or whatever the statutory term is, to demand fair value for their shares.

A dissenting shareholder then must send a letter to the company indicating that he is a shareholder of record of so many shares; that he dissents from the merger; and that he demands fair value for his shares. The company then must make the shareholder an offer, which is usually accompanied by copies of recent financial statements and a copy of an investment banker's assessment of the fairness of the offer. An investor can then accept or reject the offer.

Carney said that in states that are governed by the Model Business Corporation Act, the company has an obligation at that point to begin the appraisal proceeding if the shareholder rejects the company's offer. Otherwise, the shareholder can begin the action, and if he has set his own target price, then he's legally entitled to get the price he demanded. "That never happens, for obvious reasons," Carney said.

Like many legal rights, however, the right of appraisal does not come cheap. Each party must pay for its own legal counsel and experts. "Only in cases where the court finds that one party has been unreasonable will they appoint attorneys' fees and expenses," Carney said. For this reason, most such disputes are settled privately before they make it to court. "If you have a few hundred shares of stock and you're talking about the difference between two or three dollars a share, [exercising the right of appraisal] just isn't going to make sense. It takes a very large stock holding to make an appraisal proceeding make sense."

Moreover, dissenting shareholders will find it difficult to win a higher price in cases where the transaction is treated as a sale under Delaware law. That's because the board of directors is legally required to conduct an auction and get the best price they can for a company. Carney said that under these circumstances, the board is usually safe in asserting that the sale price is not just fair but the best price available anywhere.

The issue is a bit more complicated in the case of mergers where the board doesn't publicly put a company up for auction and shop it to potential suitors. Carney explained that in these cases, a company's board will always get the opinion of an investment banker indicating that the transaction is fair from a financial point of view. "Investment bankers have gone through the deal looking at comparable values and comparable acquisitions and come up with a number where they can say, yeah, this is in the range of fairness. And at that point, the board is legally allowed to rely on the opinion of investment bankers with respect to any challenge to their judgment."

Historically, a further problem for investors seeking a better price for their shares is that the courts often do a poor job of determining value. Given the influence of Delaware in matters of corporate law, it's no surprise that that state led the way on the legal issues surrounding stock appraisals. Up until 1983, the "Delaware block method" dominated such valuation proceedings.

This process involved forming a weighted average of three separate measures of share value: net asset value, earnings value, and market value. Court-appointed appraisers would, on a case-by-case basis, weight the three measurements to reflect their different contributions to a firm's value. The three values were then averaged to calculate a single dollar figure as the appraisal value.

For years, problems with the block method were debated. Finally, in the landmark 1983 case of Weinberger v. UOP, Inc., the Delaware Supreme Court directed the state's Court of Chancery to review this "clearly outmoded" valuation procedure and, henceforth, to permit "proof of value by any techniques or methods which are generally considered acceptable in the financial community."

At the same time the court ruled that "Elements of future value... which are known or susceptible of proof as of the date of the merger and not the product of speculation, may be considered in an appraisal proceeding." As some commentators at the time pointed out, the financial community generally values a company based on discounted future cash flow. Such forward-looking methods are never based solely on what is certain to occur but on presumably highly informed speculation about what's likely to occur. If the Weinberger decision opened up the appraisal process to new modes of valuation, its nonetheless contradictory position regarding the use of real-world methods left the issue muddied.

Such conceptual problems at the core of the appraisal process have tended to put a premium on the opinion of experts. And experts are expensive. Increasingly powerful institutional investors such as public pension funds can afford to fight such cases in the courts, but the right of appraisal is generally not a right that individual investors can afford. On the other hand, it's possible to imagine online communities of individual investors someday using the threat provided by the right of appraisal to thwart some truly ill-advised mergers without actually incurring the expense of taking a company to court.

As Carney pointed out, many mergers are structured as a "pooling of interests" to allow the acquiring company to avoid having to charge off goodwill, or the amount of the purchase price that exceeds the target company's book value. In a direct purchase, the cost of these intangible assets must be deducted from future earnings. In a pooling of interests, depreciation expenses of the combined companies will remain the same as they were before the merger, meaning that reported earnings won't be reduced.

In a direct purchase, higher depreciation expenses would actually lead to higher real earnings since the company's taxes would be reduced in kind. "You'd think that in a reasonable world, managers would want to reduce taxes," Carney said. "But managers are so concerned about financial statements that they focus on not reducing stated earnings, even though the company will pay more taxes. So they prefer the pooling."

The accounting profession may be ready to do away with this practice. Until that happens, though, dissenting shareholders can use their threat of appraisal rights either to force an acquiring firm to raise its offer or to altogether kill a deal. That's because a merger can only be structured as a pooling of interests if at least 90% of the consideration paid for the target firm comes in shares.

If shareholders owning more than 10% of a company's shares demand cash payment for their stock under their right of appraisal, an acquirer determined to do the deal as a pooling of interests will be forced to negotiate or back off. Indeed, proxy statements typically indicate that a merger is contingent upon dissenting shareholders exercising appraisal rights for no more than 10% of a company's stock.

Last July, for example, Wayne Huizenga's REPUBLIC INDUSTRIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: RWIN)") else Response.Write("(Nasdaq: RWIN)") end if %>, a consolidator in auto retailing, attempted to acquire ADT LIMITED <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ADT)") else Response.Write("(NYSE: ADT)") end if %>. But the merger was scratched once it became clear that WESTERN RESOURCES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WR)") else Response.Write("(NYSE: WR)") end if %>, a utility and security company that owns a major stake in ADT, would exercise its appraisal rights to block the deal. Western Resources has since launched its own bid for ADT and has filed a lawsuit demanding that TYCO INTERNATIONAL LTD. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TYC)") else Response.Write("(NYSE: TYC)") end if %>, another ADT suitor, structure its acquisition offer to provide for appraisal rights as required by Bermuda law.

Of course, making use of this threat of dissent still requires a sizable chunk of stock. More than likely, individual investors would need to team up with unhappy institutional investors to muster the 10% stake. Still, the online medium does open the door for individual shareholders to communicate with each other at relatively little cost. Given this ready means of building a faction of dissenting shareholders, it's possible that an individual investor armed with a persuasive argument regarding a company's true value could shift the balance of power in a corporate merger.

Without such communities of investors banding together, the right of appraisal, unfortunately, remains a rather feeble one for individual investors simply because the process is too costly and the rewards of fighting a merger too uncertain.

-Louis Corrigan ([email protected])

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