Appraisal Rights

Many jurisdictions give shareholders the possibility to get a court to value their shares when a company is acquired. Even though the transaction may be approved by the requisite majority dissenting minority shareholders have such anti-oppression remedies available to them. Switzerland was the first country to introduce an anti-oppression statute in the year 1936.

In Delaware, appraisal rights, sometimes called dissenters' rights, are available only in cash deals and not normally in the case of stock-for-stock deals.² Shareholders in cash deals who feel that they are not getting a sufficient payment for their shares can apply for a court-supervised valuation of their shares. They will receive the value determined by the court, whether higher or lower than what was paid in the merger.

Appraisal rights are for shareholders what covenants are for bond holders: an implicit contract that protects them from abuses by management or majority shareholders. They are particularly relevant in squeeze-outs of minority shareholders, as will be seen in the Chaparral Resources/Lukoil example later.

However, for most investors, perfecting appraisal rights is unappealing because they have to be performed individually and cannot be combined into a class action. That means that each shareholder has to bear its own legal costs.³ Legal costs can amount to $100,000 or much more, depending on the length and complexity of the litigation. In addition, the cost for valuation studies, court costs, deposition, expert witnesses, and similar expenses also must be borne by the plaintiff. These costs will amount to at least five figures and cannot always be paid on contingency. Therefore, perfecting appraisal rights is attractive only for shareholders with sufficiently large holdings to make the litigation economically viable. Small shareholders who feel shortchanged can always use traditional class action litigation to get a higher payout. Some prominent large investors who have sought appraisal rights are Mario Gabelli's Gamco Investors Inc. in several instances (8.25 percent holding in a $10.8 billion Cablevision buyout, Carter Wallace, Medpointe Healthcare) and Applebee's director and sixth largest shareholder, Burton “Skip” Sack, who held over $60 million worth of Applebee's stock. Small shareholders may be restricted even further in their ability to demand appraisal if proposals are enacted that, at the time of writing, have been put forth by the Corporation Council of Delaware. Under this proposal, holders of less than 1 percent of $1 million worth of shares, based on the merger price, would no longer have the ability to seek appraisal.

One of the advantages of appraisal rights over litigation for breach of fiduciary duty is that shares are valued based on their intrinsic value. In a breach of fiduciary duty litigation, a shareholder needs to prove first that such a breach occurred. This makes the argument in appraisal litigation a little easier for plaintiffs. However, it can be implied that if an appraisal action is successful, there must have been a breach of fiduciary duty. If there were no breach of fiduciary duty, then the company would have been sold at fair market value, and it would be unnecessary and impossible to sue for appraisal.

A substantial economic difference between appraisal rights and litigation for breach of fiduciary duty lies in the compensation of lawyers representing plaintiffs. It is not uncommon to see both types of litigation submitted in parallel to the court. Breach of fiduciary duty litigation usually is filed as a class action on a contingency fee basis. This implies that the law firm representing plaintiffs assumes the risk of not getting paid if the class action fails. In return for this risk, the law firm typically is rewarded with one-third of the proceeds of the litigation in case of a success. For large holders, one-third of their incremental proceeds from the litigation can amount to more than they would pay if they pursued litigation independently from the class action. Therefore, the optimal strategy for large shareholders is to file a demand for appraisal and opt out of the class action. Of course, plaintiffs are free to negotiate a compensation formula of their choice when retain counsel to pursue appraisal rights. The author has retained counsel on a contingency fee basis in appraisal cases under the assumption that the interests will be better aligned under such an arrangement. A contingency fee for legal counsel helps to mitigate economic risks.

More recently, appraisal rights have been discovered as a tactic by hedge funds. It has been reported that hedge funds specializing in appraisal rights have been launched with considerable capital commitments. It remains to be seen what backlash, if any, this new popularity of appraisal rights will have. It has been reported that in recent years, the popularity of appraisal actions has soared among investors to the point that some observers are now talking of appraisal arbitrage as an investment strategy.⁴ The cause of this increase has been blamed by different observers on the Transkaryotic decision of 2007 (see below) as well as on an increase in the statutory rate of interest to 5 percent. However, these changes do not fundamentally alter the chances of success and economics of appraisal cases. They make, at best, marginal improvements. Therefore, other factors are more likely to be the drivers of this popularity.

