A year ago I wrote about a novel ruling by Manhattan Commercial Division Justice Shirley Werner Kornreich permitting the majority owners of a family-owned textile business to proceed with a cash-out merger on the eve of trial of a 25% shareholder’s derivative lawsuit. The contemplated appraisal proceeding materialized after the dissenting minority shareholder rejected the corporation’s offer of $1.5 million for the statutory “fair value” of her 25% stake. A bench trial was held before Justice Kornreich over 11 days between March and July 2014. Last week, Justice Kornreich released her 32-page decision in Zelouf International Corp. v Zelouf, 2014 NY Slip Op 51462(U) [Sup Ct, NY County Oct. 6, 2014], fixing the fair value of the 25% stock interest at $2.2 million.

Zelouf raises a number of interesting issues surrounding appraisal proceedings, including burden of proof, tax affecting, the discount for lack of marketability (DLOM), and control premiums. In this post, I’ll focus on Justice Kornreich’s rejection of any DLOM. Next week I’ll highlight the remaining issues of interest.

The Appraisal Proceeding

The company filed the appraisal proceeding in October 2013. The bench trial concluded in July 2014 and the parties submitted post-trial briefs in August 2014.

The parties agreed to use as a baseline appraisal the analysis and report prepared in August 2013 by a jointly retained neutral evaluator. The so-called Vannucci Report utilized the capitalization method under the income-based approach to appraise the company’s fair value as a going concern, both on a controlling, marketable basis (i.e., without DLOM) and a controlling, non-marketable basis (i.e., with DLOM). The former basis, after normalizing adjustments to the net income including officer salaries, yielded an appraised value of almost $8.9 million and the latter, using a 30% DLOM, about $6.2 million.

The company maintained that the Vannucci Report, with various downward adjustments, supported a fair value award in the amount of $1.3 million for the 25% interest. The dissenting shareholder maintained that the Vannucci Report, with various upward adjustments, supported a fair value award in the amount of $3.8 million.

In her decision, Justice Kornreich resolved disagreements between the two sides and their opposing experts over two aspects of the Vannucci Report, namely, tax affecting and DLOM, as well as other disagreements over certain adjustments to the Vannucci Report proposed by one side or the other. The court’s fair value award of about $2.2 million for Nahal’s 25% interest:

  • rejected S corporation tax affecting
  • rejected DLOM
  • rejected a control premium
  • rejected an upward adjustment for the company’s revenue in the first half of 2013

The Court’s Rejection of DLOM

As regular readers of this blog know, the marketability discount in fair value proceedings has generated much controversy within both the legal and appraisal communities. Essentially, the debate centers on (a) whether imposition of DLOM is inconsistent with fair value’s core notion, as representing a pro rata share of the company’s going-concern value determined at the control level and without penalizing a minority interest for lack of control, and (b) how to compute DLOM in a fair value proceeding in the absence of empirical data supporting application of DLOM at the control level.

The issue most recently and prominently came to the fore in the Giaimo case where the Appellate Division, First Department, disagreed with the lower court’s refusal to apply DLOM in valuing real estate holding companies and instead ordered a 16% DLOM. (Read here my post on Giaimo and here my post entitled “The Marketability Discount in Fair Value Proceedings: An Emperor Without Clothes?”)

In Zelouf, at counsel’s joint instruction the Vannucci Report valued the company with and without DLOM. Based on its review of restricted stock studies and other data, the Vannucci Report determined a 30% DLOM, at the same time noting that “typically, a discount for lack of marketability is usually only applicable for valuations of minority interests in closely-held companies under the assumption that a controlling owner would be able to force the sale of the company.”

At trial, the company argued that under New York case law, the court “must” consider DLOM. It also cited case precedents using 25% as the “most commonly-applied DLOM,” and it urged the court to adopt the Vannucci Report’s 30% DLOM.

The dissenting shareholder’s expert argued that the Vannucci Report created an “obvious mismatch” by applying a minority level DLOM to a controlling interest in the company, and that DLOM either should be eliminated completely or, at most, should range from 0% to 15%.

In her DLOM discussion at pages 12-15 of the decision, Justice Kornreich adopted the Vannucci Report’s and the dissenting shareholder’s expert’s skeptical view, agreeing that

the assumptions behind the DLOM and its calculation, such as hypothetical impediments to sale and the actual likelihood that [the company] would be sold, are entirely irrelevant to the determination of the fair value of [the dissenting shareholder’s] shares, which is based on her pro rata share of the value of the entire company on a controlling basis.

The judge also rejected the company’s position, that New York law “requires” a DLOM, stating:

While many New York cases discuss DLOM, and, particularly, how much DLOM is proper in various circumstances, no New York case stands for the proposition that a DLOM must be applied to a closely-held company. The idea of a DLOM is that, since the company as a whole can be difficult to sell (e.g., buyers of closely-held companies in niche businesses are not as plentiful as buyers of publicly traded corporations), a frozen-out, minority shareholder should recover less to reflect this fact. While it is surely true that it would have been difficult to sell [Zelouf International] . . . the rationale for generally applying a DLOM is inapplicable to [Zelouf International]. [Footnote omitted.]

*     *     *     *     *      *     *

While petitioner is correct that a DLOM is applied in most instances, petitioner provides no support for the proposition that applying a DLOM is a mandatory part of the formula for valuing [Zelouf International]. A rule requiring courts to mechanically apply a DLOM to all closely held companies without considering whether, in some instances, the purpose of a DLOM may not apply, is inconsistent with this court’s legal mandate.

Justice Kornreich’s rejection of DLOM relied on the absence of an actual sale of the company coupled with the assumption that the controlling owners were not looking to sell the company:

This makes the company’s illiquidity irrelevant, mooting the concern for which a DLOM accounts. If the other Zelouf family members will never pay a price for the company’s theoretical illiquidity, then there is nothing “fair” about artificially depressing [the dissenting shareholder’s] recovery due to a hypothetical sale that will never occur. To impose such a cost on [the dissenting shareholder] is tantamount to levying the very sort of minority penalty that New York law prohibits. . . . Liquidity risk only manifests into real cost in an actual sale and should not be imposed here where there will never be a sale and, thus, no real cost.

The purpose of a DLOM is to account for “risk associated with the illiquidity of the shares.” Giaimo, 101 AD3d at 524 (emphasis added). Risk, of course, is a function of probability times the threatened harm. While the threat of harm here (a lower net purchase price due to illiquidity costs) is undisputed, the probability that such a threat will actually occur is negligible. Ergo, there is no risk that warrants a DLOM.

Were the court’s DLOM ruling to be appealed, a number of interesting issues likely would be raised:

  • Does Justice Kornreich’s analysis undermine application of DLOM in all instances where the company is not for sale in the foreseeable future? Such a conclusion would rule out DLOM in most if not all fair value cases.
  • How does the court’s reliance on the probability of a sale reconcile with the traditional definition of fair value used by courts in New York, based on what a hypothetical willing purchaser, in a hypothetical arm’s-length transaction, would offer for the corporation as an operating business?
  • Does the probability-of-sale rationale beg the ultimate issue, acknowledged elsewhere in the court’s opinion, whether there exist any theoretical or empirical bases for applying DLOM at the control level of value?
  • If DLOM must appropriately be considered to reflect the greater degree of illiquidity relative to publicly traded corporations, how can courts quantify and apply DLOM when all the DLOM studies deal with minority interests?

As mentioned, my post next week will examine a number of other interesting aspects of the Zelouf ruling.