Beware the (fair market) value trap

Vague, incomplete and ambiguous valuation clauses in shareholders agreements are traps for the unwary and create unintended consequences.

Shareholders Agreements often include valuation provisions to be invoked when one party wishes to sell its shares or upon the forced transfer of shares in a breach situation. Two cases in the New South Wales Court of Appeal (one recent; the other not so) illustrate how the drafting of these provisions requires careful consideration.

In Network Ten Pty Ltd v. TX Australia Pty Ltd [2018] NSWCA 312, the Court looked at circumstances affecting Network Ten’s shareholding in TXA following the appointment of a receiver and manager to Network Ten in June 2017.

TXA was a joint venture entity into which each of Network Ten, Nine Network and Seven Network tipped transmission equipment and assets in exchange for one third of the equity each. The TXA Shareholders Agreement provided (as they often do) that, if there were a material breach, the defaulting shareholder would be taken to give a transfer notice to the other shareholders covering its entire shareholding in TXA. Needless to say, the appointment of a receiver and manager would constitute an event of default, triggering these deemed transfer provisions. The price for the defaulting shareholder’s shares was to be agreed between the defaulting shareholder and TXA, or, failing that, “a price determined by [TXA’s] auditor [acting] as an expert [and] whose decision [would] be final and binding.

PwC was TXA’s auditor and they proceeded (with some difficulty, it must be said, bearing in mind the absence of valuation guidelines or criteria) to value Network Ten’s TXA shares. They adopted a market value approach. Their valuation report put forward a number of scenarios (including an ‘as is’ scenario, a scenario involving Network Ten entering into a long term access agreement with TXA and various scenarios assuming an arms’ length access agreement between TXA and a hypothetical third party), each resulting in a different valuation of TXA. A discounted cash flow methodology was used in each case.

In the event, no long term access agreement was entered into between TXA and Network Ten, so the ‘as is’ scenario (resulting in a net liability valuation for the whole of TXA and a ‘nil’ valuation on the Network Ten’s shares in TXA) was adopted by the non-defaulting parties. On that basis, Network Ten’s shares in TXA were deemed offered to, and taken up by, Network Seven and Nine Network for a dollar each. In fact, the spread of values given in the PwC report for the whole of TXA ranged between a net liability amount (the one adopted by TXA and the non-defaulting shareholders) and $42.9 million (the latter assuming a long term contract between TXA and Network Ten).

It is obvious why this case ended up in Court.

At first instance (TX Australia Pty Ltd v Network Ten Pty Ltd [2018] NSWSC 559), the judge, Justice Stevenson, ruled that PwC had done what was required by the contract and had determined the price payable for Network Ten’s shares (even though the report included a range of values without preferring or fixing a particular price). The judge also ruled that PwC had not erred in basing their valuation on the concept of market value even though the contract required the price to be determined.

The Court of Appeal reversed the primary judgement on the ground that the PwC report had not determined the price for Network Ten’s shares in TXA, but, rather, had put forward a series of valuation scenarios, leaving the non-defaulting parties to select the one they considered most appropriate.

However, on the issue of market value, the Court of Appeal agreed with the primary judge. The issue before the Court was how a reasonable businessperson would have understood the provision requiring the auditor to determine the price for the shares, having regard to “the language used by the parties, the surrounding circumstances known to them and the commercial purpose or objects to be served by the contract”.

Applying this principle, Chief Justice Bathurst put forward a number of grounds for the price to be determined on the basis of objective factors (rather than on a subjective basis giving effect to relative fairness and equity between the parties).

First, the objective of the price determination provisions was to enable a price to be determined promptly in the absence of agreement between the parties. The requirement for promptitude left little scope for the auditor to have regard to subjective issues.

Secondly, the price so determined would be the price at which the non-defaulting shareholders could either acquire the defaulting shareholder’s shares or procure their sale to a third party. The fact that the shares could end up in the hands of a third party suggested the need for an objective determination of value.

Thirdly, the fact that the parties had chosen the auditor to make the determination pointed to a determination of price by reference to ordinary valuation considerations with which the parties, as sophisticated commercial entities, would have been familiar. Such valuation considerations would have been matters that an auditor would have been well-qualified to take into account (as distinct from an enquiry based on what was just and equitable between the parties). On that basis, the price was to be determined as “the price, in cash or in kind, which would be obtained for the property in question in an arm’s-length dealing between a willing but not anxious seller and a willing but not anxious buyer”.

