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.
Splitting the Baby: Court in Oppressed Shareholder Dissolution Case Divides the Company Assets
Over two years ago I posted about a decision by Suffolk County Commercial Division Justice Emily Pines in a father vs. son corporate dissolution case called Matter of Wenger. I characterized Wenger as a classic illustration of the "ordinary" dissolution case in which "there are no knockout punches in the first round" and where the court orders an evidentiary hearing based on disputed issues of fact.
Two years, one fruitless summary judgment motion and a six-day trial later, Wenger has turned into anything but the ordinary dissolution case.
Justice Pines' December 14, 2010, post-trial decision in Matter of Wenger (L.A. Wenger Contracting Co.), 2010 NY Slip Op 52236(U) (Sup Ct Suffolk County), contains two novel rulings. First, the court holds that the father/69% shareholder is estopped from denying his son's position as 31% shareholder notwithstanding the failure of the Grantor Retained Annuity Trust (GRAT) under which shares were to be transferred to the son. Second, after finding that the son demonstrated oppression by his 87-year old father, in lieu of dissolution or compelled buyout the court orders that the multiple real properties and certain escrow funds held by the subject corporations be appraised and distributed such that the son winds up with 31% of the net value of the properties and cash.
The threshold issue in the case was the son David Wenger's shareholder standing to seek dissolution of L.A. Wenger Contracting Co. (L.A. Wenger) and a series of affiliated companies. It was undisputed that, in 1996, the father, Louis Wenger, had his attorneys draw up documents to create a GRAT under which 31% of the company's outstanding shares valued at $1.25 million would be transferred to the GRAT's trustee and distributed to David over four years in exchange for four annual cash payments of $200,000 each. The transaction was reflected in the stock ledger, but share certificates never were delivered to the named trustee and David did not make the cash payments. Nonetheless, beginning in 1996 and continuously thereafter, all of the corporate tax returns for L.A. Wenger, and for the affiliates that were subsequently created to hold assets of L.A. Wenger, consistently identified Louis and David as the 69% and 31% shareholders, respectively. In addition, there were adjusting entries in the financials and deemed "distributions" of $800,000 reflected in the tax returns that apparently correlated to the GRAT payment schedule.
Prior to trial, Louis moved for summary judgment dismissing David's petition on the ground he was not a shareholder. He supported his motion with expert testimony to the effect that the GRAT was never properly funded and therefore failed under Section 7-1.18 of the Estates, Powers & Trusts Law. In her ruling dated September 23, 2010, reported at 2010 NY Slip Op 32675(U), Justice Pines denied the motion, stating that "the Court is faced with issues that require a trial, which will likely involve both questions of fact and a battle of the experts."
In her post-trial decision, and having had the benefit of the "battling" experts' complete testimony, Justice Pines concludes that the GRAT "failed under state law, since it was never properly funded." She nonetheless goes on to hold that Louis is "equitably estopped" from denying David's 31% shareholder status, based primarily on the corporate tax returns. Here's what she writes:
[B]oth Louis Wenger and the five corporations that are the subject of these combined lawsuits are equitably estopped from denying David Wenger's position as a 31% shareholder. Nine years of corporate tax returns filed by the five corporations as well as corporate K-1's given to David Wenger by those entities, many of which are beyond the reach of the IRS at this point, cannot be ignored. When combined with the clear intent set forth in Louis Wenger's years of actions, the statements by Louis Wenger to sureties and lenders to the corporations, and the numerous correspondence, including that written after the parties were in dispute (Petitioner's 165) cannot be ignored. All the corporations and their majority shareholder, Louis Wenger, acted for years as though and for their mutual advantage, David Wenger was a 31% share holder. The Court finds that he remains so to this date. The Court, therefore, agrees with Petitioner's counsel that the validity of the GRAT at this point is irrelevant.
Next, Justice Pines holds that David "has met the requirements to demonstrate 'oppressive conduct' under BCL 1104-a" based on the father's improper actions which began "as soon as David Wenger began to question Louis Wenger's handling of the corporation's finances," including "demanding that he [David] turn over his interests in corporations holding over $10 million in assets for $10" and unilaterally transferring corporate assets to other relatives.
