In Unusual Case, Illinois Appellate Court Reduces Fair Value Award to Dissenting Shareholder
Dissenting shareholder statutes give shareholders the right to opt out of fundamental corporate transformations -- typically by way of merger or consolidation with another corporation -- by redeeming their shares for "fair value". Case law in New York and many if not most other states defines fair value as the shareholder's proportionate share of the value of the enterprise as a going concern, as opposed to liquidation value, determined as of the date immediately prior to the objected-to transaction.
In some states, including New York, another transformative corporate transaction giving rise to an appraisal remedy is the sale of all or substantially all of the assets of the corporation, other than in the usual course of the corporation's business. However, under the New York statute (Section 910 of the Business Corporation Law), if the sale of assets (a) is wholly for cash, (b) the shareholders' approval is conditioned upon the dissolution of the corporation and (c) the proceeds are distributed within one year, the opt-out/appraisal remedy is not available.
The majority shareholders in the recently decided case, Brynwood Co. v. Schweisberger, No. 02-CH-1297 (Ill. App. Ct. 2d Dist. July 23, 2009), could have saved themselves a lot of trouble had they incorporated in New York rather than Illinois. That's because Section 11.65 of the Illinois Business Corporation Act gives dissenting shareholders an appraisal remedy upon the proposed sale or other disposition of all the corporation's assets with no exception for sales linked to a proposed dissolution and distribution plan, which is what happened in Brynwood.
Making matters even stickier, the corporation in Brynwood owned as its sole asset a highly appreciated parcel of commercial real estate, the sale of which triggered a large gains tax at the corporate level because the corporation was organized as a "C" corporation rather than an "S" corporation. The dissenting shareholder, Mr. Schweisberger, argued with some theoretical justification that his shares in the corporation should be valued based on the going-concern value of the company as of the date prior to the property sale, without regard to the gains taxes and other costs of the actual sale. Schweisberger won at the trial court level but lost on appeal. What exactly happened, and how could the problem have been avoided?
The Facts
Let's start with a boiled-down version of the facts. Brynwood Company was formed in 1979 as a C corporation to own and operate as its sole asset a commercial office building in Rockford, Illinois. Some of the shareholders were building tenants, others were not. Other tenants were non-shareholders. Brynwood never issued its shareholders dividends; rather, their only expected return was through appreciation of the building's value.
Around 2000, by which time the building's original financing was retired, the directors began evaluating options including immediately selling the building and dissolving, as well as converting Brynwood to an S corporation which prospectively required a 10-year holding period to avoid gains taxes on a future sale. In 2000-01 the corporation redeemed shares of two shareholders for $42.50 per share. Schweisberger, who at 26% controlled the largest block of shares, was offered $50 per share but he refused to sell for less than $62.
The dispute came to a head in July 2002, when the board advised Schweisberger of an opportunity to sell the building to a third party for $1.4 million, and of its willingness to forego a sale if Schweisberger would consent to convert Brynwood to an S corporation. Schweisberger would not consent, giving as his reason that some of his shares were held in an IRA which was not qualified to hold shares in an S corporation and would have required him to transfer shares out of the IRA thereby incurring taxes on the withdrawal.
On July 29, the board formally recommended the sale of the building for $1.4 million in accordance with the proposed buyer's real estate contract which was executed on July 30. Pursuant to notice a special shareholders meeting was held on August 5 at which all shareholders other than Schweisberger voted to sell the building and to dissolve the corporation. The sale of the building closed on August 7. The mortgage balance of about $350,000 was paid from the proceeds. Brynwood paid another $450,000 for state and federal taxes on capital gains of almost $1 million along with professional fees and other costs associated with the sale of the building and the dissolution of the corporation.
On August 16, Schweisberger gave a notice of his dissenter's rights, objecting to the sale of the building and demanding payment for the fair value of his shares. On August 19, Brynwood filed articles of dissolution with the Illinois Secretary of State. Brynwood and Schweisberger thereafter exchanged estimates of fair value of $30.08 and $66.31 per share, respectively. In December 2002, Brynwood filed a petition for determination of the fair value of Schweisberger's shares pursuant to Section 11.70 of the Illinois Business Corporation Act.
