Opinion Leaders' Digest 99-06
Date: Feb 12, 1999
Author : Chung Ho Kim, Director of Law and Economics Div. at CFE

Pitfalls of Appraisal

An appraisal refers to a device by which shareholders demand a company to buy their stocks. When a company decides over the transfer of corporate opportunity or merger, this right is given to dissenting shareholders. When the appraisal is made, the company has to buy the stocks at the price determined by the preset criteria within 20 days.

This device has become an obstacle to the restructuring. In the last year, companies such as Daehanjungsek, Erex, Kyunggihwahak, Shinwon, failed to conclude merger agreements because of this device. Since 1992, there have been 14 cases where the merger or sale of business division failed due to this device.

There are two reasons why the appraisal makes the merger difficult. First, it becomes a problem when an appraisal price is higher than a current price. In this case, the merging company has to pay additional cost. The value of the merged company goes down as far as the additional costs require and there will be less incentive to merge the company.

The second reason derives from the fundamental nature of this device. To exercise the appraisal, shareholders have to express the dissent to the merger. Therefore, when the number of shareholders asking the appraisal grow beyond a certain number, the merger becomes impossible. Of course, because controlling shareholders initiate the merger usually and institutional shareholders do not oppose quite often, it is not common that the dissent of minority shareholders obstructs the merger process or transfer of corporate opportunity. But, when the share of controlling shareholders become lower and minority shareholders demand the appraisal to a greater extent, we may see the situation where the merger becomes virtually impossible.

What can we make of this situation? Is this the natural course of events we have to undergo in order to protect the right of minority shareholders? Or is there something wrong with the current device? To understand the issue better, we need to see why the appraisal is necessary.

Needs for the Appraisal

The appraisal is designed for the same reason we want to protect against thieves and robbers. Men live by making constant exchanges with others. As long as the exchanges are made voluntarily, the exchanged goods are transferred to those who can use the goods more efficiently. Otherwise, the exchange can not take place.

However, the transfer of resources by theft and robbery is not made in the same manner. The thief benefits all the time and those who lose always suffer. So, there is no guarantee that the thief who stole the goods will use the goods more usefully than those who owned the goods. The opposite will be true. Though the owner places the value of 10,000 won on the goods, the thief will steal even when the goods is worthy of 1,000 won to him. If the theft is not allowed, no one can get the goods without paying over 10,000 won. When the theft is allowed, our precious resources will be used for trivial purposes. In the long run, this will result in the misfortune for everybody. Thus, the theft and robbery should be prevented.

The appraisal is based on the same principle. Managers and controlling shareholders exercise general managerial discretion. Though the important items are decided by the resolutions of the general meeting, decisions are usually made according to the intentions of the controlling shareholders. The problem is that the discretionary power can be abused. That is, decisions can be made, which are favorable to controlling shareholders or managers, yet detrimental to the interests of other shareholders. This can occur regarding the decisions over the merger or transfer of corporate opportunity. There are many transactions where controlling shareholders profit while other shareholders lose. Once the decisions detrimental to the minority shareholders are made, the stock price will go down. So far as the decisions are not canceled by controlling shareholders, the losses are inevitable. In such a case, there is no guarantee that invested resources can be used for more productive purposes. As the theft has to be prevented, so the appraisal should be recognized.

Current State of the Appraisal in Korea?

What we concern most is whether the properties of companies can be transferred to more productive purposes. To judge over this issue, "Pareto improvement," employed frequently by economists, is useful. It refers to the situation where nobody loses and some body profits. To dissenting shareholders, the Pareto improvement is achieved if they are provided with "the price of the stocks which prevails without the merger agreement." If the controlling shareholders pursue the merger while compensating dissenting shareholders, it indicates there is something profitable for the controlling shareholders. If the merger or transfer of corporate opportunity takes place when the appraisal is asked for, it is the instance of Pareto improvement.

The snag is that for the merger to achieve Pareto improvement, the company has to pay for the shareholders "the price of the stocks which prevails without the merger agreement." Note that this price is not "the price of stocks before the merger agreement." According to the appraisal provisions, the company has to buy the stock at the weighted price of stocks for the "past" sixty days. Is this desirable?

