Those who follow the society pages may recall that gossip columnist, television reporter and socialite Claudia Cohen married, had a child with and later divorced billionaire Ronald Perelman, and that she died tragically young in 2007.  Less well known is the fact that Cohen herself came from family wealth; her father, Robert Cohen, built a highly successful media distribution business known as Hudson Media.  It is from the Cohen-family wealth, and the sorting out of Claudia Cohen’s estate, that the following tale of partnership valuation controversy emerges, culminating with a recent New Jersey court decision in Estate of Cohen v. Booth Computers, Memorandum Decision, C.A. Docket No. BER-C-135-08 (N.J. Super. Ct. Aug. 4, 2009).

In 1978, when Claudia was 27 and her two brothers were 21 and 19, their parents set up a general partnership called Booth Computers (the “Partnership”) with the children as equal one-third partners.  The idea was to provide income for the children and to shift assets for tax and estate planning purposes from the parents to the children.  The children did not negotiate the Partnership Agreement which was prepared at the parents’ direction by one of their lawyers.  Later the same year, a limited partnership was formed called HCMJ Realty Ltd. (“HCMJ”) of which the parents owned a 55% general partner interest and the Partnership was given a 45% limited partner interest.  HCMJ’s limited partnership certificate reflected a $90,000 cash contribution by the Partnership.

HCMJ’s sole asset was a Palm Beach ocean front estate used as the Cohen family vacation home, which was transferred by another Robert Cohen entity to HCMJ in 1978.  In addition to its 45% interest in HCMJ, the Partnership directly owned a pair of New Jersey commercial warehouses acquired in 1980 and 1984.  The court’s opinion doesn’t disclose the warehouse purchase prices or indicate if they were conveyed to the Partnership by other Cohen-owned entities.  In any event, none of the three Cohen children put their own money into the Partnership.

The Partnership Agreement included standard restrictions on the transfer of partnership interests to an outsider.  In the event of a partner’s death, it obligated the surviving partners to purchase the deceased partner’s interest at a purchase price based on a “net worth” valuation as of the date of death, as set forth in Paragraph 16 of the Partnership Agreement providing:

Each of the Partners has considered the various factors entering into the valuation of the Partnership and has considered the value of its tangible and intangible assets and the value of any goodwill which may be present.  With the foregoing in mind, each of the Partners has determined that the full and true value of the Partnership is equal to its net worth plus the sum of [$50,000].  The term “net worth” has been determined to be net book value as shown on the most recent Partnership financial statement at the end of the month ending with or immediately preceding the date of valuation.

Throughout the Partnership’s existence, its financial statements and tax returns reflected the value of its assets at cost, as opposed to market value.  Thus, the Partnership’s tax returns in the years 1992 though 2007 listed the book value of its 45% interest in HCMJ — which generated no income — as a negative value notwithstanding its ownership of the Palm Beach property obviously worth many millions including significant appreciation in the intervening 30 years since the Partnership’s formation.

The middle sibling, Michael Cohen, died in 1997 at which point Claudia and James Cohen became 50/50 partners pursuant to the Partnership Agreement’s buyout provision.  Michael’s estate was paid approximately $34,500 for his one-third Partnership interest pursuant to the buyout formula, reflecting a negative book value offset by a portion of the $50,000 add-on.  Claudia did not actively participate in the buyout of Michael’s interest but, according to the court, she was aware of the buyout and knew that she and her surviving brother had become 50/50 owners.

Claudia died on June 15, 2007.  The sole, remaining sibling, James Cohen, tendered a buyout price of approximately $178,000 based on the Partnership Agreement’s formula.  The Estate, by Ronald Perelman as its Executor, rejected the tender and brought a lawsuit contending that the Estate’s interest was worth in excess of $10 million based primarily on a $45 million valuation of the Palm Beach property.  The lawsuit asserted that the language of Paragraph 16 of the Partnership Agreement required a buyout for “fair market value” using 2007 real property valuations.  The Estate alternatively argued that a fair market valuation was necessary because enforcement of the $178,000 buyout tendered by James based on book value would be “unconscionable”.  James counterclaimed for specific enforcement of the $178,000 buyout.

The court conducted a six-day trial featuring testimony by opposing pairs of real estate and business appraisers.  The parties agreed that the two Partnership-owned warehouses had a combined fair market value of $2.75 million.  James’s real estate appraiser valued the Palm Beach property at $30 million — $15 million less than the Estate’s valuation — but the court ultimately sided with the Estate’s higher valuation.

The valuations set the stage for the central questions in the case:  What was the correct interpretation of Paragraph 16’s valuation provision?  If interpreted to mean net book value without regard to fair market value, would its enforcement nonetheless be barred by the unconscionability doctrine, i.e., that its enforcement would be so egregious to a court of equity as to “shock the conscience”?

On both questions, the court sided with James, finding that Paragraph 16’s plain terms mandated buyout based on the net book value as reflected in the Partnership’s financials, and that so construed the provision was not unconscionable.

