DiscountOn the heels of last week’s post titled The DLOM Debate Heats Up, a timely new ruling by a New Jersey intermediate appellate court adds yet another interesting twist to the application of the discount for lack of marketability in fair value proceedings involving dissenting shareholder appraisals and oppressed minority shareholder buyouts.

New Jersey courts have a more restrictive approach to DLOM in fair value contests than New York courts, generally reserving it for “extraordinary circumstances” involving inequitable or coercive conduct by the seller. This latest New Jersey ruling doesn’t make new law but, to this observer at least, its application and quantification of DLOM seem equally if not more reliant on legal doctrine and, in particular, free-floating equity considerations than on empirically-based appraisal theory and methodology.

The New Jersey Appellate Division’s unpublished decision in Wisniewski v Walsh, 2015 N.J. Super. Unpub. LEXIS 3001 [App. Div. Dec. 24, 2015], caps an astonishing 20-year litigation saga involving a family-owned trucking business taken over from the founding father by three siblings, one of whom sued the other two under New Jersey’s oppressed shareholder statute. In 2000 the trial judge ruled that the petitioner himself was the oppressor and ordered him to sell his one-third interest to the company or his siblings for fair value to be determined by the court.

In 2008, following a series of trial and appellate court rulings including a valuation hearing with expert testimony by two business appraiser heavyweights — Roger Grabowski of Duff & Phelps for the purchasers and Gary Trugman of Trugman Valuation Associates for the seller — the trial court valued the seller’s shares at $32.2 million adopting Trugman’s discounted cash flow (DCF) approach.

Both sides appealed and eventually, in 2013, the Appellate Division affirmed the valuation in most respects but concluded that a marketability discount should have been applied to the extent no such discount was already embedded in the trial court’s DCF valuation. The decision (read here) drew largely upon the twin pillars of New Jersey DLOM jurisprudence — the New Jersey Supreme Court’s 1999 rulings in Balsamides v Protameen Chemicals, Inc., 160 N.J. 352, 734 A.2d 721 [1999] and Lawson Mardon Wheaton, Inc. v Smith, 160 N.J. 383, 734 A.2d 738 [1999] — in finding that a DLOM was warranted on the ground that the seller-oppressor “should not be rewarded when his conduct not only harmed the other shareholders but necessitated this forced buyout.”

On remand, the trial court did not hear additional expert testimony and instead issued a decision based on the prior record of the valuation hearing, concluding that a DLOM was not embedded in the prior DCF valuation and that a separate DLOM of 25% should be applied.

Again, both sides appealed, with the seller arguing that the build-up discount rate developed by Trugman for his DCF approach considered the same factors used by the opposing expert, Grabowski, in arriving at the latter’s proposed, separate DLOM of 35%, and that applying a separate discount based on those same factors consequently would double-count the same factors.

The purchasers argued that the trial judge should have adopted Grabowski’s 35% DLOM, and that the judge had no basis to select his own 25% DLOM.

In its affirmance last month, the appellate court rejected both sides’ contentions, holding that the trial court “soundly determined that no marketability discount was already embedded in the valuation” and that there was no basis to “second-guess” the trial judge’s 25% DLOM determination “in this most difficult case.”

DLOM Not Embedded in DCF.  As noted above, the embedded-DLOM issue turned on whether the factors incorporated in Trugman’s build-up discount rate used in his DCF approach already reflected an illiquidity adjustment. Those factors included a size premium and an adjustment for a series of company-specific factors including the company’s reliance on key personnel, its concentration in the retail industry, and high debt. The appellate court agreed with the trial judge that, despite the similarity of the factors with those used by Grabowski for his separate DLOM, “Trugman had certainly ‘utilized them in a different way’ than to adjust for any lack of liquidity.” While the same factors can influence value in two distinct ways, the court was satisfied that Trugman “set the applicable premiums in his discount rate to values meant to adjust for uncertainty in receiving the expected income stream, but not for any lack of marketability.” In addition, in his trial testimony Trugman “rejected the notion that any discount for liquidity should apply,” maintained that shareholders “stood in no danger of losing liquidity” during a sale of the company, and insisted that DLOM “was more appropriate” in connection with the sale of “a minority share of restricted stock in a publicly-traded company.”

25% DLOM Upheld.  The appellate court concluded that it had no basis to substitute its judgment for the trial court’s in rejecting both sides’ proposed DLOM — the seller wanted 0%; the purchasers wanted 35% — and arriving at its own 25% DLOM. As the court wrote:

The [trial judge] was not bound to accept either expert opinion at face value or for all purposes; he was entitled to find a figure that no expert in the case had specifically favored so long as it was plausible, based on the evidence in the record, and — in the final analysis — fair and equitable.

