A federal appeals court once remarked that “the valuation of a closely held company is an inexact science”, adding, “some might say an art” (Okerlund v. U.S., 365 F3d 1044 [Fed. Cir. 2004]). Looking at the gallery of New York valuation law, the artist must be Jackson Pollack.
By that I mean, the valuation rules seem like a hodgepodge when one compares the different settings in which interests in closely held companies are valued by the New York courts, including dissenting shareholder appraisals and oppressed minority shareholder buyouts under the Business Corporation Law, accounting proceedings under the Partnership Law, and equitable distribution proceedings under the Domestic Relations Law. This holds especially true with respect to valuation discounts, as highlighted in a recent appellate decision concerning a fractured partnership in a case called Vick v. Albert, 47 AD3d 482 [1st Dept 2008] (read decision here).
Vick involved a nasty family feud that spawned multiple litigations and arbitration lasting almost a decade. Beginning in 1975, Susan Vick and her brother, Richard Albert, co-owned a number of investment real properties in New York City. Some of the properties they owned as tenants in common, others were owned by partnerships in which Vick, Albert and others held partnership interests. Vick died in 1999, leaving her interests to her two children. About eight months after their mother’s death, the children sued their uncle and others seeking, among other things, a partition of certain properties and a dissolution and accounting with respect to various partnerships. The complaint alleged that the uncle took exclusive control of the partnerships’ books, records, properties and assets; that he misappropriated certain assets including rental income for his own benefit; and that he failed to wind up the partnerships’ affairs after his sister died and failed to provide a final accounting for each of the partnerships. (The appellate court’s decision unfortunately recites very few facts. More can be learned from the prior lower court decisions, two of which from 2001 and 2004 can be viewed here and here.)
The death of a partner in a general partnership triggers rights and obligations spelled out in the New York Partnership Law. Under Partnership Law Section 62, absent an agreement to the contrary, the death of a partner is an event of dissolution of the partnership. Under Partnership Law Section 73, when a partner dies (or retires) and the remaining partner or partners opt to continue the business rather than dissolve the partnership and settle the partner accounts, the deceased partner’s legal representative is entitled to be paid “as an ordinary creditor an amount equal to the value of his interest in the dissolved partnership” to be ascertained as of the date of dissolution.
In other words, when the uncle and the other remaining partners continued the real estate businesses after Susan Vick’s death without winding up and settling accounts, they became obligated to pay her estate the “value” of her partnership interest plus, at the estate’s option, interest on that amount or the interim profits attributable to the use of Susan Vick’s rights to the use of the property of the dissolved partnership.
The appeal in Vick followed a nonjury trial at which the judge valued Vick’s interests in two of the partnerships. Her 20% interest in one of the partnerships was valued around $1.2 million. Her 9% interest in the other was valued around $170,000.
A number of issues were raised by both sides on the appeal. The one of interest here is the uncle’s contention that the trial court improperly refused to discount the values of Susan Vick’s partnership interests for lack of control and for lack of marketability.
The discount for lack of control (“DLOC”), also referred to as the minority discount, is an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control. The discount for lack of marketability (“DLOM”) is an amount or percentage deducted from the value of an ownership interest to reflect the absence of marketability compared to publicly traded investments. Depending on the business and assets involved, combined reductions for DLOC and DLOM can top 50% of the pro rata value of the enterprise, hence at trial they are often the subject of high stakes duels between the opposing appraisal experts whose opinions require significant judgment calls a/k/a art. (For those who want to learn more about the basics of valuation discounts, a good resource is the IRS’s Valuation Training for Appeals Officers Coursebook. The section on DLOC and DLOM is on pages 94-99.)
The trial court in Vick ruled that DLOC and DLOM are barred by Section 73’s requirement for payment of the value of the deceased partner’s interest to the estate “as an ordinary creditor”. The appellate court sided with the uncle and disagreed with the trial court, holding that this language does not address valuation but, rather, “the method of collecting the value of the deceased partner’s interest vis-a-vis creditors of the partnership and of the individual partners”.
