Law360 (March 22, 2019, 2:50 PM EDT) --
The Delaware Supreme Court will soon decide whether to
adopt the efficient market hypothesis, or EMH, in the
valuation of Delaware incorporated companies. The case,
Verition Partners Master Fund LTD. v. Aruba Network
Inc., is nominally an “appraisal” proceeding to
determine the fair value shareholders dissenting from
Hewlett Packard Enterprise
2015 buyout of Aruba should be paid for their shares.
The principle at play, however, has far-reaching
implications. A Delaware Supreme Court affirmance of
this application of the EMH will ultimately thwart the
ability for corporate boards to defend themselves when
under attack by activists or hostile acquirers.
Let’s start with some context about appraisal. The Delaware General Assembly long ago developed a balanced approach for shareholder approval of mergers: Votes need not be unanimous but dissenting shareholders may decline to participate in the sale and instead request a court to appraise the fair value of the shares. When target company boards are able to run full, fair and nonconflicted sales processes and all prospective bidders are given access to the same information and management, this would normally result in a merger price that is in the range of “fair value.”
From time to time, however, mergers result from flawed sales processes or involve serious conflicts of interests. Shareholders — individuals, mutual funds and alternative investment managers such as Magnetar — brought “fair value” cases when they viewed the merger price to substantially undervalue the company. Some of these cases resulted in the courts awarding fair value increases. Others did not. But the system operated according to the legislature’s intended balance.
That balance has started to slip. In 2017, the Delaware Supreme Court in Dell Inc. v. Magnetar Global Event Driven Master Fund Ltd. overruled the trial court’s appraisal of fair value. The Supreme Court held that in determining fair value, the judge should place “heavy, if not dispositive weight” on the merger price. For most M&A contexts, the decision means that judges determining appraisal should arbitrarily select the merger price as the fair value. Notably, the 82-page decision also contained dicta — not necessary to the decision — categorizing “the efficient market hypothesis [as] long endorsed by [the Delaware Supreme] Court.”
This dicta has taken on a life of its own. In the context of the Aruba merger, shareholders appraised for “fair value” in lieu of the $24.67 merger price. Rather than determining fair value through valuation techniques such as a discounted cash flow, or even simply deferring to the merger price, the trial judge instead took the Supreme Court’s dicta endorsing EMH to its logical extreme. Despite evidence that the Aruba board had significant nonpublic information — including an upcoming strong earnings report — the court held that because Delaware adheres to the EMH, fair value should be appraised based on the unaffected $17.13 share price where Aruba stock traded in the days before the merger was announced.
There are serious problems with this ruling.
Start by examining the logic that ‘stock prices equal fair value.’ Investors know a lot about companies. They have access to company-disclosed information about their strategic and financial guidance, as well as publicly researchable data about the customer and competitive landscape. Corporate boards, however, possess significant incremental information, including the details of upcoming earnings announcements, multiyear financial projections, and nondisclosed strategic plans. Any of these data points may be material to “fair value” if disclosed to the outside world.
The usefulness of these data points is the basis for legal restrictions on “insider trading.” If stock prices were to already reflect all pertinent information — including information that only the board and executives had — trading on inside information would provide no advantage.
Aruba is a case in point where the unaffected stock price failed to reflect material information. Aruba’s board knew that it would soon release excellent quarterly results and that the stock price would jump after this information was released. But fearing the stock price jump — and the reduced implied merger price premium — Aruba delayed releasing earnings until it publicly leaked its plans to merge. How then can the pre-announcement stock price — which Aruba’s board knew didn’t incorporate upcoming positive news — serve as a marker of Aruba’s fair value?
The contention that ‘stock price equals fair value’ also lacks academic support. Numerous studies highlight return anomalies for certain categories of stocks that are inconsistent with EMH. Such “style factor” categories include the outperformance of value stocks, small capitalization stocks and stocks with significant price momentum relative to what the theory would suggest.
In the decades since EMH was developed, the field of behavioral finance has developed a deep understanding of investors’ psychological biases and resultant decisions. Well-reported biases include anchoring, loss aversion, lottery seeking and herding behavior, all of which cast doubt on the “all investors are rational” premise that EMH rests upon. Even evidence supposedly supportive of market efficiency focuses on how quickly new information is incorporated into stock prices (information efficiency), not whether stock prices reflect “fair value” (fundamental efficiency).
The lack of fundamental efficiency was clearly illustrated in well-known market events, including the Oct. 19, 1987, stock market crash — 20 percent single-day market decline, the “irrational exuberance” of the late 1990’s tech bubble and the 2010 flash crash.
Leaving aside whether EMH is correct, the notion that EMH has been the long-standing legal regime flies in the face of decades of court precedents and Delaware state policy. Delaware courts have allowed boards to operate in accordance with their sincere business judgment. This is particularly salient in the context of approaches from hostile acquirers or activists.
Delaware courts have blessed boards’ attempts to fend off hostile approaches with defense tactics such as poison pills, characterizing the tactics as proportionate responses to protect shareholders from “low ball bid[s].” In 2010 and 2011, the industrial gas company Airgas was under siege from a $70 per share hostile approach by its competitor Air Products and Chemicals Inc. The Airgas board deemed the $70 bid a lowball offer — despite exceeding where Airgas stock was trading. The Delaware courts deferred to the Airgas board, allowing Airgas to maintain its poison pill for more than a year. In 2015, Airgas eventually decided to sell itself to Air Liquide SA for a $143, more than double the price of the Air Products offer.
The underlying principle is that the board is permitted to defend the company from a hostile approach — even at a higher than prevailing stock price — because the board knows better than the market price.
That principle cannot coexist with the Aruba trial court’s application of EMH. If that version of EMH were adopted in Delaware, there would be no basis for corporate boards to deem a hostile bid as “lowball” — because the market knows best. Simply put, corporate defense mechanisms would be at risk. And corporate boards may logically start to question why they should remain in Delaware rather than in other states that would continue to permit themselves to maintain appropriate defenses.
Fortunately, we needn’t go down this path at all. The Delaware Supreme Court has an opportunity in the coming weeks to strike the right balance and eliminate its EMH dicta.
Alec Litowitz is the founder and CEO of Magnetar Capital LLC, an alternative asset management firm.
David Wilansky is a strategic analyst at Magnetar Capital LLC.
Disclosure: Magnetar Capital LLC was a party in Dell Inc. v. Magnetar Global Event Driven Master Fund Ltd., a case discussed in this article.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 Dell Inc. v. Magnetar Global Event Driven Master Fund Ltd. , 177 A3d 1 [Del 2017].
 Verition Partners Master Fund Ltd v. Aruba Networks Inc. , 2018 Del. Ch. LEXIS 52 [Ch Feb. 15, 2018, No. 11448-VCL].