In this post, we continue the analysis of Friedman v. Beway, a 1995 New York Court of Appeals case that addresses the prevailing judicial interpretation of statutory fair value in New York. In the first post in the series, we examined certain “principles” regarding fair value espoused in Beway. In the second post, we reviewed the Supreme Court’s (i.e., the trial court’s) valuation analysis and then discussed additional guidance from Beway and Blake, an earlier New York Court of Appeals case.
In this third post in the series, we examine further guidance from Beway, discuss why “marketing” has already occurred as of valuation dates in both real estate and business appraisal, then look at a more recent case involving asset holding entities, Giaimo v. Vitale, to see where current “logic” has led the Court of Appeals (First Department) in New York on the issue of marketability discounts in statutory fair value determinations.
In the final post in this series, we examine the actual marketability discounts concluded in statutory fair value matters since about 1985. The analysis will differentiate between appellate-level and trial court cases that stand and were not appealed. The results will likely be surprising for those interested in statutory fair value in New York.
I have said this before, but it bears repeating: I am not an attorney. Any analysis that I perform regarding case law in any jurisdiction is conducted from my perspective as a business appraiser and a businessman. I have and offer no legal opinions. However, I can examine the logic of relevant cases from business and valuation perspectives and do so in this series on statutory fair value in New York.
More Guidance from Beway
In the prior two posts, we cited certain “principles” regarding New York fair value determinations that suggest to me, as a valuation expert reading the case, that marketability discounts should not be allowed. Nevertheless, the cat is out of the bag: Beway allowed a 21% marketability discount. But wait, there’s more from Beway arguing for no DLOMs, including the following:
Consistent with that approach, 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 was calculated on the basis of the petitioners’ proportionate share of all outstanding corporate stock (Matter of Seagroatt Floral Co., 78 NY2d, at 442, 446, supra [emphasis added]).
Seagroatt was an operating company. The petitioner’s expert testified that he took the company’s lack of marketability into account in his capitalization rate and applied no marketability discount. The Court of Appeals affirmed the reasonableness of this position.
When companies are valued, or when buyers and sellers negotiate over price, they negotiate directly based on the expected cash flows, their growth, and the risks associated with achieving them, as well as the net assets available. I have been involved in more than one hundred corporate transactions over the last forty years. There has been no discussion of a value and then a lower value based on a “lack of marketability” in a single transaction.
Companies do not lack marketability. They sell in a different market than the public securities markets. The market for businesses is not a market where “cash is available in three days.” It is unrealistic and incorrect to compare the “marketability” of entire companies with transactions of minority interests in the public securities markets. Owners of companies have all the rights of ownership during any period of marketing entire companies, including access to distributions and any benefits from growth during the marketing period.
The discount rates developed by business appraisers to appraise companies reflect the risks associated with marketing a business. When multiples are developed based on comparable transactions, those multiples reflect any consideration of prior marketing since they are calculated on the transaction dates.
Marketing Occurs Prior to the Valuation Date in Real Estate
Similarly, the discount rates (or capitalization rates) developed by real estate appraisers to value real property also take “unmarketability” into account.
For further perspective on the applicability of marketability discounts, we look at the concept of exposure time in real estate appraisals. Exposure time is defined at the right (from the current edition of the Uniform Standards of Professional Appraisal Practice, or “USPAP”).
Real estate appraisals assume exposure to the market has occurred, often for six to nine months before the valuation date and that a hypothetical sale occurs on the effective date of the appraisal. The implication is that the appraisal conclusion is a cash-equivalent price.
Exposure time has been considered and is not a reason to justify a marketability discount. Exposure time is defined in the Uniform Standards of Professional Appraisal Practice (USPAP) as (with numbers and emphasis added):
 an opinion, based on supporting market data,
 of the length of time that the property interest being appraised would have been offered on the market
 prior to the hypothetical consummation of a sale
 at market value
 on the effective date of the appraisal.
In market value determinations for real estate, it should be clear that the property has been exposed to the market before the valuation date. We now look at the definition of “market value” in real estate for further clarity (from Advisory Opinion 22 of USPAP). Numbers and emphasis are added.
“Market value means 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 is 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)
The combination of the concepts of exposure time and market value makes clear that when a real estate appraisal is conducted as of a specified valuation date, the exposure/marketing time to achieve the appraised value has already been considered by real estate appraisers. A hypothetical transaction occurs on the valuation date for cash or its equivalent in pricing. The figure below shows exposure time in relation to the valuation date in real estate appraisal.
