Fair Value in Stock Valuation Proceedings: Podcast Interview of Peter Mahler by Business Appraiser Mark Gottlieb
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Forensic accounting and business valuation specialist Mark S. Gottlieb (on the left; that's me on the right) has a spanking new website featuring podcast audio interviews of professionals addressing topics of interest to business appraisers and lawyers whose practices involve business valuation and other modes of economic analysis.
Mark recently invited me to speak with him on the subject of fair value and discounts in stock valuation proceedings. During the interview I answer Mark's questions about the elusive definition of fair value; the differences between fair value and fair market value, particularly as regards treatment of discounts; the varying quality of expert testimony in these proceedings; and the impact of shareholder agreement buy-sell provisions on judicial determination of fair value.
You can listen to the podcast by clicking here. The play button is at the bottom of the linked page. The interview lasts about 16 minutes.
Valuing Shares in a Residential Co-op Corporation: Is the Whole Worth More Than the Sum of its Parts?
The residential co-operative corporation is a strange breed of closely held business entity. In New York, the co-op is formed as a for-profit corporation under the Business Corporation Law (BCL), yet it doesn't operate for profit in the traditional sense of returning cash dividends to shareholders. Instead, ownership of co-op shares entitles the shareholder to occupancy of an apartment under an appurtenant long-term proprietary lease. The co-op's income derives mostly if not entirely from tenant-shareholder maintenance payments, the level of which is designed merely to cover the common charges for building expenses. The market value of the shares held by individual shareholders within the same co-op can vary greatly, not just due to the number of shares allocated to the particular apartment, but also due to the unique characteristics of the apartment.
One of the consequences of being a for-profit corporation is that co-ops in New York are subject to the same statutes governing voluntary and involuntary dissolution as any other closely held business corporation, including BCL Section 1104-a authorizing a petition for judicial dissolution by an "oppressed" minority shareholder holding at least 20% of the corporation's shares. At least in New York City, where co-ops tend to have many apartments, the shares usually are too widely dispersed for any single tenant-shareholder to own 20%. In addition, and with all due respect to noise and odor complaints, the idea of a co-op dweller being oppressed by her neighbors is a far cry from the usual freeze-out/squeeze-out scenarios involving loss of employment, removal from the board, financial abuse by the majority, and lack of a market exit.
The fact is, however, that New York City also has many smaller co-op buildings such as converted townhouses and brownstones featuring four or five apartments, each of which may be allocated 20% or more of the co-op's shares. And, New York City being a litigious kind of town when it comes to expensive real estate (think Trump), it's inevitable that an alienated tenant-shareholder in such a co-op would opt to bring a dissolution proceeding instead of exiting by selling her apartment on the open market. A rational shareholder presumably would do so only if she believes she'll get more value from a liquidation of the corporation's assets than from selling her apartment, i.e., that the value of the entire building is greater than the sum of its parts.
Continue Reading...Appellate Ruling in Stock Valuation Case Further Muddies the Marketability Discount Waters
In determining the fair value of corporate shares, should the discount for lack of marketability (DLOM) apply only to the company's good will value, or to the entire enterprise value including tangible assets? Court decisions in New York tend to apply DLOM in the 25% range, so the answer can make a big difference in the ultimate award, particularly when the business is asset-heavy.
I've written before (read here) about conflicting case precedents in the Manhattan-based First Department (DLOM applies to enterprise value) and the Brooklyn-based Second Department (DLOM applies to good will value). Permit me to quote from that prior post, where I wrote:
With locked horns in the two downstate appellate departments, and no decisions on the subject from the two upstate appellate departments, it'll likely take some yet-to-be-born big-money valuation case to wend its way up to New York's highest court, the Court of Appeals, before we get a definitive answer.
Well, we still don't have a definitive answer from the Court of Appeals, but we do have a new decision on the subject from one of the upstate departments. The result aligns the Rochester-based Fourth Department with the First Department (DLOM applies to enterprise value), but the decision offers no analysis and, if anything, further muddies the DLOM waters.
