A Cross-Country Tour of Five Recent Stock Appraisal Cases
March 10, 2019
When it comes to business valuation principles in contested appraisal proceedings, I’d say the 50 states have far more in common than separates them. Certainly this is true in cases applying the fair market value standard deriving not from state law but from generally accepted appraisal doctrine as embodied in a number of IRS revenue rulings. But even in cases applying the statutory fair value standard, which is derived purely from state law governing buyouts in dissolution and dissenting shareholder proceedings, there is much to be learned by examining cases from other states.
Below I’ve selected five recent business valuation cases decided by appellate courts in five different states. Not surprisingly, the main area of dissension in four of the five cases concerns the applicability of discounts under both statutorily and contractually imposed standards of value. Each case contributes a little bit to our understanding of how courts and appraisers grapple with the difficulty of placing values on interests in closely held business entities for which no ready market exists.
Louisiana: Court Distinguishes “Fair Value” from “Fair Market Value” in Refusing to Tax-Effect S Corporation’s Accounts Receivable
Last month, in Kolwe v Civil and Structural Engineers, Inc., No. 18-398 [Ct. App. La. Feb. 21, 2019], an intermediate Louisiana appellate court upheld a trial court’s determination of the statutory fair value of a one-third stock interest in a professional engineering firm that elected pass-through taxation as an S corporation. Both sides’ experts used a net asset value approach. The company challenged the lower court’s $871,000 award principally on the ground that the company’s accounts receivable should have been tax-effected to reflect the tax liability that would accrue on their collection.
Before deciding the issue, the court took what it considered a necessary detour into the meaning of “fair value” as used in the shareholder oppression statute included in Louisiana’s revised Business Corporation Act adopted in 2015 and, in particular, “to distinguish the colloquial usage of fair market value from that of the legal definition of fair value.”
Why the detour? Because the company’s position, as construed by the court to require valuation under the hypothetical buyer standard, essentially converted the statute’s fair value standard to a fair market value standard by ignoring the legislature’s express prohibition on marketability and minority discounts and by its elimination of oppression as ground for dissolution with the possibility of a buyout election (“dissolution unless buyout”) in favor of a provision requiring a buyout unless the corporation elects to dissolve (“buyout unless dissolution”). The company’s argument, the court noted,
illustrates the common, yet erroneous, injection of fair market value principles into the legal definition of fair value where the valuation difference between these two approaches is equivalent to the amount, and, thus, the applicability, of discounts.
The court’s analysis ultimately led to its rejection of the company’s expert’s argument for tax-effecting accounts receivable, i.e., that a hypothetical third-party purchaser of the company would demand a discount for future taxes on accounts receivable regardless that taxes are incurred at the shareholder level. Rather, the court held that the lower court did not commit error in accepting the plaintiff’s expert’s argument that, because the company itself will not assume any future tax liability in purchasing the plaintiff’s shares, the plaintiff “will remain liable for his share of the corporation’s tax liability for as long as he remains a shareholder and receives a K-1 reporting them.”
Georgia: Stock Redemption Agreement’s “Current Value” Pricing Provision Excludes Minority Discount
Wallace v Wallace, 813 S.E.2d 428 [Ct. App. Ga. 2018], involved the application of a provision in the shareholders’ agreement that compelled the company’s redemption of shares “for a purchase price equal to the current value” upon the termination of employment of a shareholder. The valuation-related issues on appeal were whether the lower court erroneously used a 1994 valuation date (the company’s position) instead of 2003 (the terminated shareholder’s position) and whether the lower court erroneously applied a 15% minority discount (the company’s position) instead of no discount (the terminated shareholder’s position).
The terminated shareholder prevailed on both issues. As to the minority discount, even though the shareholders’ agreement did not specify a fair value standard, the appellate court found “persuasive” the “logic” of statutory stock appraisal cases under the fair value standard, generally awarding a shareholder a proportional interest in the corporation valued as a whole rather than the value of the shareholder’s shares when valued alone. Said the court: “Where, as here, the stock involves a small, family-owed business, with little marketability, the value of the shares necessarily accounts for the minority interest without further reduction.”
If you’re looking to invite future litigation over a shareholder buyout, you can’t do much better than using the undefined term “current value” as the sole pricing mechanism. The only surprising thing about Wallace is that there weren’t more disputed valuation issues reflected in the appeal.
West Virginia: Court Sustains Jury’s Valuation Award Excluding Marketability and Minority Discounts Under Stock Redemption Agreement’s Fair Market Value Standard
Tri-State Petroleum Corp. v Coyne, 814 S.E.2d 205 [Sup. Ct. App. W. Va. 2018], is another dispute involving the mandatory redemption of interests in affiliated family-owned businesses, this time with agreements expressly requiring determination of the shares’ fair market value. A jury awarded the terminated shareholder (Kevin) over $5 million based on the valuation calculated by his expert appraiser. On appeal, the companies argued that, contrary to the agreements, Kevin’s expert opined regarding fair value and not fair market value.
