Two speakers at the recent Business Valuation Conference of the New York State Society of CPAs (May 21, 2012) addressed the topic of shareholder litigation in New York related to determinations of statutory fair value.
At the outset of this post, let me say, as I have said many times before, I am not a lawyer. I am agnostic with respect to what the definition of statutory fair value in any jurisdiction should be. However, if statutory and/or judicial guidance is unclear, there is much room for disagreement and misunderstanding on the part of all parties.
Marketability Discount Violates Preponderance of Beway Guidance
I was the first speaker at the conference and gave a presentation entitled “Shareholder Litigation in New York” [link to slides]. I have addressed this topic in previous posts, although the presentation had a particular twist. In the presentation, I concluded that there is no economic rationale for the employment of a marketability discount in New York statutory fair value proceedings based on a review of Friedman v. Beway Realty Corp. (87 N.Y. 2d 161 (1995)), the most recent case on the topic from the highest New York court, the Court of Appeals.
Some of my logic will show through in the remainder of this post and story.
Marketability Discount Here to Stay?
Fred D. Weinstein, a New York lawyer with Kurzman Eisenberg Corbin & Lever, LLP who has considerable experience in statutory fair value matters, spoke immediately following me. Mr. Weinstein reached a different conclusion regarding marketability discounts in New York statutory fair value matters based on a discussion of a range of cases, including Beway. His conclusion:
Marketability discounts have been and are likely to be repeatedly upheld.
While Mr. Weinstein indicated that his review of New York case law did not reveal any, or at least hardly any, rationale for the application of marketability discounts, he seemed to believe that the matter is so ingrained in case law that it will be difficult for the marketability discount to disappear.
Mr. Weinstein cited principles of New York law with respect to the valuation of businesses for statutory fair value purposes in New York:
- Value the corporation as an operating business, not one in liquidation. Blake Agency, Inc., 107 A.D.2d 139 (2nd Dept. 1985)
- Valuation is based on “the shareholder’s proportionate interest in a going concern. Friedman v. Beway Realty Corp., 87 N.Y.2d 161 (1995)
- Equal treatment of all shares of the same class of stock. Matter of Cawley v. SCM Corp., 72 N.Y.2d 465 (1988)
These principles were actually enumerated in Beway in a discussion primarily addressing the minority interest discount. I quoted the Beway guidance in a previous post. Having stated these valuation principles of New York statutory fair value law, all of which relate to the valuation of enterprises, Mr. Weinstein then pointed out that:
Whatever the method of valuation of an interest in a closely held enterprise, it should include consideration of any risk associated with illiquidity of the shares. (Citing Matter of Seagroatt Floral Company, Inc. 78 N.Y.2d 439 (1991), which is referenced in the later Beway case.)
Note that the italicized the in the quote above references the illiquidity of shares and not of the enterprise. Mr. Weinstein cited cases in which the marketability discount has been considered and/or upheld. He also pointed out that where the assets of corporations (or other entities) consist primarily of real estate, the New York courts have tended to limit the magnitude of the marketability discount. Nevertheless, the marketability discount is likely here to stay per Mr. Weinstein.
Let’s put Mr. Weinstein’s logic, which is driven by his analysis of cases, to a simple test by setting up a hypothetical statutory fair value situation. By the way, I am not at all picking on Mr. Weinstein. He provided an excellent summary of the current state of statutory fair value in New York in his presentation. His excellent summary does, however, provide a starting point for the following story.
A Hypothetical “Fair Value” Story
Seaway Corporation (“Seaway” or “the Company”) is an S corporation domiciled in New York. The Company operates a small chain of restaurants in New York City and is owned by a controlling owner (75%) and a minority owner (25%). The two owners were life-long friends and had invested in Seaway together more than a decade ago. Over time, they bought out the other owners and the ownership was as described at the time of this story.
Unfortunately,the two owners have had a falling out of major proportions over the future direction of the business. As a result, their friendship and the business were threatened. They did, however, have the common sense to call upon their long friendship to try to work things out so they could go their separate ways.