In the 10 years from 2004 to 2013, a total of 129 appraisal cases were filed against 106 public company mergers in Delaware for an average of $30 million in forgone consideration. This number of cases and dollar amounts are a small fraction compared to the myriad of breach of fiduciary duty claims that were brought over the same time in connection with mergers. In 2004, roughly 5 percent of all mergers where appraisal rights were available in Delaware saw this being taken up. In 2013, this had surged to about 17 percent. The investors who file appraisal actions are mostly repeat offenders. Since 2011, more than 80 percent of cases filed involve a plaintiff who has previously litigated other appraisal cases. Most of these, in turn, are filed by only seven groups of investors.

The study by Wei Jiang, Tao Li, and Danqing Mei mentioned above also looks at the outcome of appraisal actions in Delaware's Chancery Court. Over the period covering the years 2000 though 2013 they find that activist merger arbitrageurs filed appraisal against 23 unique targets, a rather modest number but consistent with the success rate that activist merger arbitrageurs have. The consequence of their success is that they do not need to file for appraisal because they obtained fair value through their intervention.

Because Delaware does not want its courts to be flooded by appraisal cases, it has instituted a complex procedure that makes appraisal actions difficult for investors. The procedure must be adhered to exactly, and any deviation will void an appraisal action. The shareholder will instead receive the default consideration. An investor seeking to perfect appraisal rights needs to meet a number of stringent requirements, which are spelled out in Section 262 of Delaware General Corporation Law (DGCL). This section is included as an appendix in proxy statements in deals for which appraisal rights are available:

1. The shareholder must notify the company of her dissent and plan to seek appraisal prior to the shareholder meeting.
2. The shares must not be voted in favor of the transaction at the shareholder meeting. This means that the shareholder must abstain, vote against, or not vote at all.
3. The company sends a letter to shareholder who notified it (under point 1) of its intent to seek appraisal, giving the shareholders 30 days to demand fair value for the shares.
4. The shareholder must then notify the company of the number of shares for which she seeks appraisal. The shareholder has 60 days to reverse the election to seek appraisal.
5. The company has 20 days to respond to the shareholder. It must include in its response a list of all the shareholders who are seeking appraisal.
6. The shares must be held through the effective time of the merger.
7. The shareholder must file a petition with the court within 120 days of the effective time of the merger. If no petition is filed, the shareholder will receive the same merger consideration as the other shareholders. This is a last-minute exit strategy for shareholders who seek appraisal rights but then change their mind.

The court will look at the value of the company at the time of the merger in its appraisal decision. This means that all benefits that the company might get from the merger, such as synergies, will be ignored.

Merger agreements frequently limit the percentage of shares for which appraisal rights can be sought. It is typical to terminate a merger agreement if appraisal is sought for more than 5 percent, sometimes 10 percent, of shares. This provision aims to reduce litigation risk for the buyer. In addition, tax-free treatment of some mergers can be lost as a result of appraisal rights under some circumstances.

Beyond the cost of legal fees and uncertainty whether a shareholder will win, there is another important factor that limits the attractiveness of appraisal rights: time value of money. Delaware courts award shareholders who seek appraisal rights interest at a rate of roughly 5 percent over the Federal Reserve discount rate from the time of the merger until the court has a decision or the litigation is settled. This interest earned amounted to roughly 10 percent throughout most of the 2000s and only 5 percent at the time of writing. Whether this return is sufficient to compensate a plaintiff for the time value of money is a question that each potential plaintiff must weigh carefully. If the litigation is drawn out over an extended period of time, potentially several years, then the forgone time value of money can more than offset any increase in payouts received. On the other end, the acquirer of a company potentially can benefit from making payment for the shares later if its cost of capital is above the statutory rate. The compounding on the interest can be semiannual, monthly, or quarterly at election of the court.

