Basics of Valuation Proceedings – Litigating an Appraisal from Start to Finish – Part 1
July 09, 2018
Last month, seasoned business appraiser Andy Ross of Getty Marcus CPA, P.C., and I made a presentation at the Nassau County Bar Association about appraisal proceedings in business divorce cases. With the subject of business valuations front of mind, this article – the first in a three-part series – is a treetops summary of the rules governing how business owners may wind up in an appraisal proceeding. Later articles will address the legal and accounting principles that apply in the valuation proceedings.
But before we get started, some context. What exactly is a valuation proceeding? A valuation proceeding is a special kind of lawsuit in which the owners of a business litigate the “value” (the relevant standard under New York’s Partnership Law) or “fair value” (the standard under the New York Business Corporation Law and Limited Liability Company Law) of a partnership, stock, or membership interest in a business for the purpose of a potential buyout or liquidation of that owner’s interest. Appraisal proceedings may be forced, or they may be voluntary. They may involve a variety of different accounting approaches or methodologies to value an ownership interest. They are always heavily dependent upon expert testimony of accountants. For that reason, the “determination of a fact-finder as to the value of a business, if it is within the range of testimony presented, will not be disturbed on appeal where the valuation rests primarily on the credibility of the expert witnesses and their valuation techniques” (Matter of Wright v Irish, 156 AD3d 803 [2d Dept 2017]).
What are the ways in which a business owner can wind up in a valuation proceeding? The statutory paths, or routes, to a litigated appraisal depend on the kind of entity involved. This article discusses three basic entity forms: partnerships, corporations, and LLCs, and provides a non-exhaustive list of the most common ways to get to a valuation proceeding.
Statutory Routes to an Appraisal Proceeding Under the Partnership Law
Under the Partnership Law, there are two main ways to get to an appraisal proceeding.
The first is Partnership Law 69, which addresses “wrongful” withdrawal of a partner. Under Partnership Law 62, the default rule is that a partnership is “at will,” meaning that a partner can withdraw from the partnership at any time without breaching the partnership agreement. A partnership is “at will” where there is no partnership agreement establishing a “definite term” or “particular undertaking” for the business, or otherwise prohibiting withdrawal. Where the partnership is at will, upon the withdrawal of a partner, the partnership is dissolved by operation of law, the partnership must be wound up, assets liquidated, liabilities discharged, and surplus paid in cash to the partners. Where the partnership is not at will, however, and a partner withdraws, the withdrawal is deemed in “contravention” of the partnership agreement, and the non-withdrawing partners then have an option. Under Partnership Law 69, they can either (a) do nothing, in which case the partnership must be wound up or (b) elect to continue the business, either by themselves or jointly with others. If the remaining partners elect to continue the business, the partner who caused the wrongful dissolution shall “have the value of his interest in the partnership, less any damages caused to his copartners by the dissolution, ascertained” in an appraisal proceeding. The leading case on this route to an appraisal is the recent Court of Appeals decision Congel v Malfitano, 31 NY3d 272 (2018).
The second is Partnership Law 73, which addresses death or retirement of a partner. Under Partnership Law 62, the default rule is that death or retirement or a partner dissolves the partnership. Under Partnership Law 73, the non-deceased or non-retiring partners have an option, similar to Partnership Law 69, to continue the business, in which case the deceased or retired partner shall “have the value of his interest at the date of dissolution ascertained” in an appraisal proceeding. The leading case on this route an appraisal is Vick v Albert, 47 AD3d 482 (1st Dept 2008).
Statutory Routes to an Appraisal Proceeding Under the Business Corporation Law
Under the Business Corporation Law, there are at least four common ways one can wind up in an appraisal proceeding.
The first is a petition for dissolution based on “oppression” under BCL 1104-a and the corresponding “buyout election” under BCL 1118, which states that “[i]n any proceeding brought pursuant to [BCL 1104-a] any other shareholder or shareholders or the corporation may, at any time within ninety days after the filing of such petition or at such later time as the court in its discretion may allow, elect to purchase the shares owned by the petitioners at their fair value” in an appraisal proceeding. “Business Corporation Law 1118 is a corollary to section 1104-a. It grants non-petitioning shareholders, as well as the corporation itself, the right to avoid dissolution by timely electing to purchase the petitioning shareholder’s shares ‘at their fair value’” (Matter of Penepent Corp., 96 NY2d 186 ).
