Opinion ID: 2178740
Heading Depth: 2
Heading Rank: 1

Heading: Valuation of the CM Stock Exchanged for Oahe Stock

Text: As we interpret it, Golden's real complaint is that Emmick was allowed to use as the value of his CM stock a value arbitrarily affixed by the CM board of directors for a strictly internal purposethat of raising badly needed funds for CM by offering stock options at a desperate juncture in its corporate life. This value admittedly bore no relationship to the book value of CM stock, which the trial court found to be forty-seven cents per share. Emmick admitted that he used for his valuation of CM stock the internal stock option price set by the CM board of directors. Yet when that same board reduced the CM stock option price to $9.50 per share on September 16, 1966, a fact Emmick knew, this reduction was not reflected in the value Emmick set on the CM shares transferred into Oahe a month and a half later. SDCL 47-3-29 provides: In the absence of fraud in the transaction, the judgment of the board of directors or the shareholders, as the case may be, as to the value of the consideration received for shares shall be conclusive. Prior to the enactment of SDCL 47-3-29, the comparable section of our Code read: When property is taken by the corporation in consideration for capital stock of the corporation, the judgment of the board of directors, made in good faith, and entered in the minutes of the corporation, shall be conclusive as to the value of such property. SDC 1960 Supp., § 11.0301. This provision was carried over from R.C. 1919 § 8775, alluded to in Ipswich Printing Co. v. Engler, 63 S.D. 396, 259 N.W. 497 (1935). The change in 1965 from the good faith test to the absence of fraud test is derived from Section 19 of the Model Business Corporation Act, drafted by the American Bar Association's Committee on Corporate Laws. The committee's comment following this section states: The third paragraph of section 19, dealing with valuation, adopts the absence of fraud rule. . . . A court might well reach the same result under the absence of fraud rule as under the good faith, reasonable judgment or actual fraud rules. . . . Model Bus.Corp. Act Ann.2d, § 19 ¶ 2 at 436. In Lloyd v. Preston, 146 U.S. 630, 13 S.Ct. 131, 36 L.Ed. 1111 (1892), the Supreme Court held that the overvaluation of property exchanged for corporate stock, even though such valuation was ratified by the corporation's board of directors, established fraud and entitled complaining creditors to enforce full payment from the transferor for the stock issued him. In Donald v. American Smelting & Refining Co., 62 N.J.Eq. 729, 48 A. 771 (1901), the court in construing language similar to that in SDCL 47-3-29 stated: different estimates may be formed of the value of property [exchanged for stock]. When such differences are brought before judicial tribunals, the judgment of those who are by law intrusted with the power of issuing stock to the amount of the value of the property, and on whom, therefore, is placed the first duty of valuing the property, must be accorded considerable weight. But it cannot be deemed conclusive when duly subjected to judicial scrutiny. Nor is it necessary that conscious overvaluation or any other form of fraudulent conduct on the part of these primary valuers should be shown, to justify judicial interposition. Their honest judgment, if reached without due examination into the elements of value. . . or if plainly warped by self-interest, may lead to a violation of this statutory rule, as surely as would corrupt motive. . . . [I]t is the duty of the courts . . . to see that this standard is not violated, either intentionally or unintentionally. 48 A. at 772-3 (emphasis supplied). We believe that this approach should be applied to the case at bar. Courts faced with the situation in which a promoter benefits from a violation of his fiduciary duty at the expense of the corporation or its members often characterize the promoter's gain as secret profit. Such profit is not secret if all interested parties know of and assent to it. But where a promoter through, for example, overvaluation of property exchanged for stock and failure to disclose all material facts regarding such exchange, takes more from the corporation than he transfers in, he is held liable for what courts term secret profit. Lomita Land & Water Co. v. Robinson, 154 Cal. 36, 97 P. 10 (1908); Old Dominion Copper Mining & Smelting Co. v. Bigelow, 203 Mass. 159, 89 N.E. 193 (1909); Koppitz-Melchers, Inc. v. Koppitz, 315 Mich. 582, 24 N.W.2d 220 (1946); Thompson v. Walker, 253 Mich. 126, 234 N.W. 144 (1931). As a promoter of Oahe, Emmick stood in a fiduciary relationship to both the corporation and its stockholders and was bound to deal with them in the utmost good faith. The obtaining of a secret profit by a promoter through the sale of property to a corporation is uniformly held to be a fraud on the corporation and stockholders, and the promoter may be required to account for such profit. [2] Annot., 84 A.L. R.3d 163, 164, § 2[a] (1978). The valuation of the CM stock was based on Emmick's self-serving estimate of matters well known to him as a CM insider and was