In a case decided Tuesday by the Business Court, the parties were at loggerheads over how the assets of a partnership were to be valued upon the dissolution of the partnership or the withdrawal of a partner.  Judge Jolly granted the motion for summary judgment by EHP Land Company, the withdrawing partner of HPB Enterprises, which was the developer of a resort community on 750 acres of land in Perquimans County.  EHP Land Co., Inc. v. Bosher.

The partnership agreement said that EHP was entitled to the book value of its interest, to be adjusted based on the fair market value of  "any inventory owned by the partnership."  The critical word for construction by Judge Jolly was "inventory," which was undefined in the agreement and as to which there was a huge difference of opinion between the parties regarding the meaning of the word.  To  the plaintiff corporate partner it included all the developed and undeveloped real property owned by the Partnership, "as well as development amenities such as the golf course, pro shop, clubhouse, restaurant and marina."   Op. ¶21. 

The defendant partners had a much more limited view, arguing that the term was ambiguous and therefore void.  In the alternative, they contended that "inventory"  was limited to assets developed and held for sale, which would not have included much of the property owned by the partnership.

Given the lack of any evidence regarding the intention of the parties as to the construction of the undefined word, Judge Jolly determined that it had  a "natural and ordinary meaning."  Op. ¶52.  Looking to dictionary definitions, he concluded that undeveloped lots to be developed in the future were within the scope of the "inventory" of the partnership.

The Court recognized testimony that the partnership had not discussed the term at the time the partners entered into the agreement and that there was no draftsman who could testify as to the meaning of the undefined word. The lawyer who had drafted the agreement testified that the partnership agreement was the "standard, ‘cookie-cutter’ Partnership Agreement that [he] used for partnerships at that time."  Judge Jolly said:

It is not uncommon for contracts to be form-based and not created from "scratch."  Indeed, one reason the use of form contracts is beneficial is because terms may acquire meaning from continual use over time.  The very fact that the term“inventory” appears in the Partnership Agreement weighs in favor of according it specific meaning; that is, the term was chosen not haphazardly without thinking, but was chosen for inclusion in a form contract precisely because it carries meaning. 

Op. ¶50.

I can’t end without saying that my partner John Buford deserves a public thank you for running this blog very well during the many months (since February) I have not been working or writing on this blog due to a stroke.  He did a great job and only gave the blog back somewhat unwillingly when I asked for it a few days ago.  I hope to be back to work in a few months but will start keeping up the blog now.  I’ll leave it to you whether you preferred John over me.  Please don’t hurt my tender feelings.  I appreciate all of you who wrote to me while I was in the hospital.  Thank you for reading and for noticing that I was missing.

 

Valuing a closely held business is often a debate over hypothetical dollars, particularly when the company’s sole asset is unproven technology.  The Business Court confronted such a situation recently in Vernon v. Cuomo.

The company in question developed a new technology with potential widespread medical application:  silicone-free syringes, which would enable syringes (especially of high-priced medicines) to be pre-filled without risk of contamination.  The potential of the technology, however, was not enough to keep the company together.  Two shareholders asserted dilution and self-dealing claims against the other shareholders.  After a bench trial, the Court concluded that the defendants engaged in self-dealing and breached their fiduciary duty to the plaintiffs.  The Court ordered the judicial dissolution of the company to protect the interests of the complaining shareholders pursuant to N.C.G.S. § 55-14-30(2)(ii).  (Mack wrote about the bench trial opinion last year).

In lieu of dissolution, the defendants exercised their statutory option to purchase the plaintiffs’ shares at fair value under N.C.G.S. § 55-14-31(d).  That statute neither defines fair value nor specifies the procedures for a court to use in arriving at it.  In Vernon, Judge Tennille followed a procedure similar to two previous valuation cases, Garlock v. Hilliard and Royals v. Piedmont Electric Repair Co.:  solicit the opinion of an independent appraiser, "but also [take] into account other equitable and practical considerations based on the arguments and submissions of counsel and matters of record."

The added complication of Vernon was that, with the only asset an unproven technology, there was a high risk of windfall on both sides:  "One of the key problems faced by the Court in this valuation process has been how to protect against a windfall by the majority shareholders if the technology proves to be extremely valuable while not requiring the majority to pay an initial price that may be too high if the technology is not adopted widely in the industry."

The Court approved of the methodology of the appointed appraiser, who had extensive IP valuation experience.  The appraiser’s methodology included:

  • the discounted future economic income method to discern fair value
  • Latin Hypercube simulation algorithms to generate income estimates
  • a Fisher Pry model to project a market adoption rate for the technology
  • Monte Carlo simulation methods to consider uncertainties in the company’s underlying earnings potential

However, because of the uncertainties and the windfall risk, the Court concluded that a royalty sharing arrangement would best capture the value of the technology for both sides.  The Court found that the plaintiff’s shares were worth a specific amount, plus a royalty sharing arrangement of a specified percentage.  (The amounts themselves are redacted in the public version of the Court’s opinion).  The Court ordered the closing to take place within 20 days, with 50% of the purchase price paid at closing and the balance paid in two annual installments with no interest.

