Peter Mahler reported this week on a recent New Jersey appellate level case focusing on the application of a 25% marketability discount in a statutory fair value determination in his New York Business Divorce blog. The New Jersey Appellate Division issued an unpublished decision in Wisniewski v Walsh, 2015 N.J. Super. Unpub. LEXIS 3001 [App. Div. Dec. 24, 2015]. The case is interesting in that it attempts to determine a marketability discount in relationship to the “bad behavior” of a selling shareholder. Given the timeliness of the case, I’ll interrupt the background posts on statutory fair value for a week and look at this New Jersey case.
The Wisniewski case has a long and tortuous history dating back to the mid-1990s. The case involves a successful family-owned trucking business founded by the father in 1952. Three siblings, Frank, Norbert and Patricia owned the business equally following the father’s death. Frank had assumed leadership of the business by 1973, and Norbert and Patricia’s husband also worked in the business. In 1992, Frank was sentenced to a prison term, leaving Norbert in charge of the business. Norbert stopped paying certain bills that had customarily been paid for Patricia and her husband, and diverted certain revenues from a business owned by Patricia to one in which she had no interest. In addition, even after Frank’s return, Norbert tried to exclude Patricia from a real estate deal that she ordinarily would have participated in.
The litigation began in about 1995. Interestingly, the trial court held that Norbert was an oppressing shareholder, and none of the parties contested that finding or the court’s later decision that Norbert should be bought out. Hold that thought, because it becomes a key factor in the court’s determination of statutory fair value. I can only call the concluded marketability discount in the matter a “bad behavior” discount.
The court’s valuation was determined in two trials in 2007 and 2008. Roger Grabowski of Duff & Phelps was retained by Frank and Patricia (the company) and Gary Trugman of Trugman Valuation Associates was retained by Norbert. I have been unable to locate the trial court’s decision in that matter, and so can only write about the valuation from the perspective of the appellate decision.
The trial court issued opinions in October 2007 and July 2008 which explained how and why the trial judge concluded that the fair market value of Norbert’s interest was about $32.2 million. We learn in the appellate decision that the trial court applied a separate 15% “key man” discount “to account for Frank’s importance.” If the conclusion was $32.2 million for Norbert’s interest, then the value before the discount was about $37.9 million ($32.2 / (1 – 15%)). No marketability discount was applied by the trial court. This would place an implied value of the trucking business at about $114 million.
We do not know the conclusions of either Grabowski or Trugman that were considered by the trial court. According to the appellate decision, the trial judge found Trugman’s discounted cash flow analysis more credible than Grabowski’s market approach. However, the trial judge used assumptions suggested by Grabowski for certain normalizing adjustments to operating expenses for Trugman’s discounted cash flow method.
The Initial Appeals and Application of a Marketability Discount
There was an appeal of the trial court’s decisions in 2007 and 2008. The appellate court, in a decision issued April 2, 2013, held in part that “the trial judge erred in not applying a marketability discount” and remanded “for the fixing and application of a marketability discount to the extent not already subsumed in the judge’s findings…”
The 2015 appellate decision states regarding the remand to the trial court in 2013:
On remand, Judge Hector R. Velazquez briefly contemplated that the record might need to be supplemented with expert testimony pertaining to the narrow issues presented, but ultimately decided against it; none of the parties quarrel with that approach now. Left to resolve the matter on the record developed after the first remand, Judge Velazquez heard oral argument and issued an opinion on October 16, 2013, concluding that a discount for marketability was not embedded in the prior valuation and that a discount of twenty-five percent should be applied. He entered a second amended final judgment to that effect on January 7, 2014.
And of course the parties appealed and cross-appealed.
The Final (?) Appeal
The appellate decision was issued December 24, 2015. To cut to the chase, the appellate court found “no merit” in the appeal and affirmed Judge Velazquez’ 2014 opinion. The appellate decision recounts that Norbert was found to be an oppressing shareholder. This turns out to be important point, because in New Jersey, the marketability discount is typically reserved for “extraordinary circumstances” involving inequitable or coercive conduct on the part of the seller, which is Norbert in this case.
The issue on appeal was whether the trial judge had erred in application of the 25% marketability discount because marketability may already have been considered in Trugman’s DCF analysis. The key facts relating to the marketability discount question, as best I can glean them from the 2015 appellate decision, include:
- Trugman’s Discount Rate Risk Factors. Trugman used a build-up method to develop his discount rate for his DCF analysis. The company-specific risk factors in the build-up included key man risk regarding Frank’s perceived management ability and customer relationships, customer concentrations, the closely-held nature of the trucking business, and undercapitalization. Trugman made two important additional points regarding the marketability of the business. He stated that the company is profitable and attractive and marketable and that the company made substantial distributions on a regular basis that should offset any risks during a normal marketing period (of six to nine months). Trugman did not apply a marketability discount (or assumed it to be zero), noting that the discount rate was the “right place” to consider these risks. Recall also that the trial judge in the valuation trial had already applied a separate 15% key man discount after accepting Trugman’s DCF (as modified by Grabowski’s expense assumptions).
