Statutory Fair Value in New York | 2012 | Mercer Capital

1Presented by Z. Christopher Mercer, ASA, CFA, ABAR, Mercer Capital, to the 2012 Business Valuation Conference of the New York Society of CPAs. May 21, 2012. © Mercer Capital 2012. Reproduction prohibited unless authorized by Mercer Capital. | 901.685.2120 | www.mercercapital.com

Shareholder Litigation in New YorkZ. Christopher Mercer, ASA, CFA, ABARMERCER CAPITAL901.685.2120 » [email protected] » linkedin.com/in/zchristophermercer

New York State Society of CPAs Business Valuation ConferenceMay 21, 2012


Contents of Presentation

Chris Mercer & Statutory Fair Value Experience

Statutory Fair Value Defined in New York

The Standard of Value

The Levels of Value

Judicial Guidance re the Levels of Value in Beway

The Marketability Discount

Matter of Giaimo

Questions // Comments

Built In Capital Gains

Implied Minority Interest Discount in Delaware


Z. Christopher Mercer, ASA, CFA, ABAR

Chris Mercer is the founder and CEO of Mercer Capital, a national business valuation and financial advisory firm.

Chris began his business valuation career in the 1970s and has prepared, overseen, or contributed to more than a thousand valuations for purposes related to mergers & acquisitions, litigation, and estate and gift tax planning, among others.

Chris has extensive experience in litigation engagements including statutory fair value cases, business damages, and lost profits. He is also an expert in buy-sell agreement disputes.

In 2011, Chris was appointed to the International Valuation Professional Board of the International Valuation Standards Committee (IVSC). The role of the International Valuation Professional Board is to promote the development of the valuation profession globally.

Designations held include Accredited Senior Appraiser (ASA) from the American Society of Appraisers, Chartered Financial Analyst (CFA) from the CFA Institute, and Accredited in Business Appraisal Review (ABAR) from the Institute of Business Appraisers.

Chris is a prolific author on business valuation-related topics and a frequent speaker on business valuation issues for national professional associations and other business and professional groups.

Recent books authored by Chris include Buy-Sell Agreements for Closely Held and Family Business Owners (Peabody Publishing, LP 2010) and Business Valuation: An Integrated Theory, 2nd Edition, with Travis W. Harms, CFA, CPA/ABV (John Wiley and Sons 2008).

For a complete list of the books authored by Chris, as well as further information on his valuation-related experience, view his complete CV at www.mercercapital.com.

Z. Christopher Mercer, ASA, CFA, ABARCEO, Mercer Capital

[email protected]

Linkedin.com/in/zchristophermercerwww.ValuationSpeak.comwww.MercerCapital.com


Z. Christopher Mercer, ASA, CFA, ABAR

Statutory Fair Value

My first three testimonies were in statutory fair value determinations (1981, 1983)

20% of testimonies, at deposition or trial, have been on statutory fair value matters over the last 30 years (testified at trial 16 times in 10 different states)

» 16 times for shareholders

» 7 times for companies

» Court-appointed three times

Very little written on Statutory Fair Value in Business Appraisal Literature

Series on Statutory Fair Value on my blog: www.ValuationSpeak.com

Please ask me to connect with you on LinkedInhttp://www.linkedin.com/in/zchristophermercer


Z. Christopher Mercer, ASA, CFA, ABARDeposition and trial testimony

Fair Value MattersTRIAL

TESTIMONY

Arkansas

Colorado

Kansas

Minnesota

Mississippi

Missouri

New York*

Tennessee

Texas

Alabama

Alabama (Arbitrator)

DEPOSITION TESTIMONY

Alabama

Arkansas

Colorado

Kansas

Illinois

Minnesota

Mississippi

Missouri

Nevada

Tennessee

Texas

West Virginia

Other MattersTRIAL

TESTIMONY

Arkansas

Florida

Georgia

Hawaii

Kansas

Minnesota

Missouri

Mississippi

North Carolina

Oklahoma

Tennessee

Texas

Utah

Washington, D.C.

Alabama

Arkansas

California

Colorado

Delaware

Georgia

Hawaii

Kansas

Kentucky

Louisiana

Mississippi

Missouri

Montana

Nebraska

New Jersey

North Carolina

Ohio

South Carolina

Tennessee

Texas

Utah

Washington, D.C.

DEPOSITION TESTIMONY

*Matter of Giaimo Matter of Jack Alpert, et al.