The second, also under BCL 1104-a, is the so-called “remedy short of dissolution.” Under BCL 1104-a, “once oppressive conduct is found, consideration must be given to the totality of circumstances surrounding the current state of corporate affairs and relations to determine whether some remedy short of or other than dissolution constitutes a feasible means of satisfying both the petitioner’s expectations and the rights and interests of any other substantial group of shareholders” (Matter of Kemp & Beatley, Inc., 64 NY2d 63 ). What this remedy typically means is an appraisal and buyout of the minority’s shares.
The third, also under BCL 1104-a, is the rule under Kemp & Beatley that “[e]very order of dissolution . . . must be conditioned upon permitting any shareholder of the corporation to elect to purchase the complaining shareholder’s stock at fair value.”
The fourth is the important dissenting shareholder appraisal proceeding under BCL 623. BCL 623 provides rights and procedures for a minority shareholders to “dissent” from certain corporate actions deemed potentially harmful to the minority and to “demand for payment of the fair value of his shares” in an appraisal proceeding. Kinds of corporate actions that trigger right to dissent and demand an appraisal under BCL 623 include:
- BCL 806 – changes to certain rights in certificate of incorporation
- BCL 905, 907, and 910 – various kinds of mergers
- BCL 913 – share exchanges
A frequent subject of this blog is the corporate “cash-out” or “freeze-out” merger. Under New York law, the consummation of a cash-out merger divests the former shareholder of all rights in the merged entity, including the right to sue derivatively, and renders his or her “sole” remedy an appraisal proceeding. In an appraisal proceeding, however, the shareholder can still litigate his or her derivative claims, to the extent they have an impact on fair value (see e.g. In the Matter of Carolina Gardens v Menowitz, Trial Order, Index No. 112637/1995 [Sup Ct, NY County Feb. 23, 1995]). BCL 623 (k) also contains an important exception to the exclusive appraisal remedy, allowing a dissenting shareholder to bring an “equitable action” outside of an appraisal proceeding to set aside the merger as “unlawful or fraudulent” as to that shareholder.
Statutory Routes to an Appraisal Proceeding Under the Limited Liability Company Law
Under the Limited Liability Company Law, there are three common ways one can wind up in an appraisal proceeding.
The first is member withdrawal under LLC Law 509, which provides that “upon withdrawal as a member of the limited liability company, any withdrawing member is entitled to receive . . . the fair value of his or her membership interest in the limited liability company as of the date of withdrawal.” The leading case on this route to an appraisal is Chiu v Chiu, 125 AD3d 824 (2d Dept 2015).
The second is judicial dissolution under LLC Law 702, and the corresponding, elusive, common-law LLC “equitable buyout.” “The Limited Liability Company Law does not expressly authorize a buyout in a dissolution proceeding. Nonetheless, in certain circumstances, a buyout may be an appropriate equitable remedy upon the dissolution of an LLC” (Mizrahi v Cohen, 104 AD3d 917 [2d Dept 2013]). In an equitable buyout, the court orders dissolution, but then gives one member (or group of members) an opportunity to buy out the other’s interest, usually after an appraisal, as an alternative to dissolution of the business and liquidation of its assets.
The third is cash-out mergers under LLC Law 1002. Unlike the corporate merger statute, with its “fraud or illegality” exception under BCL 623(k), an LLC member who dissents from an LLC merger under LLC Law 1002 “shall not have any right at law or in equity under this chapter to attack the validity of the merger . . . or to have the merger . . . set aside or rescinded.” Rather, the dissenting member’s sole remedy is “to receive in cash . . . the fair value of his or her membership interest” in an appraisal proceeding.
Contractual Routes to an Appraisal Proceeding
The Partnership Law, BCL, and LLC Law appraisal statutes are all default rules. Partners, shareholders, and members may opt out of the statutory default rules and agree to whatever procedures / formulas they like for valuation of an equity interest in a business upon death, disability, withdrawal, expulsion, etc. And where an agreement controls, the issue of valuation is not governed by statute (see e.g. Jacobs v Cartalemi, 156 AD3d 635 [2d Dept 2017] [“the issue of valuation of his membership interest upon withdrawal is not governed by Limited Liability Company Law 509, because WIC’s operating agreement includes a controlling provision”]).
Tune in next month for a summary of the legal rules, principles, and standards that apply in the valuation proceedings.