Practical issues when negotiating and drafting Shareholders Agreements

Courts are often reluctant to rewrite commercial contracts, but this case illustrates the willingness of the NSW Court of Appeal to interpret ambiguous or ineffective valuation provisions to achieve business effectiveness (or something resembling it).

It is rare for modern Shareholders Agreements to leave significant issues - such as share valuation at the point of the parties’ separation - to chance. Typically, these provisions call for the determination of market value (a well understood, if not always clear, concept), or fair market value (to which, see further below), or they include a level of prescription designed to make the expert’s job easier (provided the prescription is consistent and logical). However, clarity is not uniform or universal, and examples where a price or value is to be agreed between the parties, or determined by an expert (but no further guidance is provided on how that is to be achieved), are encountered relatively frequently.

This case suggests that Courts in New South Wales may fill a void by interpreting the parties’ presumed intention (based on a reasonable business person’s understanding in all the circumstances) to determine value by reference to the market (or exchange) value concept. Whilst there may be situations where leaving valuation of shares to market or exchange value will be advantageous (e.g. where prescription is likely to become irrelevant or outdated), this approach disregards special valuation considerations which may be intrinsic in a particular relationship. Leaving determination of value to judicial exegesis of the relevant provisions (which is likely to involve consideration of a range of factors and hypotheses outside the parties’ control and understanding) is akin to playing a high stakes game of cards. This may not end well for all or any concerned.

Determination of “fair market value” can be an imprecise and paradoxical exercise

Quite often, Shareholders Agreements require the fair market value of shares to be determined upon separation of the parties. Fair market value is a frequently used composite expression, so you could be forgiven for thinking that it has become a reliable and intuitive concept. But this is not the case (as the Court of Appeal decision in MMAL Rentals Pty Ltd and Others v. Bruning [2004] NSWCA 451 illustrates).

The judgment was delivered in 2004, but the reasoning of the Court still represents the law in New South Wales.

MMAL Rentals was the investment vehicle (owned as to 81.75% by Mitsubishi Motors and 18.25% by Mr Bruning) which owned 80% of Kingmill (Australia) Pty Ltd, the company which was Australian franchisee of the car rental business, Thrifty. The remaining 20% of Kingmill was owned by the franchisor, Thrifty Inc. of the USA. Kingmill had a management agreement with Mr Bruning for his services. In the previous decade (i.e. up until 1984), Mr Bruning had been an owner and manager of the Australian franchise of Thrifty. In 1990, Mitsubishi acquired the old Thrifty Australian franchise business (which was on the verge of insolvency) with a view to supplying the franchise with Mitsubishi vehicles. Mitsubishi invited Bruning to participate in the venture, and Bruning invested his own money to acquire 18.25% of the shares in the investment vehicle, MMAL Rentals.

The investment agreement between Mitsubishi and Bruning (in relation to MMAL Rentals) provided that, if the management agreement between Bruning and Kingmill terminated, then Mitsubishi could purchase Bruning’s shares in MMAL Rentals for their fair market value. Fair market value was to be agreed between the parties, or, failing that, determined through an expert process.

In 1997 (following a two year extension), the management agreement was terminated by Kingmill, and Mitsubishi exercised its option to purchase Bruning’s shares in MMAL Rentals. The parties could not agree fair market value for the shares, and, having dispensed with the expert determination process, they headed straight to the Equity Division of the NSW Supreme Court with their respective valuation experts. The expert evidence adduced by Mitsubishi was that, using a net asset valuation (bearing in mind earnings were negligible), Bruning’s shares in MMAL Rentals were worth only $59,000. The evidence adduced by Mr Bruning (relying on a more complex, industry specific methodology (which involved significant normalisation of earnings)) was that the fair market value of the shares was closer to $6 million.

The primary judge, Chief Justice Young, rejected both sets of expert evidence - see Bruning v. MMAL Rentals Pty Ltd (2004) 136 IR 124. In relation to the net assets approach adopted by Mitsubishi, the primary judge commented that this method was as useful as valuing the Sydney Harbour Bridge on the basis of its scrap metal value, a basis of valuation which would have no regard to the Bridge’s considerable value to the community. The judge observed that the available information relating to fair market was limited, but that the role of the Court was to do the best it could with the evidence before it. This should serve as a stark warning to those drafting and negotiating key provisions of shareholders agreements.

