Forensic Accounting Examination in a Minority Shareholder Oppression Case


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Forensic Accounting Examination in a Minority Shareholder Oppression Case

  1. 1. By definition, minority shareholder oppression cases are complex to investigate. The minority shareholders cannot control or in most cases even influence important decisions that have an impact on the value of their stock. The majority shareholders own the controlling interest in stock, dominate the board of directors and special committees and hold most, if not all, the important management positions. In addition, the majority shareholders are most often uncooperative. For this reason a forensic accounting examination is frequently necessary to help identify and document the issues of oppression against the minority shareholders. The forensic accountant must rely on information provided through interviews, analysis of books and records, interrogatories, document discovery, depositions and expert reports. A valuation expert is also typically used to calculate the fair value of the company. A forensic examination requires the application of accounting principles and tax requirements to facts at issue in a legal dispute. A forensic examination can be used to help document areas of minority shareholder oppression such as the following: 1. Excessive compensation and/or benefits paid to the controlling shareholders 2. Personal expenses of the controlling shareholders paid with corporate funds 3. Personal use of company assets and/or employees by the controlling shareholders 4. Demonstrate the true financial condition of the company, which many times is considerably better than portrayed by the controlling shareholders 5. Board of directors merely rubber stamping controlling shareholder decisions 6. Waste and dissipation by the controlling shareholders 7. Restricting the payment of dividends 8. Buy back of company stock at a depressed price below fair market value 9. Hiring family members and friends for management positions If the payment of personal expenses of the controlling shareholders with corporate funds is not reported to the IRS, it may be considered as tax fraud. For this reason, the forensic accountant will examine the payroll tax returns of the company along with 1099 forms and W-2’s to see if the additional income has been taxed to the individuals. This also holds true for the value of using employee labor and/or other corporate assets for personal projects. Dividends may be reduced under the pretense that the company is in poor financial condition. Minority shareholders are often not in a position to assess these representations. When dividends are reduced, or stopped all together, very frequently there is a corresponding increase in compensation to the controlling shareholders who occupy management positions. This allows the majority shareholders to maintain and/or increase their compensation at the expense of the minority shareholders. An executive compensation expert may be useful to help show that the compensation received by the majority shareholders is above that which would be expected in a similar company in the same industry and region. Most often, minority shareholder oppression cases involve smaller privately held businesses. Because of the limited market for the stock, the majority shareholders are in positions of power at the company and offer less than a fair price to buy back the stock from minority owners. By virtue of their position, the majority shareholders know the real value of the company’s stock. However, without a market for their stock the minority stockholders are often forced to sell at much less than a fair price. II SS SS UU EE SS AA NN DD AA CC TT II OO NN SS II NN BB UU SS II NN EE SS SS NN EE WW SS Block out text box FORENSIC ACCOUNTING, LITIGATION SUPPORT Forensic Accounting Examination in a Minority Shareholder Oppression Case CBIZ MHM, LLC ▪ 3 Bethesda Metro Center Ste 600 ▪ Bethesda, MD 20814 (301) 951-3636 ▪
  2. 2. Forensic Accounting Examination in a Minority Shareholder Oppression Case – Page 2 of 2. During a forensic examination, documents such as general ledgers, subsidiary ledgers, bank statements, emails, vendor invoices, tax returns and financial statements are reviewed and analyzed. This can become difficult because the majority shareholders typically control the company books and records and attempt to limit or deny access by the minority shareholders. Analysis of these company records helps the forensic accountant to uncover possible acts that contribute to minority oppression. While the forensic accountant cannot provide an opinion as to intent, certainly patterns of behavior and negative trends can be uncovered and reported. Emails, handwritten notes and lack of documentation (board minutes, personal expense receipts, financial statement disclosure, etc.) can help to show the objectives of the majority shareholders. Because of the deliberate lack of transparency and disclosure by the majority shareholders, the forensic accountant must act as a financial detective. In this case, the accountant is testing to see if there is adherence to generally accepted accounting principles (GAAP), the federal and state tax laws and common sense. One of the defenses that the majority shareholders use in an oppression suit is the business judgment rule. Basically, the controlling shareholders take the position that the reduction in dividend payments or other questionable act, was in the best interest of the company. They argue that this was a fair, supportable judgment at the time. This can be a slippery slope. The applications of GAAP, and in some cases grey areas of the tax law, require the application of judgment, estimates and common sense. One of the roles of the expert forensic accountant is to demonstrate to the court that the actions of the majority shareholders were not prudent, demonstrated poor business judgment in view of the real facts, lacked substance and/or were injurious to the interests of the minority shareholders. Many times the forensic accountant makes use of specialized software that aids in tracking the flow of funds. The same software can also be helpful in developing charts and exhibits for trial. One of the crucial requirements for a forensic accountant is to distill very complex financial information in to a clear, logically prepared report. This, of course, must be supplemented with straight forward, easily understood testimony at trial. If the forensic examination report were viewed as a report card for the majority shareholders, it might look something like the following: Subject Grade Accounting and Financial Disclosure F Accounting and Financial Transparency F Adherence to GAAP & Tax Laws F Proper Authorization for Corporate Acts F Ethical Conduct - Overall Corporate Governance F Destroying Minority Shareholder Value A Metamorphosis A+ The “metamorphosis” is the act of transforming the company into an alter ego of the majority shareholder. Ultimately, there is no difference. They are one in the same. The majority shareholders use corporate resources and assets for their personal use and enjoyment. They decide when there will be a dividend payment. They decide when the company will be profitable. They decide when the stock value will rise. It is the ultimate laboratory experiment entirely controlled by the majority shareholders. ABOUT THE AUTHORS ABOUT CBIZ MHM Forensic, Litigation Support and Valuation Services (FLVS) Our Mid-Atlantic FLVS group, under the leadership of Maurice Whelan, brings a combination of practical experience and in-depth knowledge in business and a variety of industries to our work on your behalf in forensic investigation, commercial litigation, business valuation, damages, shareholder disputes, family law, bankruptcy, and due diligence cases. Maurice Whelan has extensive experience in auditing and tax and has acted as a discussion leader in these subjects for the AICPA. Maurice has testified in Federal Court, State Court, Bankruptcy Court and the International Tribunal in London, England. FORENSIC ACCOUNTING, LITIGATION SUPPORT Maurice J. Whelan, CPA, CFF, ASA, ABV, CVA Maurice is the Mid-Atlantic Practice Leader for CBIZ MHM, LLC Forensic, Litigation and Valuation Services. He was a testifying expert in a recent minority shareholder case decided in Virginia, Colgate, et al. v. The Disthene Group, Inc. Case No. CL-11-117. Maurice can be reached at 240-396-2787. MaryEllen Redmond, CPA, CFE, CDFA, CVA MaryEllen is a manager with the CBIZ MHM, LLC Forensic, Litigation and Valuation Services group. She has extensive experience in fraud investigations, family law and valuation cases. MaryEllen can be reached at 240-396-2781