New York Business Divorce : New York Business Dissolution Lawyer & Attorney : Farrell Fritz Law Firm : Buy-outs, Shareholder Disputes : New York, NY

Adelstein involves a family-owned distributor of specialty foods called Finest Food. It was started by the Adelstein brothers Sidney, Jack and Joel over 50 years ago as a pickle distributor and later became the largest distributor of Caribbean foods in the New York metropolitan area. By 2006, Sidney and Jack passed their interests on to their respective sons who, in 2009, terminated their uncle Joel's employment after he spurned their buy-out offer.

Joel initially sued his nephews for breach of contract and other claims which were dismissed in 2010. Shortly afterward he filed a petition for judicial dissolution of Finest under the oppressed minority shareholder statute, §1104-a of the Business Corporation Law (BCL). In August 2010, after Justice Kitzes denied the nephews' motion to dismiss the petition on various grounds (read here my post on the decision), Finest elected to purchase Joel's shares for fair value under BCL §1118. The court then held a valuation hearing featuring appraisal reports and testimony by the Company's appraiser, Brian Serotta, a CPA with no appraisal certifications, and Joel's appraiser, Paul Marquez, a CPA with an array of appraisal and financial forensic credentials.

The Company's Appraisal

Serotta submitted a 3-page report based upon his review of the company tax returns, the "sparse records" he found and conversations with the company's accountant and principals. He valued Finest using the capitalized income method only, with income adjustments to salaries, depreciation and loans to arrive at average normalized earnings of $206,000. Serotta computed a 20% capitalization rate (i.e., 5x earnings) that included specific company risk factors for limited management and its significant amount of business with the A&P supermarket chain which might end due to A&P's bankruptcy. Serotta also purported to apply a 20% marketability discount to arrive at a $230,000 value for Joel's one-third interest. I say purported because, as quoted in the decision, Serotta described what sounds suspiciously like a prohibited minority discount. Here's what he said:

[The 20% marketability discount was used because of the] difficulty finding somebody to buy a one-third interest. There's really no market. It's a privately-held company. Anybody who bought that one-third interest would conceivably have nothing to say about the company.

Joel's Appraisal

Justice Kitzes's decision describes in great detail the comparatively rigorous methodology used by appraiser Marquez  whose $1,287,000 conclusion of value of Joel's one-third interest is 560% higher than the Serotta valuation. In a nutshell, the disparity derived mainly from (1) Marquez's determination of a weighted average net income of approximately $486,000 -- more than double Serotta's earnings base; (2) his application of a 12% capitalization rate (8.3x earnings) as compared to Serotta's 20%; and (3) his application of a 5% marketability discount based on estimated transaction costs.

Marquez's calculation of the company's dramatically higher earnings base illustrates forensic accounting at work. Marquez discovered that while the company's sales doubled in the years 2004 to 2010, from $5.1 million to $10.2 million, and its cost of goods sold grew commensurately, the gross profit margin oddly decreased in the last two years from 27.5% to 24%, at the same time the salaries of the two owner/officers went from zero to $500,000 annually. Critically, Marquez could find no reason for the gross profit margin to decrease when sales were significantly increasing, other than the existence of unreported sales.

Marquez tested his unreported-sales hypothesis by using a "stress test" to the sales invoices and other data. Here's how Justice Kitzes describes the process:

He compared what was being received and invoiced for sales versus what was being reported as paid for those goods. According to this test, the company had a gross margin of profitability of almost 35%, rather than the 25% reported by the Company in its tax returns. Based upon this differential in profitability, given a company like Finest with gross sales of approximately $10,000,000, the amount of unrecorded sales was likely to be approximately $1,000,000 in 2010. He also based this conclusion on his analysis of the sales invoices, truck manifests and tax returns which showed that the gross profit experienced by the company was higher than that being reported. Consequently, he made a correction in the gross profitability of the company based upon the imputed existence of unreported sales. He then imputed gross profit for the company at the industry-wide level of 35% rather than the lower level of 25% reported by Finest.

Marquez's forensic testing for unreported sales was bolstered by Joel's testimony that some of Finest's smaller chain store customers, as well as the many small bodegas it serviced, pay cash on delivery which is collected by the Finest truck drivers. According to Justice Kitzes's summary of Joel's testimony,

These cash sales are not computerized, but are contained in the salesmens' reports. According to [Joel] Adelstein, about twenty percent of the entire business consists of smaller stores which pay cash in this manner.

