Discounts inappropriate in valuing minority interest in mandatory buyback, appeals court rules

BVWireIssue #212-3
May 20, 2020

judicial dissolution, buy/sell agreement
fair value accounting, discount for lack of control (DLOC), discount for lack of marketability (DLOM), fair market value (FMV), minority discount, minority interest, controlling interest, stock buyback

When a minority shareholder in an Indiana company was terminated as a director and officer, a dispute arose over whether, under a buyback agreement, the use of discounts for lack of control and marketability was permissible in valuing his shares. The trial court said yes, but the appeals court, citing case law, reversed.

Compelled buyback: The plaintiff was a founder as well as a director and officer of a company that fabricated and installed natural gas and pipeline equipment. He owned a 17.77% interest in the business. When he was terminated (involuntarily), his departure from the company triggered a provision in the controlling shareholder agreement requiring the company to buy back his shares. The valuation was to be based on the “appraised market value of the last day of the year preceding the valuation, determined in accordance with generally accepted accounting principles by a third party valuation company within the twenty-four months preceding the transfer of shares.”

The retained outside appraiser said it was engaged “to estimate the fair market value of the property…. This valuation was performed solely to assist with the valuation requirement in a shareholder agreement due to a triggering event involving [the plaintiff].” The appraiser found the plaintiff’s interest was worth about $3.5 million but applied discounts for lack of control (DLOC) and marketability (DLOM) and concluded the final value was $2.4 million.

The plaintiff sued, and the company countersued. Both sides filed motions for summary judgment. The issue for the trial court was whether, as a matter of law, under the buyback provision, the valuation could include discounts. The trial court found for the company and granted its motion.

The plaintiff appealed the decision. The gist of the plaintiff’s argument to the Court of Appeals was that, under the controlling case, Wenzel v. Hopper & Galliher, discounts were inappropriate because the transaction involved a compulsory sale. Further, the language of the shareholder agreement regarding the appraisal method precluded the use of the fair market value standard because the sale of the contested shares did not take place in the open market and the buyer already controlled the company.

Avoid windfall: The appeals court found Wenzel was applicable to the situation at hand. In Wenzel, the Court of Appeals rejected discounts in the context of a law firm’s purchase of a departing partner’s interest in the firm. The case was brought under the state’s professional corporation act. The court differentiated between fair value and fair market value and rejected the use of minority and marketability discounts in fair value cases where a controlling interest holder buys back the stock. Minority and marketability discounts were “open market concepts” that did not apply where a shareholder is compelled to sell to the majority, the court found. The use of discounts would mean a “windfall” to the buyer.

In the instant case, in rejecting the company’s argument that using the fair market value was consistent with the shareholder agreement, the court said:

The Shareholder Agreement itself recognizes that the mandated buyback of shares to the Company differs from a sale to a third party on the open market and thus, different interests must be recognized by implementing an appraised market value rather than the open-market valuation method of fair value or fair market value.

The appeals court concluded the trial court erred as a matter of law when it allowed the discounts.

A digest of Hartman v. BigInch Fabricators & Construction Holding Co., Inc., 2020 Ind. App. LEXIS 183 (May 5, 2020), and the court’s opinion, will be available soon at BVLaw. A digest and the court’s opinion in Wenzel v. Hopper & Galliher, 779 N.E.2d 30 (Ind. Ct. App. 2002), are available to BVLaw subscribers.

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