For LLC Minority Owners, “Fair Value” Often Isn’t
The Illinois Business Corporation Act (BCA) and the Illinois Limited Liability Company Act (LLC) contain references to the term “fair value.” In the BCA, we find this term in the context of dissenter’s rights (805 ILCS 5/11.60-70) and in the minority shareholders’ rights section (805 ILCS 5/12.56). In the LLC act, the term occurs in the provision giving members the right to dissociate and receive payment for their interest in the company (805 ILCS 180/35-60).
Lack of Control Leads to Lack of Marketability
The Illinois courts have looked at the issue of fair value on a number of occasions, and the Journal published a very good article a couple of years ago. John T. Shriver and Paul J. Much, Determining Fair Value for Minority Shareholders Who Sue for Corporate Wrongdoing, 91 Ill B J 199 (April 2003). Discounts for lack of control and lack of marketability are one aspect of fair value, and they are the focus of this column.
An illustration is helpful. Assume we have a company with two shareholders, one called “Boss” having 70 percent of the stock and another called “Worker” with the remaining 30 percent. Assume for simplicity’s sake that we know that the company is worth exactly $100,000.
Worker comes to Boss and says, “Hey, Boss, I’ve got an idea! We’re making decent money here, we’ve both got kids about to go to college; let’s put the kids on the payroll and let them earn some money for college. Boss responds, “Good idea! We’ll put my kid to work next week. We don’t have an opening for yours. The minority shareholder is thus made painfully aware of his lack of control.
Come year’s end, Worker stops by again, with another idea: “We’ve had a good year; let’s reduce our corporate profit by paying ourselves each a bonus.” To which Boss responds, “Good idea! I’ll take that bonus, but you haven’t impressed me that much, so you won’t be getting one.” (See a pattern here?)
So Worker tries to sell his shares for the $33,000. The response is “Are you nuts? I can’t put my kid on the payroll, I can’t get a bonus. Why should I pay $33,000 for your shares? On the off chance that the whole place may get sold someday, I’ll pay you $20,000.” Thus we have lack of marketability and a corresponding discount.
But It Ain’t Fair, Judge…
In Hickory Creek Nursery, Inc v Johnston, 167 Ill App 3d 449, 455, 521 NE2d 236, 239-40 (3rd D 1988), the court held that a minority discount should not be applied. But in Independence Tube Corp v Levine, 179 Ill App 3d 911, 917, 535 NE2d 927, 931 (1st D 1988), the court held that “[t]here may be situations in which the minority or illiquid nature of the stock diminishes its value. In such instances, these factors should be considered in determining fair value.”
In Institutional Equipment & Interiors, Inc v Hughes, 204 Ill App 3d 922, 562 NE2d 662 (2nd D 1990), the court sustained the trial court’s action rejecting both premium and discount. However, in Stanton v Republic Bank of South Chicago, 144 Ill 2d 472, 581, 581 NE2d 678 (1991), the court upheld discounts for minority interest.
In Weigel Broadcasting Co v Smith, 289 Ill App 3d 602, 682 NE2d 745 (1st D 1996), the court discussed valuation methodology in detail: “The fact that the statute requires dissenting shareholders to be given ‘fair value,’ without specifically defining the term, we think, evidences a legislative intent to allow courts the freedom to fashion a remedy without limiting them to any single form of valuation. It is a legislative grant of broad discretion.” Id at 607, 682 NE2d at 749. The court then went on to uphold the trial court’s valuation, relying on the testimony of an expert who applied discounts for illiquidity and minority.
It would seem the rationale in valuing a minority interest in an LLC would be the same. Note that the LLC Act calls for a withdrawing (dissociating) member to receive the “fair value” of his interest. Like the Business Corporation Act, the Limited Liability Company Act does not define “fair value.”
These discounts are not inventions. They reflect market reality. The question is, in the context of a merger, a reverse stock split, or section 12.56 litigation, is it fair to impose the discount?
The Wisconsin appellate court put it rather well in HMO-W, Inc v SSM Health Care System, 228 Wis 2d 815, 598 NW2d 577 (1999):
We conclude that minority discounts are inappropriate under dissenters’ rights statutes. These statutes were intended to be a trade-off. Majority shareholders were given the power to make fundamental corporate decisions free from minority-shareholder interference and, in exchange, minority shareholders were given the opportunity to receive the appraised fair value of their shares. That appraised fair value should be equal to the shareholder’s share of the corporation. It would not be a fair trade-off to require minority shareholders to surrender their veto power in exchange for a discounted return on their investment, while allowing majority shareholders to obtain control over the corporation as well as a premium on their investment. Such a relationship favors one side at the expense of the other, which we conclude is inconsistent with the purpose of the statute. In short, we conclude that each dissenting shareholder should be assigned his or her pro rata share of the corporation’s net assets, undiscounted for minority status.
Id at 827, 598 NW2d at 582-83.
Secretary of State Jesse White’s Business Laws Advisory Committee is studying amendments to both the BCA and the LLC Act. One could add dissenters’ rights to the LLC Act and another might exclude these discounts from the statutory definition of fair value. Whether this study will result in a proposal for legislative change is uncertain.
Meanwhile, prudent practice when representing a minority shareholder or minority owner in an LLC is to negotiate for agreements protecting the minority from a forced buy-out including discount(s). Obviously, a buy/sell agreement with either a fixed price or an appropriate valuation formula would be a first objective.
Other provisions for the protection of the minority owner would be a contractual veto power. The business corporation act permits either increasing or decreasing the minimum vote requirement(s) in the case of organic acts (merger, sale of assets in bulk, charter amendment or dissolution). If your client holds 20 percent, negotiate for an 85 percent vote requirement, giving your client a veto.
Chapter 2A of the Business Corporation Act (Close Corporations) is little used, but it contains a provision allowing a shareholder (even a minority shareholder) to elect to liquidate the corporation, a powerful negotiating position. The LLC act permits any number of such protections to be included in the Operating Agreement. The only things you can’t do in the operating agreement are listed in section 805 ILCS 180/15-5(b).
If you represent a minority owner, you and your client cannot afford to rely on the statute for protection. You need to negotiate and draft aggressively to protect the interests of your client.
Linscott R. “Lin” Hanson is a member of Di Monte & Lizak, LLC in Park Ridge and is past chair of the Secretary of State’s Business Laws Advisory Committee.