The Trial
A trial was held in early 2006. Brynwood's CPA testified that under Brynwood's business model, "fair value comes down to the liquidation value." In his view, the taxes, professional fees and other costs associated with the sale of the building and Brynwood's dissolution should be deducted in calculating the fair value of the shares, which he calculated at $36.15 per share. He also calculated that if Schweisberger was paid his figure of $66.31 per share for his 26% interest, the remaining shareholders would receive only $25 per share.
Schweisberger, who also was a CPA, testified as an expert witness on his own behalf. He calculated the fair value of Brynwood's stock at $66.31 per share as of August 6, 2002, the day before the closing on the sale. He testified that as a dissenting shareholder he was not obligated to pay his share of the gains taxes which were a "contingent liability" realized only upon the sale of the building. A second expert testified for Schweisberger. He likewise testified that under the going concern premise of value, the taxes and other sale expenses should not be deducted because those expenses "would not have accrued but for the actions of Brynwood, and Schweisberger had dissented from those actions."
The trial court sided with Schweisberger and arrived at a per share value of $60.68 without any deduction for the gains taxes and other closing and dissolution expenses. The court found that exempting the taxes and expenses was not inequitable because the sale "occurred with Brynwood's knowledge that Schweisberger dissented from the decision to sell the building and that selling the building would trigger a capital gains liability and accompanying costs and professional fees for the corporation."
The Appeal
Brynwood appealed. The appellate court's analysis of the valuation issue begins on page 23 of its 41-page opinion. Schweisberger urged affirmance on the basis that the taxes and closing expenses had not yet been incurred as of the August 6, 2002, valuation date. He also argued that deducting those amounts effectively would amount to a calculation of the "fair market value" of a corporation in the process of liquidation rather than the required "fair value" of a going concern.
Brynwood argued that the failure to deduct taxes, closing and dissolution expenses resulted in an artificial inflation of the value of the shares and resulted in a windfall to Schweisberger at the majority's expense. It also contended that the trial court's decision was inconsistent with the purpose of the dissenting shareholder's statute, which is to ensure that all shareholders are treated fairly and equally.
The appellate court's opinion quotes the Illinois statute's definition of fair value as follows:
"Fair value," with respect to a dissenter's shares, means the value of the shares immediately before the consummation of the corporate action to which the dissenter objects excluding any appreciation or depreciation in anticipation of the corporate action, unless exclusion would be inequitable.
Next, the court noted that fair value is based on the "intrinsic value" of the corporation as a going concern and, quoting from a1950 Delaware ruling (Tri-Continental Corp. v. Battye, 31 Del. Ch. 523, 74 A.2d 71):
In valuing a corporation to make a fair value determination as to a dissenter's shares, "the important thing to bear in mind is that value of stock in a going concern is to be measured in terms of [the shareholders'] ability to realize that value."
Schweisberger's ability to realize the investment value of his interest in Brynwood, the court continued,
was affected by its inherent and unique nature as a closely held corporation. . . . As investors in a closely held corporation, Brynwood's shareholders did not have an open and available market in which they could sell their shares of stock for cash. . . . [W]hether a shareholder decided to monetize the investment through a private sale or through the sale of the building, a proper calculation of the true, intrinsic value of the shareholder's percentage ownership should have necessarily taken into account all of the previously detailed foreseeable and ascertainable transactional costs that were known and inherent in the unique nature of Brynwood and its business as a closely held C corporation whose business was to hold a single parcel of real estate for its appreciated value.
