Fair Value
A fair value appraisal of shares required under California Corporations Section 2000 in shareholder buyouts is quite different from a fair market value appraisal.
The law of unintended consequences is a frequent companion to the legislative process. Such is the case concerning California Corporations Code Section 2000, enacted in 1977. This statute affords a corporation or its nondissenting shareholders the option of avoiding a corporate dissolution by purchasing a dissenting shareholder’s ownership interest. In practice, however, the statute has often proven impenetrable to the lawyers charged with navigating its terms and the appraisers responsible for valuing the shares to be purchased.
In involuntary dissolution, if one-half of the board of directors or one-third of the shareholders (excluding shareholders who personally participated in the alleged wrongdoing) files a claim for involuntary dissolution of a corporation, or, alternatively, in voluntary dissolution, if 50 percent of the shareholders elects to voluntarily dissolve a corporation, under Section 2000, the remaining 50 percent (or possibly lesser percentage in an involuntary dissolution) may avoid dissolution by acquiring, for cash, the shares of the parties initiating that action. On its face, this process seems straightforward; however, the legislature requires that the acquired shares be purchased at “fair value.” This is an appraisal metric foreign to most appraisers and the corporate world at large, and one that can, and sometime does, wreak havoc for clients, lawyers, and appraisers navigating the often complex terrain of shareholder disputes in the context of dissolution.
Section 2000 and the buyout process that it prescribes raise a myriad of issues, including, but not limited to 1) deciding whether to opt for a Section 2000 valuation/buyout, 2) selecting appraisers and obtaining a court order appointing these appraisers, 3) evaluating whether to challenge the appraisal process and the findings of the appraisers after the report is completed, and 4) explaining what may transpire after the appraisal report is issued, specifically whether and how to request an evidentiary hearing concerning the report’s findings. Any client facing a prospective dissolution—voluntary or involuntary—must be aware of the protections and risks in opting to acquire shares in lieu of dissolution. The result is a tale of caution and lawyerly restraint in advising clients on a complicated process in which success and failure can sometimes be difficult to distinguish.
Taking the Section 2000 Leap
Section 2000, and its related statutes, Sections 1800 and 1900, generally come into play when there is a dispute or deadlock between shareholders resulting in litigation and possibly even claims for involuntary dissolution. One common scenario, for example, is the sudden and unannounced departure of a prominent shareholder. This most often involves closely held corporations with two or more equal shareholders in which one of them surreptitiously plots his or her separation from the business and abruptly—without advance notice—secretly decamps to a new and directly competitive business. The remaining shareholder, usually stunned and harboring a sense of betrayal, moves to protect the business and challenge the departing shareholder’s conduct, particularly if that departure involves the taking of corporate opportunities and other assets. Other scenarios occur when the shareholders or board are deadlocked or accusations of fraud or mismanagement arise. In these situations, litigation often ensues, with claims and cross-claims asserted by the now competing shareholders, frequently including derivative and direct counts for wrongful conduct.
In the midst of this already contentious environment, a shareholder (or group of shareholders) may seek to dissolve the corporation that is the corpus of the dispute. The mechanics of initiating dissolution are not complicated. Under Section 1900, 50 percent of the shareholders may file with the secretary of state to voluntarily dissolve the corporation. Alternatively, Section 1800 permits one-half or more of the directors or one-third of the shareholders to file a lawsuit for involuntary dissolution.
Involuntary dissolution is not self-executing, however, and Section 1800 demands that the filing shareholder allege that one of the following four delineated grounds for involuntary dissolution exists: 1) the business has been abandoned, 2) the directors are deadlocked, 3) the shareholders are deadlocked, or 4) there is fraud or mismanagement involving the company. Based on their decisions, courts consider this form of dissolution a drastic remedy and view these claims with a critical eye; consequently, they impose a heavy burden on those seeking to implement it.
To Dissolve or Not
Against that backdrop, shareholders faced with dissolution confront a difficult dilemma—whether to allow the company to dissolve, fight dissolution on the merits, or acquire the filing party’s shares to maintain the existence of the corporation. The last option is superficially appealing but it is also a potential minefield and requires lawyers to advise their clients on its pros and cons.
