I recently had a fair value appraisal hearing at which the opposing business valuation expert’s report and testimony in support of his proposed percentage discount for lack of marketability (DLOM) relied heavily on the percentages used in a number of reported court decisions in other cases. The reported cases were selected and supplied to the expert by the retaining counsel. The expert made no effort to draw meaningful comparison between the facts and circumstances concerning the subject company and the companies involved in the other cases. Indeed, some of the decisions in the other cases shed little if any light on the factors or methodology underlying the DLOM accepted by the court.
Should business appraisers rely on case precedent in determining discounts?
Not according to the IRS, one of whose many jobs is to review and sometimes challenge the marketability (and other) discounts reflected in estate and gift tax returns valuing interests in family limited partnerships and other closely held business entities.
In 2009, the IRS issued for its own internal use a 111-page paper called Discount for Lack of Marketability Job Aid for IRS Valuation Professionals (available online here). The DLOM Job Aid subsequently went public and serves as an important resource for business appraisers and lawyers involved in business valuation matters in which the applicable standard and level of value warrant consideration of a marketability discount. As regular readers of this blog know, DLOM often can be the single most contentious issue in fair value proceedings in the New York courts resulting from dissenting and oppressed minority shareholder lawsuits.
The DLOM Job Aid’s Executive Summary describes its overall purpose thusly:
This Job Aid is meant to provide a background and context for the Discount for Lack of Marketability as such is commonly applied in business valuation analyses and reports. It reviews past and existing practices and attempts to provide insight into the strengths and weaknesses of these practices. It is not meant to provide a cookbook approach to evaluating a marketability discount as proposed by a taxpayer or to setting a proposed marketability discount in the case of an independent governmental appraisal. Nor is it meant to be an IRS position or cited as precedent. . . . It is emphasized that, all background and existing practices aside, the establishment of a Discount for Lack of Marketability is a factually intensive endeavor that is heavily dependent upon the experience and capability of the valuator.
Reliance on Case Precedent
The bulk of the DLOM Job Aid is devoted to a general discussion of the marketability discount (including how it differs from the minority discount) and a review of the dominant approaches (benchmark, securities-based, analytical, Mercer’s QMDM, etc.). In the Evaluation and Recommendations section, at page 82, is a brief discussion under the heading “Reliance solely on court decisions,” in which the Service strongly discourages valuation professionals from relying on DLOM percentages applied by judges in other cases to the valuation assignment at hand. Here’s the entire discussion with some minor excision:
Sometimes a valuator will base a decision as to the choice of marketability discount on previous court decisions. For example, the valuator will review the results of several cases . . . and then base the choice of discount on the discounts accepted by the court in the reviewed cases. For example, the range of court discounts might have been from 20% to 25% so the valuator chooses 22.5% with the rationale that his valuation subject is similar to the subjects under consideration in the cases cited. Judges are sometimes found to adopt this approach as well. The judge will look at [a case] with its 20% discount and add a factor of say 3% based on his analysis of the special factors of his case to arrive at a chosen DLOM level of 23%.
It must be remembered that judges are not valuators and are not constrained to the environment in which professional valuators operate. A judge can adopt any approach that is considered useful and can arrive at any result that seems reasonable in his or her view based on all the considerations of the case which often go well beyond the discount for lack of marketability. In addition, a judge will often select one discount over another simply based on the ability or lack thereof that the two sides of the dispute display in arguing their respective cases. The court is a trier of fact and need not, if that is its choice, go beyond what is presented to it. If one side argues persuasively while the other side disappoints the court for one reason or another a discount may emerge without any real justification for why it has been chosen. In fact, the discount selection may not be based on any clear valuation logic at all.
The courts are an excellent source of information when legal precedent is in question but can be a very questionable source when valuation guidance is desired. If the decisions from various court deliberations are to be utilized in the selection of valuation methods or parameters such should be looked at for the underlying reasoning applied and the logic and flow of the judge’s thinking not for the results that were finally reached. No two valuation assignments are identical. Therefore, basing one’s results on the results of another assignment whether litigated or not is a failure of proper diligence with regard to the assignment presently at hand.
An article by business appraiser Michael Paschall in the Summer/Fall 2013 edition of Fair Value (published by Banister Financial; available online here) provides an excellent summary of the DLOM Job Aid including positive commentary on the above-quoted passage. Paschall identifies several limitations on an evaluator’s reliance on court cases to support a marketability discount, including:
- The uniqueness of every case. As Paschall explains, “the determination of DLOM in one case does not imply that the same DLOM is applicable in another situation. There are few certainties in life, however, one of them is that you will never find a reported case with the exact same fact pattern as your situation.”
- Decisions discuss DLOM poorly. Paschall notes that some cases “are concerned with other legal issues and do not address the discount issue at all. Other cases do not provide enough detail to determine the marketability arguments and decisions. Also, some cases determine the DLOM with no rationale or discussion at all.”
- Other valuation issues can muddy the water. The presence of other valuation issues, Paschall writes, “muddies the water in pointing to a particular outcome in a case as support for a desired DLOM. For example, the taxpayer and the IRS may disagree on the overall, pre-discount value of the company, the discount for lack of control, the DLOM, and many other issues. It may be impossible to know if decisions were made among these items in a ‘balancing’ fashion to reach some desired end result.”
Paschall concludes that court decisions in other cases “may be helpful in understanding an appropriate analysis of a DLOM, however, they are not useful in a sense of indicating that a specific DLOM in a case is also applicable to the interest at hand.”
The logic of Paschall’s conclusion is compelling. There are plenty of decisions by New York judges in fair value cases applying DLOMs ranging from 0% to 30% or higher. Most of the DLOM decisions offer little or no explanation for the percentages used, or the methodology used to reach them. The mere fact that a judge applied, for example, a 25% DLOM in a prior, unrelated case valuing shares in Company A provides meagre support for a testifying business appraiser to apply a 25% DLOM to shares in subject Company B.