66discountTalk about playing your cards wrong.

A partner with a 3.08% interest worth $4.85 million in a partnership that owns a major shopping mall likely will walk away with only a few hundred thousand dollars after a court decision finding that he wrongfully dissolved the partnership and deducting from the value of his interest the other partners’ damages including legal fees, a 15% discount for goodwill, a 35% marketability discount, and a whopping 66% minority discount.

Last week’s decision by the Brooklyn-based Appellate Division, Second Department, in Congel v Malfitano, 2016 NY Slip Op 03845 [2d Dept May 18, 2016], rejected the partner’s appeal from the trial court’s determination of wrongful dissolution and also upheld its valuation determination with one major exception: the appellate court held that the trial court erred by failing to apply a minority discount and that it should have applied a 66% minority discount based on the “credible” expert testimony “supported by the record.”

The defendant partner’s fateful decision took place in 2006, when he sent his fellow partners a written notice unilaterally electing to dissolve the partnership due to what he described as a “fundamental breakdown in the relationship between and among us as partners.” The other partners quickly responded with a damages lawsuit claiming that he had wrongfully dissolved in violation of the partnership agreement in an effort to force the partnership to buy out his interest at a steep premium. The defendant, arguing that the partnership was at-will and of indefinite duration, denied wrongful dissolution and counterclaimed for his full, pro rata share of the partnership’s value upon dissolution.

In a series of interim trial court and appellate rulings in 2008 and 2009 (here, here, and here), the courts agreed with the plaintiffs that the partnership was not at-will and that unilateral dissolution by a partner was not permitted under Partnership Law § 62 based on the provision in the partnership agreement authorizing voluntary dissolution by majority vote of the partners.

The trial court subsequently conducted a nonjury trial on the issue of the damages incurred by the plaintiffs as a result of the wrongful dissolution of the partnership, and the issue of the value of the defendant’s interest in the partnership under Partnership Law § 69 (2) (c) (II) providing that when the business is continued by the remaining partners, a partner who wrongfully dissolves is entitled to be paid “the value of his interest in the partnership, less any damages caused to his copartners by the dissolution” but without consideration “of the good-will of the business.”

Notice that Partnership Law § 69 uses the term “value” and not “fair value,” the latter being the statutory standard of value in dissenting shareholder appraisals and oppressed minority shareholder buy-outs under Sections 623 and 1118 of the Business Corporation Law. “Value” under the Partnership Law has been interpreted as “fair market value” which is the standard commonly used for purposes of matrimonial, estate and gift tax valuation. (Read here my post on the difference between fair value and fair market value.) This distinction became critical in last week’s appellate decision on the issue of minority discount, as explained below.

At trial, the parties stipulated that the unadjusted value of the defendant’s total interest in the partnership as of the date of his wrongful dissolution in 2006 was $4.85 million. Each side offered expert testimony on the issue whether the stipulated value included a deductible goodwill component, and whether the defendant’s interest should be discounted for marketability and the defendant’s status as a minority partner.

The trial court valued the defendant’s interest at slightly over $857,000 after applying to the stipulated unadjusted value a 15% discount for goodwill, a 35% discount for lack of marketability, and after deducting the plaintiffs’ damages including legal fees. The trial court declined to apply a minority discount, concluding that it was not permitted to do so based upon case law involving valuation of a minority shareholder’s stock in a close corporation under BCL Sections 623 and 1118.

The Appellate Decision

The primary issue addressed in last week’s appellate decision, authored by Associate Justice Thomas A. Dickerson, was whether the trial court erred by not applying a minority discount.

Justice Dickerson’s opinion reveals that, at trial, the plaintiffs’ expert testified that, in determining the fair market value of the defendant’s 3.08% partnership interest, a minority discount should be applied to reflect the lack of control that a minority owner has in the operations of the partnership and that, based on a variety of factors including sales of comparable interests and provisions in the partnership agreement restricting the rights of minority owners, the appropriate minority discount was 66%.

The defendant’s expert did not offer any minority discount analysis or computation. As related in Justice Dickerson’s opinion, the expert instead testified that, although a minority discount “would ordinarily be applied to determine the fair market value of the defendant’s interest, he did not apply a minority discount in his valuation in this case because he ‘was advised, under the relevant statutes, that a minority discount was not applicable.'” (My interpretation: The defendant’s expert didn’t do the analysis at the direction of the defendant’s lawyers.)

Justice Dickerson noted that, in declining to apply a minority discount, the trial court cited the Court of Appeals’ 1995 decision in Matter of Friedman v Beway Realty Corp. — a dissenting shareholder appraisal case under BCL § 623 — and the Second Department’s 2010 decision in Matter of Murphy v U.S. Dredging Corp. — an oppressed minority shareholder buy-out proceeding under BCL § 1118 — in both of which the courts applied the statutory fair-value standard.

Friedman is best known for its refusal to allow a minority discount in stock valuation proceedings applying the statutory fair-value standard, reasoning that doing so would violate the principle of equal treatment of all shares of the same class while also incentivizing oppressive majority conduct with the prospect of reaping a windfall from the appraisal process. Murphy followed Friedman (and its forebears including Blake) to the same effect.

