Dissenting shareholder statutes give shareholders the right to opt out of fundamental corporate transformations — typically by way of merger or consolidation with another corporation — by redeeming their shares for "fair value". Case law in New York and many if not most other states defines fair value as the shareholder’s proportionate share of the value of the enterprise as a going concern, as opposed to liquidation value, determined as of the date immediately prior to the objected-to transaction.
In some states, including New York, another transformative corporate transaction giving rise to an appraisal remedy is the sale of all or substantially all of the assets of the corporation, other than in the usual course of the corporation’s business. However, under the New York statute (Section 910 of the Business Corporation Law), if the sale of assets (a) is wholly for cash, (b) the shareholders’ approval is conditioned upon the dissolution of the corporation and (c) the proceeds are distributed within one year, the opt-out/appraisal remedy is not available.
The majority shareholders in the recently decided case, Brynwood Co. v. Schweisberger, No. 02-CH-1297 (Ill. App. Ct. 2d Dist. July 23, 2009), could have saved themselves a lot of trouble had they incorporated in New York rather than Illinois. That’s because Section 11.65 of the Illinois Business Corporation Act gives dissenting shareholders an appraisal remedy upon the proposed sale or other disposition of all the corporation’s assets with no exception for sales linked to a proposed dissolution and distribution plan, which is what happened in Brynwood.
Making matters even stickier, the corporation in Brynwood owned as its sole asset a highly appreciated parcel of commercial real estate, the sale of which triggered a large gains tax at the corporate level because the corporation was organized as a "C" corporation rather than an "S" corporation. The dissenting shareholder, Mr. Schweisberger, argued with some theoretical justification that his shares in the corporation should be valued based on the going-concern value of the company as of the date prior to the property sale, without regard to the gains taxes and other costs of the actual sale. Schweisberger won at the trial court level but lost on appeal. What exactly happened, and how could the problem have been avoided?
Let’s start with a boiled-down version of the facts. Brynwood Company was formed in 1979 as a C corporation to own and operate as its sole asset a commercial office building in Rockford, Illinois. Some of the shareholders were building tenants, others were not. Other tenants were non-shareholders. Brynwood never issued its shareholders dividends; rather, their only expected return was through appreciation of the building’s value.
Around 2000, by which time the building’s original financing was retired, the directors began evaluating options including immediately selling the building and dissolving, as well as converting Brynwood to an S corporation which prospectively required a 10-year holding period to avoid gains taxes on a future sale. In 2000-01 the corporation redeemed shares of two shareholders for $42.50 per share. Schweisberger, who at 26% controlled the largest block of shares, was offered $50 per share but he refused to sell for less than $62.
The dispute came to a head in July 2002, when the board advised Schweisberger of an opportunity to sell the building to a third party for $1.4 million, and of its willingness to forego a sale if Schweisberger would consent to convert Brynwood to an S corporation. Schweisberger would not consent, giving as his reason that some of his shares were held in an IRA which was not qualified to hold shares in an S corporation and would have required him to transfer shares out of the IRA thereby incurring taxes on the withdrawal.
On July 29, the board formally recommended the sale of the building for $1.4 million in accordance with the proposed buyer’s real estate contract which was executed on July 30. Pursuant to notice a special shareholders meeting was held on August 5 at which all shareholders other than Schweisberger voted to sell the building and to dissolve the corporation. The sale of the building closed on August 7. The mortgage balance of about $350,000 was paid from the proceeds. Brynwood paid another $450,000 for state and federal taxes on capital gains of almost $1 million along with professional fees and other costs associated with the sale of the building and the dissolution of the corporation.
On August 16, Schweisberger gave a notice of his dissenter’s rights, objecting to the sale of the building and demanding payment for the fair value of his shares. On August 19, Brynwood filed articles of dissolution with the Illinois Secretary of State. Brynwood and Schweisberger thereafter exchanged estimates of fair value of $30.08 and $66.31 per share, respectively. In December 2002, Brynwood filed a petition for determination of the fair value of Schweisberger’s shares pursuant to Section 11.70 of the Illinois Business Corporation Act.
A trial was held in early 2006. Brynwood’s CPA testified that under Brynwood’s business model, "fair value comes down to the liquidation value." In his view, the taxes, professional fees and other costs associated with the sale of the building and Brynwood’s dissolution should be deducted in calculating the fair value of the shares, which he calculated at $36.15 per share. He also calculated that if Schweisberger was paid his figure of $66.31 per share for his 26% interest, the remaining shareholders would receive only $25 per share.
Schweisberger, who also was a CPA, testified as an expert witness on his own behalf. He calculated the fair value of Brynwood’s stock at $66.31 per share as of August 6, 2002, the day before the closing on the sale. He testified that as a dissenting shareholder he was not obligated to pay his share of the gains taxes which were a "contingent liability" realized only upon the sale of the building. A second expert testified for Schweisberger. He likewise testified that under the going concern premise of value, the taxes and other sale expenses should not be deducted because those expenses "would not have accrued but for the actions of Brynwood, and Schweisberger had dissented from those actions."
The trial court sided with Schweisberger and arrived at a per share value of $60.68 without any deduction for the gains taxes and other closing and dissolution expenses. The court found that exempting the taxes and expenses was not inequitable because the sale "occurred with Brynwood’s knowledge that Schweisberger dissented from the decision to sell the building and that selling the building would trigger a capital gains liability and accompanying costs and professional fees for the corporation."
