California limited liability company disputes | Courtroom war stories and lessons learned

Statutory LLC Buyouts — “Fair Value” vs. “Fair Market Value”

Under section 17707.03 of California’s Revised Uniform Limited Liability Company Act, when a member sues the other members for dissolution of the LLC, the other members can exercise a statutory buyout of the suing member’s interest.  This statutory buyout mechanism allows the LLC to survive, avoiding dissolution and liquidation.

A similar statute (section 2000 of the Corporations Code) governs corporations.  Under that statute’s buyout mechanism, the shareholders wishing to avoid dissolution must pay the departing shareholder the “fair value” of his or her shares, which is determined on the basis of “liquidation value.”

But under section 17707.03, the buyout price for LLC members is based on the “fair market value,” and no reference is made to “liquidation value.”

A recent opinion from California’s Second Appellate District — Pourmoradi v. Gabbai — highlights the difference between “fair value” and “fair market value.”  While the opinion is unpublished and therefore not precedential, it is nonetheless a useful guidepost in the LLC Jungle.

Facts: plaintiff LLC member sues for dissolution; defendant LLC member exercises statutory buyout

Plaintiffs John and Andrea Pourmoradi (as trustees for their family trust) formed 2801 East Vernon LLC with Defendants Behruz and Katherine Morovati Gabbai (as trustees for their family trust).  Each couple owned a 50% membership interest in the LLC.

John and Behruz were appointed as the managers of the LLC.  The operating agreement provided that disputes regarding management of the company could only be resolved by a majority of the managers.  The parties became deadlocked over whether to restructure a secured loan or sell the property.

After voluntary buyout negotiations failed, plaintiffs filed an action to dissolve the LLC and wind up its affairs.  Defendants exercised their statutory buyout rights under Corporations Code section 17707.03(c).

Trial court: no discount because buyers would get total control of the LLC

The trial court appointed three appraisers — one proposed by plaintiffs, the second proposed by defendants, and a neutral third appraiser — to determine the buyout value.

The appraisers agreed on the value of the real property and other assets owned by the LLC, but expressed uncertainty over the “fair market value” of plaintiffs’ interests.  Their report concluded that the “fair value” of plaintiffs’ interest was approximately $5 million, but the “fair market value” was only about $4.5 million after application of a 15% discount to “account for lack of control and marketability.”  Plaintiffs urged the trial court to adopt the higher valuation.  Defendants argued in favor of the discounted number.

The trial court issued an order adopting the higher valuation without a discount.  The trial court reasoned that since the LLC essentially had only two members (the two family trusts), and the purchasing member would get total control over the LLC, “a reduction for lack of control or lack of marketability would serve no purpose under this scenario.”  Such a discount, the trial court held, would only make sense if the buyer was a third party who lacked control over the LLC’s affairs.

Defendants appealed.

Court of Appeal: reversed; “fair market value” focuses on a hypothetical buyer and requires application of discount

The Court of Appeal reversed the trial court’s order, holding the valuation required a market-based discount.

The court observed that the statutory buyout provisions governing corporations (Corporations Code section 2000) and LLCs (Corporations Code section 17707.03) use different language.  Section 2000 uses a “fair value” standard, which is determined on the basis of “liquidation value.”  Under that standard, “valuation discounts for market factors, such as lack of control, are not permitted.”

In contrast, section 17707.03 uses a “fair market value” standard, with no reference to “liquidation value.”  This “market-based” standard, the court held, includes “valuation discounts based on the amount a hypothetical willing and able buyer would pay for the interest in the marketplace.”

In short, under the statutory language, the relationship between the parties (e.g., small LLC; buyer to attain complete control) does not matter; what matters is what a third party buyer in the marketplace would pay.

The court sent the matter back to the trial court to determine the “fair market value” buyout price — with an appropriate discount based on market factors.

Lesson

Unlike statutory corporate shareholder buyouts, which are determined based on “fair value” or “liquidation value,” statutory LLC member buyouts are governed by “fair market value,” a concept which includes a discount based on market factors such as lack of control.