CHAPTER 9

Fair Value

The world of fair value is among the most tightly constricted value worlds. It applies only to minority shareholders who are either oppressed by the majority or dissent from majority actions. The governing authorities in this world are the laws and court systems of the various states. This world is entirely statutory. Each state has adopted laws to grant rights to minority shareholders. Further, each state is an independent authority regarding these matters. The definition and application of fair value can be quite different from state to state.

The language in this world is legalistic because a legal action has been taken by the minority shareholder to determine the value of the shares. Although some of the general concepts are similar to those in other worlds, a unique language and set of concepts are found in the world of fair value.

This world is especially important to minority shareholders in private companies since they have no public market in which to sell shares. Shareholders in this world are motivated to receive fair value for their shares and must assert their claim through court action.

A snapshot of key tenets of the fair value world is provided in Exhibit 9.1.

EXHIBIT 9.1 Longitude and Latitude: Fair Value

DISSENTING AND OPPRESSED SHAREHOLDERS

The fair value world can be entered in one of two ways: dissension or oppression. Minority shareholders who believe the majority has taken corporate actions that negatively affect them are called dissenters. Examples of corporate actions include merging or selling the assets of the corporation, or changing key tenets of the corporate bylaws. Every state has dissenter's rights statutes that serve to protect the minority, typically through the purchase of their stock at fair value, called the appraisal remedy.

“Oppression” is a legal term that means the minority shareholder's reasonable expectations have not been met. Oppressed shareholders’ statutes or dissolution statutes are meant to protect minority shareholders from oppressive action, fraud, and mismanagement by the majority. Oppression covers actions taken against a minority shareholder in her capacity as an employee, officer, director, or shareholder. The courts have recognized the special nature of shareholders in private corporations, such as:1

• Shareholders usually expect to be active participants in management.
• When dissention arises, the majority shareholder is likely to have the power to undermine or disappoint the minority shareholder's expectations and prevent the minority shareholder from obtaining a fair return on his investment.
• The lack of a ready market for the minority shareholder's stock restricts the holder from liquefying his position.

In oppression cases, some state courts can dissolve the corporation and award the fair value of the shares to the oppressed. Although the dissension and oppression statutes differ in terms of triggering events and latitude of the courts to deliver a remedy, both rely on the payment of fair value for the minority shareholder's stock.

“Fair value” usually is considered to mean the economic value of the securities assuming a continuing ownership and without consideration of diminished value in exchange associates with lack of control or marketability.

TRIGGERING EVENTS

Some action must be taken by an aggrieved party to initiate a fair value claim. Two such triggering events, minority dissent and oppression, are predominant in this world.

Dissent

Majority shareholders may take actions the minority has no control over, and these may reduce the value of the minority shareholders’ shares. A number of triggering events may cause a minority shareholder to dissent. States have adopted different triggering events. Any party who believes he or she has a fair value claim should seek legal advice on this and the other issues in this chapter.

Some of the more common actions triggering dissent are:

• Consummation of a plan of merger
• Consummation of a plan of share exchange
• Consummation of a sale or exchange of substantially all of the assets used in the business
• Significant changes to the corporate bylaws

An appraisal remedy is available to those minority shareholders who can prove to the courts that they have been damaged by the actions of the control group of shareholders.

Oppression

A number of actions by the majority may trigger an oppressive suit by the minority. Two of these actions are:2

Oppression does not necessarily mean the controlling shareholders have committed fraud or mismanaged the company. It often involves unreasonable compensation or insider transactions to benefit the majority.

To protect minority shareholders, states have enacted laws providing an appraisal remedy for dissenting or oppressed shareholders. The process is determined by each state to enable fair valuation to occur. Fair value is not determined differently based on a triggering event.

Perfecting the Dissenters’ Appraisal Rights

Most states require a dissenting shareholder to perfect their appraisal rights before the appraisal remedy is available. This process typically is quite specific and must be followed exactly if the dissenter expects to bring the action to the courts. The Model Business Corporation Act (MBCA), which many states have adopted, outlines the process:3

• A shareholder who wishes to exercise appraisal rights must first give written notice of her intent to dissent prior to the meeting at which the matter giving rise to appraisal rights (e.g., a sale of the company's assets) will be voted on.
• The shareholder must not vote in favor of the action.
• If the action is approved, the shareholder must then demand payment for her shares and deposit her share certificates with the corporation.
• The corporation must then pay the shareholder the fair value of the shares.
• If the shareholder does not agree with the corporation's determination of value, the shareholder then is required to notify the corporation of her estimate of fair value and demand payment from the corporation.
• If the corporation disagrees with the shareholder's estimate, it must initiate a judicial appraisal proceeding.

Shareholders who fail to follow this process lose the right to the appraisal remedy.

