Appraisal Remedy - Independence in Context

In the previous newsletter, I set out the purpose of the appraisal remedy, and how a dissident investor would engage the remedy, from a procedural point of view.

In this post, I will discuss how a company undertaking a fundamental transaction may prevent or avoid an adverse appraisal of the fair value of its shares.

Appraisal litigation arises out of the dispute between the company and dissidents regarding the value of the dissidents' shares the company is obliged to acquire, in terms of section 164 of the Companies Act.

In order to substantiate their claim for a higher price per share, dissidents will either rely upon or undermine opinions, information, reports or statements that have a bearing on the determination of the share price or value of the transacting company.

I will assume that the transacting company is regulated and that the transaction is affected, as contemplated in section 117 of the Companies Act.

The independent expert's opinion
 
In the case of a scheme of arrangement, the transacting parties will typically agree on the transaction consideration. The company is then required to appoint an independent expert, who will compile an opinion.

The purpose of the expert's opinion is to inform shareholders of inter alia the effects of the scheme, the material interests of directors, and the value of the securities affected by the transaction.

An independent subcommittee of the board is then required to assess the transaction, and consider and approve the expert's opinion. It does this in isolation from management's subjective and sentimental considerations which may impair the objectivity of the hypothetical director, discharging his duties in good faith, and with care, skill and diligence.
The expert's opinion and the subcommittee's report are included in the notice to shareholders convening the meeting, at which the transaction will be approved.

Independence
 
The standout features of the aforegoing is that the expert and the subcommittee must be independent. Independence is extensively defined in the Company Regulations.

By submitting the terms of the transaction to the scrutiny of the expert and the subcommittee, the shareholders are assured that the opinions and reports put to them are objective and free from management's interests.

In our experience, transacting companies fail to appreciate the nature, function and role of the subcommittee and the expert, and their need for independence. As a result, transacting companies expose themselves to appraisal remedy litigation and valuation disputes.

Independent expert, independent board?
 
In one particular matter, the expert rendered an opinion that was adverse to management's interests. The opinion was considered by the subcommittee, which rejected it. We discovered that two of the members of the subcommittee were directors of the companies operating subsidiaries. The third member was the chief financial officer. Clearly, the subcommittee was not at all "independent". As a consequence, its report regarding the expert's opinion was undermined.

In another matter, the expert retained by the disposing company had advised the acquiring company in a recent transaction. In that case, the expert failed to meet the test of independence provided for in the Companies Regulations.

The failure to observe the independence requirements may be detrimental to an otherwise beneficial transaction. Whilst the expert opinion on the subcommittee's report may be perfectly acceptable, its lack of independence may tarnish its otherwise good work.

As lawyers, we say that not only should justice be done, but also that it should be seen to be done. The same principle applies to the work of the expert and the subcommittee.

Ensuring independence, independent assurances
 
A perceived conflict of interest or lack of independence may undermine the probity of the expert's opinion, and call into question the company's reliance upon it.

The company should, therefore, take special care to ensure that the subcommittee is properly constituted, lawfully convened, quorate and that its powers and duties are exercised in good faith. Similarly, the company should ensure that the expert retained is indeed independent, as contemplated in the Company Regulations.

To insulate a transaction from an attack based on independence, a transacting company should do the following:
 
  • as soon as a fundamental transaction is proposed, the transacting company should immediately form a subcommittee of independent non-executive directors;
  • if there are insufficient independent non-executive directors on the board, the company should appoint them;
  • the terms of reference and the mandate of the subcommittee should be drawn up, finalised and made available to any shareholder requesting it;
  • the subcommittee's terms of reference should be such that it has powers to appoint its own independent expert to prepare the expert opinion;
  • the expert should not have advised any of the transacting parties within the previous two years;
  • the subcommittee should also ensure that it has the power to appoint independent legal and financial advisers to assist it in its deliberations; and
  • the meetings of the subcommittee should not be attended by management and should be meticulously minuted.
These steps may be costly and administratively burdensome. However, they would inoculate the expert's opinion and the subcommittees report from attack by dissidents.

In the next article, I will identify and discuss difficulties faced by dissident litigants, and propose solutions to mitigate and avoid them.