The children also lost their argument based on provisions in the Business Corporation Law (BCL) including “fair value” buyouts under BCL Sections 623 and 1118. Here’s what the court said:
Nor, contrary to plaintiffs’ contention, does the buyout of a deceased partner’s interest implicate all of the factors that our courts have relied upon in denying discounts in the corporate minority or dissenting shareholder contexts (see Matter of Penepent Corp., 96 NY2d 186, 194 ; Matter of Friedman v Beway Realty Corp., 87 NY2d 161, 167, 169-170 ). A partnership minority discount would not contravene the distinctly corporate statutory proscription (Business Corporation Law § 501 [c]) against treating holders of the same class of stock differently, or undermine the remedial goal of the appraisal statutes to protect shareholders from being forced to sell at unfair values, or inevitably encourage oppressive majority conduct. Nor would a decreased marketability discount implicate these policy concerns, as it applies equally to all partnership interests, not those of the deceased partner only (see Matter of Blake v Blake Agency, 107 AD2d 139, 149 , lv denied 65 NY2d 609 ;see also Matter of Fleischer, 107 AD2d 97, 101 ; Hall v King, 177 Misc 2d 126, 134-135 ).
The uncle’s victories on these points proved Pyrrhic, however, because in the end the appellate court upheld the non-discounted award based on several other factors. As I read the opinion, (1) the deceased partner’s estate should not be financially penalized by the surviving partners’ choice either to wind up the business or continue it; (2) real estate holding companies are poor candidates for discounts; and (3) you can’t fault a partner for causing dissolution by dying. Read it for yourself and decide:
[A]pplication of the discounts sought by defendants would deprive plaintiffs of the value of the decedent’s proportionate interest in a going concern, since they would not receive what they would have received had the entire entity been sold on the open market unaffected by a diminution in value as a result of a forced sale (see East Park Ltd. Partnership v Larkin, 167 Md App 599, 619-620, 893 A2d 1219, 1231 , cert denied 393 Md 243, 900 A2d 749 ; Winn v Winn Enters., Ltd. Partnership, 100 Ark App 134, —, — SW3d —, —, 2007 Ark App LEXIS 693, *10-11 [Ct App 2007]). The unavailability of the discounts is particularly apt here, where the business consists of nothing more than ownership of real estate (see Cohen v Cohen, 279 AD2d 599 ; Matter of Cinque v Largo Enters. of Suffolk County, 212 AD2d 608 ; East Park, 167 Md App at 610, 893 A2d at 1226 [fair value of partnership interest equals amount partners would receive if property sold at arm’s length]), and where the valuation ensues from the death of a partner and not as the result of any misconduct of a withdrawing partner in causing dissolution (cf. Anastos v Sable, 443 Mass 146, 150-151, 819 NE2d 587, 591 ). In this regard, we note that Haymes v Haymes (298 AD2d 117, 119 , lv denied 100 NY2d 509 ), in which we applied minority interest and decreased marketability discounts to the valuation of partnership interests in an equitable distribution matter, should not be understood as an imprimatur on such discounts as a matter of law, but only as addressing the trial court’s resolution of a conflict in expert testimony, and is therefore limited to its particular facts.
There’s an awful lot going on in that one paragraph, enough to justify a separate article on each sentence. For now, I’ll sum up as follows:
- Vick neither requires nor forbids application of DLOC and DLOM in determining the “value” of partnership interests under Partnership Law Section 73. Perhaps it can be said that Vick places the burden on the remaining partners to justify the discounts. Compare this to “fair value” determinations under BCL Sections 623 and 1118 where the case law makes clear that DLOC is prohibited but DLOM is generally to be applied absent exceptional circumstances. Also compare it to the valuation of business interests in equitable distribution proceedings under the Domestic Relations Law where the standard is “fair market value” and both DLOC and DLOM are generally to be applied absent exceptional circumstances. Confused? You should be.
- One of the factors the Vick court relies on is that the valuation ensued from the death of a partner and not because of wrongful misconduct by a withdrawing partner. Remember, Section 73 also deals with a partner who retires, not just with deceased partners. Vick therefore gives added incentive to the remaining partners to argue wrongful withdrawal in the case of a retired partner.
- The court’s citation to Cinque v Largo Enterprises is curious considering that, in a case called Hall v. King decided in 1999, the First Department affirmed a valuation decision that explicitly refused to follow Cinque, which is a Second Department case holding that DLOM only applies to good will value. Making matters more confounding, in the paragraph that precedes the citation to Cinque, the Vick court cites with approval — you guessed it — Hall v. King. Oh well, as Ralph Waldo Emerson wrote in his essay, Self-Reliance, “A foolish consistency is the hobgoblin of little minds”.