Court interprets meaning of “fair value” on a forced buy-out

04 February 2021

The High Court has held that, where one shareholder amended a company’s articles to allow him to forcibly acquire the other shareholder’s minority holding at “fair value”, the value of those was discounted to reflect the minority shareholding.

What happened?

In the matter of Euro Accessories Ltd [2021] EWHC 47 (Ch) concerned a company whose business was the supply of various construction accessories.

The company was incorporated in December 2000 by a Mr Gilsenan, who held all of the shares in the company. In 2003, a Mr Monaghan joined the company as a sales representative. In February 2008, Mr Gilsenan transferred 24.99% of the company’s shares to Mr Monaghan, retaining a controlling stake of 75.01% himself.

Around January 2010, the relationship between the two shareholders broke down and Mr Monaghan tendered his formal resignation. Negotiations began for Mr Gilsenan to buy Mr Monaghan’s 24.99% stake back from him. However, the two shareholders were unable to agree a price for the stake.

This continued for a number of years until, in March 2016, Mr Gilsenan proposed a series of special resolutions, which he passed as the majority shareholder, with the following effect:

  • Mr Gilsenan’s shares were converted into “A” shares and Mr Monaghan’s shares into “B” shares.
  • The articles were amended to give the B shareholder (i.e. Mr Gilsenan) a right, by written notice, to force the A shareholder (i.e. Mr Monaghan) to sell the A shares to the B shareholder for “fair value”.

In April 2016, Mr Gilsenan sent Mr Monaghan a notice under the amended articles requiring Mr Monaghan to sell his shares to Mr Gilsenan for a total price of £175,000. Mr Monaghan did not comply and so Mr Gilsenan ultimately implemented the share transfer himself using a power under the amended articles to do so.

A few years later, Mr Monaghan brought legal proceedings. He did not dispute that Mr Gilsenan had a right to forcibly buy his stake. However, he claimed that the amount he should be paid – the “fair value” of his shares – was a pro rata proportion (i.e. 24.99%) of the total value of the company’s shares.

Mr Gilsenan argued that “fair value” of Mr Moneghan’s shares needed to include a discount to reflect the fact that they represented a minority stake in the company and that control rested with Mr Gilsenan.

Mr Monaghan argued that no discount should be applied for three main reasons:

  • The amended articles gave a majority shareholder an “unrestricted right to expropriate the shares of the minority at will” without cause and at any time. No reasonable businessperson would think that Mr Monaghan was a willing seller who would agree to a discount.
  • The ordinary meaning of “fair value” was akin to that given in the 2013 edition of the International Valuation Standards of the International Valuation Standard Council (IVSC).
  • The “fair value” of the shares was one that was “just and equitable in the circumstances”. Here, the shareholders were parties to an arrangement of mutual trust and so it would be unfairly prejudicial to Mr Monaghan to apply a discount.

The parties jointly instructed a single valuer to decide the value of the total share capital and the discount that should be applied if a discount were warranted. She calculated that value at £2.18 million and the discount at 55%. This meant that, if no discount were applied, Mr Monaghan would receive £545,000 for his shares and, if a discount were applied, he would receive £245,000.

The question for the court was: did the phrase “fair value” require a discount to be applied?

What did the court say?

The judge agreed with Mr Gilsenan and ordered that the discount was to be applied.

The key question was how the phrase “fair value” in the amended articles was to be interpreted.

A company’s articles of association are a contract between it and its members and so the usual principles apply when interpreting a contract. These are now set out in a trio of Supreme Court judgments – Rainy Sky SA v Kookmin Bank [2011] UKSC 50, Arnold v Britton [2015] UKSC 36 and Wood v Capita Insurance Services Ltd [2017] UKSC 24 – and allow the courts to consider both the literal meaning of the words and the factual context in which the contract was made.

