In the
United States Court of Appeals
For the Seventh Circuit

No. 00-1107

Joseph D. Olsen, Trustee
of Huntley Ready Mix, Inc.,

Plaintiff-Appellant,

v.

Gary A. Floit,

Defendant-Appellee.



Appeal from the United States District Court
for the Northern District of Illinois, Western Division.
No. 99 C 50203--Philip G. Reinhard, Judge.


Argued June 1, 2000--Decided July 14, 2000



  Before Bauer, Easterbrook, and Manion, Circuit Judges.

  Easterbrook, Circuit Judge. In May 1993 Huntley
Ready Mix sold all of its operating assets for
$151,000 to Harvard Ready Mix. This plus cash on
hand was just enough to pay off Huntley’s secured
debt, which had been guaranteed by Gary Floit,
Huntley’s founder, president, and principal
shareholder. Huntley retained its accounts
receivable, eventually collecting and
distributing about $100,000 to its general
creditors, but another $200,000 or so remained.
When Huntley filed a petition under Chapter 7 of
the Bankruptcy Code of 1978 its only asset was
some $125,000 owed by deadbeats. As part of the
transaction, Harvard hired Floit as its plant
manager under a three-year employment contract
(at approximately the salary he drew from
Huntley) and paid $249,000 for a five-year
covenant not to compete in the concrete business.
Huntley’s trustee believes that Huntley’s assets
were worth at least $400,000, more than enough to
pay off its debts, and that Floit diverted to
himself under cover of the no-compete agreement
the value of the unsecured creditors’ interests.
If so, then Huntley "received less than a
reasonably equivalent value in exchange for [the]
transfer". 11 U.S.C. sec.548(a)(1)(B)(i). As
events revealed that Huntley either was insolvent
when the sale occurred or became insolvent as a
result, the transaction may have been a
fraudulent conveyance, and the estate might have
recovered from Floit as "the entity for whose
benefit such transfer was made". 11 U.S.C.
sec.550(a)(1). But Huntley entered bankruptcy 15
months after the sale, and sec.548(a)(1) reaches
back just one year.

  Instead of giving up or arguing that Floit is
equitably estopped to take advantage of the time
limit in sec.548(a)(1), Huntley’s trustee in
bankruptcy tried a novel approach: he sued Floit
(in an adversary proceeding) under state
corporate law on the theory that Floit violated
his fiduciary duty to Huntley as one of its
directors. The theory is akin to that of a
fraudulent-conveyance action--that Floit obtained
too little for Huntley and too much for himself--
without the need to show that Huntley was
insolvent, and with the benefit of a longer
period of limitations under Illinois law. We call
this "novel" because the state-law claim is
designed to protect shareholders rather than
creditors, and the Floit family held all the
shares. Under 805 ILCS 5/8.60, the statute in
question, a director who receives a personal
benefit from a transaction with or by the
corporation must demonstrate that the arrangement
was "fair" to the corporation, unless either
disinterested directors or disinterested
shareholders approved the transaction with
knowledge of all material facts. This statute--
similar to the 1984 version of the ABA’s Model
Business Corporation Act sec.8.31--provides that
directors and shareholders who do not participate
in the transaction are free to approve it, which
they will do when it benefits them (or at least
does not harm them) as equity holders. Because
shareholders acting in their own interests are
entitled to approve, 805 ILCS 5/8.60 cannot be a
creditor-protection rule. It is passing strange
to say that a single minority shareholder with a
trivial stake could have approved the sale to
Harvard and thus insulated it from any later
attack (other than a fraudulent-conveyance
action), but that, because there were no minority
shareholders in Huntley, approval was impossible.
Yet Floit has not picked up on this logical
problem in the trustee’s invocation of 805 ILCS
5/8.60, forfeiting whatever arguments might be
available to terminate the claim on strictly
legal grounds. His sole response is that the
transaction was indeed "fair" to Huntley. The
bankruptcy judge held a trial and agreed with
Floit; the district judge affirmed; the trustee
now contends that the critical findings were
clearly erroneous, an uphill battle. See Anderson
v. Bessemer City, 470 U.S. 564 (1985).

  Illinois defines "fair" as market value. A
transaction is "fair" to a corporation when it
receives at least what it would have obtained
following arms’ length bargaining in competitive
markets. Shlensky v. South Parkway Building
Corp., 19 Ill. 2d 268, 283, 166 N.E.2d 793, 801
(1960) (discussing common-law requirement of
fairness preceding enactment of 805 ILCS 5/8.60);
cf. BFP v. Resolution Trust Corp., 511 U.S. 531
(1994) (a foreclosure sale produces "reasonably
equivalent value" for purposes of bankruptcy
law). Floit and the trustee produced expert
witnesses who estimated the price that Huntley’s
assets would have fetched in a competitive sale.
Floit’s expert valued the business (including
Floit’s services) at approximately $440,000, and
the trustee’s at $380,000 to $410,000. Floit’s
expert differed from the trustee’s by opining
that most of this value was contributed by Floit
personally and that the corporation assets were
worth $151,000 or less. Floit also offered his
own testimony and that of Jay Nolan, Harvard’s
president, in support of the lower valuation. The
bankruptcy judge accepted this view.

