Fair Market Value vs. Fair Value

Forensic accounting and business valuation specialist Mark S. Gottlieb (on the left; that’s me on the right) has a spanking new website featuring podcast audio interviews of professionals addressing topics of interest to business appraisers and lawyers whose practices involve business valuation and other modes of economic analysis.    

Mark recently invited me to speak with him on the subject of fair value and discounts in stock valuation proceedings.  During the interview I answer Mark’s questions about the elusive definition of fair value; the differences between fair value and fair market value, particularly as regards treatment of discounts; the varying quality of expert testimony in these proceedings; and the impact of shareholder agreement buy-sell provisions on judicial determination of fair value.

You can listen to the podcast by clicking here.  The play button is at the bottom of the linked page.  The interview lasts about 16 minutes.

See full size imageDissenting shareholder statutes give shareholders the right to opt out of fundamental corporate transformations — typically by way of merger or consolidation with another corporation — by redeeming their shares for "fair value".  Case law in New York and many if not most other states defines fair value as the shareholder’s proportionate share of the value of the enterprise as a going concern, as opposed to liquidation value, determined as of the date immediately prior to the objected-to transaction.

In some states, including New York, another transformative corporate transaction giving rise to an appraisal remedy is the sale of all or substantially all of the assets of the corporation, other than in the usual course of the corporation’s business.  However, under the New York statute (Section 910 of the Business Corporation Law), if the sale of assets (a) is wholly for cash, (b) the shareholders’ approval is conditioned upon the dissolution of the corporation and (c) the proceeds are distributed within one year, the opt-out/appraisal remedy is not available.

The majority shareholders in the recently decided case, Brynwood Co. v. Schweisberger, No. 02-CH-1297 (Ill. App. Ct. 2d Dist. July 23, 2009), could have saved themselves a lot of trouble had they incorporated in New York rather than Illinois.  That’s because Section 11.65 of the Illinois Business Corporation Act gives dissenting shareholders an appraisal remedy upon the proposed sale or other disposition of all the corporation’s assets with no exception for sales linked to a proposed dissolution and distribution plan, which is what happened in Brynwood.

Making matters even stickier, the corporation in Brynwood owned as its sole asset a highly appreciated parcel of commercial real estate, the sale of which triggered a large gains tax at the corporate level because the corporation was organized as a "C" corporation rather than an "S" corporation.  The dissenting shareholder, Mr. Schweisberger, argued with some theoretical justification that his shares in the corporation should be valued based on the going-concern value of the company as of the date prior to the property sale, without regard to the gains taxes and other costs of the actual sale.  Schweisberger won at the trial court level but lost on appeal.  What exactly happened, and how could the problem have been avoided? 

Continue Reading In Unusual Case, Illinois Appellate Court Reduces Fair Value Award to Dissenting Shareholder

The following testimony was given by an accredited business appraiser, testifying on behalf of the purchasing majority shareholders in a buy-out valuation proceeding under Section 1118 of the Business Corporation Law, to determine the “fair value” of the petitioner’s 45% interest in two related companies:

Q:     . . . I see that for the [first] appraisal there was no separate marketability discount analysis, but there is one for the [second] appraisal.  Could you explain the basis of that?

A:     After the issuance of both reports, . . . we were asked to come up with a value on a fully enterprise, the value of both entities.  After the second report, [the majority shareholders’ lawyer] asked me to address it because the case had become a 1118 case, and in that case the definition of value is fair value, and under that definition of value for the minority interest, what other considerations would one take into consideration, and I said, well, you would address the marketability discount of that specific block of stock under that statute.  And he asked me then could I quantify what the marketability discount would be applicable to the stock.

Q.     Applicable to the minority interest?

A.     To the block of stock, the 45 percent interest.

The same expert, in a written report, wrote that “[a] minority equity holder of [the two companies] owns an equity interest for which no market exists. . . . It is our opinion that no less than a 30%-to-35% discount for lack of marketability is appropriate for the equity interest in [the two companies] to derive the fair value of the specific fractional interest in each company . . ..”

The judge in that case rejected the expert’s position and refused to apply the proposed discount.  Can you guess why?

Continue Reading What’s the Difference Between Marketability and Minority Discounts?

It’s the perfect LLC storm:  Accusations by the minority member of overreaching and breach of fiduciary duty by the controlling members, no operating agreement, and an LLC statute that affords neither party a judicial means of achieving the separation they each want.

