Forensic Accounting Helps Wins the Day in Oppressed Shareholder Stock Valuation Proceeding
A company's financial statements constitute the core data used by business appraisers to value shareholder equity in statutory appraisal proceedings triggered by dissolution petitions brought by oppressed minority shareholders.
In my experience, most small and medium sized closely held businesses do not have audited financial statements but instead rely on their outside accountant to prepare either a compilation or review report which merely compiles management's financial reports without any probing whatsoever (compilation) or employs a limited analysis of the company's accounting practices and other factors but without any data testing as would be done in an audit (review).
When using the income and market approaches to value a business, appraisers engaged as expert trial witnesses routinely make "normalizing" adjustments to the income statement (a/k/a Profit & Loss statement or "P&L") before applying a capitalization rate or market value ratios. For instance, the appraiser will eliminate extraordinary gains or losses, or may adjust officer/owner compensation to reflect reasonable compensation rates based on generally accepted industry surveys.
But beyond standard normalization, an expert appraiser using non-audited statements must determine whether the underlying income, expense, asset and liability data provided by management are reliable to a reasonable degree. Otherwise it's GIGO -- garbage in, garbage out.
That's where forensic accounting comes in, as nicely illustrated in a recent case decided by Queens County Commercial Division Justice Orin R. Kitzes in Matter of Adelstein (Finest Food Distributing Co. N.Y., Inc., 2011 NY Slip Op 33256(U) (Sup Ct Queens County Nov. 3, 2011).
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:
| Risk Free Rate | 4.43% |
| Equity Risk Premium | 5.2% |
| Industry Risk Premium | (1.74%) |
| Small Stock Risk Premium | 6.28% |
| Company Specific Risk Premium | 0.5% |
| Long-Term Growth Rate | (2.7%) |
| Cap Rate | 12% |
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.
The Marketability Discount in Fair Value Proceedings: An Emperor Without Clothes?
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The discount for lack of marketability, or DLOM, has reigned supreme in New York fair value proceedings since 1985 when the Appellate Division, Second Department, decided Matter of Blake, 107 AD2d 139. DLOM's basic premise accepted in Blake is that "shares of a closely held corporation cannot be readily sold on a public market" (id. at 149) and therefore should be discounted to reflect the additional risk factors associated with the time and difficulty of finding buyers for non-publicly traded shares.
Equally vital to the Blake doctrine is the assumption that DLOM "bears no relation to the fact that the petitioner's shares in the corporation represent a minority interest" (id.). For that same reason, Blake ruled out application of a separate minority discount, also known as discount for lack of control or DLOC, as inconsistent with the protections afforded minority shareholders against oppression by the majority under the judicial dissolution statute, BCL §1104-a, and likewise to deny controlling shareholders a "windfall" from exercising their right to elect to purchase the petitioning minority shareholder's stock for fair value under BCL §1118.
In other words, the dichotomy between DLOM and DLOC adopted in Blake views "good" DLOM as applicable at the enterprise level to all shares in determining the selling shareholder's proportionate interest in the going concern, whereas "bad" DLOC applies only at the shareholder level to minority shares. New York's highest court, the Court of Appeals, further cemented this view in its 1995 Beway decision. Since then it has been followed without question in countless trial and appellate court decisions wherein business appraisers have relied primarily on restricted stock and pre-IPO studies to compute DLOM.
The question is, is there any sound appraisal doctrine or empirical evidence supporting Blake's premise that DLOM exists and can be quantified at the enterprise or majority-control level? If not, are Blake, Beway and their progeny predicated on flawed, internally inconsistent assumptions that effectively compute fair value at the non-marketable minority interest level of value rather than proportionate interest in the company's going concern value at a control level?
