Indiana Court of Appeals: No Discounts in Unclear and Mandatory Shareholder Agreement Buyout

Blake B. Hartman, Appellant – Plaintiff v. BigInch Fabricators & Construction Holding Company, Inc., Appellee-Defentant.  This case is fresh off the press from the Court of Appeals of Indiana.  Hartman v. BigInch is a case about a buy-out provision in a Shareholder Agreement that required BigInch (“the Company”) purchase the shares of any officer or director who was involuntarily terminated.

Basic Facts of the Case

Mr. Hartman was involuntarily terminated as an officer and director of BigInch in March 2018. At the time of his termination, he owned 8,884 shares of the Company, which represented 17.7% of the outstanding shares. There were nine other shareholders, and no shareholder held control.

Pursuant to the Shareholder Agreement, the Company retained an appraisal firm to provide the appraisal required by the Agreement. Readers of this blog have heard me say (or write) that the “words on the pages” of buy-sell agreements are important. In this case, they proved to be critical to the matter on appeal.

The Shareholder Agreement provided for the “Valuation and Payment for the Shares,” and the section was partially quoted by the Court of Appeals.

The price per Share for the Shares of the Corporation to be sold pursuant to Article III or Article IV of of this Agreement shall be the appraised market value on 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… (emphasis added)

The Agreement is unclear on a number of things. However, there was apparently no disagreement about the valuation date or the financial statements to be used. The instructions called for a “third party valuation company,” and a credentialed appraiser was retained. He provided an appraisal of the “fair market value” of the Shares owned by Hartman.

Appraisal Summary

The appraiser first determined what the Court of Appeals called the “market value” of the Shares (which I would refer to as the financial control value) and “then applied the open market concepts of minority and marketability discounts, as required by the concept of fair market value.”

The appraisal is summarized in the following table.

chart 1

The 17.7% interest was appraised initially at an appraised market value (financial control value) of $3.53 million.  A discount for lack of control and a discount for lack of marketability were then applied, lowering the appraiser’s conclusion of fair market value at the nonmarketable minority level of value to $2.40 million.  I have estimated the discounts above, because the actual discounts, which totaled 32% after application, were not provided in the opinion.

The Legal Setup

In September 2018, Hartman filed a petition for declaratory judgment seeking an opinion that the Company had improperly applied discounts to the mandatory sale of the Shares. The Company filed an Answer and Counterclaim for declaratory judgment. Following additional legal maneuvering on both sides, the trial court issued summary judgment in September 2019, concluding that the Company could discount the value of the Shares for lack of control and marketability.

Hartman then appealed and the cited opinion is the result.

Hartman contended that the trial court had improperly allowed for the application of lack of control and marketability discounts because these discounts should not be allowed in a forced sale as called for by the Shareholder Agreement. He further argued that the language in the Agreement quoted above, i.e., appraised market value, should not be equated with the willing buyer and willing seller concept of fair market value.

The Company obviously argued otherwise.

The Court of Appeals cited precedent Indiana cases regarding statutory fair value and one involving divorce. To cut through the analysis, the Court of Appeals found that the fact that the Company had an obligation to purchase the Shares and therefore, an obligation to create a market for them, rendered the “open market” concepts of fair market value moot.

The Court of Appeals observed, citing the Wenzel case regarding statutory fair value:

“[i]t would be incongruous to discount the shares of the minority shareholder for lack of liquidity when valuation is being done in connection with a proceeding that creates liquidity.” When there is a “ready-made market” for shares through a mandatory purchase agreement, “[a]llowing a minority or non-marketability discount to be deducted from their value would indeed amount to a windfall to the [buyer] and its majority shareholders, which is precisely what the Wenzel court sought to avoid.”

Wenzel was a case to determine statutory fair value, unlike the present shareholder buyout case. However, the “windfall” that the Court of Appeals recognized lies in the fact that if the Company were to purchase the Shares at a discounted value, they could then potentially sell them at an undiscounted value, therefore recognizing a windfall.

The Math Behind the Decision

Since the idea of a windfall is not obvious, we look at the underlying arithmetic of the repurchase of the Hartman Shares at a discounted price (i.e., their fair market value) and an undiscounted price (i.e., their appraised market value, or financial control value).

Based on the undiscounted appraisal at  $3.53 million for 17.7%, we estimate the undiscounted value of BigInch to be $19.92 million ($3.53 million / 17.7%).  If the Hartman Shares are purchased at their discounted price ($2.4 million), the remaining equity value after the repurchase is $17.52 million, or $424.21 per share for the remaining shares.

chart 2

On the other hand, if the purchase is at the undiscounted price of $3.53 million, the remaining equity value after the repurchase is $16.40 million, or $396.90 per share. In other words, the remaining shareholders have exactly the same per share value both before and after the repurchase.

The windfall to which the Court of Appeals objected is the difference between the two remaining values for the remaining shareholders, or $1.13 million (or an extra $27.31 per share).

The Court of Appeals reversed the trial court judge and concluded that the Company could not use a discounted value as a substitute for its appraised market value.

The Rest of the Story

The Court of Appeals used statutory fair value precedent opinions to argue against discounting. But underlying the Court’s analysis there is likely something like the following logic, in addition to the scholarly legal analysis.

  1. When the Shareholders Agreement was signed years ago, there were ten minority shareholders.
  2. The Hartman matter was the first exercise of the triggering clause regarding involuntary termination, which had to be agreed upon by the remaining shareholders.
  3. The remaining shareholders, by offering a discounted value, stood to gain advantage to the disadvantage of the shareholder they had terminated and were forcing to sell.
  4. The Shareholders Agreement was designed to create a market for the shares, so it make little sense to discount for lack of control or liquidity.
  5. Let’s conclude that discounting is impermissible.

There is another aspect to this analysis. Given that ten minority shareholders agreed on the Agreement years ago, it is unlikely that they, individually or collectively, would have agreed on a discounted value for the Agreement. To do so would be to punish the first to have to sell at the benefit of the remaining owners. Had they discussed this fact, the likelihood they would have agreed on a discounted value is nil.

All This Because

The BigInch Shareholders Agreement was a buy-sell agreement. The parties agreed to its terms in 2006, and it had not been revised since then. Had the parties put plain language in the Agreement regarding the desire that the appraised value would be discounted, or undiscounted, all this litigation could have been avoided.

The solution to problems like this lies in crystal clear language defining the kind of value that is desired for purpose of buy-sell agreements.

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