Appraisal Rights In Public M&A: Deal Structure, Deal Price, And Trading Price

The "one true rule" in dissent and appraisal disputes in Canadian public M&A is that the courts will consider all relevant evidence in deciding fair value. This has the practical effect of making appraisal proceedings highly discretionary and situation-specific.

That said, recent decisions demonstrate that the courts tend to place significant weight on deal price relative to other factors. The ruling of the British Columbia Supreme Court (the Court) in Michalowski v Gold Flora is the latest example.

Our key practical takeaways include:

• The Court distinguished between a merger of equals, where "implied value" may be more indicative of relative value but not necessarily fair value, and an auction process aimed at maximizing value. The Court viewed the transaction as more consistent with an auction even though the buyer's shareholders held 51% of the new entity and the Target's shareholders held 49% of the new entity.
• The Court appraised the fair value of the dissenters' shares at US$0.9847 per share, which was the implied deal price publicly announced by the Target. The Court did not view the trading price of the Target's shares on the valuation date – being only US$0.17 per share – as indicative of fair value for several reasons, including that it viewed the shares as trading in an inefficient market (i.e., a market that did not reflect the true value of the shares).
• The Court put weight on (1) the value to the buyer that the Target was a publicly traded company that would improve the buyer's access to equity and debt financing, and (2) the fact the implied deal price was disclosed in the Target's securities filings, which implied the parties thought this value was not misleading. The Court also repeatedly noted "valuation work" regarding the Target and the buyer it identified in two fairness opinions obtained by the Target in connection with the transaction.

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Deal Structure, Deal Price and Trading Price

The Target was a cannabis company trading on the Cboe Canada exchange^[1] and the OTCQX. The buyer (Buyer) was a privately held cannabis company. The transaction was effected by a plan of arrangement (the Arrangement) under the British Columbia Business Corporations Act (the BCBCA).

The Arrangement's Background

The Target's board initiated a strategic process (the Strategic Process) in July 2022 and retained external financial advisors. A broad market canvass for potential merger parties was undertaken. Twenty-four potential third parties were identified, contact was made with twelve of them, and several non-disclosure agreements were executed, including with the Buyer.

Beginning in November 2022, the Buyer made several acquisition proposals to the Target, and this prompted the Target's board to form a special committee (the Special Committee). The Buyer's first proposal was for a merger whereby the Buyer's shareholders would own 70% of a new company and the Target's shareholders would own the remaining 30%. The Buyer's second proposal was for a merger whereby the Buyer's shareholders would own 57.5% of the new company and the Target's shareholders would own the remaining 42.5%. The parties ultimately agreed to a merger whereby the Buyer's shareholders would own 51% of the new company and the Target's shareholders would own the remaining 49%. The Target announced the Arrangement in February 2022, and the press release stated, inter alia, that the transaction valued the Buyer at US$1.50 per share and the Target at US$0.9847 per share.

During the parties' negotiations, the Target received multiple competing offers, including an all-cash offer at US$0.40 per Target share. The Special Committee rejected this offer as it believed the Arrangement created more value. The Special Committee's recommendation that the Target pursue the Arrangement was in part based on two separate fairness opinions (the Fairness Opinions) obtained by the committee. Each of these stated that the consideration to be received by the Target's shareholders was fair, from a financial point of view, to the shareholders. Each of these also included customary disclaimers stating that the opinions did not involve any valuation of the Target or the Buyer. In presenting the Fairness Opinions to the Target's board, each of the financial advisors noted that the Arrangement represented a premium to the Target's shareholders of 226% over the Target's then-current trading price.

The Dissent Group

Shareholders owning 84% of the target's shares voted to approve the Arrangement. A group of minority shareholders (the Dissent Group) opposed the Arrangement and exercised their dissent rights under the BCBCA and the Arrangement. This led to appraisal proceedings requiring the Court to establish the "payout value" of the Dissent Group's shares (the Shares), being the "fair value" of the Shares on the applicable "Valuation Date".^[2] It was agreed that this was June 15, 2023, being the day immediately before the approval of the Target shareholder resolution adopting the Arrangement. The trading price of the Target's shares when the Arrangement was announced in February 2022 was US$0.27. The trading price of the shares on the Valuation Date was US$0.177.

