FVS Consulting. A Method to Adjust the Cost of Equity Capital for Prevailing Market Conditions. Chairman s Corner WHAT S INSIDE

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1 FVS Consulting Issues, cases, practice management tips and news for Forensic and Valuation Services Section members Issue 23 April 2015 A Method to Adjust the Cost of Equity Capital for Prevailing Market Conditions By Marc Vianello, CPA, ABV, CFF The basic cost of capital build-up approaches using the Duff & Phelps CRSP and Risk Premium Report data employ the formula K = RFR + ERP + SP. In this formula, K is the cost of capital, RRF is the risk free rate, ERP is the equity risk premium, and SP is a size premium. The 2014 Valuation Handbook Chairman s Corner We all rely on high-quality professionals with the specialized skills we need to perform the services that set our firms apart. One great way to encourage and retain promising professionals is to recognize their value. That s one of the many reasons the AICPA established the Standing Ovation Recognition Program, which spotlights young CPAs in forensic accounting and business valuation who exhibit exemplary professional achievement. Recipients will be featured in a press release on the FVS Section site, in the FVS conference brochure and during the town hall at our annual conference. Partners and managers are encouraged to submit nominations on behalf of your top talent. And if you re new to valuation or forensics, you should be aware of two great programs presents, among others, the cost of equity capital components shown in Table 1 (on next page) through calendar year The conventional valuation approach is to modify the historical cost of equity capital to a current cost by substituting a current risk free rate for the historical risk free rate used in the CRSP and Risk Premium Report calculations. As that match with you mentors who are seasoned professionals who can help you develop your skills. If you want to advance your knowledge and your career, take the time to learn more about the ABV Mentor program or the CFF Mentor program. Meanwhile, whether you re a relatively new partner or have long experience in the field, consider volunteering for membership on the FVS committees. I can tell you from personal experience that it offers excellent learning experiences and the chance to network with highly skilled professionals and develop longlasting friendships. If you are interested in participating, be sure to apply at volunteers.aicpa.org/. Carol Carden, CPA/ABV, CFE, ASA continued on page 2 WHAT S INSIDE Assembled Workforce RUL and Business Combinations Court Rejects IRS Claim that Art Business is a Hobby A Virginia Case Sheds Light on Shareholder Oppression Round-Up of Recent Business Divorce Cases from Across the Country Calendar of Events Contact Us We welcome your comments, questions or article ideas. Please send them to fvsconsultingdigest@ aicpa.org. FVS CONSULTING DIGEST APRIL

2 A Virginia Case Sheds Light on Shareholder Oppression By Michele Burke Craddock, John H. Craddock, Jr. and Brian D. Burns, CPA/ ABV/CFF, ASA Business owners focus on the demanding requirements of operating a closely held business. Managing the relationships among executives, board members, and shareholders is frequently an after-thought until disputes arise at which point the cost and risk to the business and its owners may be severe. Recently, the court ordered dissolution of a highly profitable fourth generation closely held Virginia company due to the oppression of minority shareholders. This case shed new light on the rights of minority shareholders, the duties of controlling shareholders, directors and officers, and the limitations of certain perceived protective measures. Forensic accountants and valuation professionals can play an important role in assisting business owners and their counsel in the evidentiary and valuation aspects of these matters. This article focuses on corporate law, however, judicial dissolution is provided for in limited liability and partnership statutes as well as the corporate statutes. A variety of risk areas relating to unforeseen events and changes in the interests, objectives, and circumstances of business owners may eventually lead to disputes. Divergent owner characteristics can take many forms, including the level of ownership, operational involvement and personal and investment characteristics. These characteristics frequently change as businesses pass from generation to generation, and intra-family fighting and power struggles can eventually lead to litigation. Succession planning can be extremely challenging in such circumstances, and as ownership evolves, the relationships among owners may become contentious. Disputes may arise when controlling or majority shareholders take actions that are inconsistent with the desires of all shareholders or are harmful to the minority shareholders interests. Such actions can be referred to as freezeout or squeeze-out techniques that oppress the minority shareholder. Shareholder litigation, among other claims, may involve two types of legal remedies