Role of Inequitable Conduct

Dissenting shareholders tend to prevail if the court case involves an inequitable act by the majority. Most appraisal cases decided since 1983 that were litigated to a final disposition have resulted in favorable verdicts for the dissenting shareholders.4 In most cases, the offered price to the dissenters or oppressed parties was obviously unfair.5

When the offered price was fair, the controlling shareholder typically breached a fiduciary duty or otherwise engaged in unfair conduct. Examples of bad conduct where dissenters achieved favorable outcomes include:

• Controlling shareholders who wrongfully usurped opportunities belonging to the corporation whose shares were being appraised.
• Insiders who froze out the dissenting shareholders, failed to disclose information with respect to the cash-out merger, and failed to use due care in effecting the merger.
• Controlling shareholders who did not even challenge the minority's claims of self-dealing, inadequate disclosure, and unfair dealing.

The courts appear to penalize inequitable conduct of the controlling shareholder in favor of the minority. In a typical dissent case, the dissenting shareholder claims his stock has a fair value between two and ten times the fair value claimed by the corporation.6 Obviously, there is a large range of fair values in these cases.

DETERMINATION OF FAIR VALUE

Ultimately it is up to the courts in the appropriate jurisdiction to determine fair value. There is no consensus on a definition of fair value. The MBCA defines fair value as:

The value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.7

According to the MCBA, the definition of fair value leaves to the parties, and ultimately to the courts, the process by which fair value is derived. Although case law provides guidance as to how each state interprets the definition of fair value, no state specifically equates fair value with fair market value.8 Thus, the courts delineate between the worlds of fair market value and fair value.

Generally, however, the market value world is of little or no importance when determining the fair value within the context of a private company because the shares of stock are not traded on any public market. Moreover, a sale of its stock usually does not qualify as an arm's length transaction because the sale usually involves corporate officers, employees, or family members. The court may give no weight to market value if the facts of the case so require.

Although no single valuation method is employed in fair value cases, the discounted cash flow (DCF) method is well known by most courts. For example, Delaware courts describe the DCF method as “the preeminent valuation methodology.”9 The facts of each case determine the appropriate methods. Such methods have included net asset value, the private guideline method, valuation based on earnings and book value, and a combination.10

The valuation methods used by a court are dependent on the valuation evidence presented by the parties. The parties create the valuation methodology, and the court reacts to the processes. If both parties present evidence of fair value utilizing the net asset method, the court probably will incorporate a net asset value analysis in its decision. Similarly, if the parties agree on a market approach, the court typically will adopt it.

Appraisal experts usually are engaged by the opposing parties to render value opinions. Even though the appraisal organizations may require nonadvocacy among their certified members, expert opinions often reflect the client's position. The “dueling experts” problem has been dealt with by two Delaware Court of Chancery decisions in a non-Solomon-like way. Rather than “adding the competing valuations then dividing by two” to resolve the issue, the courts determine the stronger valuation argument and incorporate the argument into their final decision. This is a clear effort by the courts to differentiate between value worlds. Further, it shows the game of appraisal Twister can lead to conclusions based on hopelessly entangled logic. Unfortunately, not all courts have adopted this position, and many courts still rely on compromised valuations.

Proportionate Interests

The Delaware courts have held dissenting shareholders are entitled to a “proportionate interest in a going concern.”11 That value is determined on a going-concern basis rather than a liquidation basis. A famous Delaware court case, Bell v. Kirby Lumber Corp., shows how important this use of value premise can be. Kirby Lumber owned a large amount of forestland, which it used to supply a sawmill and plywood plant. Kirby was asset-heavy but profit-poor. Court records showed Kirby was worth approximately $682 per share on a net asset value basis but less than $200 per share on an earnings basis. The dissenting shareholders argued Kirby should be valued based on what the shareholders would receive in a merger negotiated at arm's length with a third party, which presumably would allow for a sale at liquidation value.12 The court concluded an arm's length sale analysis was inappropriate because it “presupposes an acquisition value based on the very fact that the company will not continue in business on the same basis.”13 In the Kirby Lumber decision, the court ruled that the dissenting shareholders were entitled to a proportionate interest in a going concern and fair value should not be based on liquidation value. The Kirby case is a prime example of how the courts, acting as an authority in a value world, prescribe the process in that world.

Valuation Date

According to the MCBA, fair value is “the value of the shares immediately before the effectuation of the corporate action to which the dissenter objects.” Most state statutes provide the valuation date for a dissenting shareholder's fair valuation to be the day prior to the meeting of shareholders at which the action dissented from was opposed.14 The MCBA goes on to define fair value “excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.” The dissenting shareholder neither receives credit nor is penalized from the action from which he dissented.

