All posts tagged: business divorce

A New Approach

Because no Arizona statutes allow for a business owner to generally depart from a private company and receive the value of their interest, there is little motivation for the company and the other owners to deplete company or personal assets to fund a buyout of the departing owner. Generally, owner agreements do not deal with the issue of a general buyout upon termination of employment or departure from the entity. It is not good public policy to force an owner departing the company to look to or find past conflict to force a buyout under certain existing laws. Nor should the company or remaining owners be forced to contend with an owner who does not wish to be part of the company and must force past wrongful conduct to be heard. So why shouldn’t a business divorce follow the same no fault principles of a marital divorce with respect to a division of assets and liabilities?

I have proposed and presented to various groups a no fault business divorce statute. A departing owner who has not concluded a negotiation should apply to a court seeking a division of certain assets and liabilities to receive fair value for his or her interest. In theory, the owner should be given value commensurate with the stock interest held since they have a percentage share of those net assets. This process would require all owners to be within the jurisdiction of the court since each of their stock interests would be affected. The court in an expedited proceeding should take evidence only with respect to what would be a fair and equitable division of the assets and liabilities to equate to the shareholders’ ownership interest. The court then would determine which assets that the owner would take upon departing.

Such a no fault business divorce procedure would provide immediate relief and circumvent the necessity of trying to find wrongful conduct to start litigation and force through a unique statute or common law claim a buyout of the interest. Thus an owner who has been in conflict with other owners or simply for acceptable reasons wishes to depart the company will have an opportunity to recognize and receive their fair value in relation to their ownership interest upon divorce from the other owners. Moreover, such procedure being ultimately available, would likely serve as a deterrent and foster negotiated settlements knowing that a judge may ultimately divide assets and liabilities.

One major sticking point in the business divorce is what to do with a departing owner’s interest in the company. That departing owner has invested money, sweat, and maybe committed a large share of his or her life to the company to build its value. Unless the corporate governing documents allow for the payment of that value upon departure, and provide a formula for calculating the value of such buyout, Arizona statutes provide no independent procedure to solve the problem. As a result, the parties create leverage, attempt to negotiate, and if necessary, file litigation utilizing certain statutes if applicable all in an effort to force the buyout.

Buyout Value

Assuming no corporate governance documents exist, the departing owner certainly will start negotiating for a buyout in exchange for returning their interest to the company or the other owners. But how do you set the value? The company accountant can be called upon to state the book value as then existing in the corporate records. But that is a low end value. Perhaps there have been third parties who have offered to buy the company. Most privately held shares are restricted preventing sale. Professionals may be employed to value the stock or appraise assets.

Valuation presents its own issues unique to the closely held business. Valuation experts utilize discounts from fair market value because of the lack of marketability generally of ownership interests in private companies and for a minority owner interest which may total up to 70% of the enterprise value. However, a concept has been created known as “fair value” which eliminates the concept of a willing buyer and seller in a fair market without compulsion. The rationale is that the other owners of the business who own the other restricted ownership interests are really the only persons interested in controlling those shares giving them full value and as a result, the discount should not apply. Thus, the more accepted practice is for the entire enterprise to be valued, no discount should be taken, and a pro rata value attached to the shares. In fact case law in Arizona has held under the dissenter’s rights statutes that no discount should be taken in a fair value valuation.

Several Arizona statutes permit a buyout that may assist the departing shareholder. First, under the dissenter’s rights statutes, a shareholder who objects to a merger, plan of share exchange, or a sale or exchange of all or substantially all of the assets of the company may dissent and be paid their fair value for their shares. Under the judicial dissolution statutes discussed in the last column, the corporation may elect or if they fail to elect one or more shareholders may elect to buyout the shares owned by the departing owner. In both circumstances, procedures to conclude the fair value process including court proceedings if necessary, are set forth in Arizona statutes.

There have been cases in other jurisdictions which have held that the court has the equitable power to order a buyout. This equitable remedy is fashioned out of  necessity, probably because insufficient statutory procedures exist in corporate settings.

The ability to have a court assist or force a buyout, under particular circumstances, helps solve the complexities of a negotiated buyout that the departing owner views as essential. But I propose the Arizona Legislature adopt a new approach to help resolve business divorce issues.

Read Part 2: here.

The Court Determines Fair Value 

The court shall take evidence and determine fair value but has a right to assess expenses and attorney fees. The expenses assessed may also include the cost of experts. The court may find against the corporation in favor of the dissenter if it finds the corporation did not comply with procedural requirements, against the dissenter if the fair value does not materially exceed” the amount offered by the company; or against either the company or dissenter if it finds that the party against whom the fees and expenses assessed acted “arbitrarily, vexatiously, or not in good faith with respect to the rights provided …” by the dissenters’ rights process.

The term “fair value” is defined in the dissenters’ rights statutes to mean the value of shares immediately before the effectuation of the corporate action to which the dissenter objects excluding any appreciation or depreciation in anticipation of the corporate action unless such exclusion is inequitable. The statutory definition does not deal with the issue of discounts for either a minority interest or lack of marketability, discounts commonly given for fair market value calculations. However, in Arizona, case law states that fair value is not the same as fair market value and does not include discounts for marketability or minority interest.