The appellate court observed that in the Balsamides case mentioned above, the New Jersey Supreme Court remarked that “marketability discounts for closely-held companies frequently ranged from thirty to forty percent” and sometimes as low as 20% according to studies and case law, but that the selection of a specific rate “must always be responsive to the equities of a given matter.” In Wisniewski, based on record evidence that “it would not likely take long to sell the company,” that the company’s historical financial performance and growth “would ensure shareholders would receive sufficient earnings while they attempted to sell,” and that Grabowski “simply failed to adequately weigh these other ‘strong indicators of liquidity,'” the trial judge had appropriately concluded that a 30%-40% DLOM “would excessively punish . . . the oppressing shareholder beyond what the equities of this case required” and constitute a “windfall” for the purchasing shareholders, and that the equities in the case therefore favored application of a 25% DLOM on the “low end of normal.”

Closing Thoughts. If you ask accredited business appraisers whether the determination of a marketability discount rate for the shares of a particular closely-held company should be based on case precedent involving other companies, I think the vast majority will answer “no.” I wrote a piece on that very subject last year, quoting from the IRS’s DLOM Job Aid and experts in the field. Yet cases such as Wisniewski point the other way, effectively encouraging advocates and judges to select a rate within a self-perpetuating, “established” range of case precedent based as much if not more on the “equities” of the case than the financial performance, prospects, and liquidity risks of the company being valued. It’s not for me to say whether appellate courts and legislatures should decide as a matter of policy to incorporate into fair value determinations equitable considerations based on the good or bad conduct and motives of the litigants toward one another. But I am saying that if that’s the way it’s going to be, there’s an associated cost in the form of greater indeterminacy in fair value adjudications which makes it harder for lawyers and valuation professionals to advise their clients and to reach buyout agreements before they ripen into litigation.

Hat tip to Andy Dzamba, editor of the online BVWire, for highlighting the Wisniewski case in last week’s issue and, so he reports, in the upcoming March issue of Business Valuation Update.

Update February 3, 2016:  Chris Mercer today posted on his blog an in-depth, critical analysis of Wisniewski titled The Bad Behavior (Marketability) Discount in New Jersey in which he calls the case “a business appraiser’s nightmare.”

  • Douglas Moll

    Peter —

    I couldn’t agree more. I once wrote the following at 54 Duke Law Journal 293 (sorry for the length):

    While Perle, as the oppressive shareholder, is certainly at “fault” in the dispute, it is far from clear that such fault should affect the applicability of a marketability discount. As mentioned, a marketability discount is a well-accepted valuation convention that reflects the economic reality that purchasers will pay less for close corporation stock because, without an established market, such shares are difficult to sell. Application of the discount should turn on whether that economic reality is present on the facts of the case — i.e., will the buyout result in the purchaser owning a block of close corporation stock that will be difficult to liquidate? If yes, a marketability discount is appropriate. If no, a marketability discount is inappropriate. The discount’s application, in other words, is meant to turn on whether the purchaser will be left with an illiquid stake in the company, not on whether the shareholder’s conduct is viewed as good or bad. Not surprisingly, one can apply a similar analysis to the minority discount.

    As a conceptual matter, therefore, it makes little sense to use a discount (or the lack thereof) as a means of punishment. Beyond the lack of a conceptual fit, the use of a discount as a punitive tool has related practical problems as well, as there is a significant risk of over- or under-punishing the oppressive shareholder. For example, a marketability discount is poorly calibrated to the conduct of the oppressive investor. Valuation experts derive marketability discounts from empirical data comparing sales of illiquid securities to sales of liquid publicly-traded securities. To fit the particular circumstances of the company at issue, experts may adjust the data by considering a number of factors, including the presence of a “put” right, the existence of potential buyers, the prospect of a public offering or sale of the company, and the existence of restrictive transfer provisions. Neither the empirical data nor these factors, however, has any relationship to the conduct of the oppressive shareholder. In most disputes, therefore, the size of the marketability discount is no more tailored to the “bad” conduct of the oppressor than the current U.S. divorce rate is tailored to the “bad” conduct of the oppressor. Even in the shareholder oppression context, the punishment should fit the crime. If a court believes that the oppressive shareholder’s conduct warrants punishment, the court should mete out that punishment with damages awards or other remedies (e.g., payment of fees, injunctions) that are more tailored to the punishment-worthy behavior.

    Enjoyed the post!