It appears that a number of investors who use appraisal arbitrage file a petition for arbitrage specifically to earn the 5 percent interest rate spread while not expecting to receive an increase in the merger consideration. Essentially they view appraisal as a high yield investment. It has been suggested by corporate lawyers that this has become a rampant problem in Delaware as most appraisal actions, allegedly, are no longer motivated by the merits of the merger valuation. However, most appraisal practitioners doubt that the problem is as severe as it has been suggested. Nevertheless, a remedy has recently been proposed by the Corporation Council of Delaware that would allow a company to make the payment of the merger consideration, or a partial payment thereof, and thereby reduce the amount of interest that would have to be paid. Although this proposed measure may have the intended effect of making appraisal arbitrage for the purpose of earning interest less attractive, it actually increases the attractiveness of appraisal for many other investors. Under the current procedures, an investor who files for appraisal holds an illiquid position in an unsecured claim of uncertain value against the company. However, if part of that claim is prepaid by the company, the position is no longer illiquid and the investor can put that capital to work in other investments. As a result, appraisal actions may actually become more attractive in the future.

The typical time frame for an appraisal action is one year, and another year should be added in the case of an appeal. An appeal in Delaware must be filed with the Delaware supreme court. If the company appeals the appraisal judgment, it is required to post a bond with the court. This bond should be equal to the amount of the judgment that is being appealed. The Supreme Court generally defers to findings of the chancery court, so that most appeals are of little consequence other than increasing legal costs for all parties. The time frame can stretch if a shareholder class action is litigated in parallel with the appraisal action. In this case, courts will try to combine discovery of the two cases. Because class actions proceed more slowly than appraisal cases the latter is delayed. In one case the author is familiar with, the delay due to the class action, which ultimately was dismissed, exceeded one year.

Delaware courts will look at a variety of measures to determine fair value and usually do not put much weight on market value. Instead, the company is valued as a going concern. “Proof of value can be established by any techniques or methods that are generally acceptable in the financial community or otherwise admissible in court.”⁴ Discounted cash flows (DCFs) are among their favorite tools. Under this approach, cash flow projections are made, a terminal value is estimated, and these are then discounted at a weighted average cost of capital (WACC). Cash-flow projections are usually based on management's own forecasts. The terminal value is more difficult to determine; the courts go with multiples or a constant growth rate approach. Finally, the WACC is estimated using the capital asset pricing model (CAPM). It is clear that these methodologies are highly dependent on the assumptions. As a result, the expert witnesses of the shareholder and the company usually find highly divergent values. The Gordon dividend growth model also is used frequently. It is very sensitive to growth rates and thereby can lead to very high valuations. More recently, comparable company analysis and comparable transactions have become more prominent in appraisal cases. The toolbox used by the courts is evolving. Table 13.1 shows the valuation methods used in some appraisal actions.

^* 5% over the Federal Reserve discount rate as that rate fluctuates during the period.

Source: Based on Geoffrey Jarvis, “State Appraisal Statutes: An Underutilized Shareholder Remedy,” Corporate Governance Advisor 13, no. 3 (May/June 2005); Committee on Business and Corporate Litigation, Annual Review of Developments in Business and Corporate Litigation (Chicago: American Bar Association, 2006); J. Eisenhofer and M. Barry, Shareholder Activism Handbook (New York: Aspen Publishers, 2008 supplement); and author's research.

One of the key requirements of appraisals is that the fair value determined by the court be “exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation.”⁵ This means that any synergies that a buyer expects to realize in the merger cannot be considered in the valuation. Similarly, no minority discount is used in appraisal actions, and costs related to the merger also cannot reduce the appraised value. In a two-step merger, the date on which the company is appraised is that of the second step. This is important in that the new majority holder can already take actions to improve the value of the firm once it gains control after the tender offer. Any such improvements will increase the value of an appraisal action.

In addition to receiving the appraised value of the investment, the shareholder has also the right to interest from the date of the merger until the judgment. Interest rates used vary widely. Table 13.1 lists rates used in some appraisal cases.

