Kentucky Supreme Court rejects shareholder level discounts

The recent decision by the Kentucky Supreme Court in Shawnee Telecom Resources, Inc., successor by merger to Shawnee Technology, Inc. v. Kathy Brown establishes important precedent for determining fair value in dissenters’ rights actions. The decision outlines the factors that may be taken into account and holds that shareholder level discounts may not be applied in the determination of the fair value of a dissenting shareholder’s shares. With this decision, the Kentucky Supreme Court aligned Kentucky’s position relative to the valuation of dissenters shares with the majority of jurisdictions by rejecting shareholder level discounts.

Certain transactions undertaken by Kentucky corporations trigger statutory dissenters’ rights. Those transactions, set forth in KRS 271B.13-020, include mergers, share exchanges, sales of all or substantially all of a corporation’s assets, conversion of a corporation into a limited liability company, certain amendments of the articles of incorporation of a corporation, and other business combinations. If such a transaction is undertaken, a shareholder may dissent and obtain payment of the “fair value” of his, her or its shares. KRS 271B.13-010(3) defines “fair value” as “the value of the shares immediately before the effectuation 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.” If a shareholder believes he, she or it is being offered less than “fair value” for the shares following consummation of the transaction giving rise to the right to dissent, the shareholder may object, thereby potentially giving rise to a fair value proceeding.

Kentucky’s legal standards for determination of “fair value” have developed through a series of decisions. Among the points at issue in Shawnee Telecom Resources were shareholder level discounts, such as marketability or control discounts, the use of which had been previously considered by the Kentucky Court of Appeals in Ford v. Courier Journal Job Printing Co., 639 SW2d 553 (Ky. App. 1982). In Ford v. Courier Journal Job Printing Co., the Kentucky court upheld the use of minority and marketability discounts in a “fair value” proceeding.

The Shawnee case arose from the merger of Shawnee Technology, Inc. (“Shawnee Tech”), a Kentucky corporation, into Shawnee Telecom Resources, Inc. (“Shawnee Telecom”), also a Kentucky corporation. Under the merger, one of Shawnee Tech’s shareholders, Kathy Brown (“Ms. Brown”), would receive cash for her shares, making the transaction a “cash out merger” authorized by KRS 271.B.11-010. The merger triggered Ms. Brown’s dissenters’ rights and she demanded “fair value” for her shares. Shawnee Tech disputed the claimed value of Ms. Brown’s shares and brought an action in Fayette Circuit Court for an appraisal of the shares.

Ms. Brown and Shawnee Tech offered competing expert testimony as to the value of Ms. Brown’s shares. Shawnee Tech’s valuation consultant used a series of valuation techniques and, following his enterprise valuation analysis, discounted Ms. Brown’s proportionate interest to account for the absence of a ready sales market for Ms. Brown’s shares of the closely-held Shawnee Tech.

Ms. Brown’s valuation expert did not disagree generally with the valuation techniques used by Shawnee Tech’s consultant, although he did object to certain adjustments made to the factors underlying the valuation. Importantly, he maintained that the marketability discount should not apply because the value being sought was not the market value of the shares but rather the proportionate interest of the shares in Shawnee Tech’s total value as a going concern. Based upon this opinion and the other valuation discrepancies, he concluded that Ms. Brown’s shares had a considerably higher valuation.

The Master Commissioner to whom the appraisal was referred by the trial court made a number of rulings but, based upon the precedent of Ford v. Courier Journal Job Printing Co., he approved the use of a marketability discount. His ruling was upheld by the trial court. Both parties appealed. On appeal, Ms. Brown argued that the Commissioner and trial court erred by allowing the marketability discount in the fair value calculation. A unanimous panel of the Court of Appeals agreed with Ms. Brown, holding that a marketability discount was inappropriate in a fair value proceeding under the dissenters’ rights statutes and should not have been applied to the fair value determination of Ms. Brown’s shares. The Supreme Court granted discretionary review to consider the question of fair value under Subtitle 13 of the Business Corporation Act.

The Supreme Court considered the continuing viability of a marketability discount in a dissenters’ rights appraisal action. The Court gave considerable attention to the development of the appraisal remedy, noting that it was designed to serve as an anti-oppression mechanism “to protect minority shareholders from majority overreaching.” The Court specifically addressed the use of marketability discounts and the justification for their application: “Under statutes such as KRS 271B.11-010 and KRS 271B.6-040, which authorize mergers and reverse stock splits the effect of which is to ‘cash out’ a minority shareholder, a lack of liquidity is not the minority shareholder’s concern.” Rather “it is the amount that the shareholder will receive for an investment that is being usurped.” The Court observed a broad consensus that fair value in the context of a dissenters rights transaction was widely understood to be not a hypothetical price at which the dissenting shareholder might sell his or her particular shares, but rather as the dissenter’s proportionate interest in a company as a going concern. Based on this rationale, the Court determined that shareholder level discounts, such as discounts for a lack of control or a lack of marketability, were not appropriate and may not be applied, overruling the contrary holding of the Kentucky Court of Appeals in Ford v. Courier Journal Job Printing Co.

The Court concluded that “fair value” is a shareholder’s proportionate interest in the value of a company as a whole and as a going concern. The Court discussed at length the valuation of a company as a going concern: “The value of the going concern may be determined by any valuation technique generally recognized in the business financial community and shown to be relevant to the circumstances of the particular company at issue.” The Court recognized that enterprise wide discounts may be appropriate in certain circumstances: “Entity level discounts, where justified, are appropriate because they are factors that affect the intrinsic value of the company as a whole….An entity level discount must be based upon particular facts and authority germane to the specific company being valued.” The Court even noted a list of potentially appropriate entity-wide discounts, such as a key manager discount, a limited customer supplier based discount, a trapped in capital gains discount, an environmental liability discount, a pending litigation discount, a portfolio discount, a small size discount or a privately held company discount.

The Kentucky Court’s decision in Shawnee Telecom Resources is important to any entity engaged in a transaction that triggers dissenters’ rights. The holding offers clear guidance on factors that may, and may not, be taken into account in determining fair value of an interest in a company in what are often highly contentious circumstances.