available to shareholders: 1) appraisal or dissenters rights or 2) dissolution actions. Both dissenting shareholder and dissolution actions are governed by state law that includes corporate law statutes and case law. Dissenting minority shareholders may petition for appraisal in specific transactions in which they are forced to give up the ownership of their shares, whereby the dissenting shareholders shares are redeemed at fair value as defined by state statute. Shareholders customarily have appraisal rights in an involuntarily merger or consolidation, and certain states also allow dissenting shareholder claims in other corporate actions, such as asset sales, recapitalizations, stock exchanges, amendments to the articles of incorporation, etc. Alternatively, dissolution actions involve minority shareholders seeking judicial dissolution of the company on certain grounds. Examples may include when the directors or shareholders are deadlocked; the directors or controlling shareholders act in a manner that is illegal, oppressive, or fraudulent; or the corporate assets are being misapplied or wasted. The remedies available under judicial dissolution statues vary from state to state. Oppressed shareholders may seek to establish that the majority has excluded them from their proper share of the benefits attributable to their ownership in the business. Oppression often 12 APRIL 2015 FVS CONSULTING DIGEST

3 involves egregious majority actions that target individual minority shareholders, such as: Removal of minority shareholders from the board of directors or as officers of the company Reduction in compensation for and/ or termination of employment of minority shareholders Increased compensation of controlling shareholders Reduction or termination of dividends, which can also lead to flowthrough income tax liability concerns Diversion of corporate funds for various personal benefits flowing only to controlling shareholders Use of corporate assets for personal benefit Withholding information from minority shareholders and minority directors In using these actions to squeeze out the minority shareholders, the controlling shareholder may seek to benefit by purchasing stock at an artificially deflated price below market value or limiting returns to minority shareholders. The standard of value in these matters is typically fair value, a statute-based standard for dissenting shareholder deadlock, oppression or waste valuations in most states. Differing approaches to its meaning and measurement have evolved through legislative changes and judicial interpretation. In recent years, most, but not all, jurisdictions have accepted the position that what has been taken from the shareholder is a pro rata share of the value of the company as a whole as compared to the fair market value standard of value which may incorporate discounts for lack of control and lack of marketability. The difference in value for a minority interest in a closely-held interest under a fair value standard and a fair market value standard may be significant. Shareholder oppression statutes are frequently part of corporate dissolution statutes that provide guidelines for dissolving corporations, and the statutes vary from state to state. Dissolution statutes exist to provide procedures by which businesses may wrap up their business affairs and end their existence. Courts may be hesitant to find in favor of the minority shareholder as dissolution is drastic measure. Consequently, some states provide alternative remedies such as a buyout of an oppressed shareholder s shares at a court determined fair value. Although dissolution can be viewed as an extreme measure, the risk to corporations is real as was demonstrated in the recent case of Colgate, et al. v. The Disthene Group, Inc. ( Disthene ) in the Circuit Court of Buckingham County, Virginia. Judge Jane Marum Roush issued an opinion that the controlling shareholders had engaged in a longstanding practice of oppression of the minority shareholders, and as a result, Judge Roush agreed to provide the remedy mandated under Virginia law and ordered the judicial dissolution of Disthene. The case could arguably be the most important minority shareholder oppression case in Virginia. Colgate, et al. v. The Disthene Group, Inc., 85 Va. Cir. 286 (Buckingham County 2012) In Virginia, dissolution, not a courtordered buyout, is the exclusive judicial remedy for judicial dissolution, including cases brought on the grounds of oppression, waste or deadlock. 1 However, upon a shareholder filing of a petition for judicial dissolution, first the corporation and then the other shareholders may elect to purchase all of the petitioner s stock at fair value. 