Now we come to the most interesting part: the remedy. The statutes governing judicial dissolution provide no express remedial authority for oppressive conduct other than dissolving the corporation and liquidating its assets (see BCL Section 1111). There is appellate case law, cited in Justice Pines' decision, that expands the court's remedial powers to include buyout of the minority shareholder on a voluntary or compelled basis. Justice Pines orders neither dissolution nor buyout. Instead, in an exercise of equitable discretion in the circumstances of a family dispute, she orders a distribution in kind to David, consisting of a portion of the subject companies' realty plus whatever cash is required such that he receives 31% of the net value of the corporate assets, thereby leaving Louis as 100% shareholder of the going concern, reduced-asset companies. Here's how Justice Pines explains it:
[T]his is a case, where dissolution does not appear to the Court to be in the best interests of the majority shareholder, who has reached 87 years of age, nor is it the only solution to provide the minority shareholder with his due, in view of the significant amount of real property held by the five subject corporations. Petitioner's counsel has recommended an alternate remedy, which the Court adopts, in part. Under the circumstances, by appraising the net values of the real properties in question; transferring sufficient real property and cash from the escrow account holding the proceeds of the sale of 770 Railroad Avenue so that David Wenger or his designee receives 31% of the net value of such properties and cash, the Court finds that David Wenger's claims will be satisfied without the need for the drastic remedy of dissolution. In order to accomplish such task, the Court is appointing Robert Lynn, Esq., by separate order, as a Temporary Receiver, with limited powers, to retain a real estate broker; and to obtain the net values of the real properties (taking into account all mortgages and liens) on the real properties currently held by the five corporations that are the subject of these proceedings. To this will be added the net value of the real property transferred without David Wenger's consent to his sister located in Palm Beach, Florida and the amount of $50,000 removed by Louis Wenger from the proceeds of the sale of 770 Railroad Avenue. The Court determines the net value of the Florida property, based on appraisals placed into evidence by both parties to be $150,000 (Petitioner's 186), since such was the appraised value at the time of the improper act of transfer. After calculating the 31% figure, the Temporary Receiver will have the authority to choose a property or properties, other than that located in Palm Beach, Florida and owned by David Wenger's sister, to transfer to David Wenger or David Wenger's designee, utilizing the remains of the escrow account, if necessary.
In the Old Testament story, Solomon pretended he would physically split the baby claimed by two women rather than allowing either one to win at the other's expense, to trick them into revealing the true mother's identity. Wenger has what I'll call a reverse Solomonic twist, in which the judge actually splits the assets in order to preserve the companies rather than liquidate them. We can only hope it returns some measure of harmony to the Wenger family.
Final Round of Corfian Case Features Diverse Dissolution Issues
Once in a while there comes along a corporate dissolution case fraught with so many interesting and challenging issues of fact and law that, as the saying goes, a student of business divorce could "go to school on it." Of course, it also helps to have an engaged judge willing to serve as "teacher", i.e., a judge who carefully parses the issues and writes a thoughtful, well-reasoned decision that sets forth the competing factual narratives and operative legal principles.
A protracted dissolution battle in Brooklyn Supreme Court called Matter of Pappas (Corfian Enterprises, Ltd.), presided over by Justice Jack M. Battaglia (pictured), is just such a case.
Pappas began in 2004, when the widow of Eleftherios Pappas embarked on what became a 6-year trek through the legal system trying to establish and get paid for her late husband's ownership interest in commercial realty and two closely held corporations which, she alleged, were co-owned with two other individuals, Theodoros Kalogiannis and Paul Fotinos. There was no direct evidence, by way of shareholder agreement or other reliable records, establishing ownership of the corporations, of which Mr. Fotinos claimed to be 100% shareholder.
In January 2009, after holding an evidentiary hearing on the issue of Mrs. Pappas' standing to seek corporate dissolution, Justice Battaglia wrote a tour-de-force opinion weighing the conflicting evidence and analyzing a slew of legal issues, in which he concluded that only one of the two corporations, named Corfian Enterprises, Ltd., was co-owned as equal one-third shareholders by the late Mr. Pappas' estate along with Messrs. Kalogiannis and Fotinos. (Read here my post about the January 2009 decision.)
A year and a half later, and after holding a second trial on the merits, Justice Battaglia has issued another lengthy, fact-filled, law-laden decision in which he grants Mrs. Pappas' petition to dissolve Corfian based on shareholder oppression by Mr. Fotinos, and directs the appointment of a referee to close the business of the corporation, marshal its assets, and determine and discharge its liabilities. The decision, dated July 23, 2010, and reported at 2010 NY Slip Op 51300(U), can be read here.