Marquez next capitalized the $486,000 earnings base at a 12% rate, which he arrived at as follows:

Applying the 12% cap rate to the $486,000 earnings base produced an enterprise value of $4,051,862, to which Marquez assigned a 70% weight. As a "cross-check" on his valuation he utilized the merged and acquired method weighted at 30%, looking at private market sales transactions that have occurred within the industry of companies falling within the same or similar Standard Industrial Classification (SIC) code. Marquez used Pratts Stats to determine valuation multiples of revenues, gross profit and EBITDA (earnings before interest, taxes, depreciation and amortization), which ultimately indicated enterprise values fairly close to his capitalized value, ranging from $3,990,000 to $4,094,000.

The weighted values produced a control, marketable value for Finest of $4,063,800 which Marquez then discounted 5% for lack of marketability reflecting the low end of his estimate for transaction costs in the sale of a small business like Finest. This generated a "fair value on a non-marketable value basis" of $3,860,610 which in turn generated a value of $1,287,000 for Joel's one-third interest in Finest.

The Court's Decision

Justice Kitzes' decision highlights the crucial role of expert appraisals in a fair value proceeding, stating that "[i]n the case at bar, the valuation of Joel Adelstein's interest in Finest rests primarily on the credibility of the appraisers and the reliability of their valuation methods." Justice Kitzes further notes that "the extent of the witness's qualifications has a bearing on the weight to be given to his testimony."

Justice Kitzes concludes that appraiser Marquez's testimony and report "are credible and reliable" based on his valuation and financial credentials; his "thorough process of evaluation of Finest" which included a site visit, understanding the business and industry, interviewing management, and carefully selecting valuation approaches; carefully selecting evaluation factors such as the capitalization rate; having a knowledge of New York law relevant to valuations; and taking into consideration Joel's testimony concerning the "considerable cash business that would not be noted in the financial statements." Justice Kitzes sums up on the last point:

He [Marquez] also explained the indications in the financial statements that such unreported sales existed. Significantly, [Joel's] testimony regarding cash sales was not refuted by Respondents. In sum, the court finds that Marquez' valuation report is clear, thorough, professional and reliable.

Justice Kitzes then contrasts the report and testimony of Finest's appraiser who does not possess valuation credentials; prepared his 3-page report primarily relying on Finest's accountant; did not take into consideration the existence of cash sales; devised a discount rate that relied on Joel's minority interest in Finest; used a single method of valuation that was not checked against any other method; and in "an apparent contradiction," stated that the gross sales of Finest had more than doubled between 2004 and 2010 but claimed that the profitability of the company had been "basically flat." For these reasons, the decision goes on, "the court places diminished weight on the testimony and report of the Respondent's expert concerning the valuation of Finest" and finds that the value of Joel's interest in Finest is $1,287,000 -- the exact value indicated by Joel's expert.

Joel did not get everything he wanted, however. Justice Kitzes denies his request for an adjustment or surcharge against the other two owners in the sum of $863,000 for "salary, distributions and benefits" not shared with Joel. The requested adjustment, Justice Kitzes states, "functioned as a component of [Joel's] calculation of the fair value of his shares," presumably referring to normalization adjustments to the financial statements. In addition, Joel did not offer evidence that the salaries amounted to "willful or reckless dissipation" of company assets as required by the surcharge provision in BCL §1104-a(b)(2)(d).

Justice Kitzes also denied Joel's requests for an award of attorney's fees and for interest at 9% (the statutory rate) from the date of the filing of the dissolution petition. On the other hand, he denied the company's request for a 5-year pay-out of the valuation award and ordered entry of judgment for the full amount, stating that "an extended payout period is not warranted in view of the time that this valuation proceeding has been pending and the time that the Respondents have had to allocate funds for payment."

Adelstein is hardly the first valuation case in which the accounting for a company's cash receipts became an issue. Business appraiser Mark Warshavsky, who also frequently lectures on forensic accounting, tells me that "whenever you have a company with cash sales, employing analytical procedures to benchmark account balances for the years included in your valuation as compared to other company years or industry data, is an excellent forensic technique."

The forensic accounting done by Joel's expert, tying in the company's significant cash business to what was otherwise an anomaly in the financial statements, clearly resonated with the judge and, I can only speculate, cast a shadow on the company's entire appraisal from which it never emerged. It is a lesson every appraiser and lawyer in a valuation case should not forget.