Mergers typically will be done at a premium because the buyer expects to achieve savings through synergies and is willing to share these savings with the selling shareholders. Therefore, if the sale had been negotiated in a fair manner, there would be no incentive for shareholders to seek appraisal rights. It becomes an attractive option only in two scenarios:

1. Shareholders feel that the merger consideration is grossly inadequate, and a solid case can be made for a significantly higher payout.
2. The merger agreement stipulates a maximum percentage of shares that can seek appraisal, and a shareholder with a block larger than the maximum seeks appraisal rights. In this case, a buyer sometimes can be encouraged to pay more. A precondition is, of course, that the original merger consideration valued the target at the low end of a reasonable valuation range. Pressing appraisal rights to squeeze additional concessions from a fully priced merger is doomed to fail.

Most shareholders do not hold their shares directly but through a brokerage or trust account. These shares are not held on the books of the corporation in the name of the shareholder but in the name of Cede & Co., which acts as the depository for most brokers in the United States. In legal parlance, the shareholder is a “beneficial” owner, whereas Cede & Co. is the owner of record. When a shareholder is required to notify the company of the intent to seek appraisal, the notification actually must come from the record holder of the shares, or Cede & Co. for these investors. The shareholder must contact Cede & Co. and instruct it to demand appraisal for the shares held by the investor. The time required to get the relevant documents from that firm should not be underestimated.

An important aspect is the availability of appraisal rights on shares acquired after the record date under certain limited circumstances. In a recent ruling by Chancellor Chandler of the Delaware chancery court involving an appraisal action brought for shares of Transkaryotic Therapies, which was acquired by Shire Pharmaceuticals, the court ruled that even shares acquired after the record date can be included in an appraisal action. In this case, Cede & Co. had demanded appraisal for shares for which it was the record holder on behalf of a beneficial owner. The beneficial owner subsequently sold these shares, and the new owner sought appraisal. The court ruled that the change in beneficial ownership was irrelevant because the statue requires only that the holder of record make the demand for appraisal. This opens the door for arbitrageurs to obtain full value on shares acquired after the record date. It often can be difficult to buy large positions before the record date, because the proxy statement has been available only for a short time and there may not be enough trading volume in a stock to permit the acquisition of a significant position. The Transkaryotic decision is often blamed for the recent increase in appraisal cases. However, as already discussed, it does not change the economics of appraisal actions fundamentally, and this is unlikely to be a driving factor in the surge of appraisal cases. After all, appraisal is sought only when shareholders believe that their shares are worth significantly more than what they receive in a merger. This is also confirmed by a study that shows that appraisal actions tend to target mergers with smaller premia.

The crucial question is naturally whether litigation for appraisal rights makes empirical sense for shareholders. Geoffrey Jarvis of law firm Grant and Eisenhofer gives encouraging statistics:⁶ Shareholders who exercise their appraisal rights successfully receive a median increase of 80 percent in their merger consideration. Table 13.1 shows a list of appraisal actions and the premia received. Most actions take two to four years to litigate, and a few cases even run for over a decade. The most crucial problem for the investor is that its investment is tied up for the duration of the legal proceedings. If successful, the investor will receive interest in addition to the premium. This interest is intended to compensate for the lost time value. Since 2007, the rate in Delaware is the legal rate, which is 5 percent over the Federal Reserve discount rate, as that rate fluctuates during the period from the closing of the merger to the payment of the award. However, investors still face liquidity constraints for the duration of the case. For example, most investment funds have a need for liquidity to pay redeeming investors. Hedge funds may be able to place illiquid positions in side pockets for the duration of the litigation, but this option is not available for open-ended mutual funds. Therefore, open-ended funds are structurally disadvantaged and may find it optimal not to seek appraisal rights even if they have a very strong case and it would benefit their investors.

It is important to note that Table 13.1 shows only appraisal actions that were adjudicated. However, the vast majority of appraisal actions are settled prior to trial. The terms of the settlements are usually kept confidential. Therefore, Table 13.1 provides only a subset of all outcomes of appraisal actions, and most notably those in which the parties were unable or unwilling to compromise. It is possible that this only happens in the most extreme cases of all. If that is the case, then the average appraisal action may result in less spectacular returns than those implied by the statistics shown in the table. What the real impact of settled cases is on the overall economics of appraisal actions may never be known because settlements generally are accompanied by confidentiality requirements so that neither party is allowed to disclose the terms of the settlement. Of course, if one of the parties to the settlement is a public entity with disclosure requirements it can be possible to reverse engineer the terms of the settlement if one reads the footnotes carefully and makes a number of assumptions. The appraisal cases that the author has been involved with were all settled under the condition that the terms of the settlement remain confidential.