Some prominent voices in the business valuation field have been raising these questions in critique of New York fair value jurisprudence. One of the voices belongs to Z. Christopher Mercer who, regular readers of this blog may recall, convinced the Special Referee in the Giaimo case that applying DLOM made no theoretical or economic sense and, contrary to the statutory protections acknowledged in Blake, would generate an "illiquid minority interest value" instead of a proportionate share of a financial control level of value. When it came time to confirm the referee's report, however, the presiding judge rejected Mercer's theory as inconsistent with Beway, and instead approved non-applicability of DLOM based on the market exposure period built into the underlying realty appraisals and on evidence of the extremely limited availability on the market of real property portfolios similar to those owned by the subject companies. (Read here my post on Giaimo and here my post on Mercer's recent articles on New York fair value proceedings.)
Mercer is on record since the mid-1990s against application of DLOM to controlling interests. In his post #6 on New York fair value proceedings, Mercer states that the restricted stock and pre-IPO studies routinely used by appraisers to support DLOM compare minority interest values and "ha[ve] no bearing on controlling interests." Rather, he explains, "[t]he marketability discount has meaning because it applies to the marketable minority level of value and reduces value for lower expected cash flows and greater risk normally associated with holding illiquid minority interests." In other words, applying a marketability discount is inconsistent with Beway's definition of fair value as a "proportionate interest in a going concern, that is, the intrinsic value of the shareholder's economic interest in the corporate enterprise" (Beway, 87 NY2d at 167). Yet Beway itself approved a marketability discount in that case!
Another of the critical voices belongs to business appraiser Joel Rakower who, along with attorney Ken Weinstein, authored an article published last week in the New York Law Journal entitled "Marketability Discount and Dissenting Minority Ownership." (Here's a link to the article, but I'm afraid it's only accessible to Law Journal subscribers.) The article's thesis, in line with Mercer's analysis, is that the application of DLOM in fair value proceedings necessarily violates the proscription against minority discount because DLOM only exists at the minority shareholder level.
Over two years ago I reported on a case called Matter of Beattie (read my post here) in which Rakower as the expert for the selling minority shareholder, like Mercer in Giaimo, argued that DLOM should not be applied. The judge in Beattie, which involved a software company rather than a realty holding company as in Giaimo, rejected the position based on Blake and applied a 25% DLOM.
In last week's article Rakower again challenges the theory head-on, stating that
Academics and lecturers within the appraisal community are clearly united on the conclusion, succinctly stated, that discounts for lack of marketability are not applied to majority positions.
The article then addresses the lack of evidentiary basis for applying DLOM at the control level. It quotes Alina Niculita, co-author with Shannon Pratt of Valuing a Business (5th ed. 2007), as saying, "There is no empirical transaction database from which to draw guidance for quantifying DLOM for controlling interests." The article then adds:
While some appraisers contend a discount for lack of marketability may exist for a controlling interest, they proffer no empirical data supporting such claim, nor any studies currently available substantiating a discount for lack of marketability for majority positions. Moreover, no information or guidance is provided as to its quantification.
In Chapter 1 of Shannon Pratt's book, Business Valuation Discounts and Premiums (2d ed. 2009), he distinguishes between "entity level" discounts applied to a control level of value affecting all shareholders, such as a "key person" discount, and "shareholder level" discounts affecting one or a specified group of shareholders such as minority shareholders. Pratt places both DLOM and DLOC in the latter category. In a Levels of Value chart shown as Exhibit 1.2, footnote "a" states that "[c]ontrol shares in a privately held company may also be subject to some discount for lack of marketability, but usually not nearly as much as minority shares." It's not clear -- at least to me -- how that statement jibes with his co-author Niculita's above-quoted statement concerning the absence of empirical data supporting DLOM for controlling interests.
My above musings only scratch the surface of this highly complex and technical issue which, I hasten to add, has tremendous financial impact in contested fair value proceedings given the DLOM percentages applied by New York courts usually hovering in the 25% range. In many states outside New York, either by statute or case law, DLOM and DLOC both have been banished from fair value determinations based on a policy decision that to apply either works an injustice against oppressed or dissenting minority shareholders and represents a windfall to the controlling shareholders.
I imagine we will continue to see both theoretical and empirically based attacks on DLOM in fair value proceedings by New York lawyers and their appraisal experts representing selling shareholders. Certainly on the theoretical side, as we saw in Giaimo, it will be a formidable task to overcome almost 30 years of appellate precedent uniformly supporting DLOM. Possibly, rather than challenging Blake and Beway directly, courts will find that a marketability discount is built into the hypothetical, arm's-length transaction pricing as of the valuation date, which essentially was the rationale ultimately adopted by the court in Giaimo.
