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Beware The Fair Value Trap For Selling Shares In A Private Company

03 June 2012

Many New Zealand private companies will have rules in their constitutions, in an agreement between shareholders or contained in some other agreement or contract, about how the price of shares in the company will be calculated when a shareholder wishes to sell their shares.

What is often misunderstood or overlooked, is that the Companies Act has a requirement that over-rides any agreed share valuation processes in certain, and not uncommon, circumstances. The application of this section has been brought to light in some recent cases.

Where it’s a director of the company who is selling or buying shares, s149 of the Act generally requires the price of the shares to be at ‘fair value’. This applies even if the other party is also a director and/or has access to all the information about the company. S149 applies even if the shareholders have previously reached an agreement about how share price is to be determined when one of them wishes to sell. Even where the director discloses all relevant information to the other party, the fair value requirement will still be applicable.

The requirement extends to directors selling or buying shares as one of a number of joint holders of the shares, for example as a trustee shareholder. The requirement most likely extends to people (not directors) selling or buying shares as trustees where the trust is controlled by a director.

What is fair value? The Act leaves this open for interpretation, but states that in determining what amounts to fair value, you must consider all information known to the director or publicly available at the time of buying or selling the shares. Fair value is essentially a price which is just and equitable in the circumstances of the particular company and the particular shareholders, and the particular reasons for the sale or purchase of the shares. The courts have said that fair value is “a value which is fair as between vendor and purchaser”.

What is not fair value? Counter-intuitively, market value may not be fair value. Also a value as determined by a formula previously agreed between the shareholders may not be fair value, even though all shareholders were more than happy with the formula at the time it was agreed.

On a practical level what does this mean for you? Where a director is the buyer or seller of shares, no matter who the other party is, the final price for the shares will be fair value, not the value as agreed or as per the contract or as per the constitution. Any agreement as to a formula, a fixed value or a discount may be unenforceable if this does not result in a ‘fair value’.

Where the other party seeks to enforce the requirements of s149 through the courts, a director who acquired shares at less than the fair value amount will be liable to pay the shortfall amount. A director who disposed of shares at over the fair value amount will be liable to reimburse the excess that was received.

What can be done? There may be options depending on the circumstance. In essence, however, there is no contracting out of s149, so a share seller will have no choice but to work the requirements of s149 into the deal.

In summary, selling shares is not straightforward. Care and the right advice needs to be obtained to ensure any sale does not come with any nasty surprises.

 

Dan Moore is a partner of Norris Ward McKinnon. Information in this article should not be a substitute for legal advice. With offices in Hamilton and Huntly, we have friendly, expert legal advisors ready to help you with your business and personal legal matters.