Continue Reading...What's the Difference Between Marketability and Minority Discounts?
The following testimony was given by an accredited business appraiser, testifying on behalf of the purchasing majority shareholders in a buy-out valuation proceeding under Section 1118 of the Business Corporation Law, to determine the "fair value" of the petitioner's 45% interest in two related companies:
Q: . . . I see that for the [first] appraisal there was no separate marketability discount analysis, but there is one for the [second] appraisal. Could you explain the basis of that?
A: After the issuance of both reports, . . . we were asked to come up with a value on a fully enterprise, the value of both entities. After the second report, [the majority shareholders' lawyer] asked me to address it because the case had become a 1118 case, and in that case the definition of value is fair value, and under that definition of value for the minority interest, what other considerations would one take into consideration, and I said, well, you would address the marketability discount of that specific block of stock under that statute. And he asked me then could I quantify what the marketability discount would be applicable to the stock.
Q. Applicable to the minority interest?
A. To the block of stock, the 45 percent interest.
The same expert, in a written report, wrote that "[a] minority equity holder of [the two companies] owns an equity interest for which no market exists. . . . It is our opinion that no less than a 30%-to-35% discount for lack of marketability is appropriate for the equity interest in [the two companies] to derive the fair value of the specific fractional interest in each company . . .."
The judge in that case rejected the expert's position and refused to apply the proposed discount. Can you guess why?
Continue Reading...Court Rejects Experts' Appraisals in Fair Value Proceeding, Relies on Own Computation Using Income Approach
No matter how many times I see it happen, I'm always intrigued when a new stock valuation decision comes along in an oppressed shareholder buyout proceeding in which the opposing experts come up with valuations light years apart. How is it that two impeccably credentialed business appraisers, operating under the same independence principle, looking at the same data, and following the same valuation guidelines, can produce such divergent numbers? Is the court required to accept one or the other, or should it appoint its own neutral appraiser, or compute value itself?
Last December I wrote about one ill-fated valuation decision in which the lower court adopted wholesale one of the two widely divergent expert appraisals, only to be reversed on appeal and remanded for a new valuation hearing. Today I write about another valuation decision in which the trial court rejected both experts' appraisals and came up with its own computation of fair value. Matter of Beattie (PlanData Systems Corp.), 2009 NY Slip Op 30181(U) (Sup Ct Suffolk County Jan. 15, 2009).
PlanData Systems Corp., located in Huntington, New York, offers space management services to owners and facility managers of commercial buildings. The business uses a proprietary computer program called SpaceMan to design and manage the clients' commercial properties. In 2006, 40% shareholder Ronald Beattie sought judicial dissolution of PlanData under the oppressed minority shareholder statute, Section 1104-a of the Business Corporation Law. The 60% shareholder, Steven Smith, elected to purchase Beattie's shares for fair value under the buyout statute, BCL Section 1118. After the two shareholders failed to reach agreement on price, the fair value question went to a hearing before Suffolk County Commercial Division Justice Elizabeth Hazlitt Emerson.
Continue Reading...Top 10 Business Divorce Cases of 2008
The nominations are in, the votes are counted, envelope please! Following are my picks for last year's top 10 business divorce cases, all of which were featured in prior posts:
- Tzolis v. Wolff, 10 NY3d 100 (2008), in which the Court of Appeals resolved conflicting First and Second Department decisions on the question whether LLC members can bring derivative actions on the LLC's behalf. They can.
- Matter of Beverwyck Abstract, LLC, 53 AD3d 503 (3d Dept 2008), in which an appellate court upheld a lower court's ruling that the de facto dissolution of an LLC did not terminate the members' fiduciary duty to account for ongoing profits up until formal dissolution.
- Tal v. Superior Vending, LLC, 20 Misc 3d 1103(A) (Sup Ct Westchester County 2008), in which the court crafted an equitable remedy in an LLC dissolution by ordering a return of the petitioner's investment.