Brynwood appealed. The appellate court’s analysis of the valuation issue begins on page 23 of its 41-page opinion. Schweisberger urged affirmance on the basis that the taxes and closing expenses had not yet been incurred as of the August 6, 2002, valuation date. He also argued that deducting those amounts effectively would amount to a calculation of the "fair market value" of a corporation in the process of liquidation rather than the required "fair value" of a going concern.
Brynwood argued that the failure to deduct taxes, closing and dissolution expenses resulted in an artificial inflation of the value of the shares and resulted in a windfall to Schweisberger at the majority’s expense. It also contended that the trial court’s decision was inconsistent with the purpose of the dissenting shareholder’s statute, which is to ensure that all shareholders are treated fairly and equally.
The appellate court’s opinion quotes the Illinois statute’s definition of fair value as follows:
"Fair value," with respect to a dissenter’s shares, means the value of the shares immediately before the consummation of the corporate action to which the dissenter objects excluding any appreciation or depreciation in anticipation of the corporate action, unless exclusion would be inequitable.
Next, the court noted that fair value is based on the "intrinsic value" of the corporation as a going concern and, quoting from a1950 Delaware ruling (Tri-Continental Corp. v. Battye, 31 Del. Ch. 523, 74 A.2d 71):
In valuing a corporation to make a fair value determination as to a dissenter’s shares, "the important thing to bear in mind is that value of stock in a going concern is to be measured in terms of [the shareholders’] ability to realize that value."
Schweisberger’s ability to realize the investment value of his interest in Brynwood, the court continued,
was affected by its inherent and unique nature as a closely held corporation. . . . As investors in a closely held corporation, Brynwood’s shareholders did not have an open and available market in which they could sell their shares of stock for cash. . . . [W]hether a shareholder decided to monetize the investment through a private sale or through the sale of the building, a proper calculation of the true, intrinsic value of the shareholder’s percentage ownership should have necessarily taken into account all of the previously detailed foreseeable and ascertainable transactional costs that were known and inherent in the unique nature of Brynwood and its business as a closely held C corporation whose business was to hold a single parcel of real estate for its appreciated value.
The court then addressed the relevant transaction costs as follows:
As it applies to the instant case, the transaction costs inherent in selling Brynwood’s only asset, the building, necessarily included the taxes, fees, and other costs. Therefore, the true, intrinsic value of Schweisberger’s percentage ownership would not, and could not, have been, as the trial court found, a strict percentage interest in the $1.4 million fair market value of the building, because the fair market value of the building could not have been realized without also incurring the transaction costs, that is, the known, foreseeable, and ascertainable capital gains taxes, professional fees, and other costs . . . [which were] intimately tied to the true and intrinsic value of the corporation as a whole, and correspondingly, to the investment value of each of the shareholders’ interest in the corporation.
The court broadly rejected Schweisberger’s contention that recognizing the transaction costs amounts to a calculation of "fair market value" instead of fair value. The court’s decision further declares that deducting the taxes and other costs "effectuate[s] the purpose of the statute and is consistent with the equities of the situation presented" in that Schweisberger was not the "victim of majority overreaching in an attempt to eliminate him from the corporation at a price below fair value or in an attempt to usurp the voting power of his shares." Rather, it was Schweisberger "who, in effect, ‘trapped in’ the capital gains tax liability for all of the shareholders when he declined to allow Brynwood to convert from a C corporation to an S corporation." The court also noted that Brynwood had offered Schweisberger $50 per share prior to entering into a third-party sale of the building.
The court therefore remanded the case to the trial court for a re-calculation of Brynwood’s fair value including deduction for capital gains taxes, professional fees, and other costs related to the sale of the building. In a small reprieve for Schweisberger, the court directed that any dissolution or other expenses incurred after the "consummation" of the building’s sale on August 7, 2002, were not chargeable against the value of his shares.
Until Brynwood I’d never seen or heard of a dissenting shareholder case involving a sale of the company’s assets combined with dissolution. If nothing else this case affirms the wisdom of dissenting shareholder statutes such as New York’s, which deny appraisal rights for the sale of the corporation’s assets preceding dissolution and distribution of the net proceeds.
Even if there’s room to argue the theoretical basis for the appellate court’s application of liquidation value, based on the case’s unique facts and the equities, the result feels right. Why should Schweisberger come out way ahead of the other shareholders when he was offered a much higher buyout previously which would have allowed the remaining shareholders to convert Brynwood to an S corporation? If there’s such a thing as a reverse squeeze-out, this was it.
Could the majority shareholders have avoided what turned into a seven-year appraisal fight? Perhaps they could have effectuated a voluntary dissolution first, and then sold the building under a plan of liquidation. I can’t really say if that technique would have worked without knowing if Brynwood had a shareholders’ agreement with a super-majority or unanimity requirement for voluntary dissolution, which might have required the consent of Schweisberger’s 26% interest. A pre-sale voluntary dissolution also might have caused problems under the existing mortgage financing, or otherwise jeopardized the sale in hand.
Hat tip to Matthew O’Hara, Esq. of Reed Smith LLP and his article on Brynwood in the Chicago Daily Law Bulletin.