A separate problem is the credit risk faced by investors during appraisal proceedings. If the company declares bankruptcy during the appraisal action, the investors become unsecured creditors and may be able to recover only a fraction of their judgment. This problem is particularly acute in leveraged buyouts that use large amounts of leverage to buyout public shareholders.

A better route may be a class action, which we discuss in the next section. The minority squeeze-out of Chaparral Resources' public shareholders by Lukoil saw a group of hedge funds managed by London money manager SISU Capital Ltd., SISU Capital Fund, and SISU Capital Fund II opt out of the class action and instead seek to perfect appraisal rights. The two cases were settled simultaneously after approximately 18 months, with Lukoil paying the same gross per share amount to the public shareholders in the class action and the funds seeking appraisal. However, the net payment to the two groups was not the same due to the different structure of legal fees and the small number of claims forms submitted by the deadline.

One of the most successful appraisal actions of all time is probably that conducted by Bill Fagan in the 2001 going-private transaction of sandwich chain Quiznos. Public shareholders (including this book's author) were cashed out for $8.50 per share, but Fagan managed to get $32.50 per share in the appraisal proceedings. According to data from Jarvis, the record is held by the 1999 action of Borruso v. Communications Telesystems Intern., where the shareholder seeking appraisal received $0.645 instead of the $0.02 per-share merger consideration. This represents an increase of over 3,000 percent. But appraisal actions can also work to the disadvantage of shareholders: In an August 2007 decision, Delaware's Leo Strine set the value of shares of The MONY Group, acquired by AXA in 2004, at only $24.97 per share plus interest for the three years that it took to get to the final decision. For hedge fund Highfields, it was a lot of effort for a disastrous result. AXA had acquired the other shareholders' stock for $31 per share.

Class Actions

Class action lawsuits have a bad reputation. Martin Lipton, inventor of the poison pill, labels them “a type of extortion.”⁷ One of the most prominent law firms that brought the class action format to securities litigation, Milberg Weiss, was indicted, and at least one of its former partners had serve a prison sentence.

Nevertheless, class actions are an option that can be more viable for shareholders in a merger than seeking appraisal rights. Even though the press reports of an explosion of securities litigation, it is a strategy that is underutilized by investors.

There are two types of securities class actions:

1. Lawsuits under Section 10b-5 of the Securities and Exchange Act; these are federal cases.
2. Lawsuits under state law for breaches of state corporation law.

Federal class actions under Section 10b-5 are the ones that are most often caricatured by opponents of shareholder litigation. They usually involve claims of false or misleading statements by the company or its officers that have led to a decline in the share price. Various attempts of reform, such as the Class Action Fairness Act of 2005 and the Private Securities Litigation Reform Act of 1995, have limited abuses of class actions filed in relation to 10b-5 claims. Class actions of this type are of no interest to an activist merger arbitrageur.

Class action litigation under state corporation law, however, is a tool that can help activist merger arbitrageurs maximize the consideration paid in a merger. Mergers are always done pursuant to the corporation laws of the state in which the company is incorporated. Therefore, responsibility for litigation lies with the state. Chapter 8 explained the responsibilities that a board of directors has when selling a company. The most common approach to attack a merger is to find a breach of one of these fiduciary duties and file a class action under state law.

Such a lawsuit can have a number of goals:

• Lawsuits that seek to block a merger
• Lawsuits that seek additional disclosures
• Lawsuits for damages if shareholders believe that their firm has been sold for too little consideration

Legal action to block the sale of a company is hardly ever successful. The courts will weigh whether more damage is done in blocking the sale of a firm than in letting the transaction proceed, and will almost always find that blocking a transaction will cause irreparable harm. Moreover, shareholders who attempt to block a sale do so because they are unhappy with the consideration obtained. Therefore, the court will argue that if there is only disagreement about the price, unhappy shareholders can obtain redress through litigation for damages more easily than through blocking a sale, which would interfere with the ongoing business operations. Motions to enjoin a merger are almost always dismissed. A rare exception was the acquisition of Topps by Michael Eisner. The Delaware court enjoined the transaction, but only to give another buyer, Upper Deck, the opportunity to launch a tender offer for Topps' shares at a premium to Eisner's proposed price. When this tender offer did not come forth, the Eisner transaction closed.