Recognizing the novelty of the approach (and the appellate courts’ distrust of novelty), the Court also reached a backup conclusion of the total fair value of the plaintiffs’ shares, which would take effect if an appellate court struck down the royalty sharing arrangement.

 

 

[The photo of the syringe is from Zaldylmg’s photostream on Flickr, some rights reserved.]

The Court allowed a motion to bifurcate in this shareholder dispute.  Shortly before trial, the Court agreed to try first Plaintiffs’ claims for reasonable expectations, mismanagement, and breach of fiduciary duty; and after determination of those issues to try, if necessary, the issues of valuation and dissolution.  The Order allowing bifurcation was entered with the consent of the parties.

Full Opinion

Motion to Bifurcate

The Court ruled, on summary judgment, that the word "value" in a Trust Agreement meant "’fair market value’ of the shares of the railroad company which was the subject of the case as value would be viewed by the Trust, as prospective seller, and the Blue family [those entitled to buy them per the Trust Agreement], as prospective purchasers."  The term "value" did not mean the fair market value of the shares if they had been offered to the general public.

The Court rejected, at least at the summary judgment stage, the value for the shares established in a report prepared by the railroad’s accounting firm.  The Court noted that this report had been prepared "for the limited purpose of determining the fair market value between a willing buyer and a willing seller in the general marketplace of a minority interest of a share of the Railroad’s common stock for gift and estate tax purposes."   The Court found that there were material issues of fact whether this valuation, which incorporated a significant discount for the lack of marketability of the shares, reflected the intent of the settlor of the trust.

The Court rejected an argument by the Plaintiffs that they were entitled to challenge the methodology of the accounting firm.   It held "the court notes that since [the testator] is deemed to have embraced the expertise of [the accounting firm] by virtue of paragraph 8.01 of the Trust Agreement, it is likely that criticism of [the accounting firm’s] valuation methodology would be of limited probative value, if it would be admissible at all."

The Court also allowed an amendment to the Complaint even though the proposed new allegations were "substantively different" from those in the original Complaint.  It held that the duty of construing the relevant provisions of the Trust Agreement was its domain, and stated "variations existing between the Petition and the Amended Petition regarding the Trustee’s contended construction of the Trust Agreement are not of material consequence in this setting."

Full Opinion

Defendants’ Brief In Support Of Their Motion For Summary Judgment And In Opposition To Motion To Amend

Plaintiffs’ Brief In Opposition To Defendants’ Motion For Summary Judgment

Plaintiffs’ Reply Brief In Support Of Their Motion To Amend

This Business Court case concerns the valuation of shares of the Aberdeen and Rockfish Railroad Company, a North Carolina short-line railroad.  Judge Jolly granted in part, and denied in part, the Defendants’ Motion for Summary Judgment, on May 20, 2008, in In The Matter Of The Ruth Cook Blue Living Trust.

The shares at issue were held by a Trust.  The Trust Agreement provided that upon the death of the settlor (Mrs. Blue), the shares were to be offered to the members of her family "at the value established by the accounting firm engaged by the Railroad as of December 31 of the year preceding my death."

The Trustees (the Plaintiffs) and the family members entitled to buy the shares (the Defendants) were at odds about their value.  The Court ruled, on summary judgment, that the word "value" meant "’fair market value’ of the Railroad shares as the same would be viewed by the Trust, as prospective seller, and the Blue family, as prospective purchasers."  The term "value" did not mean the fair market value of the shares if they had been offered to the general public.

The Defendants argued that a valuation report done by the Railroad’s accounting firm shortly before Mrs. Blue’s set the value for the shares.  The Court noted, however, that this report had been prepared "for the limited purpose of determining the fair market value between a willing buyer and a willing seller in the general marketplace of a minority interest of a share of the Railroad’s common stock for gift and estate tax purposes."   The Court found that there were material issues of fact whether this valuation, which incorporated a significant discount for the lack of marketability of the shares, reflected the intent of Mrs. Blue.  (There were similar issues raised by the Classic Coffee Concepts case earlier this year.)

The Court granted summary judgment, however, on the issue of whether the accounting firm issuing the report was in fact the proper firm to perform the valuation.  It found that it was.  Then, the Court rejected an argument by the Plaintiffs that they were entitled to challenge the methodology of the accounting firm.   It held "the court notes that since Ruth Cook Blue is deemed to have embraced the expertise of [the accounting firm] by virtue of paragraph 8.01 of the Trust Agreement, it is likely that criticism of [the accounting firm’s] valuation methodology would be of limited probative value, if it would be admissible at all."

The Court also allowed an amendment to the Complaint which, if not allowed, might have been determinative of the valuation  issue.   

Continue Reading Valuation Of Railroad Company’s Shares Presented Issues Of Material Fact

Defendant, a terminated employee, owned one third of the outstanding stock of Classic Coffee Concepts. The issue was the price to be paid for the stock, which the corporation was obligated to repurchase under a Stockholders Agreement. The Agreement said that the price would be determined by looking to the fair market value of the stock as determined by an independent appraisal of the Employee Stock Ownership Plan. But no ESOP had ever been established.