- Dingle v. Xtenit, Inc., 20 Misc 3d 1123(A) (Sup Ct NY County 2008), in which the court required a bona fide purpose for a controlling shareholder's dilution of the minority shareholder's interest.
- Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC, 19 Misc 3d 1138(A) (Sup Ct Monroe County May 12, 2008), subsequent decision, 20 Misc 3d 1104(A), in which the court upheld the petitioner's standing to seek LLC dissolution after finding that the other member lacked authority to engage the LLC's attorney who had accepted the petitioner's resignation.
- Hellman v. Hellman, 19 Misc 3d 695 (Sup Ct Monroe County 2008), modified, 2009 NY Slip Op 02418 (4th Dept Mar. 27, 2009). involving a corporation owned 50-50 by brothers, in which the court upheld a new company lease executed by the brother who served as president over the other's objection that the lease required board approval.
- Murphy v. U.S. Dredging Corp., 2008 NY Slip Op 31535 (Sup Ct Nassau County May 19, 2008), a valuation proceeding involving shares in a subchapter C real estate holding corporation in which the court applied a discount for built-in capital gains.
- Matter of Youngwall, 2008 NY Slip Op 30811(U) (Sup Ct Nassau County Mar. 14, 2008), adhered to upon reargument in unreported decision dated July 28, 2008, in which the court granted dissolution of an unprofitable LLC and also ruled that a provision in the operating agreement waiving the right to seek judicial dissolution is void as against public policy.
- Ross v. Nelson, 54 AD3d 258 (1st Dept 2008), in which the court enforced the LLC's default statute in upholding a majority vote of the members to remove one of the managers.
- Manitaras v. Beusman, 56 AD3d 735 (2d Dept 2008), in which the court found that an LLC operating agreement's silence on the sale of the LLC's sole asset permitted majority approval under the default statute even though the sale automatically triggered dissolution.
What will 2009 bring? It's not illogical to think that the stress of the economic meltdown will lead to an increase in business divorce. But in my years watching the scene I've never detected any correlation between business cycles and the rate of litigious business break-ups involving closely held companies. If anything, I would lean in favor of the theory that financial success and opportunity in a business create even more incentive for dissension among co-owners. A recent NY Times article pointed out how falling real estate values are impeding marital divorces by eliminating the primary resource for financial settlement. I think a similar phenomenon could be at play with businesses in the current climate, by reducing the upside for a disgruntled owner contemplating a tactical lawsuit designed to induce a buyout.
Courts Differ on Application of Marketability Discount in Stock Valuation Proceedings
Ever since the Appellate Division, Second Department's 1985 landmark decision in the Blake case (107 AD2d 139), it has been fairly well settled that courts apply a discount for lack of marketability -- but not for lack of control -- in stock valuation proceedings under Section 1118 of the Business Corporation Law. That's the statute that permits the majority stockholder to elect to purchase for "fair value" the shares of an "oppressed" minority shareholder who seeks judicial dissolution of a close corporation under BCL Section 1104-a.
The discount for lack of marketability (DLOM) typically is the single largest downward adjustment to stock value, and therefore tends to be the most heavily contested in valuation proceedings. DLOM essentially reflects the greater time and expense of selling shares of a close corporation versus shares for which there exists an efficient public market. The cases generally reflect DLOM percentages ranging from 10% on the low end to 35% on the high end, with 25% being most frequent. Of course, every case is different and it is up to the expert appraiser to do a proper analysis taking into account all relevant factors.
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
Business appraisers generally apply discounts of one sort or another to value an interest in a closely held business entity. Discounts for lack of control (DLOC) and lack of marketability (DLOM) are most commonly used, depending on the context (estate taxes, matrimonial divorce, dissenting shareholder appraisal, etc.) and the applicable standard of value (fair market value, fair value, investment value).
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.