- Grabowski’s Marketability Factors. Grabowski had applied a marketability discount of 35% in his valuation. Judge Velaquez concluded that Grabowski and Trugman had considered several of the same factors in reaching their discount rate and marketability discount, respectively. Grabowski’s marketability factors included heavy dependence on Frank as a key man, customer concentrations in the retail industry, the company’s size and closely held nature, its profitability and the anticipated holding period. Grabowski per the court noted that his marketability discount was also “consistent with guidance from applicable [minority] studies and legal precedent.” Grabowski viewed the company as having a relative lack of marketability.
The appellate court notes the trial court’s decision:
Judge Velazquez concluded, based on that record, that although Trugman and Grabowski had considered several of the same factors in formulating their discount rate and marketability discount, respectively, that Trugman had made no adjustment for marketability in building up his discount rate — in short, the judge concluded that no marketability discount was embedded in his evaluation. The judge rejected both expert opinions, moreover, in selecting an appropriate discount, and fixed the rate at twenty-five percent.
It gets more interesting for valuation professionals. The appellate court reasoned that a marketability discount was necessary because of Norbert’s bad behavior towards his fellow shareholders (there was never a finding that his behavior harmed the company in any way).
The second trial judge rejected application of a marketability discount following our first remand. He considered Frank’s criminal conviction, a factor Grabowski suggested would reduce the company’s value, but noted that while the company endured a lull during Frank’s absence, it resumed its growth on his return with no apparent hindrance attributable of his criminal history. Neither that nor any other circumstance, the trial judge at the time reasoned, justified application of the discount.
Although the reasoning was sound for the most part, we reversed because the judge at the time failed to consider that Norbert’s oppressive conduct had harmed his fellow shareholders and necessitated the forced buyout…[paraphrasing the New Jersey Supreme Court in Balsamides under similar circumstances]. …[A]bsent the application of a discount, the oppressing shareholder would receive a windfall, leaving the innocent party to shoulder the entire burden of the asset’s illiquidity in any future sale. Equity demanded application of the discount, or else the statute would create an incentive for oppressive behavior. (emphasis added)
The appellate decision restated some of Judge Velazquez’ logic in making the following point:
On remand, Judge Velazquez determined on the existing record that a marketability discount was not already embedded in the valuation. He recounted that the discount rate Trugman build up included a size premium and an adjustment for a series of company-specific factors including the company’s reliance on Frank, its customer concentration in the retail industry, and high debt. Although Grabowski had considered similar factors in formulating his marketability discount, the judge concluded that Trugman had certainly “utilized them in a different way” than to adjust for any lack of illiquidity. (emphasis added)
As a business appraiser examining this case from business and valuation perspectives, the economic logic for applying a 25% marketability discount by the court is considerably strained. If a group of risk factors are considered in the DCF method that lower value in the context of that method, it is difficult to see how their further consideration for the application of an additional marketability discount is not double-counting. However, the appellate court addressed this issue as follows:
Grabowski analyzed a handful of the same factors, among many others, in formulating his marketability discount, but, in contrast, focused on the inherent liquidity of closely-held companies and the anticipated holding period for a rational investor in this company. There was no clear indication in the record, then, that Trugman and Grabowski had accounted for the same risks relative to marketability, such that application of a separate marketability discount would cause double counting. (emphasis added)
In the light of day, it would seem that there is double-counting to the extent that both appraisers considered the same factors that would reduce each of their values, even if they used those factors in different ways. And note that the original trial judge had already allowed for a key man discount of 15%, which occurred, obviously, after the experts had testified and provided their evidence. This discount, which certainly pertains to the “marketability” of a business, is substantial discount that had already been considered in the trial court’s conclusion. It just wasn’t labeled as a marketability discount.
The Marketability (Bad Behavior) Discount
What it seems that we have in Wisniewski v. Walsh is a situation that is a business appraiser’s nightmare. At the original valuation trial, the court held that there should be no marketability discount. That was appealed. The appellate court then remanded back to the trial court for the application of a marketability discount to the extent that one was not already embedded in Trugman’s DCF analysis. The trial judge then, based on logic outlined above, concluded that no marketability discount was embedded in the DCF analysis and that the appropriate punitive marketability discount was 25%. This was appealed, and in this current appellate decision, the trial court’s marketability discount is affirmed.
