RKS thanks Daniel Kalansky, Partner at Loria e Kalansky Advogados and Professor in the LLM program at Insper University for this guest post.  Professor Kalansky holds a PHD in Corporate Law from the University of São Paulo – USP and is the Former president of the Brazilian Institute of Business Law – IBRADEMP.   To contact the author: dkalansky@lklaw.com.br

*** RKS does not practice in the Federative Republic of Brazil and takes no position on Brazilian law or changes to it. ***


Appraisal Rights and Fair Value as Investor Protection: A Needed Brazilian Reform

It was in Professor Joshua Mitts’ class, based on his article “Asking the right question: The Statutory Right of Appraisal and Efficient Markets”, co-authored with Professor Jonathan Macey, that made me reflect on the share value for appraisal rights in Brazilian law and subsequently formed the basis of my thesis to achieve my PHD in Brazil, which later was published as a book prefaced by Judge Karen Valihura of the Supreme Court of Delaware.

My thesis focuses on the following questions: what would be the best valuation method to determine the value of the shares of a company in an appraisal process? Should a mandatory legal criterion be predetermined, or should the law allow for the corporation itself determine such criteria in the bylaws? Is calculating the reimbursement model adopted in Brazilian legislation the most adequate to produce the desired effects of the appraisal rights in publicly held corporations?

The current Brazilian Corporation Law (Law nº 6.404 of 1976) sets book value as the standard method to define the share value, even in the case of a listed company. Companies may adopt a different approach in their corporate by-laws; however, few have done so. This method does not reflect the company’s inherent value, which results in shareholder’s not being offered a fair value.

Appraisal rights are unlikely to be effective in Brazil, since the valuation criterion used, the book value (in the omission of the bylaws), does not consider the goodwill, or the profitability of the company, and, consequently, produce smaller measures of fair value. Thus, the disparity in the application of such is evident because: (i) the impact on the company’s management is minimal, since the chances of a shareholder requesting appraisal rights are small; (ii) the minority shareholder is provided with the misconception of choice between staying in the company and enduring an ownership environment that could potentially be non-beneficial to them or leave and receive only a fraction of the value of what the investment represents; (iii) the company provides for reimbursement at a value well below that of the market and, from this perspective, retains unjust enrichment.

In Brazil, appraisal rights do not effectively manage to boost investor protection, because the valuation method leaves most of the company value out of the equation, since the valuation method provided for in the Law, whenever the bylaws do not provide for one, is the book value of the company, regardless of any particularities of the company.

In the State of Delaware, United States of America, Section §262 of the Delaware General Corporations Law, dissenting shareholders shall receive the fair value of their shares. This means that, for each case, the Court must seek the best method for meeting the company’s fair value. In Italy, the reimbursement must be calculated using the six-month running average of closing prices on the stock exchange, for listed companies.

Considering such a theoretical framework used in Unites States of America or in Italy, it is evident to observe flaws in the Brazilian Corporation Law, which regulates appraisal right in Brazil. It is fair to conclude that, when the law determines that the appraisal right must be calculated according to the book value, the value for the shares would be below fair value, as the law would stipulate that the shareholder buy the shares based on profitability however receive the company’s book value when requesting appraisal rights.

The setting of an appraisal right amount in the bylaws is at the company’s discretion; the Brazilian Corporation Law does not require companies to provide for this, but they are allowed to, if they wish to do so.

However, based on the assumption that almost all listed companies do not adopt an assessment criterion in their bylaws, the appraisal rights operating scenario is not practical to provide adequate protection to the minority shareholder, in view of the prevailing notion that, in the absence of not being listed in the bylaws, book value is applied.

This results in the minority shareholder being left with an illusion of choice between leaving the company and receiving reimbursement or remaining and accepting the new shareholder environment. This is a choice between suffering the decision they disagree with or paying to leave the company.

Thus, the Brazilian Corporation Law should take it upon itself to determine the calculation of the value of the shares for the purpose of reimbursement, expressly establishing the valuation criteria, and not leaving this to the freedom of varied interested parties.