A variety of conflicting appraisals were presented to the Court at trial.  Defendant would have been entitled to a multi-million recovery under two of them. The first, prepared pre-litigation for the accounting purpose of conducting a goodwill impairment, set the company’s "fair value" at $12,500,000. A "fair value" appraisal ignores discounts in value that are typical for closely held corporations, like those for lack of marketability and lack of control. Defendant’s shares would have been worth $4 million if this appraisal applied. A second appraisal factored in the discounts applicable to closely held corporations, and concluded that the corporation had a value of $8,390,000. If this appraisal had controlled, defendant’s shares would have been worth more than $2.7 million.

For purposes of the litigation, the company obtained a hypothetical appraisal which valued the company as if the ESOP required by the Agreement was in place. The value placed on defendant’s shares under this approach was markedly lower, only $120,000. Yet another appraisal assuming the existence of the ESOP valued defendant’s shares at $192,000, and the last of the many appraisals before the Court valued them at zero.

After analyzing this thicket of conflicting appraisals, the Court held that it would apply the first hypothetical ESOP appraisal, because that was "the only evidence of value that attempts to honor the parties’ agreement." The Court ruled that the establishment of the ESOP was not a condition precedent excusing performance by both parties, because conditions precedent are not favored in the law and also because neither party had argued the point at trial.

The Court also found that the company had materially breached the Stockholders Agreement by failing to redeem defendant’s shares within sixty days of the date of the termination of his employment, and that the pledging of defendant’s stock as collateral did not excuse it from having to do so. In a small victory for the defendant, the Court held that the company could not invoke its right to pay for defendant’s stock over a sixty month period, but that it was required to make an immediate, lump sum payment.

Full Opinion

Plaintiff’s Trial Brief

Defendant’s Trial Brief

 

The issue here was whether the parties had reached an agreement by which defendant was to pay fees to plaintiff for managing an advertising program. Plaintiff alleged that the agreement was "non-cancellable" for a term of one year. The Court found that the correspondence relied upon by plaintiff did not establish a binding contract. Although the parties had agreed on the price to be paid for each advertisement, they had not agreed on the number of advertisements that would be posted by the plaintiff, or when or where they would be posted. Material terms had been left open for negotiation, hence there was no valid contract.

The Court also rejected the argument that the contract had been ratified It held that ratification occurs when the person making the contract purported to act for its principal. Plaintiff’s argument, however, was that the principal had ratified the contract, which the Court found to be the "legal equivalent of attempting to force a square peg into a round hole." The Court further ruled that an oral promise of a guarantee term to the contract was barred by a merger clause, pursuant to the parol evidence rule.

The Court found, however, that there were material issues of fact as to plaintiff’s unfair and deceptive trade practice claims. It ruled that the oral statements by the defendant as to the term of the contract, which it had no authority to make, might have been fraudulent and were certainly unethical, and the defendant had failed to do anything to correct them. The Court also found a factual question on whether the defendant which spoke the misleading statements was acting with the authority of another defendant. Whether the speaking defendant had the apparent authority to act on behalf of the other defendant was a question of fact.

Finally, the Court granted summary judgment on plaintiff’s claim for damages based on diminution in business value. Plaintiff’s remaining claim was essentially for fraud in the inducement, and the measure of damages for that claim is the difference between plaintiff’s expected profit if it had been permitted to perform for the full year, and the amount that it was actually paid before being terminated." Furthermore, the only reason for plaintiff to be in business was to perform under the contract at issue, making a diminuntion in value theory inapplicable and one of "unbounded speculation." The business was a new one, and had value only to the extent that the defendant chose to renew the contract. Although new businesses can recover for loss of profits, they must show them with reasonable certainty like an established business.

Full Opinion

The plaintiffs in this case sought the dissolution of a closely held corporation pursuant to N.C.G.S. §55-14-30(2)(ii) on the ground that the business of the corporation was being conducted to the unfair advantage of the majority shareholder. The Court found that dissolution was appropriate because the reasonable expectations of the majority shareholders were not being met.

Since the dissolution statute gives the corporation the opportunity to avoid dissolution by paying the oppressed shareholders the "fair value" of their shares, the Court moved on to a discussion of that concept. As it had in the Royals case, the Court considered market value, equitable considerations, practical considerations and changes in condition of the company from the market valuation date. It determined that it would be inappropriate to apply discounts for lack of control and lack of marketability. The Court also ruled that the purchase price could be paid over a period of 36 months.

Full Opinion

Plaintiffs had established their right to involuntary dissolution of the closely held corporation in which they were shareholders because their reasonable expectations had not been met, and the business of the corporation was being conducted to the unfair advantage of the minority.

The corporation was entitled to avoid dissolution by paying the oppressed shareholder the "fair value" of his shares. Fair market value is not the same as "fair value," but is a determinant in that consideration.

Discounts for lack of control and lack of marketability do not apply when minority shareholders are compelled to sell their shares.

Full Opinion