The Equitable Value of an Oppressed Minority Shareholder’s Interest

  • A New Jersey Court conducing the valuation of a business may use any technique or method generally acceptable in the financial community.

  • The application of a minority discount is a question of law, but likely will be based on the factual determinations of the court about the culpability of the litigants.

  • Business divorces cases are commonly heard in the Chancery Division, a court of equity in which principles of fairness and justice may be applied in addition to any statutory cause of action.

  • New Jersey’s statutory cause of action for oppression of a minority shareholder does not prevent the court from providing equitable remedies available outside the statute as a matter of common law.

New Jersey Business Valuation ATORNEYIn Sipko v. Kroger, the New Jersey Supreme Court declined to apply a minority discount in valuing the interest of a minority shareholder.

There was no real surprise there.  New Jersey courts are reluctant to apply a minority discount in the valuation of closely held businesses, which reduces the value of the minority interest.  Those discounts, which can signicantly lower the value of an interest — often by a third, or more — tend to reward wrongdoers.

I had an opportunity recently to hear the opinions of several chancery judges discuss the latest Sipko opinion.  What was striking was the extent that the technical transformation of valuation may become a morality play.

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How Principles of Equity Affect the Valuation Decisions of Courts

Why is this important?  It has a great deal to do with the way New Jersey courts are organized and the survival of a distinct court – the Chancery Division – to apply distinct principles of equity.  Chancery courts survive today in only a handful of states.

In most states the application of equitable principles survive but are applied by judges in a merged court system. New Jersey’s equity courts function as a distinct unit and that administration has distinct impacts.

There are only one or two chancery judges in the largest New Jersey counties.  The judges individually manage all aspects of the case and will preside at the trial, determining the factual and legal issues.  Case are presumptively to be resolved in one year.

That means that the same judge will preside over the pleadings, motion practice, discovery, trial and make all factual and legal decisions about the case.  There is a limited docket, and the judge will quickly come to know the parties and undoubtedly have opinions about their conduct.

So what these trial judges say about a controlling opinion that addresses a central issue in business divorce cases speaks a great deal about how an individual case might be seen, and how it might be resolved.

And the consensus among these judges was that the Kroger decision turned to a great extent on the misconduct of the defendants, and that the judges who decide these cases in the first instance may will be strongly influenced in technical decisions by their views of fair play.

Family Dispute Results in Decade-Long Buusiness Divorce Litigation

The Kroger litigation, still ongoing after 16 years in the court system and two opinions of the Supreme Court, involved a family-owned business fractured into two by the family’s disapproval of a romantic relationship in which one of two sons became involved.

George Sipko started a software company catering to the hedge fund industry.  After the exit of another owner, his two sons, Ras and Robert, joined George in the business.  The business began to prosper with all three members, until Robert became involved with a woman who met with his family strong disapproval.

The case was tried and when to the Supreme Court the first time in 2013.  (Kroger I). That case is most notable for the holding that although Robert had failed to establish conduct that rose to the level of oppression, that failure did not necessarily deprive him of a remedy.  The first Kroger opinion noted that the statutory provision creating a cause of action for minority oppression “was not intended to supersede the inherent common law power of the the Chancery Division to achieve equity.”

The Kroger case was remanded and the court ultimately rendered an award based on prior expert testimony that the 50 percent interest claimed by the plaintiff Robert had a value of more than $18 million.  The trial judge issued award that was based on the cause of action for an accounting, holding that the defendants had acted in concert to siphon the assets out of the business.

Defendants appealed and the Appellate Division reversed and remanded to the trial court, holding that the acceptance of the prior expert evidence was not a “reasoned, just and factually supported conclusion” and that the court had failed to determine the amount of discount for lack of marketability. (Opinion)

Discounts for Lack of Marketability and Lack of Control

A marketability discount is a reduction in value to account for the fact that interests in a closely held business are hard to sell and that buyers pay as as a result.  The discount is a percentage reduction from the full or “fair” value of the entity.  A similar discount may be applied when to a minority interest for lack of control.  These discounts result in a “fair market value” that is generally applied in other circumstances, for example in calculating tax liabilities.

The Supreme Court’s Kroger II opinion devotes substantial attention to the efforts taken by the defendants to move and hide assets, which it described as a “pattern of acts calculated to prevent Robert from obtaining compensation for his interests” in the Kroger entities.  Kroger II cites defendants’ misconduct as supporting its decision to affirm the trial court and reverse the appellate division.  On remand, the defendants had declined to submit their owner valuation report and limited themselves to commenting on the expert opinion proffered by the plaintiff.

The application, or not, of a marketability is a question of law, but all other aspects of the valuation determination of a trial court are inherently factual and subject to reversal in the rare case of abuse of discretion.  Proof of value may be by “any techniques or methods which are generally acceptable in the financial community and otherwise admissible in court.”

The real guts of the opinion, however, is that the defendants did not deserve any better outcome:

Defendants’ bad-faith behavior throughout this 15-year litigation occurred for the specific and obvious purpose of preventing Robert from being fairly compensated for his interests. Defendants now ask the Court, after acting unfairly at almost every turn, to apply a doctrine rooted in fairness to relieve them of their responsibility to buyout Robert for the amount determined by the trial court. We decline to do so. If ever there was an instance in which equity did not fall in a party’s favor, it is this case.

And that was the takeaway from the trial judge’s observations about the Kroger opinion.  At least for the judges sitting on the panel, it was clear that how the court determines value may well have much to do with how the court views the parties and their relative culpability.

I tell my own clients that the Chancery judge sees and remembers everything that the litigants say and do.  In that sense, equity may be something of a political process.  Behavior matters, and so does optics.

Litigators know that every lawsuit is a tale of good and evil.  The difference in the Chancery court is that the story unfolds in large part in the presence of the ultimate arbiter of the outcome.  This is very much unlike what happens in a jury trial, when cases are assigned out for trial, typically to judges who do not know the case, and to juries that will learn about the dispute only through the testimony of the parties.

That does not mean that the Chancery court is a popularity contest, but it does warn that the equity – the broad question of fairness and justice – is a broad net, and litigants that are know to the court as inequitable have a difficult path ahead.

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