The court then addressed the relevant transaction costs as follows:
As it applies to the instant case, the transaction costs inherent in selling Brynwood's only asset, the building, necessarily included the taxes, fees, and other costs. Therefore, the true, intrinsic value of Schweisberger's percentage ownership would not, and could not, have been, as the trial court found, a strict percentage interest in the $1.4 million fair market value of the building, because the fair market value of the building could not have been realized without also incurring the transaction costs, that is, the known, foreseeable, and ascertainable capital gains taxes, professional fees, and other costs . . . [which were] intimately tied to the true and intrinsic value of the corporation as a whole, and correspondingly, to the investment value of each of the shareholders' interest in the corporation.
The court broadly rejected Schweisberger's contention that recognizing the transaction costs amounts to a calculation of "fair market value" instead of fair value. The court's decision further declares that deducting the taxes and other costs "effectuate[s] the purpose of the statute and is consistent with the equities of the situation presented" in that Schweisberger was not the "victim of majority overreaching in an attempt to eliminate him from the corporation at a price below fair value or in an attempt to usurp the voting power of his shares." Rather, it was Schweisberger "who, in effect, 'trapped in' the capital gains tax liability for all of the shareholders when he declined to allow Brynwood to convert from a C corporation to an S corporation." The court also noted that Brynwood had offered Schweisberger $50 per share prior to entering into a third-party sale of the building.
The court therefore remanded the case to the trial court for a re-calculation of Brynwood's fair value including deduction for capital gains taxes, professional fees, and other costs related to the sale of the building. In a small reprieve for Schweisberger, the court directed that any dissolution or other expenses incurred after the "consummation" of the building's sale on August 7, 2002, were not chargeable against the value of his shares.
Closing Comments
Until Brynwood I'd never seen or heard of a dissenting shareholder case involving a sale of the company's assets combined with dissolution. If nothing else this case affirms the wisdom of dissenting shareholder statutes such as New York's, which deny appraisal rights for the sale of the corporation's assets preceding dissolution and distribution of the net proceeds.
Even if there's room to argue the theoretical basis for the appellate court's application of liquidation value, based on the case's unique facts and the equities, the result feels right. Why should Schweisberger come out way ahead of the other shareholders when he was offered a much higher buyout previously which would have allowed the remaining shareholders to convert Brynwood to an S corporation? If there's such a thing as a reverse squeeze-out, this was it.
Could the majority shareholders have avoided what turned into a seven-year appraisal fight? Perhaps they could have effectuated a voluntary dissolution first, and then sold the building under a plan of liquidation. I can't really say if that technique would have worked without knowing if Brynwood had a shareholders' agreement with a super-majority or unanimity requirement for voluntary dissolution, which might have required the consent of Schweisberger's 26% interest. A pre-sale voluntary dissolution also might have caused problems under the existing mortgage financing, or otherwise jeopardized the sale in hand.
Hat tip to Matthew O'Hara, Esq. of Reed Smith LLP and his article on Brynwood in the Chicago Daily Law Bulletin.
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.
Murphy involved a dredging company formed in the 1930's owned by several families. The company ceased dredging operations in the 1970's but continued to own valuable waterfront properties in Brooklyn and Jersey City which more recently were sold for over $30 million. Most of the proceeds were reinvested, through tax exempt §1031 like-kind exchanges, in commercial properties under long term triple net leases. A minority shareholder faction sued for judicial dissolution claiming oppression by the controlling shareholders who then elected under Business Corporation Law §1118 to purchase the minority's shares for "fair value."
The valuation hearing featured dueling business appraisal experts, each of whom used net asset value and discounted cash flow methods in valuing the company's shares. In computing net asset value the purchasing shareholders' expert subtracted 100% of deferred capital gains tax on the property sales (about $11.6 million). The selling shareholders' expert deducted the present value of the gains tax assuming a 19-year holding period for the replacement properties (about $3.4 million). This was the primary reason for the experts' widely disparate company net asset valuations, almost $25 million (sellers) versus about $15 million (purchasers). A secondary factor was the purchasers' expert's use of a 15% discount for lack of marketability (DLOM) whereas the sellers' expert objected to any DLOM.