The second type of litigation is quite common and generally successful. Plaintiff attorneys sometimes drive these lawsuits. The proxy or tender offer statements filed with the Securities and Exchange Commission (SEC) often are deficient. This is partly due to the haste with which they are assembled, partly due to negligence. In some instances, companies withhold information deliberately in order to make the transaction look fairer than it actually is.

Lawsuits seeking damages are the most difficult and longest of all. They usually end in a settlement. The fact that a settlement has been agreed on is not at all an indication that the original lawsuit had no merit. Instead, it is often optimal for both sides to settle rather than continue to litigate. For the defendant company, the legal costs can be cut when it settles early rather than fight a lawsuit that it knows it will lose anyway. For the plaintiff, time value of money makes an early settlement more attractive, even if it amounts to a slight discount compared to what could have been obtained at trial.

Securities class actions are filed by a plaintiff who represents all shareholders. A subtle difference between 10b-5 cases and merger litigation based on state law is the choice of a representative plaintiff for the class in federal cases, whereas in state merger litigation the first plaintiff to file will be the representative plaintiff. All shareholders who own stock at the time of the merger will be part of the class and are entitled to a payout from the award or settlement. The submission of claim forms is a requirement for obtaining a payout from a securities class action. When a claim form is submitted, the proceeds of the award or settlement have already been deposited and need only to be distributed to shareholders who submit a claim. For most shareholders, the claim form is submitted by their broker or custodian bank. A claim form is equivalent to the coupons that used to be attached to physical bond certificates and allowed the holder to claim interest payments. Contrary to statements made by industry leaders, including Legg Mason's chief operating officer and general counsel Andrew Bowden,⁸ after the SEC cited firms for failing to claim the proceeds of class actions for their clients, submitting a claim form is not the same as filing a lawsuit, and it does not require a legal determination. Filing a proof of claim is akin to claiming a dividend payment from a company that has declared a dividend.

For an activist arbitrageur, the principal advantage of filing a class action over filing an individual lawsuit lies in the legal fees charged to the plaintiff. If a shareholder files a lawsuit individually against a company, it must pay its own legal fees. Class actions, however, are based on contingency fees that are charged to the entire class, and only in the case of a success. Therefore, an arbitrageur not only does not face an up-front cost but also will not suffer any expense in case the action is unsuccessful. The corollary is that law firms vet these cases very carefully before taking them on to avoid the substantial up-front costs involved. A law firm that agrees to file a merger-related class action typically will retain a valuation expert at its own expense to determine whether the price is fair. This expert, usually a firm specializing in business valuations, will often cost $100,000. In addition, the law firm incurs costs for depositions and document review, which can add up to another six-figure amount. Due to these high costs, it is unlikely for meritless class actions to be filed against mergers.

Large investors often file individual lawsuits rather than class actions. The contingency fee structure compensating the law firm in a class action is the driver for this decision. Contingency fees are calculated as a percentage of the damages or settlement paid to shareholders. One-third is frequently cited, but actual percentages are often lower. For the holder of a large block of stock who expects to receive many millions of dollars of damages, it can be less expensive to retain a law firm on a retainer plus an hourly rate rather than sharing a large fraction of the proceeds. Because such an arrangement eliminates the risk for the law firm of not receiving compensation at all if the case is dismissed, the overall cost of litigation is lower. In order to file individually, the shareholder must opt out of a class action if one has been filed.

Opting out of a class action is what SISU Capital Ltd. did in the litigation against Lukoil. SISU filed a separate legal action. Lukoil settled both the class action and SISU's lawsuit simultaneously. The gross proceeds amounted to a 45 percent increase to the $5.80 offered to shareholders originally by Lukoil. SISU received a settlement of $2.61 per share, out of which it had to pay its legal costs. Public shareholders who participated in the class action received $2.38 per share, partly because not all shareholders filed claim forms. Although SISU received $0.23 per share more than the participants of the class action, it is not clear whether it was worth the effort financially. SISU held 1.3 million shares, so the additional proceeds of $0.23 per share amount to a total of $300,000. SISU's legal costs are likely to have exceeded this amount, so that it would have been better off had it not opted out of the class action.

