In this article, we discuss the concept of valuation and insider information as well as the role of “informed and prudent parties” .
By James A. DeBresser and Steve Z. Ranot
The concept of “fair market value” is fundamental to the valuation of business interests, and is the definition that has been accepted by our highest courts. Fair market value is generally defined as follows:
The highest price available in an open and unrestricted market between informed and prudent parties, acting at arm’s length and under no compulsion to act, expressed in terms of cash.
Valuation and Insider Information: The Definition of Fair Market Value
The definition of fair market value has several key elements, all of which have been addressed by the Courts. In this article, we discuss one of these key elements, that is, the concept of “informed and prudent parties” and the impact thereon by the existence of insider information about a business.
Most of the time, business valuations prepared for matrimonial litigation are prepared notionally, in other words, a live transaction is not being contemplated. In a notional valuation prepared under the definition of fair market value, it is assumed that the notional vendor and notional purchaser are informed and prudent parties. The relevant questions for valuation purposes therefore are:
1) How much prudence should the notional vendor and purchaser be assumed to have?
2) How much knowledge should the notional vendor and purchaser be assumed to have?
Although the degree of the participants’ prudence has not been tested by the Courts, the extent to which they are informed was first tested in the English Court of Appeal case Hinchcliffe v. Crabtree 1971 2 All. E.R. In Hinchcliffe, negotiations were taking place on the valuation date with respect to the takeover of a public company, whose shares on that date had a trading price of the equivalent of about $85. Because news of the takeover was not public, the argument was made that the shares should be valued at the ultimate takeover price, which was the equivalent of about $200. On the valuation date, the only parties that had knowledge of this information were the investment advisor to the company and his insider client shareholders. The argument was made that if the owner of the shares wanted to sell them on the valuation date, he would have been compelled to disclose information about the takeover offer to the purchaser, thereby causing the price to be bid up to the takeover price. The Court of Appeal held that there was no evidence that such information would have been available to purchasers in the open market, and, accordingly the argument for the higher value was not accepted.
Determining the Fair Market Value
In National System of Baking of Alberta Limited v. The Queen 1978 DTC 6018, taxpayers who owned shares in a public company argued that their shares should be valued higher than the public market price for tax purposes because 1) the shares were thinly traded, 2) they had information prior to the valuation date of a pending takeover and 3) an actual takeover bid took place shortly after the valuation date, driving the stock price from $85 to $200. The Court fixed the value at about $93 based on the average closing price of the stock for the ten-week period prior to the valuation date, and paid no attention to the post-valuation date impact on the takeover bid. In the finding, the Court stated that there was no reason for departure from the ordinary functioning of the open market in determining the fair market value, as it remained the best indicator available. The Federal Court of Appeal upheld the decision of the lower Court.
At least in Hinchcliffe and National System of Baking of Alberta, it was assumed that neither the vendor nor the purchaser had perfect knowledge – only the knowledge that can reasonably be expected to be present in a normal open marketplace. The second part of this article examines the debate about insider trading in a more recent case, as well as the appropriateness of valuing employee stock options under the generally accepted approach when the owner is privy to insider information.
The appropriateness of considering insider trading was debated in LeVan v. LeVan 2006 CanLII 31020 (ON S.C.), a case better known for the legal issues pertaining to marriage contracts. In LeVan, the husband and his direct family owned multiple voting shares in a publicly-traded company such that the family-controlled 87% of the votes on the date of separation. The remaining 13% of the votes were widely held by the public and were traded on both the Toronto and Nasdaq stock exchanges. The public company was a manufacturer of exhaust manifolds for the major automobile manufacturers. Historically, the company had three major customers: General Motors, Ford and Chrysler. Several months prior to the date of separation (in or around April 2003), Ford notified the company that it was not going to renew its contract with the company and that it was going to move its business to a Chinese competitor. This knowledge was not public on the date of separation (October 2003). The valuator for the wife calculated the value of the husband’s interest on the date of separation by multiplying the public market share price by the number of shares that were directly or indirectly held by him.
The valuator for the husband disputed the approach taken by the wife’s valuator, and argued that a valuation based on the share price was inappropriate given the significant insider information that existed on the valuation date that would likely impact the share price if it was made public. Furthermore, the husband argued that, as an insider with material insider information, he was precluded from selling his shares because he was subject to a “blackout window” under securities law. However, an en bloc valuation of the public company was not prepared on behalf of the husband, because it was his position that he was not required to prepare one under the marriage contract. Because the Court set aside the marriage contract, the only evidence before it was the calculation of value based on the share price. Furthermore, the Court found that the wife’s valuator was not provided with the necessary information and access to management required to do an en bloc valuation. Accordingly, the Court accepted the value based on the share price, notwithstanding the insider information that was present on the date of separation.
Although the findings in LeVan relied on the public trading price, it did so at least partially because that is all the Court had to rely on – time will tell if a different case with similar facts distinguishes between the use of the share price to calculate the value of a business interest and an en bloc approach to value when there is significant insider information that is present on the valuation date.
Appropriateness of Valuing Employee Stock Options
Another yet-to-be-litigated issue is the appropriateness of valuing employee stock options using the generally accepted Black-Scholes formula, when the owner of the employee stock options is privy to insider information. For employee stock options, the relevant definition of value is “value-to-owner”, which is defined as follows:
The economic advantage to the owner regardless of a property’s transferable nature, or, the measure of loss to the owner if the property was removed rather than what an arm’s length party would pay for that asset.
In Ross v. Ross 2006 CanLII 41401 (ON C.A.), the Court of Appeal endorsed the use of the Black-Scholes formula in valuing employee stock options, which is appropriate as long as the owner of the employee stock options is not privy to significant insider information. Is the use of Black-Scholes appropriate otherwise?
The Use of the Black-Scholes Formula
An implicit assumption in the use of the Black-Scholes formula is that its user only has access to the public information that is available on the date that the options are being valued. Since stock options are granted to CEO’s and insiders, who are often privy to information that is not public, the use of the Black-Scholes formula for all cases may not be appropriate. If the owner of the employee stock options is privy to significant insider information on the relevant valuation date, it is possible for the “value-to-owner” to be higher or lower than the value that the Black-Scholes formula would predict. Given the frequency with which employee stock options are awarded to senior employees who are typically privy to insider information, it is somewhat surprising that this issue has not yet been considered by the Courts. Time will tell if the Court, given the right set of facts to consider, will distinguish between a Black-Scholes based valuation and some other approach when the owner of the employee stock options is privy to significant insider information on the valuation date.
Steve Z. Ranot, CA·IFA/CBV, and James A. DeBresser, CA·IFA/CBV are partners in Marmer Penner Inc., a Business Valuator and Litigation Accountant firm in Toronto, Ont.