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.
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.
