IRS & Business Taxation of the Cannabis Industry

The valuation of companies in the ever-growing cannabis space has become an increasing area of focus within this valuation sphere.  Cannabis presents a highly unique valuation landscape given the regulatory environment, increasing popular acceptance of recreational as well as medical usage, and the expanding product mix as between flower, oils and edibles, and challenges and opportunities facing vertically integrated businesses trying to find the right balance as between their cultivation, lab & extraction, manufacturing and retail sectors.

As a reflection of this trendline, many traditional valuation, accounting and investment banking professionals have turned their attention to cannabis and the unique valuation analyses associate with it.  For example, FTI has prepared this white paper outlining valuation approaches to cannabis in this evolving market.

We’ll continue to cover cannabis valuation issues and how they are both similar, and very different, from traditional valuation debates.

 

Shareholder rights (at least in Delaware) include the right to inspect the books and records of the company for a “proper purpose”.  What is a proper purpose? We’ll be covering a number of cases in the coming months on this oft-contested issue.  For today: enter Woods Tr. of Avery L. Woods Tr. v. Sahara Enterprises, Inc., No. CV 2020-0153-JTL, 2020 WL 5200421, at *5 (Del. Ch. July 22, 2020), judgment entered sub nom. In re Woods v. Sahara Enterprises, Inc. (Del. Ch. 2020), reaffirming the proposition that the ascertainment of the value of a shareholders interest in a (here, private) company is a proper purpose.

In Woods, a trustee sought books and records from a private company in order to determine the value of the Trust’s interest in the company.   The company argued that a shareholder claiming a valuation purpose should be required to show not only a proper purpose for the investigation, but also a proper ‘end use’ for the resulting valuation.  In other words: was the trustee really seeking books and records to establish a valuation?

The Chancery Court dismissed this argument, writing “The Company’s position is contrary to Delaware law. It would require that a stockholder establish both a proper purpose (valuing shares) and an end use for the resulting valuation.” The Court continued: “It is sufficient under Delaware law that a stockholder has a proper purpose reasonabl[y] related to its interests as a stockholder, such as valuing its shares.” The Court refused to engage in the end use analysis as beyond Delaware law.

The Woods case contains additional analysis beyond the proper purpose analysis that we will cover in the future.

For investors, the scope of what is a proper purposes versus improper purpose is critical to determining their inspection rights.  One tentpole: valuation of an interest is generally a proper purpose.

AmerisourceBergen Corp. has asked the Delaware Supreme Court to reverse a Chancery Court ruling allowing shareholders the right to investigate the company’s books and records for corporate wrongdoing in connection with the opioid crisis.  Amerisource Bergen argued before the full five-member panel that Vice Chancellor Laster’s prior ruling went too far and invites harassment.

Books and records rights (also known as inspection rights or accounting rights) have a variety of proper uses and purposes for shareholders – here, the shareholders have sought books and records with respect to the Company’s compliance with opioid distribution controls, citing corporate wrongdoing as the relevant purpose.

For investors, one key issue in the case  is whether a shareholder seeking books and records must tell the company, up front, in effect ‘what they plan to do with the material’ – despite an inspection request being the start of an investigation rather than its terminus.

For more coverage on the Amerisource Bergen oral argument, check out the Law360 article [$$$] available here.

We will continue to cover inspection rights alongside other important rights available to investors, including appraisal rights, shareholder proposals and remedies for corporate misconduct.

The SEC has recently enacted rules that make it tougher for shareholders to submit ballot proposals.  As we previously blogged about, the rules now approved by the SEC by a 3-2 vote:  (1) increase the monetary amounts and length of investment required to submit shareholder proposals and (2) raise the threshold of shareholder support required to resubmit proposals previously voted down by shareholders.

In supporting the revised standards, SEC Commissioner Hester M. Peirce stated the changes “help to ensure that the shareholder-proponent’s interests are aligned with those of her fellow shareholders.”  However, opponents argue the new rules silence small investors with the monetary thresholds.

For larger investors, the more interesting (or perhaps, concerning) aspect is the change to resubmission thresholds – which now require that a proposal have received at least 5%, 15%, or 25% support, if voted on once, twice, or three times, respectively, in the past five years, or else the proposal will be barred from reconsideration for three years.  25% support is a significant increase from the prior threshold of 10%, as are the other thresholds, going from 3% to 5% and 6% to 15%, respectively.  This change may be relevant to activists as they build positions in companies and consider shareholder proposals.

We will continue to cover updates to shareholder proposals, as they are one of the important tools available to minority investors who seek to enforce corporate governance.

As our securities litigation practice group has spun off from our prior firm and formed our own new shop, we are excited to announce that The Appraisal Rights Litigation Blog we created years ago has now become the Valuation Litigation and Shareholder Rights Blog.  Along with the name change comes a new, broadened focus, consistent with our new firm’s goals.  This blog remains committed to bringing its readers informative, useful information about investor rights and valuation issues around the world, acting as a clearinghouse for information on court decisions, academic research, statutory changes, and providing a forum for guest authors to discuss investor rights and valuation issues from diverse fields and jurisdictions.