2 In that context, a dissolution action was filed in the Circuit Court of Buckingham County by Boyd Colgate, his son Curtis, and step-daughter Sharon, who sought an involuntary dissolution of Disthene alleging oppressive, wasteful, and fraudulent conduct by Gene Dixon, Jr. and his son Guy by virtue of their ownership, director, and executive positions in Disthene. Dissolution was granted in favor of the plaintiffs, and a receiver was appointed to liquidate Disthene. In August 2012, Judge Jane Marum Roush issued her opinion that largely addressed the duties of majority shareholders in closely held corporations in Virginia. At the time the opinion was issued, a corporate derivative litigation brought by the Colgate family on behalf of Disthene was pending. The derivative action included claims against all of the officers and directors of Disthene and its subsidiaries relating to their breaching fiduciary duties and other wrongful conduct. Both the derivative and the related corporate dissolution litigation were eventually settled via a buyout of the stock owned by the Colgates and other minority shareholders. Disthene is a large, profitable business headquartered in Buckingham County, Virginia, and is organized as a Virginia C corporation. At the time of the litigation, Disthene operated the following whollyowned subsidiaries 1. Kyanite Mining Corporation, a Virginia corporation that operates as the world s largest producer of the minerals kyanite and mullite. 2. Cavalier Hotel Corporation, a Virginia corporation that owned the landmark Cavalier Hotel in Virginia Beach, Virginia. 3. Blue Rock Resources LLC, a Virginia limited liability company that owns approximately 28,000 acres of land in and around Buckingham County, Virginia. 1. Va. Code Va. Code continued on page 14 FVS CONSULTING DIGEST APRIL

4 continued from page 13 Based on the publicly filed settlement agreement, the estimated total value of Disthene approximated $200 million. Disthene s capital structure included two classes of stock: Class A Voting stock and Class B non-voting stock. The Class A Voting stock was entirely owned by Gene Dixon, Jr. and his son, Guy Dixon, who were grandson and great-grandson, respectively, of the co-founder of Disthene. Gene and his children, individually or through other related entities, also owned Class B non-voting stock, and most of the nonvoting shares not owned by Gene and Guy were owned by descendants of the company s founder, Gene Dixon Sr. The ownership at the time of the litigation was as follows: 1. Gene Dixon, Jr. family 51% (inclusive of the voting and nonvoting 2. Colgate family 42% (non-voting 3. Former employees/heirs 7% (nonvoting The Colgate family brought suit, alleging that Gene and Guy conducted corporate operations in an oppressive and fraudulent manner to the detriment of the minority shareholders involving the misapplication and waste of corporate assets. The defense primarily focused on the business judgment rule to justify their actions in an effort to demonstrate that the actions were supported by sound business practices. The business judgment rule is designed to insulate directors of a corporation and provides a safe harbor for directors actions or inactions and protects their good-faith business judgments from being second-guessed in court. However, this defense applies only when the director exercises his business judgment on behalf of the corporation. It does not apply when the director engages in conflicted transactions, when the director places his interests above the interests of the corporation, or when the director fails to engage in the decision making process (i.e. a director that rubber stamps decisions made my others). Judge Roush found that the business judgment rule did not apply as a defense in the case because the decisions were not made to further the directors good faith belief of what was in the best interests of the company, but instead were made to further the Dixons best interests. Judge Roush noted that both corporate officers and directors have a fiduciary duty to exercise good faith in their dealings with shareholders. For example, Judge Roush found that both officers and directors owe a duty of fair dealing to shareholders seeking to sell their stock back to the company which preclude them from making misrepresentations to those shareholders. Judge Roush heard evidence and issued her opinion finding oppression of the minority shareholders, waste of corporate assets, and misrepresentations and half-truths with respect to the efforts of some of the minority shareholders to redeem their shares. Judge Roush concluded that non-voting shareholders in a closely-held corporation are inherently disadvantaged by virtue of their nonvoting status and the lack of a market to sell their shares. However, Judge Roush provided that minority shareholders have a, right to be treated fairly by the corporate officers and directors in accordance with the officers and directors fiduciary duties. Judge Roush found that the officers and directors of Disthene had breached their duties because: 1. The controlling shareholders engaged in misrepresentations and half-truths as to the value of its stock when negotiating with the minority shareholders who were selling shares of stock back to the company. 2. The controlling shareholders significantly, and in bad faith, reduced dividends to retaliate against the Colgates for filing an earlier lawsuit against Gene Dixon Jr. relating to a marital trust that held Disthene stock. 