Statutory Fair Value Defined – New York§ 623. Procedure to enforce shareholder's right to receive payment for shares

§ 623 (h) (4).» The court shall determine whether each dissenting shareholder, as to whom the corporation

requests the court to make such determination, is entitled to receive payment for his shares. If the corporation does not request any such determination or if the court finds that any dissenting shareholder is so entitled, it shall proceed to fix the value of the shares, which, for

the purposes of this section, shall be the fair value as of the close of business on the day prior to the shareholders' authorization date. In

fixing the fair value of the shares, the court shall consider the nature of the transaction giving rise to the shareholder's right to receive payment for shares and its effects on the corporation and its shareholders, the concepts and methods then customary in the relevant securities and financial markets for determining fair value of shares of a corporation engaging in a similar transaction under comparable circumstances and all other relevant factors. The court shall determine the fair value of the shares without a jury and without referral to an appraiser or referee. Upon application by the corporation or by any shareholder who is a party to the proceeding, the court may, in its discretion, permit pretrial disclosure, including, but not limited to, disclosure of any expert's reports relating to the fair value of the shares whether or not intended for use at the trial in the proceeding and notwithstanding subdivision (d) of section 3101 of the civil practice law and rules.


Standard of Value» What is a “standard of value”?

A standard of value provides a foundation for constructing an appraisal

Standards of value include, among others, fair market value and fair value

» The standard of value in this appraisal is “fair value”

New York State Limited Liability Company Law §509 uses the term “fair value” to determine the purchase price in applicable LLC litigation

The statutes do not define fair value and provide limited guidance re how to apply in appraisal proceedings


Standard of Value Levels of Value

» “Level of value” concept defines the kind of value for appraisals

» Fair value determinations must be rendered in the context of the appropriate “level of value”

Necessary to define an appraisal Provides framework for organizing an appraisal of securities consistent with the

assignment Provides basis for selection of valuation methods that reach a value consistent

with the selected level of value

» Fair value ultimately defined in relationship to the “levels of value” Premiums and discounts mentioned in many court cases are (direct and indirect)

references to the “levels of value” used by appraisers Appraisers can provide opinions of fair value consistent with the appropriate

level(s) when specified Differing interpretations re level of value can create wide swings in conclusions of

appraisers Court ultimately must decide on appropriate level of value


Traditional Levels of Value

Control Value The control value refers to the value of the enterprise as a whole

Marketable Minority Interest

Value

The marketable minority interest value refers to the value of a minority interest that lacks control but enjoys the benefit of liquidity as if it were freely tradable in an active market

Nonmarketable Minority Interest

Value

The nonmarketable minority interest value refers to the value of a minority interest that lacks both control and market liquidity


Traditional Levels of Value

Control Premium

Control ValueThe control premium is the additional amount that an investor would pay to acquire control of a firm versus a publicly traded minority interest in that company

Marketable Minority Interest Value

The minority interest discount is the decrement to value owing to the fact that the holder of a minority interest cannot exercise control over the firm

Nonmarketable Minority Interest

Value

The marketability discount relates to the decrement to value, versus the marketable minority interest value, that arises because no liquid trading market (such as the NYSE) exists for the subject firm’s shares

Minority Interest Discount

Marketability Discount

Appraisers refer to valuation discounts and premiums, which are based on relationships between the levels of value


Levels of Value» The appropriate level of value in a fair value matter involves

a legal interpretation

Legal counsel for Mr. Winston Chiu provided guidance

Based on legal counsel’s interpretation of applicable New York statutory law, a controlling interest value is appropriate

In context of current levels of value charts, this represents value at the financial control level of value

Valuation premiums and discounts

» No minority interest discounts applied

» Consistent with Beway, marketability discount considered- 0% marketability discount applied


Judicial Guidance re Levels of Value in Beway

» After discussing the background of the case the Court of Appeals provided two sections of guidance regarding fair value upon which it would base its ultimate rulings.

» We analyze this guidance from business and valuation perspectives in the following slides and discuss this guidance in the context of the levels of value charts employed by appraisers and (explicitly or implicitly) by courts.



» “Several principals have emerged from our cases involving appraisal rights of dissenting shareholders under Business Corporation Law § 623 or its predecessor statute

(1) The fair value of a dissenter’s shares is to be determined on their worth in a going concern, not in liquidation, and fair value is not necessarily tied to market value as reflected in actual stock trading. The purpose of the statue being to save the dissenting stockholder from loss by reason of the change in the nature of the business, he [or she] is entitled to receive the value of his [or her] stock for sale or its value for investment.” (italics in original, emphasis added)


Value of Stock for Sale or Its Value for Investment

When actual stock trading is not appropriate for determination of fair value, it is most often because the market is not active and actual transitions are influenced by adverse policies of controllers, limited or no access to distributions, and an inability to obtain liquidity. There are two implications here. First, no minority discount would appear to appropriate. Second, no marketability discount would be appropriate. Since we know that Beway considers a marketability discount, we will continue this analysis.

Language here is consistent with determining fair value in New York at the Financial Control Level




(2) The three major elements of fair value are net asset value, investment value and market value. The particular facts and circumstances will dictate which element predominates, and not all three elements must influence the result.”


The Old “Delaware Block” Concept

This is a recitation of the old “Delaware Block” concept. In Delaware, at least, this has been replaced (since Weinberg) with a consideration of all relevant factors and allowing the use of discounted cash flow. Nevertheless, the Delaware Block was an enterprise concept, taking into account the value of a business as a going concern.


» “Several principals have emerged from our cases involving appraisal rights of dissenting shareholders under Business Corporation Law §623 or its predecessor statute

(3) Fair value requires that the dissent stockholder be paid for his or her proportionate interest in a going concern, that is, the intrinsic value of the shareholder’s economic interest in the corporate enterprise.”



Proportionate Interest in Going Concern / Intrinsic Value

This statement is fairly clear that, given the value of the business as a going concern, fair value is the shareholder’s proportionate interest of that value.

This would suggest that there would be no minority interest discounts and no marketability discounts, since the statement refers again, to a Financial Control Level of Value.




(4) Not Applicable (5) Determinations of the fair value of a dissenter’s shares are

governed by the statutory provisions of the Business Corporation Law that require equal treatment of all shares of the same class of stock.”


Equal Treatment of All Shares of Same Class

Language here is consistent with determining fair value in New York at the Financial Control Level. The majority owner’s shares are worth the Financial Control Value. The only way for this to hold is for there to be no minority discount and no (or zero percent) marketability discount.



» “…[I]n fixing fair value, courts should determine the minority shareholder’s proportionate interest in the going concern value of the corporation as a whole, that is, ‘what a willing purchaser, in an arm’s length transaction, would offer for the corporation as an operating business.”

Court of Appeals of New York offers guidance re valuation interpretation of fair value in New York


Willing Purchaser, Arm’s Length, Offers for Corporation as Operating Business

This language contemplates, that in determining fair value, appraisers should determine value analogous to the price that would be determined in a real transaction for the entire corporation as an operating business

A hypothetical sale of the business is contemplated (just as in fair market value determinations)

Language synonymous with Financial Control Level of Value




» “Imposing a discount for the minority status of the dissenting shares here, as argued by the corporations, would in our view conflict with two central equitable principles of corporate governance we have developed for fair value adjudications of minority shareholder interests under Business Corporation Law § 623 or 1118. A minority discount would necessarily deprive minority shareholders of their proportionate interest in a going concern, as guaranteed by our decisions previously discussed. Likewise, imposing a minority discount on the compensation payable to dissenting stockholders for their shares in a proceeding under Business Corporation Law § 623 or 1118 would result in minority shares being value below that of majority shares, thus violating our mandate of equal treatment of all shares of the same class in minority stockholder buyouts.”



Minority Discount Violates Proportionate Interest in a Going Concern and Equal Treatment

Guidance is consistent with that of numerous other jurisdictions in stating that application of a minority interest discount is not consistent with fair value in New York

Language is synonymous with Financial Control Level of Value




» The next paragraph actually discusses a valuation approach “taking into account the unmarketability of the corporate stock.”

Address this paragraph in the discussion of the appropriate marketability discount.




» “A minority discount on the value of dissenters’ shares would also significantly undermine one of the major policies behind the appraisal legislation embodied now in Business Corporation Law §623, the remedial goal of the statute to ‘protect’[] minority shareholders ‘from being forced to sell at unfair values imposed by those dominating the corporation while allowing the majority to proceed with its desired [corporate action]’”



No Unfair Values Imposed by Controllers of Corporation

This guidance suggests that corporate earnings should be normalized to eliminate the financial impact of actions on part of controllers that would diminish value to dissenting shareholders (this is done in real estate appraisals as standard practice)

Language synonymous with Financial Control Level of Value




» “This protective purpose of the statute prevents the shifting of proportionate economic value of the corporation as a going concern from minority to majority stockholders. As stated by the Delaware Supreme Court, ‘to fail to accord to a minority shareholder the full proportionate value of his [or her] shares imposes a penalty for lack of control, and unfairly enriches the majority stockholders who may reap a windfall from the process by cashing out a dissenting shareholder.’”



No Shifting of Economic Value from Minority to Majority

» Once again, this guidance calls for fair value to be determined at the Financial Control level of Value. If it were not so, then the controllers would be “unfairly enriched.”

