Article

USING THE EQUITIES TO SET THE VALUATION DATE IN OPPRESSED SHAREHOLDER ACTIONS
by Eric I. Abraham, Esquire

The decision to file a lawsuit is one that is fraught with risk, and therefore never taken lightly. That maxim takes on added importance in lawsuits filed by minority shareholders under the New Jersey Oppressed Shareholder Act1 because the commencement date of such actions often becomes the date used to value the minority shareholder's shares.

The valuation date has great significance in the outcome of the lawsuit because the value of a business can fluctuate wildly depending on the date used. As a result, the business litigator must be mindful of the valuation date ramifications of filing a lawsuit under the act, as well as the equitable factors that may persuade a court to depart from the commencement date in selecting the valuation date.

The act states that "(t)he purchase price of any shares so sold shall be their fair value as of the date of the commencement of the action or such earlier or later date deemed equitable by the court..."²  Based upon that language, the Appellate Division has termed the commencement date as the "presumptive" valuation date.³ However, the act allows the court to deviate from the commencement date when doing so is justified by the "equities of the case" and does not create any weighty burden for a party seeking such a deviation. Thus, identifying the equitable factors justifying a departure from the commencement date devolves into an analysis of the rationale underlying the use of the commencement date as the valuation date, as well as the case law addressing the equities of departing from it in selecting the valuation date. Fortunately, clarity has begun to emerge from a series of decisions addressing this critically important valuation issue.

Use of the Commencement Date

 One purpose behind using the commencement date as the valuation date is to protect the value of the departing minority shareholder's shares from any adverse impact his or her departure may have on the company's operations. This recognizes that the majority shareholder may not be able to replace the minority shareholder's contributions to the company's success, therefore causing the business to founder. Another purpose is to protect the minority shareholder from the power of the majority after he or she departs. This recognizes that the majority shareholder would otherwise have an incentive to manipulate the company's revenues and expenses to lower the company's overall valuation, and, proportionally, the value of the minority shareholder's shares. By presumptively fixing the valuation date as the date the action was commenced, the act solves both the foregoing problems and protects the value of the minority shareholder's shares. Up to that point, the minority shareholder had a right to participate in the company's value, and after that point he or she is protected from the majority shareholder's potential manipulation, or bad decisions, or both.

An example of when the commencement date might be an appropriate valuation date is when the minority shareholder is also an employee whose termination precedes, if not prompts, the beginning of an oppression action.⁴ In that situation, it would be unfair if the value of the ousted shareholder's shares could be impacted negatively by the manner in which the majority shareholder ran the company in his or her absence. Using the commencement date as the valuation date would therefore protect the departing minority shareholder from any decrease in the value of his or her shares after his or her departure, thereby serving the purpose of the act.

Conversely, using the commencement date in that scenario also protects the majority shareholder by preventing the minority shareholder from enjoying any increase in the value of the company that occurs after the minority shareholder's separation from the company. Thus, viewed from the perspective of the remaining majority shareholder, using the commencement date properly aligns the risk he or she incurs of continuing the business with the reward of gaining the exclusive enjoyment of any increase in value that occurs after the date the minority shareholder departs.

Similarly, using the commencement date as the valuation date can protect the company itself, separate from its shareholders. Where the minority shareholder has departed from the company at or around the time the action is commenced, use of the commencement date will protect the company from the instincts of the majority shareholder to make imprudent short-term business decisions designed to suppress the value of the business until the buy-out of the minority shareholder is completed.

The Appellate Division's two reported decisions in Musto demonstrate how the courts apply the equities of the case mandate of the act to the typical scenario where the minority shareholder leaves the company at about the time the lawsuit is filed. Musto was ousted from the company's management in 1987.5 In December 1990, the defendants terminated his employment after determining that he had contributed little, if anything, to the company since 1987. Musto then filed suit. The trial court fixed the commencement date as the valuation date, choosing not to allow Musto to participate in the company's growth after his departure.⁶

The Appellate Division accepted that approach, distinguishing Musto from Muellenberg v. Bikon Corp.,⁷ where a minority shareholder was actively involved in the company for many years, including during the litigation, and it was his sole source of income. The Appellate Division thus confirmed that an important equitable consideration in setting the valuation date is whether the oppressed minority shareholder remained employed in the business during the litigation. In sum, the Appellate Division in Musto I and Musto II identified the following equitable considerations justifying a valuation date other than the commencement date: 1) passage of time between filing the complaint and resolving the litigation; 2) the oppressed minority shareholder's participation in the company during the litigation; and 3) the company's financial performance.⁸

Use of an Alternate Date Before the Lawsuit

The Appellate Division's decision in Hughes v. Sego Int'l Ltd.⁹ confirms that a valuation date before the commencement date can be appropriate where the minority shareholder departs before commencing suit. In Hughes, the plaintiff was terminated as an employee on Dec. 20, 1978, and filed his complaint alleging oppression six months later, on June 25, 1979. The court entered a judgment of dissolution on Oct. 15, 1980, more than a year after commencement of the lawsuit. Selecting the Dec. 20, 1978, termination date as the valuation date, the court reasoned that it would be inequitable to give the plaintiff the higher value as of the date of the dissolution judgment because "the subsequent increase in value of Sego could not be attributed to plaintiff's efforts."¹⁰

