Uncertainty paves way for abuse of share appraisal remedy by wily investors

Section 164 of the Companies Act is a statutory mechanism designed to provide a dissenting shareholder with a remedy to exit a company if the majority of shareholders resolve to pursue a transaction the dissenting shareholder disagrees with. The provision prescribes an onerous process that ultimately allows the dissenting shareholder to demand that the company pay them fair value for all the shares they hold.

The appraisal remedy is not there for the mere asking. Section 164 is widely regarded as a “procedural morass” given the numerous peremptory hurdles that must be crossed in the prescribed manner and time periods to secure an offer of fair value. It is a procedural minefield that requires the utmost caution and circumspection.

Dissenting shareholders may apply to court to determine a fair value for their shares if the company has failed to make an offer, or if it has made an offer the shareholder considers inadequate and the offer has not lapsed. However, given that SA lacks specialised commercial courts or forums, the decision is often left to judges with little or insufficient commercial experience.

One of the major concerns about appraisal rights is that it may be subject to abuse by unscrupulous or opportunistic investors who chance their luck by approaching the court in the hope that the judge will accept and apply a valuation methodology that extracts profits in excess to the market value of the relevant shares.

This concern arises from the advent of appraisal arbitrage as a calculated hedge fund investment strategy, which is illustrated by the increase in appraisal rights litigation. The trend shows a growing awareness among opportunistic investors that section 164 can be misused to extract profits through appraisal rights litigation. The bottom line is that appraisal rights are open to abuse by the minority at the expense of the majority.

A simple example is an investor who acquires a minority share in a public investment holding company whose listed share price trades at a significant discount to its underlying net asset value. The shares of the company are tightly controlled, with a relatively low free float and an illiquid and inactive market.

Some time later the company issues a circular notifying its shareholders of an intention to adopt a resolution to pursue a course of action as envisaged in section 164(2). The investor, as a dissenting shareholder, objects to the intended resolution in terms of section 164(3) and successfully triggers the appraisal rights mechanisms in section 164(5) by demanding the company make an offer for the fair value of its shares.

The board applies the volume weighted average price (VWAP) of the issued share capital as a valuation method for a period of 90 days immediately preceding the resolution date to determine a fair value, and consequently makes an offer to the dissenting shareholder in terms of section 164 (11).

The dissenting shareholder then approaches the courts in terms of section 164 (14)(b) on the basis that the offer is inadequate. In his or her papers the dissenting shareholder secures the opinions of expert valuers motivating the use of net asset value (NAV) or sum of the parts (SOTP) methods of valuation, which place enormous value on the company’s underlying assets.

Obvious inequity

The dissenting shareholder’s postulation of a fair value based on NAV or SOTP results in a rand per share that is many multiples higher than the company’s VWAP method of valuation. It is also multiples higher than the company’s listed share price.

The inequity is obvious: the majority of shareholders can only sell their shares at the prevailing share price as traded on the JSE, whereas the dissenting shareholder not only extracts profit from an unrealised sale of the company’s assets, but is also a preferred creditor in respect of payment for the shares.

In many instances the company may not have the necessary cash reserves to pay the dissenting shareholder and would have to either make a rights issue or borrow funds at the company’s prevailing share price to pay out the dissenting shareholder at the much higher price per share. It may also adversely affect the company’s solvency, though section 164 does provide remedies to deal with a company’s inability to pay the fair value due to adverse liquidity issues.

The costs and delays caused by court processes may render the appraisal mechanism a costly and protracted affair with no end in sight. A motion procedure on affidavit may lead to the filing of additional affidavits or the referral to trial and oral evidence.

There are other types of abuse where a dissenting shareholder objects but then does not vote against the resolution, or votes but then does not make demand or accept the offer to secure a settlement or payoff.

How the courts should go about determining fair value in these circumstances remains an open question because the Companies Act of 2008 does not define “fair value”. There is also no other legislative guidance provided as to the meaning, application, or content of the term.

Nor are there are any provisions in the Companies Act of 2008 prescribing a specific basis of valuation, set of rules or criteria to determine fair value. The court may rely on the opinion of the dissenting shareholder, or it may appoint one or more appraisers to determine the value of the shares. Ultimately it is this lacuna and uncertainty that gives rise to an abuse of the appraisal remedy by wily investors.

Fortunately, the determination of a fair value for the shares of dissenting shareholder is not the courts’ first rodeo. There is a rich reef of case law arising from the Companies Act of 1926, the Companies Act of 1973, and most recently the Companies Act of 2008, in which our courts have opined on the relevant principles applicable to the determination of fair value of a dissenting shareholder’s shares.

The sentiment of our court has largely been that the onus of proof that the offer of a company is inadequate lies with the dissenting shareholder, which must do so on the production of tangible and credible evidence, and it must discharge its onus on a balance of probabilities.

