New Law Journal – 20 September 2019

George Sim considers the valuation of shareholdings when shareholders fall out

In Brief

  • Determining the valuation of a shareholding.
  • Addressing the company’s financial management.

As the economy’s growth rate slows, financial pressures on companies of all sizes are increasing. A harsher economic climate tends to lead to increased scrutiny by shareholders of company performance and one consequence may be an increase in disputes between shareholders. Such disputes may be protracted and emotive: they may also be complex in cases where the same shareholders control a group of companies.

This article outlines the causes of disputes and the remedies available to shareholders together with the valuation and investigation work which will need to be undertaken to enable the available remedies to be effective.

Causes of Disputes

Shareholder disputes may arise for a variety of reasons. Individual shareholders or groups of shareholders may feel that they have insufficient influence over the direction of the company. Alternatively, there may be irreconcilable differences between the aims of specific shareholders: for example, a shareholder/director in a family company may want to retire from the management of the business and to realise his stake while the others may not want to have to deal with a new ‘outside’ owner wishing to influence the running of the business.

In other situations, minority shareholders may have a more general perception that the company is being run by and for individual shareholders or a group of shareholders rather than for the benefit of the shareholders as a whole. Various aspects of the activities of directors and/or specific shareholders may result in benefit for them and/or reduce the value of the other shareholders’ shares. These may include the following:

  • Excessive directors’ remuneration or management fees will increase the expenses of the company and hence reduce its distributable profit. Excessive directors’ remuneration may be combined with low dividends: if the majority shareholders are also directors, they will not be concerned by the poor return on their shares if they are enjoying substantial directors’ fees.
  • Diversion of business from the company to entities controlled by the directors or their associates will reduce the company’s turnover and profitability. In addition to reducing the profits which can be distributed by way of dividend, such actions, if carried out on a sufficiently large scale, will reduce the attractiveness of the company to a potential purchaser given that trading companies are generally valued on the basis of their maintainable annual post-tax earnings.
  • Mismanagement of the company may also reduce the company’s profitability: this may arise, for example, from the under-utilisation of assets or unnecessary expenses e.g. allowing property assets to stand empty or from employing excessive numbers of staff.
  • Related party transactions at an overvalue or undervalue, in which the directors and/or certain shareholders or their associates sell supplies or assets to the company at above market value or make goods or services from the company available to themselves or associates at below market value, will have an adverse effect on the profits of the company compared with transactions undertaken on an arm’s length basis.

Remedies Available to Shareholders

Shareholders who believe that they are being unfairly treated have limited options, particularly if they are minority holders. They may only normally recover by way of a personal action a loss suffered personally, as distinct from a loss suffered in their capacity as members of the company, and the exceptions to this rule are limited. One of the few exceptions is in the case of ‘fraud on the minority’ by wrongdoers in control of a company. ‘Fraud’ in this context means an unconscionable use of majority power which results in or is likely to result in financial loss or unfair or discriminatory treatment of the minority.

Shareholders may petition the court to wind up the company under s 122(1)(g) of the Insolvency Act 1986 on ‘just and equitable’ grounds and may also petition the court for relief under s 994 of the Companies Act 2006 on the basis that the affairs of the company are being or have been conducted in a manner which is unfairly prejudicial to the interests of its members generally or some part of its members (including at least the petitioner) or that any proposed act or omission of the company would be so prejudicial. Although the courts have discretion over the remedies which they can order, they generally favour the purchase of the petitioning members’ shares.

Valuations and Investigations

Independent expertise will be required to value shareholdings which are to be transferred as a result of a dispute between shareholders or to comment on any valuations prepared on behalf of the other party to a dispute. The valuation of a shareholding will normally start with a valuation of the company as a whole. Most valuations of trading companies in a healthy financial position (as opposed to companies whose activity is the holding of property or of financial assets) are based primarily on a multiple of estimated maintainable annual post-tax earnings, which takes into account the company’s historical profits, or through discounting its future cash earnings stream to obtain a present value for the stream. A valuer may need to have regard to any recent transactions in the company’s shares, which can serve as a benchmark against which to test the valuation indicated by his investigations and analysis, and to valuations of businesses in the relevant sector.