The appellate panel disagreed and affirmed the award. Reviewing the trial evidence in the light most favorable to Kevin as the prevailing party, the court held that the jury in this “classic battle of the experts” was entitled to credit Kevin’s expert’s testimony that marketability and minority discounts, while normally considered under the fair market value standard, “should not be applied on the facts of this case because deposition testimony demonstrated that the siblings did not intend to sell their interests for at least ten years, so ‘if nobody else is going to suffer those . . . discounts at any point in time, then you wouldn’t have [Kevin] suffer those discount.’”
Sound familiar? It should if you’re familiar with the Zelouf case previously featured on this blog.
Alaska: Court Rejects Challenge to Appraisal Panel’s $54 Million Valuation of Realty Holding Company Based on Claimed Failure to Value Entire Business as Going Concern
In Ivy v Calais Co., 397 P.3d 267 [Sup. Ct. Ak. 2017], a 6.25% shareholder (Ivy) of a realty holding company sued for dissolution, resulting in a settlement buyout agreement based on the statutory “fair value” of the shares to be determined by three appraisers. The Alaska statute incorporated by reference in the agreement requires determination of fair value “on the basis of liquidation value, taking into account the possibility of sale of the entire business as a going concern in a liquidation.”
On remand from a prior appeal, the three appraisers summed up the individual property values of the company’s real estate holdings to arrive at a cumulative market value over $87 million, from which they subtracted liquidation costs and capital gains taxes and accounted for other assets and liabilities to reach a final fair value of $54 million.
The trial court subsequently overruled Ivy’s objections to the appraisers’ determination of fair value. Ivy then appealed to the Alaska Supreme Court, arguing that the appraisers never considered the possibility of a sale of the company as a going concern and “must have” failed to carry out their “‘contractually assigned task’ because they reached (according to Ivy) an inaccurate valuation.” The Supreme Court disagreed, finding no direct evidence in the record to support Ivy’s assertion and refusing to substitute its judgment for that of the expert appraisers.
Pennsylvania: Stock Redemption Agreement’s “Adjusted Net Book Value” Provision Permits Marketability and Minority Discounts
In Hornberger v Dave Gutelius Excavating, 176 A.3d 939 [Pa. Super. Ct. 2017], a minority shareholder in an excavation construction business brought suit challenging the company’s valuation of his shares under the stock redemption provisions of a shareholder agreement. The provision calculated price based on the company’s “Adjusted Net Book Value” as determined by the company’s independent CPA subject to three adjustments: (1) no allowance for goodwill or trade name, (2) accounts receivable and payable to be taken at face amounts less specified discounts, and (3) all real and personal property to taken into account at fair market value.
At trial, the sole area of disagreement between the opposing appraisal experts was the company appraiser’s application of marketability (5%) and minority (30%) discounts. The plaintiff’s expert contended that the agreement’s listing of the three mandated adjustments was exclusive and did not permit further adjustments for discounts. The company’s expert countered that adjusted net book value “is a fair market value method” and that “it is customary in the accounting industry to apply discounts for lack of marketability and minority interest.” The trial judge, observing that the agreement “qualified” but did not “define” the phrase “adjusted net book value,” held that the discounts applied as “the standard, the normal and accepted practices within the industry.”
On appeal to the Superior Court, the panel agreed with the lower court, reasoning that under the agreement, “the valuation, by its terms, is an adjustment to book value based on the expertise of [the company’s] CPAs.” As the court further explained:
No one disputes that adjustments for minority interest and lack of marketability are consistent, as a general matter, with expert valuation methodologies. The Agreement then provides that the application of that expertise is “subject to the following provisions,” which address good will, accounts payable and receivable, and the valuation of real and personal property. The listing of three types of adjustments that [the company’s] accountants must make cannot reasonably be understood to preclude the application of any other adjustments that valuation experts would ordinarily make. Indeed, the structure of the relevant provision calls on [the company’s] CPAs to determine the value of the shares, which presumptively calls for the exercise of their professional judgment, and only then mandates the application of particular adjustments. While the parties could have contracted to exclude other adjustments, they did not do so here.
The passage’s last sentence says it all: if parties to a buy-sell or stock redemption agreement want to exclude discounts in pricing the interest, make it explicit in the agreement. Otherwise, when a purchase event occurs years later pitting the buyer’s financial interests squarely against those of the seller, well, then you get cases like Hornberger and the Wallace case discussed above.