Chris Mercer Tackles Statutory Fair Value
By statute in New York and many other states, including Delaware, the standard of value used in dissenting shareholder appraisals and buy-outs in corporate dissolution proceedings brought by minority shareholders is "fair value." Fair value is to be distinguished from its better known cousin, "fair market value," which is the standard applied in federal estate and gift tax proceedings and in matrimonial cases. In one of the first posts I wrote for this blog over three years ago, I quoted Shannon Pratt's leading treatise's definition of fair value -- "a legally created standard of value that applies to certain specific transactions" (Valuing a Business, p. 45 [5th ed. 2008]) -- which I in turn translated as meaning "whatever the courts say it means."
Leave it to Chris Mercer, one of America's leading authorities on business appraisal and author of countless books and articles, to tackle the elusive subject of fair value in a series of posts for his new blog called ValuationSpeak. Chris's posts are must reading certainly for any attorney or business appraiser who handles a valuation proceeding applying the statutory fair value standard. I also commend the articles to any business owner who wants to get a handle on what a fair value appraisal entails, and what discounts will or won't be taken, to help them make more informed decisions about commencing or defending a judicial valuation proceeding. Here's an overview of the six posts written to date:
Part 1: Introduction. Calling himself an "agnostic" on the subject, Chris begins his series with the fundamental observation that "fair value is ultimately a legal concept" as to which the appraiser must take guidance from legal counsel "regarding their legal interpretation of fair value in each jurisdiction." He then highlights the Delaware appraisal statute's definition of fair value, which he says gives "little effective guidance" and merely requires consideration of "all relevant factors" akin to the criteria found in IRS Revenue Ruling 59-60 applicable to fair market value determinations. (Note: New York's fair value jurisprudence, beginning with the seminal Blake case, likewise invites consideration of the factors identified in Revenue Ruling 59-60.) Chris contrasts the willing buyer/willing seller, "objective" standard of fair market value versus the willing buyer/unwilling seller "equitable" standard of fair value, leading him to conclude that "fair value is intertwined with concepts of fair market value and equity, which can be highly confusing for participants in fair value proceedings and for business appraisers as well."
Part 2: Discounted Cash Flow Method. Chris's second post offers a somewhat technical primer on the basic models or methods used within the income approach to value (the other approaches being the asset and market approaches), including the Discounted Cash Flow (DCF) method, the Gordon Model, and a "two-stage" DCF model that combines elements of the first two. The basic DCF method determines the net present value of future cash flows projected in perpetuity, whereas the Gordon Model uses a single-period income capitalization method. Chris also discusses the market approach in which the appraiser compares certain valuation metrics of the subject company with similar metrics of "guideline" public companies. According to Chris, the DCF method "is a commonly used valuation method, particularly when valuing sizeable companies where management routinely prepares forecasts of future financial performance" and is the "favored valuation method" in the Delaware Court of Chancery.
Part 3: Traditional Levels of Value Chart. Third in the series is an explanation of the traditional levels of value chart that Chris says is "at the heart of every valuation decision made in statutory fair value determinations, either judicially or by appraisers." Here's what the chart looks like:
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The middle level, Marketable Minority Interest Basis, is the "benchmark" level representing, for a closely held company, the equity value of the enterprise as if there were a free and active public market for the shares. Above this benchmark is the Controlling Interest Basis representing pricing as if the entire company (or a controlling interest in it) is sold. A control premium is added when moving up from the benchmark to the control level of value, while a minority discount is applied when moving in the opposite direction. The lowest level is Nonmarketable Minority Interest Basis representing the value of an illiquid minority interest in a closely held company. Movement from the middle, benchmark level to the lower level is achieved by applying a marketability discount a/k/a discount for lack of marketability (DLOM) usually based on restricted stock and pre-IPO studies. Chris closes his post with the intriguing comment, "Appraisers and courts have used and misused these studies for years. The misuse of available evidence has contributed to confusion in the statutory fair value arena."