However, the judge also noted that, when interpreting a company’s articles association, the courts will not take all of the factual background into account. They will have regard only to any facts that any reader would reasonably be expected to know (Attorney General of Belize v Belize Telecom Ltd [2009] UKPC 10). This is for two reasons:

  • Unlike a commercial contract, articles of association are not usually the product of a commercial negotiation leading to a meeting of minds.
  • A company’s articles are a public document and have to be capable of being understood by anyone who inspects them.

As a result, when interpreting a company’s articles, a court will look at the natural meaning of the words, how they are used in the articles, any readily ascertainable facts about the company, and commercial common sense.

In this case, the judge noted the following:

  • A third party would see that Mr Gilsenan introduced the buy-out right as the holder of 75.01% of the company’s shares. At most, an “astute and assiduous” reader might conclude that Mr Monaghan had not agreed to the right, given his signature did not appear on the written resolution.
  • The breakdown between Mr Gilsenan and Mr Monaghan would not have been apparent to a third party and so it could not be taken into account when interpreting the company’s articles.
  • There was nothing in the articles that pointed towards the meaning of “fair value”. However, importantly, the articles stated: “the consideration payable for the Sale Shares … shall be … fair value”, which suggested that the focus was on the property, not the identity, of the shareholder.
  • Previous cases suggested that, unless the articles state otherwise, a discount should be applied to a minority stake. To attribute a proportionate value of a company’s total value to a minority stake is to attribute part of the “control value” of the company to a stake that confers no control. The fact that Mr Gilsenan could exercise the option at any time and without limit in time did not indicate that a different approach should be taken.
  • There was no reason to pick the 2013 IVSC definition of “fair value” over and above any other definition. The articles did not refer to the 2013 Standards, and third party would not necessarily have made a connection with them. Indeed, the 2013 Standards had been superseded by new standards in 2017 precisely to avoid confusion between different concepts of “fair value”.
  • Even if inserting and exercising the buy-out right amounted to unfair prejudice (and the court did not think it did), there was no reason why a discount should not nonetheless be applied. A discount had been applied in previous, similar cases.

What does this mean for me?

The judgment in this case helpfully re-establishes some of the principles that apply when interpreting a company’s articles, as opposed to a standard commercial contract. In particular, members of a company should avoid falling into the trap of re-visiting historic negotiations when trying to work out what a provision in a company’s articles means, as a court is very unlikely to take these into account.

However, perhaps the more relevant point for anyone who is negotiating a set of articles, or indeed any kind of contract, that bases payments on the “value” of an asset is to make it clear how that value is calculated. It is common to for contracts to be drafted using phrases such as “market value”, “fair value” or (perhaps most awkwardly) “fair market value”, but these phrases can have different meanings to different people.

When fixing a value, it is worth bearing a few points in mind:

  • Explain what is meant by the phrase “value”. This could be achieved by reciting a commonly used accounting definition, or by referring to a definition in appropriate accounting or audit standards. The 2017 edition of the International Valuation Standards is not a bad place to start.
  • Use terminology that is understood by financial experts, especially valuers. Phrases such as “market value”, “fair value” and “equitable value” are often easier for valuers to pin down, as they often focus on identifiable principles. By using an established phrase, it may be possible to calculate the value with some certainty even if the contract does not set out a specific definition.
  • Avoid non-technical phrases with no established meaning. A common offender is the phrase “fair market value”, which is commonly used in the United States but which is not a term of art in the UK and which confuses the concepts of “market value” and “fair value”.
  • Cater for any special factors. For example, in the context of shares, make it clear whether a discount will be applied to the value of a minority stake or, conversely, a premium attached to the value of an asset that, if acquired, will give the buyer a controlling or blocking stake.
  • Include a determination mechanism. Court proceedings can be costly. Often the easiest way to resolve a dispute is to appoint an independent expert, such as an accountant or valuer, to value the asset. A good determination mechanism will state that the expert’s valuation will, in the absence of any gross or manifest error, be binding on the parties.