Institutional investors should be keenly aware of their returns during the pendency of an appraisal proceeding, since such costs may go a long way toward reimbursing the investor for the cost of such a proceeding. Under Delaware law, a shareholder who seeks to appraise the value of its shares is generally entitled to “interest from the effective date of the merger to the date of payment of the judgment . . . compounded quarterly . . . at 5% above the Federal Reserve discount rate . . . .” 8 Del. C. § 262(h). At current interest rates, this translates into approximately 5.8% interest on the unpaid merger consideration per year. Given that appraisal proceedings normally last approximately two years, it provides a floor of almost 12% of the merger consideration to help cover the costs of experts and attorney’s fees in the appraisal proceeding.
Although the Delaware statute provides a formula for interest, it also allows the amount to be changed in the court’s discretion for “good cause.” Given the statute’s apparent delegation of authority to the trial court, there are several very good reasons to argue for more interest. Indeed, under the old version of Delaware’s interest statute, parties made a number of arguments for why the interest rate should be something above the market rate. First, for example, consider that Delaware law imposes the merger payment obligation on the “surviving corporation.” In cases where an acquisition has improved the creditworthiness of the company, the credit risk of non-payment may arguably decline. However, many acquisitions are leveraged buy-outs and may be financed through high-yield debt instruments. In these circumstances, the surviving corporation has become much more leveraged and there is a market measure of the credit risk associated with the company — namely, the coupon on its high-yield debt. Since payment of the merger consideration is in fact an unsecured debt, one could argue that the yield on the surviving corporation’s unsecured bonds is the better measure. In most cases, that rate will substantially succeed the statutory interest rate.
Alternatively, one could argue that the consequences of not receiving the merger consideration at the time of the merger should be compensated with an equity return. Under this approach, one would argue that the shareholder should be compensated with the return that an equity investor would require to invest in the company. In other words, the investor has been forced to “forgo” an equity investment in a company of similar risk. One proxy for the “equity return” can be found in the discounted cash flow analysis frequently used by Delaware Courts in appraisal proceedings. In determining the discount rate, courts routinely calculate the “cost of equity capital” that investors require to invest in a company of the size and risk of the target. Again, the equity return on invested capital will likely be substantially higher than the statutory interest rate.
Finally, during a period of rising equity markets, a broad equity index — such as the S&P 500 — can be used as a measure for the forgone opportunity of an equity investment. Under this theory, the investor exercising appraisal rights would argue that if it had received the merger consideration at the time of the merger, it would have invested those proceeds into a general equity investment the return on which can be measured by the return on the S&P 500 or other index during the applicable time. Again, in some instances this will result in returns in excess of statutory interest.
Whether or not these arguments remain viable under the “good cause” provision of the current statute has yet to be tested. No party has pressed these kinds of arguments yet to our knowledge. Although professional investors should avoid needless disputes over interest owed in appraisal proceedings, the arguments outlined above could well constitute “good cause” sufficient to enhance the overall returns in appraisal proceedings and help professional investors defray the legal cost of expert fees associated with pursuing appraisal rights actions.