Investors who conclude that the price of an M&A transaction is too low may have the ability to reject that price by exercising dissent and appraisal rights, asking a court to fix the fair value at which their shares of the target will be acquired. Activist investors in the United States are increasingly turning to appraisal litigation as a way to challenge M&A transactions and put pressure on bidders and targets to improve deal terms. Indeed, some investors are taking positions in targets just for the purpose of appraisal litigation, turning it into a form of deal arbitrage.
The Appeal of Appraisal Litigation
Courts can employ a variety of valuation methodologies in appraisal litigation and, as a recent academic study has shown, in most U.S. cases, courts have typically fixed fair value at a premium to the transaction price offered for the target shares; where the bidder is an insider or related party, the premium may be even higher.1 M&A transactions are routinely the subject of litigation challenges in the U.S. and these deals are increasingly attracting activist investors. Challenging a transaction through the statutory appraisal remedy—rather than through challenging the target board's M&A process under corporate law—may well be a more effective way to use litigation as an activist tool. While appraisal litigation takes time, reducing an investor's liquidity, the investor is entitled to claim interest at a relatively high rate compared to market alternatives. This may not only compensate the investor for the loss of the use of the investment, but may also actually encourage appraisal litigation.
In the U.S., the rate at which appraisal rights are exercised has spiked in recent years. Appraisal rights are being exercised in more transactions and in connection with large numbers of shares. In 2013, appraisal rights were exercised in 17% of transactions where they were available in connection with US$1.5 billion of shares, representing 1% of the equity value of all mergers. Several specialized investment funds have been established for the sole purpose of pursuing appraisal litigation, including buying into a transaction in order to exercise appraisal rights. In connection with the Dell going-private transaction, for example, shareholders threatened to block the transaction by voting against it and exercising appraisal rights, resulting in the bidder increasing the offer price. Creative activists even established a trust into which dissenting shareholders could deposit their Dell shares in exchange for tradable securities with an interest in the appraisal litigation.
Appraisal Rights and Canadian Deal Dynamics
While appraisal rights have become an attractive tool for activists in U.S. transactions, this trend has not spread to Canada. Appraisal litigation in Canada shares some common features with its American counterpart; however, Canada hasn't yet seen the same spike in appraisal litigation as the U.S. The recent experience of investment manager Paulson & Co in the Deer Creek litigation in Alberta may suggest an approach to dissent cases in Canada that could discourage other activists from employing them as a tool. When Deer Creek was taken over by Total, Paulson claimed that the bidder vastly undervalued the shares of the target, by a factor of at least 300%. After trial, though, the court found that the best measure of the value of Deer Creek shares was the market price, leaving the dissenter with no improvement to the deal price following years of litigation. While a Canadian court, like a U.S. court, can employ a range of valuation methodologies in fixing the fair value of shares, the decision in Deer Creek suggests that where the shares of a target trade actively, the market price likely represents fair value.
The approach to valuation taken in Deer Creek is less promising to activists in Canada hoping that litigating fair value will yield a premium to the price offered in a transaction. Moreover, if activists do begin to make more use of dissent rights in connection with Canadian deals, bidders and targets might be able to limit the effectiveness of that activist tool. In Canada, a friendly M&A transaction is usually completed as a plan of arrangement, a process in which it is possible to use the power of the court to constrain or even eliminate dissent rights, subject to the requirement that the court still finds that the transaction is fair and reasonable. Although arrangements typically provide for dissent rights as a matter of course, the availability of this possible structuring solution may also mean that dissent rights will not become a more popular tool for activist investors in Canada even as they are increasingly used in the United States.
As investors turn to appraisal litigation as a form of deal arbitrage in the United States—a trend we expect to continue—in Canada, both investors seeking better value from their investments in the context of M&A transactions and activists looking for new forms of deal arbitrage may have to pursue alternative strategies.
Footnote
1. M. Myers and C. Korsmo, "Appraisal Arbitrage and the Future of Public Company M&A," Brooklyn Law School Legal Studies Research Paper No. 338, August 2014.
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