[Shareholder Oppression] Valuation of Minority Shares in an Oppression Case
Eric Fryar
Kaplan v. First Hartford Corp., --- F.Supp.2d ----, 2009 WL 737681 (D. Me. March 20, 2009) [Read Opinion]
This opinion states the findings of fact and conclusions of law of the United States District Court of the District of Maine regarding the valuation issues in a shareholder oppression case, the liability portion of which was analyzed here earlier. [See Case Analysis] Having determined that the minority shareholder had been oppressed and that buy-out was the appropriate remedy, the court proceeded to determine "fair value" pursuant to Maine's statutory oppression remedy. 13-C MRSA §1434. The Maine Law Court has not interpreted that particular provision, but it has interpreted the identical language in Maine's appraisal rights provisions (13-C MRSA §1301 et seq) available to dissenting shareholders. See In re Valuation of Common Stock of McLoon Oil Co., 565 A.2d 997 (Me.1989); In re Valuation of Common Stock of Libby, McNeill & Libby, 406 A.2d 54 (Me.1979).
Under Maine law, "[t]he question for the court becomes simple and direct: What is the best price a single buyer could reasonably be expected to pay for the firm as an entirety?" McLoon, 565 A .2d at 1004. The Maine Law Court instructs that there is to be no discount for minority shares, or for lack of marketability. Id. at 1003. The Law Court also has specified that the determination of value is not subject to "hard and fast rules." Libby, 406 A.2d at 60.
The company here, First Hartford Corporation, manages real estate development properties, primarily neighborhood or strip malls, through a number of subsidiaries. Although it is a publicly-held corporation, it is only thinly traded on the Pink Sheets, and the court held that it behaves much like a closely-held corporation. Although it has some similarities to a Real Estate Investment Trust (REIT), there are also many differences ( e.g., structure; tax status; requirements as to distributing profits; more focus on developing properties for sale). According to the District Court: "In a word, this is a difficult business to value."
At a bench trial on value, the court heard from three experts—one from the plaintiff and two from the defendants. Although the court's opinion is thoughtful and detailed, it does not really delve into the hard questions of the proper approach valuation—and perhaps this is entirely proper. As the court notes, a trial court does "not have a roving commission to make an ideal determination of First Hartford's fair value. Instead, I am bound by the record that the parties have presented me and the inadequacies it contains." The court also states that its opinion is not based on burden of proof in any way, and admits candidly, "I am not even sure what burden of proof would mean in this context: zero value until the plaintiff proves something higher?"
Maine case law constrains the federal court to determine value based on "the best price a single buyer could reasonably be expected to pay for the firm as an entirety." To that end, the plaintiff's expert, an experienced businessman in the same industry, relied primarily on a discounted cash flow analysis, which he calculated to yield a value of $48.3 million. He also did a net asset value, which yielded a $31.4 million value (to which he gave no weight), but he did not attempt any sort of market valuation. Defendant's first expert, an accomplished professional appraiser, did a weighted valuation based on three methodologies: asset-based valuation, income-based valuation, and market value. This expert's net asset valuation was $13.3 million, which was based primarily on third-party real estate appraisals, adjusted downward to deduct for capital gains taxes, transaction costs, and defeasance costs that she concluded would be incurred if a purchaser bought First Hartford's assets. The court acknowledged that there is case law support for subtracting such items. Bogosian v. Woloohojian, 158 F.3d 1, 6 (1st Cir.1998) (applying Rhode Island law). For the income approach, the defendants' first expert took the current reported net operating income and then added expenses for additional executive compensation (which she believed was currently below market) and debt service, thus yielding a value of $7.6 million. Finally, this expert calculated the market value based on Pink Sheet stock sales for First Hartford and comparisons of other publicly-traded similar companies, which yielded a value of $10 million. The expert weighted the three approaches and came up with a$9.3 million valuation. The defendants' other expert was a college professor who did a similar analysis but gave a much heavier weighting to the Pink Sheet sales, and arrived at a valuation of $9.8 million. It should be noted that both of the defendant's expert attempted both explicitly and implicitly to have their valuation numbers influenced by minority and marketability discounts, despite the clear law to the contrary.
