As discussed in our article on Corporate Struggles: Who Has the Power When Push Comes to Shove, the struggle for control of operations or access to economic benefits in a California corporation can run the gamut from fights for control of officer positions and/or employment by the Company to control of the Board of Directors. Ownership of shares and contractual rights usually determine who can win in such disputes.
It is not uncommon for a shareholder who is stymied in seeking effective control of a company to decide to abandon the company or begin a new one thus to seek access to such corporate assets as good will, customer lists and employees. Such actions are contrary to the interests of the corporation, of course, and breach of fiduciary duty can prohibit that attempt. See our article on fiduciary duty. However, one way such a shareholder can seek to still obtain those assets is by eliminating the corporation as an entity entirely. The shareholder can seek to dissolve the company, to “kill” the company.
A shareholder of a California corporation owning fifty percent or more of the shares has the right to initiate, even against the wishes of the other owners, a Voluntary Dissolution of the Corporation pursuant to the California Corporations. Code Section 1900. However, as set forth below, Cal. Corp. Code Section 2000 provides the other shareholders wishing to halt the dissolution an effective remedy if the shareholder only owns fifty percent of the shares.
The other shareholders can apply to a court to exercise the absolute right to purchase (or to have the corporation purchase) the shares of the party desiring the liquidation for “liquidation value.” Any such application automatically stays the dissolution.
Once the court (through three appraisers) has valued the shares, the shareholders contesting the dissolution have the right, but not the obligation, to purchase the shares.
The basic details of the procedure are discussed in this article.
Cal. Corporations Code section 2000 provides as follows.
Subject to any contrary provision in the articles, in any...proceeding for voluntary dissolution initiated by the vote of shareholders representing only 50 percent of the voting power, the corporation or, if it does not elect to purchase, the holders of 50 percent or more of the voting power of the corporation (the “purchasing parties”) may avoid the dissolution of the corporation and the appointment of any receiver by purchasing for cash the shares owned by the...shareholders so initiating the proceeding (the “moving parties”) at their fair value.
However, if the purchasing party, after receiving the evaluation, does not elect to purchase the shares, they could be liable for the moving party’s costs, including attorney’s fees. Moreover, upon filing the action, the purchasing parties have to post a bond to cover these anticipated costs and fees. The bond would not be expensive but is required.
Notice that the corporation can elect to purchase the shares. This is important because, as the legislature noted in its legislative history:
Frequently, the only source of sufficient cash to avoid dissolution is the corporation. In order that the statutory “buy-out” procedure establishes a meaningful alternative to termination of the enterprise, this section provides the corporation with the first right to purchase the shares of the moving parties.
Accordingly, the corporation has the ability to purchase the shares.
Further, note the following statutory provision:
The election of the corporation to purchase may be made by the approval of the outstanding shares (Section 152) excluding shares held by the moving parties.
This is a truly critical power since it means that the party who sought involuntary dissolution can not vote on whether to invoke the powers of Corp. Code Section 2000 and use the corporation itself to purchase his or her shares at “liquidation” value as appraised by the Court appointed experts. Suddenly, the power to make the decision is vested in the other shareholders. Utilizing Corp. Code Section 1900 can be a dangerous move, indeed.
(Be sure not to confuse this petition for voluntary dissolution for an adversarial petition for involuntary dissolution. The grounds for involuntary dissolution are that:
(4) Those in control of the corporation have been guilty of or have knowingly countenanced persistent and pervasive fraud, mismanagement or abuse of authority or persistent unfairness toward any shareholders or its property is being misapplied or wasted by its directors or officers.)
KEY QUESTION: PRICE: WHAT IS “FAIR VALUE?”
The statue defines the critical question as to how the price of the shares to be purchased from the moving party shall be determined. The fair value shall be determined on the basis of 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.
Note that the liquidation value is less than fair market value because it seems to contemplate an involuntary sale. It does appear, however, to contemplate an aspect of goodwill. The statute continues as follows:
In fixing the value, the amount of any damages resulting if the initiation of the dissolution is a breach by any moving party or parties of an agreement with the purchasing party or parties may be deducted from the amount payable to such moving party or parties, unless the ground for dissolution is that specified in paragraph (4) of subdivision (b) of Section 1800.
Thus, if there were any agreements which may have been breached by the moving party in seeking dissolution, the damages from that breach may be indirectly obtained by reduction in the value of the stock. .
If the parties are unable to agree to a price, a court may stay the dissolution and set the price after the posting of a bond:
If the purchasing parties (1) elect to purchase the shares owned by the moving parties, and (2) are unable to agree with the moving parties upon the fair value of such shares, and (3) give bond with sufficient security to pay the estimated reasonable expenses (including attorneys’ fees) of the moving parties if such expenses are recoverable under subdivision c, the court upon application of the purchasing parties, either in the pending action or in a proceeding initiated in the superior court of the proper county by the purchasing parties in the case of a voluntary election to wind up and dissolve, shall stay the winding up and dissolution proceeding and shall proceed to ascertain and fix the fair value of the shares owned by the moving parties
The court ascertains the price by appointing three disinterested appraisers to do the work. This decision is final. Once this process has concluded, the court orders the purchasing party to pay the price within a set time, and after the payment, the remaining shareholders become the sole owners. They, of course, would have the full right to protect all corporate assets, including employees, goodwill, etc. as discussed in other articles.
