July 24, 2014

Have you been engaged to value a minority interest in a closely held Texas corporation which does not have a shareholder agreement? If so you need to be aware of the recent Texas Supreme Court decision Ritchie v. Rupe.

In Rupe, the court ruled that officers and directors of closely held businesses owe a fiduciary duty solely to the corporation and not for the benefit of individual shareholders. The Texas Supreme Court has given broad latitude to the controlling shareholders, officers and directors of closely held Texas corporations in dealings with minority shareholders. Specific to the Rupe case, the Court found that a business could refuse to allow its officers and directors to meet with potential buyers of a minority shareholder’s interest and could refuse to provide the prospective buyers with its financial statements since such actions did not create a risk of serious harm to the corporation.

Roger A. McEowen, Director of the Iowa State University Center for Agricultural Law and Taxation describes the Rupe decision as “provid[ing] a greater measure of certainty for the corporation as a whole.” According to Professor McEowen, potential purchasers of a minority interest in a closely held Texas corporation without a shareholders agreement can reasonably expect the following:

  1. the corporation will likely not pay dividends if it is not required to do so
  2. the shareholder will not be able to participate in corporate decisions;
  3. there will be little, if any, return on their investment;
  4. it will be difficult, if not impossible, to sell the interest to an outsider; and
  5. any sale, whether to an insider or a third-party, will be substantially discounted to fair value.

The Rupe decision allows closely held companies without shareholder agreements to refuse to provide financial information to potential purchasers of minority interests. The decision effectively eliminates anyone considering purchasing such interests access to “reasonable knowledge of relevant facts” about the company. As a result, the pool of “willing buyers” of minority interests in closely held businesses is reduced to corporate insiders – the only potential buyers with access to information about the business needed to be a reasonably informed purchaser – and speculators willing to take a gamble similar to buying a lottery ticket.

The facts of the Rupe case provide an example of the degree to which discounts may increase as a result of the decision. The value of the plaintiff’s pro rata share of the company on a controlling interest basis was $7.4 million. A broker engaged to sell the plaintiff’s stock priced it at “$3.4 million because of the directors’ refusal to meet with prospective buyers.” He did not succeed in selling the stock because, in his opinion, “everybody wanted to be able to meet … and talk to the executives . . . as part of their due diligence.” The Company offered to purchase the interest for $1 million in cash. Later it increased the offer to $1.76 million in cash – a 76% discount to the stock’s value on a controlling interest basis.

Each valuation is based on the facts and circumstances specific to the company and the interest being valued. A key factor in any valuation analysis is the ownership rights of the interest holder. By its decision in Rupe, the Texas Supreme Court has clarified the limited ownership rights that a minority shareholder has in a Texas closely held corporation when no shareholders agreement is in place. Unlike partners in partnerships, minority shareholders in Texas corporations do not have a statutory right to exit a business and receive fair value for their interest.  Furthermore, according to the Texas Supreme Court, minority shareholders without a shareholders agreement “[are] ‘uniquely subject to potential abuse by a majority shareholder or group’ … unable to extract themselves from the business relationship, at least without a financial loss.”

While Rupe is specific to Texas, anyone valuing similar interests for businesses incorporated in other states should be aware of the decision and its impact on the rights of minority shareholders. While some state courts have addressed the issue of the minority shareholders’ rights, many have not. For jurisdictions where the rights of minority shareholders in closely held businesses remains unsettled, the Rupe decision is expected to be an influential case in future decisions.

 

Lindsey Lee