  Both sides also looked through the other end of
the telescope, asking whether the covenant not to
compete would have been worth $249,000 in a
competitive market--on the sensible theory that
if the covenant had been overvalued, then it must
have represented a disguised portion of the
purchase price for Huntley’s assets.
Unsurprisingly Floit, Nolan, and Floit’s expert
all testified that the covenant was worth at
least $50,000 per year, for a total of $250,000.
This testimony received some support from a
disinterested source: when Harvard Ready Mix was
itself sold in mid-1996, the buyer paid $200,000
for the two remaining years of Floit’s
abnegation. Perhaps conditions changed in the
cement industry, making the threat of his
competition more serious; the question in this
litigation is what the covenant was worth in
1993, not what it was worth in 1996; but a
$100,000-per-year valuation in 1996 lends
verisimilitude to the assertion that in 1993 the
covenant was worth at least $50,000 per year. The
trustee’s expert disagreed, stating that a
covenant not to compete in the cement business
should be valued at between 0.7 and 1.5 times the
promisor’s annual earnings, which implies that
the value of Floit’s covenant could not exceed
$93,000 (given his salary of $62,000 during the
year preceding sale). The expert conceded that
covenants sometimes represent a percentage of a
closely held corporation’s sales, and that in one
case of which he was aware the owner-principal of
a closely held firm had received 16% of its
annual sales. Applied to Huntley’s sales (about
$1.5 million in 1992, its last full year of
operation), this implied a value of $240,000 for
the covenant not to compete, but the trustee’s
expert rejected this conclusion as unrealistic
for Huntley and Floit. The bankruptcy judge,
however, thought it entirely realistic given
Nolan’s testimony and the $200,000 value later
placed on two years of Floit’s covenant by
parties who had no stake in the outcome of this
litigation. That buyer also paid Nolan and his
brother (Harvard’s two principals) $1.5 million
apiece for their covenants not to compete for
five years.

  Valuation of closely held businesses is
something of a black art. Experts try to project
the firm’s net cash flow into the future, then
discount that stream to present value. This
process is difficult for public companies, see
Metlyn Realty Corp. v. Esmark, Inc., 763 F.2d 826
(7th Cir. 1985); Richard A. Brealey, Stewart C.
Myers & Alan J. Marcus, Fundamentals of Corporate
Finance 122-35 (2d ed. 1999); Lucian Arye Bebchuk
& Marcel Kahan, Fairness Opinions: How Fair Are
They and What Can Be Done About It?, 1989 Duke
L.J. 27, 35-37, and almost impossible for private
companies, for which uncertainties abound. What
was apt to happen to Huntley? The trustee’s
expert assumed that, if not sold, it would have
remained in business and generated about the same
cash flows as before; Floit and Nolan testified,
however, that Huntley’s plant was decrepit and
that the expense of renovation could not be
justified. Nolan recounted that most of Huntley’s
equipment had been "hauled off to the junkyard"
soon after the acquisition. These two stories
implied dramatically different futures for the
firm and correspondingly large differences in the
present value of its earnings and the price-
earnings multiple on sale.

  Similarly unclear was how to calculate the
firm’s real earnings. The trustee’s expert
calculated that over the last few years before
its sale Huntley generated a weighted annual
average of $115,000 in "discretionary income,"
with a high of $166,000 in 1992. "Discretionary
income" in this formulation is whatever is left
after the costs of paying for all materials and
labor, other than Floit’s. But it is artificial
to assume that the full cost of an entrepreneur’s
labor is the nominal salary he pays to himself;
the entrepreneur also benefits from perquisites
of office and changes in the value of the firm’s
stock. To determine how much Huntley’s assets
could have fetched in an arms’ length sale, it
would have been necessary to know the full cost
of Floit’s services--which is to say his
reservation wage, what he could earn in other
employment--not just his nominal salary.
Sometimes a court can pin down the entrepreneur’s
entitlement by asking whether what remains
adequately compensates minority investors for the
risk they bear, see Exacto Spring Corp. v. CIR,
196 F.3d 833, 838-39 (7th Cir. 1999), but Huntley
did not have minority shareholders. Reservation
wages, alas, are hard to pin down otherwise,
unless perhaps by observing how much Harvard was
willing to pay Floit. That answer turned out to
be $115,000 per year ($65,000 in salary plus
$50,000 as the annual portion of the covenant not
to compete). Viewed this way, the numbers imply
that Huntley didn’t have much if any value beyond
its physical assets; its net cash flow was needed
to retain Floit’s services. (That the
"discretionary income" increased to $166,000 in
1992 may do more to show that Huntley had
deferred replacing its assets, and thus curtailed
its out-of-pocket costs, than to show an
improvement in its true economic position. Nor is
it dispositive that Harvard paid Floit both for
employment and for a covenant not to compete. The
latter was independently valuable to Harvard in
the event Floit should quit, be fired, or just
leave at the expiration of the three-year
employment contract.)

