Is Your Valuation Procedure Watertight?

July 16, 2009

Introduction

Articles of association used in private equity and venture capital transactions will, almost without exception, contain compulsory transfer provisions requiring management shareholders to offer their shares for sale in the event that their employment comes to an end. Depending on the circumstances of the departure, it is common for there to be a need to determine the "fair value" of the shares in question. If the parties cannot agree the value, the usual default position is for the value to be determined by a third party, often the company's auditors or an independent firm of accountants. A recent case has shown that, where the fair value is to be determined by an independent expert, the departing employee could prevent the valid appointment of the expert by refusing to sign the expert's letter of engagement.

Why was the Case Brought?

Mr. Davenport was a shareholder, director and employee of Cream Holdings Limited ("the Company"). He was removed as a director of the Company. This triggered a mandatory share transfer provision in the articles of association of the Company ("Articles"), which stipulated that Mr. Davenport had to sell his shares to other members of the Company at "fair value". The parties were unable to reach agreement between themselves on what constituted the fair value of the shares, which meant that this fell to be determined by independent firm of accountants chosen by the Company and Mr. Davenport. The parties agreed on a firm of accountants to ascertain the value of the shares but only the Company signed the firm’s engagement letter.

Mr. Davenport subsequently sought a declaration that the valuation formulated by the accountants was not binding on him as there had been no valid appointment in accordance with the Articles, since he did not sign the engagement letter. Although Mr. Davenport agreed the identity of the independent accountant, the Articles specifically stated that the accountant should be "appointed". The appointment should have involved a tripartite agreement between Mr. Davenport, the Company and the firm of accountants, which was very different from simply agreeing the identity of the proposed valuer. The Court of Appeal agreed with Mr. Davenport's argument and added that it would be surprising if a firm of accountants could be "independent" without the agreement of both parties

Implications of the Decision:

A number of issues arise from the decision: 
• The ambiguity in the drafting of the articles was construed against the Company in light of the importance of the point in issue. The role of the independent accountant in signing off a valuation which would be binding on all concerned was of such magnitude that it could not assume this role simply by means of "nomination" by the parties.
• One comment made by the Court of Appeal was that the issue would not have occurred had the Company's auditors been appointed to undertake the valuation exercise, since they would already be in office.
• In any event, articles of association often provide a fallback position, allowing the valuation to be referred to an independent accountant where the auditors are unable or unwilling to act. In these circumstances the nomination and appointment formalities should be carefully set out in the articles, to remove any ambiguity.
• Additionally, from an investor’s perspective, a method of ensuring that a reluctant seller is bound by the valuation provisions may be to include a power of attorney in the articles, authorising the company to sign any relevant documents in connection with the engagement of the independent accountant.
• Determination of disputes by an independent expert is found in many commercial agreements, and the principles set out in this case are therefore not necessarily confined solely to share valuations.

Action Points

In the light of the above, it would be sensible for shareholders generally to:
• review their standard documentation to identify any deficiencies in the appointment process for independent experts, and amend the documents if necessary;
• if necessary (and possible) take steps to amend the articles of association; and
• ensure that legal advice is taken before entering into a valuation process.


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