Part 4: Proportionate Interest in a Going Concern. Chris's next post addresses a central theme pervading fair value case law, i.e., that the minority or dissenting shareholder whose interest is being bought out is entitled to be paid his or her "proportionate interest in a going concern" also sometimes expressed as the "intrinsic value" of the shares. Chris points out that the Controlling Interest Basis and the Marketable Minority Interest Basis levels in the chart both are enterprise concepts and reflect going concern value, leading to confusion for appraisers and courts in statutory fair value determinations. "The crux of the problem with the term 'proportionate interest in a going concern,'" he continues, "is that it can mean different things to different people." Appraisers either should request a specific legal interpretation from counsel or provide indications of value at both levels, Chris recommends.
Part 5: The Implicit Minority Discount. Fifth in the series is a discussion of the Implicit Minority Discount (IMD) which took root in Delaware case law based on works by Messrs. Pratt and Mercer in the 1990s. The IMD posits that all publicly traded shares trade at a substantial discount relative to their proportionate share of the corporation and that, accordingly, when using the Guideline Public Company Method to value shares in a non-public company there must be a substantial upward adjustment to correct the IMD. Chris explains that both he and Pratt have modified their positions on the use of control premiums when using the Guideline Public Company Method as reflected in the updated, four-levels of value chart shown on the right side below:
In other words, whereas an upward adjustment would be required if consideration were to be given to a strategic buyer of a public company based on cash flow-driven differences, the same is not necessarily true for a financial buyer.
Part 6: Applicability of Marketability Discounts in New York. The last of Chris's six posts so far on statutory fair value addresses an issue closer to home, namely, the doctrinal and evidentiary bases for the marketability discount in New York case law. Chris's discussion begins with a summary of New York law concerning marketability discount that I prepared for a post several months ago featuring the Cole v. Macklowe case which he then relates to the levels of value chart. Chris pulls no punches in stating that, while "the issue may be well-settled, it is also well-debated in New York statutory fair value cases because the logic is simply incorrect." The problem, he says, is that "[i]t is incorrect, both theoretically and practically, to apply a marketability discount to a controlling interest in a business" and that "[t]here are no studies that provide market evidence of a lack of marketability for controlling interests in companies." Chris questions the current validity of the authorities relied upon in the 1985 Blake ruling that cemented the marketability discount in New York fair value case law. He also illustrates his point using a hypothetical real estate holding company, suggesting that no marketability discount ought to be imposed on top of the "time to market" assumption built into the underlying real estate appraisal. Reminding readers of his "agnostic" stance on "what courts in any jurisdiction call fair value," he closes with a plea to the judiciary:
What I am concerned about, however, is the fact that courts provide valuation guidance in the process of making their statutory fair value determinations. If that valuation guidance is unclear, or if it is based on inadequate or inappropriate market evidence, then the stage is set for future disputes in fair value determinations.
I'll close simply by re-urging my interested readers to take the time to study each of Chris's posts on this important, timely and complex subject.
Note to Chris: Keep 'em coming!
Court Rejects Minority and Marketability Discounts in Assessing Damages for Breach of Equity Participation Agreement
The rules for the two most important valuation discounts in New York statutory "fair value" (FV) proceedings, such as shareholder oppression and dissenting shareholder cases, are well established: the discount for lack of marketability (DLOM) is in; the minority discount a/k/a discount for lack of control (DLOC) is out. DLOM applies because it reflects the additional time and risk of selling even a controlling, nonmarketable interest in a closely held business as compared to publicly traded shares. In contrast, the reasoning goes, if DLOC were applied in FV proceedings the majority shareholders would receive a windfall that would encourage squeeze-out and unfairly deprive minority shareholders of their proportionate interest in the venture as a going concern.
As I've previously written here and here, the exclusion of DLOC in FV appraisals is the principal distinguishing feature from the "fair market value" (FMV) standard used in matrimonial, gift and estate tax matters where, premised on a hypothetical arm's-length transaction under which neither buyer nor seller is under any compulsion to buy or sell, both discounts generally apply. The two discounts, individually and certainly when combined, can substantially reduce the value of an interest in a closely held business entity.
