Directors with inside information must buy and sell shares for 'fair value'

Insider trading is not usually associated with share dealings by directors of small private companies. However, a recent High Court case provides a useful reminder that section 149 of the Companies Act 1993 requires share transactions involving directors with material non-public information to be for 'fair value'. If they are not, the director is liable to the seller (or buyer) for the difference between the 'fair value' and the price at which the shares were sold, regardless of whether the parties have reached a prior express agreement on the sale price.

The facts

In Wong v Fong¹, a family business was set up through a holding company (Pave Capital) in 2005. Mr Fong provided most of the finance for the business and through a trust (the Hobson Trust) was the majority shareholder in Pave Capital. His daughter and son-in-law (Mr Wong), who had initiated the business venture and managed the business, were minority shareholders in the company (through their interests in the Cobblestone Trust).

In 2007, the family business arrangements became unsustainable when the minority shareholders wished to pursue a business venture which Mr Fong refused to entertain. As a result, Mr Wong pressed Mr Fong to sell Hobson Trust's shareholding in Pave Capital to Cobblestone Trust. Mr Fong refused and eventually Cobblestone Trust, under the terms of Pave Capital's constitution, issued a share transfer notice to Hobson Trust nominating a price for its shares. Mr Fong disagreed with the nominated price and elected to have the shares valued at arbitration as provided by Pave Capital's constitution. A dispute then arose between the parties as to the basis Pave Capital's shares should be valued. The constitution provided for a 'fair value' to be fixed independently. Cobblestone Trust's position was that this meant the shares should be valued on the basis of a "price at which 100% of the shares would change hands between a willing buyer and a willing seller on the open market" and was insistent that it should not involve a minority discount. However, before this issue was resolved, Cobblestone Trust, which was in debt to Hobson Trust, was pressured into entering into a Deed of Dissolution for the sale of its shares to Hobson Trust with an agreement that the 'fair market value' of the shares was to be determined by an independent accounting firm (PwC).

PwC's determination of the 'fair market value' incorporated a 30% minority discount, although they did note that their assessment may have been different had they been asked to determine a 'fair value' rather than a 'fair market value'. When Cobblestone Trust refused to settle the Deed, Hobson Trust brought a summary judgment application against Cobblestone Trust. The High Court refused to grant summary judgment on the basis that there was an argument that section 149 of the Companies Act required the sale to be at a 'fair value'.

Following the summary judgment application, Cobblestone Trust, under further pressure from Hobson Trust, chose to complete the sale of shares at the PwC 'fair market value' price under the Deed of Dissolution and then brought a claim based under section 149 against Hobson Trust for the difference in the sale price and the 'fair value'.

The High Court had to determine whether section 149 applied despite the fact that Cobblestone Trust had accepted the 'fair market value' price under the express provisions of the Deed of Dissolution. Further, if section 149 did apply, the court also had to determine whether there was a difference between the statutory 'fair value' and the 'fair market value' determined by PwC.

High Court's decision

Application of section 149

Under s149 of the Companies Act a director of a company who has material non-public information about the value of the company's shares as a result of his or her capacity as a director or employee and who purchases (or sells) shares in the company is liable to the seller (or purchaser) for the difference between the 'fair value' and the price at which the shares were traded.

The High Court agreed with Cobblestone Trust, relying on a 2001 Court of Appeal decision², that the transfer of the shares was subject to section 149, even in light of the parties' express agreement set out in the Deed of Dissolution. The transfer was between the trustees of the respective Trusts, but the trustees (Mr Fong and Mr Wong) were also directors of Pave Capital. As such, the court held that they could only have known of the value of Pave Capital (and its related companies) because they were directors.

Statutory fair value

Section 149 provides no guidance on how 'fair value' is to be calculated. Justice Asher in the summary judgment hearing noted that the "application of [section] 149 does not automatically result in a certain valuation formula being applied to ascertain fairness. Rather, 'fair value' has to be assessed objectively, on a case by case basis, after an examination of all the relevant circumstances".

In this case, the court acknowledged that it was not uncommon for the 'fair market value' of a minority shareholder's shares to be discounted to reflect the shareholder's lack of control over the affairs of the company which makes the shares less valuable to an arm's length purchaser on the open market. However, this it noted was not invariable. There are exceptions where a minority shareholder can be unfairly exploited if a discount is imposed. English and Australian authorities recognise that this may occur:

• where a company is a quasi-partnership which has been formed on the basis of a personal relationship involving mutual confidence with an agreement or understanding that all or some of the shareholders will participate in the conduct of the business and restrictions on share transfers; and

• where the minority interest has a special strategic value to the majority shareholder.

On the facts, the High Court concluded that both of these exceptions were applicable. Pave Capital was an example of a quasi-partnership of the type noted above. It was founded on the basis of a personal relationship involving mutual confidence. It rested on an understanding that the two shareholders would participate together in business and it also restricted share transfers. Further, under Pave Capital's constitution which required a 75% majority for ordinary as well as special resolutions, Cobblestone Trust's shareholding had a special strategic value to Hobson Trust. As such, the court held that PwC was wrong to discount the value of Cobblestone Trust's holding in Pave Capital to the extent of 30%. In its opinion, 10% of the PwC valuation represented a more appropriate discount in the context of the transaction as a whole.

Judgment

The High Court held that Hobson Trust had paid less than 'fair value' in breach of section 149 and gave judgment to Cobblestone Trust for the difference in the amount it received from Hobson Trust and the full PwC valuation less a 10% discount (being the 'fair value' set by the court).

Conclusion

This case illustrates the extent to which section 149 of the Companies Act can affect share dealings by directors. The fact that the directors held their shares through trusts did not take them out of the reach of section 149. It also did not matter that both directors were likely to be privy to the same inside information. Under section 149 inside information does not cease to be no longer "material to an assessment of the value of shares or other securities issued by the company" merely because the information is already known or is disclosed to the person with whom the director trades. Information only ceases to be held by a director "in his or her capacity as a director or employee of the company, being information that would not otherwise be available to him or her" if that information is made available to the public.

Further, section 149 applies to share dealings by directors regardless of whether there has been a prior agreement on how they are to be valued under the company's constitution, under the terms of a shareholders' agreement or in a subsequent contract of sale.

Share dealings by directors of listed companies have been specifically excluded from the application of section 149. Instead, they are subject to the insider trading regime provided under the Securities Markets Act 1988. For further information on this regime refer to the article The new insider trading laws on our website.

¹ Wong and Fong v. Fong & Chong , High Court Auckland, CIV 2009-404-002469 , 16 December 2009

² Thexton vThexton [2002] 1 NZLR 780

Enquiries and information

For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.