On Wall Street
Delaware hedge fund tussle puts
efficient market hypothesis in spotlight
Issue at heart of hedge fund
battle over Hewlett-Packard takeover
Delaware: in a handful of cases, the US state’s judges have
agreed with dissenting shareholders that a company was not sold
at fair value © Getty
Sujeet Indap in New York
[March 1, 2019]
would be no surprise if Delaware judges are tired of inputting data
into complex spreadsheets.
Sophisticated hedge funds are turning in ever greater numbers to
Delaware’s courts to deploy “appraisal rights”, a once obscure legal
remedy that gives shareholders of companies incorporated in the east
coast state the right to challenge the price of a mergers and
acquisition transaction. Given the majority of US companies are
incorporated in Delaware, the state’s judiciary has been busy.
a handful of cases, Delaware judges have agreed with dissenting
shareholders that a company was not sold at fair value. The judgments
have triggered windfalls for a breed of specialist hedge funds
engaging in what is known as “appraisal arbitrage”, with more than
$1bn flowing to them.
trend has seen judges hold an increasing number of trials over
disputed M&A valuations, sending those draped in black robes on a
crash course in equity betas, market risk premiums and other textbook
esoterica. One judge in a high-profile valuation ruling made a maths
error that required a correction. Another pointed out in a ruling that
the necessary financial “formulas did not spring from the mind of this
judge, softened as it has been by a liberal arts education”.
this burst of number-crunching by Delaware’s judiciary may soon become
nothing more than an historical oddity. On March 27 the Delaware
Supreme Court is set to deliberate on a case in which the hedge fund
Verition Partners is appealing a ruling by a Delaware lower court
judge on Hewlett-Packard’s $3bn acquisition of Aruba Corp in 2015. The
judge, vice-chancellor Travis Laster, shocked observers by ruling that
the fair value for Aruba was just $17.13 a share, less than the $24.67
a share Hewlett-Packard had agreed to pay.
Even more startling was how the judge reached his valuation. Eschewing
a traditional calculations-laden discounted cash flow model, he simply
relied on the famed efficient market hypothesis, which would contend
that the price at which Aruba’s shares were trading at before the
takeover refected the company’s fundamental value. If Delaware’s
Supreme Court afrms the lower court’s faith in efcient markets it
would be a landmark moment. But the raging controversy over appraisal
rights has already demonstrated the perils of having to impose science
— even a theory with little maths required — on an exercise, corporate
valuation, that is largely art.
Hedge funds’ appetite for using legal appraisals to challenge M&A
deals hasn’t simply been about the chance of a big pay-off. It’s also
been seen as a largely risk-free strategy.
Just like the student who never expects a lower grade if they ask for
their exam to be remarked, those funds disrupting takeovers largely
disregarded the possibility that a judge would say a company had
the same time, in cases where judges have ruled that the agreed
takeover price was a fair one, awkward compromises are required. The
Delaware statute calls for the company’s standalone, “going-concern”
value to be determined, excluding any potential benefits, or
synergies, stemming from the acquisition. But a deal price is
typically struck at large premium to pay for such synergies, raising
questions over how exactly to judge fair value.
Just before the case of Aruba, whose sale process Verition claims was
tainted, the Delaware Supreme Court acknowledged this when reviewing
the appraisals of two other companies, Dell and DFC Global. In each
case, the lower Delaware court awarded hedge funds significant
premiums to the original deal price.
However, the Supreme Court overturned the decisions, endorsing the
deal price standard for fair value. And in the written opinions in the
cases, it arguably laid the groundwork for a new efficient markets
standard that will be under the microscope later this month.
its decision in the case of Dell, the Supreme Court ruling said the
efficient markets hypothesis “is generally a more reliable assessment
of fair value than the view of a single analyst, especially an expert
witness who caters her valuation to the litigation imperatives of a
well-heeled client”. The witnesses in question are the top-end,
mercenary economists each side in appraisal cases hire to produce the
valuation they need.
With that green light, vice-chancellor Laster ruled Aruba’s fair value
was simply its 30-day moving average before the deal being announced.
if efficient markets theory is now suddenly the new standard for
appraisal cases, a new legal morass will open. Market structure
experts will testify about stock liquidity and debate the vagaries of
“fundamental” efciency versus “informational” efficiency.
While the controversy over appraisals comes just as Delaware has
become less friendly towards shareholder lawsuits of all types, one
hedge fund investor predicts the Supreme Court will deliver an
ambiguous ruling in the Aruba case. That will be welcomed by the
state’s lawyers who want a healthy volume of cases. “It does no good
for Delaware to have no litigation,” he said.
Judges may need to hold of uninstalling Microsoft Excel just yet.
Copyright The Financial Times Limited 2019.