An important aspect of shareholder litigation is the discovery phase, during which plaintiffs' attorneys review internal documents of the company. Discovery can take two forms: Before a trial, discovery is made to uncover all information needed in the trial. Sometimes, a settlement is negotiated and discovery is made afterward to confirm the representations made in the settlement. If the representations turn out to have been untrue, then the settlement will have to be renegotiated, or the case will proceed to trial.

Because of its favorable cost structure, securities class actions are the best method for small investors to defend their interests in mergers in which they are shortchanged. But even large institutions use class actions to obtain fair value in mergers. Some examples of recent actions are:

• Shareholders of Foodarama Supermarkets were paid initially only $53 per share but stand to receive another $14 per share after a class action lawsuit against the management buyout group.
• When Restoration Hardware was acquired by management and private equity funds for $4.50 per share after it spurred a higher bid from Eddie Lampert's Sears Holdings, shareholders received an extra $0.19 payout through a class action.
• Former shareholders of National Home Health Care Corp., which was acquired by Angelo Gordon in 2007, received an extra payout of $0.10 per share, or just over one extra quarterly dividend payment, thanks to litigation brought by Helaba Invest Kapitalanlagegesellschaft, an investment advisory subsidiary of state-owned Hessische Landesbank.

It should be noted that securities class actions under Delaware law are heard by a professional judge in the court of chancery, which is a court of equity that does not provide for jury trials. Indeed, all cases involving corporate law are decided by the court of chancery, so that decisions tend to be expert and consistent.

Inspection of Books and Records

Activist shareholders have the right to inspect the books and records of a corporation. All states have such statutes. Under Delaware law, any shareholder can inspect the books and records. Other states have more stringent requirements. Texas and Nevada, for example, award this right only to 5 percent shareholders or those investors who have held their shares for at least six months. In Delaware, the right to inspect books and records is also available to beneficial owners, which are those who hold their shares through a brokerage account.

Requests to inspect books and records are often referred to as “220 requests,” after Section 220 of Delaware General Corporate Law, which specifies the procedure to be followed:

1. (b) Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose, and to make copies and extracts from:
   1. (1) The corporation's stock ledger, a list of its stockholders, and its other books and records; and
   2. (2) A subsidiary's books and records […]
2. (c) If the corporation, or an officer or agent thereof, refuses to permit an inspection sought by a stockholder or attorney or other agent acting for the stockholder pursuant to subsection (b) of this section or does not reply to the demand within 5 business days after the demand has been made, the stockholder may apply to the Court of Chancery for an order to compel such inspection. […] Where the stockholder seeks to inspect the corporation's books and records, other than its stock ledger or list of stockholders, such stockholder shall first establish that:
   1. (1) Such stockholder is a stockholder;
   2. (2) Such stockholder has complied with this section respecting the form and manner of making demand for inspection of such documents; and
   3. (3) The inspection such stockholder seeks is for a proper purpose.
   4. Where the stockholder seeks to inspect the corporation's stock ledger or list of stockholders and establishes that such stockholder is a stockholder and has complied with this section respecting the form and manner of making demand for inspection of such documents, the burden of proof shall be upon the corporation to establish that the inspection such stockholder seeks is for an improper purpose. […]
3. (d) Any director (including a member of the governing body of a nonstock corporation) shall have the right to examine the corporation's stock ledger, a list of its stockholders and its other books and records for a purpose reasonably related to the director's position as a director.

8 Del. C. § 220

If a company refuses a request and a shareholder files a lawsuit, as described in Section 220(c), Delaware courts will try the demand expeditiously within a few months. Shareholders almost always win these cases. However, there are a few exceptions where courts routinely deny access to books and records. Most important, shareholders do not have the right to inspection to determine whether to tender shares in a tender offer. The rationale is that the tender offer statement should contain all the information required to take that decision. If the tender offer statement is defective, then shareholders have a basis to sue for additional disclosures.

