Shareholder and partner disputes may arise for a myriad of reasons, from a falling out between practicing physicians over compensation to the breakup of a company subsequent to the admission of fraud by a controlling owner. In most cases, the valuation process and methodology for these types of engagements is similar to those employed in other matters. However, there are a handful of nuances specific to shareholder disputes of which counsel and experts for the parties involved must be cognizant. One such nuance involves the appropriate standard of value to be applied in deriving the value of the business interest at issue.
Shareholder and partner disputes fall into three categories, namely dissenting shareholder actions, minority oppression actions, and “other” matters (e.g., transactions in company stock).
Dissenting shareholder matters relate to the “appraisal rights” provided to minority shareholders that allows them the opportunity to dissent from extraordinary corporate actions that will adversely impact their interests. Appraisal rights, which are governed by state statutes and case law, are triggered by various actions, including a merger, sale of assets, or exchange of shares, to which a minority shareholder objects. A shareholder must “perfect” their appraisal rights by following a series of predetermined steps before they are allowed the remedy for said action, which is generally the fair value of their shares.
Minority oppression actions are founded in corporate dissolution statues. These statutes allow minority shareholders who have been “oppressed” to file for judicial dissolution of a corporation and cover acts by majority shareholders or directors of a company that are considered illegal, fraudulent, or oppressive, or serve to waste or misapply the assets of the corporation. Many states have adopted statutory provisions which allow for the buy-out of a minority shareholder’s interest at fair value as a remedy for oppression, in addition to the standard remedy of judicial dissolution of the corporation at issue.
A valuation may also be required in a variety of other disputes amongst shareholders or partners, including the terms of a buy-sell or operating agreement or transactions involving new or departing shareholders or partners. These matters are often guided by the agreements or other documents controlling the relationship amongst the owners of a business.
Standard of Value in Shareholder Matters
Valuation theory generally recognizes three standards of value applicable in the valuation of an interest in a closely held business, including fair market value, investment value, and fair value. The appropriate standard of value in shareholder matters is generally driven by statutes and case law in the jurisdiction where the matter is filed. As discussed below, the most widely applied standard of value in shareholder and partner disputes is fair value, although it may not always be clearly defined.
The foundation for much of the state law surrounding the definition of fair value in these matters is the Revised Model Business Corporation Act (“RMBCA”). The RMBCA was issued by The Committee on Corporate Laws of the American Bar Association Section of Business Law in 1950 and has been revised several times since and most recently in 1984. The 1984 RMBCA defined fair value as:
The value of the shares immediately before the effectuation of the corporate action to which the shareholder objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.1
Of particular interest in the above definition is the lack of any explicit mention of shareholder level valuation discounts, that is, discounts for lack of control and lack of marketability. However, in 1999, the provision of the RMBCA was revised to read as follows:
The value of the corporation’s shares determined immediately before the effectuation of the corporate action to which the shareholder objects using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal without discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to section 13.02(a)(5).2
As stated above, fair value is similar to fair market value without the consideration of valuation discounts.3 However, while the 1999 amendments to the RMBCA clarify the definition of fair value (specifically, the inapplicability of valuation discounts in shareholder disputes), few states have adopted these amendments. Rather, the statutes for many states have language similar to that found in the 1984 RMBCA. Thus, the issue of whether or not to apply discounts may not be clear cut in many jurisdictions.
Fair Value is Not Fair Market Value
When the definition of fair value is not clearly defined, parties may turn to relevant case law for guidance. Given its meaningful history with shareholder matters, Delaware case law is often cited in texts covering the application of shareholder level discounts in a fair value context. Opinions in three cases, Tri-Continental Corp. v. Battye,4 Cavalier Oil Corp. v. Harnett,5 and Swope v. Siegel-Robert, Inc.,6 shed further light on the subject. In Tri-Continental, the Supreme Court of Delaware held that “the stockholder is entitled to be paid for that which has been taken from him, viz., his proportionate interest in a going concern.” Further, in Cavalier Oil, the Supreme Court rejected the use of a minority or marketability discount, stating “the appraisal process is not intended to reconstruct a pro forma sale but to assume that the shareholder was willing to maintain his investment position,” and that failing “to accord a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholder.” Finally, in Swope, the Eight Circuit held that, “the marketability discount is incompatible with the purpose of the appraisal right, which provides the dissenting shareholder with a forum for recapturing their complete investment in the corporation,” and that “the application of a minority discount undermines the purpose of a fair value appraisal statute by penalizing minority shareholders for their lack of control and encouraging majority shareholders to take advantage of their power.” These sentiments, which are echoed in various opinions issued by the Delaware courts, suggest that the fair value standard is similar to the fair market value standard without application of valuation discounts (i.e., the pro-rata value of a shareholder’s interest in a company).