While our commitment to informative posts remains unwavering, a number of items have changes.  The new blog name reflects a broadened scope: appraisal litigation, at core, stands at the intersection of valuation disputes and shareholder rights.  With attorneys having more than 50 years of appraisal experience collectively, we have increasingly seen that appraisal issues are not confined solely to Delaware appraisal: appraisal decisions inform, and in turn are informed by, valuation decisions more generally.  Likewise, shareholder rights go well beyond appraisal, now often intersecting with shareholder inspection rights and other jurisprudence surrounding investor remedies.

Our broadened focus does not mean we will stop covering appraisal rights, indeed, appraisal rights remain a critical window both jurisprudentially and academically to operationalizing valuation issues and shareholder rights.  Instead, the blog will cover a broader swath of issues in valuation litigation and shareholder rights.  Regular readers may have already seen that the blog has covered shareholder inspection rights issues, voting rights issues, LLC issues, among others.  We intend to continue covering appraisal whenever we can, including significant decisions, research, statutory changes, or appraisal in non-US jurisdictions (eventually, aiming to have covered every country in the world), but that will be as part of an expanded look at valuation issues more broadly, including developments in fast-changing sectors, such as crypto, cannabis, and financial products.

Along with the change of name and focus is a change of firm.  We are thrilled to announce that this blog is brought to you by Rolnick Kramer Sadighi LLP, a premier securities litigation boutique focused on the investment management community.  All the founders and regular contributors of the previous Appraisal Rights Litigation blog have joined to form Rolnick Kramer Sadighi LLP, a firm built on the idea of partnering with clients to achieve exceptional results.   With the change in firm is also the ability to host more advanced content, including opinion and thought pieces in the areas of business valuation litigation and shareholder rights.

Finally, a new look.  Some changes to the look and feel of the blog have occurred as we have sought to modernize.  We fervently hope you will still find this a source of valuable information and useful insight.

~ The entire RKS Team

JPMorgan Asset Management released their 2020 proxy guidelines in April, and, like many other investors we have covered, the guidelines support appraisal rights. JPMorgan Asset Management’s guidelines even lay out the value of appraisal rights in a short sentence, providing:

G.  Appraisal Rights

Vote for proposals to restore, or provide shareholders with, rights of appraisal. Rights of appraisal provide shareholders who are not satisfied with the terms of certain corporate transactions the right to demand a judicial review in order to determine a fair value for their shares.

Does increased appraisal risk have an effect on manager behavior?  Recent research (unpublished) suggests it does.

In this paper (earlier version), the author examines target manager disclosure behavior before and after the significant Transkaryotic decision.  Reviewing mergers before and after that merger, the returns, abnormal returns, and associated disclosures by target management, the author concludes that “target managers’ disclosure strategies respond to increased appraisal risk.”  They find that “at-risk target managers significantly alter their disclosure behavior after the [Transkaryotic] ruling in that they strategically withhold good news to reduce the threat of appraisal during mergers.”  The author also documents and suggests that this “is driven by those target firms whose managers have future economic ties with the acquiring firm, and that acquirers benefit from these ties in the form of a lower likelihood of an appraisal lawsuit and higher post-merger returns after the ruling.”

In a reminder to all investors, the author suggests the importance of further work on target managers’ person incentives, considering the role that those incentives play in “determining the disclosure strategies of their firms during mergers and acquisitions.” Leaving the door open for much-needed research, the author suggest that further study could review whether and how “target CEO retention can assist acquirers in mitigating appraisal risk in Delaware mergers” and how “target CEO-acquirer ties might influence target firm disclosure strategies that benefit acquirers in other meaningful ways in the takeover market.”  Unsurprisingly, the benefits to acquirers often come in part in the form of lower deal premia and lower returns to shareholders.

This work continues the numerous pieces of research showing appraisal, and the exercise of a robust appraisal “check” is good for investors and for the market.

In April, the North Carolina Business Court issued a decision in an appraisal case stemming out of Reynolds American’s 2017 merger with British American Tobacco.  The court ultimately awarded deal price.  The Buyer was a 42% shareholder but did not control the Company.  The Seller conducted no auction or market check.  The Court ultimately deferred to the price negotiated by a Special Committee, citing certain decisions interpreting both North Carolina and Delaware law.  See the decision here.*

*RKS attorneys serve as counsel to dissenters in this matter.

Business Law Today previously posted this piece discussing key Delaware General Corporate Law differences between merger, conversions and domestications.  A sometimes forgotten reason for a merger or other major corporate action is to change the jurisdiction of incorporation and thus, usually, the regulatory or tax regime associated with it.  Mergers effectuated even for this purpose may carry appraisal rights if they trigger DGCL 262.  But a merger is not the only way of changing jurisdictions, as the article notes.  Conversions and domestications offer an alternative path to the same result.

And why no appraisal rights, even when such a change may be very significant and of interest to a minority shareholder?  Perhaps because, as we have covered before, the history of appraisal was an outgrowth of the death of unanimous consent provisions.  But conversions and domestications, under the DGCL still require unanimous stockholder consent – making an appraisal concept superfluous.

For completeness, its worth noting that this piece discusses the rights associated with Delaware law; an interested party would be advised to also check the law of the jurisdiction the company is entering (or leaving) if not Delaware.  As we’ve seen before, surprising appraisal rules remain in some places.

We previously wrote about the Interoil decision, where the Yukon Court of Appeal overturned a decision applying a discounted cash flow analysis to a Canadian appraisal proceeding, holding that the trial court failed to give proper consideration of merger price. Discussion of the Interoil decision has been significant among Canadian and international law firms, including pieces discussing: