The discount for lack of marketability (DLOM) is one of the most hotly debated and heavily litigated issues in New York fair value proceedings involving dissenting shareholder appraisals and oppressed minority shareholder buyouts.
A new note in the DLOM debate is sounded in an article by Gilbert E. Matthews, CFA, Senior Managing Director and Chairman of Sutter Securities, published in this month’s Business Valuation Update with the provocative title, “NY’s Unfair Application of Shareholder-Level Marketability Discounts.” The article’s thrust is that New York law is singularly out of step with predominant fair value jurisprudence excluding DLOM in statutory fair value proceedings. (BV Update subscribers can access the article here; non-subscribers can obtain a copy by email request to Mr. Matthews at firstname.lastname@example.org.)
For those not familiar with valuation discounts, the International Glossary of Business Valuation Terms defines DLOM as “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability” where marketability in turn is defined as “the ability to quickly convert property to cash at minimal cost.” It is not to be confused with the minority discount a/k/a discount for lack of control (DLOC) defined 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.”
New York’s DLOM Experience
For at least 30 years, starting with the Appellate Division, Second Department’s 1985 decision in Matter of Blake followed by a raft of trial and appellate court rulings including the Court of Appeals’ Seagroatt and Beway decisions, New York courts have approved DLOM and condemned DLOC in fair value proceedings. Under settled New York law, courts disallow DLOC because it deprives minority shareholders of their proportionate interest in the corporation as a going concern and treats shares of the same class unequally, and allow DLOM because it reflects the absence of a public market for the rapid sale of close corporation shares and has no relation to the fact that the shares being valued represent a minority interest.
New York’s fair value jurisprudence surrounding DLOM theory has been nothing if not consistent, as exemplified dramatically in the Arizona Iced Tea decision applying a 25% DLOM reportedly worth $478 million. Even in the few New York cases that have rejected DLOM, such as the recent Zelouf and Chiu decisions, the courts did so, not because of any doctrinal objection to DLOM’s general applicability under the fair value standard, but due to unique circumstances present in those cases.
The Matthews Article
Matthews launches his critique by asserting that “in contrast to the other states, New York applies marketability discounts at the shareholder level in fair value determinations, which harms dissenters by transferring value to continuing shareholders” contrary to the “core principle of fair value [requiring] equal treatment of all shareholders in the same entity.” Matthews contends that New York, alone among all U.S. jurisdictions, “favors (and some lower courts believe requires) the imposition of a marketability discount on dissenting shareholders in fair value determinations” (italics in original).
To be clear, the critique makes an important distinction between DLOM at the entity level (good) versus the shareholder level (bad). Matthews justifies DLOM at the entity level, explaining that it “impacts all shareholders equally [and] does not impact a dissenter’s right to receive a pro rata share of equity value” based on adjustments made “to reflect company-specific factors that may affect the liquidity of the company as a whole.” Matthews cites the Appellate Division’s 1990 decision in the Seagroatt case, which the Court of Appeals affirmed, as an example of the proper application of DLOM at the entity level based on “the use of a higher discount rate to adjust for marketability.”
According to Matthews, “New York is the only state that generally applies marketability discounts in fair value cases to specific shareholder interests.” All other states, he writes, reject DLOMs at the shareholder level “in both appraisal and oppression cases, either by statute or by state supreme or appellate court decisions.” Thirty-five states have gone even further, he continues, by statute or case law barring outright any marketability discount, with seven of those states “allow[ing] an exception to permit an ‘equitable’ application of DLOM to a minority interest on the basis of minority opportunism, aggrandizement, or self dealing.”