In his 29-page decision dated May 19, 2008, Commercial Division Justice Ira B. Warshawsky sides with the sellers' expert on BIG and with the purchasers' expert on DLOM. In discussing the applicable law, Justice Warshawsky significantly observes that the determination of fair value under BCL §1118 "is not identical to the procedure of Tax Court" in estate and gift tax cases where company liquidation as of the valuation date may be assumed. Rather, the judge writes, "it is clear from the evidence that no liquidation was or is contemplated by [the controlling shareholders] in our case and thus a ‘liquidation’ or semi-liquidation scenario is not appropriate when dealing with the BIG tax." The evidence in the case included a report by the company's president, shortly before the dissolution case was filed, indicating a plan to hold the replacement properties until the financing is retired in 19 years. For that reason, among others, Justice Warshawsky agrees with the sellers' expert that a hypothetical buyer would demand, and the hypothetical seller would give, a discount equal to the present value of the BIG tax assuming liquidation in 19 years.
In the La Sala case noted above, Justice Kenneth W. Rudolph of the Westchester County Supreme Court's Commercial Division denied a deduction for BIG taxes in a §1118 valuation case also involving a real estate holding C corporation (read decision here). Justice Warshawsky in Murphy writes that he “agrees with the logic expressed by Justice Rudolph" but that "under these circumstances with the BIG representing such a large portion of corporate assets it appears that a willing purchaser would expect to deduct the present value of the BIG tax along with a percentage for lack of marketability."
The Murphy decision does not render a final award. The decision recomputes the net asset value based on the present value of the BIG tax and 15% DLOM, and directs the parties to submit new computations of their income approach valuations using a court-determined working capital figure. As of this writing the court has not issued its final ruling.
In sum, Murphy may be the first and only case to date in which a BIG discount, albeit a partial one, is granted in a valuation under the fair value standard. If another such case comes along, undoubtedly there will be an interesting debate as one side draws comparison to the facts and circumstances in La Sala while the other side does the same with Murphy.
P.S. I have written a more detailed analysis of Murphy which will be published in the upcoming August issue of Business Valuation Update. BVU is a highly informative monthly newsletter published by Business Valuation Resources in Portland, Oregon. I have subscribed to BVU for many years, and highly recommend it to lawyers who want to stay current on valuation theory and case law.
Update October 26, 2008: This past week the Appellate Division, First Department, in Wechsler v. Wechsler, 2008 NY Slip Op 07983 (Oct. 21, 2008), issued a lengthy opinion in a matrimonial case vacating the trial judge's equitable distribution award insofar as it computed BIG discount based on the historical tax rate of annual taxes paid by the husband's securities trading firm. The court ordered application of a dollar-for-dollar discount as contended by the husband's expert and the court-appointed neutral. The decision, with one judge dissenting, seems to endorse the Eleventh Circuit's Jelke approach but does not close the door under the right circumstances on a partial discount based on the present value of future gains taxes. Indeed, the majority decision explicitly notes that the latter approach was not advanced by the wife's expert in the trial court proceedings. Wechsler therefore cannot be read as mandating a dollar-for-dollar discount in all matrimonial cases applying a fair market value standard, much less in dissenting or oppressed shareholder buyout proceedings applying a fair value standard.
Update December 16, 2008: The final verdict is in. In a written decision dated December 9, 2008 (2008 NY Slip Op 33318(U)), Justice Warshawsky determined a fair value award of $5,956,735 for the petitioners' 36.77% interest in United States Dredging Corp. The number, based on a 45% and 55% weighting of the net asset cost and income approaches, respectively, is eerily close to the midway point between the two experts' competing valuations at the time of trial. The decision contains detailed discussions of the discrepancies in the post-trial submissions of the parties' experts on a variety of issues. The only point of law in the decision is at the end, where Justice Warshawsky states that the First Department's Wechsler decision "is not applicable to our facts, and not binding on this court."
Update June 6, 2010: On June 1, 2010, the Appellate Division, Second Department, decided appeals brought by both sides from Justice Warshawsky's rulings. The decision affirms the key rulings on marketability and BIG discounts. You can view the decision here, and my article on the decision here.
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.