The court had problems with all three of the experts. Because First Hartford is a real estate company and always has the ability to sell its some or all of its holdings, the court found that the net asset values to be the most significant factor in the reaching final value, and the court was particularly troubled by the defendants' first expert's analysis that the going concern value of the corporation was less than its net asset value—which suggests that the company is worth more dead than alive. The court also held that the sales of the company's own stock on the Pink Sheets was very persuasive, notwithstanding the plaintiff's argument that the market was too thinly traded to be of any probative value. The court essentially dismisses the plaintiff's expert's analysis with almost no discussion of the validity of his approach. The court plainly believed that the actual analysis done by the plaintiff's expert was inadequate. The court was also troubled by the fact that the plaintiff's expert failed to consider several important factors that would negatively affect the sale's price to a third party—such as the majority shareholder's willingness to make personal guarantees for the corporation's debt, which a third-party buyer might not be willing to do. In the end, the court found a value of $15 million, which was essentially based on a readjustment of the defendants' numbers—increasing the weight of the net asset value and grossing up to eliminate the improper minority and marketability discounts.
Allow me to use this case to suggest some ideas about the correct approach to valuation in shareholder oppression cases—although I admit from the outset that the existing law in Maine is not entirely consistent with these ideas and that the analysis as presented here might not have been feasible in the Kaplan opinion. Most jurisdictions that have recognized a buy-out remedy for oppression have stated that the number to be reached through valuation is "fair value" and not "fair market value." At one level, as noted by the court here, the concept of "fair value" as opposed to "fair market value" precludes the application of a minority interest discount. As the court also noted, the origin of this concept is in the appraisal remedies for dissenting shareholders. Typically, the appraisal remedy arises as a result of a merger approved by the majority of the shareholders that forces the dissenting minority to sell their shares along with everybody else. The idea is that the minority shareholders do not believe the price is fair and would not agree to sell their shares at that price absent statutory compulsion, and therefore the statutory remedy is to require the corporation to pay the minority shareholders the difference between the agreed value and the fair value found through an appraisal. In this context, the object of the valuation exercise is very clear and very logical. The corporation is being sold as a whole. All the shareholders are receiving their percentage interest in the sales proceeds. The chief danger is that the sale may not be at arm's length, and so the court pays the dissenting shareholders what they would have received in a hypothetical sale conducted at arm's length for a fair price. This hypothetical situation necessarily precludes any application of a minority discount because the dissenting shareholders are not selling their minority interests separately but as part of the sale of the entire company.
In a forced buy-out ordered as a remedy for shareholder oppression, there is no sale of the entire corporation, but a special sale of a minority interest. The application of a minority discount is inappropriate but for reasons different than those in the context of dissenter's rights. Take a typical oppression fact situation: two shareholders, one with 60% and the other with 40%. Both work in the corporation. They have a falling out. The 60% shareholder fires the 40%, refuses thereafter to allow the minority shareholder to know what is going on in the corporation, participate in management, or earn any economic return on his ownership interest. In effect, the 60% shareholder has already taken for his own benefit everything of value that the 40%'s share ownership represents. In such a case, a court of equity steps in to force the 60% shareholder to pay a fair price for what he has already taken. The goal of the court is to reconstruct a hypothetical sale between fiduciaries in which they acted equitably and in accordance with their duties. It is important to remember that the award in a shareholder oppression case is not an award of damages but is an award of restitution for the purpose of avoiding unjust enrichment. The transaction between the parties is a zero-sum game. The plaintiff may gain a monetary award, but he loses his ownership in the corporation. The defendant may be ordered to pay money, but that loss is balanced by the gain of the plaintiff's ownership interest in the corporation. The court should attempt to reconstruct the consideration for the plaintiff's interest that the defendant would have paid if he had acted with scrupulous honesty, utmost good faith, and absolute fairness, putting the interests of the plaintiff before his own.