In Vassilakis, the alleged 20% shareholder of a pizza/delicatessen business petitioned for judicial dissolution under Section 1104-a of the Business Corporation Law on the ground of oppression.  He alleged that the majority shareholder expelled him from the day-to-day operation and management of the company and terminated his relationship with the corporation.  The majority shareholder contended that the petitioner was never a shareholder by reason of his failure to pay his portion of the amount invested in the corporation; that he did not sign any closing documents for the purchase of the business; and that he worked as an employee only at the corporation.  The petitioner, who never was issued a stock certificate, countered by submitting various tax documents identifying him as a shareholder.

Justice Kitzes first concluded that the petitioner had sufficiently pleaded a cause of action for dissolution based on oppression under BCL Section 1104-a(a)(1), and that his affidavit and tax documents on the one side, and the respondent's denial of petitioner's shareholder status on the other, required an evidentiary hearing to determine petitioner's standing to seek dissolution.  Turning to the preliminary injunction application, Justice Kitzes denied the petitioner's request to restrain the majority shareholder from selling the business or, alternatively, sequestering the sale proceeds, writing as follows:

As noted, this action is primarily one for the dissolution of a pizza/delicatessen and there is conflicting evidence regarding Petitioner being an owner of the corporation.  While the mere existence of an issue of fact does not preclude a finding of likelihood of success on the merits, this Court finds that the submitted evidence suggests that the resolution of this matter is likely to be resolved without the dissolution of the corporation.  Consequently, Petitioner has not established the first element in procuring injunctive relief, likelihood of success on the merits.

Justice Kitzes also found that the petitioner, who sought "to recoup money invested and payments for the sale of his shares of ownership in the corporation when it is sold," failed to establish that he would suffer irreparable injury without an injunction, and that the burden upon the corporation of enjoining a potential sale outweighed the threatened harm to petitioner.

Now let's turn to the Kan case, in which a 50% shareholder petitioned under BCL 1104-a for judicial dissolution of a series of commonly-owned corporations involved in the trucking business.  The petitioner alleged that the other 50% shareholder "looted" corporate funds to purchase a private residence and for other non-corporate purposes.  The petitioner asked to preliminarily enjoin him from transacting any unauthorized business and from exercising any corporate powers except in the ordinary course of business; from taking any action to dissolve the corporations(presumably meaning voluntarily); and otherwise compelling the respondent to maintain the status quo pending the dissolution proceeding.  As in Vassilakis, the respondent asserted the defense of lack of standing based on evidence not specified in the court's decision, although it does note that no stock certificates were issued reflecting the ownership interests of either party.  Also as in Vassilakis, Justice Kitzes ordered an evidentiary hearing to determine the petitioner's shareholder status.

With respect to the application for preliminary injunction, Justice Kitzes employed the same analysis (and virtually the same wording) used in Vassilakis but reached the opposite conclusion to grant the application, as follows:

As noted, this action is for the dissolution of several trucking corporations and there is conflicting evidence regarding petitioner being an owner of the corporation.  The Court notes that the mere existence of an issue of fact does not preclude a finding of the likelihood of success on the merits and this Court finds that the submitted evidence suggests that, assuming standing is found, the resolution of this matter is likely to be resolved with the dissolution of the corporation.  Consequently, Petitioner has established the first element in procuring injunctive relief, likelihood of success on the merits.

Justice Kitzes went on to find that the relief sought by petitioner, "to recoup corporate assets and preventing further looting of the corporations," was "sufficiently unique" to establish irreparable injury, and that the balance of equities weighed in his favor as compared to the burden upon the corporations from preventing a sale or relocating operations to New Jersey.

The pair of decisions in Vassilakis and Kan lack detailed recitations of the facts and the parties' contentions, making it more difficult to draw lessons from the different outcomes notwithstanding some basic similarities in the two cases.  We don't know, for instance, if the evidence of the 50% petitioner's shareholder status in Kan was significantly stronger than the 20% petitioner's in Vassilakis.  Is that why the court found a likelihood of ultimate dissolution in the former but not the latter?  Or was it based on the comparative strength of the underlying merits of the oppression and/or looting allegations?  Or -- this is pure speculation -- perhaps the respondent shareholder in Vassilakis but not in Kan indicated his willingness to elect a buyout of the petitioner in the event the court sustains the petitioner's stock ownership after a hearing?