The Buyer's Appraisal Arguments

Merger of Equals

The Buyer argued that the Arrangement was properly understood as a "merger of equals", in which case a key issue is the share exchange ratio that sets the proportionate ownership in the combined company as between the owners of the predecessor companies. The Buyer's position was that the US$0.9847 per share price publicly announced did not equate to fair value, but was merely an "implied value" derived from the agreed share exchange ratio and the deemed value of US$1.50 per share attributed to the Buyer's shares.

Implied Value in Share Deal

The Buyer introduced expert evidence that such a deemed value was necessary because the purchase price was being paid in shares rather than in cash, and because the Buyer was a private company without a publicly traded share price. It was therefore incorrect to interpret the "implied value" of US$0.9847 per Target share as reflective of the actual or fair value of the Shares. The Buyer argued that the "fair value" of the Shares was more accurately reflected by the trading price of the Shares on the Valuation Date, which was only US$0.17 per share. The Buyer disputed the Dissent Group's claims that the Target's shares were not trading in an efficient market.

Trading Price and Other Offers

The Buyer relied on an expert valuation opinion that the fair value of the Shares on the Valuation Date was "in the range" of US$0.17 to US$0.18. In arriving at that range, the Buyer's expert relied on the other offers received by the Target during its Strategic Process (including the offer of US$0.40 per share). The Buyer argued that any reliance on the Fairness Opinions was inappropriate as such opinions are not de facto opinions on valuation. Nor did the Fairness Opinions conclude that the fair value of the Shares was US$0.9847.

The Dissent Group's Appraisal Arguments

Announced Deal Price

The Dissent Group argued that the payout value should be set at the announced deal price, i.e., the US$0.9847 per share price identified by the Target to its shareholders, the public, and regulators in publicly announcing the deal. The Dissent Group argued that the Strategic Process more closely resembled an auction than a merger of equals and that value maximization was a greater focus for the Target during the parties' negotiations than the share exchange ratio.

Fairness Opinions

The Dissent Group's valuation expert opined that the US$0.9847 per share deal price was the result of arm's length negotiation between knowledgeable parties who were under no compulsion to act, and as such was a reliable indicator of fair value. The expert also opined that US$0.9847 per share was a reasonable estimate of the fair value of the Target's shares as of the Valuation Date. The expert opined that the trading price of the Target's shares on the Valuation Date was not reflective of the share's fair value as the shares were not trading in an efficient market.

The Court's Appraisal Ruling

Applicable Law

The Court observed that the "one true rule" in appraisal proceedings is to "consider all the evidence that might be helpful, and to consider the particular factors in the particular case..." This meant that "the value attributed to the shares by the plan of arrangement is but one piece of evidence to be considered..." Other evidence to be considered included:

The Sale Process

The Court agreed with the Dissent Group that the Strategic Process was "much more similar to an auction process than the typical genesis of a merger of equals". The Court highlighted that, while the final ownership split in the combined business was 51/49, the Buyer's initial proposal was for a 70/30 split. Nor did the evidence "reflect that the parties' focus in their negotiations was the share exchange ratio..." Rather, it indicated that the Target's "focus throughout was value maximization" and that "share value was a measure of that maximization..." This included that, in the Arrangement agreement, the Target had maintained the right to accept a "superior proposal" received before the Arrangement had closed.

Real Value, Not "Implied" Value

The Court rejected the Buyer's argument that the US$0.9847 announced by the Target was merely an "implied value" that was "simply illustrative" of the Target's "relative piece of 'the pie'". In the words of the Court, the figure "had meaning." It saw the figure as the product of an arms' length negotiation in an open and unrestricted market informed by extensive mutual due diligence. The Court noted that the valuation of the Buyer's shares (US$1.50) and the Target's shares (US$0.9847) announced by the Target had been disclosed in the Target's securities filings which, under law, could not be misleading. The Court also noted that the valuation of the Buyer's shares had legal consequences in that it "drove the conversion ratio" at which the Buyer's convertible debentures could be exchanged for shares in the Buyer.

