The discount for lack of marketability, or DLOM, has reigned supreme in New York fair value proceedings since 1985 when the Appellate Division, Second Department, decided Matter of Blake, 107 AD2d 139. DLOM’s basic premise accepted in Blake is that “shares of a closely held corporation cannot be readily sold on a public market” (id. at 149) and therefore should be discounted to reflect the additional risk factors associated with the time and difficulty of finding buyers for non-publicly traded shares.
Equally vital to the Blake doctrine is the assumption that DLOM “bears no relation to the fact that the petitioner’s shares in the corporation represent a minority interest” (id.). For that same reason, Blake ruled out application of a separate minority discount, also known as discount for lack of control or DLOC, as inconsistent with the protections afforded minority shareholders against oppression by the majority under the judicial dissolution statute, BCL §1104-a, and likewise to deny controlling shareholders a “windfall” from exercising their right to elect to purchase the petitioning minority shareholder’s stock for fair value under BCL §1118.
In other words, the dichotomy between DLOM and DLOC adopted in Blake views “good” DLOM as applicable at the enterprise level to all shares in determining the selling shareholder’s proportionate interest in the going concern, whereas “bad” DLOC applies only at the shareholder level to minority shares. New York’s highest court, the Court of Appeals, further cemented this view in its 1995 Beway decision. Since then it has been followed without question in countless trial and appellate court decisions wherein business appraisers have relied primarily on restricted stock and pre-IPO studies to compute DLOM.
The question is, is there any sound appraisal doctrine or empirical evidence supporting Blake‘s premise that DLOM exists and can be quantified at the enterprise or majority-control level? If not, are Blake, Beway and their progeny predicated on flawed, internally inconsistent assumptions that effectively compute fair value at the non-marketable minority interest level of value rather than proportionate interest in the company’s going concern value at a control level?
Some prominent voices in the business valuation field have been raising these questions in critique of New York fair value jurisprudence. One of the voices belongs to Z. Christopher Mercer who, regular readers of this blog may recall, convinced the Special Referee in the Giaimo case that applying DLOM made no theoretical or economic sense and, contrary to the statutory protections acknowledged in Blake, would generate an “illiquid minority interest value” instead of a proportionate share of a financial control level of value. When it came time to confirm the referee’s report, however, the presiding judge rejected Mercer’s theory as inconsistent with Beway, and instead approved non-applicability of DLOM based on the market exposure period built into the underlying realty appraisals and on evidence of the extremely limited availability on the market of real property portfolios similar to those owned by the subject companies. (Read here my post on Giaimo and here my post on Mercer’s recent articles on New York fair value proceedings.)
Mercer is on record since the mid-1990s against application of DLOM to controlling interests. In his post #6 on New York fair value proceedings, Mercer states that the restricted stock and pre-IPO studies routinely used by appraisers to support DLOM compare minority interest values and “ha[ve] no bearing on controlling interests.” Rather, he explains, “[t]he marketability discount has meaning because it applies to the marketable minority level of value and reduces value for lower expected cash flows and greater risk normally associated with holding illiquid minority interests.” In other words, applying a marketability discount is inconsistent with Beway‘s definition of fair value as a “proportionate interest in a going concern, that is, the intrinsic value of the shareholder’s economic interest in the corporate enterprise” (Beway, 87 NY2d at 167). Yet Beway itself approved a marketability discount in that case!
Another of the critical voices belongs to business appraiser Joel Rakower who, along with attorney Ken Weinstein, authored an article published last week in the New York Law Journal entitled “Marketability Discount and Dissenting Minority Ownership.” (Here’s a link to the article, but I’m afraid it’s only accessible to Law Journal subscribers.) The article’s thesis, in line with Mercer’s analysis, is that the application of DLOM in fair value proceedings necessarily violates the proscription against minority discount because DLOM only exists at the minority shareholder level.
Over two years ago I reported on a case called Matter of Beattie (read my post here) in which Rakower as the expert for the selling minority shareholder, like Mercer in Giaimo, argued that DLOM should not be applied. The judge in Beattie, which involved a software company rather than a realty holding company as in Giaimo, rejected the position based on Blake and applied a 25% DLOM.
In last week’s article Rakower again challenges the theory head-on, stating that
Academics and lecturers within the appraisal community are clearly united on the conclusion, succinctly stated, that discounts for lack of marketability are not applied to majority positions.
The article then addresses the lack of evidentiary basis for applying DLOM at the control level. It quotes Alina Niculita, co-author with Shannon Pratt of Valuing a Business (5th ed. 2007), as saying, “There is no empirical transaction database from which to draw guidance for quantifying DLOM for controlling interests.” The article then adds:
While some appraisers contend a discount for lack of marketability may exist for a controlling interest, they proffer no empirical data supporting such claim, nor any studies currently available substantiating a discount for lack of marketability for majority positions. Moreover, no information or guidance is provided as to its quantification.
In Chapter 1 of Shannon Pratt’s book, Business Valuation Discounts and Premiums (2d ed. 2009), he distinguishes between “entity level” discounts applied to a control level of value affecting all shareholders, such as a “key person” discount, and “shareholder level” discounts affecting one or a specified group of shareholders such as minority shareholders. Pratt places both DLOM and DLOC in the latter category. In a Levels of Value chart shown as Exhibit 1.2, footnote “a” states that “[c]ontrol shares in a privately held company may also be subject to some discount for lack of marketability, but usually not nearly as much as minority shares.” It’s not clear — at least to me — how that statement jibes with his co-author Niculita’s above-quoted statement concerning the absence of empirical data supporting DLOM for controlling interests.
My above musings only scratch the surface of this highly complex and technical issue which, I hasten to add, has tremendous financial impact in contested fair value proceedings given the DLOM percentages applied by New York courts usually hovering in the 25% range. In many states outside New York, either by statute or case law, DLOM and DLOC both have been banished from fair value determinations based on a policy decision that to apply either works an injustice against oppressed or dissenting minority shareholders and represents a windfall to the controlling shareholders.
I imagine we will continue to see both theoretical and empirically based attacks on DLOM in fair value proceedings by New York lawyers and their appraisal experts representing selling shareholders. Certainly on the theoretical side, as we saw in Giaimo, it will be a formidable task to overcome almost 30 years of appellate precedent uniformly supporting DLOM. Possibly, rather than challenging Blake and Beway directly, courts will find that a marketability discount is built into the hypothetical, arm’s-length transaction pricing as of the valuation date, which essentially was the rationale ultimately adopted by the court in Giaimo.