This article was originally published by Law360 on January 27, 2022, and is reproduced below in full with permission.

The North Carolina Supreme Court recently concluded that shareholders dissenting from Reynolds American Inc.'s 2017 merger with British American Tobacco were not entitled to more consideration than the deal price — even in a conflicted-party transaction where the acquirer already owns a significant stake in the target corporation and publicly announces its opposition to consideration of alternative transactions.

The Dec. 17, 2021, Reynolds American Inc. v. Third Motion Equities Master Fund Ltd. decision has important implications for future corporate acquisitions in states, like North Carolina, that have adopted the Model Business Corporation Act.

Despite BAT's near-majority ownership of Reynolds American and its refusal to consider other transactions, the court affirmed the state business court's reliance on deal price as evidence of fair value because the parties used a "robust deal process," according to the decision.

In addition, the court held that a trial court is not required to give weight to a discounted cash flow analysis over other methods and that dissenting minority shareholders are not entitled to a pro rata share of the acquiring shareholder's control premium without the introduction of specific evidence to prove that their shares traded with a minority discount.

Background of the Merger and Appraisal Action

BAT had owned 42% of Reynolds American and controlled several seats on its board of directors since 2004, when BAT merged its subsidiary Brown & Williamson with R.J. Reynolds to form Reynolds American.

Both BAT and Reynolds American were publicly traded corporations. In 2017, after BAT's 10-year standstill agreement had expired, BAT offered to buy the remaining shares of Reynolds American in a long-anticipated merger.

BAT publicly announced its opposition to alternative transactions during negotiations, and it prevented Reynolds American from conducting a formal market check.

After months of negotiations between BAT and a committee of Reynolds American's independent directors, BAT agreed to pay 0.5260 shares of its stock plus $29.44 in cash for each share of Reynolds American, or approximately $59.64 per share, which represented a 26.4% premium over the unaffected stock price.

By closing, the value of the consideration had risen to $65.87 per share due to an increase in BAT's stock price. Reynolds American's shareholders cast votes for an overwhelming majority of the outstanding shares in favor of the merger, including 99% of the non-BAT shares voted. A group of dissenting shareholders sought appraisal, arguing that the fair value of their shares was between $81.21 and $94.33 per share.

After a lengthy trial, the North Carolina Business Court held that the fair value of the dissenting shareholders' shares was less than or equal to the deal price and that no additional payment was required.

Like many other states that have adopted the MBCA, North Carolina's appraisal statute — North Carolina General Statues Section 55-13-01(5) — requires a trial court to determine the fair value of the dissenters' shares "using customary and current valuation concepts and techniques."

Reynolds American's dissenting shareholders had characterized the trial court's decision as one that deferred to the deal price as conclusively establishing fair value, without using any other valuation techniques required by the statute.

The court disagreed, however, holding that the trial court had relied on valuation analyses that took into account, among other things, Reynolds American's competitive positioning, its relationship with BAT, the industry's regulatory outlook, a share-price analysis, commentary from research analysts, valuations produced during the deal process, comparable transactions, and an analysis of a comparable company.

The court thus concluded that the trial court had appropriately considered the transaction's deal price as only evidence of fair value, particularly when informed by the other analyses.

Against this backdrop, the court analyzed the necessity of:

• Conducting a market check;
• Using a discounted cash flow analysis, or DCF; and
• Awarding the dissenting shareholders a pro rata share of BAT's control premium.

Relying on Deal Price as Evidence of Fair Value Without a Market Check

In recent years, courts have relied on deal price as evidence of fair value, particularly when the negotiation process included a formal market check. Market checks ensure that the deal price agreed to actually represents fair value for shareholders.

Acquisitions involving controlling or significant minority shareholders, such as BAT in this situation, often proceed without a formal market check, however, given that shareholder's opposition to alternative transactions. That can create an issue for a target corporation and its directors.

Reynolds provides some helpful guidance to those target corporations and their directors, however. It confirms that deal price is considered evidence of fair value, even without a formal market check, so long as there are other indicia of reliability.

The court pointed to the aggressive negotiating by Reynolds American's committee of independent directors "who twice rejected BAT's merger offers without countering and seriously considered strategic alternatives to a merger with BAT," and observations from external observers about the fairness of the transaction.

Those indicia, in addition to the five factors below, can render a formal market check unnecessary under the appropriate circumstances:

• Arm's-length negotiations; 
• Board deliberations without any conflicts of interest;
• Buyer due diligence and review of confidential information concerning the target's value;
• The target's extraction of multiple price increases; and
• The absence of post-signing bidders.

In particular, Reynolds highlights the importance of a strong committee of independent directors during a deal process when a corporation negotiates a transaction with one of its significant or controlling shareholders.

DCF as a Customary and Current Valuation Concept and Technique

The court also held that a DCF analysis was not necessary to establish fair value under the state's appraisal statute.

North Carolina General Statues Section 55-13-01(5), like those of many other MBCA states, requires an appraisal court to use "customary and current valuation concepts and techniques." But while DCF analyses are a universally accepted valuation technique, the court held that a DCF analysis is not required under the statute, so long as other customary and current valuation concepts and techniques are used to calculate fair value.

Only the dissenting shareholders offered a DCF analysis in Reynolds, and their expert's DCF model implied that Reynolds American's shares were mispriced by $50 billion. The significant flaw with the dissenters' DCF model, according to the North Carolina courts, was its use of a "set of internal [Reynolds American] projections showing steady short-term growth continuing consistently for ten years."

That use of an elevated perpetuity growth rate ignored evidence that the 10-year projections were not probability weighted and that the PGR disregarded certain sensitivities to Reynolds American's tobacco businesses.

The court specifically noted that "the results of a DCF analysis are extremely sensitive to minor variations in the value of a single input [here, the PGR]" and that that fact "may itself be reason to doubt" the results of a DCF analysis.

Awarding a Pro Rata Share of a Control Premium

The dissenters also argued that a court must award dissenting shareholders a pro rata share of BAT's control premium. The court held that there was no evidence of BAT's having acquired a control premium or that the dissenters' publicly traded shares had an implicit minority discount, but it surveyed recent decisions and academic literature and noted that a court must review the record in each case to determine whether a particular valuation method includes a minority discount.

While the Business Court had categorically rejected minority discounts for publicly traded shares, the Supreme Court was unwilling to adopt a categorical rule. The dissenters here, it held, failed to offer proof of the existence and size of any minority discount for Reynolds American's shares.

Conclusion

Reynolds was the first public-company appraisal case tried in North Carolina, but it has important implications for corporations considering transactions in other states that have adopted the MBCA.

Specifically, the decision highlights the latitude afforded to trial courts during an appraisal proceeding when determining fair value.

Reynolds does not mark the end of market checks or DCF analyses. Both approaches can be helpful in appropriate circumstances to establish fair value. But, as Reynolds shows, those analyses are not always probative for establishing fair value, even when a significant minority or controlling shareholder is the acquiror.

When the parties to a merger or acquisition put in place a robust deal process, supervised by a committee of independent directors, courts are likely to defer to their judgment, particularly for transactions involving public companies.

After all, Reynolds American's transaction committee provided a concrete benefit to the company's shareholders here by negotiating billions of additional dollars in consideration for the company's shareholders. That is a fact that most courts will find hard to ignore

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