In my opinion there are rights that should not be bargained against contractual freedom, that is, they should be non-negotiable and exposed to pricing, as they represent “public order laws” that cannot be waived by the will of the parties.

Appraisal rights are a legal remedy to protect the minority shareholder against the decision-making power of the controlling shareholders. The current wording of the appraisal right calculation allows for parties to choose the calculation criterion for a right that is essential, whose function should be to “cure” a problem.

It is safe to conclude that the reimbursement value should be provided for as public law and be non-negotiable. It is also understood that the criterion adopted by Section 45 of the Brazilian Corporation Law obscures the intention of the law. While creating a necessary right, it allows for compensation to be minimal. In this scenario, the dissenting shareholder is unlikely to be effectively reimbursed for his investment.

If the amount the shareholder will receive does not result in a material difference to the company, the right will be considered virtually useless, who “wins, however does not gain the spoils”. Thus, it is unacceptable, for the legislator to grant an ineffective right.

However, despite this legislative drama, one case judged by the Brazilian Superior Court of Justice, contrary to the prevailing doctrine, understood that, in the case of omission of the bylaws, the criterion of book value should not be applied, as the value calculated for the appraisal right harmed the minority shareholder. (BRASIL. STJ. RE No. 1.572.648).

It can be said that the Superior Court introduced the use of the “fair value” thesis in Brazil. The existence of this decision confirms the premise that the Brazilian Corporation Law is controversial in relation to the valuation method in the absence of the bylaws and that there is room for interpretation of what price effectively corresponds to the share value mentioned in the caput of art. 45 of the Brazilian Corporation Law.

My conclusion was that an amendment in our Brazilian Corporation Law is required to establish the fair value as a mandatory rule to obtain the payment for the dissenting shareholder to protect the minority shareholders and foster the capital market.

Stewart Investors, an asset manager focused on emerging markets equity, reaffirmed its policy of voting in favor of appraisal rights in its most recent proxy guidelines.  Keeping it simple, Stewart wrote it would “Vote for proposals to restore, or provide shareholders with, rights of appraisal.”

This is consistent with its prior proxy guidance, which we covered here.

For US readers, the idea of voting in favor of appraisal rights may not entirely track – appraisal rights are (generally) set by state law.  But this ignores two salient details. First, even in the US, appraisal rights are sometimes a matter of shareholder vote – especially in LLC or alternative corporate firm scenarios.  Second, appraisal rights, especially in non-US jurisdictions, can be a creature of contract and shareholder proposal.

The near unanimity of investors in voting in favor of appraisal rights speaks to the reality that appraisal rights are pro-investor.

Boston Partners Logo

Boston Partners, a specialized equity investor with nearly $75 billion under management, says to vote for appraisal rights as part of its proxy guidelines.  This is no surprise as appraisal rights are critical shareholder rights, especially in instances of unfair mergers or management’s actions that undervalue the company.

Boston Partners’ proxy guidelines join those of major proxy advisory firm ISS and many others in guiding votes in favor of appraisal.

The State of Michigan Retirement System Proxy Voting Guidelines are straightforwardly “for” on appraisal, writing:

“Appraisal rights are intended to help protect shareholders from unfair pricing in corporate transactions. The SMRS will vote for proposals that (i) provide shareholders with appraisal rights, (ii) restore rights of appraisal, or (iii) which otherwise support rights of appraisal.”

Voting in favor of appraisal, a right that, as SMRS recognizes, helps protect shareholders from unfairness, is a common theme among proxy guidelines.

Major proxy advisory firm Institutional Shareholder Services (ISS) issues guidance every year for investors laying out ISS’ recommendations for voting on various shareholder issues.  The 2022 US voting guidelines recommend voting in favor of appraisal rights when such rights are on the ballot.  This is in line with the 2021 guidelines (which we covered).  Continued support of appraisal rights is unsurprising as appraisal rights remain critical shareholder rights and can provide immense value to shareholders in varied situations, including as a check on minority shareholder oppression.