Several implications are immediately apparent. First, the minority discount is completely inappropriate because the hypothetical transaction is not a third-party transaction. The 60% will not hold a minority interest as a result of the transaction, but will hold a 100% interest. In acquiring the 40%'s shares, the 60% is not faced with any of the risks or burdens that a third party might face by stepping into the 40%'s shoes. The question is not what 40% could have gotten if he had tried to sell his shares outside the corporation; the 40% did not choose to sell his shares at all, and the forced transfer of those shares to the 60% is not outside the corporation. Second, a host of discounts and other factors that influenced the valuation of the defendant's experts and the court in Kaplan are completely irrelevant. It is completely irrelevant whether a third party might be inclined to reduce the price because of the necessity of taking over the majority shareholder's personal guarantees. There will be no third party sale. The actual buyer has already given the personal guarantees and will not take on any additional burden by the transfer. (If the situation were that the minority shareholder would be relieved of personal guarantees for the corporation, then that is value conferred to the minority shareholder and should probably be reflected in the cash valuation.) The discounts for capital gains taxes, costs of transferring titles, and other frictional and transaction costs are improper because none of those costs will be incurred. And any attorneys' fees and litigation expenses incurred by the corporation should be credited to the minority shareholder, because those fees and expenses would not have been incurred had the defendant acted consistently with his duties. Furthermore, because the plaintiff's award will be taxable, any discount for tax consequences of the hypothetical sale necessarily involves double counting. The defendant's first expert in Kaplan artificially increased expenses to account for the fact that current executive compensation was below market, and presumably any third-party buyer would have to replace the executives at market value. However, there are no third-party buyers. The actual buyers have already agreed to work at the current rates, and after the sale they can pay themselves anything they want. Third, actual measures of market value, such as prior sales or comparable sales, are relevant, but only slightly so. Every sale to a third party necessarily includes discounts off the value that the buyer hopes to receive to account for risks, transaction costs, and the necessity of a fair return. In the forced sale from minority to majority shareholder, the majority shareholder should not be compensated for the risks or transaction costs. The majority shareholder will not face those risks or costs. The majority shareholder should not receive the benefit of any discount for a return. The majority shareholder has already chosen to acquire the shares; he does not need to be induced to make this investment instead of another, as would a third party. Furthermore, the goal of the remedy is to avoid enriching the majority shareholder for forcing an involuntary transaction on the minority shareholder. Any explicit or implicit allowance of a profit on the majority shareholder's part would be antithetical to that goal.
What the court should be attempting to achieve in placing a value on the minority shareholder's interest is to grant the minority shareholder the full and fair value of what is being transferred to the majority shareholder. The full and fair value is not what a third party would pay in an arm's-length, voluntary transaction. The full and fair value is the current cash value of all the benefits that are transferred to the majority shareholder. For the most part, shareholders in closely-held corporations get benefits from their ownership through having a mechanism to generate cash. An oppressive majority shareholder acts to deprive the minority shareholder and to acquire for himself that stream of income. Therefore, in most situations, a discounted cash flow analysis is the only realistic way to measure value. The analysis must be done from the perspective of economic benefit to the shareholders as a group—from which the minority shareholder would receive his percentage interest. The benefit to the shareholders is the amount of cash generated by the business to pay the shareholders, including any amounts that have been misappropriated or diverted to any of the owners. Depreciation and taxes (if the company is a pass-through entity or fully deducts all disbursement to shareholders) would necessarily be excluded. The cash-for-owners generating ability of the enterprise can be measured, reasonably projected into the future, and discounted to present value. Also any other value that would remain in the corporation and be available for distribution should be included. For example, if the corporation routinely keeps a cash balance in its bank or investment accounts or holds real estate or other property that will retain its value, then the minority shareholder's current interest in that value should be awarded in addition to his interest in the cash generated by operations.
Finally, the burden of proof does play a part in this analysis. As the benefiting fiduciary, the majority shareholder has the burden of proof. Therefore, the value is not zero until the plaintiff proves otherwise. Rather, the use of the burden of proof is similar to that in actions against a trustee. The majority shareholder has the burden of accounting for all the money and property of the corporation. Anything that cannot be accounted for, or any expense that can't be justified, is charged to the majority shareholder's account and thus increases the size of the cash generated for owners that is being measured.
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Posted By Eric Fryar to Shareholder Oppression at 3/24/2009 11:21:00 AM