Minority Shareholder Buyouts under Corporations Code section 2000

When minority shareholders have problems with the majority, one of their remedies is to petition for involuntary dissolution of the business.  When sued for involuntary dissolution, Corporations Code section 2000 provides the majority shareholders with an option to buyout the minority shareholders.  (Go v. Pacific Health Services, Inc. (2009) 179 Cal.App.4th 522, 532.)  Section 2000 provides that when a shareholder sues for involuntary dissolution, the corporation, or the holders of 50 percent or more of the voting power of the corporation, may avoid the dissolution by purchasing for cash the shares owned by plaintiffs at their “fair value.”  (§ 2000, subd. (a).)  The statute defines “fair value” as the “liquidation value as of the valuation date but taking into account the possibility, if any, of sale of the entire business as a going concern in a liquidation.”  (Ibid.)  If the parties cannot agree on a valuation, the trial court shall appoint three disinterested appraisers to appraise the fair value of the shares.  (§ 2000, subd. (c).)  “The order shall prescribe the time and manner of producing evidence, if evidence is required.  The award of the appraisers or of a majority of them, when confirmed by the [trial] court, shall be final and conclusive upon all parties.”  (Ibid.)

In Goles v. Sawhney, (Nov. 22, 2016) — Cal.App.5th —, the California Court of Appeal clarified several important aspects of this appraisal process.  In Goles, the minority shareholders sued for involuntary dissolution and the majority owners invoked the Section 2000 appraisal process.  Three different appraisals were obtained, but none of the appraisers could agree on a value.  The trial court overruled minority shareholder objections to the methodologies used and without holding an evidentiary hearing, the trial court simply averaged the three appraisals.

Derivative Claims

On appeal, the minority shareholders argued the appraisals were flawed because they did not take into account the value of their derivative claims on behalf of the corporation. Derivative claims are legal actions shareholders bring for the benefit of the corporation. Minority shareholders often make derivative claims when the people in control of the corporation damage the business or take its property.  In Goles, the minority shareholders claimed the managers took unauthorized loans, employed family members, used corporate funds to pay personal expenses, and purposefully neglected corporate governance.  The Court of Appeal agreed these derivative claims should be included in the corporate valuation.

“A derivative claim (or other claim that may yield a potential recovery for the corporation) is a corporate asset that must be considered when determining ‘fair value.’”  (Friedman et al., Cal. Practice Guide:  Corporations (The Rutter Group 2016) ¶  8:873.6, p. 8-176; see Cotton v. Expo Power Systems, Inc., supra, 170 Cal.App.4th at p. 1380.)  “If successful, a derivative claim will accrue to the direct benefit of the corporation and not to the stockholder who litigated it.  [Citations.]”  (Grosset v. Wenaas (2008) 42 Cal.4th 1100, 1114.)

None of the derivative claims were considered by the appraisers or the trial court in determining the fair value of Katana.  This was erroneous.  (See Cotton v. Expo Power Systems, Inc., supra, 170 Cal.App.4th at p. 1374; Kennedy v. Kennedy (2015) 235 Cal.App.4th 1474, 1485 [dismissal of derivative claim requires court approval].)  Where a minority shareholder claims that his shares were undervalued because of self-dealing and misconduct by corporate directors and officers, he should be afforded the opportunity to demonstrate that the alleged misconduct in fact occurred.

Control Discount

The minority shareholders also challenged the use of a “control discount” to reduce the value of the minority shares in two of the appraisals.  A “control discount” reduces the value of a minority share based on the presumption that shares are less valuable when you do not control the company.  The Court of Appeal agreed with the minority shareholders and held it was improper to use a control discount in Section 2000 appraisal proceedings.

Section 2000 does not permit a lack-of-control discount when determining the fair value of a minority shareholder interest.  (Friedman et al., Cal. Practice Guide:  Corporations, supra, ¶  8:876, p. 8-178; Ronald v. 4-C’s Elec. Packaging (1985) 168 Cal.App.3d 290, 298.)  “[T]he rule justifying the devaluation of minority shares in closely held corporations for their lack of control has little validity when the shares are to be purchased by someone who is already in control of the corporation.  In such a situation, it can hardly be said that the shares are worth less to the purchaser because they are noncontrolling.  [Citation.]”  (Brown v. Allied Corrugated Box Co. (1979) 91 Cal.App.3d 477, 486.)  The trial court erroneously did not follow section 2000 because it averaged the three appraisals, two of which used a lack-of-control discount to determine the fair value of appellants’ shareholder interest.

Averaging Method

Although the code allows trial courts to reject the three appraisals and make a new determination, the Court of Appeal reversed the trial court’s decision to average the three appraisals because they were based on flawed methodologies, i.e. no derivative claims and a control discount.

Section 2000, subdivision (c) provides that “[t]he award of the appraisers or of a majority of them, when confirmed by the court, shall be final and conclusive upon all parties.”  (Italics added.)  But such an award requires that at least two of the appraisals reach a consensus on fair value.  (See, e.g., Abrams v. Abrams-Rubaloff & Associates, Inc. (1980) 114 Cal.App.3d 240, 248; Brown v. Allied Corrugated Box Co., supra, 91 Cal.App.3d at pp. 489, 491.)  Here, the trial court confirmed all three appraisal reports even though there was no consensus.  If the trial court intended to determine fair value de novo, it could not do so by “confirming” the appraisals and taking the mathematical average of defective appraisals that use a lack-of-control discount and do not consider the derivative claims. … [T]he trial court could not select among conflicting appraisals or decide the matter de novo unless 1. the derivative claim was considered, and 2. the “lack of control” discount was removed from consideration.

The opinion did not squarely address whether trial courts may still make a de novo determination by averaging three non-defective appraisals that relied on proper criteria.

Posted on December 1st, by reyfrancesco@aol.com in Uncategorized.

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