3. Contemporaneous with the reduction in dividends, compensation for certain controlling owners/executives was materially increased. 4. The controlling shareholders favored the interests of their own family members at the expense of the non-voting shareholders. 5. The controlling shareholders misused and/or wasted corporate assets by using them for personal purposes without fair compensation or benefit to the company. Expert witnesses with expertise in forensic accounting and valuation played an important role in analyzing and presenting pertinent evidence and opinions to support the merits of the claims of the plaintiffs and the opinion of Judge Roush. As previously discussed, both the derivative and the related corporate dissolution litigation were eventually settled under a buyout of the stock owned by the Colgates and other minority shareholders for approximately $77 million. The impact of the case on the financial position of Disthene, the composition of its business units, and the cost of the litigation was significant as described below. 1. Disthene previously operated with limited debt but was forced to raise $77 million in cash for the settlement. 2. Disthene incurred significant costs relating to the receivership fees, legal fees (including the plaintiffs legal fees), and expert fees. 3. Disthene s historical asset, the Cavalier Hotel in Virginia, Beach, was sold to pay for the settlement. Key Takeaways A significant portion of Judge Roush s letter opinion addressed common 14 APRIL 2015 FVS CONSULTING DIGEST

5 techniques of the oppression of minority shareholders. These squeeze-out techniques, among many, may include withholding or reducing dividends to force minority shareholders to sell the shares at considerably less than actual value or providing unjustifiable jobs or compensation to the majority shareholders, their relatives, or affiliated parties. Forensic accountants can offer investigative and analytical services into various areas to identify potential oppressive actions. Valuation professionals may assist with assessing the implications of such oppressive actions on value. For example, an opinion could be rendered with respect to the value of the business had it been cleanly managed and operated absent the oppressive conduct. A sampling of potential areas subject to investigation could include the following: Shareholder and intercompany transactions Owner compensation Healthcare, retirement, and fringe benefits Related party transactions Expense reimbursements Capital structure manipulation Excess intercompany fees and payments to affiliates under common ownership Non-business expenses for shareholders or key personnel Excess or insufficient interest on loans to/from shareholders Non-operating/excess assets/liabilities The investigation into these areas may be a highly invasive process into company records that could potentially go well beyond the testing and procedures performed in a financial statement audit. Business owners and their advisors may believe that financial statement audits are a bullet-proof defense against certain claims of oppression. While audited financial statements are designed to provide assurance, it is important to distinguish that the general purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial reporting framework, which enhances the degree of confidence that intended users can place in the financial statements. The financial statements subject to audit are those of the entity, prepared and presented by management of the entity with oversight from those charged with governance and do not override laws and regulations that govern their responsibilities. As such, CPAs may assist business owners and their advisors in distinguishing the benefits and limitations of audited financial statements in shareholder litigation. As previously discussed, the matter of Colgate, et al. v. The Disthene Group, Inc. involved the ordered dissolution of a highly profitable fourth generation closely held Virginia company due to the oppression of minority shareholders. The decision shed new light on the rights of minority shareholders, the duties of controlling shareholders, directors and officers, and the limitations of certain perceived protective measures. While Judge Roush s opinion is not necessarily the controlling law of Virginia, the opinion sets forth established Virginia law and certainly provides guidance in this area of corporate law with respect to the rights of minority shareholders. Its impact may potentially include increased claims requiring the specialized expertise of forensic and valuation professionals. As the matter was tried under Virginia law, it is important for forensic and valuation professionals practices in different jurisdictions to understand the state specific statutes and case law in supporting attorneys and clients in these types of matters. Michele Burke Craddock, is Partner, Craddock Law PLC. John H. Craddock, Jr., is Partner, Craddock Law PLC. Brian D. Burns, CPA/ABV/CFF, ASA, is Senior Manager, DHG Forensics and Valuation Services, Dixon Hughes Goodman LLP. FVS CONSULTING DIGEST APRIL