At least three issues should be addressed at the outset of the process. First, Section 2000 is unambiguous that the purchase price must be paid in cash; the statute does not permit a structured payment or a payment-in-kind arrangement. Accordingly, before considering proceeding down this path, the client must be certain it has or will have the funds to buy the filing shareholder’s shares when the time arrives to do so. If the client does not have the money or is uncertain that it will have the cash, Section 2000 serves more as a false panacea than an escape from dissolution. Moreover, if the acquiring shareholder initiates this process and is unable to see it through to completion, this can have severe consequences, including certain dissolution of the corporation and liability for payment of all appraisers’ fees and opposing party’s attorney’s fees in connection with the Section 2000 proceeding.
Second, the fair value evaluation, which is distinctly different from “fair market value,” precludes a minority or noncontrolling interest discount. This means that the acquiring shareholder(s) is (are) compelled to pay a purchase price predicated strictly on the filing shareholder’s percentage interest in the company. That proscription may inversely increase the purchase price and should inform the client’s determination of whether it has the financial wherewithal to purchase that shareholder’s shares.
Third, there is the obvious but sometimes unasked question of whether the time, expense, and risks of a Section 2000 proceeding are justified under the circumstances. In other words, does the business have sufficient value to justify the time and expense of valuing and purchasing the filing shareholder’s shares? If not, defending the lawsuit on the merits or permitting dissolution may be the wiser course of action.
If these various issues are addressed and resolved in favor of acquiring the filing shareholder’s shares, the next question is whether the parties can agree on a price for those shares. If so, the purchaser simply proceeds in accordance with that agreement. If not—and a meeting of the minds on the purchase price is a rarity—the purchaser may exercise its right of election to acquire the filing shareholder’s shares under Section 2000(b). This requires that a bond be posted “with sufficient security to pay the estimated reasonable expenses (including appraisers’ and attorneys’ fees) of the moving party if such expenses are recoverable under subdivision (c)."
The mechanics of initiating a Section 2000 proceeding are straightforward. In an involuntary dissolution proceeding, the purchaser applies to the court to 1) stay the winding up and dissolution proceeding and 2) commence the process of determining the fair value of the shares owned by the party seeking dissolution. (In a voluntary dissolution, the purchaser simply serves notice of election to buy the shares on the other shareholder(s) and files that notice with the secretary of state.) The courts notably lack discretion to deny these applications; if the conditions under Section 2000(b) are met, the statute requires a court to stay the pending dissolution proceedings in favor of valuation.
This right comes at a price, however. The appraisal process is a special proceeding and is assigned priority over any existing litigation between the shareholders, irrespective of whether that litigation extends beyond the subject of dissolution. If the shareholders have filed direct or derivative claims seeking damages or other remedies, the claims will be stayed or otherwise relegated in priority until the Section 2000 proceeding is completed. Thus, taking the example above when a 50 percent shareholder suddenly leaves without notice, if the purchasing shareholder is invested in prosecuting litigation against that shareholder, the litigation will likely be stayed until the appraisal of the shares is complete and the court enters its decree.
Selection of Appraisers
Once the Section 2000 proceeding is initiated, the most critical component of the appraisal process follows immediately: the selection of appraisers and the negotiation and entry of the court order appointing them. The statute provides that the “Court shall appoint three disinterested appraisers to appraise the fair value of the shares owned by the moving parties, and shall make an order referring the matter to the appraisers so appointed for the purposes of ascertaining such value.” The order “shall prescribe the time and manner of producing evidence, if evidence is required.” As the statute suggests, this forms a roadmap for the appraisal process.
In selecting the appraisers, certain issues must be considered. First, identifying and retaining genuinely impartial and unbiased appraisers is not only required statutorily, but essential for practical purposes. This mandate is intended to foster a panel that works collaboratively and reaches a conclusion that is fair and, hopefully, unanimous. The latter decreases the possibility of a later dispute over the valuation found in the report and may reduce the degree of post-report contentiousness. Thus, selecting a party’s retained expert as an appraiser is almost certainly a bad idea. Although retained experts are considered disinterested, it needlessly introduces a concern about bias into the valuation and invites the other side to argue that the party-affiliated appraiser is compromised and his or her conclusions concerning valuation are necessarily questionable. The resulting risk also creates a more partisan panel in which one appraiser appears affiliated with a party and the other two diminish the credibility of his or her contribution as a consequence. This circumstance will give rise to additional expense and possibly a muddled and wavering valuation conclusion.
Second, few appraisers have actually participated in a Section 2000 panel (particularly in the context of litigation in which the matters to be valued will likely include claims—both direct and derivative), emphasizing the importance of the vetting process. The peculiarity of Section 2000’s valuation metric—i.e., fair value—is material here because many appraisers have never conducted an analysis based on this standard. Many do not recognize the distinction between this and the fair market value standard governing most of their work. These distinctions are considerable; therefore, the safest course is selecting appraisers with Section 2000 experience (especially in the litigation context).
