The case of Sassower v. 975 Stewart Avenue Associates, LLC is fast approaching poster-child status as an illustration of the headaches that can follow from poorly drafted valuation criteria in the buy-sell provision of a shareholders’ or operating agreement.
The case involves a medical practice known as Cardiovascular Medical Associates, P.C. ("CMA"), whose seven doctors also owned the building housing the practice through a separate limited liability company named 975 Stewart Avenue Associates, LLC ("975 Stewart"). Dr. Sassower resigned from CMA in late 2007, triggering his obligation to offer his interest in 975 Stewart to the remaining doctors.
The CMA shareholders’ agreement set forth an appraisal procedure for fixing the purchase price, whereby the exiting member and the company each hire an appraiser followed by an exchange of appraisal reports within 30 days. If the appraisals fall within 10% of each other, the purchase price is the average of the two; if more than 10%, the two appraisers select a third appraiser whose valuation opinion determines the price.
Nothing unusual about this arrangement. Rather, the problem is seeded in the provision’s vague and inarticulate language purporting to establish either a standard or method of valuation. Specifically, the operative Section 8.5(c) of the agreement states that the two, party-appointed appraisers must use "the market value approach appraisal methodology" while further providing that the opinion of the third, neutral appraiser "shall establish the fair market value" of the offered interest.
In August 2008 the two sides exchanged appraisal reports based on an enterprise "market value" of $7.8 million (Dr. Sassower) versus $6.8 million (the company) and a purchase price for Dr. Sassower’s 12.5% interest of $962,500 (Dr. Sassower) versus $850,000 (the company). Being more than 10% apart, the parties were required under Section 8.5(c) to engage a third appraiser.
Before that happened, however, the company’s appraiser issued an amendment to its report stating as follows:
It is the understanding of this appraiser that there is an outstanding mortgage balance on the property in the amount of $2,668,750.00. At the request of the client, we have deducted the mortgage balance from the final value to arrive at an equity position value.
The deduction reduced the purchase price to about $512,000. (The amendment also newly applied a 20% discount, further reducing the purchase price to about $350,000, but the discount subsequently was withdrawn.)
The amendment ignited litigation which is about to enter its third year without resolution and in which, I hazard to guess, the parties are destined to incur attorney and expert fees rivaling if not surpassing the difference between their competing valuation figures.
Dr. Sassower struck first with a lawsuit seeking a declaratory judgment that the purchase price should not be reduced by the mortgage balance on the property. The company moved to dismiss the complaint based on documentary evidence, arguing that the agreement requires determination of the "equity" in the building net of the mortgage balance. In December 2008, in the first of several substantive decisions in the case, Nassau County Commercial Division Justice Ira B. Warshawsky denied the motion on the ground that the term "market value approach methodology" used in Section 8.5(c) is ambiguous. (Read decision here.)
In March 2009, the remaining doctors voted to voluntarily dissolve and liquidate 975 Stewart, which they contended mooted Dr. Sassower’s buy-out. This led to a second written opinion by Justice Warshawsky in which he ordered the company to proceed with the buy-out, observing that the company "cannot opt to buy out the Plaintiff, then, when unhappy with the outcome of that decision, choose to dissolve the entity." (Read decision here.)
In that same decision, which I previously reported on here, Justice Warshawsky offered some future guidance for the unresolved valuation dispute, stating that "the sought after number is fair market value" and that the phrase "market value approach methodology"
is not an appraisal methodology, but a defined value to be arrived at by one of the three traditional appraisal approaches, namely, direct sales comparison, income capitalization, or replacement cost. For a building of the type owned by 975 Stewart, the most appropriate approach is the direct income capitalization approach, upon which both appraisers apparently relied. . . . The deduction of the outstanding mortgage on the property from the estimate of fair market value does not produce market value, but rather equity position value.
I won’t say the guidance was all for naught, but based on yet another, recent decision by Justice Warshawsky, it’s hard to discern any real evolution over the last year in the parties’ diametrically opposed, all-or-nothing approaches.
The latest decision dated June 29, 2010 (read here) denied cross motions for summary judgment on the same, bedeviling question whether the mortgage balance must be deducted from the market value of the realty. Justice Warshawsky reframes the issue as follows, with a finishing hint of exasperation:
The Court concludes that the role of the Appraisers retained by the parties, or the Appraiser selected by the original two appraisers, is, at a starting point, to determine the market value of the subject property. This however, does not conclude their responsibility, because the Agreement calls upon them to establish the "purchase price of the Offered Interests". It appears that the question which should have been asked of the appraisers is "What would a typical buyer pay for an investment of a 12.5% interest in a building with a continuing first mortgage of what was $2,668,750 at the time of valuation?" This question has never been asked of them.
Justice Warshawsky then offers a series of observations explaining why summary judgment is inappropriate and, again, offering the parties future guidance on the path toward determination of the contractual purchase price.
First, he notes that the third appraisal was completed and that the parties agreed to accept $7.1 million as the fair market value of the realty on an unencumbered basis.
Second, he finds that the statements and deposition testimony of the doctors, offering their recollections of discussions (or lack thereof) and beliefs surrounding the mortgage deduction question, do not provide "adequate clarification to avoid the conclusion that there remains a question of fact as to what the parties intended."
Third, and perhaps most importantly, he offers a nuanced view of how an appraiser should approach the mortgage question, writing:
This may or may not involve simply deducting the mortgage principal from the estimated fair value. The value estimate may, for example, treat the mortgage interest payment as an additional expense in valuing the property under the Income Capitalization Approach, which the appraisals to date have not done. It may also consider whether or not the mortgage interest rate is above or below market, which could impact on the valuation process. This involves consideration as to whether a reasonably prudent investor would refinance so as to reduce interest payments if the existing rate is significantly above the currently available rates.
In the concluding portion of his opinion, Justice Warshawsky acknowledges the illogic of ignoring the mortgage, stating that it is "mathematically clear that distributing a proportionate share of full market value to a departing member will result in a depletion of the equity before the departure of the last members," and that this "unlikely" was the parties’ intent. "But neither is it clear," he continues, "that the simplistic solution of deducting the mortgage from market value was unquestionably the intention of the parties."
I said it in my prior post on this case, and I’ll say it again: the proper time to carefully consider and specify valuation parameters is when the company co-owners and their counsel sit down to draft the buy-sell provisions of the shareholders’ or operating agreement. When parties fail to do so or, as in Sassower, employ confusing terminology, the temptation to adopt extreme valuation positions on both ends can take over, generating employment opportunity for lawyers and great expense to business owners.