Along comes an interesting court decision by a Manhattan judge that adds a new twist to the FV/FMV discount dichotomy, holding that neither discount should apply in measuring damages due for breach of an agreement to give the plaintiff a 10% equity interest in specified real properties owned by the defendant through a series of closely held entities. The unreported decision is Cole v. Macklowe, Memorandum Decision, Index No. 604784/99 (Sup Ct NY County Sept. 25, 2010).
Background
The decision in Cole springs from an epic, 11-year (and counting) litigation between the well-known New York real estate developer, Harry Macklowe, and Warren Cole whom the decision describes as Macklowe's former "right-hand man." In 1994, Macklowe orally advised Cole that he had decided to give him a 10% equity interest in all Macklowe investment projects going forward. In 1996, Cole drafted, and Macklowe signed, a five-paragraph agreement stating that Macklowe was holding equity interests in a number of specified properties "for the benefit of" Cole and acknowledging their intent to "fully document these interests" in the form of a limited partnership interest or an LLC membership interest. The more formal arrangement never materialized, and in 1998 Cole drafted, and Macklowe again signed, a four-paragraph "addendum" which added a number of additional properties to those listed in the 1996 agreement.
The close relationship between Macklowe and Cole subsequently deteriorated, leading to Cole's resignation in April 1999 and Macklowe's repudiation of the 1996 agreement and 1998 addendum. Cole sued Macklowe in late 1999 to recover for breach of his equity participation rights along with several additional claims relating to other transactions.
The Prior Proceedings
The case suffered years of procedural delays, including an interim appeal, before Justice Marylin G. Diamond issued her January 2006 decision in Macklowe's favor (2006 NY Slip Op 30551(U)), in which she held that the 1996 and 1998 documents were non-binding, preliminary agreements which anticipated that Cole would not actually receive an equity interest until the execution of more formal agreements. Cole appealed to the Appellate Division, First Department which, in a 2007 decision reported at 40 AD3d 396, reversed Justice Diamond's ruling, held that the 1996 and 1998 agreements were fully enforceable, and remanded the case for a determination of damages under the contract.
In a February 2009 trial court decision reported at 2009 NY Slip Op 30410(U), Justice Diamond rejected Cole's position that his damages included his pro rata share of ongoing distributions to date, and instead agreed with Macklowe that Cole's damages
should be calculated based on (1) the total distributions which were withheld from Cole prior to Macklowe's repudiation of the agreements in September, 1999 and (2) the value of Cole's interests based on market conditions which existed as of the time of the breach. [Emphasis added.]
Cole again appealed. The Appellate Division, in a July 2009 decision reported at 64 AD3d 480, modified the date of Macklowe's breach to April 1999 but otherwise affirmed Justice Diamond's stated measure of damages.
The Ruling on Discounts
In anticipation of a bench trial on damages, both sides requested a ruling from the court on whether Macklowe may present expert testimony regarding the application of DLOC and DLOM in valuing Cole's equity interests in the properties, each of which is owned by a Macklowe-controlled LLC or limited partnership. Macklowe contended that the prior decisions in the case require application of the FMV standard which, in turn, must include discounts for lack of control and unmarketability. Cole countered that he is not a "willing seller" as contemplated under the FMV standard, that his damages action is more akin to an involuntary sale by an oppressed or dissenting minority shareholder, and that no discount should be applied.
Justice Diamond begins her analysis by agreeing with Cole that, based on the finding of Macklowe's breach of contract, the calculation of damages does not involve a willing seller and that, "in cases involving the involuntary sale of the interests of a minority owner who has essentially been forced out of a company, the minority owner is entitled to receive the 'fair value' of these interests." She then cites decisions in oppressed and dissenting shareholder cases holding that DLOC is inapplicable. In rebuttal to Macklowe's contention, that the discount "ban" is limited to statutory valuation proceedings that expressly require the FV standard, Justice Diamond cites Vick v. Albert, 47 AD3d 482 (1st Dept 2008), where the First Department upheld the rejection of DLOM and DLOC for a valuation award obtained by the estate of a deceased partner in a real estate partnership under Section 73 of the Partnership Law, which requires payment to a deceased partner for the "value of his interest" in the partnership. (Read here my analysis of the Vick decision.)