The Court of Appeal (led by Chief Justice Spigelman) affirmed Chief Justice Young’s primary judgement, but varied the orders. The following points are key:

  • The requirement to determine a market value (albeit one qualified by the word ‘fair’) did not involve determining what was just and equitable as between the parties (as would be the case with fair value), but, rather, pointed towards an objective standard. That said, the word ‘fair’ still had “work to do.”
  • It was not possible to set out in abstract terms how a fair market value should be computed.

Beware the (fair market) value trap

  • The ‘fair’ component suggested that valuation should proceed on the assumption that there were no impediments to the process of bargaining (such as inequality of information between the parties, the existence of restraints or restrictions in the articles of association, the rights of third parties (e.g. financiers, licensees or franchisors) or otherwise). This was the case even when at odds with the facts of a particular relationship or situation. The primary judge used similar reasoning to dismiss the argument that a net asset valuation based on a hypothetical liquidation should exclude goodwill because ‘fair’ (according to the judge) demanded consideration of a theoretical liquidation which would preserve goodwill, and not an actual liquidation which would allow the franchisor to terminate the franchise and take back the all-important airport desks.
  • That said, in order to be included in the valuation mix, an issue would still need to inhere in the property which was the subject of the valuation. The exercise was still to determine an objective value for the relevant property - just one grounded in the actual relationship, rather than the hypothetical transaction-based relationship between a willing (but not anxious) buyer and a willing (but not anxious) seller.
  • The fact that MMAL Rentals had substantial accumulated losses and substantial debt owing to its parent did not detract from the special potentiality or value that the Company represented to Mitsubishi (which had no intention of winding the company up). On that basis, net asset value was irrelevant for valuation purposes. This special potentiality should be taken into account when determining the fair market value of the Bruning shares. The special potentiality (or special value) included the benefit of preserving a sales channel for vehicles. Further, the chance to avoid having to deal with a third party investor with no involvement in the underlying business operations was in itself valuable (even though the Company’s articles of association prevented transfers of shares to third parties - see third point above). This might encourage greenmailing by the minority, the Court found, but that was neither illegal nor improper.
  • Past discussions about value resulting in an offer to purchase shares may well be relevant evidence of value and serve to establish a floor price. The context to this was that Mitsubishi had, the previous year, told Bruning that his shares were worthless. When Bruning offered to buy Mitsubishi’s shares on that basis, Mitsubishi instead offered Bruning excess of $500,000 for his shares (an offer which was obviously not accepted at the time). In the opinion of Spigelman CJ, where the Company’s financial position and performance had been substantially the same at the time of the offer as they were presently, then it would be absurd to exclude evidence of the offer from the present proceedings.
  • Applying a discount factor for a minority shareholding was irrelevant where the valuation exercise involved an assessment of special potentiality or value to the purchaser. Conversely, the fact that the asset held special value for the purchaser did not mean that fair market value should have regard to future financial benefits (e.g. profits and cost savings) that the purchaser would enjoy by moving to 100% ownership. The test was what a prudent person in the purchaser’s position would be willing to pay rather than lose the relevant asset. This brought the matter back to the objectivity of the market or exchange value methodology.

Lessons when drafting Shareholders Agreements

Whilst fair market value is still a market value based concept, it nevertheless allows subjective factors to encroach. The Court of Appeal would not support this view - after all, market value is an objective standard, the determination of which does not involve an enquiry into what is just and equitable between the parties (which is a fair value test). However, there is no other reasonable explanation for seeking to put a value on factors which are personal or subjective to the purchaser (e.g. the special value in preserving core business strategy by maintaining an existing sales channel, or the imputed desire not to deal with a new minority investor not otherwise involved in the business – although Mitsubishi probably was not Robinson Crusoe on that particular island).

In any event, the fair market value concept can be difficult, unintuitive and paradoxical.

The problem with this paradox is that it is likely to result in an outcome which fails to live up to the parties’ expectations and commercial goals. As the primary judge in the proceedings said, it is the role of the Court to do the best job that it can with the evidence available to it. The scarcer the evidence, the more arbitrary and less empiric the outcome (if the matter is litigated or arbitrated). Judges are not valuers. And how, in any event, would one go about valuing special potential or value? Parties to shareholders agreements should also be careful with prior discussions and offers where the primary measure is fair market value. As we see in the last case, an offer made (but rejected) subsequently gained unforeseen relevance.

If you are negotiating a shareholders agreement, beware the (fair market) value trap and other similar concepts which are often taken for granted, but little understood (if actually considered).

We would be happy to help you avoid these and other pitfalls in your next shareholders agreement.


Christopher Brown

Chris advises on public company takeovers and private M&A deals; business and share sales, equity investments and joint ventures.

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