July 14, 2020

Further Observations on Fair Value: FAED, the Fair and Equitable Discount

Current Issues in Closely Held Businesses Series: Part 7
Holland & Knight Shareholder Rights Blog
Michael J. Zdeb
Shareholder Rights Blog

Once it is understood that "fair value" is not the same as "fair market value," there appears to be two general views of what is "fair value" in the context of breach of fiduciary duty or shareholder oppression cases. For more information, see Buy Out at Fair Value (Part 5).

Fair Market Value with Discounts

Frequently, fair value is viewed as "fair market value" but without one or both of the discounts for lack of control or market. Under this view, without the application of those two discounts, the fair value of a share is its proportionate interest in the value of the entire enterprise.

Whether any discount may be applied at the enterprise level of value is a discussion for a later day. While the discount for lack of control is not allowed in most jurisdiction that have considered it, the discount for lack of a market has been handled differently.

The range of approaches on discounts for lack of marketability run from disallowing the discount; to allow it only in "extradentary circumstances" to leaving it to a determination by court.

The extraordinary circumstances view can be found both in cases and in at least one statute regarding the oppression action. However, given that the term uses "extraordinary," it is not surprising that clear definitions exist.

The discount for lack of market also has been considered in circumstances of the minority obstructing a corporate action that have reduced the dissenters' value. It also has been applied as a reduction of the purchase price when the defendant was ordered to sell rather than buy.

The Model Business Corporation Act (MBCA) takes the "proportionate" view that explicitly rejects the discount for lack of control or lack of market in an appraisal proceeding following the dissenter's actions. However, in the context of an oppression action, there is no similar language in the MBCA that explicitly refers to either discount.

Context Dependent View

Another view is that fair value is dependent on context. Under this view, fair value is not a financial analysis result without the application of the discounts for lack of control or market. Rather, it is part of a remedy and therefore a judicial or legal matter, and a determination of what is fair and equitable under the circumstances of the matter.

This context-based fair and equitable approach may or may not produce the same result as the first view.

The circumstances of a particular case under this view could produce a value that is not proportionate or equal to an amount equal to the fair market value without discounts.

Equity may require consideration of the plaintiff minority shareholder's conduct before or during the pendency of the case. The conduct may be bad acts or competition, which while not prohibited, nonetheless has a substantial negative effect on the enterprise's value.

The court might take into consideration the "reasonable expectations" of all parties, including those formed at the time of investment as well as those that developed over time. Not applying the discounts could result in a loss of value to other shareholders whose conduct was not in question. For example, other minority shareholders or trusts holding gift shares could be affected by the price at which the shares were to be sold or purchased.

An award for compensation in a separate breach of duty claim or proceeding has in at least one case resulted in a reduction of the value of the shares of the oppressed shareholder.

In other cases, the financial ability of the corporation to satisfy the purchase price has resulted in the court reducing what was otherwise seen as the fair value.

For example, the Illinois statute provides that the court may take into consideration "any financial or legal constraints on the ability of the corporation or purchasing shareholder to purchase the shares." In prior cases, the court was presented with testimony regarding the ability to finance the purchase of the shares and banking constraints on the corporation.

The concern is the impact on the business's continuing viability, particularly if the award comes after a disruption of the business or its industry, which was beyond the control of the parties.

Arguments have been made that interim distributions during the case should reduce the value and that fairness requires the reduction, as the distributions represented part of the value of the interest. Of course, the contrary argument was the "fruit and tree" theory.

FAED: the Fair and Equitable Discount

The discount for lack of control and for lack of a market are often referred to by the acronym, DLOC and the DLOM. While those two discounts have data points that can be used to measure the impact, there are times when the court reduces values based on equitable considerations.

There are decisions in which the appellate courts approved of discounts not referred to as discount for lack of control (DLOC) or discount for lack of marketability (DLOM). On appeal, the arguments were that the jurisdiction did not allow for the DLOC or DLOM in the determination of fair value. In these cases, the appellate courts allow the trial court discounts, noting that the trial court did not identify the discounts as DLOC or DLOM.

In the determination of fair value, equity and fairness are a significant consideration in the context of the case. This would be beyond only considering whether a DLOC or DLOM should be considered. So it would seem, that there may be a discount that can be called the "fair and equitable discount." It seems the fair and equitable discount (FAED) can now be added to the acronyms of DLOC and DLOM.

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