Risk Of Appraisal Rights Arbitrage Grows

A recent court case may encourage hedge funds to try to hold out for a bigger payday when they own shares in a company being acquired in a leveraged buyout. And that could force LBO shops to pay more for companies than they bargained for.

Here’s the strategy in a nutshell: Let’s say you’re a hedge fund looking for arbitrage opportunities in the buyout market. First, you wait for a buyout shop to pounce on a deal. Then, after having time to absorb the proxy materials, typically released after the date of record, you gobble up shares. Next you cross your fingers that a healthy minority of shareholders is disappointed enough with the share price to either vote no or abstain from voting for the acquisition.

The final step is to take advantage of appraisal rights—statutory provisions in each state designed to protect minority investors from being forced to swallow a deal they don’t like. In Delaware, shareholders can assert appraisal rights in all transactions, both public and private, except for stock-swap transactions. Such rights let you file a lawsuit requesting that a judge, not the buyer, determine the fair value of your stock at the time a deal closed.

In such a suit, the judge can decide that your shares are worth more than was offered, less than was offered, or the same as offered. It’s a crap shoot, and you have to pay legal expenses (easily $1 million to $2 million) either way. But, being a savvy hedge fund investor, you aren’t anticipating having to go to court. You figure that the buyout firm, to avoid litigation, will offer you a premium to what you paid for your shares for your agreeing not to file suit. Then it’s on to the next investment opportunity.

Sound farfetched? Well, a recent court case tested a key element of this arbitrage strategy—whether shareholders asserting appraisal rights have to prove that the shares they bought after the date of record had been voted no or abstained.

In a case not unlike my scenario drawn above, only about 52 percent of stockholders in Transkaryotic Therapies Inc., a biopharmaceutical company, approved the company’s acquisition by Shire Pharmaceutical Group in July 2005. Earlier that April, Shire had agreed to pay $37 per share for the company, or a 44 percent premium.

Twelve shareholders that owned some 3 million shares acquired another 8 million after the June 10 record date but before the merger was consummated. Those shareholders—among them Deephaven Capital Management and Icahn Partners—then asked Delaware Chancery Court for an appraisal of their shares, valued at more than $400 million, in hopes of getting a better price.

In asking for partial summary judgment, Transkaryotic argued that, under Delaware law, those asserting appraisal rights must prove that their shares were not voted in favor of the merger. But both parties agreed that, given how shares are bought and sold, it is impossible to determine how those shares had originally been voted. And in an early May decision, the court sided with the arbitrageurs. So long as the arbitrageurs didn’t hold more shares than the number originally eligible for appraisal rights, they could seek appraisal on all of their shares.

Transkaryotic will either settle with the arbitrageurs, or the case will move ahead to trial, most likely next year. John L. Reed, an attorney for Deephaven Capital Management, said that earlier this year some of the same shareholders asserting appraisal rights also filed a lawsuit alleging that the board breached its fiduciary duty in agreeing to the Shire offer. The two cases are going to be consolidated, Reed said. I was unable to reach a Shire spokesperson for comment.

What can buyout firms do to protect themselves from appraisal rights arbitrage? According to Charles Nathan, co-chair of the Latham & Watkins M&A Group, they can choose to impose as a closing condition a requirement that shareholders not claim appraisal rights on more than, say, 5 percent to 10 percent of the shares. That obviously limits the risk of having to pay an appraisal premium. But Nathan also sees a downside to this tactic.

By imposing the closing condition, buyout firms would actually signal to the market that they feel at risk of an appraisal, and that they care about limiting the damage. Sensing blood in the water, arbitrageurs might then dive in to assert claims on at least that 5 percent to 10 percent cap. For more on appraisal rights, contact John L. Reed of Edwards Angell Palmer & Dodge LLP at 302-425-7114; or contact Charles Nathan of Latham & Watkins at 212-906-1730.