Delaware Chancery Court Rulings Address Valuation and Insolvency Disputes
January 15, 2018
The steady flow and scholarly character of Delaware Chancery Court opinions in company valuation contests provide an important resource and learning tool for business divorce practitioners, appraisers, and judges in New York and elsewhere.
Over the years, I’ve reported on a number of Chancery Court decisions in statutory fair value cases arising from dissenting shareholder proceedings. In this post, I highlight two recent post-trial opinions by Vice Chancellors Sam Glasscock (photo left) and Tamika Montgomery-Reeves (photo right) addressing valuation and what I’ll call quasi-valuation in more atypical settings.
In the first case, Vice Chancellor Glasscock applied a fair value standard to resolve a buy-out settlement agreement between ex-spouses who co-owned two operating companies and a real estate holding company. In the second case, Vice Chancellor Montgomery-Reeves determined whether a biotechnology start-up company was insolvent for purposes of appointing a receiver under Section 291 of the Delaware General Corporation Law.
VC Glasscock’s Fair Value Determination in Wright v Phillips
Wright v Phillips, C.A. No. 11536-VCG [Del Ch Dec. 21, 2017], is another one of those cases that underscores the perils of not having a buy-sell agreement when married business partners decide to remain co-owners following their divorce.
The petitioner/ex-wife and respondent /ex-husband in Wright each owned 50% of two companies that shred and recycle waste materials. They also were co-equal owners of a single asset real estate company that held the property on which the other two companies operated.
The parties continued to jointly run the profitable businesses following their divorce in 2013. A few years later, following some sort of impasse, the petitioner sued her ex-husband for breach of fiduciary duty and seeking his exclusion from the affairs of the business. The parties thereafter entered a settlement agreement under which the ex-husband agreed to acquire the petitioner’s 50% interests at a value to be determined by the court.
The petitioner’s expert business appraiser concluded the combined value of the two operating businesses at $1,359,000 versus the $1,155,000 combined value concluded by respondent’s expert business appraiser. The gap stemmed largely from (1) an S corporation premium applied by petitioner’s expert and disputed by the respondent’s expert, (2) a 20% marketability discount, including a 10% brokerage discount, applied by respondent’s expert and disputed by petitioner’s expert, and (3) petitioner’s expert’s addition of certain “synergies” of the transaction to overall value, also disputed by respondent’s expert.
As to the realty company, the petitioner relied on a 2015 bank appraisal of the property prepared by an independent, accredited realty appraiser, which averaged a comparable sales method and an income approach to conclude the property was worth $1.4 million before deducting the $855,000 mortgage liability. The respondent relied on a value estimate of $1.1 million prepared by a commercial real estate agent based solely on comparable sales analysis.
VC Glasscock initially determined that,
[b]ecause Petitioner, via agreement, has agreed to give up, and the Respondent has agreed to purchase, an interest in a going concern (the business or businesses represented by the three entities), a fair value analysis by analogy to Section 262 [dissenting shareholder] appraisal valuation is appropriate here. This requires me to determine the fair value of the three entities as going concerns as of the time of the transfer, using recognized valuation techniques.
On the issue of tax affecting, and relying on the oft-cited decision by then-Vice Chancellor Strine in MRI Radiology v Kessler, VC Glasscock agreed with the Petitioner that the operating companies’ status as S corporations “adds value beyond that of a Delaware C corporation.” The additional value in Wright was $204,000 resulting from application of an individual tax rate of 14.5% instead of a C corporation rate of 31%.
On the issue of marketability discount, VC Glasscock found that
a lack of marketability is part of the operative reality of the entity, half of which is being purchased by the Respondent and sold by the Petitioner here. While this court-enforced sale does not involve marketing the businesses, a lack of marketability is inherent in the property the Petitioner owns, and not accounting for such would result in a windfall here.
VC Glasscock nonetheless rejected as “too speculative to be justified” the Respondent’s expert’s inclusion of a 10% brokerage discount as part of his proposed 20% marketability discount, thus reducing it to 10%.