The Estate put up a good fight.  Its accountant and business valuation expert opined that the phrase “full and true value of the partnership” as used in Paragraph 16 signified the parties’ intent to fix the purchase price based on “actual value” whether defined as fair market value or fair value.  In his view, Paragraph 16’s use of the additional terms “net worth” and “net book value” did not alter the stated intent to use “full and true value” as the measure of value.  The court disagreed, commenting as follows:

That, to me, gets it exactly backwards.  Rather, the plain language of  the provision, given its natural reading, tells us that the “full and true value” of the partnership, in the event of a buy out, is to be determined by a specific, clear formula. . . . The term “net worth” could certainly mean the market value of one’s assets, less the amount of one’s liabilities.  That is what my banker meant by net worth when I applied for a mortgage on my home.  But the buyout provision here defines “net worth” in a distinctly different fashion:  “the term ‘net worth’ has been determined to be the net book value . . .” as shown on the most recent Partnership financial statement.  Had the partners — or their parents — intended to provide for the buyout of a deceased or divorcing partner’s interest at fair market value, they could easily have said so.  They plainly did not provide for a buy out at fair market value. . . . I find that the phrase net worth — the specific buy out standard — was not defined as full and true value, but rather that full and true value was defined, specifically, to be book value.  And the books and records and tax returns of [the Partnership], and the corresponding K-1’s from HCMJ, invariably reflect book value predicated on cost, less distributions, plus any additional contributions, with no reference whatsoever to actual or fair market value.

The court also stressed that the Partnership’s financial and tax accounting was typical of such ventures, as testified to by James’s expert:

I found informative, useful, and reliable the testimony of the defendants’ expert in accounting and business valuation, Samuel Rosenfarb.  His testimony and the underlying documentation reflects that [the Partnership] carried on its books its investment in HCMJ at cost ($90,000), less pass through losses and distributions, and upward for capital contributions.  This was not out of some long term plan to cheat one or more of the siblings, or their estates, but rather the bookkeeping was in accordance with the way the overwhelming number and types of businesses carry assets, and liabilities, on their books. . . . As aforesaid, HCMJ generated no income.  There were no subsequent capital contributions by [the Partnership].  HCMJ passed through its losses (expense payments for taxes, mortgage and insurance) to [the Partnership], decreasing the net book value of [the Partnership’s] interest in HCMJ, eventually, to a negative: -$97,547. . . . And that negative value is the book value properly used in determining the buy-out of the Estate’s interest in [the Partnership].

The Estate’s valuation based on date-of-death fair market value ($11.5 million) was almost 64 times the net book value computed under Paragraph 16’s buyout formula ($178,000).  While having commented to counsel prior to trial that the “disparity offends my inner scale,” the court stated that, after weighing all the evidence at trial, “I find that enforcement of the buy-out does not rise to the level of unconscionable.”  The court offered a number of reasons:

  • The Partnership interests were a gift from parents to children, the terms and conditions of which were equally applicable to each child.
  • The book value formula was used for the $34,500 buyout of Michael’s estate in 1997, which amount likewise was not remotely related to actual value, and of which Claudia was a beneficiary.
  • Book value is commonly used as a readily ascertainable buyout formula in small, family businesses, to shield the partners “from destruction through the avenue of intra-family litigation” over the inherently more elusive measure of fair market value or fair value.
  • There was no evidence that, in the ten years after Michael’s death, Claudia and James as 50/50 partners sought to amend the Partnership Agreement’s buyout provision.
  • Under the existing provision, it was just as likely that Claudia could have ended up the Partnership’s sole owner had James pre-deceased her.
  • All the children received substantial income and benefits from the Partnership, without ever having contributed their own funds.

Although a “fairer, more even-handed buy-out provision, or result, might occur to the court, or to the reader of this opinion,” the court added, “it is not the court’s function or prerogative to simply re-write agreements.”

Neither the lawyer who drafted the Partnership Agreement nor the father, Robert Cohen, testified at the trial, so, as the court noted, the language used was the only evidence of the parties’ intent.  Most observers would agree that net book value is, to say the least, a peculiar choice of definition of “full and true value”.  Given the family setting, the age of the children at the time and the purpose of the Partnership, the idea that the language chosen was designed to mislead anyone seems preposterous.  Perhaps the drafter didn’t appreciate how cost-based tax accounting would affect the application of the buyout formula.

I have seen other instances of what I call the “death lottery” buyout provision used in this case.  It can be especially harsh and conducive to internal strife when, as here, it is tied to book value.  That’s true whether the entity’s assets are appreciated real estate, as in the Cohen case, or an operating business with good will which also will not be reflected in book value.  Particularly when the ownership is 50/50 — and assuming more or less equal life expectancies — one would think that both sides have equal incentive to make a new and different arrangement.

Update July 19, 2011:  By decision dated July 13, 2011 (read here), a three-judge panel of the Appellate Division unanimously affirmed the trial court’s rulings.