I have no problem if a court of equity wants to penalize a party for oppressive behavior to other shareholders. That is certainly one of the jobs that courts of equity are called upon to do in appropriate circumstances. And that discount can be zero, 10%, 20%, 25% or anything the court determines is appropriate in a specific case.
I do have a problem with a court making an “equitable” decision and then trying to justify that decision based on parsing of valuation evidence.
Assume an appraiser provided a valuation in another New Jersey statutory fair value matter involving the oppressive behavior of a selling shareholder named John. Let’s say that the value conclusion for the interest before the application of a “bad behavior discount” was $100 per share. The appraiser then concludes as follows:
Based on my analysis of John’s bad behavior, I believe that a marketability (bad behavior) discount of 20% is appropriate.
The appraiser might be thrown out of court. His opinion would certainly be given no weight. How then, is an appraiser to respond when the ultimate marketability, or bad behavior, discount will be determined by a judge who is responding to the equities of a matter? After all, valuation evidence pertaining to the marketability of a company or of an interest in a company has absolutely nothing to do with the behavior of any shareholder.
Let’s look further at the appellate decision and we will see that the trial court’s conclusion has nothing to do with the economics of the trucking business in Wisniewski.
The Court noted in Balsamides, supra, 160 N.J. at 377, 379, that marketability discounts for closely-held companies frequently ranged from thirty to forty percent, though the Court explained that selection of an appropriate rate, and the applicability of a rate in the first place, must always be responsive to the equities of a given matter.
Judge Velazquez properly rejected from the outset Norbert’s suggestion that the marketability discount be set at zero percent. Indeed, we had already decided that a marketability discount was required and Judge Velazquez was bound by our mandate.
After carefully canvassing the record, Judge Velazquez came to the conclusion that selecting a thirty to forty percent rate as described in Balsamides would excessively punish Norbert, the oppressing shareholder, beyond what the equities of this case required and, in light of the company’s past financial success and anticipated continued future growth, stood to “give the remaining shareholders a significant windfall.”
In choosing an appropriate marketability discount after rejecting portions of both expert opinions on the issue, Judge Velazquez acknowledged our Supreme Court’s advice in Balsamides that such discounts frequently ranged from thirty to forty percent, but noted that other studies supported a broader range, reaching as low as twenty percent. He alluded to authorities from other jurisdictions approving the application of a wide range of discounts, sensitive to the equities of each individual case, and to our decision in Cap City Products Co. v. Louriero, 332 N.J. Super. 499, 501, 505-07 (App. Div. 2000), allowing application of a twenty-five percent discount. (emphasis added)
If trial courts determine marketability discounts as bad behavior discounts, there really is no way that business appraisers can provide meaningful information to a court. If the court’s concern is one of “the equities” in a matter rather than in determining the fair value or the fair market value of a business or interest in a business, then there is little that appraisers can do to help. In Wisniewski, the application of a marketability discount flowed, not from the lack of marketability of the trucking business, but from the bad behavior of Norbert. Neither Trugman nor Grabowski had a chance in that determination. All we can say is that the court’s ultimate conclusion for the bad behavior (marketability) discount fell within the range of that suggested by Trugman (0%) and Grabowski (35%) and had nothing to do with the relative marketability of the business at hand.
Peter Mahler’s Conclusion
Mahler concluded similarly in his blog post:
If you ask accredited business appraisers whether the determination of a marketability discount rate for the shares of a particular closely-held company should be based on case precedent involving other companies, I think the vast majority will answer “no.” I wrote a piece on that very subject last year, quoting from the IRS’s DLOM Job Aid and experts in the field. Yet cases such as Wisniewski point the other way, effectively encouraging advocates and judges to select a rate within a self-perpetuating, “established” range of case precedent based as much if not more on the “equities” of the case than the financial performance, prospects, and liquidity risks of the company being valued. It’s not for me to say whether appellate courts and legislatures should decide as a matter of policy to incorporate into fair value determinations equitable considerations based on the good or bad conduct and motives of the litigants toward one another. But I am saying that if that’s the way it’s going to be, there’s an associated cost in the form of greater indeterminacy in fair value adjudications which makes it harder for lawyers and valuation professionals to advise their clients and to reach buyout agreements before they ripen into litigation
Readers can see the bad news in this appellate decision in Wisniewski. The good news, I guess, is that most statutory fair value cases do not involve bad behavior on the part of a selling shareholder.