Though each case falls to be determined on its own merits, the courts have generally rejected NAV as a method of valuation in these circumstances because it has inherent difficulties. This is because NAV:

• relies on outdated and depreciated book values that often bear little or no resemblance to the present value of the company’s assets;
• ignores market and economic and business cycles;
• ignores the skill and use of assets by the company’s management,
• does not incorporate the lower prices the assets will obtain in the ensuing fire sale;
• is more suitable for winding-up or liquidation rather than the valuation of companies operating as going concerns; and
• requires expert valuers familiar with the specific assets in question, which will increase the cost and time required to determine the fair value of the shares.

As opposed to definitions ascribed to “fair value” in the International Valuation Standards or International Financial Reporting Standards, “fair value” in the context of the 2008 Companies Act is a legal construct rather than a value set by the market. In other words, “fair value” is not a basis of valuation nor a method of valuation. The meaning of “fair value” must be interpreted according to the plain, ordinary meaning ascribed thereto.

Accordingly, the concept “fair value” in section 164 is outcome based, and must be understood to mean an offer that is fair, reasonable and equitable considering the interests of all role players concerned. It would therefore require a balancing of interests, namely the interests of the dissenting shareholder on the one hand and the interests of the company and majority shareholder on the other. There is no rule of universal application as to what is fair. The fairness envisaged is fairness to both sides.

This is markedly different to other legislation, such as section 46 of the Property Rates Act of 2004, which prescribes the basis of valuation as market value. It is also unlike the Expropriation Act of 1975, and the now repealed Property Valuation Ordinance (Cape), both of which prescribe two alternative bases of valuation.

It is for this reason that our courts and academic writers have warned that the determination of “fair value” is merely an estimation that cannot be done with “mathematical precision”. The court must merely determine “a fair value” and not “the fair value”. Accordingly, it is discretionary and based on a value judgment. It is more than an accounting exercise.

The courts are also not intended to be super-valuers. They are limited to logical deductions flowing from credible evidence presented by the parties and their experts. They may also not delegate responsibility to determine fair value to an expert, and must remain mindful of the fact that appointed experts may prolong the duration and increase the cost of legal proceedings.

In his review of Australian case law academic writer Richard Brockett distinguishes between valuation in a non-oppression context and valuation in an oppression context. The gist of the distinction appears to be that in the oppression context the court is vested with a broad and unrestricted discretion in making its determination to do what is fair in the circumstances.

Brockett also makes the point that it is becoming more common for Australian courts making judicial valuations to ignore or alter normal commercial valuation principles, and even to apply different rules depending on the circumstances of the case. He concludes that the broad discretion of the courts is in fact the only constant consistent principle of interpretation that can be gleaned from oppression judgments of the Australian and UK courts.

Ultimately, each case must be determined on its own merits. It is a value judgment based on the court’s discretion and ought to be based on the after general principles:

• Section 164 is a dissenting shareholder remedy. It is not a profitmaking remedy.
• The ultimate onus will lie with the dissenting shareholder to prove on a balance of probabilities that the company’s offer is inadequate.
• Fair value is outcome based and must result in a fair, equitable and reasonable value by balancing the interests of the company, the majority shareholders and dissenting shareholders.
• It is important to distinguish between public and private companies. A court will enjoy wide discretion if there is no access to a private company’s financial records and statements, whereas it will have narrow discretion with a public company whose financial information exists in the public domain and is easily accessible. Further, a public company’s quoted share price as traded on the JSE will always be the best available evidence of a market price a willing buyer will pay for the shares, acting at arm’s length and fully informed. A quoted share price acts as a real time reflection of value and factors in the company’s publicly available results, as well as the market's positive and negative sentiments. In other words, a quoted share price neither under nor overvalues a company’s shares.
• It is also important to distinguish between oppressive and non-oppressive conduct. A court’s discretion will be narrow where there is no oppressive conduct on the part of the company, whereas it would have a wider discretion for oppressive behaviour. That said, section 164 is not the appropriate remedy for minority shareholders raising complaints related to oppressive conduct, as the appropriate remedy would be to exhaust those provided in section 163 of the 2008 Companies Act.
• Valuation standards such as the International Valuation Standards seek to do no more than provide guidance to valuers to achieve a value. These standards are not prescriptive as to the choice of valuation methods, but in respect of various methods emphasise that market factors need to be considered to achieve the basis of value. 
• The dissenting shareholder and company should each produce at least two sets of valuation exercises as market checks for reasonableness and accuracy.
• A court must not place too much reliance on the (paid) opinions of experts, as it cannot abdicate its responsibilities to determine a fair value.
• Ultimately, the exercising of a dissenting shareholder’s appraisal right must be a cost-effective and efficient process, and the court must jealously guard against protracted and expensive delays in the litigation process. This will bring certainty to bear and ensure a balance of interests between the company and its shareholders.

• Pocock is an independent advocate practising at the Maisels Group of Advocates in Johannesburg. The contents of this article is provided for general information purposes only and does not constitute legal or other professional advice.