warped by Emmick's self-interest. Emmick was not trading stock that had an easily ascertainable value; he was not dealing with people experienced in transactions of this type. He failed to make known facts of which he, as an insider of CM, was aware. It is true that Emmick was not the only member on the Oahe board of directors. He was, however, the controlling member and the one in possession of information pertinent to the value of his CM stock not generally available to the public or to the other Oahe board members. In addition to being an insider of CM, he was both a director of and the dominant and controlling force in Oahe. We hold, therefore, that he failed in his duty to the corporation to disclose information regarding stock he intended to transfer into Oahe for Oahe shares and is therefore liable for the shortfall to the corporation therefrom. We conclude that the CM stock that Emmick transferred into Oahe was greatly overvalued at its $19.00 per share figure. We do not consider the $19.00 per share figure affixed by Emmick to be supported by credible evidence in the record, nor do we find it to be indicative of the true value of CM stock at the time of transfer, all factors considered. [3] Nothing in the record indicates that Emmick knew at the time of the transfer whether any sales of CM stock in 1966 had actually occurred, nor did Jerry Jackson, a fellow CM associate, indicate that Emmick knew of any sales Jackson made in 1966. The certified public accountant who helped prepare the receiver's report advised the court that it should take judicial notice that the CM stock was watered or fictitiously increased at the time of the exchange. Further, the trial court found that valuation of the stock by the CM Board of Directors was substantially based on future growth and profit. Article XVII, § 8 of the South Dakota Constitution [4] prohibits the use of future or potential value for purposes of valuing property exchanged for corporate stock. Value based on future potential is speculative and arbitrary. Thompson v. Commonwealth Finance Corp., 46 S.D. 141, 191 N.W. 447 (1922). Statutory authorization for the issuance of stock in exchange for property does not permit the issuance of stock for property that is overvalued or is worth substantially less than the par value of the stock. Gamble v. Queen's County Water Co., 123 N.Y. 91, 25 N.E. 201 (1890); Frey v. Geuder, Paeschke & Frey Co., 4 Wis.2d 257, 90 N.W.2d 765 (1958); 18 Am.Jur.2d Corporations § 259 (1965). It is the cash value of the exchanged property, not its future value or the hopes or expectations or the prospects of future value, that must be taken as the basis for exchange. 18 Am.Jur.2d, supra, § 262, at 784. Accordingly, we conclude that the trial court erred insofar as it allowed future, potential or speculative value to determine the value assigned to the CM stock. Because the total value of the CM stock Emmick transferred to Oahe was less than the value Emmick received in Oahe stock, the difference can be equalized by canceling the number of Oahe shares held by Emmick that is proportional to the over-valuation. Frame v. Mahoney, 21 Ariz. 282, 187 P. 584 (1920); Koppitz-Melchers, Inc. v. Koppitz, 315 Mich. 582, 24 N.W.2d 220 (1946); Topanga Corporation v. Gentile, 249 Cal.App.2d 681, 58 Cal.Rptr. 713 (1967). We note that this Court has upheld the cancellation of stock under circumstances where original issue stock was transferred for the worthless stock of another corporation or for services to be performed in the future. Thompson v. Commonwealth Finance Corporation, supra; Walton v. Standard Drilling Co., 43 S.D. 576, 181 N.W. 96 (1921); and Anderson v. Scandia Mining Syndicate, 26 S.D. 558 128 N.W. 1016 (1910). In Thompson, supra, the Court held that where a corporation issued stock to its directors for services to be performed in the future, the stock was void under our state constitution even though it had been transferred to an assignee of a director. See also Frame v. Mahoney, supra; Koppitz-Melchers, Inc. v. Koppitz, supra; Topanga Corporation v. Gentile, supra. In Axford v. Western Syndicate Inv. Co., 141 Minn. 412, 170 N.W. 587 (1919), which involved a South Dakota corporation and the application of South Dakota law, including article XVII, § 8 of the South Dakota Constitution, the Minnesota Supreme Court held that the trial court was justified in canceling shares of corporate stock that had been issued to defendant in exchange for the worthless stock of another corporation. The court rejected defendant's argument that because all the directors and stockholders had participated in the transaction, the stock issuance could not later be questioned, stating that the corporate entries fell far short of being sufficient proof to establish [that] for which they purport to stand. 170 N.W. at 590. The $19.00 per share valuation had no basis in fact and was meaningless except as an internal stock option price for sale to CM shareholders. Accordingly, we hold that the trial court erred in concluding that the value set by Emmick on the CM stock in the Emmick/Oahe transaction of $19.00 per share did not constitute fraud, deceit or misrepresentation.