» The guidance suggests, in essence, that 100% of the cash flows of the enterprise should be used in the determination of “the economic value of the corporation as a going concern.”




» “Furthermore, a mandatory reduction in the fair value of minority shares to reflect their owners’ lack of power in the administration of the corporation will inevitably encourage oppressive majority conduct, thereby further driving down the compensation necessary to pay for the value of the minority shares.”



Minority Discount Encourages Oppressive Majority Conduct

Once again, this guidance calls for fair value to be determined at the Financial Control Level of Value. If it were not so, then the controllers would benefit from their “oppressive majority conduct” and therefore, again, be “unfairly enriched.”

This guidance suggests, in essence, that the cash flows of the enterprise should be normalized to account for any “oppressive majority conduct.” If it were not so, then value would be driven down to the benefit of the controllers.

This guidance, in light of the further guidance regarding marketability discounts, underscores the Beway court’s misunderstanding of the causes of marketability discounts (understandable in light of the evidence presented)




» “We also note that a minority discount has been rejected in a substantial majority of other jurisdictions. ‘Thus, statistically, minority discounts are almost uniformly viewed with disfavor by State courts’. The imposition of a minority discount in derogation of minority stockholder appraisal remedies has been rejected as well by the American Law Institute in its Principles of Corporate Governance.”



Other Jurisdictions Reject Minority Discount

Beway was published in 1995. It is true, based on my experience, that most jurisdictions have rejected the use

of minority discounts, and this is true in 2011. What is also true, again, based on my experience, is that most jurisdictions have also rejected the use of marketability discounts.

Nevertheless, the “rejection” of a minority interest discount places value at the Financial Control Level of Value.



Discount for Lack of Marketability (aka Marketability Discount)

» Beway – Court of Appeals of New York fair value advice continues

Confusing language in Beway regarding illiquidity or unmarketability

“McGraw’s technique was, first, to ascertain what petitioners’ shares hypothetically would sell for, relative to the net asset values of the corporations, if the corporate stocks were marketable and publicly traded; and second, to apply a discount to that hypothetical price per share in order to reflect the stock’s actual lack of marketability.”

McGraw’s valuation technique was clearly a minority interest technique.

» Application of marketability discount based on reference to restricted stock studies derives a shareholder level value and presumes the inclusion of any minority interest discount (the court agreed, at least in part)

» This apparently was not evident to the court in Beway


Marketability Discount» “An amount or percentage deducted from the value of an

ownership interest to reflect the relative absence of marketability.”

- ASA Business Valuation Standards definition for a Marketability Discount (p. 26)

» “A discount has no meaning until the conceptual basis underlying the base value to which it is applied is defined.”

» “A premium has no meaning until the conceptual basis underlying the base value to which it is applied is defined.”

- ASA Business Valuation Standards, BVS-VII Valuation Premiums and Discounts, Section III. A-B


Marketability Discount» On levels of value chart

Use of marketability discount yields nonmarketable minority value» Nonmarketable minority value is the value of an illiquid, minority interest in a business for which there is

no active market for these shares

» Nonmarketable minority value does not represent a “…proportionate interest in the going concern value of the corporation as a whole.”

Nonmarketable Minority Level of Value is inconsistent with value at the Financial Control Value

Violates all previous guidance


» “Consistent with that approach [determining the going concern value of the corporation as a whole, that is, ‘a willing purchaser, in an arm’s length transaction’, would offer for the corporation as an operating business.], we have approved a methodology for fixing the fair value of minority shares in a close corporation under which the investment value of the entire enterprise was ascertained through a capitalization of earnings (taking into account the unmarketability of the corporate stock) and then fair value calculated on the basis of the petitioners’ proportionate share of all outstanding corporate stock.”

Guidance anticipates a transaction in the corporation’s stock (for all of the stock)

» Transactions occur at the prices at which they occur – obvious, but overlooked point

» Transaction evidence of multiples includes consideration by market participants of any aspects of “unmarketability of the corporate stock”

» No further discount from transactional evidence is warranted based on this guidance if looking at guideline transactions

Judicial Guidance re Levels of Value in BewayCourt of Appeals of New York offers guidance re valuation interpretation of fair value in New York


Cap Rate Takes Into Account Unmarketability in Real Estate Appraisals» Guidance suggests that the capitalization of earnings to derive investment value

is done “taking into account the unmarketability of the corporate stock.”