If the purchasing parties do not make payment for the shares within the time specified, the dissolution moves forward and judgment is entered against them and the surety on the bond for the amount of the expenses (including attorneys fees) of the moving parties.
Once the fair value is set on the shares of stock held by the non-majority shareholder who wishes to dissolve the corporation, the purchasing parties have the right, but no corresponding obligation, to purchase the moving parties’ shares at the fair value price. Mart v. Severson (2002) 95 Cal.App.4th 521.
CASE LAW ON SETTING VALUE:
In Mart v. Severson, supra, plaintiff and defendant each were 50% shareholders and directors of B corporation. When plaintiff requested court supervision in the voluntary winding up of B, defendant exercised his section 2000 right to purchase plaintiff’ shares at their fair value in order to avoid dissolution. Three appraisers were appointed and they determined that B could be sold as a going concern, and using both “income approach” and “market approach” valuation methods, determined the fair value of 100% of B's common stock to be $5.6 million. Defendant argued for a liquidation value. The appraisers had rejected the liquidation value method because that approach was commonly used when companies are insolvent, the tangible assets sold piecemeal, the liabilities retired, and remaining equity distributed to shareholders. The appraisers concluded that approach was irrelevant here because of B’s historical earnings records and future earnings capability. The appraisers did not adjust their valuation to account for potential future competition by shareholders and assumed that hypothetical covenants not to compete would be executed by the shareholders and key employees. The trial court directed that non-competition covenants be submitted and that the appraisers conduct an appraisal using the liquidation method. The appraisers found a liquidation value of $1.48 million. The trial court found the non-competition agreement submitted by plaintiff to be ineffective and untimely because the agreement did not exist as of the valuation date. The trial court adopted the piecemeal liquidation value and issued its decree and judgment winding up and dissolving B.
The court of appeals reversed, holding as follows.
(a) The trial court misinterpreted Section 2000. The court held that the statute provides a method for establishing a fair value price of a moving party’s stock; it neither governs nor addresses covenants not to compete or other terms of a sale under which a purchaser may buy out the shares of the moving party. Moreover, the court held that the section does not permit the trial court to require, or evaluate the validity of, a covenant not to compete.
(b) The court also held that the valuation date for voluntary dissolutions is the date the proceeding is initiated. Substantial evidence established that the fair value of B’s shares as of the valuation date was $5.6 million. The court stated that liquidation value under Section 2000 can mean going concern value if the corporation could be sold as a going concern in liquidation. Thus, the hypothetical question posed by Section 2000 is whether the entire corporation could have been sold as a going concern in liquidation on the valuation date. To answer that question, the appraisers considered hypothetical reasonable sellers, hypothetical reasonable buyers, and a hypothetical forced sale liquidation environment. (95 Cal.App.4th at 533.) Evidence that plaintiff would not give defendant a covenant not to compete prior to the valuation date was not relevant to the appraisers’ scenario. (95 C.A.4th 533.)
In Trahan v. Trahan (2002) 99 Cal.App.4th 62, plaintiffs and defendants were the sole shareholders of T corporation, a business providing sheet metal and general contracting services. Plaintiffs together owned 50% of the shares, as did defendants. On May 30, 2000, plaintiffs executed an election to dissolve T. At that time, T had a backlog of outstanding construction contracts. Defendants sought to avoid dissolution by purchasing plaintiffs’ shares and, failing to agree on fair value, petitioned the court to stay the dissolution and to fix the value. The trial court ordered that the fair value of T’s shares as of May 30, 2000, the valuation date, be determined on the basis of the liquidation value as of that date, taking into consideration the possibility of T being sold as a going concern. The appraiser concluded that T could not be sold as a going concern, and assigning no value to outstanding and unperformed contracts, determined that the fair value was a negative amount. The trial court confirmed the appraiser’s award. The court of appeals affirmed, noting that plaintiffs never requested that the trial court exercise its discretion and defer the valuation date to allow the backlog of construction contracts to be completed. In addition, plaintiffs neither suggested that T could be sold as a going concern, nor did they challenge the appraiser’s conclusions as to the liquidation value excluding the outstanding contracts. Thus, the court of appeals concluded that substantial evidence supported the trial court’s confirmation of the appraiser’s determination of the fair value based on piecemeal sale of the assets as of the valuation day.
SOME TACTICAL THOUGHTS
As with all the powerful tools available in corporate warfare, both Corp Code 1900 and Corp Code 2000 must be very carefully analyzed and various scenarios pondered before a petition is filed. The aggressive party seeking to liquidate the company may find him or herself forced to sell at liquidated value (or not…see above cases) and what was a power grab becomes a surrender of a valuable asset below value. Likewise, the party facing an attempt at dissolution should realize that it can be stopped…but it may require a cash buy out, albeit using corporate resources.
This should be seen as just one more tool in the toolbox of those available in struggles within a corporation. To use it without considering alternatives would be a mistake and the time to determine the “game plan” is before…not after…steps are actually taken.