New York City Bar

Rolnick Kramer Sadighi is sponsoring a panel alongside the New York City Bar Association’s Foreign & Comparative Law Committee on appraisal rights across jurisdictions, including practical differences between jurisdictions in the use and effectiveness of the appraisal remedy. Appraisal experts in Cayman Rocco Cecere, South African Adam Pike of Pike | Law and European Union (as well as EU states) appraisal rights Dr. Alexandros L. Seretakis will join RKS partner Steven Hecht, a seasoned United States appraisal rights trial lawyer, on a panel moderated by RKS’ Anna Menkova.

Register here!

MJBizCon2021 was as explosive as the cannabis industry itself.  The range of programs, volume of exhibits and sheer number of attendees, despite the continuing impact of the pandemic, reflected the vibrant and fast-growing cannabis space itself.

Cannabis valuation continues to take center stage in any discussion about the operational, financial or regulatory aspects of the industry.

Among the several take-aways from this conference, the prospect of federal legalization is not necessarily accretive for all cannabis valuations; it’s not as simple as concluding that national legalization is good for the space in an absolute sense, or that the status quo is bad for cannabis values.  Indeed, national legalization is not a binary equation that translates to unqualified benefit for the industry, as the analysis is multifactorial and far more nuanced.  A fully vertically-integrated MSO in Maine, for instance, will likely face exponentially higher transportation and cultivation costs if its growing operations were relocated to a more hospitable, year-round fertile climate such as California or New Mexico, and yet federal legalization may well compel that operator to so move its flower to the US Southwest to remain competitive.  In addition, even highly scaled, successful MSOs currently operating in more than one state or region may face stiffer competition and existential threats from the legacy tobacco oligarchs if national legalization were to allow those bystanders, currently sidelined, to enter – and threaten to take over outright – the cannabis market.  These considerations are just some of the factors underscoring the vagaries of any highly regulated industry, where growth prospects and assumptions about future value must reasonably capture the anticipated trends in business as well as the political arena.

Whether a dispute arises over the valuation of an entire MSO, one of its acquisition targets, its retail dispensaries or any other key assets, an operator needs to be well armed with every valuation tool and weapon available.  MJBizCon helped demonstrate, once again, that such a valuation exercise demands a seasoned blend of art as much as science, and that the unique facts and circumstances of any asset or enterprise must be fully taken into account before applying the relevant valuation metrics.

[RKS Partner Steve Hecht is currently at MJBizCon, the largest Cannabis business conference in the US.]

The diversity of businesses and business lines here at MJBizCon is one of the first things that hits you.  While cannabis itself is sometimes thought of as either an agricultural business or a retail business, the reality is it’s both and much more.  Here exhibitors ranging from agricultural machinery to varied service providers in the accounting, law, insurance and consulting space sit side by side.  What’s particularly notable is that basically every one of these businesses – those directly in the cannabis space and those serving them – sit within a regulatory grey area.  That grey area, reflecting classic federalism at its core, appears to underlie how every business here does its work.  Issues of interstate commerce (usually the stuff of law school exams) are not hypothetical but a very real, day-to-day phenomenon for these businesses.

Additionally, the energy at the convention speaks to a growing market and one that is seeing horizontal and vertical expansion.  It’s worth noting that valuation issues are front and center for the investors and business people we have met so far.

Further updates tomorrow.

See the source image

Sports teams often prize the benefits of home-field advantage, but when it comes to valuing a cannabis multi-state operator, playing in your home court does not necessarily result in the highest valuation.  As we have posted about before, different states take vastly different approaches to valuation litigation, resulting in the same MSO potentially having a significantly different valuation depending on where that litigation is brought.  Among other things, to the extent that different states select a different point in time for the valuation exercise is alone often outcome-determinative of the resulting value.  Thus, for instance, Delaware law requires the court to determine the company’s fair value as of the date that the merger closes, while California law directs a court to figure out what the fair value was immediately prior to the announcement of the merger.  In addition, the degree to which different states recognize the so-called market-out exception leads to variable availability of appraisal rights where the target company’s stock trades in a highly liquid market: states such as Arizona adopting the market-out exception to preclude appraisal of targets whose stock trades on large, liquid stock exchanges, while states such as Massachusetts have not adopted the market-out exception (although appraisal in that jurisdiction is limited to transactions presenting potential conflicts of interest).  Delaware’s appraisal statute bears the unique feature of having incorporated the market-out exception, while also yet allowing appraisal for M&A transactions where the merger price is paid in whole or in part in cash.  And focusing on these variations across the United States does not even take into account the unique attributes of Canadian appraisal, a totally different animal with a different federal/state interplay altogether.