VC Glasscock also rejected as too speculative the Petitioner’s expert’s calculation of additional, synergistic value based on an amount of income attributed to the removal of the Petitioner as a principal of the companies, given the “little detail” in the record “about how the Petitioner’s compensation is determined, the exact nature of the compensation, or what she was ‘paid’ for.”
As to the property holding company, VC Glasscock accepted as the more credible analysis the $1.4 million valuation prepared by the independent bank appraiser. In particular, the court found that “the addition of the income generation valuation method used in the [bank appraisal] makes it more likely an accurate indicator of the value of the [realty] than the [realtor agent’s] estimate.”
Subject to the adjustments ordered in his ruling, VC Glasscock determined the pre-adjustment combined value of the three companies to be about $1.77 million, with a pre-adjustment half interest value of about $884,000.
VC Montgomery-Reeves’ Insolvency Determination in In re Geneius Biotechnology, Inc.
In re Geneius Biotechnology, Inc., C.A. No. 2017-0297-TMR [Del Ch Dec. 8, 2017], is something of a quasi-valuation case, centering on the question whether the subject biotechnology start-up company met the “insolvency plus” test applied by Delaware courts in deciding applications for appointment of a receiver under DGCL § 291.
Under the “insolvency plus” standard, the petitioner must show (1) by clear and convincing proof that the company is insolvent at the time the petition was filed, and (2) the necessity of a neutral third party to protect the insolvent company’s creditors or shareholders by showing some benefit that such an appointment would produce or some harm it could avoid.
A § 291 petitioner can establish insolvency in the receivership context by showing either (1) that liabilities exceed assets, with no reasonable prospect that the business can be successfully continued, or (2) the company is unable to meet maturing obligations as they become due in the normal course of business.
In Geneius, VC Montgomery-Reeves analyzed both prongs of the insolvency component of the test, and in both instances found that the petitioning minority shareholder came up short. Under the first prong, after finding with little trouble that the company’s liabilities totaled $605,000, she turned to the “more onerous task” of determining the value of the company’s assets which included intellectual property (i.e., a pending patent application), a small amount of cash, lab equipment and other fixed assets, and certain research funds and lab materials/reagents.
I’ll spare you the details. Essentially, VC Montgomery-Reeves ruled that “the flaw in Petitioner’s approach to this entire case” was its misguided attempt to shift the burden of proof to the respondent while failing to present any competent evidence of its own of asset value. “Having failed to provide any evidence of value of the assets or to sufficiently rebut Respondent’s evidence of the value of the assets,” the court wrote, “I conclude that Petitioner has not met its burden of proof by clear and convincing evidence that the Company’s liabilities exceed its assets.”
VC Montgomery-Reeves also found that the petitioner failed to satisfy the “plus” component of the “insolvency plus” standard, based on unrefuted evidence that the company’s board had potential alternative strategies to obtain financing, such as a rights offering and reverse merger, that undermined any showing that any assumed insolvency was “irretrievable.”
The court similarly found that the petitioner failed to carry its burden to establish cash flow insolvency. The respondent’s principal, Dr. Alfred Slanetz, testified that, notwithstanding the company’s lack of cash to pay off all of its outstanding invoices, it was able to “pay all the invoices required to run the business and keep it moving forward on an ongoing basis.” He also testified as to his willingness personally to make interest-free loans to the company and to cover its travel and other business expenses with no expectation of repayment until the company is sufficiently healthy. Wrote VC Montgomery-Reeves:
Petitioner could have tested the veracity of Slanetz’s testimony of such payment plans either on cross-examination or through vendors; Petitioner made the strategic decision not to do that. I have no reason not to accept Slanetz’s testimony on this.
DGCL § 291 has no direct counterpart in New York’s Business Corporation Law. New York practitioners nonetheless can draw guidance from the Chancery Court’s insolvency analysis in other contexts, such as appointment of a receiver at the behest of a judgment creditor under CPLR § 5228, and potentially under the financial infeasibility prong of the test for judicial dissolution of LLCs under LLC Law § 702.