Further supports the fact that normal controlling interest valuation methods already take into account “unmarketability” (as did both real estate appraisers)


Marketability Discount» No conceptual basis for applying a marketability

discount to the control value of a business Marketability discount is applied to an entirely different

level of value

Application of marketability discount would convert a financial control or marketable minority value to an illiquid minority interest value

An illiquid minority value would have the effect of imposing an implied minority discount



» “We likewise find no basis to disturb the trial court’s discretion in failing to assign any additional diminution of value of petitioner’s shares here because they were subject to contractual restrictions on voluntary transfer. As we noted in Matter of Pace Photographers (Rosen)(supra), a statutory acquisition of minority shares by a corporation pursuant to the Business Corporation Law is not a voluntary sale of corporate shares as contemplated by a restrictive stockholder agreement, and, there , ‘the express covenant is literally inapplicable’…”.



Restrictions on Transfer (part of Marketability Discount) Not Applicable

Restrictions on transfer are factors that are taken into account when determining marketability discounts.

If such restrictions are said to be inapplicable, and also, if cash flows should be normalized in order to eliminate the impact of oppressive majority shareholder behavior, then the preponderance of the economic discussion in the Beway actually argues against the application of a marketability discount



Marketability Discounts for Controlling Interests of Companies

» Not a new question

» 1994 article in Business Valuation Review in response to confusion among appraisers (precisely as demonstrated by the expert testimony in Beway)

» Reprinted as Chapter 11 of Quantifying Marketability Discounts

No articles or references in valuation texts have been published since 1994 refuting the logic in the 1994 article


Marketability Discounts» Vick (Appellate Division, First Department case in New York)

Addresses minority interest and marketability discount issues in a case involving a partnership which was a real estate holding company

“However, application of the discounts [minority interest and marketability] sought by defendants would deprive plaintiffs of the value of the decedent’s proportionate interest in a going concern, since they would not receive what they would have received had the entire entity been sold on the open market unaffected by a diminution in value as a result of a forced sale. The unavailability of discounts is particularly apt here, where the business consists of nothing more than ownership of real estate, and where the valuation ensues from the death of a partner and not as the result of any misconduct of a withdrawing partner in causing dissolution. In this regard, we note that Haymes v. Haymes, in which we applied minority interest and decreased marketability discounts to the valuation of partnership interests in an equitable distribution matter, should not be understood as an imprimatur on such discounts as a matter of law, but only as addressing the trial court’s resolution of a conflict in expert testimony, and is therefore limited to its particular facts.”


Marketability Discounts» Additional economic reason why no marketability

discounts should be applied to controlling interests of asset holding entities holding primarily real estate

In the case of the Company, its property has been independently appraised by [named appraiser]

Each appraisal assumes that a hypothetical sale of the subject property occurred on the valuation date


“Market Value” for Real Estate Defined

“The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition are the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

1. Buyer and seller are typically motivated;

2. Both parties are well informed or well advised, and acting in what they consider their own best interests;

3. A reasonable time is allowed for exposure in the open market;

4. Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and

5. The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.” (emphasis added)

Exposure time (from viewpoint of appraisal at valuation date) has already occurred

- As defined by The Dictionary of Real Estate Appraisal, Fourth Edition, The Appraisal Institute, 2002.


Marketability Discounts“Exposure in the open market” defined as:

The estimated length of time the real property interest appraised would have been offered in the market prior to the hypothetical consummation of a sale at market value on the effective date of the appraisal; a retrospective estimate based on an analysis of past events assuming a competitive and open market.

In the [named] appraisal, the exposure time was estimated to be between “six and twelve months” (this period was twelve to eighteen months in the [named] appraisal)


Marketability DiscountsThe definition of exposure time above is from Statement on Appraisal Standards No. 6 (SMT-6) of the Uniform Standards of Professional Appraisal Practice. SMT-6 reiterates that exposure time has occurred prior to the valuation date:

The fact that exposure time is always presumed to occur prior to the effective date of the appraisal is substantiated by related facts in the appraisal process: supply/demand conditions as of the effective date of the appraisal; the use of current cost information; the analysis of historical sales information (sold after exposure and after completion of negotiations between the seller and buyer); and the analysis of future income expectancy projected from the effective date of the appraisal.


Marketability Discounts» The primary asset of the Company has been valued assuming that

exposure to the market has already occurred

» Double-dipping to apply a marketability discount to the interests of the Company, when exposure to the market is presumed in the underlying appraisal

» Application of a marketability discount to the value of an enterprise as a whole would be tantamount to applying a disguised minority interest discount

Recognized in the recent Murphy decision

“Though this court has great respect for stare decisis, in most cases such as ours, the lack of marketability discount serves to cloak what is really a minority discount.”


