An epic corporate governance and stock valuation battle between rival siblings, fighting over a Manhattan real estate portfolio worth upwards of $100 million, generated an important ruling last week by New York County Supreme Court Justice Marcy S. Friedman.  Justice Friedman’s decision in Matter of Giaimo (EGA Associates, Inc.), 2011 NY Slip Op 50714(U) (Sup Ct NY County Apr. 25, 2011), and the underlying, 184-page Report & Recommendation by Special Referee Louis Crespo dated June 30, 2010, are must reading for business appraisers, attorneys and owners of closely held real estate holding corporations who are involved in, or who are contemplating bringing or defending against, a “fair value” proceeding under New York’s minority shareholder oppression or dissenting shareholder statutes.

In the end, after both sides essentially accepted Referee Crespo’s net asset valuation of the 19 real properties owned by two Subchapter “C” corporations, the valuation controversy boiled down to two issues presented to Justice Friedman.  First, did Referee Crespo properly adopt what he dubbed the “Murphy Discount” (I’ll explain below) in requiring the deduction of the present value of taxes on built-in capital gains (BIG)?  Justice Friedman answered “yes.”  Second, did Referee Crespo properly exclude a separate discount of the companies’ shares for lack of marketability (DLOM)?  Although she disagreed with Referee Crespo’s reasoning, Justice Friedman again answered “yes.”

Giaimo involves two corporations, abbreviated as EGA and FAV, owned more or less in equal one-third shares by siblings Edward, Robert and Janet.  Together the corporations owned 18 residential apartment buildings (mostly walk-up tenements) and one undeveloped land parcel located mostly in Manhattan’s Upper East Side.  Edward died in March 2007.  His will provided for division of his shares equally between Robert and Janet, however Janet produced an assignment to her of one EGA share made by Edward two weeks before his death, giving her majority control of that company.  Robert brought a lawsuit challenging the assignment as a violation of the corporation’s right of first refusal endorsed on the back of the stock certificates.

Eventually Robert won that lawsuit (read here my report on the appellate court’s December 2009 decision), but in the interim he filed separate proceedings seeking judicial dissolution of EGA and FAV based on shareholder oppression and deadlock.  Janet then elected under Section 1118 of the Business Corporation Law to purchase Robert’s shares for “fair value” to be determined by the court.  In December 2007, Justice Friedman ordered a referral of the valuation to a court referee to hear and report.  Referee Crespo thereafter conducted a hearing consisting of two phases, the first for valuation of the real properties and the second for valuation of the shares of the two corporate entities.  The hearing lasted 18 days and featured testimony by eight expert witnesses and over 165 exhibits.

Referee Crespo’s Report

No short description possibly can do justice to Referee Crespo’s massive, extraordinarily detailed Report which has over 120 pages of findings of fact and almost 60 pages of conclusions of law.  Describing his months-long, “exhausting” review of over 2,300 pages of transcript amidst the burden of his other case responsibilities, Referee Crespo remarks with tongue firmly planted in cheek, “But no good deed goes unpunished” (pg. 3).

As noted above, both sides accepted the real estate values ultimately determined by Referee Crespo, so I won’t dwell on that aspect of his Report.  Essentially, Referee Crespo agreed with the valuations performed by Robert’s real estate appraiser as to the 18 residential apartment buildings with one significant exception whereby, in most instances, the referee adjusted downward the appraiser’s appreciation projections (and correspondingly increased the capitalization rates) over the hypothetical buyer’s assumed 10-year holding period.  Janet’s real estate appraiser’s valuation of the one, undeveloped land parcel prevailed, albeit also subject to some adjustment based on testimony by Robert’s rebuttal expert.

Referee Crespo’s summary of his property value determinations, listed at pages 150-51 of the Report, totals about $85 million for both corporations’ properties, or about $16.8 million more than Janet’s appraiser (pg. 22) and about $14.5 million less than Robert’s appraiser (pg. 110).  I would urge anyone interested in the finer points of real estate appraisal to read carefully pages 3-80 and 131-51 of the Report.  If that’s too much, at least read page 133 where Referee Crespo gives a laundry list of errors he finds in Janet’s expert’s real estate appraisals.

