A few weeks ago, this blog – in the first of a three-part series about business valuation proceedings – addressed the various statutory triggers by which owners of New York partnerships, corporations, and limited liability companies can wind up in a contested business appraisal proceeding.
So you, or your client, have found yourself in an appraisal proceeding. The question then becomes: What are the legal rules, principles, and standards that apply in the valuation proceeding itself? That is the subject of today’s article.
“Value” Versus “Fair Value”
The ultimate purpose and objective of an appraisal proceeding is to determine the correct “value,” the term found in the Partnership Law (i.e. Sections 69 and 73), or “fair value,” the term used in both the Business Corporation Law (i.e. Sections 623 and 1118) and Limited Liability Company Law (i.e. Sections 509, 1002, and 1005), of an owner’s interest in a business for the purpose of a buyout of liquidation of that ownership interest.
The interplay of the “value” and “fair value” standards raises a trio of threshold questions.
First, does “fair value” mean the same thing when used in different provisions of the BCL? Definitely yes. “[T]here is no difference in analysis between stock fair value determinations under Business Corporation Law 623 and fair value determinations under Business Corporation Law 1118” (Matter of Friedman v Beway Realty Corp., 87 NY2d 161 ).
Second, does “fair value” under the LLC Law mean the same thing under the BCL? Probably yes. In a pioneering case on the subject of fair value under the LLC Law, Chiu v Chiu, Index No. 021905/2007 [Sup Ct, Queens County Aug. 30, 2012], the court noted that the “LLCL does not define the term ‘fair value,’ and the parties have not called the court’s attention to any cases which discuss the term in connection with a limited liability company.” As a result, the court relied upon “fair value” jurisprudence under the BCL and treated it as fully applicable to LLCs.
Third, does “value” under the Partnership Law mean the same thing as “fair value” under the BCL? In effect, “not quite,” said the Court of Appeals in Congel v Malfitano, 31 NY3d 272 . In the Court’s view, the right of a wrongfully withdrawn partner to be paid “value” meant something less than “fair value,” as in a dissenting shareholder appraisal proceeding, because, in the case of the former, the partner has done something contrary to the interest of the majority (i.e., breached a partnership agreement prohibiting withdrawal), while in the latter, the majority shareholders have, at least in theory, done something contrary to the interest of the dissenting minority shareholder:
Business Corporation Law 623 invokes a statutory term of art, ‘fair value,’ in requiring that a dissenting shareholder who exercises appraisal rights be paid the ‘fair value’ of his or her shares, as opposed to their fair market value. The term ‘fair value’ is not present in [Partnership Law 69].
The terminological difference reflects an underlying difference in statutory scheme. . . . . Unlike shareholder dissent and appraisal, wrongful dissolution is not necessarily preceded by upheaval inimical to the position of the minority, so trial courts need not substitute a ‘fair value’ for the actual value a third party would pay. Indeed, here the upheaval took the form of an action by a minority partner inimical to the majority’s interests.
One question left undecided in Congel is whether the standard for “value” in a wrongful partner withdrawal under Partnership Law 69 differs in any way from death or retirement of a partner under Partnership Law 73. We will have to wait and see if the Court of Appeals ever takes up the issue.
The next article in this series will address how the distinction between “value” and “fair value” plays out in practice: application to partnership interests, but not stock interests, of discounts for lack of control (the so-called “DLOC”) and the exclusion of any consideration of the value of the business’s goodwill.
The “No Burden” Approach
Who bears the burden in an appraisal proceeding of proving value or fair value? Some courts have adopted a so-called “no burden” approach. As the court explained in Zelouf Intl. Corp. v Zelouf, 45 Misc 3d 1205 [A] [Sup Ct, NY County Oct. 6, 2014]:
Though the Court of Appeals has not decided the question of who bears the burden of proof in a BCL appraisal proceeding, the parties propose following this court’s tradition of applying the ‘no-burden’ approach. Under this approach, the court will consider the parties’ expert testimony as persuasive evidence of fair value, but, at the end of day, and even if the court finds neither expert to be persuasive, it is the court’s burden to make a fair value determination.