Conclusion re Marketability Discount

» The preponderance of economic guidance in Beway actually argues against the application of a marketability discount

» There is no theoretical basis for the application of a marketability discount at the Financial Control Level of Value

» To the extent that a marketability discount is considered, given that the underlying real estate, the predominant asset of the Company, has been appraised under the assumption that a) the property was exposed to market for six to twelve months prior to the valuation date, and b) a hypothetical sale for cash occurred on the valuation date, the need for a marketability discount is eliminated, if applicable.

» Conclusion

Appropriate marketability discount might be zero percent (0%)


Discounts for Lack of Marketability

» Pointing out the obvious… The use of discounts for lack of control and lack of

marketability can have a significant impact on the buy-out price of a minority shareholder’s interest in a closely held corporation. Thus, it is important for an attorney dealing with an appraisal or dissolution case (or the decision to bring such an action) to have an understanding of this issue and the relevant Florida statutes and decisions, as well as the significant decisions from around the country, in order to be prepared to address the potential arguments regarding the use of the two discounts.

Rebecca C. Cavendish and Christopher W. KammererFlorida Bar Journal, September 2008


Conclusion 2Effect of DLOM Application

Average of the Two Net Asset Value Conclusions $10,438,296

Assumed Ownership Interests

Man Choi 75%

Winston 25%

Winston Man Choi

Assumed $2,609,574 $7,828,722

Marketability Implied Value of

Discount 1% Interest 25% Interest 75% Interest Total Value

0% $104,383 $2,609,574 $7,828,722 $10,438,296

5% $99,164 $2,479,095 $7,959,201 $10,438,296

10% $93,945 $2,348,617 $8,089,679 $10,438,296

15% $88,726 $2,218,138 $8,220,158 $10,438,296

20% $83,506 $2,087,659 $8,350,637 $10,438,296

25% $78,287 $1,957,181 $8,481,116 $10,438,296

Any marketability discount greater than zero enriches the majority at the expense of the minority – contrary to Beway

MajorityMinority

MajorityMinority

$20,000


Effect of Marketability Discount per Beway

» Reduces the value of the minority interest below its investment value

» Denies the minority interest its “proportionate interest in a going concern”

» Provides unequal treatment of the minority interest relative to the controlling interest

» Provides for minority shares being valued at less than the controlling shares (unequal treatment)

» Denies protection to minority from being forced to sell at “unfair values” imposed by those dominating the corporation

» Shifts “proportionate economic value of the corporation as a going concern from minority to majority shareholders”

» “…imposes a penalty for lack of control and unfairly enriches the majority stockholders, who may reap a windfall from the appraisal process by cashing out a dissenting shareholder.”


Exposure to Market Eliminates Applicability of Marketability Discount

Address

Month X, XXXXAppraised Value

$20.0 million

Hypothetical Transaction Occurs

Cash equivalentvalue after marketing

Exposure (time) to Market

Property Producing Cash Flows

Restricted Stock Studies-Little or no cash flows

LLC


Exposure to Market Eliminates Applicability of Marketability Discount

Address

Month X, XXXXAppraised Value

$20.0 million

Hypothetical Transaction Occurs

Cash equivalentvalue after marketing

Exposure (time) to Market

V = Cash Flow / r – g = NOI / cap rate

Property Producing Cash Flows

LLC




New York Matter of Giaimo




“Marketability Discount – The Problem

» While the use of a “marketability discount” is stated in Beway, there is no economic rationale for its application by appraisers

» The base valuation in New York is definitely, or so it seems based on business and valuation perspectives, definitely a financial control concept

» There is no economic rationale for applying a “marketability discount” to a controlling interest in a business

Remember the definition of fair market value

Hypothetical transaction between arm’s length parties occurs on the valuation date.

» If a hypothetical transaction occurred, it occurred at the price concluded in the appraisal at the financial control level

» Exposure to market has already occurred (or is assumed to have occurred in the hypothetical negotiation between the parties)

Reference to restricted stock studies and pre-IPO studies to validate a so-called “marketability discount” for a controlling interest makes no economic sense


Assignment DefinitionClient Name Robert T. Giaimo

Business Name1. EGA Associates, Inc. (“EGA”)2. First Ave. Village Corp. (“FAV”)

Type of Entity C Corporation

State of Organization New York

Principal Business Location New York, New York

Business Interest Under Consideration 100% of the Common Stock

State of Value Fair Value. Fair value in Accordance with New York Business Corporation Law §623

Level of Value Controlling Interest Basis

Effective Date August 1, 2007

Purpose & Intended UseLitigation Concerning the Petition of Robert T. Giaimo, as Co-Executor of the Will of Edward P. Giaimo, Jr. Deceased for the Judicial Dissolution of EGA Associates, Inc.