The practitioner should be alert to any of the possible triggering events during an owner dispute as the existence of any such triggering device may conclude a business divorce. The parties must carefully calculate their estimations and demands of fair value since the entire cost of the proceeding, including expert fees is at risk of being awarded to a successful party. The statutes were designed to deter an actual court proceeding by increasing the risk of loss. The court proceeding should probably only be one day with the evidence likely limited to the expert reports and perhaps some other related matters.

The dissenters’ rights statutes present an admirable, limited procedure to allow a shareholder, under key circumstances, to remove themselves from their business partners and hopefully terminate a dispute receiving fair value for their interest in the company.

Dissenters’ rights is a little known and little used statutory procedure that can be invoked under particular circumstances which may solve disputed issues in a business divorce. The basic concept of dissenters’ rights is to allow a shareholder to be bought out at fair value when a substantial change in corporate structure is about to take place. Arizona statutes provide a detailed procedure for the exercise of dissenters’ rights. No comparable provision exists in the Arizona limited liability company statutes.

Triggers for Dissenters’ Rights 

A number of corporate actions trigger the right of a shareholder to dissent and obtain fair value for the shares. First, if the corporation is a party to a plan of merger, including where a subsidiary is merging into a parent company, dissenters’ rights apply. If the corporation is a party to a share exchange and the shareholders are entitled to vote on the plan dissenters’ rights are triggered. Next is when a sale or exchange of all or substantially all of the property of the company occurs, unless the sale is pursuant to a court order or a sale for cash payable one year from the date of the sale. Dissenters’ rights exist if there is going to be an amendment to the Articles of Incorporation that materially and adversely affects a dissenters’ preferred rights in shares, creates or alters a right of redemption, alters a preemptive right, or excludes the right of the shares to vote on any matter including cumulative voting for directors. If a shareholder elects to dissent from any of these actions, a shareholder may not object or challenge the corporate action unless such action is fraudulent. Finally, the right to dissent is not applied to shares traded on a national exchange.

Dissenters’ Rights Procedures

If any of these proposed actions will be submitted to a vote at a shareholder meeting, the meeting notice must state that the shareholders may assert dissenters’ rights. Even if there is no meeting, a notice still must be given in writing to shareholders about their right to dissent to the corporate action. Once the notice is received, any shareholder who may want to dissent must deliver in writing their intent to demand payment for their shares and dissent. It is incumbent upon the corporation to send a writing to all shareholders not later than ten days after the triggering corporate action is taken and advise the shareholders where payment demand must be sent and where share certificates may be deposited. That same notice will advise the dissenting shareholder when the corporation must receive the shareholder’s demand for payment of their shares. The shareholder must comply and send a demand for payment consistent with that notice. If no demand for payment is received the rights are waived. Upon receipt of the payment demand, the corporation shall pay the dissenter what the corporation estimates to be the “fair value” of the shares and shall send to the shareholder the Company balance sheet together with an explanation as to how the fair value estimate was calculated.

If the shareholder is dissatisfied with the corporation’s estimate of the fair value, the dissenter may notify the corporation in writing of their estimate, less any payment tendered or otherwise reject the offer and demand full payment of fair value. Thereafter, if the matter is not resolved, the corporation is required to commence a court proceeding within sixty days and ask the court to determine the fair value of the shares, or otherwise pay the amount the dissenter estimates to be the fair value. All disputing dissenters must be a part of this action. There is no right to a trial by jury and the court may appoint a master or others to assist it in determining fair value. Each dissenter is entitled to obtain a judgment for the amount which the court finds is the fair value of the shares exceeding the amount offered by the corporation, if any. This is often called an “appraisal proceeding.”

Continue Reading Part 2

In my last article I reviewed how directors, officers and employees may receive an advancement of their attorney fees prior to judgment when they are brought in to a proceeding based on actions taken in their official capacities for the company. However, the ultimate authority to indemnify, allowing the person to keep their advancement and further obtain from the company payment for any judgment or settlement, is governed by the indemnification statutes in Arizona. If litigation is settled or goes to trial, indemnification requires that the company pay the judgment or settlement, including expenses, again providing the company’s financial support for actions taken on behalf of the company if certain conditions are met.

Authority to Indemnify

A company may indemnify a director or officer, made a party to a proceeding if the individual’s conduct was in good faith and, the individual reasonably believed that while acting in their official capacity the conduct was in the company’s best interest or in all other cases the conduct was at least not opposed to the company’s best interest. In criminal proceedings, if the individual had no reasonable cause to believe their conduct was unlawful they may obtain indemnification. A second basis allowing such permissive indemnification is if the director or officer engaged in conduct for which broader indemnification allowances exist in the Articles of Incorporation.

Permissive indemnification is not available when a director or officer receives a financial benefit to which the person is not entitled, intentionally inflicts harm on the corporation or shareholders, intentionally violates criminal law, or unlawfully makes a distribution of company funds. In addition, the company may indemnify after the termination of a proceeding resolved by judgment, order, settlement or conviction if it is not itself determinative of whether the director met the good faith, best interest standard of conduct.

Required Indemnification

The company is required to indemnify a director or officer who was a prevailing party in the defense of any proceeding to which a person was a party in their official capacity for the reasonable expenses incurred by another person in connection with that proceeding. If a director was not an officer, employee or stockholder holding more than 5%, who then qualifies as an outside director, they are entitled to receive mandatory indemnification. But an outside director shall not receive indemnification if the director did not meet the standard of good faith and acting in the best interests or not opposed to the best interests of the company as described above.