A Case of Mutual Frustration: Minority Member of LLC Can't Compel Dissolution, Majority Can't Compel Buyout
It's the perfect LLC storm: Accusations by the minority member of overreaching and breach of fiduciary duty by the controlling members, no operating agreement, and an LLC statute that affords neither party a judicial means of achieving the separation they each want.
The case, Matter of Koutelos (Mouhlas Realty, LLC), was decided last month by Queens County Supreme Court Justice Patricia P. Satterfield (read decision here). The petitioner, Mary Koutelos, holds approximately 15% membership interest in Mouhlas Realty, LLC which was formed in 2000 as a member-managed LLC. The decision doesn't describe the LLC's business or tell us if Koutelos is actively involved in running it. All we can glean is that Koutelos filed a petition under LLC Law Section 702 for judicial dissolution of the LLC based on allegations of overreaching and breach of fiduciary duty by two of the other three members, apparently involving a capital call and/or loan to be used for compensation of one or more member-managers; the members have no operating agreement; and the other members refused Koutelos's request to adjourn a meeting.
The decision also tells us that the "respondent" -- we don't find out if this refers to the LLC or one of the other members individually -- filed an answer with a counterclaim for an "equitable buyout" conditioned on the court applying a 30% discount for lack of marketability in valuing the petitioner's interest.
Continue Reading...Court Discounts Fair Value Award for Built-In Gains Tax in Shareholder Oppression Case
In a posting last December I wrote about an important estate tax case, Jelke v Commissioner, in which a federal appeals court adopted a bright-line rule requiring 100% discount for built-in capital gains tax ("BIG") in the valuation of C corporation assets. At the time I made the following prediction about Jelke's impact on stock valuation in corporate dissolution cases:
Jelke likely will not have wide impact on valuation contests in dissolution cases, for two main reasons. First, the great majority of dissolution cases involve S corporations and other entities that opt for pass-through partnership tax treatment. Second, the standard of value in estate tax cases such as Jelke is fair market value as opposed to the fair value standard specified by New York’s buyout statute. In a BCL §1118 valuation case involving a real estate holding C corporation called Matter of La Sala, a New York trial court refused to apply a discount for BIG tax liability on the ground that it was required to value the corporation as a going concern and, therefore, it would not consider capital gains taxes triggered upon liquidation. Undoubtedly, this will not be the last word on the subject of BIG discounts in stock valuation proceedings.
I was right about one thing: it was not the last word on BIG and §1118 stock valuation proceedings. As it turns out, when I wrote those words there already was percolating in Nassau County Supreme Court a buy-out proceeding in a shareholder oppression case, Murphy v. U.S. Dredging Corp., requiring the court to decide the same issue presented in the La Sala case, namely, the appropriateness under the fair value standard of applying a BIG discount to the appreciated assets of a real estate holding C corporation. The Murphy court's answer -- applying a partial discount based on the present value of future gains taxes -- lands between Jelke's 100% discount and La Sala's zero discount.
Continue Reading...Court Refuses to Apply Marketability and Minority Discounts in Valuing Deceased Partner's Interest
A federal appeals court once remarked that "the valuation of a closely held company is an inexact science", adding, "some might say an art" (Okerlund v. U.S., 365 F3d 1044 [Fed. Cir. 2004]). Looking at the gallery of New York valuation law, the artist must be Jackson Pollack.
By that I mean, the valuation rules seem like a hodgepodge when one compares the different settings in which interests in closely held companies are valued by the New York courts, including dissenting shareholder appraisals and oppressed minority shareholder buyouts under the Business Corporation Law, accounting proceedings under the Partnership Law, and equitable distribution proceedings under the Domestic Relations Law. This holds especially true with respect to valuation discounts, as highlighted in a recent appellate decision concerning a fractured partnership in a case called Vick v. Albert, 47 AD3d 482 [1st Dept 2008] (read decision here).
Vick involved a nasty family feud that spawned multiple litigations and arbitration lasting almost a decade. Beginning in 1975, Susan Vick and her brother, Richard Albert, co-owned a number of investment real properties in New York City. Some of the properties they owned as tenants in common, others were owned by partnerships in which Vick, Albert and others held partnership interests. Vick died in 1999, leaving her interests to her two children. About eight months after their mother's death, the children sued their uncle and others seeking, among other things, a partition of certain properties and a dissolution and accounting with respect to various partnerships. The complaint alleged that the uncle took exclusive control of the partnerships' books, records, properties and assets; that he misappropriated certain assets including rental income for his own benefit; and that he failed to wind up the partnerships' affairs after his sister died and failed to provide a final accounting for each of the partnerships. (The appellate court's decision unfortunately recites very few facts. More can be learned from the prior lower court decisions, two of which from 2001 and 2004 can be viewed here and here.)