Scope of Work Appraisals

Premise of Value Going Concern


New York Matter of Giaimo» Quoting from the text of the appraisal…

Mercer Capital is not a law firm and Z. Christopher Mercer is not a lawyer. We therefore offer no opinions regarding the legal interpretation of the definition of fair value from a valuation perspective. We have requested that Mr. Giaimo’s legal counsel provide a legal interpretation of the relevant case law.

Counsel for Mr. Giaimo has indicated to Mercer Capital that the precedent case law regarding the determination of fair value in the type of case currently in litigation is clear as to judicial interpretation of minority discounts and counsel notes that New York court decisions uniformly hold that no minority discount be applied.

Counsel also indicates that case law holds that a marketability discount is applicable only to “good will” and several cases, including a 2008 holding for the First Department, explicitly state no discount for lack of marketability is to be applied when a company’s sole assets are cash and real estate.



The cases we have been shown and legal counsel’s interpretation of fair value would suggest that our appraisal conclusion should reflect a controlling interest level of value, though without a control premium, and that we should apply neither a minority interest discount nor a marketability discount in this appraisal.

In rendering this opinion of fair value, however neither Mercer Capital nor Z. Christopher Mercer, ASA, CFA is rendering any opinion regarding the interpretation of fair value under New York law.

This valuation opinion is provided to counsel and to the court for consideration in the context of the legal interpretation of fair value.



To complete this discussion relating fair value to the fair market value standard of value, let’s refer back to the “Assignment Definition.”

We noted that fair value would be determined on a controlling interest basis. Then, based upon legal instruction, in the “Fair Value Considerations in New York” section, we further refined that assignment for each of the Companies to determine fair value at the financial control level of value.

From an appraiser’s viewpoint then, fair value, as interpreted above in New York, can be described as the valuation equivalent of fair market value at the financial control level of value.



Source: Business Valuation: An Integrated Theory, 2nd Edition | Mercer & Harms (John Wiley & Sons, 2007)



“Marketability Discount” in New York What’s an Appraiser to Do?

» Beway, the leading appellate level case in New York, indicates: Going concern valuation as if arm’s length parties negotiated a sale of the

company Then, consider (?) or apply (?) a “marketability discount”

» No economic basis or rationale for it» No help from the underlying data relied upon by the experts (and the court) in

Beway

» If there is a “marketability discount” it must be quite small, since the risks associated with illiquidity (i.e., exposure to market) in the hypothetical transaction involving the company has already occurred

» Beway says to ignore contractual restrictions on voluntary transfer (because transfers are necessitated by actions of the majority)

» Call the application of a “marketability discount” an “implied minority discount” that New York courts will have to figure out in future cases when provided with appropriate economic and valuation evidence


“Marketability Discount” in New York What’s an Appraiser to Do?

Source: Business Valuation: An Integrated Theory, 2nd Edition | Mercer & Harms (John Wiley & Sons, 2007)

If applicable, economics suggest nil or smallIf applicable, economics suggest nil or small


Discussion of Built-In Capital Gains Tax in Giaimo


Fair Market Value Treatment of Embedded Capital Gains

1998 Mercer Article on Built-In Gains (“BIG”)

» Followed Davis case in Tax Court allowing partial allowance for BIG liabilities in fair market value tax appraisals

» Central conclusion of article In fair market value determinations, appropriate to charge appraisals

of C corporation asset holding entities for the full amount of BIG liabilities

» Jelke decision in Tax Court (2005)

» 2005, the Tax Court rendered its decision in Jelke, again allowing for partial consideration of BIG liabilities Ultimately reversed by the Eleventh Circuit Court of Appeals in

late 2007

Case remanded for recalculation of net asset value using a dollar-for-dollar reduction of the entire BIG liability, but not without dissent


Fair Market Value Treatment of Embedded Capital Gains

» Important assumption in 1998 article “When analyzing the impact of imbedded capital gains in

C corporation holding companies, one must examine that impact in the context of the opportunities available to the selling shareholder(s) of those entities

One must also consider the realistic option that potential buyers of the stock of those entities must be assumed to have – that of acquiring similar assets directly, without incurring the problems and issues involved with imbedded capital gains in a C corporation”


Fair Value Treatment of Embedded Capital Gains

» Murphy v. U.S. Dredging Corp.

