|This is the second installment of a two-part examination of a recent post-trial decision by Queens County Supreme Court Justice Allan B. Weiss in Chiu v. Chiu, a decade-long fight between two brothers over the ownership of commercial realty in Long Island City purchased in 1999 for use as a warehouse for a business separately owned by one of the brothers. Last week’s post analyzed the court’s ruling, based on some old tax returns and subsequent advances deemed to be capital contributions, that the percentage ownership split of the title-holding LLC is 90/10. This second post looks at the court’s valuation of the 10% member’s interest triggered by his withdrawal from the LLC.
In Chiu v. Chiu (read decision here), after deciding that brothers Man Choi Chiu (MCC) and Winston Chiu (WC) held 90% and 10% membership interests, respectively, in the single asset realty company known as 42-52 Northern Boulevard, LLC (the “LLC”), Justice Weiss’s next task was to calculate the “fair value” of WC’s 10% interest as of February 9, 2008, the date on which WC withdrew from the LLC pursuant to LLC Law §509.
Justice Weiss initially observes that the LLC Law “does not define ‘fair value,’ and the parties have not called the court’s attention to any cases which discuss the term in connection with a limited liability company.” He then proceeds to interpret fair value “as used in connection with other business forms,” i.e., by reference primarily to fair value case law involving stock buy-outs and dissenting shareholder appraisals under New York’s Business Corporation Law.
MCC and WC each offered the testimony of two experts — a real estate appraiser and a business appraiser — to value WC’s membership interest. In an unusual twist, MCC’s real estate appraiser (representing the buyer) valued the property $200,000 higher than WC’s real estate appraiser (representing the seller), with the former arriving at a figure of $13.7 million versus the latter’s $13.5 million.
On the business appraisal side, MCC’s valuation expert, Joseph Nelson of Berdon LLP, and WC’s valuation expert, Z. Christopher Mercer of Mercer Capital, each used the net asset value (NAV) approach which is not unusual in cases involving single-asset real estate holding companies. The two expert’s NAV figures came within a virtual hair’s breadth of each other, with Nelson’s at $10,449,739 and Mercer’s at $10,427,000, prompting Justice Weiss to comment, “Surprisingly, WC, who is seeking the buyout, produced experts who arrived at the lower figure.” Justice Weiss adopts the higher figure before turning to the primary disputed issue: whether or not to apply a discount for lack of marketability, or “DLOM.”
A Little Background on DLOM
The International Glossary of Business Valuation Terms defines marketability as “[t]he ability to convert property to cash at minimal cost” and the discount for lack of marketability as “[a]n amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.” Consider a publicly traded company whose shares can be sold and the proceeds deposited within three days. Now consider a closely held business with no public market, whose shares cannot be quickly sold and converted to cash, and the final price of which is at risk and may decline due to the uncertain time frame required to complete the sale. Because of this uncertainty a buyer likely will pay less for the shares of the close corporation than publicly traded shares of a comparable company.
DLOM is to be distinguished from the discount for lack of control a/k/a the minority discount a/k/a DLOC, which the International Glossary defines as “an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control.” At least since the Blake case in 1985, New York jurisprudence has allowed DLOM and forbidden DLOC in determining the fair value of equity interests in closely held businesses. (Click here for more on the difference between DLOM and DLOC.)
A more recent, major development in the evolution of New York’s DLOM jurisprudence occurred in 2010, when the Brooklyn-based Appellate Division, Second Department, decided the Murphy v. U.S. Dredging case which tacitly set aside prior decisions limiting application of DLOM to goodwill value, and held that DLOM may be applied to the subject company’s entire enterprise value. In Chiu, both parties’ valuation experts agreed that the single asset, real estate holding LLC had no good will value.
The Parties’ DLOM Arguments in Chiu
The decision in Chiu only briefly summarizes the parties’ competing arguments on the DLOM issue. Fortunately we have the parties’ post-trial briefs to help us understand the finer points of their positions. Click here for MCC’s post-trial brief and here for WC’s post-trial brief.
Nelson, MCC’s expert, testified in favor of a 25% DLOM. Nelson claimed support for the discount based on restricted stock studies and something called the Pepperdine study which summarized survey results. MCC’s counsel argued that the 25% DLOM was consistent with New York case precedent including the Beway Realty case (26% DLOM), the above-mentioned Blake case (25% DLOM), the Jamaica Acquisition case (25% DLOM), and the Beattie case (25% DLOM).
Mercer, WC’s expert, testified in favor of a 0% DLOM. Mercer explained that any DLOM would have the effect of denying WC his proportionate share of the LLC’s going-concern value, in contravention of the Beway decision, and provide MCC with a windfall. Mercer also testified, based on his presentation of the levels of value, that application of DLOM effectively would constitute a prohibited minority discount. He also contended that marketability risk was fully reflected in the market exposure period built into the real estate appraisal. WC’s counsel relied on several valuation cases involving real estate holding companies where the courts rejected DLOM, including Vick v. Albert, the Cinque case, and the Giaimo case.
The Court’s Ruling
Justice Weiss sides with Mercer in rejecting application of DLOM to the fair value of WC’s interest in the LLC. The decision devotes just a single paragraph to the subject, as follows (citations omitted):
MCC is not entitled to a lack of marketability discount. It is true that in determining the fair value of a limited liability company, as with a close corporation, the illiquidity of the membership interests should be taken into account. While the application of a lack of marketability discount is not always limited to the goodwill of a business, in the case at bar, the LLC’s business consisted in nothing more than the ownership of realty which is easily marketable. In any event, Nelson’s testimony that MCC is entitled to a whopping 25% lack of marketability discount for what is essentially real property placed in a limited liability company package has no credibility, and the record does not permit the court to determine what lesser percentage might be appropriate.
The quoted paragraph cites a number of case authorities, but seems to rely most heavily on Vick v. Albert and Cohen v. Cohen in which the courts also rejected application of marketability discounts to real estate holding companies. However, neither case involved valuation under the fair value standard.
Justice Weiss accordingly determines that WC is entitled to a fair value award in the sum of $1,044,974, equal to an undiscounted 10% of the LLC’s NAV of $10,449,739. Justice Weiss also grants WC interest on the award at the statutory rate of 9% from the February 9, 2008 valuation date.
A Few Closing Thoughts
- Chalk up another win for Chris Mercer, coming on the heels of last year’s ruling in the Giaimo case, another New York fair value decision involving a real estate company in which Mercer testified on behalf of the selling shareholder, and in which the court likewise rejected application of DLOM.
- His wins notwithstanding, Mercer’s central argument in both cases, that application of DLOM is inconsistent with fair value doctrine as enunciated by New York’s highest court in Beway Realty, and concomitantly that it constitutes a prohibited minority discount, has yet to be accepted by a New York court, although it did gain traction with the referee who heard the Giaimo case before being overruled by the trial judge in subsequent proceedings.
- So what’s the main takeaway from Chiu? If you’re the seller in a fair value proceeding involving a real estate holding company, you want your real estate appraiser to testify concerning exposure to market assumed in his or her appraisal and/or that the realty has some unique attraction in the realty market, and you want your business appraiser to testify that marketability issues are adequately addressed in the realty appraisal. The buyer’s experts will want to argue that the exposure to market does not fully reflect the uncertainties associated with the realty’s corporate or LLC “wrapper” and that similar properties are readily available on the market.
Update: The trial court’s decision in Giaimo discussed in this post subsequently was modified on appeal by the Appellate Division, First Department, which rejected the 0% DLOM and instead imposed a 16% DLOM. Read here my post on the appellate ruling.