One final note.  BCL Section 1115 grants the court in judicial dissolution proceedings broad authority at any stage of the proceeding to grant injunctive relief against the corporation, its directors, officers and creditors to preserve corporate assets.  There are decisions in the Manhattan-based Appellate Division, First Department (e.g., Matter of Greenhouse (HGK Asset Management, Inc.), 238 AD2d 291 (1st Dept 1997)) holding that an applicant for injunctive relief under Section 1115 need not show a probability of irreparable injury, which is one of the elements of the traditional tri-partite test for interim injunctive relief under Section 6301 of the Civil Practice Law and Rules, and which Justice Kitzes applied in Vassilakis and Kan.  I have not seen any decisions treating this issue by the Second Department, which encompasses Queens County where Justice Kitzes presides, nor do I know if the point was raised by the litigants' counsel in Vassilakis and Kan. 

The court's authority to grant or deny a tardy election is discretionary, and there is not much case law on the subject.  In Matter of Ambrosio (NYLJ 11/20/92, Sup Ct Suffolk County), the court permitted an election to purchase three years post-petition, conditioned on the respondent paying the petitioner's pre-election counsel fees and giving an undertaking to secure the fair value award.  In Sobol v. Les Pieds Nickles, Inc., 262 AD2d 194 (1st Dept 1999), the court affirmed an order rejecting an election made eight years after commencement of the proceeding.  In Matter of Flushing Office Center, Ltd., 276 AD2d 629 (2d Dept 2000), the court affirmed an order permitting a late election, observing that the "petitioners' rights to the fair value of their shares in the corporation shall be preserved by the appointment of an independent Referee whose responsibility will be to report to the Supreme Court as to the amount of such fair value."

The Weingarten case pits Victor Weingarten against his brother Fred and the Estate of Jacob Popovic as the three equal shareholders of a corporation that owns a commercial property in Long Island City.  In May 2007, Victor filed a petition to dissolve the corporation under Section 1104-a, alleging that the other two shareholders without his consent had leased and subleased the property to other companies owned by the two of them to operate a taxi management business.  Fred and the Popovic Estate denied the petition's allegations of oppression but offered to consent to dissolution provided the leases remained undisturbed.

In a decision dated April 29, 2008, Justice Kitzes ruled that the parties' conflicting allegations raised issues of fact requiring a hearing to determine whether judicial dissolution is warranted.  In August 2008, Fred and the Popovic Estate moved for authorization to purchase Victor's shares under Section 1118.  In a decision dated October 17, 2008, Justice Kitzes denied the motion, offering the following reasons:

First, movants offer no excuse for their failure to timely exercise the right of election.  Second, there is no indication that continuing the corporation is a viable and worthwhile endeavor.  Third, movants' claims that allowing the election would save further litigation and expense is not supported by any evidence and fails to take into account the work involved with a valuation under an election to purchase shares.  Furthermore, movants have also failed to demonstrate irreparable harm, likelihood of success on the merits, or a balance of the equities in their favor in support of their application for a stay of the dissolution proceedings.

It's difficult to extract much guidance from Weingarten and the few earlier cases cited above.  The facts and equities are unique in each case.  In many instances a petitioner prefers even a late buyout to dissolution, but that's not always the case, particularly when the corporation's value mainly consists of real estate or other readily marketable hard assets.  For the respondent shareholder who wants to fight the allegations of oppressive conduct but who also wants to preserve the buyout option until the court determines the merits, it may be prudent to make a motion promptly after the petition is filed, seeking to toll the election period pending the court's ruling.

But wait, there's more.  The New York Court of Appeals, in its 1984 Kemp & Beatley decision (64 NY2d 63) adopting the reasonable expectations test for "oppressive actions" under Section 1104-a, stated that "[e]very order of dissolution . . . must be conditioned upon permitting any shareholder of the corporation to elect to purchase the complaining shareholder's stock at fair value."  In that case, where the respondent shareholders never sought to elect to purchase, the orders of the lower courts and the Court of Appeals directing dissolution nonetheless all included extensions of the time for exercising the election to purchase, long past the original 90 days.  I have yet to see a case that reconciles Kemp & Beatley's seemingly inflexible command with the court's discretionary authority under Section 1118(c)(1) to grant or deny an untimely election.  Until that happens, we may continue to face the anomalous circumstance in which a respondent who fails to elect within the first 90 days but later decides to do so, may be better off waiting for a conditional order of dissolution than moving for leave to make an untimely election.       

Update December 18, 2009:  Fred and the Estate appealed Justice Kitzes' denial of their Section 1118 motion.  On December 15, 2009, the Appellate Division, Second Department, turned down their appeal.  Read here.