The opening lines of Nassau County Commercial Division Justice Ira B. Warshawsky’s 41-page opinion in Matter of Jamaica Acquisition, Inc., 2009 NY Slip Op 32320(U) (Sup Ct Nassau County Sept. 29, 2009), wax nostalgic about several privately operated bus lines that primarily served New York City’s Queens County from the 1920’s until the 1990’s, when the routes were taken over by the Metropolitan Transportation Authority. These included the Green Bus Lines, Triboro Coach and Jamaica Buses. The rest of the opinion in this dissenting shareholder appraisal case is anything but nostalgic, as it referees a classic “battle of the experts” in which the two sides clashed over numerous issues including capitalization rates, deductions for built-in capital gains and income tax liabilities, marketability and minority discounts, and the award of attorney’s fees and interest.
Shares in the three bus companies were widely dispersed among approximately 200 descendants of the original shareholders, many of whom owned shares in two or all three companies. While each shareholder technically was a minority shareholder, for decades there were voting trust agreements that ensured a stable, common management of the bus companies under the control of Jerome Cooper, the son of the founder of the Green Bus Lines.
In 2005, the City paid the companies $25 million to acquire their routes, tangible personal property and good will. The companies retained eight real estate parcels consisting mainly of bus depots and maintenance facilities which were then leased to the City and private interests, in most instances under long-term triple net leases generating aggregate annual revenues of about $9.5 million.
As Subchapter “C” corporations, the bus companies’ income was subject to double taxation at the corporate and shareholder levels. In addition, a sale of the fully depreciated real estate would have generated a capital gains tax of $58 million. Therefore, in February 2007, management formally proposed merging the three companies into a REIT (real estate investment trust) which would achieve pass-through taxation and, after a 10-year holding period, the ability to sell the realty free of capital gains tax. The merger was structured as a share swap under which shares in each bus company entitled the holder to a specified number of REIT shares based on an allocation formula utilizing a February 2006 appraisal of the real estate assets by Cushman & Wakefield (the “Pre-Merger Appraisal”). The Pre-Merger Appraisal concluded an aggregate valuation of over $153 million using a discounted cash flow analysis for certain properties and direct capitalization and market approaches for others.
The shareholders overwhelmingly approved the merger agreement in March 2007. Eight shareholders holding approximately 2.5% of the potential REIT interests objected to the merger and demanded an appraisal pursuant to Section 623(h) of the New York Business Corporation Law. Management offered the dissenters an amount equivalent to $7 per REIT share based on an April 2007 appraisal by Empire Valuation Consultants. As Justice Warshawsky’s opinion repeatedly notes, the 2007 Empire Report incorrectly valued the REIT shares as of the day after the merger whereas the statute required payment for the fair value of the dissenters’ shares in the pre-merger companies as of the day before the approval of the merger. This also became an issue in the court’s assessment whether the offer was made in “good faith” for purposes of an award of counsel fees (see below).
The dissenters rejected the offer. As required by statute, the companies then paid the dissenters 80% of the offered amount and commenced a judicial proceeding to determine the fair value of the dissenters’ shares.
Eventually, following discovery proceedings (read here the court’s December 2007 discovery rulings) and a succession of modified appraisal reports by the companies’ experts, Justice Warshawsky conducted a lengthy trial featuring sharply conflicting opinions and approaches by the dueling experts. Readers who want the full flavor and complexity of the contested valuation issues and testimony will just have to read the entire opinion. For everyone else, here are the highlights:
- Built-In Gains and Post-Merger Corporate Taxes (pp. 21-22). The companies and their experts argued that a hypothetical willing buyer of the shares would take into account the capital gains tax, estimated at $58 million, that would be due when the fully depreciated properties are sold. Justice Warshawsky disagreed, based on the language of BCL Section 623(h)(4) (“in fixing the fair value of the shares, the court shall consider the nature of the transaction giving rise to the shareholder’s right to receive payment for shares and its effects on the corporation and its shareholders”) and on the explicit statement in the merger proposal that the real properties would not be sold for at least 10 years after reconstitution as a REIT. For the same reason Justice Warshawsky rejected the companies’ experts’ valuation based on capitalization of earnings insofar as it failed to eliminate income taxes at the corporate level. (Read here and here for my prior posts on treatment of built-in gains tax in fair value cases.)
