51 RI Bar J., No. 2, Pg. 25 (September, 2002). Fair Value and the Closely Held Corporation.

• Author: THOMAS M. MADDEN, ESQ.

Rhode Island Bar Journal

Volume 51.

51 RI Bar J., No. 2, Pg. 25 (September, 2002).

Fair Value and the Closely Held Corporation

Fair Value and the Closely Held CorporationTHOMAS M. MADDEN, ESQ.Thomas M. Madden's practice is The Madden Law Firm, P.C. in Providence, RI.A member of the Rhode Island and New York Bars, his publications are included in the Federal Regulation of Securities Annotated and ALR Fed.Editor's Note: Attorney Madden's prior article on this subject, "Oppression of Minority Shareholder Rights in Closely Held Corporations," appeared in the Rhode Island Bar Journal March/April 2002 issue.My previous article discussing oppression of minority shareholders' rights in closely held corporations prompted several inquiries and comments regarding the valuation of shares for which minority shareholders may obtain compensation. (fn1) That article addresses the definition of oppression central to minority shareholders (fn2) exercising their right to petition for dissolution of a closely held corporation under R.I. Gen. Laws § 7-1.1-90. (fn3) The ensuing queries lead to a natural follow-up topic - the issue of determining fair value of shares in the closely held context - an issue triggered when rights under R.I. Gen. Laws § 7-1.1-90 are exercised and subsequent rights under R.I. Gen. Laws § 7-1.1-90.1 (fn4) arise. Recall that where a minority shareholder's rights are found to be oppressed under R.I. Gen. Laws § 7-1.1-90, a minority shareholder may petition to dissolve the corporation, whether or not the corporation is operating at a profit. Under R.I. Gen. Laws § 7-1.1-90.1, a shareholder may file to purchase the petitioning shareholders' shares in order to avoid dissolution. This article focuses on determining the value of the shares to be purchased under R.I. Gen. Laws § 7-1.1-90.1.

While the prior discussion of minority shareholder rights was centered largely around the terms of R.I. Gen. Laws § 7-1.1-90, the valuation issue centers chiefly around R.I. Gen. Laws § 7-1.1-90.1 which grants a shareholder the right to avoid dissolution petitioned for by buying out the petitioning shareholder and R.I. Gen. Laws § 7-1.1-74 (fn5) which grants a dissenting shareholder the right to obtain fair value for his or her shares where such a shareholder disapproves of a major corporate action such as the sale of substantially all of the assets of the corporation or the merger of the corporation with another entity. (fn6) Under R.I. Gen. Laws § 7-1.1-74, a dissenting shareholder must file a written objection with the corporation and make a demand on the corporation in order to exercise his or her rights to obtain fair value for his or her shares.

Note that R.I. Gen. Laws § 7-1.1-90 and R.I. Gen. Laws § 7-1.1-90.1 do not apply exclusively to close corporations. However, in practice, application of these statutes is often seen in the closely held context because they offer a clear statutory means of addressing oppression of minority shareholders where ready markets do not exist. Indeed, "the prevalence of the buyout remedy in litigated cases" would support the theory that the doctrine of shareholder oppression serves to protect close corporation investors. (fn7) These statutes are vital mechanisms for shareholders of closely held corporations.

Unlike the public corporation context where a ready, liquid and ascertainable market often exists to determine share value, the closely held context presents us with myriad idiosyncrasies that impede the simple determination of share value. (fn8) Shareholders of closely held corporations tend to have more complex interests in their investment than large or public corporation shareholders. "[C]lose corporation shareholders view their investments as having three central components - an employment position, a management role, and a proportionate share of the company's earnings - it should not be assumed that reasonable shareholders would permit one investment component to be harmed for any benefit in another." (fn9) Therefore, the mechanisms provided by the statutes discussed herein are of particular utility to shareholders of close corporations.This article examines the situations in which the need to determine fair value arises and the manner of attaining that fair value as applied by the Rhode Island state and federal courts. (fn10) The focus is on the above-mentioned statutes as the law around which the cases on the topic are built. (It might be interesting to note that many of the cases discussed herein have had long lives in the courts in various procedural forms, reflecting the often difficult situations in which these valuation issues arise.)

Determining Fair Value in PracticePerhaps the clearest and most thorough discussion of applying fair value under Rhode Island law exists in Judge Kelleher's discussion in Charland v. Country View Golf Club. (fn11) In Charland, a minority shareholder asserted his rights seeking to dissolve a corporate owner/operator of a golf club. The golf club, in turn, asserted its rights under R.I. Gen. Laws § 7-1.1-90.1 to avoid dissolution by electing to buy back the minority holder's shares. (fn12)

In Judge Kelleher's simple terms, R.I. Gen. Laws § 7-1.1-90.1 consists of three parts. "First, a corporation, rather than be forced to dissolve by a shareholder dissolution petition, can elect to buy out the shareholder's stock. Second, the corporation must pay fair value for such shares. Third, if the fair value cannot be agreed upon, the court shall determine the value of such shares as of the close of business on the day on which the petition for dissolution was filed." (fn13) Where the court must appoint an appraiser, R.I. Gen. Laws § 7-1.1-74 must be followed. Such was the case in Charland.

The Charland court was dissatisfied with the first appraiser who testified in the case and directed a second appraiser to determine the value of the shares at stake as of the close of business on the date of the filing of the petition for dissolution. That second appraiser applied a minority discount to the valuation that the court found ambiguous as that appraisal conflated discounts based upon non-marketability and minority percentage ownership. (fn14)

Judge Kelleher presented the issue again in thee parts. First, should the court apply a minority discount to the shares at issue? Second, should the court apply a discount for lack of marketability? Third, was a discount applied such that the share price was actually less than fair value? (fn15)

The Charland court determined that, generally, no discount should apply to share value where the corporation elects to buy out a petitioning shareholder. In doing so, the court relied on prior case law, especially Brown v. Corrugated Box (fn16) that held where a corporation elects to buy out a dissenting shareholder, the noncontrolling nature of the shares is irrelevant. Judge Kelleher went on in agreement with Brown to declare adoption of the rule that a discount of shares shall not be applied in determination of fair value solely because of their minority status. (fn17) Moreover, Judge Kelleher further proceeded to adopt the rule that no discount to fair value shall apply for lack of marketability where a corporation elects to buy out a shareholder. (fn18)

On the facts of Charland, the court found that the trial court had applied a discount to fair value of the petitioner's shares and that such discount should not apply. Thus, Charland was remanded to the lower court to determine fair value without applying any discounts.

Charland sets out a clear approach to applying fair value to the corporate buyout of a dissolution petitioning minority shareholder's shares. The issue of determining fair value is left mostly to appraisers heard by the court, but is subject to the court's review, and in Charland, a rule of denying discounts in corporate buyouts is clearly established.

If Charland gives us a clear approach to getting to and applying fair value, Hendrick v. Hendrick (fn19) gives us a clear indication that courts are generous in applying the statutory remedies for minority shareholders. In Hendrick, the rights set out in R.I...