  When hard numbers are difficult to come by or
evaluate, people often rely on reputations. The
trustee insists that his expert had better
academic credentials and more experience valuing
closely held companies than did Floit’s, so that
the bankruptcy judge should have adopted the
estimates of the trustee’s expert. A reasonable
trier of fact might have proceeded that way, but
we cannot say that a contrary view was clearly
erroneous. After all, the bankruptcy judge’s
views do receive support from the $100,000-per-
year valuation of Floit’s covenant as of 1996.
Floit may have been well respected by others in
the business, and thus able to attract a
substantial package of compensation to deter him
from starting a new firm or defecting to another
producer. What is more, the trustee’s expert did
not do all that would be expected of a specialist
in valuing closely held firms. Why leap to a
discounted cash flow analysis when other methods
are available? Most trade associations maintain
records of sale prices for firms in the business.
What multiple of free cash flow did other small
cement ready-mix producers sell for? See To-Am
Equipment Co. v. Mitsubishi Caterpillar Forklift
America, Inc., 953 F. Supp. 987, 996-97 (N.D.
Ill. 1997), affirmed, 152 F.3d 658 (7th Cir.
1998). It would have been especially interesting
to know the answer to this question for sales
following the departure (or death) of the
founding entrepreneur. For although Huntley owned
its assets, Floit was not among these. He did not
have a long-term contract with Huntley or a no-
compete agreement and thus could leave and
compete at will. E.J. McKernan Co. v. Gregory,
252 Ill. App. 3d 514, 530-31, 623 N.E.2d 981, 994
(2d Dist. 1993). Floit owned his human capital
and was free to withdraw from Huntley and sell
his services to a higher bidder without violating
any fiduciary duty. For what price could
Huntley’s plant, customer list, goodwill, and so
on have been sold without assurance of Floit’s
services? That’s where price-earnings ratios for
firms sold after the death or departure of their
founders would have come in handy. The trustee’s
expert did not attempt to estimate this figure;
instead he assumed that whatever value Floit’s
services produced was "owned" by Huntley and
would be capitalized in its sale price. When
asked about this at oral argument, the trustee’s
counsel conceded that his expert had valued
Huntley as a going concern with Floit as its
manager, adding that Floit’s expert had done the
same thing and that Floit bears the risk of non-
persuasion. But this case was not a tossup as the
bankruptcy judge saw things, so allocation of the
burden was not dispositive. A solid demonstration
that Huntley was worth more than $150,000 even if
Floit was planning to leave would have gone a
long way toward establishing that the bankruptcy
judge made a clear error. Without such evidence
it is awfully hard to say that the bankruptcy
judge’s findings are clearly erroneous.

  According to the trustee, however, valuation is
a matter of law rather than fact, and the trustee
contends that under In re Prince, 85 F.3d 314
(7th Cir. 1996), corporate value includes the
value of its entrepreneur’s services. If that is
so, then even a penny for Floit’s covenant not to
compete violates the duty he owed to the firm.
But it is not so. Prince does not concern
Illinois corporate law in general or 805 ILCS
5/8.60 in particular. It is instead an
application of contract law to a bankruptcy case.
Prince, an orthodontist, promised his creditors
as part of an agreed plan of reorganization that
he would turn over the value of his stock in his
professional corporation. He agreed to sell that
practice to a Dr. Clare for $450,000 but proposed
to turn over only $7,500 to his creditors,
claiming that the rest of the value was
attributable to a no-competition agreement. One
difficulty with this contention is that the
$450,000 was the price set on "the practice";
unlike Harvard Ready Mix, Clare did not pay
separately for physical assets and a covenant not
to compete. What Prince had to sell was
principally goodwill--that is, a client base,
client records (exceptionally valuable in a
dental practice), and a promise to continue
working for six months to ensure that patients
transferred their allegiance to Dr. Clare. Prince
held that the agreement between Prince and his
creditors included goodwill as part of the
practice’s value. We did not hold that for this
purpose "goodwill" included the value of Prince’s
personal services for the indefinite future. Our
understanding of the bargain between Prince and
his creditors does not imply that Huntley owned
the value of Floit’s services for the foreseeable
future, despite the absence of an employment
agreement between Huntley and Floit.

  Doubtless Huntley owned its goodwill--its
customer lists, the value of repeat business, and
so on. See Hagshenas v. Gaylord, 199 Ill. App. 3d
60, 557 N.E.2d 316 (2d Dist. 1990). But the
trustee does not accuse Floit of trying to make
off with these assets, or of including their
value in the $249,000 allocated to the covenant
rather than the $151,000 allocated to assets.
Even the trustee’s expert conceded that Huntley’s
tangible assets were worth no more than $106,000;
the rest was goodwill. Harvard did not assume
Huntley’s name, and cement usually is sold by
competitive bid, so Huntley did not have the sort
of goodwill that is associated with a personal-
services business such as a medical practice. In
the end, the trustee’s position depends on
allocating the value of Floit’s human capital to
Huntley, and we do not think that the bankruptcy
judge committed clear error in ruling otherwise.

Affirmed