- Marketability Discount (pp. 22-26). In what I view as the single-most important ruling in the case, Justice Warshawsky agreed with the companies that a 25% discount for lack of marketability should be applied against the value of the entire enterprise, i.e., should not be limited to good will of which there was none since the 2005 sale to the City included all good will. Justice Warshawsky’s opinion discusses conflicting precedent in the First and Second Departments, and concludes that the cases limiting the discount to good will “do not support this position and on their face appear inconsistent with the cases of the Court of Appeals [New York’s highest court].” (Read here and here my prior posts concerning the conflicting case law on marketability discount application.)
- Minority Discount (pp. 26-30). Fair value case law in New York uniformly rejects application of a discount for lack of control a/k/a minority discount. The companies argued unsuccessfully that their case was exceptional because (a) the proposed merger was not a squeeze-out merger and (b) all shareholders of the pre- and post-merger companies were minority shareholders. In applying the prevailing rule, Justice Warshawsky opined that it is of no moment the reason why a shareholder exercises his or her statutory appraisal rights, and that case precedent does not “graft on to BCL 623 an additional burden of proof to show some type of corporate wrongdoing by the majority; and, yes, the court considers everyone else the majority.” (Read here my prior post on the difference between marketability and minority discounts.)
- Valuation (pp. 30-38). It’s impossible in one paragraph to capture the complexities and conflicts of the opposing appraisal methodologies, so I won’t even try. Justice Warshawsky repeatedly chastised the bus companies’ experts for what he described as a series of shifting valuation reports, inconsistencies and selective use of data. The companies’ experts’ “final” appraisal valued the dissenters’ shares (with discounts) at slightly less than the original $7 offer, whereas the dissenters’ expert arrived at a value of $18.37 (without discounts). One “monumental difference” between the two was the companies’ experts’ use of a 9% capitalization rate versus the dissenters’ expert’s use of the same 6.5% rate used by Cushman & Wakefield in its real estate appraisal. Justice Warshawsky agreed with the lower rate. On the other hand, Justice Warshawsky disagreed with the dissenters’ expert’s disregard of interest expense on the money borrowed to fund the dividend that had to be paid for the new entity to qualify as a REIT, which Justice Warshawsky viewed as part and parcel of the REIT conversion. In the end, Justice Warshawsky favored a modified version of the dissenters’ expert’s Adjusted Book Value (“ABV”) approach rather than the weighted combination of Net Asset Value (“NAV”) and earnings approach of the companies’ expert. This produced (after applying the 25% marketability discount) a value of about $137 million for the three companies, from which Justice Warshawsky deducted about $20.5 million for capitalized going-concern costs, arriving at a value of $116,923,409 or the equivalent of $11.69 per REIT share.
- Attorney’s Fees and Costs (pp. 38-39). The general rule under BCL Section 623(h)(7) is that each side pays its own costs including attorney and expert fees. The statute also authorizes the court to shift costs against the dissenters if their refusal of the company’s offer was arbitrary, vexatious or otherwise not in good faith, and against the company if its offer was arbitrary, etc. or if the award “materially exceeds” the company’s offer. Both sides asked Justice Warshawsky to impose costs against the other. Justice Warshawsky found that the $11.69 per share award materially exceeded the $7 offer, and that the “ongoing changing fair value calculations proffered by [the bus companies], even during trial, was vexatious to the [dissenters].” On that basis he ordered that the companies reimburse the dissenters for 50% of their costs and legal fees to be determined at a later hearing.
- Interest (pp. 40-41). BCL Section 623(h)(6) directs the court to award interest at an “equitable” rate on the unpaid portion of the award, unless the shareholder’s refusal to accept the offer was arbitrary, vexatious or not in good faith. Justice Warshawsky granted interest at 6.5% which was the rate paid by the bus companies on their line of credit at the time of the merger. He rejected the dissenters’ request for interest on their costs, attorney’s fees and expert’s fees.
Trial lawyers are fond of saying that every case partakes something of a crap shoot. The dissenting shareholder statute raises the stakes for both sides in the fair value casino. As the Jamaica Acquisition case illustrates, the statute invites uncertainty by requiring valuation on a pre-merger basis as of the date prior to consummation and, at the same time, requiring a forward-looking analysis of the post-merger impact on valuation. The statute further heightens the risks by imposing liability for the other side’s legal fees, for making what turns out to be an unreasonable offer (in the company’s case) or arbitrarily rejecting what turns out to be a reasonable offer (in the dissenter’s case). The fair value award in Jamaica Acquisition, at the approximate mid-point between the $7 per share offered by the companies and the $18 sought by the dissenters, suggests that both sides made comparable misjudgments of value. However, the companies alone faced a greater statutory risk, and ended up paying a higher price for their misjudgment, in the form of an assessment for half the dissenters’ legal fees and costs based on the material discrepancy (67%) between the offer and the award.