Dissenting Shareholders’ Challenge to Appraisal of Famed East End Resort Hits Dead End
November 30, 2020
Gurney’s Inn is an iconic oceanside resort located in Montauk, New York, on the eastern tip of Long Island’s South Fork affectionately known as “The End.”
The history and growth of Montauk over the last century — from small fishing village to summer hot spot catering to high-end, party-seeking New Yorkers — mirrors the transformation of Gurney’s from a modest 20-unit hotel opened in 1926 by a local resident to its current incarnation as luxury resort, spa and beach club owned by a private equity fund, featuring 109 rooms, suites, and beachfront cottages plus facilities for weddings, conferences, and other special events.
Gurney’s fortunes had faded under prior ownership when the property was operated for decades as a timeshare cooperative. According to a local news report, the resort “was plagued by high maintenance costs and special assessment fees, which led to a shareholder lawsuit against management. At the time, many owners decided to give up their units, leaving those who remained burdened with an ever-burgeoning share of the upkeep.”
In 2013, a supermajority of the remaining timeshare owners entered into an agreement (the “2013 MOU”) under which the new majority owner would invest tens of millions to renovate the resort which would cease operating as a timeshare cooperative after five years. At that point the timeshare owners’ shares would be sold either to a third-party purchaser or to the majority owner at a price based on an independent appraisal of the resort as a going concern plus a premium based on a percentage of gross sale proceeds in excess of $50 million.
In March 2018, again with approval by a supermajority of the timeshare owners, the majority owner completed the de-cooping process via merger and tender offer at $118.81 per share based on the $84 million valuation of the resort property as appraised by CBRE Hotels.
A small group of shareholders who had rejected the 2013 MOU, holding less than 1% of Gurney’s issued and outstanding shares, dissented from the merger and demanded to have the fair value of their shares judicially determined under Section 623 of the Business Corporation Law. This is the story of what happened next. Spoiler alert: it did not end well for the dissenters.
Gurney’s Commences the Appraisal Proceeding
In May 2018, Gurney’s filed a petition in Manhattan Supreme Court under the caption Matter of Gurney’s Inn Resort & Spa, Ltd., Index No. 154466/2018, for the judicial determination of the fair value of the dissenters’ shares as of March 28, 2018.
Referring to Gurney’s majority owner as “White Knight,” the petition accused the respondent shareholders of dissenting “in order to capitalize on continued investments and improvements by White Knight and the anticipated increase in profits and value that White Knight hopes will follow.” The respondents, it continued, “are entitled to receive only the fair value of their shares immediately preceding the merger. Respondents are not entitled to share in the potential future returns from an investment that they did not make.”
The dissenters filed an answer to the petition in which they shot back that CBRE’s appraisal not only substantially undervalued the hotel property, it also excluded the value of its other assets including service marks, government permits, development value of the land, goodwill or “brand” value, and net operating loss (“NOL”) carry forwards.
The Dueling Appraisals
Gurney’s relied on the $84 million CBRE appraisal prepared shortly before the merger. The dissenters relied on an appraisal report by HVS Valuation & Consulting which concluded a value of $115 million.
Both appraisals relied on the income approach using the discounted cash flow model with a 10-year forecast of income and expense. The HVS appraisal used 8% discount and 6% terminal capitalization rates compared to CBRE’s 8.5% and 6.5% rates.
The main driver of the difference between the two appraisals was the historical and projected EBITDA estimates. CBRE estimated EBITDA of $4.5 million in the base year of the merger — an increase of $2.2 million over actual 2017 EBITDA due in large part to the availability for rental of units previously used by timeshare owners — growing at a 3% annual rate to approximately $6.5 million in year ten. CBRE’s estimates used a uniform average daily rate (ADR) for all 109 rooms including the units formerly held by timeshare owners made available for rent after the merger.
HVS estimated a significantly higher EBITDA of approximately $6.2 million in the base year and $8.5 million in year ten. HVS arrived at its estimates by “normalizing” (re-calculating) the hotel’s 2017 revenues as if the remaining timeshare units were available for rental at an ADR significantly higher than the non-timeshare units, applying a 6% growth rate in the base year, and utilizing a higher ADR across the board in the base and subsequent years.
The addendum to HVS’s appraisal also presented a valuation matrix for the Gurney’s “brand” based on fees earned from affiliated resort properties located in Montauk and Newport, Rhode Island that licensed the Gurney’s name, with a midpoint value of $8.5 million.
The Trial Court’s Decision
The case was assigned to Manhattan Commercial Division Justice Barry R. Ostrager who conducted a two-day bench trial in December 2018 at which the only two witnesses to testify were the parties’ respective expert appraisers from CBRE and HVS.
Gurney’s post-trial memorandum urged the court to find that the resort’s value was $84 million and that the fair value of the dissenters’ shares, after deducting mortgage debt, was $94.93 per share. The dissenters’ memorandum urged the court to find that the value of Gurney’s as of the valuation date was $126.3 million consisting of $115 million for the land and hotel operations, $8.5 million for the Gurney’s brand, and $2.8 million for NOL carry forward tax benefits. It also called for calculation of per-share value using the formula in the 2013 MOU inclusive of a premium for the portion of the valuation exceeding $50 million.