The case, Matter of Koutelos (Mouhlas Realty, LLC), was decided last month by Queens County Supreme Court Justice Patricia P. Satterfield (read decision here).  The petitioner, Mary Koutelos, holds approximately 15% membership interest in Mouhlas Realty, LLC which was formed in 2000 as a member-managed LLC.  The decision doesn’t describe the LLC’s business or tell us if Koutelos is actively involved in running it.  All we can glean is that Koutelos filed a petition under LLC Law Section 702 for judicial dissolution of the LLC based on allegations of overreaching and breach of fiduciary duty by two of the other three members, apparently involving a capital call and/or loan to be used for compensation of one or more member-managers; the members have no operating agreement; and the other members refused Koutelos’s request to adjourn a meeting.

The decision also tells us that the "respondent" — we don’t find out if this refers to the LLC or one of the other members individually — filed an answer with a counterclaim for an "equitable buyout" conditioned on the court applying a 30% discount for lack of marketability in valuing the petitioner’s interest.

Continue Reading A Case of Mutual Frustration: Minority Member of LLC Can’t Compel Dissolution, Majority Can’t Compel Buyout

In a posting last December I wrote about an important estate tax case, Jelke v Commissioner, in which a federal appeals court adopted a bright-line rule requiring 100% discount for built-in capital gains tax (“BIG”) in the valuation of C corporation assets.  At the time I made the following prediction about Jelke‘s impact on stock valuation in corporate dissolution cases:

Jelke likely will not have wide impact on valuation contests in dissolution cases, for two main reasons. First, the great majority of dissolution cases involve S corporations and other entities that opt for pass-through partnership tax treatment. Second, the standard of value in estate tax cases such as Jelke is fair market value as opposed to the fair value standard specified by New York’s buyout statute. In a BCL §1118 valuation case involving a real estate holding C corporation called Matter of La Sala, a New York trial court refused to apply a discount for BIG tax liability on the ground that it was required to value the corporation as a going concern and, therefore, it would not consider capital gains taxes triggered upon liquidation. Undoubtedly, this will not be the last word on the subject of BIG discounts in stock valuation proceedings.

I was right about one thing:  it was not the last word on BIG and §1118 stock valuation proceedings.  As it turns out, when I wrote those words there already was percolating in Nassau County Supreme Court a buy-out proceeding in a shareholder oppression case, Murphy v. U.S. Dredging Corp., requiring the court to decide the same issue presented in the La Sala case, namely, the appropriateness under the fair value standard of applying a BIG discount to the appreciated assets of a real estate holding C corporation.  The Murphy court’s answer — applying a partial discount based on the present value of future gains taxes — lands between Jelke‘s 100% discount and La Sala‘s zero discount.

Continue Reading Court Discounts Fair Value Award for Built-In Gains Tax in Shareholder Oppression Case

A federal appeals court once remarked that “the valuation of a closely held company is an inexact science”, adding, “some might say an art” (Okerlund v. U.S., 365 F3d 1044 [Fed. Cir. 2004]).  Looking at the gallery of New York valuation law, the artist must be Jackson Pollack.

By that I mean, the valuation rules seem like a hodgepodge when one compares the different settings in which interests in closely held companies are valued by the New York courts, including dissenting shareholder appraisals and oppressed minority shareholder buyouts under the Business Corporation Law, accounting proceedings under the Partnership Law, and equitable distribution proceedings under the Domestic Relations Law.  This holds especially true with respect to valuation discounts, as highlighted in a recent appellate decision concerning a fractured partnership in a case called Vick v. Albert, 47 AD3d 482 [1st Dept 2008] (read decision here).

Vick involved a nasty family feud that spawned multiple litigations and arbitration lasting almost a decade.  Beginning in 1975, Susan Vick and her brother, Richard Albert, co-owned a number of investment real properties in New York City.  Some of the properties they owned as tenants in common, others were owned by partnerships in which Vick, Albert and others held partnership interests.  Vick died in 1999, leaving her interests to her two children.  About eight months after their mother’s death, the children sued their uncle and others seeking, among other things, a partition of certain properties and a dissolution and accounting with respect to various partnerships.  The complaint alleged that the uncle took exclusive control of the partnerships’ books, records, properties and assets; that he misappropriated certain assets including rental income for his own benefit; and that he failed to wind up the partnerships’ affairs after his sister died and failed to provide a final accounting for each of the partnerships.  (The appellate court’s decision unfortunately recites very few facts.  More can be learned from the prior lower court decisions, two of which from 2001 and 2004 can be viewed here and here.)