Similarly, in Pueblo Bancorporation v. Lindoe, Inc.,7 the Colorado court surveyed the interpretation of fair value provided by courts and others throughout the nation, while also examining the purpose underlying related dissenters’ rights statutes. The court ultimately concluded “that ‘fair value’ is not synonymous with ‘fair market value,’” rather, “the proper interpretation of fair value is the shareholder’s proportionate ownership interest in the value of the corporation, without discounting for lack of marketability.” The court further stated that, “in a dissenters’ rights action, the dissenting shareholder is not in the same position as a willing seller on the open market – he is an unwilling seller with little or no bargaining power.” Moreover, after conducting a review of law in various other jurisdictions, the court indicated that “the interpretation of fair value which we adopt today is the clear majority view,” and that “[t]his view is consistent with the underlying purpose of the dissenters’ rights statute and the strong national trend against applying discounts.”
Other Standards of Value
While most states recognize fair value as the applicable standard of value in appraisal or oppression actions, certain jurisdictions do vary from this standard. One such jurisdiction is Ohio, which calls for the application a ‘fair cash value’ standard in appraisal rights matters. As defined in Ohio’s statute, fair cash value is “the amount that a willing seller who is under no compulsion to sell would be willing to accept and that a willing buyer who is under no compulsion to purchase would be willing to pay, but in no event shall the fair cash value of a share exceed the amount specified in the demand of the particular shareholder.”8 This language is similar to the commonly held definition of fair market value.
The above was supported in English v. Artromick International, Inc., whereby the Ohio court held that, “‘any factor which a reasonable [person] would take into consideration in determining value’ is relevant to the fair cash value,” and “the fact that a stock is a minority interest is a factor that a reasonable person would consider in determining the value of the stock.”9 In affirming the trial court’s consideration of both a discount for lack of control and a discount for lack of marketability in the valuation of a minority interest in the company, the court further held that, “The concept of ‘Fair Value’ is far different from the ‘fair cash value’ concept.”
The Concept of Fairness
In the absence of definitive statutes or relevant case law, parties may also argue the concept of fairness, specifically absolute versus relative fairness. Absolute fairness relates to whether the consideration received was adequate relative to the value of the interest that was given up. This concept, which is typically argued by the “buyer” in a dispute (i.e., the controlling interest holder(s)), suggests that were a minority interest holder to sell his shares in the market, he would likely receive a value less than the pro-rata value of his interest in the company due to the lack of control and marketability inherent in said interest. The buyer would further argue that the dissenting shareholders would be unjustly enriched were they to receive the equivalent of a controlling-interest level of value for their minority interest in a privately-held company.
Alternatively, relative fairness contemplates whether the consideration received was fair in comparison to what other stockholders received. This concept, typically argued by the “seller” in a dispute, suggests that the remaining shareholders would be unjustly enriched if they paid anything less than the pro-rata value for the seller’s interest.
Shareholder and partner disputes can arise for a variety of reasons. Parties to these disputes should be cognizant of the nuances that may be involved in the valuation of interests in closely held businesses in such matters, including the appropriate standard of value to be applied. Moreover, careful consideration should be given to the statutes and case law in the relevant jurisdiction when determining whether or not valuation discounts are applicable in valuing the business interest at issue. Professionals should also be aware that interpretation of the appropriate standard of value in these matters is a legal issue which will be argued by counsel according to relevant statutes and case law and ultimately decided by the Trier of Fact.
1 Model Business Corporation Act § 13.01(3)(ABA 1984).
2 Model Business Corporation Act § 13.01(4)(ABA 1999).
3 A commonly held definition of fair market value is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.
4 Tri-Continental Corp. v. Battye, 74 A.2d 71 (Del. 1950).
5 Cavalier Oil Corp. v. Harnett, 564 A.2d 1137 (Del. 1989).
6 Swope v. Siegel-Robert, Inc., 243 F.3d 486, 492 (8th Cir. 2001).
7 Pueblo Bancorporation v. Lindoe, Inc., 63 P.3d 353 (Colo. 2003).
8 Oh. St. § 1701.85.
10 English v. Artromick International, Inc., 2000 Ohio App. LEXIS 3580 (Ohio Ct. App. Aug. 10, 2000)