Expert accountants will need to investigate and adjust for any ‘funny business’ perpetrated by the directors and/or majority shareholders which has reduced a company’s historical profits in one or more of the ways noted above. Similarly, it will be necessary to adjust for legitimate but ‘one-off’ items which are not relevant to a consideration of the company’s maintainable profits.

Aspects of a company’s financial management which will need to be investigated include:

  • management charges levied on the company by companies owned or controlled by the majority shareholders;
  • consultancy fees paid by the company to directors or shareholders or to companies or individuals associated with them;
  • assets such as land and buildings held in excess of the company’s trading requirements;
  • expenses which are personal to shareholders or directors such as travel and entertainment ‘put through the company’;
  • goods and/or services purchased at prices significantly above normal market levels from particular suppliers;
  • unusually large discounts given on sales to specific customers;
  • the granting of extended credit to certain customers;
  • the employment of superfluous staff or staff whose remuneration is out of proportion to the value they add to the company;
  • directors’ salaries and other benefits which are excessive when compared with those of directors of companies of a similar size;
  • work carried out by the company on behalf of directors or shareholders without charge or at an undervalue;
  • unusual fluctuations in turnover which may indicate the diversion of business from the company;
  • the division of overheads in situations where facilities are shared with other entities, particularly where those entities are connected to the directors and/or majority shareholders; and
  • ‘one-off’ items such as reorganisation costs.

As far as valuations of individual shareholdings are concerned, in quasi-partnership cases, there is generally no discount applied to reflect the minority status of a petitioner’s holding. For companies not regarded as quasi-partnerships, however, the courts have taken conflicting views in recent years. In Re Blue Index Ltd [2014] EWHC 2680 (Ch) and Re Addbins Ltd [2015] EWHC 3161 (Ch), for example, the court favoured the valuation of a minority holding on a ‘pro rata’ basis, without applying any discount. But more recently, in Dinglis v Dinglis [2019] EWHC 1664 (Ch), [2019] All ER (D) 48 (Jul) the court considered as a ‘working hypothesis’ the view that, outside the quasi-partnership scenario, it will be a very unusual case which calls for no discount to be applied at all.

The date at which the shareholding is to be valued may be important. The Court of Appeal ruled in Profinance Trust SA v Gladstone [2001] EWCA Civ 1031, [2002] 1 BCLC 141, [2001] All ER (D) 08 (Jul) that the date of the court’s order to purchase is generally the correct date for a valuation. However, as in the Scottish case of Croly v Good [2010] 2 BCLC 569, [2010] All ER (D) 177 (May) there may be circumstances in which fairness requires that an earlier date be used, e.g. where the business had been controlled solely by one of the parties since the expulsion of the other. Moreover, where unfairly prejudicial conduct has damaged the value of a petitioner’s shares, a buy-out can be ordered based on historical valuations or on the hypothetical basis that such conduct, such as the payment of excessive directors’ remuneration for a number of years, has not occurred. In Booth and others v Booth and others [2017] EWHC 457, [2017] All ER (D) 57 (Jul) for example, the court ruled that the petitioners’ shares should be valued after six years of excessive remuneration had been added back to the balance sheet.

Conclusion

If shareholders in a company feel aggrieved enough to seek statutory remedies against the majority, they will clearly no longer wish to be associated with the other shareholders given that such remedies sought are most likely to be the acquisition of the dissenting minority’s shares or the winding up of the company. In these circumstances, it will be important to investigate the company’s affairs and to obtain an objective valuation of the shareholding in question or for the minority to obtain a critical review of any valuation presented to them.

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This article was first published by New Law Journal on 20/09/19, and is reproduced by kind permission.

The information contained in our Articles is provided as general information only. It does not constitute professional advice and should not be relied on or treated as a substitute for specific advice relevant to particular circumstances. In addition, since the Articles were published in recent years, the information contained in them may not be applicable at the current time.