October 2011

Statutory Fair Value: Courts Tackle DLOM, BIG Discounts and Burden of Proof

One of the most important and often overlooked aspects of a valuation engagement is the correct standard of value

COMMENT: Different standards of value implicitly assume different treatment of valuation discounts for lack of control and lack of marketability. It is therefore important for the valuation professional to understand the relevant standard of value given the purpose of the valuation engagement. Using the wrong standard of value could have a significant impact on the validity of the valuation conclusion. – Lynton Kotzin

From New York to Nevada, courts are still struggling to interpret the standard of value in statutory fair value determinations, including whether to include discounts for lack of marketability (DLOM) and for built-in capital gains (BIG), and which party bears the ultimate burden of proof. Expert appraisal evidence (or its absence) can prove critical to the courts’ ultimate conclusions of fair value.

In Giaimo v. Vitale, 2011 WL 1549064 (N.Y. Sup.)(April 25, 2011), a special referee determined the statutory fair value of a 50% interest in a family business that owned and operated 19 Manhattan apartment buildings. Although the referee declined to apply a marketability discount to the net asset value (NAV), he did accept a present value discount for BIG tax liability, based on expert evidence. After the trial court adopted the referee’s findings, both parties appealed the application of discounts to statutory fair value, which is unsettled in New York.

In particular, New York has not adopted the amendments to the Model Business Corporation Act (MBCA), which prohibit marketability and minority discounts in statutory fair value appraisals. Instead, New York courts determine fair value based on a going concern standard, which precludes a minority discount but should account for the shares’ illiquidity, the appellate court held. An expert can capture this risk through a marketability discount or the selection of a cap rate or even in the assessment of goodwill value. Thus, the court rejected the referee’s rationale for omitting a marketability discount but approved his ultimate conclusion of value, based on the inherent discretion in the standard and the “ample” evidence that similar properties were unavailable in the market and, therefore, a prospective buyer would have to purchase the property owned by the corporation.

Based on this same evidence, the court found a “sound legal and factual basis for the referee’s decision to reduce the BIG to present value” and rejected the argument that no BIG deduction should apply or, alternatively, that the court should make a dollar-for-dollar deduction. Although other jurisdictions might preclude a BIG discount unless there is evidence of an imminent sale, “New York follows the contrary view that it is irrelevant whether the corporation will actually liquidate its assets,” the court held.

Similarly, in Dawkins v. Hickman Family Corp., 2011 WL 2436537 (N.D. Miss.)(June 13, 2011), several dissenting shareholders requested a judicial dissolution and buyout of their nearly 40% combined interest in a family business that primarily owned farmland. Although the corporation declined to submit an appraisal, it presented an expert who determined that the NAV of the partnership was worth $225,000, after application of a BIG discount. The federal district court accepted this value, and the plaintiffs moved to reconsider the discount.

The court denied the request. Although state law precluded the application of minority and marketability discounts, the court held that “a tax adjustment must be taken into account” to determine “actual fair value of the shares.”. The current tax basis of the farmland was less than $20,000, creating a substantial liability on sale. “From even just a fairness standpoint, it only makes sense to include the built-in capital gains tax liability when valuing the corporation based on its assets,” the court emphasized, in confirming its original findings of fair value.

In American Ethanol, Inc. v. Cordillera Fund, LP, 2011 WL 1706823 (Nev.)(May 5, 2011), the Nevada Supreme Court faced an issue of first impression: Which party bears the burden of proving fair value under the applicable statute in a dissenting shareholder case?

Like New York’s, Nevada’s dissenting shareholder statute is patterned after the original MBCA, without the subsequent amendments that bar discounts. “Like other [MBCA] states, we conclude that, in determining fair value, the trial court may rely on proof of value by any technique that is generally accepted in the relevant financial community,” the court held, citing cases from Minnesota, Colorado, and New Jersey, “but the value must be fair and equitable to all parties.”

The court also noted that various jurisdictions place the burden of proving fair value on the corporation, the stockholder or neither. Delaware corporate laws, like Nevada’s, leave the ultimate determination to the trial court. Rather than imposing the “no burden” approach (as in New York, for example), Delaware courts require both sides to support their respective valuation positions “by a preponderance of the evidence,” the Nevada court explained, leaving the trial court to make independent determination. Since the Delaware approach accords with concepts of judicial fairness as well as economy, the Nevada court adopted its ”flexible” standard, finding in this particular case that the trial court did not err when it determined fair value according to the dissenting shareholders proof of a recent merger price plus SEC documentation of the same. ■

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