The Report at pages 80-117 recites in detail testimony by the parties’ respective business appraisal experts as to the fair value of EGA and FAV as going concerns.  Janet’s experts (Joan Lipton and Jeffrey Baliban) testified in favor of application of a 20% marketability discount of each corporation’s net asset value, as well as a 100% BIG discount computed as of the valuation date.  The latter discount was calculated to be approximately $24.8 million based on the virtual absence of any tax basis in the properties, using a 45.87% tax rate.  Lipton opined that it cannot be presumed that a hypothetical buyer of a “C” corporation with appreciated property would convert it to an “S” corporation after 10 years to avoid the BIG, and that the purchaser would acquire comparable properties outside the corporate wrapper unless offered a 100% BIG discount for the shares.  Lipton and Baliban both testified that they see no double counting in their analysis of market exposure of the real properties and DLOM for the shares.

Robert’s expert (Z. Christopher Mercer) testified that neither DLOM nor BIG discounts should be applied in a fair value proceeding, but that if BIG is applicable it should be computed at 40% because of the scarcity in the market of similar real estate portfolios and based on his industry research supporting an equivalent 15%-20% “rule of thumb” discount off net asset value for such properties.  More specifically, Mercer argued that fair value is the functional equivalent of fair market value at the financial control level, hence the application of a marketability discount makes no economic sense.  He also argued that both real estate appraisers had considered exposure to market prior to reaching their opinions of fair market value for the properties, therefore it made no economic sense to apply an additional exposure to market concept, i.e., DLOM, to the corporate wrapper.

Referee Crespo, whose conclusions of law on DLOM are found at pages 151-58 of the Report, adopts Mercer’s view that application of DLOM improperly would assign Robert’s interest an “illiquid minority interest value” instead of his proportionate share of a financial control level of value.  “Mercer makes an excellent point,” Referee Crespo writes, “that his valuation of a control level of interest in EGA and FAV captures the risk in the control valuation, rather than apply ‘a nebulous unspecified marketability discount that no one can justify'” (pg. 157).  (Regular readers of this blog will recognize this concept from my recent post entitled “Chris Mercer Tackles Statutory Fair Value” in which I digested an online series of articles authored by Mercer.)  Referee Crespo also bases his rejection of DLOM on case law, including Vick v. Albert, 47 AD3d 482 (1st Dept 2008) (read here my post on Vick), standing for the proposition that the shares of a real estate holding company are least suited to DLOM.

Pages 158-68 of the Report contain Referee Crespo’s legal analysis and conclusion that a BIG discount should be applied, not at 100% as contended by Janet’s experts, but at present value consistent with both sides’ real estate appraisers’ assumption, for capitalization purposes, of a 10-year holding period.  The key evidence underlying this conclusion, as presented through Mercer’s testimony, is the absence of a “ready supply of naked assets available in the marketplace as those held by EGA and FAV” (pg. 164).  With no substitute portfolio of properties available outside the “corporate wrapper,” the “rational buyer and seller would negotiate the BIG adjustment” (pg. 165).  However, Referee Crespo does not agree with Mercer’s use of a 40% BIG discount.  Instead, he agrees with the logic and methodology approved in Matter of Murphy (United States Dredging Corp.), 74 AD3d 815 (2d Dept 2010) (read here my post on Murphy), requiring a present value computation of the gains taxes to be paid at a projected future date, here, at the end of the assumed 10-year holding period.

Pages 174 and 178 of the Report tabulate the final values for EGA and FAV, including certain non-real estate assets and liabilities, at slightly over $100 million combined, subject to the yet-to-be-computed BIG discount calculated at a 45.87% tax rate assuming a 10-year holding period and then brought to present value at a10% discount rate.  At pages 179-81, Referee Crespo recommends that Robert be granted interest on the fair value award at 4% from the July 2007 valuation date (instead of the 9% statutory rate of interest requested by Robert) and that Janet be allowed to pay the award in three installments over a six-month period following entry of judgment.

Justice Friedman’s Decision

Robert and Janet each filed motions to confirm in part and reject in part Referee Crespo’s Report in regard to DLOM, BIG, the interest award and terms of payment.  Justice Friedman’s analysis at page 5 of her recent decision begins with a general endorsement of Referee Crespo’s Report, as follows:

Here, the Special Referee was confronted with sharp legal disputes and unsettled law as to the appropriate methodologies to be followed in assessing marketability and potential capital gains tax liability.  As discussed more fully below, he issued a thoughtful, exhaustive Report on these complex issues. While the court does not agree with the Referee’s stated reasons for not applying a DLOM, there is support in the record for his decision not to do so. The court also finds that there is support in the record for the Referee’s calculation of the BIG. The award will therefore be confirmed in these respects.