A company in any space may wind up with substantially divergent values depending on the jurisdiction hearing its valuation litigation, but the inherent vagaries of cannabis valuations only magnify the already significant differences that valuation disputes may experience across different jurisdictions.

What is the IRS 280E Tax Code and Why is It Killing the Marijuana Industry  Right Now?

Players in the cannabis space already understand that federal tax law as currently structured extracts a far greater tax bite from marijuana businesses than corresponding companies, as cannabis companies are prohibited from deducting their business expenses from gross income.  Of course, with U.S. cannabis sales expected to grow by nearly 2.5x from 2018 to 2025, the excessive tax liability still leaves lots of room for cannabis companies to experience outsized profits.  Clearly, navigating the perils of the tax code is a critical step in any cannabis valuation.

Internal Revenue Code Section 280E

Because marijuana is classified as a Schedule I controlled substance under the Controlled Substances Act, the production, distribution and possession of cannabis is illegal, even where marijuana is legal under state law.  As a result, Section 280E prevents taxpayers from taking any tax deductions or claiming tax credits attributable to marijuana businesses.

This short overview by the Congressional Research Service, The Application of Internal Revenue Code Section 280E to Marijuana Businesses: Selected Legal Issues, frames the issue well: “Under federal law, all income is taxable, including income from unlawful activities.  In contrast, not all expenses are deductible from a taxpayer’s gross income.”  Consequently, given this imbalance in the tax code, all cannabis businesses, “from farmers and processors to distributors and retailers, are prohibited from writing off many of their day-to-day expenses and overhead costs, such as rent, utilities, compensation, costs of administration, and charitable gifts to promote goodwill.”  In limited cases the tax courts have shown some leniency to multiple-service facilities, allowing the deduction of expenses for that aspect of a community center that provided caregiving services for sick members, while prohibiting the deduction of expenses incurred by that community center in dispensing medicinal marijuana.  But wherever multiple activities within a single enterprise “share a close and inseparable organizational and economic relationship,” the tax court will not find the operation of more than one trade or businesses, precluding that business from taking deductions.  Likewise, Section 280E prohibits deductions even for unrelated activities if they are “ancillary” to the cannabis business.  While a marijuana company can reduce its gross receipts by the cost of goods sold, no deductions that reduce gross income are permitted.

Legislative Proposals to Limit or Eliminate Section 280E

The CRA compiled an array of legislative proposals that would render Section 280E inapplicable to cannabis businesses by recasting marijuana as a Schedule III controlled substance, or by entirely de-scheduling it altogether.  Short of making cannabis federally legal, other legislative efforts have sought to create an exception to Section 280E for marijuana companies operating legally under state law.  There are a number of proposals under consideration and the legislative landscape is far from settled.

So what does all this mean for cannabis valuation?  Under current conditions, marijuana companies owe outsized federal tax liabilities given their inability to deduce expenses.  While it is beyond the scope of this post to analyze the extent to which the IRS has actually been enforcing these laws and pursuing cannabis companies for taking improper deductions, any appraisal of marijuana companies and their assets must take into account the lack of deductions under current US tax law.  This factor alone doesn’t necessarily sink cannabis valuations – cannabis sales in the U.S. are expected to reach $25 billion by 2025 according to the CRS report, well beyond the $11 billion in sales experienced in 2018 – nor does it fully take into account the extent to which a single cannabis operation can be divided up into multiple activities, permitting some or even most of the non-cannabis facets of the business to take deductions.  In any event, the tax environment surrounding any cannabis business poses a unique valuation exercise requiring creativity and a fresh set of eyes, one that is not readily solved with a one-size-fits-all formula.