The application of discounts, Justice Diamond therefore concludes, does not turn on statutory constraints. "Rather, the issue turns on whether the policy concerns underlying the ban on the use of discounts are present in this case." Those concerns are present in Cole, Justice Diamond finds, based on four factors:
- Macklowe's repudiation of Cole's equity interests "is clearly analogous" to oppressive majority shareholder conduct intended to limit or preclude minority ownership rights, thereby implicating the statutory objective in oppression cases of obtaining a "fair appraisal remedy."
- The use of discounts would "reward" Macklowe by limiting the damages payable by him arising from his own misconduct.
- As in Vick, the unavailability of discounts is "particularly apt" since the business assets consist of real estate, and their application would deprive Cole of what the value of his interests would have been had each of the designated properties been sold on the open market.
- The use of discounts would result in a "windfall" to Macklowe by virtue of his "consolidating or increasing his ownership and control of the properties," as opposed to a sale to a third party who gains no right to control or manage the entity.
"Accordingly," Justice Diamond decrees, "Macklowe's request for leave to present expert testimony regarding the applicability of minority and marketability discounts is hereby denied."
Macklowe has filed a notice of appeal from the decision, so it may be that the Appellate Division once again will have the final word. If it does, we can hope that it will clarify the applicability of valuation discounts to the appraisal of equity interests in determining damages for breach of contract which, traditionally, are predicated on restoring to plaintiff the "benefit of the bargain" as opposed to fair value. The appeals court also can be expected to focus, even assuming a correct analogy between Macklowe's breach and majority shareholder oppression, on whether it is appropriate to exclude DLOM which routinely is applied in oppression and other FV proceedings. Finally, I'm sure many in the legal and business appraisal community would welcome further appellate explication of the controversial rationale for not applying discounts in valuing minority interests in real estate holding entities.
Ruling on Valuation Discounts for Marketability, Built-In Gains Tax Ends Rift Among New York Appellate Courts
Viewers of Saturday Night Live in the late 1970's remember Gilda Radner's frumpy, hard-of-hearing character, Emily Litella, who gave misguided, agitated responses to TV editorials. At the end of each sketch, after being told by Chevy Chase or Jane Curtin that she had misheard a critical word in the editorial, rendering moot her hilarious thesis, Litella would look straight into the camera and reply meekly, "Never mind." It became a catchphrase of the times.
I thought of Ms. Litella's catchphrase when I read the Appellate Division, Second Department's important decision last week affirming the trial court's key stock valuation rulings, in Matter of Murphy (United States Dredging Corp.), 74 AD3d 815, 2010 NY Slip Op 04794 (2d Dept June 1, 2010). Essentially, without even acknowledging it was doing so, the appellate court overruled 15 years of its own precedents, and aligned itself with contrary rulings by the other Appellate Divisions, by deciding that the discount for lack of marketability may be applied to the corporation's entire enterprise value and not just its good will value. (Read here and here my August 2008 and June 2009 articles on the inter-departmental split of authority.)
The trial judge in Murphy, Nassau County Commercial Division Justice Ira B. Warshawsky, over the minority shareholders' objection, had applied a 15% discount for lack of marketability against the subject holding corporation's entire enterprise value which consisted primarily of its ownership of several triple-net-leased real properties. In so doing, he implicitly rejected theoretically binding Second Department precedent (the Whalen and Cinque cases) holding that the discount for lack of marketability is applicable only to the company's good will value, and instead sided with the First Department's contrary ruling in Hall v. King where the discount was applied to the entire enterprise value. (What was implicit in Murphy became explicit in Justice Warshawsky's later decision in the Jamaica Acquisition case where he openly agreed with Hall v. King. This later case, which I wrote about here, settled prior to appeal.)