Signaling the court’s direction, Justice Ostrager then asked each side to submit written answers to two questions: (1) “If the Court were to conclude, based upon the evidence, that the proper IRR [internal rate of return a/k/a discount rate] should be 8 percent and the terminal cap rate should be 6 percent, is it correct that using the discounted cash flow method the appropriate valuation of Gurney’s would be $115 million, excluding any additional sums the Court might award?” (2) “And, if that is so, what would be the price per share for the dissenters?”
In their respective answers to the judge’s queries, the dissenters answered “yes” to the first question whereas Gurney’s answered that the correct valuation using the suggested discount and cap rates was $85 million using the EBITDA figures in the CBRE report rather than what it contended were improperly inflated EBITDA figures in the HVS report.
As to the court’s second question, Gurney’s calculated a per-share value of $142.05 after deducting approximately $21.5 mortgage debt from the $115 million. The dissenters calculated a per-share value of $264.82 using the formula contained in the 2013 MOU inclusive of a premium for a sale in excess of $50 million. The dissenters further contended that the per-share value should increase to $320.34 inclusive of proposed values for the Gurney’s brand and NOL carry forward.
A few days later Justice Ostrager issued his decision, agreeing with the dissenters’ $115 million figure but disagreeing with their calculation of per-share value and instead adopting Gurney’s calculation of $142.05 per share. The decision found the testimony of the dissenters’ expert to be “more realistic than the testimony of Gurney’s appraiser” and the latter’s testimony “suspect” in regard to ADR based on higher room rates at an adjacent hotel property and “because Gurney’s appraiser did not appropriately value the potential average daily room rate for units that were subject to time shares in 2017.” The decision then summed up:
After considering all the testimony and voluminous documents admitted into evidence, as well as extensive briefing of the parties, the Court concludes that the consideration offered by Gurney’s to the dissenting shareholders ($84 million or $118.81 per share) does not reflect the fair value of the shares at issue. Rather, the Court holds that using the discounted cash flow model, the value of Gurney’s land and operations would be $115 million (which the Court calculates to be $142.05 per share). The Court declines to assign any value to the speculative post hoc claim for the value of Gurney’s trademark rights. Finally, under settled principles, the dissenting shareholders are entitled to interest from March 28, 2018 pursuant to BCL §623(h)(6) at the rate of 6 percent per annum, which approximates the rate which Gurney’s must pay for capital.
Both sides appealed from Justice Ostrager’s decision to the Appellate Division, First Department. The dissenters assigned a number of errors to the decision, including:
- The trial court’s failure to consider the value of several Gurney’s assets including cash, NOLs, and the Gurney’s trademark rights and brand.
- The trial court’s refusal to allow the dissenters to testify to the value of their own units.
- The trial court’s rejection of the dissenters’ proposed per-share allocation of the $115 million hotel property valuation based on formula used in the 2013 MOU.
Gurney’s appeal primarily challenged the trial court’s acceptance of HVS’s higher ADR inputs in its normalized historical and projected EBITDA estimates.
I won’t go into further detail of the arguments for the simple reason that the non-decretal portion of the Appellate Division’s decision earlier this month, in which it reversed Justice Ostrager’s decision and remanded the matter for a corrected award based on CBRE’s $84 million appraisal, merely consisted of the following three sentences:
The record does not support the court’s conclusion that the valuation of [Gurney’s] appraiser was “suspect” because it “did not appropriately value the potential average daily room rate for units that were subject to time shares in 2017” and that [HVS’s] appraisal was more “realistic.” Rather, [dissenters’] appraiser’s calculation of the potential average daily room rate resulted in a highly inflated valuation. We have considered [dissenters’] argument that the court made certain erroneous rulings that shortchanged them on fair value and find it unavailing.
For those who want to take a deeper dive into the arguments on appeal, here are links to the parties’ appellate briefs:
Did the Dissenters Misplay Their Hand?
20/20 hindsight makes it easy for an outside observer to say that the dissenters misplayed their hand by holding out for a bigger payday based on a “pie-in-the-sky” valuation using unsupported assumptions to boost Gurney’s EBITDA and an allocation of per-share value based on the 2013 MOU which the dissenters had rejected. The case record includes a pretrial offer by Gurney’s to settle the case for $160 per share, i.e., almost $20 higher than that awarded by Justice Ostrager and about $65 more than the likely $95 per-share calculation on remand based on the $84 million valuation.
What’s also perplexing about the case and the fact that it went all the way to trial and appeal, is the relatively small amount at stake. Shortly after they filed notices of dissent, as required by statute Gurney’s paid each dissenter 80% of the value of their shares based on CBRE’s $84 million valuation. The total amount of the collective judgment entered in favor of all the dissenters following trial (based on $142.05 per share), representing the unpaid portion of the merger consideration for their shares, was somewhere in the neighborhood of $225,000. If the $95 per-share value turns out to be the final number on remand, which is almost exactly 80% of the $118.81 tender offer, there should be little or no additional monies owed the dissenters.
Gurney’s was represented in the case by one of the largest law firms in the country. Its fees undoubtedly far exceeded the amount at stake. Was it irrational intransigence in the face of a well-heeled opponent that forced the case all the way to trial, appeal, and its adverse denouement for the dissenters?
That’s hard to say and perhaps unfair to the dissenters. From what I can tell from the court filings, it appears that counsel for the dissenters represented them on a contingent fee basis as a percentage of recovery in excess of the $118.81 tender offer plus any fees awarded by the court under the appraisal statute. From that perspective, I can understand the dissenters going for the ride on the assumption that the court would not conclude a value less than $118.81 and therefore it was risk free to them.