Historically, USD [the company] made long-term property acquisitions, i.e., it held Jersey City and Brooklyn properties for thirty-six and twenty years, respectively, before selling

The specific Section 1031 exchange properties acquired by USD were the “type of investments” which reflected long-term investment goals

The possibility of converting to an S corporation gave the majority “tremendous incentive” to hold the property for at least ten years in order to avoid gains tax

A willing buyer would not expect to deduct the entire gains tax



» Murphy v. U.S. Dredging Corp. Replication of calculation in Murphy indicates that the implied discount

rate used in the present value determination was about 6.7%. The court used a deduction that represented about 29% of the embedded capital gains tax

Murphy Logic (Liquidate in 19 Years - No Growth)

Total BIG at Valuation Date $11,600,000 BIG Allowed by Court $3,400,000 Present Value as % of Current BIG 29.3%



» Similar logic to Murphy applied to EGA 2.5% growth in value of the underlying property Discount rate (10%) representing modest premium to the

underlying discount rates used in Leitner Group appraisals Ten year time to

liquidation Liquidate in 10 Years - Consider GrowthMarket Value at 8/1/2007 $63,600,000Estimated Growth rate of Value 2.5%Number of years 10Future Value at 8/1/2017 $81,413,377Cost Basis $287,994Future Embedded Gain 81,125,383Taxes @ 45.63% $37,017,512Discount Rate 10.00%Present Value of Tax Liability $14,271,853

Current BIG Tax Liability $28,889,268Present Value as % of Current BIG 49.4%



» Similar logic to Murphy applied to EGA

Another present value analysis assumes that half of the properties would be liquidated evenly over a ten year period by the buyer

Discount Rate 10.0% Assume Sell 50% of Properties Evenly Over 10 YearsProperty Apprecication 2.5% 0 1 2 3 4 5 6 7 8 9 10

8/1/2007 50% Sale

Property Sold $63,600,000 $31,800,000 3,259,500 3,340,988 3,424,512 3,510,125 3,597,878 3,687,825 3,780,021 3,874,521 3,971,384 4,070,669Tax Basis 287,994 143,997 14,400 14,400 14,400 14,400 14,400 14,400 14,400 14,400 14,400 14,400Capital Gain $63,312,006 10 Year Dribble 3,245,100 3,326,588 3,410,112 3,495,725 3,583,478 3,673,425 3,765,621 3,860,122 3,956,985 4,056,269Taxes Liability on Gain @ 45.63% 28,889,268 1,480,739 1,517,922 1,556,034 1,595,099 1,635,141 1,676,184 1,718,253 1,761,373 1,805,572 1,850,876

Present Value Factors 0.909091 0.826446 0.751315 0.683013 0.620921 0.564474 0.513158 0.466507 0.424098 0.385543Present Value of Tax Liability 1,346,127 1,254,481 1,169,072 1,089,474 1,015,294 946,162 881,735 821,694 765,739 713,593

Current Value Tax Liability $10,003,370Total BIG at Valuation Date $28,889,268

Present Value as % of Current BIG 34.6%



» Murphy also considered expectations of prospective buyers

Per discussions with Mr. Robert A. Knakal, Chairman of Massey Knakal Realty Services

» Demand for underlying assets (small apartment/retail buildings) outpaces supply in New York City

» Mr. Knakal stated he sells shares of similar corporations whose basis is (effectively) zero at a 15% to 20% discounts to net asset value

Buyers are aggressive because of limited supply

Per discussions with Mr. Joel Leitner, MAI, CRE, FRICS, Principal of Leitner Group

» Several independent families have been operating walk-ups for years

Highly interested in purchasing either or both of the Companies to gain access to their portfolios of buildings

Would not demand the full embedded gain tax liability be deducted from the price paid for the company



» Estate of Frank La Sala v. Andrea La Sala & Sons, Inc.

2003 New York Supreme Court case allowed for no discount for BIG tax liabilities;

Conclusion based upon principle that the corporation is valued as an operating business rather than a business in the process of liquidation

» Capital gains tax triggers on liquidation which is not a factor to be considered

The decision in La Sala would suggest an adjustment to net asset value based on the BIG tax liability of 0%



» Conclusion re Adjustment Factor» Factors considered

» Guidance from recent New York cases

» Analytical and anecdotal efforts to evaluate the appropriate extent of the adjustment to net asset value suggest

» Discount to net asset value of 15% to 20%

» Blended capital gains tax rate of about 45%

Reflects discount of in the range of 33% to 44% of the BIG tax liability at the valuation date

Adjustment factor of 40% of the BIG liability is used as a reduction of net asset value in this determination of fair value


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Statutory Fair Value in New York | 2012 | Mercer Capital