The order appointing appraisers must also be drafted with great care because it prescribes the manner in which the appraisers will proceed and, if the parties agree, any evidentiary hearing concerning the resulting report as there is no absolute right to a hearing after the report is issued. A handful of practical considerations deserve particular attention. For example, this includes the parties’ right to communicate with the appraisers (and the manner of doing so), the appraisers’ ability to request and receive information from the parties, how the appraisers will address the claims in the litigation (when there are assets or liabilities that must be factored in), and whether the panel will prepare one or multiple reports. If each of these issues is not clearly addressed in the order, the risk of a compromised process—and the court’s ultimately rejecting the report— increases.
A hypothetical scenario demonstrates the risk. The parties neglect to specify in the order what communications with the appraisers are or are not permissible. After the report is issued, it is disclosed that one party had ongoing communications with one or two of the three appraisers and that their conclusions trumped those of the third appraiser, favoring the party with whom they communicated. The other party, feeling prejudiced, then disputes the report and contends that the appraisers were influenced by the ex parte communications. Although it is not entirely certain how a court would respond under these circumstances, the risks of a tainted and rejected report are increased. On the other hand, if the order had explicitly permitted these communications, and one party merely exercised its right to communicate while the other demurred, the report would likely be shielded from scrutiny.
Setting practical considerations aside, legal concerns must also be addressed. If any derivative claims are pending, the claims are an asset of the corporation being appraised and must be considered as part of the fair value evaluation. The order should specify that any such claims must be valued; otherwise, the court may order a further report and convene a hearing to resolve the issue. Similarly, any direct claims for damages against the filing shareholder, claims against the corporation, or claims for indemnity of officers or directors should be delineated or identified and directed to be considered by the appraisers. Less is not more in this context—it simply invites greater scrutiny later.
The Appraisal Process
If the order is properly drafted, it should be comprehensive and detailed, leaving little to the discretion of the appraisers aside from the specific task of assessing and valuing the company and the filing shareholder’s interest. Once the order is entered and the matter is handed over to the appraisers, the task turns to identifying and interviewing qualified appraisers. The nuances of the fair value determination are many and sophisticated, and experienced appraisers are essential to ensure that client interests are appropriately protected during the appraisal.
Section 2000(a) directs that “fair value shall be determined on the basis of liquidation value as of the valuation date but taking into account the possibility, if any, of the sale of the entire business as a going concern in a liquidation.” On its face, the statutory language is hardly precise, but the courts have provided some clarity. As the court of appeal explained, Section 2000 “necessarily requires that the appraisers contemplate a hypothetical sale scenario: a sale of the entire corporation, in a liquidation setting, on the valuation date. Further, since the corporation will sometimes be closely held, ‘there will be no actual market value or any actual cash sales by which the market value could be determined. Therefore, the value to be determined must necessarily be a constructed or hypothetical market value at which the hypothetical willing seller would sell and the hypothetical willing buyer would purchase.’” The hypothetical value should not be presumably guided by the prospect of future competition from the selling shareholder. As the appellate court observed, the “goodwill of a business is the indivisible property of the corporation and the value of that asset must be reflected in the fair value determination.” In sum, appraisers must assume noncompetition in this hypothetical construct.
Accordingly, the appraisers must create a clear prospective transaction under the statute, i.e., a business capable of being sold as a going concern, though in a liquidation context, with a willing buyer and willing seller where the seller will be subjected to a noncompete covenant after the close of the transaction. These assumptions serve the statutory purpose and corollary obligation on appraisers to “consider the manner in which the parties to such a hypothetical sale are most likely to maximize their return.”
Reality, however, can intrude on this example. If the corporation cannot feasibly be sold as a going concern, the court of appeal held that Section 2000 “necessarily anticipates the piecemeal valuation of the corporation’s existing assets and liabilities as of the valuation date, without consideration of any winding-up period.” When the departing shareholder/seller is already in competition—as in the secret departure scenario—it appears the appraisers may dispense with the assumptions underlying the going concern hypothesis and proceed to a piecemeal analysis.
Further, the fair value approach precludes any minority or noncontrolling discount. The rationale supporting this proscription—as one appellate court noted—is that the purchasing shareholder already has control, thus the question becomes irrelevant. Whatever its basis, a client considering a purchase should evaluate this factor because its inherent facility increases the purchase price.
