[Shareholder Oppression] Discussion of Valuation in Forced Buyout
Eric Fryar
Encompass Teleservices, Inc. v. Scheets, Slip Op. No. 04-821-HU, 2008 WL 5156561 (D. Ore. Dec. 9, 2008).
The United States District Court for the District of Oregon has entered a judgment for shareholder oppression in favor of a minority shareholder. The case was originally filed in June 2004 by the corporation against the minority shareholder, but the minority shareholder counterclaimed and filed a third-party claim against the majority shareholders in July 2006. The corporation declared bankruptcy in 2007. The case was tried to the court. The minority shareholder asserted that the majority shareholders breached their fiduciary duties to him by 1) diverting funds to themselves or to entities in which they had a direct or indirect financial interest; 2) providing or causing the provision of false, incomplete and/or fraudulent information with the intent of depriving the plaintiff of his shareholder rights; and 3) wrongfully withholding from the plaintiff benefits enjoyed by other shareholders or controlling persons, including dividends, distributions, loans, reimbursement of expenses, and payments sufficient to pay their (S-corporation) tax liabilities on income allocated to shareholders. Under Oregon law, "[m]ajority shareholders, officers and directors owe the fiduciary duties of loyalty, good faith, fair dealing and full disclosure to a minority shareholder. Delaney v. Georgia-Pacific Corp., 278 Or. 305, 310-11; Baker v. Commercial Body Builders, 264 Or. 614, 629 (1973). These duties are owed to both the corporation and the other shareholders." The court notes that oppression and breach of fiduciary duty to a minority shareholder are essentially the same thing. "Because many things can constitute oppressive conduct or a breach of fiduciary duties what matters is not so much matching the specific facts of one case to those of another but examining the pattern and intent of the majority and the effect on the minority of those specific acts." Quoting Cooke v. Fresh Express Foods Corporation, Inc., 169 Or.App. 101, 108-09 (2000). "When shareholders of a closely held corporation use their control over the corporation to their own advantage, and exclude other shareholders from the benefits of participating in the corporation, in the absence of a legitimate business purpose, the actions constitute a breach of their fiduciary duties of loyalty, good faith and fair dealing." Citing Cooke 169 Or.App. at 108, citing Noakes v. Schoenborn, 116 Or.App. 464, 472 (1992). The Court held that over a five-year period, the majority shareholders withheld accurate financial information about the corporation from the minority shareholder and provided false financial information to the minority shareholder, primarily for the purpose of hiding mismanagement, misappropriation and usurpation of corporate opportunities. The Court held that the majority shareholders had committed oppression and ordered a buy out.
The plaintiff's business valuation expert testified that the plaintiff's minority interest was worth $2.4 million as of the valuation date, which the parties stipulated was July 2004. The court did not find the expert testimony to be credible. The expert used in income approach and a market approach to reach a valuation, and the expert testified that he weighted the income approach at 75% and the market approach at 25%. The Court stated: "In the end, these approaches, which Mr. Partin finds to be completely different in terms of their reliability, differ in their valuation prediction by only $25,000 on an overall valuation of $2,400,000. That is a discrepancy of approximately 1% between two methods that, according to Mr. Partin, differ in their reliability by a factor of three. I find this so unlikely as to call into question the manipulations of the assumptions, approximations and conclusions reached by Mr. Partin under one or both methods. This is simply 'too good to be true.'" This statement is absolute nonsense. If the court believed that the expert was manipulating the assumptions, one would certainly hope that there was a more convincing example than the one the court cited. Presumably the court would have been convinced by the expert testimony if the expert had said that both approaches were equally valid because they came to almost the same number. The court also rejects the expert's exclusion of various one-time extraordinary expenses associated with the fraud committed by the defendants, the excessive distributions to the defendants, and the shareholder litigation. The Court holds that the plaintiff's expert's assumptions regarding the stability and growth of the company are disproven by the very misconduct challenged in the lawsuit. "Indeed, Mr. Cargal's fraud and the excessive distributions to the Boyles create a disquieting picture of a company that was not well managed and doomed to early failure on the path it had chosen." Ultimately the Court holds that the plaintiff's interest was worth $900,000 and orders the majority shareholders to pay that amount.
Aside from the very strange reasoning given by the court for doubting the expert's credibility, the Court's reasoning regarding valuation is extremely troubling. Seemingly, while the misconduct of the defendant's was held to be illegal and warranted an equitable remedy, the defendants were given approximately a $1.6 million benefit in the calculation of the remedy as a result of that same misconduct. What the court misses in his analysis is that the valuation number is not really about what the plaintiff's interest is worth in reality. In imposing a buyout remedy and conducting an evaluation for purposes of that buyout, the court is attempting to construct a hypothetical purchase that equity determines should have taken place. When a majority shareholder has oppressed a minority shareholder, a majority shareholder has effectively taken the value of the minority shareholders ownership interest. The equitable remedy of a buyout makes the majority shareholder pay for the interest he has taken to prevent unjust enrichment. Therefore, the goal of a valuation is to determine the number that the defendants would have paid had they been acting in accordance with their fiduciary duties and which accounts for all the value that the defendants would have received in such a transaction. The goal is not to determine the value that a third party might pay the plaintiff for that interest. What third-party would want the interest? When the defendant acquires the interest, the defendant is acquiring something that a third party would not acquire, namely the defendant does not face the prospect of dealing with a hostile, dishonest, greedy majority shareholder whose interests are adverse to the buyer. For the same reason, it is totally inappropriate in a shareholder oppression case to apply a minority shareholder discount because the buyer is not a minority shareholder. The value that the defendants acquire in the hypothetical transaction is not and should not be diminished by their own misconduct. If the defendant steals from the corporation, then he has (from the perspective of the defendant) suffered no net loss. The fact that the defendant chooses to run the company into the ground, also should not diminish the value. The defendant could have chosen to sell the company to a third party, in which case the defendant's future mismanagement would not affect value. Certainly, the existence of shareholder lawsuits arising from the defendant's misconduct should not be a factor to diminish the valuation. Had the hypothetical transaction taken place, then the need for litigation would never have arisen.
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Posted By Eric Fryar to Shareholder Oppression at 12/12/2008 03:14:00 PM