Torres v. Schripps, Inc.¹¹ provides another illustration of the equities justifying departure from the commencement date to protect the value of the departing minority shareholder's shares. There, the court tied the valuation date to the plaintiff's departure from the company nine months before he filed his complaint. Upon Torres' departure, the value of the company declined in the absence of his participation. The court reasoned that Torres should not share in the decline because it was not his fault:

The decrease in the corporate value from February to September was not due to plaintiff's efforts, but may have been due to defendant's lack of experience in managing the corporation. Because plaintiff was terminated, it was fair not to ascribe the losses to plaintiff.¹²

Torres thus stands for the proposition that the valuation date may appropriately be tied to the point at which a minority shareholder departs, thus severing ties to the company.

Use of an Alternate Date After the Lawsuit

A trickier question is presented when the minority shareholder commences suit under the act, but remains with the company during the litigation. In closely held companies, a shareholder often also serves as an officer, director and/or employee, and may continue to serve in those roles after the lawsuit is filed. Sometimes the minority shareholder remains in place with the aid of the court, and under the court's protection, thereby obviating the need to use the commencement date as the valuation date. Under such circumstances, a compelling equitable argument exists to shift the valuation date from the commencement date to a later date to recognize the oppressed shareholder's continuing contributions to the company during that time.

Logically, in that situation the valuation date should be tied to the date on which the oppressed shareholder departs or a later date where the shareholder's contributions continue to benefit the company after departure. Under these circumstances, the use of the later date would serve the purposes of the act. The protective function of the valuation date regarding the value of the minority's shares is satisfied by the fact that the shareholder remained entrenched in the affairs of the company after filing suit and could, therefore, protect the value of his or her shares him or herself. The risk/reward function is satisfied by permitting the departing minority shareholder to enjoy the fruits of his or her labor up until the point of his or her departure, or such later date as his or her contributions are no longer adding value, and permitting the majority shareholder to have the exclusive benefits that accrue solely as a result of his or her own work. Thus, the equities of the case justify shifting the valuation date to a later date.

An illustration of this principle is found in the South Carolina case of Hendley v. Lee, where a minority shareholder's continuing role as an officer and director beyond the commencement date supported a later valuation date.¹³ There, the court used the latest practical date possible, which was the date of the valuation proceeding, because the minority shareholder remained in the company during the litigation. Because the South Carolina statute provided little guidance in setting the valuation date, the court looked to New Jersey's Oppressed Shareholder Act for guidance. The rule that the Hendley court extracted from the cases it reviewed is that where the oppressed shareholder is terminated and no longer participates in the management of the company, it is appropriate to value the shares as of the date of such a shareholder's departure from the company. Because the oppressed shareholder in Hendley remained with the company until the buy-out, the court selected the date of the valuation hearing as the most equitable under the circumstances. The Hendley rule follows the reasoning in Musto I and Musto II, where the Appellate Division ordered an alternate valuation date to reflect the shareholder's removal from the business.

Conclusion

It is important to remember that the selection of the valuation date, and thus the decision when to file a suit under the act, can be defensive, as well as offensive. If the minority shareholder feels the business is about to crumble because of poor decisions by the majority shareholder, filing suit can freeze the value of the company before such adverse events impact the value of the minority shareholder's shares. Under that circumstance, it is to the minority shareholder's benefit to have the court use the commencement date as the valuation date. As a result, counsel would be wise to file suit sooner rather than later, thereby protecting the oppressed minority shareholder from any drop in the company's value. In all scenarios, the oppressed shareholder must understand the ramifications that filing suit will have on the valuation date, and counsel must be able to spot the equities needed to persuade the court to depart from that date when appropriate.

Eric I. Abraham is a partner of Hill Wallack LLP, concentrating his practice in business counseling, shareholder disputes and commercial litigation. He wishes to thank Jeffrey J. Greenbaum and Kenneth F. Oettle, of Sills Cummis, for their intellectual contributions to this article.

This article was previously published in the June 2006 issue of New Jersey Lawyer Magazine, a publication of the New Jersey State Bar Association, and is reprinted herewith permission.

Endnotes

¹ N.J.S.A. 14A:12-7.
² Id.
³ Musto v. Vidas, 333 N.J. Super. 52, 59 (App. Div. 2000) (Musto II).
⁴ See, e.g., Musto v. Vidas, 281 N.J. Super. 548, 561 (App. Div. 1995) (Musto I), certif. den., 143 N. J. 328 (1996). See also Bonavito v. Corbo, 300 N.J. Super. 179, 190 (Ch. Div. 1996).
⁵ Musto I, 281 N.J. Super. at 554.
⁶ Musto II, 333 N.J. Super. at 64.
⁷ 143 N.J. 168 (1996).
⁸ Musto I, 281 N.J. Super. at 561; Musto II, 333 N.J. Super. at 60.
⁹ 192 N.J. Super. 60 (App. Div. 1983).
¹⁰ Id. at 66.
¹¹ 342 N.J. Super. 419 (App.Div. 2001).
¹² Id. at 437-38.
¹³ Hendley v. Lee, 676 F. Supp. 1317, 1327 (D.S.C. 1987).