Fair Value is a Question of Fact
Do the statutes provide courts or litigators any guidance in how to determine value or fair value? Unfortunately not.
The BCL, for example, “offers no definition of fair value and no criteria by which a court is to determine price or other terms of the purchase” (Matter of Seagroatt Floral Co., Inc., 78 NY2d 439 ). For that reason, “fair market value, being a question of fact, will depend upon the circumstances of each case; there is no single formula for mechanical application” (id.).
Five Guiding Principles for Determining Fair Value
What do courts consider to determine value or fair value? In Matter of Friedman, the Court of Appeals identified five principles that “have emerged from our cases involving appraisal rights of dissenting shareholders.”
First: “The fair value of a dissenter’s shares is to be determined on their worth in a going concern, not in liquidation, and fair value is not necessarily tied to market value as reflected in actual stock trading.” This means that “in fixing fair value, courts should determine the minority shareholder’s proportionate interest in the going concern value of the corporation as a whole, that is, what a willing purchaser, in an arm’s length transaction, would offer for the corporation as an operating business.”
Translation: Courts are expected to value an ownership interest in a business as if the business will continue, rather than have its assets liquidated and sold independently of its corporate shell. This may have a significant impact on value. For example, with a real estate holding company, the real estate may have substantial market value, yet the entity may have expenses approaching, or exceeding, income. In that case, an ownership interest might be worth more in a liquidation sale, rather than as a going concern. Yet, going concern value is the required method of valuation. Put another way, fair value does not necessarily mean (and usually is not) the same as “fair market value.”
Second: “The three major elements of fair value are net asset value, investment value and market value”. According to the Court of Appeals, “all three appraisal methods do not have to influence the result in every valuation proceeding. It suffices if they are all considered” (Cawley v SCM Corp., 72 NY2d 465 ).
Translation: The approach used must fit the circumstances; it is not a mechanical process. For instance, a net asset approach generally is not used for a sales or service-oriented business, and a market approach may not be feasible if there are no comparable public companies or sales of comparable firms. We will discuss these approaches in more detail in the final post in this series.
Third: “Fair value requires that the dissenting stockholder be paid for his or her proportionate interest in a going concern, that is, the intrinsic value of the shareholder’s economic interest in the corporate enterprise” (Matter of Friedman). “Once the investment value of the entire enterprise is ascertained, the dissenting shareholder should be awarded a pro rata share based on the percentage of stock owned” (Zelouf Intl. Corp.).
Translation: Courts must first value the whole pie, then determine the value of the particular owner’s slice of that pie.
Fourth: “Fair value determinations should take into account the subsequent economic impact on value of the very transaction giving rise to appraisal rights” (Matter of Friedman).
Translation: In determining an entity’s value, the court may add to the top line value of the entity the value of any derivative claims (which belong to and are considered valuable assets of the entity) or other claims of wrongdoing that might have an impact on the entity’s value (such as alleged fraud or illegality in the transaction giving rise to the right to dissent and demand an appraisal). This means that “the alleged wrongdoing or misappropriation of corporate assets may play a role in the valuation determination and is relevant if such misconduct has had an adverse impact upon the corporation’s value” (Cortes v 3A N. Park Ave. Rest. Corp., 46 Misc 3d 670 [Sup Ct, Kings County 2014] [holding that a $4.9M derivative judgment from skimming of restaurant’s cash receipts “is an asset of the corporation that should be added to the value calculated” for the value of the business]).
Fifth: “Determinations of the fair value of a dissenter’s shares are governed by the statutory provisions of the Business Corporation Law that require equal treatment of all shares of the same class of stock” (Matter of Friedman).
Translation: Discounts for minority status / lack of control are prohibited for corporations (and presumably LLCs), but not for partnerships (see Congel).
The third post in this series will examine the issue of appraisal discounts in greater detail, along with other appraisal issues including valuation date, “known or knowable” future events affecting value, the three valuation approaches, adjustments, and pre-judgment interest.