I’ve written before (see here, here and here) about the handful of New York court decisions that either apply or refuse to apply the discount for built-in capital gains taxes (“BIG”) in determining the fair value of corporate stock in dissenting and oppressed shareholder appraisal proceedings.
In two of them — the La Sala and Jamaica Acquisition cases — the courts rejected BIG discounts entirely. In the Murphy case, the court deducted the present value of future gains taxes assuming a 19-year holding period.
A case decided last week by a Manhattan appeals court doesn’t come to a final decision on the BIG question, but it nonetheless highlights an interesting BIG-related issue which I’ll pose as follows:
In a dissenting shareholder appraisal proceeding triggered by a freeze-out merger of a Subchapter C corporation that owns assets with built-in capital gains, is the shareholder entitled to pre-trial disclosure of the corporation’s post-merger tax filings showing whether it made a Subchapter S election, thereby permitting a sale of the assets after a 10-year holding period without incurring a corporate tax on the gain?
The case, Matter of Estate of Mandelbaum (Five Ivy Corp.), 2010 NY Slip Op 03373 (1st Dept Apr. 27, 2010), provides a “no” answer based on the sparse record presented in that case, in which the frozen-out shareholder’s allegation of a post-merger S election was speculative at best. It’s important to note, however, that a portion of the lower court’s order not appealed from left the door open for reconsideration based on possible “substantiation” through “other discovery.”
For readers unfamiliar with freeze-out mergers, they involve a corporate reorganization designed to remove minority shareholders by forcing them to redeem their shares for cash. When structured as a merger of the old corporation into a newly formed corporation (controlled by the majority shareholders) that holds at least 90% of the old corporation’s shares, under New York’s default statute the transaction does not require a shareholder vote (see Business Corporation Law § 905). This is known as a short-form merger.
The minority shareholders either can accept the cash or other consideration offered by the corporation, or dissent and compel a judicial appraisal proceeding under BCL § 623. In the latter event, the specified standard of value is “fair value” which is the same standard used in oppressed minority shareholder buyout proceedings under BCL § 1118. (For background on the difference between “fair value” and “fair market value,” see here).
Section 623 fixes the valuation date as of the close of business on the day prior to the authorization date of the merger or other triggering transaction. In 1982, the statute was amended to give courts broad discretion to consider the impact on valuation of post-merger factors, as follows:
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, the concepts and methods then customary in the relevant securities and financial markets for determining fair value of shares of a corporation engaging in a similar transaction under comparable circumstances and all other relevant factors.
Now let’s turn back to Mandelbaum and BIG. According to the petition in Mandelbaum, the Mandelbaum Estate owned about 4% of the outstanding shares of Five Ivy Corp. (“Old Five Ivy”) which was formed in 1959. In December 2007, the controlling shareholders implemented a short-form, freeze-out merger through an exchange of stock with a newly formed Delaware corporation (“New Five Ivy”) pursuant to BCL § 913. The plan valued the Estate’s shares at approximately $450,000. The Estate rejected the offer on the alleged ground “that there was insufficient information provided to evaluate the offer.”
In April 2008, the Estate filed its petition demanding a judicial appraisal of the fair value of its shares as of the valuation date on December 27, 2007. In August 2009, the Estate filed a pre-trial motion demanding disclosure of the 2008-09 tax returns, and any Subchapter S election, of New Five Ivy and of any predecessor or parent corporation. The supporting affirmation of the Estate’s counsel (read here) argued that the documents were relevant to the question whether, or to what extent, “there should be a discount applied to the value of the Estate’s shares to reflect unrealized built-in capital gains taxes with respect to the assets owned by” the corporation. The Estate’s counsel cited the Murphy case for the proposition that:
Where a corporation has made a Subchapter S election, and holds corporate property owned at the time of the election for at least 10 years, the corporation is not liable for capital gains taxes with respect to sales of such property after expiration of the 10-year period. Accordingly, the existence of a Subchapter S election bears directly on the issue of the valuation discount, if any, to reflect built-in capital gains taxes.
The corporation submitted its counsel’s opposing affirmation (read here) stating that “any events subsequent to the valuation date are irrelevant” and that “[a]s of the valuation date . . . Five Ivy could not convert from a C to an S corporation.” Counsel cited a 2008 appellate decision in a matrimonial case called Wechsler v. Wechsler (58 AD3d 62) in support of a 100% BIG discount. Counsel also pointed out that, because the S election entails a 10-year holding period to avoid the corporate gains tax,
any request by Petitioner for the court to consider a post-valuation date Subchapter S election with respect to the built-in gains would require the court to speculate as to future events, something which is inappropriate in valuing the corporation at the valuation date.
The lower court, in a decision by Manhattan Commercial Division Justice Charles E. Ramos dated November 23, 2009 (read here), agreed with the corporation’s position, writing as follows:
[T]he Estate’s request for discovery, while permissible, is statutorily limited to documents that predate the shareholder’s authorization date. Therefore, the possibility of a Subchapter S election will not be considered in the valuation of the Shares, unless a basis to do so is substantiated by other discovery.
The Estate appealed to the Appellate Division, First Department, which devoted all of two sentences to the issue in its order last week upholding Justice Ramos’s ruling:
The motion court properly denied production of information regarding events subsequent to the undisputed valuation date of December 27, 2007. Contrary to petitioner’s contention, the statute’s requirement that the court consider “all other relevant factors” in fixing value does not modify its time frame for fixing value “as of the close of business on the day prior to the shareholders’ authorization date” (Business Corporation Law § 623[h]).
The decision seems compatible with appellate precedent that limits post-valuation date factors to those known as of the valuation date. Along those lines, New York’s highest court, in its 1988 Cawley decision (72 NY2d 465), wrote that the 1982 amendment to § 623 was
intended [to permit] courts to supplement [the established valuation] approaches by also considering “[e]lements of future value arising from the accomplishment or expectation of the merger which are known or susceptible of proof as of the date of the merger and not the product of speculation” (Alpert v 28 Williams St. Corp., 63 NY2d, at 571, supra; see, Weinberger v UOP, Inc., 457 A2d 701, 713 [Del]).
Unfortunately for the Mandelbaum Estate, all it could do was speculate. It had no seat on Old Five Ivy’s board and, presumably, no access to discussions among the controlling shareholders concerning the reasons for, and future tax structuring of, the reorganization. Also, since the short-form merger used in Mandelbaum required no shareholder vote, the board was not required to disseminate information to the shareholders describing the objectives and post-merger implementation of the reorganization. So, even though it’s not an unreasonable inference that the planned reorganization contemplated conversion to S corporation status — interestingly, the corporation in its opposition to the Estate’s motion never denied a post-merger conversion — the inference alone is not enough to warrant the disclosure of post-valuation date transactions. As mentioned above, the lower court’s decision left open the possibility that the Estate, through other discovery, might still be able to show that an S election was part of the mix as of the valuation date.
Assuming an appraisal hearing goes forward, it will be interesting to see if the court applies a 100% discount for BIG taxes as advocated by the corporation, which, to my knowledge, would make it a first under New York’s fair value standard.