In upholding Justice Warshawsky's marketability discount ruling in Murphy, the Second Department cited Hall v. King with nary a mention of Whalen and Cinque or even acknowledging the prior split of authority. Here's the key passage from the opinion:
In this case, the Supreme Court properly applied a lack of marketability discount of 15%, on the ground that the Corporation was a close corporation. Further, contrary to the petitioners' contention, the law does not limit the application of a lack of marketability discount to the goodwill of a corporation in all instances (see Matter of Brooklyn Home Dialysis Training Ctr., 293 AD2d 747; Hall v King, 265 AD2d 244, 245; Lehman v Piontkowski, 203 AD2d 257, 259; Matter of Raskin v Walter Karl, Inc., 129 AD2d 642, 644; Matter of Joy Wholesale Sundries, 125 AD2d 310; Matter of Fleischer, 107 AD2d 97; Matter of Blake v Blake Agency, 107 AD2d at 149; see also Hall v King, 177 Misc 2d 126, 134). Moreover, this case presents no factual circumstances under which such a limitation is appropriate.
Notice how the above passage does not create a categorical rule. Rather, it leaves for case-by-case determination, based on the specific facts presented, whether the marketability discount should apply to the entire enterprise value or should be limited to good will. In any event, so ends with a whimper what had been the most controversial, open issue in stock valuation proceedings under the fair value standard used in oppressed minority shareholder and dissenting shareholder buyout proceedings.
But wait, there's more. The Murphy appeals court also upheld Justice Warshawsky's approximately $3 million discount for built-in gains tax ("BIG") using a present value computation of future taxes assuming that the corporation held its real property investments for 19 years. (Read here my July 2008 analysis of the trial court's BIG decision.) The corporation argued for a 100% discount of the entire $11.6 million BIG tax, in line with prevailing authorities in the gift and estate tax area which presume a total liquidation of assets as of the valuation date. The appeals court disagreed, finding adequate support in the record for the lengthy holding period. The court also distinguished the First Department's approval of a 100% BIG deduction in the matrimonial valuation case, Wechsler v. Wechsler (58 AD3d 62), on the ground that, in that case, the defendant husband "'necessarily will have to sell' at least some of the assets of his corporation every year."
I'll close with a few other, miscellaneous notes of interest from the Second Department's Murphy ruling:
- The appeals court found inappropriate the trial court's inclusion of a $2 million liability for officer pensions, which the corporation's Board adopted about six weeks after the valuation date although it had been under discussion for some time before the valuation date. The court rejected the corporation's reliance on dissenting shareholder valuation cases decided under Section 623(h)(4) of the Business Corporation Law, pointing out that, unlike Section 1118 governing buyout of oppressed minority shareholders, the statute expressly permits consideration of post-merger factors.
- The appeals court agreed with the trial court's determination of about $6.5 million working capital, but it found a 10% expected rate of return excessive, and directed the lower court to recalculate the income value using a 6.7% rate based on testimony of the corporation's appraiser and president.
- The lower court awarded pre-judgment interest at the statutory rate of 9% from the valuation date, except for an 11-month period (starting 60 days after conclusion of trial through the date of decision directing entry of judgment) at the rate of 5%. The appeals court directed that, upon remand, the lower court make findings of fact in support of its use of the reduced rate "and, if warranted, the application of a different interest rate for that period of time."
- The Second Department's opinion, at the outset of its legal analysis, mentions the "fair value" standard under Section 1118 and then adds, "[t]he terms 'fair value' and 'fair market value' are used interchangeably," citing to the following passage in the New York Court of Appeals' 1991 opinion in Matter of Seagroatt:
Business Corporation Law § 1118 offers no definition of fair value and no criteria by which a court is to determine price or other terms of the purchase (see also, Business Corporation Law § 623). Rather, fair market value, being a question of fact, will depend upon the circumstances of each case; there is no single formula for mechanical application. [Emphasis added.]
In my opinion, it was dicta in Seagroatt, it's dicta in Murphy, and it's misuse of terminology in both. Read here my December 2007 article on the difference between FV and FMV.