This is precisely where the critical distinction in the applicable standard of value came into play. As explained by Justice Dickerson:

[T]he concerns expressed by the Court of Appeals in declining to mandate the imposition of a minority discount in fixing the fair value of a dissenting shareholder’s stock are not implicated here. Unlike Matter of Friedman and Matter of Murphy, this case does not involve a determination of the “fair value” of a dissenting shareholder’s shares pursuant to Business Corporation Law §§ 623 and 1118, but rather, involves the determination of the “value” of the shares of a partner who has wrongfully caused the dissolution of a partnership pursuant to Partnership Law § 69(2)(c)(II). As the Appellate Division, First Department, has observed, applying a minority discount in the context of valuing a partnership interest “would not contravene the distinctly corporate statutory proscription (Business Corporation Law § 501[c]) against treating holders of the same class of stock differently, or undermine the remedial goal of the appraisal statutes to protect shareholders from being forced to sell at unfair values, or inevitably encourage oppressive majority conduct” (Vick v Albert, 47 AD3d 482, 483-84). Moreover, the Court of Appeals’ concern that imposing a minority discount in valuing a dissenting shareholder’s stock would encourage oppressive majority conduct is not relevant here, where the dissolution was caused not by any action on the part of the majority, but rather, was caused by the “wrongful[ ]” conduct of a minority partner (Partnership Law § 69[2][c][II]).

Justice Dickerson’s opinion also drew support from a 2004 ruling by the Massachusetts Supreme Court in Anastos v Sable in which that court upheld application of a minority discount to the valuation of the partnership interest of a partner who wrongfully dissolved the partnership under that state’s statute equivalent to New York Partnership Law § 69. The Anastos decision emphasized that the statute mandates valuation of the partnership as a going concern and not in liquidation. Likewise, Justice Dickerson wrote:

We find the reasoning of the [Massachusetts] Supreme Judicial Court to be sound. Here, as in Anastos, the partnership remains a going concern, and the defendant has no right to compel a liquidation sale of the partnership’s shopping mall and receive a proportionate share of the liquidation value of that asset. Under these circumstances, a minority discount may properly be applied to account for the defendant’s lack of control in the partnership as a going concern.

Justice Dickerson’s opinion provides no details concerning the computation and empirical basis for the 66% minority discount advocated by the plaintiffs’ expert and accepted by the court as “credible” and “supported by the record.” Other than taking the position that he was “advised” not to apply a minority discount, I can’t tell from the court’s decision whether the defendant’s appraisal expert challenged as excessive the 66% figure proffered by the plaintiffs’ expert. I’ve seen estimates of unknown reliability of minority discounts in fair market value appraisals generally ranging from 10% to 40%. In the abstract, a 66% minority discount seems beyond the pale, but I can’t fairly say without access to the trial record.

The Congel case sounds a clear warning of the potentially drastic, adverse consequences of pulling the plug on a partnership in contravention of a partnership agreement when the other partners continue the business. Contrast Congel with the Vick v Albert case, which is cited in Congel and which I wrote about here, where the court rejected both marketability and minority discounts in valuing the minority interest of a deceased partner under the same fair market value standard applied in Congel.

Update January 16, 2017:  The story continues. The Court of Appeals (New York’s highest court) last week granted the former minority partner’s motion for leave to appeal from the Appellate Division’s decision and the amended final judgment which awarded the plaintiffs over $900,000 including a $1.8 million offset against the value of the former partner’s interest for attorney and expert fees as damages. Read here my report on the high court’s grant of leave to appeal.

  • Chris Mercer

    Peter,

    It would be interesting to see the “credible evidence” for a minority discount of 66% because such evidence doesn’t exist. Before appraisers began to make a distinction between financial control and strategic control, it was common to use (now known as strategi) control premiums as a basis for inferring the magnitude of minority interest discounts (MID). The equation for determining MID was:

    MID = [1 / (1 + CP) -1]

    An “average” control premium of about 40% would yield a MID of about 29% under this formula. To achieve a MID of 66%, the control premium used would have to be a whopping 195%!

    The minority partner who dissolved the partnership may not have done a good thing, but he is not getting “the value” based on any concept of fair value or fair market value that I know about. If the court applied the three noted discounts sequentially, the result would have been $911 thousand.

    $4.85mm x (1 – 15% goodwill) x (1 – 35% DLOM) x (1 – 66% MID) = $911m

    That’s a total discount of 81%! And that’s before the legal fees and other expenses allocated to him by the court. I wouldn’t want to be the appraiser offering this level of discounting for a minority interest in an apparently attractive property. If a 3.08% interest is worth $4.85 million, the entirety was worth $157 million.

    The total discounting doesn’t appear to be reasonable in light of the above.

    I’d still like to see the “credible evidence” supporting a 66% minority interest discount. And I’d like to see any test of reasonableness for this conclusion.

    • morning_in_america

      Definitely appears that since the 66% was the only number offered, that the judge just went with it. The partners’ side blundered by not even calculating a number. Don’t have a chance of winning if you don’t show up, especially if you are determined to be in the wrong in the first place.