Mergers, squeeze-outs, and other corporate restructurings serve to transfer control or to save costs by streamlining the corporate structure. They also offer an opportunity for controllers to expropriate investors. Corporate law needs to provide safeguards to ensure that minority shareholders receive fair compensation when they are forced to surrender their shares. Under German law, the compensation offered to shareholders can be subjected to ex-post judicial review by way of appraisal litigation. If a shareholders’ challenge is successful, she is entitled to an additional compensation up to the value the court deems ‘fair’.
The idea of an appraisal remedy or procedure has not caught on very well—until now: The EU Mobility Directive requires Member States to introduce a procedural remedy that allows shareholders to challenge the ‘adequacy’ of the share exchange ratio in a cross-border merger or division (new Articles 126a(6)–(7), 160i(6)–(7) Company Law Directive). They must grant shareholders who have voted against the cross-border restructuring a right to ‘exit’ the corporation by offering to buy their shares at ‘adequate’ value, again subject to judicial review (Articles 86i(4), 126a(4), 160i(4) Company Law Directive). EU Member States have until January 2023 to implement an appraisal procedure in their national laws. They may look to the German experience and its Appraisal Procedure Act for inspiration.
Against this backdrop and building on a recent paper by one of us in honour of Professor Klaus J. Hopt, this blog post draws attention to a major design challenge for appraisal procedures: instead of policing undervaluation in corporate restructurings, the remedy could be creating it.
Do appraisal procedures cause the disease that they are meant to cure?
Financially speaking, the German appraisal claim has an option-like structure: Shareholders cannot receive less than the consideration stipulated in the restructuring agreement. The option’s ‘underlying’ is the court’s valuation of the share, which is unknown ex ante: At best, it exceeds the consideration offered under the terms of the restructuring, at worst, the court could find that the share is worth less than what has been offered in the restructuring terms. But even so, it may not lower the compensation below the stipulated amount. Together with fee-shifting rules that favour petitioners, the appraisal procedure strongly encourages enforcement.
Defendants seeking to avoid the substantial costs associated with an appraisal procedure can try to dissuade shareholders from initiating one by lowering the procedure’s option value. An intuitive strategy would be to offer a best guess at fair compensation in the restructuring terms to lower the chance of a positive award in response to an appraisal petition. Yet raising the regular compensation is costly to the controller: Each additional Euro offered in the restructuring terms is a certain liability, whereas it is only a potential liability if it is left to the court’s determination in an appraisal procedure. This is because fundamental valuation methods based on discounted cash-flows—as those relied upon by German courts—can lead to widely divergent outcomes depending on the method and parameter choices. The variability also implies that even if controllers try to approximate fair value in the original restructuring terms, shareholders may nonetheless choose to initiate an appraisal procedure in hopes that the court will arrive at a higher valuation.
The designers of a restructuring thus lack a viable opportunity to bargain away the option value that the appraisal procedure confers on the minority. Far from forcing controllers to offer shareholders fair compensation, appraisal litigation incentivises them to undervalue the firm. This in turn makes appraisal litigation a certainty, raising transaction costs in corporate restructurings. Available evidence tends to support this prediction, with more than 80% of eligible cases resulting in litigation in a sample of 161 going-private transactions between 2005 and 2015.
What can be done to make the original valuations fairer?
One potential reform is to introduce a downside for petitioners: courts could be allowed to not only increase, but also reduce the consideration under the original terms. On its face, Delaware’s appraisal remedy (§ 262 Delaware General Corporation Law) is symmetric: The Court of Chancery can determine a fair value that is less than the consideration offered in the merger agreement. One caveat is that the outcome of Delaware’s appraisal remedy affects only the plaintiffs. Germany’s appraisal procedure, on the other hand, has a collective redress flavour that would sit uneasily with downside risk: the procedure leads to inter omnes awards which have effect for all affected shareholders (§ 13 Appraisal Procedure Act). For cross-border restructurings, the Company Law Directive seems to preclude Member States from adopting a symmetric review of restructuring terms. For instance, Article 126a(4) stipulates that dissenting shareholders are ‘entitled to claim additional cash compensation’ (emphasis added), as compared to the Commission’s original draft proposal ‘to demand the recalculation of the cash compensation offered’.
Alternatively, legislators and courts could try to reduce the option value of an appraisal procedure by reducing the variance of awards. One possible way to do this is to link court appraisal to the outcome of bargaining over deal terms. The key idea is to reward procedural fairness in the original valuation and to rely on it when it seems to reflect an impartial assessment. To some extent, the 2003 reform of the German appraisal procedure followed this path by enabling courts to base their assessment on the valuation of the original auditor, instead of conducting another valuation from scratch (§ 7(3), (6), § 8(2) Appraisal Procedure Act). Yet the independence of auditors in relation to the dominant party in the transaction remains a neuralgic issue. While the 2003 reform has given courts exclusive competence to appoint auditors, judges have been criticised for being too willing to accept auditors proposed by the transaction controllers.
This begs the question which conditions would justify greater confidence in the negotiated terms of a restructuring. In this respect, Delaware’s jurisprudence could provide guidance. For the fiduciary duty analysis in the presence of a controlling shareholder, the Delaware Supreme Court’s landmark ruling in Kahn v. M & F Worldwide grants de facto immunity under the business judgment rule if a deal has been negotiated by a special committee of independent directors and, in addition, has been ratified by a majority of the shareholder minority. As regards the appraisal remedy, the same court has refused to specify a presumption for when the agreed-upon price can serve as a reliable indicator of fair value. It did, however, emphasise that it had ‘little quibble’ with the economic argument that the price of a merger resulting from a ‘robust market check’ will often be the most reliable evidence of fair value (see the DFC Global and also the subsequent Dell case).
Putting greater weight on a fair bargaining process in corporate restructurings could be a promising strategy for EU Member States as well. Unfortunately for Germany, the Federal Constitutional Court has limited this approach by ruling in 2012 that a court would violate shareholders’ constitutional rights if it confined itself to only reviewing the fairness of the bargaining process, arguing that even parties negotiating at arm’s length may be driven by ‘other considerations’ than arriving at a fair valuation (though it did not specify what considerations it had in mind). German courts are thus required to always undertake a substantive evaluation of fairness. Legislators and courts in other EU Member States hopefully enjoy greater leeway in relying on procedural fairness.
Andreas Engert is Professor of Civil Law, Commercial, Company, and Securities Law at Freie Universität Berlin.
Johannes Jiang is PhD Candidate in Law and Research Assistant at Freie Universität Berlin.