An Inefficient Trading Market

The Court agreed with the Dissent Group that the Target's shares were not trading in an efficient market. The Court was persuaded by evidence indicating that the Target's stock "did not react to value-relevant news", which suggested that "sophisticated investors were not setting the price". The Court noted that the Target's stock traded in an over the counter (OTC) market in the U.S. (which requires a broker) rather than on a "fully accessible centralized public exchange" like the NASDAQ.

Regarding liquidity, which was noted as an important consideration in assessing whether trading activity can be relied upon for fair value, the Court noted that, while the Target's free float percentage was 78.6%, 51% of these shares were held by Target "insiders", and the decreased free float suggested less liquidity. The Court also held that fair value includes a control premium, and the fact the Target's shares were not trading in an efficient market meant that the control premium had not been priced into the trading price.

Cash and Capital Market Access

The Court held that the Target had "significant value" to contribute to the merger that "was not recognized in its trading price..." Key here was the Target's US$80,000,000 in cash and its "status as a publicly traded company." While the Target was cash rich, the Buyer had "little" cash and "significant debt." Becoming a public company offered the Buyer "greater access" to both equity and debt financing. The Arrangement also provided the Buyer with access to a capital market "without the cost and risk associated with proceeding with its own initial public offering (IPO)." The Target being a publicly traded company was therefore a "significant asset" to the Buyer and it had repeatedly emphasized this fact to investors following the announcement of the Arrangement.

The Fairness Opinions and Valuation

The Court repeatedly noted "valuation work" regarding the Target and the Buyer it identified in the Fairness Opinions. The Court noted that the first opinion "employed numerous recognized valuation methodologies", including a trading value analysis and a discounted cash flow approach. Similarly, the Court noted that the second opinion was "critical" for stating that the US$1.50 valuation of the Buyer's shares was "within a reasonable range of valuation outcomes". The Court also noted that the Target had relied on the Fairness Opinions and the "valuation work" undertaken by the financial advisors in preparing them in approving the Arrangement. That said, the ultimate weight the Court put on the Fairness Opinions, if any, remains unclear from the ruling.

Additional Comments and Practical Takeaways

The Court set the fair value of the Shares at US$0.9847 per share, in line with the Dissent Group's position, and in so doing again demonstrated the (1) significant weight Canadian courts tend to place on deal price relative to other factors, and (2) highly discretionary and situation-specific nature of appraisal proceedings in Canadian public M&A. That said, certain aspects of the ruling warrant additional commentary:

• The case is a cautionary tale. Dissent rights are critical in share exchange deals, particularly when the buyer is a private company. The ruling highlights the need to be careful in assigning a value to the buyer and an exchange ratio that results in a high value for the target relative to the target's most recent trading price. It also highlights the strategic importance of the dissent rights closing condition. Should it be difficult to predict the trading price and liquidity of the combined company, the likelihood that shareholders will prefer to dissent and receive cash at the deal price rather than receive the share consideration may increase.
• In finding that the sale process was more like an auction than a merger of equals, the Court put weight on the Target's right in the Arrangement agreement to accept a subsequent "superior proposal". However, such a clause is omnipresent in arrangement agreements in Canadian public M&A, including in a merger of equals, and reflects the need of a target's directors to comply with their fiduciary duties should a superior proposal be made. It is also noteworthy that the Court did not meaningfully address the evidentiary weight to be given to the competing (and much lower) offer of US$0.40 received by the Target.
• The Court's treatment of the Fairness Opinions is unclear. On the one hand, the Court repeatedly refers to them, and the "valuation work" it identified in them. On the other hand, the Court acknowledged that both Fairness Opinions included customary disclaimers expressly stating that they did not include any formal valuation or appraisal of the Target, and should not be construed as such. One interpretation is that the Court viewed the Fairness Opinions, which were based on the deal price, as further evidence the parties believed the deal price reflected fair value.
• The dispute was somewhat unusual. The most common scenario in appraisal proceedings in public M&A involves the dissenting shareholders claiming that fair value is more than the deal price. In this case, the dissenting shareholders were arguing for the deal price, and the Target was arguing fair value was far below the deal price. This presented an immediate challenge for the Target. In any event, market participants may find comfort in the ruling: regardless of the unusual circumstances, deal price once again drove fair value in a dissent proceeding.

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