As to DLOM, Justice Friedman states her disagreement with Mercer’s position, upon which Referee Crespo relied, that the valuation of a business as a going concern at a financial control level of value is inconsistent with a marketability discount.  Justice Friedman finds Mercer’s position contrary to applicable precedent, particularly the Court of Appeals’ 1995 Beway decision (Matter of Friedman [Beway Realty Corp.], 87 NY2d 161) likewise involving a real estate holding company in which the court expressly upheld application of DLOM in fair value proceedings.  Justice Friedman rejects Referee Crespo’s effort in his Report to distinguish Beway on the ground that, unlike in Giaimo, the properties held by the subject realty company in that case had mortgage financing.

Justice Friedman nonetheless finds that Referee Crespo’s decision not to apply DLOM “is appropriate on this record.”  Noting that fair value is a question of fact for which there is no single formula for mechanical application, she essentially finds that the subject corporations’ shares are readily marketable, stating as follows:

As discussed more fully below, in determining the built-in gains tax issue, the Referee specifically made a finding of fact, which is amply supported by the record, that the availability of similar properties on the open market is limited and that a buyer would accordingly buy the properties that EGA and FAV own through the corporations. This finding of the marketability of the corporations’ shares is as relevant to the determination as to whether to apply a discount for lack of marketability as it is to whether to reduce the value of the corporations by embedded taxes. The court accordingly holds that the Referee’s award on the DLOM should be confirmed.

Justice Friedman next turns to Janet’s argument that Referee Crespo erred by not calculating the BIG discount at 100% assuming liquidation upon the valuation date.  Janet argued that the Manhattan trial court was bound to follow the Manhattan (First Department) appellate court’s ruling in Wechsler v. Wechsler, 58 AD3d 62 (1st Dept 2008), a matrimonial “equitable distribution” case in which the court applied a 100% BIG discount, rather than the Brooklyn (Second Department) appellate court’s Murphy decision upon which Referee Crespo relied.  Justice Friedman notes that the Murphy decision expressly distinguishes Wechsler on grounds equally applicable in Giaimo, namely, there was no issue presented or expert testimony in Wechsler about reducing the BIG taxes to present value.  “Given the lack of precedent in this [First] Department on the issue of whether the BIG should be reduced to present value,”  Justice Friedman writes, “the support for that approach in the Second Department, and the factual support in the record for the 10 year projection, the Court does not find that the Special Referee committed legal error in following the present value approach.”

Justice Friedman is equally dismissive of Robert’s legal argument that Referee Crespo erred by applying any sort of BIG discount.  Here’s what she says:

[T]his court rejects petitioner’s contention that no deduction at all should be made for the BIG. Petitioner’s support for this contention rests largely on cases from other states which decline to consider the tax consequences of the sale of any assets unless there is evidence that the corporation was actually undergoing liquidation on the valuation date. (E.g. Brown v Arp & Hammond Hardware Co., 141 P3d 673, 688 [Sup Ct Wyoming 2005]Paskill Corp. v Alcoma Corp., 747 A2d 549, 554 [Sup Ct Del 2000].) These cases treat an assumed liquidation as inconsistent with valuation of the corporation as an ongoing concern. While the reasoning of the cases has much to recommend it, New York follows the contrary view that it is irrelevant whether the corporation will actually liquidate its assets, and that the court, in valuing a close corporation, should assume that a liquidation will occur. (See Wechsler, 58 AD3d at 73.)

Justice Friedman’s decision also addresses Referee Crespo’s recommendations with respect to 4% interest on the award and deferred payment.  BCL Section 1118 authorizes the court, in its discretion, to award interest on the fair value award from the date the dissolution petition is filed “at an equitable rate,” and to impose terms and conditions for payment.  Robert argued that the court should award interest at the 9% statutory rate for pre-judgment interest based on Janet’s “misconduct,” but Justice Friedman rejected the argument based on Robert’s failure to present any evidence of misconduct in the proceedings before Referee Crespo.  She did, however, modify the recommendation to award 9% interest during the post-judgment 180-day period of the staggered payments, which she also upheld notwithstanding Janet’s argument that the entire award should be deferred 180 days.

I would not be the least bit surprised if one or both of the parties file an appeal from the final judgment in this hotly litigated, high stakes, family feud.  If it happens, and when a decision is handed down, you can be sure I’ll report on it.