The issues addressed in the decision are too numerous to relate in detail, so I'll just highlight them in the following bullet points:
- Statute of Limitations. Mr. Fotinos argued that the Pappas Estate's claims sounded in "breach of a contract to issue shares of stock" and therefore accrued some years before his death in 2000, such that Mrs. Pappas' suit brought in 2004 was time barred. The court disagreed, noting that a claim for dissolution pursuant to section 1104-a of the Business Corporation Law is governed by the "so-called six-year residual limitation" period found in section 213(1) of the Civil Practice Law and Rules; that the limitation period is measured from the "instances of alleged wrongdoing adverted to by [petitioner] as grounds for dissolution"; and that Mrs. Pappas "may legitimately support [her] claim for dissolution with evidence of 'oppressive action' during the six-year period prior to commencement of the Dissolution Proceeding on March 9, 2004."
- Laches. In 2001, about a year after her husband's death, Mrs. Pappas learned that Mr. Fotinos claimed 100% ownership of Corfian. Mr. Fotinos argued that Mrs. Pappas was guilty of laches, i.e., that he was prejudiced by her allegedly unreasonable and inexcusable delay in commencing the action in 2004. Justice Battaglia held otherwise, stating that a "period of less than four years, well within the applicable six-year statute of limitations," did not constitute laches; that Mr. Fotinos could "point to no evidence of prejudice"; and that there was no evidence "that Mr. Fotinos did anything more than would have been expected of him consistent with the 'high degree of fidelity and good faith' that he owed the other shareholders in this close corporation."
- Failure to Plead Looting as Basis for Dissolution. Mrs. Pappas' petition solely pleaded oppressive actions as the basis for dissolution under BCL section 1104-a(a)(1). She did not plead that the corporation's assets were being looted, wasted or diverted as grounds for dissolution under section 1104-a(a)(2), and she did not move after trial to conform the pleadings to the proof. Justice Battaglia therefore refused to consider her argument for dissolution based on subdivision (a)(2).
- Two Categories of Oppression Cases. Justice Battaglia's decision collects oppressed-shareholder case citations which he separates into two categories: (1) "freeze out" and "squeeze out" cases involving expulsion or other deprivations directed against a shareholder actively employed in the business, and (2) dissolution claims by a merely "passive shareholder" or based upon a failure to declare dividends when dividends were never previously paid. Corfian, the court concludes, falls in the second category based on "a reasonable expectation of sharing in the 'profits' of the business, as they might be realized by Corfian."
- Denial of Shareholder Status as Oppression. The "most important" factor in finding that Mr. Fotinos engaged in oppressive conduct, Justice Battaglia wrote, was Mr. Fotinos' "denial that Messrs. Pappas and Kalogiannis were equal stockholders with him in the business", adding that it is "difficult to recognize a more reasonable shareholder expectation than that its interest will not be repudiated in its entirety, and that legal action would be required to compel its acknowledgment."
- Analogy to Partnership Dissolution. Although, as Justice Battaglia noted, the case authorities require that every order of dissolution be conditioned upon permitting the other shareholders to elect to purchase the complaining shareholder's shares for fair value, here the parties had stipulated that none of them is seeking a buy-out. Mr. Pappas' death, and the subsequent retirement of Mr. Kalogiannis, rendered dissolution "consistent with the real-world similarity between closely-held corporations and partnerships". Just as the death or withdrawal of a partner dissolves the partnership by operation of law, Justice Battaglia wrote, "that the same result obtains here would not offend the purpose or policies of BCL section 1104-a."
- Damages/Surcharge. Mrs. Pappas also sought a money judgment against Mr. Fotinos for approximately $1.6 million allegedly representing the amount he wrongfully dissipated from Corfian mostly for salary to himself and the value of Corfian's building used rent-free by other companies wholly owned by Mr. Fotinos. The court rejected the claim which it characterized as a claim belonging to the corporation and therefore one required to be asserted in a derivative action, which Mrs. Pappas failed to bring. Justice Battaglia also rejected Mrs. Pappas' alternative claim for a "surcharge" under BCL section 1104-a(d), based on: (1) her failure to cite the provision in her petition; (2) "there is at least a question" whether surcharge is permissible when dissolution is based solely on oppressive actions and not on looting-type allegations under section 1104-a(a)(2); and (3) her failure to offer evidence to support a finding of "wilful or reckless conduct" as required by section 1104-a(d).
- Spoliation. Lastly, the court notes that Mrs. Pappas sought "conclusive inferences based upon spoliation of evidence" by Mr. Fotinos who testified that he destroyed certain financial and other business records after he became aware of the claims of Mrs. Pappas and Mr. Kalogiannis. Justice Battaglia disagreed, finding no showing that any of the destroyed documents were "essential to the proof of Petitioners' claims."
There are other nuggets in the Corfian decision, and I would urge anyone interested to read the entire opinion.