Continue Reading Court Refuses to Apply Marketability and Minority Discounts in Valuing Deceased Partner’s Interest

New York’s statutes governing buyouts in dissolution and dissenting shareholder cases use the term “fair value” (FV) as the standard used to determine purchase price. The statutes do not define FV.

In contrast, “fair market value” (FMV) is a widely recognized standard of value used in the business world, in tax assessment proceedings and elsewhere. The International Glossary of Business Valuation Terms defines FMV as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

Are FV and FMV the same?

Not by a long shot. As succinctly stated in one of the more prominent valuation treatises, “the term fair value is usually a legally created standard of value that applies to certain specific transactions”. S. Pratt, R. Reilly & R. Schweihs, Valuing a Business, p. 32 (4th ed. 2000). My even more succinct translation: FV means whatever the courts say it means.

In New York case law, the main difference between FMV and FV concerns application of a minority discount in valuing the shares of a dissolution petitioner or dissenting shareholder. A minority discount, also referred to as a discount for lack of control (“DLOC”), reflects the lower price a hypothetical buyer would pay for shares in a corporation that do not give their owner control of the board of directors, company management, distributions, changes to the articles of incorporation, etc.   For over 20 years New York courts consistently have ruled that, unlike in proceedings applying the FMV standard of value, the FV standard excludes DLOC. In many other states that also use the FV standard in statutory buyout proceedings, unlike New York, the courts also exclude the discount for lack of marketability (“DLOM”) applicable to non-publicly listed shares that cannot be sold quickly and at low cost. Bottom line: in New York statutory valuation proceedings applying the FV standard, the selling shareholder gets a significantly higher price compared to the FMV standard.

For those who want to learn more on the subject, I recommend reading a recent appellate decision out of Arkansas in which the court explains the difference between FMV and FV in the context of a dispute over the valuation of the interests of withdrawing partners in a family limited partnership.

Continue Reading Fair Value vs. Fair Market Value

See full size imageBusiness appraisers generally apply discounts of one sort or another to value an interest in a closely held business entity. Discounts for lack of control (DLOC) and lack of marketability (DLOM) are most commonly used, depending on the context (estate taxes, matrimonial divorce, dissenting shareholder appraisal, etc.) and the applicable standard of value (fair market value, fair value, investment value).

Once in a while a more exotic discount makes the news. Case in point: the discount for built-in capital gains (BIG) affecting subchapter C corporations. A recent appellate decision scores a major victory for estate taxpayers, and ultimately may also become a factor in valuation cases arising out of dissolution proceedings involving C corporations. First, some background.

Under changes made by the Tax Reform Act of 1986, proceeds from the sale of appreciated assets held by a C corporation upon liquidation are subject to gains tax at the corporate level. A buyer of C corporation shares therefore is willing to pay less for the shares than if the same assets were held by a subchapter S corporation. A C corporation can avoid capital gains taxes at the corporate level upon sale of all its assets by converting to a subchapter S corporation. [IRC §1361 et seq]. However, this option is of limited use since, among other things, the corporation must retain the appreciated assets for ten years from the date of conversion in order to avoid the tax. [See IRC §1374(d)(7)].

In a 2005 decision in a case called Estate of Jelke, in valuing an estate’s 6.44% stock interest in an investment holding company, the Tax Court reduced a $51 million BIG tax liability to $21 million by computing the present value of tax liabilities assuming the future sale of company assets over a 16-year period. On November 15, 2007, the U.S. Court of Appeals for the Eleventh Circuit ordered the Tax Court to recalculate the stock value using a dollar-for-dollar reduction of the entire $51 million in BIG tax liability, under the assumption that the company is liquidated on the date of death and all assets sold.

Jelke likely will not have wide impact on valuation contests in dissolution cases, for two main reasons. First, the great majority of dissolution cases involve S corporations and other entities that opt for pass-through partnership tax treatment. Second, the standard of value in estate tax cases such as Jelke is fair market value as opposed to the fair value standard specified by New York’s buyout statute. In a BCL §1118 valuation case involving a real estate holding C corporation called Matter of La Sala, a New York trial court refused to apply a discount for BIG tax liability on the ground that it was required to value the corporation as a going concern and, therefore, it would not consider capital gains taxes triggered upon liquidation. Undoubtedly, this will not be the last word on the subject of BIG discounts in stock valuation proceedings.