Typical reasons for demanding books and records include the launch of a proxy fight or preparation for a resolution to be brought to the annual meeting, examination of the independence of directors, communication with other stockholders regarding a stockholder class action against the corporation, and communication with other stockholders to encourage them to dissent from a merger and seek appraisal. Investigation of suspicion of mismanagement is also an acceptable reason as long as the shareholder has a “credible showing, through documents, logic, testimony or otherwise that there are legitimate issues of wrongdoing.”⁹

The shareholder can inspect all documents that are essential and sufficient for the request. The court can curtail the scope of documents that must be produced in order to protect the company from excessive costs. A confidentiality agreement usually is required from the shareholder before inspection.

Activist merger arbitrageurs cannot use 220 requests to obtain documents for a tender offer but can use it for related purposes—for example, if the tender offer is canceled or a merger collapses. An investigation of the independence of directors on the special committee should also be a valid reason for a 220 request, and in some mergers, questions about directors' independence do indeed arise.

Proxy Campaigns

In mergers, activists are at a disadvantage to management. The favorite tool used by management to pass a merger proposal is the postponement of the shareholder meeting. This allows management first of all to gather additional votes. These votes are collected by proxy solicitors who call shareholders, sometimes even retail accounts that hold only a few hundred shares, and ask the investors to vote over the telephone in favor of the merger. If this is still insufficient, management can reset the record date that allows shareholders to vote. If more arbitrageurs who support the transaction have acquired shares after the original record date, then the likelihood of gathering sufficient votes increases.

Activists that seek proxies to oppose a transaction face a number of obstacles. First, the cost of running a proxy contest can be significant. Many observers give numbers well into the six figures. This is definitely the case when a proxy solicitation firm is retained. In the absence of a proxy solicitation firm, campaigns can be run at a much lower cost, but the activist has to design a campaign carefully to ensure its effectiveness. The principal cost is the printing and distribution of the proxy materials to shareholders. Most investors hold their shares through Cede & Co., and these shareholders are serviced by Broadridge (formerly ADP). The processing fee is approximately $1 per account in addition to materials, printing, and postage. Due to new SEC regulations allowing electronic delivery of proxy materials, it should be possible to run campaigns at very low cost. As mentioned before, the critical factor for a successful campaign will be its planning, and not the retention of a proxy solicitor.¹⁰ Unfortunately, Broadridge designs its proxy ballot forms in a way that makes them confusing to investors. In uncontested elections, the control number, a reference number needed to vote, is displayed prominently in a box with a red border. In contested elections, however, the dissidents' proxy forms tend to be cluttered with text, and the control number is not displayed prominently. This places the activists at a slight disadvantage.¹¹ In close contests, this disadvantage can make the difference between winning and losing.

Withholding Shares in Tender Offers

Withholding shares in tender offers usually is more difficult to do than a campaign in a merger, where the activist asks shareholders to vote against the transaction. A shareholder who does not tender will be at a disadvantage if the minimum tender condition is satisfied: The shares will become illiquid and it may take several weeks until the second step of the transaction is completed and the investor is cashed out. In the meantime, the shareholder not only has an illiquid investment, possibly relegated to the pink sheets, but also loses the time value of money. In contrast, in a merger, the company will continue to exist and the shareholder is not forcefully cashed out in a disadvantageous way.

A rare instance where opposition to a tender offer gained traction is the attempted acquisition of Longs Drug Stores by CVS Caremark in 2008. A key factor in the success of the opposition was the number of unhappy shareholders: Hedge funds Advisory Research and Pershing Square owned a combined 18 percent of Longs, and CtW Investment Group representing several unions also opposed the transaction. This gave the opposition a large enough block of shares to make a credible case against tendering. In addition, the opposition generated significant publicity, which caused other investors to follow them into not tendering. Their credibility was enhanced further when they convinced Walgreens to partner with two commercial real estate investment trusts and submit an acquisition proposal. As a result, at the first expiration of the tender offer, less than 4.5 percent of all outstanding shares had been tendered.