As with any appraisal, the valuation date is critical: Only those facts known or knowable on the valuation date should be considered. Courts have accepted this principle, saying that “valuation of securities is in essence a prophecy as to the future, but this prophecy must be based upon facts available at the critical valuation date.”15 As two of the foremost writers in the field, Robert Reilly and Robert Sweighs, assert, “an investor's required return and the amount of available benefits usually is estimated at a single point in time. Also, the estimate of value is based solely on the information that is discernable and predictable at the valuation date.”16

Minority Discounts

The primary issue facing the courts is whether the minority interest should be valued in isolation, which might call for a minority discount, or whether the corporation should be valued on an enterprise basis, without a minority discount. The Delaware courts have strongly preferred to value the corporation as a whole, with a pro rata share of that value awarded to the dissenting shareholder. This fits with the court's preference of the DCF method, which is primarily an enterprise valuation method. The no-minority-interest-discount reasoning makes sense for two main reasons:

While most courts have not applied minority discounts, a few court cases have allowed the appraised value of the stock to reflect such a discount.17

Lack of Marketability Discounts

Private companies have no market for their shares. As such, the courts must attempt to recreate a market and give the dissenter what he or she is giving up. In this process, some courts have applied a lack of marketability discount (LOMD) to reflect the fact that no ready market for the shares is available.

The LOMD is routinely used in the world of fair market value to quantify the relative absence of marketability of a private company's shares. LOMDs are applied when a preliminary value of business interest has been derived through comparison to a public security. There are several ways to calculate LOMDs, including the use of restricted stock studies, pre–initial public offering studies, and numerous court cases.

The problem with applying LOMDs to dissenting and oppression cases, however, is that fair value is not the same as fair market value. Fair value, a statutory term, enables shareholders to be fairly compensated, which may or may not equate with the market’s judgment about the stock's value. Within this value world, “market value is, at most, one factor in determining fair value.”18 Without a comparison to the public market, there is probably no place for LOMDs in determining fair value.

The application of discounts can be significant to the ultimate fair value calculation. Chapter 8 shows typical minority and LOMDs in a fair market value setting. Fair market value and fair value are entirely different worlds. Purely for purposes of distinguishing this concept further, Exhibit 9.2 contrasts the adjusted indicated value from the fair market value world with typical discounts, versus the fair value world without discounts.

EXHIBIT 9.2 Comparison of Fair Market Value versus Fair Value

The minority interest holder in the fair value world would benefit by more than 50% over the fair market value minority holder if the discounts were not applied.

The world of fair value is quite legalistic. Success requires participants to understand and use statutory laws. Since the laws vary by state, readers who need to enter this world are strongly encouraged to confer with an expert in the appropriate jurisdiction.

Fair value is a highly legalistic value world; therefore, it is critical to check with legal counsel before taking any actions. Both statute and case law change. Some jurisdictions are very different from others. Ohio, for example, has case law that prescribes application of both minority and marketability discounts.

TRIANGULATION

Like the world of fair market value, the world of fair value is a regulated value world. This means the authorities in this world, state governments and state courts, have a high degree of influence tending toward control. Participants in this world must play by the authority's rules or be sanctioned. Regulated value worlds may exist in blind disregard to the dynamic interconnections of the private capital markets triangle. Fair value is a unique value world because it compensates individuals for losses they may have suffered relative to a majority action. In this sense, courts use valuation for purposes other than connecting to the markets. The Kirby case shows the court's reluctance to accept a higher, presumably market, value for the company because the goal of this world is fairness as determined by the court, not the markets.

The regulated fair value world is not linked to specific transfer methods or capital access points. Transfer has already occurred prior to fair value claim: The minority holder's shares have already been tendered. Further, pursuant to a successful claim, the court is not concerned with the defendant's choice of capitalization technique. The control shareholder simply pays the plaintiff fair value as determined by the court.

Fair value's lack of connection to transfer and capital only occurs in a regulated value world. Once again, the authorities in these value worlds are not concerned with how value fits within a broader capital markets context.

NOTES

1. Robert F. Reilly and Robert P. Schweihs, Handbook of Advanced Business Valuation (New York: McGraw-Hill, 2000), p. 299.

2. Ibid., p. 306.

3. Ibid., p. 298.

4. Barry Wertheimer, “The Shareholders’ Appraisal Remedy and How Courts Determine Fair Value,” 47 Duke Law Journal 613, p. 24.

5. Ibid., p. 24.

6. Ibid., p. 26.

7. Shannon P. Pratt, Robert F. Reilly, and Robert R. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th ed. (New York: McGraw-Hill), p. 790.

8. Wertheimer, “The Shareholders’ Appraisal Remedy,” p. 6.

9. Ibid.

10. Ibid., p. 7.

11. Ibid., p. 1.

12. Ibid., p. 18.

13. Ibid., p. 1.

14. Reilly and Schweihs, Handbook of Advanced Business Valuation, p. 304.

15. Ibid., p. 305.

16. Ibid., p. 305.

17. Wertheimer, “The Shareholders’ Appraisal Remedy,” p. 11.

18. Bobbie J. Hollis, “The Unfairness of Applying Lack of Marketability Discounts to Determine Value in Dissenter's Rights Cases,” Journal of Corporation Law (October 1999): 3.