The following ensued:
- The controlling owner could have caused the corporation to engage in a “reverse stock split,” the effect of which is to “squeeze out” the ownership interest of the minority owner.
- The minority owner could then have perfected his right to dissent and to receive the “fair value” of his shares.
- Instead, the parties decided to try to work things out themselves along the lines of how such a legal solution might play out.
- The parties agreed, based on advice of qualified business appraisers (one of whom was me, so we know the value is reasonable!), that Seaway has a fair (market) value of $20 million at the financial control level of value. No minority discount was applied in deriving this value. Based on this conclusion, the minority owner’s 25% interest in Seaway has a fair value of $5 million and the controlling owner’s 75% share is worth $15 million.
- The minority owner is satisfied with this result and is willing to settle. Nevertheless, the majority owner has read Beway and raises the question about the applicability of a marketability discount.
There are no lawyers involved at this point. We have two businessmen who agree on the value of a business, and then one who raises a question based on case law. Neither of the owners are lawyers, but they both can read and have read Beway, which they have been told is the latest guidance from New York’s highest court.
The minority owner explains that the Company has been valued consistent with the guidance summarized above by Mr. Weinstein. The appraisers valued the Company as a operating business (i.e., a going concern) and not in liquidation, which is consistent with the first principle mentioned above. The result provides the shareholder’s proportionate interest in (the value of) a going concern, consistent with the second principle mentioned above. Finally, the allocation of value between the minority owner ($5 million) and the controlling owner ($15 million) provides equal treatment of all shares of the same class of stock, consistent with the third principle mentioned above.
Therefore, the minority owner says the negotiation is over. All he needs is his $5 million. The controlling owner again reiterates that there needs to be a marketability discount.
The minority owner then reads Beway more carefully and pulls out further guidance. He points out that the valuation and allocation of value is consistent with virtually all of the guidance of the case and concludes, specifically that the imposition of a marketability discount into this fair value determination would:
- Reduce the value of the minority interest below its investment value.
- Deny the minority interest its “proportionate interest in a going concern”
- Provide unequal treatment of the minority interest relative to the controlling interest
- Provide for minority shares being valued at less than the controlling shares
- Deny protection to the minority from being forced to sell at “unfair values” imposed by those dominating the corporation
- Shift “proportionate economic value of the corporation as a going concern from minority to majority shareholders”
- “..Imposes a penalty for lack of control and unfairly enriches the majority stockholders, who may reap a windfall from the appraisal process by cashing out a dissenting shareholder.”
The minority owner was convinced that his logic, that was driven by his careful reading of Beway, would carry the day. But the controlling owner insisted that Beway called for the imposition of a marketability discount.
The minority owner reflected on this and developed the following chart.
The minority owner showed this chart to the majority owner and explained that the imposition of any marketability discount greater than zero would shift value from him to the majority. This is clearly illustrated in the right-most column. The majority owner could not really argue with the simple logic of the table, but he reiterated that Beway appeared to require the application of a marketability discount.
The minority owner thought about this and looked at the table again. He concluded that he would, in accordance with the apparent guidance of Beway, accept a marketability discount. He told the majority owner that he would accept a marketability discount of 0%. The majority owner said, of course, that 0% was not a marketability discount at all, to which the minority owner said that the math worked just as well at 0% as it did at any other percentage. He observed that the decision to apply a 0% marketability discount was absolutely consistent with the logic that he read from Beway.
Since there were no lawyers involved, the majority owner had a difficult time arguing with the minority owner’s logic. He paid the proportionate share of the enterprise value of $20 million, or $5 million to the minority owner. The minority owner paid his taxes and reinvested the funds in another successful venture. Absent the disagreement between the two owners, Seaway grew and became even more successful.
Everyone is happy now. The former minority owner and the controlling owner have reestablished their friendship. Both are quite successful. The world is a beautiful place. And there was a marketability discount — of 0%.
[For more information on the topic, see “The Marketability Discount in Fair Value Proceedings: An Emperor Without Clothes?” by Peter Mahler that provides additional color to the topic of this post.]