Continue Reading...Fair Value vs. Fair Market Value
New York’s statutes governing buyouts in dissolution and dissenting shareholder cases use the term “fair value” (FV) as the standard used to determine purchase price. The statutes do not define FV.
In contrast, “fair market value” (FMV) is a widely recognized standard of value used in the business world, in tax assessment proceedings and elsewhere. The International Glossary of Business Valuation Terms defines FMV as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
Are FV and FMV the same?
Not by a long shot. As succinctly stated in one of the more prominent valuation treatises, “the term fair value is usually a legally created standard of value that applies to certain specific transactions”. S. Pratt, R. Reilly & R. Schweihs, Valuing a Business, p. 32 (4th ed. 2000). My even more succinct translation: FV means whatever the courts say it means.
In New York case law, the main difference between FMV and FV concerns application of a minority discount in valuing the shares of a dissolution petitioner or dissenting shareholder. A minority discount, also referred to as a discount for lack of control (“DLOC”), reflects the lower price a hypothetical buyer would pay for shares in a corporation that do not give their owner control of the board of directors, company management, distributions, changes to the articles of incorporation, etc. For over 20 years New York courts consistently have ruled that, unlike in proceedings applying the FMV standard of value, the FV standard excludes DLOC. In many other states that also use the FV standard in statutory buyout proceedings, unlike New York, the courts also exclude the discount for lack of marketability (“DLOM”) applicable to non-publicly listed shares that cannot be sold quickly and at low cost. Bottom line: in New York statutory valuation proceedings applying the FV standard, the selling shareholder gets a significantly higher price compared to the FMV standard.
For those who want to learn more on the subject, I recommend reading a recent appellate decision out of Arkansas in which the court explains the difference between FMV and FV in the context of a dispute over the valuation of the interests of withdrawing partners in a family limited partnership.
Big News for BIG Discount
Once in a while a more exotic discount makes the news. Case in point: the discount for built-in capital gains (BIG) affecting subchapter C corporations. A recent appellate decision scores a major victory for estate taxpayers, and ultimately may also become a factor in valuation cases arising out of dissolution proceedings involving C corporations. First, some background.
Under changes made by the Tax Reform Act of 1986, proceeds from the sale of appreciated assets held by a C corporation upon liquidation are subject to gains tax at the corporate level. A buyer of C corporation shares therefore is willing to pay less for the shares than if the same assets were held by a subchapter S corporation. A C corporation can avoid capital gains taxes at the corporate level upon sale of all its assets by converting to a subchapter S corporation. [IRC §1361 et seq]. However, this option is of limited use since, among other things, the corporation must retain the appreciated assets for ten years from the date of conversion in order to avoid the tax. [See IRC §1374(d)(7)].
In a 2005 decision in a case called Estate of Jelke, in valuing an estate’s 6.44% stock interest in an investment holding company, the Tax Court reduced a $51 million BIG tax liability to $21 million by computing the present value of tax liabilities assuming the future sale of company assets over a 16-year period. On November 15, 2007, the U.S. Court of Appeals for the Eleventh Circuit ordered the Tax Court to recalculate the stock value using a dollar-for-dollar reduction of the entire $51 million in BIG tax liability, under the assumption that the company is liquidated on the date of death and all assets sold.
Jelke likely will not have wide impact on valuation contests in dissolution cases, for two main reasons. First, the great majority of dissolution cases involve S corporations and other entities that opt for pass-through partnership tax treatment. Second, the standard of value in estate tax cases such as Jelke is fair market value as opposed to the fair value standard specified by New York’s buyout statute. In a BCL §1118 valuation case involving a real estate holding C corporation called Matter of La Sala, a New York trial court refused to apply a discount for BIG tax liability on the ground that it was required to value the corporation as a going concern and, therefore, it would not consider capital gains taxes triggered upon liquidation. Undoubtedly, this will not be the last word on the subject of BIG discounts in stock valuation proceedings.
