Last week’s post summarized Justice Kornreich’s decision awarding the 25% dissenting minority shareholder $2.2 million for the fair value of her shares, and then focused on the court’s rejection of a discount for lack of marketability. If you haven’t already read last week’s post, I recommend you do so before continuing with this one.
In this Part Two, I’ll highlight a number of other, interesting issues addressed in Zelouf of importance both to business divorce lawyers and business appraisers.
Court Adopts “No-Burden” Approach
Justice Kornreich’s decision offers a useful summary of the legal standard for determining fair value in a dissenting shareholder appraisal proceeding under Section 623 (h) of the Business Corporation Law, including a brief discussion of burden of proof. Noting that New York’s highest court never has addressed the issue, the court adopted the “no-burden” approach proposed by the parties and supported by former Justice Stephen Crane’s analysis in Matter of Cohen, 168 Misc 2d 91 [Sup Ct, NY County 1995], aff’d, 240 AD2d 225 [1st Dept 1997], under which, as Justice Kornreich put it, “the court will consider the parties’ expert testimony as persuasive evidence of fair value, but, at the end of the day, and even if the court finds neither expert to be persuasive, it is the court’s burden to make a fair value determination.”
Court Adopts Neutral Evaluator’s Report
The typical fair value proceeding features a battle of the experts in which each side presents its own, full-blown appraisal report. More often than not, and particularly in cases involving owner-operated sales and service companies, the competing appraisals use different approaches and different assumptions to arrive at grossly disparate conclusions of value — what’s been referred to as the Dr. Pangloss/Mr. Scrooge appraisal phenomenon.
Zelouf is somewhat atypical, not because the opposing experts didn’t arrive at disparate valuation conclusions — they did — but because the two sides agreed to use as a baseline valuation the appraisal report prepared by a jointly retained neutral appraiser named Kevin Vannucci. The appraisal proceeding and the trial testimony of the parties’ experts therefore focused on each side’s disagreements and/or proposed adjustments to the Vannucci Report.
So, too, did Justice Kornreich’s decision in which she found the Vannucci Report “to be a comprehensive and reliable indicator” of the company’s value and also noted the parties’ “lack of substantial disagreement over the Vannucci Report’s findings” before going on to address the specific areas of disagreement and adjustments. As mentioned in the decision, the Vannucci Report solely relied on the capitalization method under the income approach to value the company based on its normalized net income. The decision also cited the Vannucci Report’s calculations of a 4.3% sustainable EBITDA margin and a 3% long-term growth rate after adjusting for inflation. The Vannucci Report reached alternative conclusions of value of about $8.9 million without a marketability discount and about $6.2 million with a 30% marketability discount. As detailed in Part One, the court’s decision rejected the marketability discount and adopted the higher figure.
Zelouf International is a pass-through entity due to its S corporation tax status, i.e, like a partnership it pays no income taxes at the corporate level. The Vannucci Report, at the direction of counsel, utilized a tax-affecting method known by its acronym, SEAM (S Corporation Economic Adjustment Multiple), which, starting with an assumed corporate income tax rate of 40% against projected earnings and then applying a number of other factors, computed an adjustment that increased the company’s equity value by about 18%. At the same time, the Vannucci Report cautioned that “inclusion of a pass-through entity adjustment is most appropriate for valuations assuming a minority level of value under the assumption that a controlling owner would be able to change the corporate structure to maximize shareholder value.”
Justice Kornreich’s decision agreed with the cautionary note and rejected the SEAM adjustment, stating that “New York law does not permit an independent valuation of the minority’s equity, which would entail a separate valuation methodology and which might warrant a SEAM premium.” (Readers interested in the subject should compare the “hybrid” approach to tax-affecting developed by the Delaware Court of Chancery in the MRI Radiology dissenting shareholder appraisal case.)
Control Premium Rejected
After rejecting a marketability discount, Justice Kornreich also gave short shrift to the position advocated by one of the dissenting shareholder’s experts for a 24% control premium predicated on the majority shareholder’s post-merger acquisition of a super-majority interest. “A control premium is improper,” she wrote, “because the company is being valued as a whole. . . . The level of control . . . gained over the company after the freeze-out merger, therefore, is irrelevant.”
Adjustment Rejected for Post-Report Financials
The Vannucci Report, prepared in August 2013, valued the company’s equity as of December 31, 2012. Under BCL § 623 (h) (4), the valuation date in a dissenting shareholder appraisal proceeding is the day before the date on which the shareholders authorize the merger, in this case, August 29, 2013. The dissenting shareholder argued that the company’s performance as reflected in its financial statements for the first six months of 2013, which were not available at the time of the Vannucci Report, warranted a 23% increase ($2.1 million) in the company’s value over the Vannucci Report’s conclusion of value.
Justice Kornreich disagreed, finding that the dissenting shareholder “has not submitted any evidence that the value of the company materially increased in the intervening eight months.” The company’s financials, she wrote, “do not actually show improvements to the company’s fundamentals, nor did [the dissenting shareholder’s] experts contend that the company’s performance improved.” Justice Kornreich also described as “problematic for many reasons” the experts’ “mathematical exercise of plugging in the 2013 numbers and applying various weighting schemes.”
Finally, Justice Kornreich awarded pre-judgment interest at the statutory rate of 9% from the date the appraisal proceeding was commenced on the difference between her $2.2 million fair value award and the lesser amount tendered by the company as merger consideration.