The question is, will the Zelouf case prove to be an outlier or the beginning of a sea change in the way New York courts view the marketability discount in fair value proceedings?
Last October I wrote about Zelouf Int’l Corp. v Zelouf, an important post-trial decision in which, among other significant rulings, Manhattan Commercial Division Justice Shirley Werner Kornreich refused to apply a discount for lack of marketability (DLOM) in a statutory fair value proceeding triggered by a cash-out merger of a family-owned business.
Justice Kornreich found the risk of illiquidity associated with the company “more theoretical than real,” explaining there was little or no likelihood the controlling shareholders would sell the company, i.e, themselves would incur illiquidity risk upon sale. Imposing DLOM in valuing the dissenting shareholder’s stake, therefore, would be tantamount to levying a prohibited discount for lack of control a/k/a minority discount.
Within weeks of the decision, both sides filed motions for reargument seeking to vacate or modify various aspects of the court’s rulings including its rejection of any DLOM. In her decision dated December 22, 2014, Justice Kornreich adhered to her prior DLOM ruling but also saw fit to revisit and expand upon her reasons for doing so, given what she described as “New York’s contentious DLOM jurisprudence and the persuasive opinions of the academic community and non-New York courts.”
The majority shareholders’ argument took direct aim at the court’s no-likelihood-of-sale rationale, arguing that New York’s fair-value jurisprudence “require[s] the appraising court to assume a hypothetical sale; the willingness of the owners to sell is irrelevant.” Were the majority shareholders “to attempt to convert their interest into cash,” they contended, “they would have to accept a significant marketability discount, as would any actual or hypothetical 100% owner.”
They also argued that omitting DLOM effectively over-compensated the dissenting shareholder, particularly given the normalizing adjustments made by the neutral appraiser which, they claimed, “entirely obviate the Decision’s concern that a DLOM would unfairly penalize Respondent for her status as a minority owner of the business.”
Justice Kornreich’s response was equally direct in rejecting the contention that a DLOM must be applied:
[N]o New York appellate court has ever held that a DLOM must be applied to a fair value appraisal of a closely held company. On the contrary, the Court of Appeals has held that “there is no single formula for mechanical application.” Matter of Seagroatt Floral Co., Inc., 78 NY2d 439, 445 (1991). Indeed, the Court of Appeals recognizes that “[v]aluing a closely held corporation is not an exact science” because such corporations “by their nature contradict the concept of a market’ value.” Id. at 446. As set forth in the Decision, since [the majority shareholder] is not likely to give up control of the Company, [the dissenting shareholder] should not recover less due to possible illiquidity costs in the event of a sale that is not likely to occur.
At the same time, Justice Kornreich made clear that she was not holding that DLOM never applies in valuing the shares of closely held companies. “Such a holding,” she wrote, “would be incompatible with binding New York precedent.” The challenge for the court, Justice Kornreich continued, is to resolve “the tension between the application of a DLOM, which is done in most cases but is not legally required, and the practical effect of a DLOM here serving as a minority discount, repugnant to New York courts and never allowed . . ..”
In Justice Kornreich’s view, the primary, guiding principle in resolving the tension is fairness, contextualized within the unique facts of each case:
[I]n this case, under the unique set of facts set forth in the Decision, applying a DLOM is unfair. This court’s understanding of the applicable precedent is that, while many corporate valuation principles ought to guide this court’s analysis, this court’s role is not to blithely apply formalistic and buzzwordy principles so the resulting valuation is cloaked with an air of financial professionalism. To be sure, sound valuation principles ought to be and indeed were utilized in computing the Company’s value (i.e., the court’s adoption of most of Vannucci’s valuation). Nonetheless, the gravamen of the court’s valuation is fairness, a notion that is undefined, making it a classic question of fact for the court. Fairness, in this court’s view, necessarily requires contextualizing the applicable valuation principles to the actual company being valued, as opposed to merely deciding a priori, and in a vacuum, that certain adjustments must be part of the court’s calculus. From this perspective, the court reached its conclusion that an application of a DLOM here would be tantamount to the imposition of a minority discount. Consequently, the court finds it fairer to avoid applying a minority discount at all costs rather than ensuring that all hypothetical liquidity risks are accounted for. [Citation omitted.]
In a footnote, Justice Kornreich added that, were she required to apply a DLOM, at most it would be 10%, citing authorities including Justice Carolyn Demarest’s recent decision in the Cortes case also applying a 10% DLOM.
Justice Kornreich made no pretense about navigating well-settled law or applying universally accepted appraisal doctrine. Citing cases from outside New York in which courts have rejected DLOM on policy grounds, and also citing a 2011 blog post by yours truly entitled, “The Marketability Discount in Fair Value Proceedings: An Emperor Without Clothes?“, Justice Kornreich referred to the issue of DLOM in fair value proceedings as “an area of heated debate in the legal and valuation communities,” and she suggested that “more compelling appellate resolution of these issues would surely be welcomed by all.”
To that suggestion I say “amen,” and so should we all, whether in agreement or disagreement with the result or supporting rationale in Zelouf. Starting with the Second Department’s 1985 Blake decision — the first New York appellate fair-value decision approving application of DLOM while prohibiting a minority discount — and in the 30 years since, there has not been a single appellate ruling in a fair value case that offers thoughtful analysis of the hotly debated policy issues surrounding DLOM, or that addresses the empirical support or lack of support for applying DLOM at the controlling (enterprise) level of value. Absent serious appellate consideration of this contentious issue, New York trial courts likely will continue to produce disparate DLOM outcomes, or will apply certain percentage discounts simply because those percentages have been applied in other cases, which will only lead to greater uncertainty and generate more litigation.