Finally, the appraisers must consider any direct or derivative claims pending between the shareholders because they are assets or liabilities of the corporation and must be accommodated in the valuation. This is a potentially complex circumstance for lawyers and appraisers to confront—a complexity that is beyond the scope of this article. Nevertheless, this consideration provides additional support for the necessity of engaging in a thorough interview of appraisers to ensure that they are capable of addressing this facet of the valuation.
Because of judicial precedents, the contours of the fair value analysis is less byzantine than the statute might otherwise suggest. The appraisers must assume, if feasible, a going concern sale with no reduction based on prospective competition and without any minority discount. If a going concern sale is not practical, a piecemeal liquidation of assets prevails with the understanding that no discount is imposed by the seller’s lack of control. While the mechanics of the analysis are the province of the appraisers, a lawyer’s command of these standards is essential to protecting client interests because it is incumbent on counsel to challenge any report not conforming to the statutory requirements.
Post-Appraisal Hearing
Once the appraisers’ reports have been lodged with the court, the parties’ rights are dependent on how the order first appointing the appraisers was drafted. If the order provides for an evidentiary hearing to examine the methodology employed by the appraisers, the court should hold one. Otherwise, if it was omitted in the order, the parties have no statutory right to a hearing. A hearing is the only oppotunity to question one or more of the appraisers in the court’s presence. At the same time, Section 2000 is a summary proceeding, and the parties may not depose the appraisers or otherwise take evidence. The right to test the appraisers’ work is, in short, a limited one in time and scope.
On the other hand, a court is not bound by the appraisal report. It may decide the matter de novo, order further information from the appraisers, require an amended report, and consider additional evidence. This is not to suggest that courts frequently exercise these rights, but there are examples in which courts have intervened to refine and supplement the record. The parties may, of course, attempt to facilitate intervention by moving to have the report vacated, amended, or simply not confirmed. The decision rests with the court in its sound discretion.
In contrast, a court does not have discretion as to the mechanics of the purchase of the shares. If the court issues a decree permitting the purchase based on the appraised price, it may not impose any conditions on the purchaser’s right to buy. However, a court cannot compel the purchase. Instead, the decree will provide that if the purchase price is not paid by a specified date, the corporation will be wound up and dissolved. If the shares are purchased as intended, the dissolution is avoided and the company continues.
The question remains as to what would happen if the prospective buyer concludes that the fair value is too high or cannot raise the required cash payments and thus ultimately decides not to proceed with the purchase of the shares. First, in an involuntary dissolution, the purchaser defendant may no longer contest the grounds for involuntary dissolution and a judgment on that count will follow. Second, the court can and will order judgment on the bond. More importantly, the purchaser may be responsible for the seller’s costs, including appraisers’ and attorneys’ fees, regardless of whether they exceed the value of the bond. In this scenario, the purchasing shareholder not only will face the disposition (dissolution) that he or she will have expended significant time and money ostensibly to avoid but also will be compelled to pay the full costs incurred by the selling shareholder regardless of whether the bond was sufficient to satisfy these costs.
Avoiding Risks
Section 2000 offers clear benefits to clients hoping to avoid dissolution but also imposes certain risks. These risks must be assessed at the outset of the process in order to avoid proceeding down an expensive, time-consuming path that may lead only to wasted time, significant cost, and defeat.
A few prophylactic steps may help avoid these risks. First, lawyers need to fully grasp the mechanics of the process—including its consequences—and provide clients with a realistic analysis of the scope, time, and expense involved. Equally important, clients need to make an honest assessment as to whether the costs and risks of a Section 2000 appraisal and acquisition are justified by the value of the corporation itself. This may include, for example, retaining a consulting expert to conduct a short form appraisal of the fair value of the company and guide the client on the utility of electing a buyout under the statute. The appraisal can support a more comprehensive cost-benefit analysis, which affords the client an opportunity for greater informed consent in initiating the process. Perhaps most significantly, the client (buyer) must have the hard cash to fund the purchase as required by Section 2000.
All of which is to say, again, that all those involved—from the lawyer to the client to the court-appointed appraiser— must understand what is involved before choosing to embark down the path of a Section 2000 proceeding. Hope may spring eternal when the process begins, but reality could bite at the end of it.
Originally published in Los Angeles Lawyer, November 2017
Robert M. Heller is the leader of the Shareholder and Corporate Disputes Group at Freeman, Freeman & Smiley in Century City. Todd M. Lander is a litigator specializing in shareholder disputes and intellectual property matters at Freeman, Freeman & Smiley.