Matthews points to the Court of Appeals’ 1995 Beway decision as setting bad precedent for allowing DLOM at the shareholder level, stating that the court “misconstrued the conceptual basis for the marketability discount” by “fail[ing] to see that a marketability discount on minority or departing shares was essentially another form of minority discount.” He then observes that “[m]ost New York courts have followed Beway in accepting a DLOM at the shareholder level,” citing the Arizona Iced Tea case as an example. He also cites a number of New York cases including Seagroatt in which, he says, the courts “appear to understand the criticisms” and “refuse to apply the marketability discount to minority shares.”
Matthews’ article cites other commentary in support of his conclusion that “[a] reexamination of New York’s obsolete position on DLOMs is long overdue,” including a 1998 law review article by law professor Barry Wertheimer titled “The Shareholders’ Appraisal Remedy and How Courts Determine Fair Value”. Matthews quotes Wertheimer’s article, which is also critical of Beway, for the proposition that “[a] ‘lack of marketability’ discount is another form of minority discount in that, if permitted, the dissenting shareholder receives less than a proportionate share of the value of the corporation as a whole.”
Matthews also cites a 2011 blog post by yours truly with a provocative title of its own, “The Marketability Discount in Fair Value Proceedings: An Emperor Without Clothes?”, in which I reported the published views of several prominent experts in the business valuation field, including Chris Mercer and Shannon Pratt, for and against application of DLOM in fair value cases. Contrary to Matthews’ suggestion, in that post I did not adopt a “position” that Blake, Beway and their progeny are based on flawed assumptions concerning appraisal doctrine and empirical evidence at the control or enterprise level of value; rather, I phrased it as a question by way of introduction to my discussion of the views of Mercer, et al. In fact, as a lawyer lacking any credentials or training as a business appraiser, I am neutral on the issue and in my cases have argued with equal vigor on behalf of clients for and against DLOM.
I can’t say how or when or even if the DLOM debate will end. Looking at the New York cases cited in the Matthews article, I’m not necessarily convinced they apply DLOM at the shareholder level; certainly none of them say in haec verba that that’s what they’re doing. In the Arizona Iced Tea case the court’s DLOM discussion centers on enterprise-level factors and, according to a detailed account by Chris Mercer, who testified against DLOM in that case, his opposing expert (Shannon Pratt) who advocated a 35% DLOM, which the court cut back to 25%, “testified that any DLOM should be based only on corporate or enterprise factors and not on shareholder level factors.”
As the debate evolves, personally I’d like to see more attention paid to appraisal doctrine, methodology, and data supporting or undermining the existence and quantification of DLOM at the enterprise level, i.e., the “good” DLOM in fair value cases. It would be nice if the business valuation community could speak with one, clear voice on the issue, which would then facilitate consideration by legislators or, should they defer to the courts, appellate judges, of any needed changes to New York’s policy toward DLOM in fair value proceedings.
Update: Gil Matthews Responds
I had the great pleasure of lunching with Gil Matthews the same day I posted this article, and of course we discussed New York’s DLOM puzzle. Gil then sent me a follow-up email which I’m pleased to reproduce here:
Your blog questioned my views on corporate-level DLOMs. After our discussion, I think that our positions are not far apart. My view is that corporate-level discounts do not violate the principle of equal treatment for all shareholders, but that such discounts are seldom applicable. I wrote in a 2013 book chapter of fair value in appraisal, “The valuator may consider, when applicable, application of a trapped-in capital gains discount, a portfolio (non-homogeneous assets) discount, a contingent liabilities discount, or a key man discount.” These are appropriate corporate-level discounts – they are not “marketability discounts” but are sometimes mischaracterized as such.
It is my view that there is no “private company discount” and that a private company usually is worth as much as a similar public company. In fact, a private company may be easier to sell because a transaction can be consummated faster because of the delays inherent in clearing a proxy statement with the SEC and the lesser risk of shareholder opposition or competitive bidders. However, there is an interesting 2009 study that concluded that companies without Big 4 auditors sell at lower multiples – it could be argued that this is a form of DLOM. In general, although there can be company-specific reasons for a corporate-level DLOM, I believe these situations are uncommon.