Let's take an example. A company is experiencing managerial difficulties. The price of the stocks naturally continues to go down. The managers of the company (controlling shareholders) try to save the company by merger. In such a case, we can think of two situations.

First, what will happen under the situation where the stocks are compensated at the price which prevails without the merger agreement? Ordinary shareholders can take one of two actions First, some may keep their stocks, anticipating that the merger will improve current financial difficulties and the fallen stock price will come back to a normal price. Some others may have a pessimistic view that even after the merger, the price of stocks will not come back up and sell out their stocks before the price goes down further. In such a situation, ordinary shareholders are apt to take a strategy of anticipating a price rise through the merger, since those who would take the latter strategy would have sold out the stocks before the situations get aggravated. In this case, it is highly likely that the Pareto improvement occur.

Second, what will happen if the appraisal stipulates that stocks be compensated for at the price of stocks before the merger? Similarly, ordinary shareholders will take one of two actions. First, some may keep their stocks, anticipating that the merger will raise the stock price. Second, some others will exercise the appraisal and will be compensated for at the price of the stocks "before the merger process begins." Here, the strategy of keeping the stocks is a highly uncertain strategy. On the other hand, realizing profits through the appraisal is a strategy of certainty. So, ordinary shareholders are very likely to take the latter strategy. If ordinary shareholders take this strategy, the merger does not take place. For instance, let's suppose that the current price of the stocks is 1,000 won and it may go up to 1,5000 won after the merger. If the appraisal price is 2,000, as for the merging company, the cost of buying the appraised stocks is greater than the benefit it will get after the merger. So, the merger will not take place. If ordinary shareholders do not ask for the appraisal or if the appraisal price is similar to the current price, the merger agreement will be concluded and the society as a whole will profit due to the merger. Yet, the social profits will disappear due to the appraisal which reflects the past price.

The fundamental imports of the appraisal is to guarantee the transfer of the company properties so that resources can be used more productively. If the current appraisal system was designed in accordance with the fundamental imports, there should be less demands for the appraisal when the merger promises more productivity. Yet, there were more demands for the appraisal when the merger took place in the period of bearish stock market. Does this mean that the merger was less productive? The opposite seems to be true. The period when the stock prices were low was the period when the companies made their best efforts to implement restructuring program. So, the productivity of the merger would have been higher. Despite it, shareholders opposed more vehemently to the merger. This indicates that there were big problems with the manner by which the appraisal price is made.

For the Desirable Appraisal System

Whatever the appraisal price may become, "the price in the past" has nothing to do with the basic imports of the appraisal. Recently, people fuss about changing 60 days into 15 days or 30 days. Yet, this debate misses wide of the target. A real appraisal price is not the price existent in the real world.

What should we do? The price which will prevail without the merger exists only in the imaginary world. Therefore, it is not easy to materialize the price in the real world. It will be useful to consult with the method of Delaware which is known for keeping the most advanced corporate law. The conventional appraisal price employed in this state was Delaware Block Method. This method calculates the weighted average out of the market stock price, net asset value and expected earning. This method sounds simple, yet, it is certainly a very complicated method. So, for the Weinberger case of 1983, the Supreme Court of Delaware made a judgment that the latest method used among the financial specialists in the Wall Street had to be employed. Yet, what it exactly meant was left unclear. To calculate the imaginary price was difficult even in a country with a long history of legal suit.

Nevertheless, there are lessons we can learn from advanced countries. In the United States, the demand for the appraisal is made only in the very exceptional circumstances. It is probably because there are provisions that make it more profitable not to demand the appraisal when the agreement is made to increase the productivity of the company. It is regrettable that the appraisal is frequently asked for when the merger or transfer of corporate opportunity is made. Which one will be greater, the earnings which will be made when the merger or transfer of corporate opportunity failed to occur due to the excessive demand for the appraisal or the earnings which will follow when the merger is agreed and the stocks of the new company are distributed? If the latter is greater, there is something wrong with the method of appraisal in our country.

(The view expressed here is the author's personal view. It is not the official view of the CFE.)