There is no economic reason to discount appraised real estate for lack of marketability. Any issues regarding marketability have already been considered, as should be clear from the diagram.
What if Real Estate is in an Asset Holding Entity?
Consider a simple example. A hypothetical New York LLC, 123 Example Street, LLC, owns the apartment building at 123 Example Street. The LLC is a “wrapper” for the underlying real estate. Many properties in New York and across the country are placed in LLC wrappers to minimize legal exposure from the property to the owners of the LLC and to facilitate ownership by multiple owners. LLCs are legal “wrappers” for properties and are generally not considered to impede the value of their underlying real properties.
123 Example Street was appraised as of an appropriate valuation date at $40 million. That is a cash-equivalent value; the building is the LLC’s only asset. There are no liabilities. Therefore, the net asset value of the LLC is $40 million.
Following the hypothetical transaction implied by the real estate appraisal, the LLC has the equivalent of $40 million in cash for fair value purposes. If the asset is sold, the cash proceeds can be distributed effectively without cost.
There is no reason to apply a “marketability discount” to the market value of the building because it has been exposed in an open and competitive market for sufficient time to conclude the hypothetical sale on the valuation date.
Similarly, there is no reason to apply a “marketability discount” to 123 Example Street, LLC, because it effectively has only cash. Some of that hypothetical cash can be used to pay the dissenting shareholder their pro rata share of the $40 million. Alternatively, the LLC can borrow the funds necessary to pay the dissenting shareholder, using the real property as collateral.
To bring closure to the concept of “marketability” or lack thereof for real estate or companies holding real estate, we examine one other figure.
The actual market data regarding earnings or revenue multiples for companies and capitalization rates for income-producing real estate reflect the fact that all “marketing” has been accomplished before transactions close.
- For business transactions, multiples derived from actual sales are developed as of the date of actual transactions, and those multiples reflect all considerations of the parties to them, leading to final pricing and closing.
- For real estate transactions, capitalization rates derived from actual sales are developed as of the date of actual transactions, and those cap rates reflect all considerations of the parties leading to final pricing and closing.
This logic and the figures above should clarify that there is no economic reason to discount appraised real estate or entities holding them for their lack of marketability. The appraisal processes take “unmarketability” into consideration.
A Step Backward in Giaimo
Two asset-holding corporations in Giaimo were owned equally by siblings Janet Vitale and Robert Giaimo, with Janet in control. The combined net asset values of the companies were about $100 million. Janet was buying out Robert’s shares, and the question before the court was the fair value of his shares.
Mercer testified in the 2011 trial conducted by a Special Referee in Giaimo that the appropriate marketability discount for the entities was 0%. Based on exposure time in the real estate appraisals and the high level of liquidity in the market for apartment buildings in Manhattan (per the real estate appraiser), Mercer further testified that there was no reason to discount the underlying real estate. He also testified that if a marketability discount must be applied, the cost of liquidation of the underlying real estate could be considered, which could not reasonably be more than 5% or so.
The Special Referee found that the appropriate marketability discount for each of the two corporations was 0%.
The Supreme Court (the trial court) also held that the appropriate marketability discount was 0% but differed with the Special Referee regarding the rationale for that conclusion.
The Appellate Division, First Department, concluded in 2012 that the marketability discount should be 16%, with the following rationale:
Here, the motion court correctly held that the method of valuing a closely held corporation should include any risk associated with the illiquidity of the shares (see Matter of Seagroatt Floral Co. [Riccardi], 78 NY2d 439, 445-446 ) [ignoring guidance in Vick regarding valuation as if the “entire entity” had been sold]. It also properly rejected petitioner’s contention that this Court’s decision in Vick v Albert (47 AD3d 482 [1st Dept 2008], lv denied 10 NY3d 707 ) limits the application of marketability discounts only to goodwill, or precludes such discounts for real estate holding companies such as the corporations at issue here.
The motion court erred, however, in assessing that the marketability of the corporations’ real property assets was exactly the same as the marketability of the corporations’ shares (see Seagroatt Floral, 78 NY2d at 445-446). While there are certainly some shared factors affecting the liquidity of both the real estate and the corporate stock, they are not the same. There are increased costs and risks associated with corporate ownership of the real estate in this case that would not be present if the real estate was owned outright. These costs and risks have a negative impact on how quickly and with what degree of certainty the corporations can be liquidated, which should be accounted for by way of a discount.
The Appellate Court believed that there are significant costs involved in liquidating real estate holding companies holding attractive apartment buildings in Manhattan other than commissions. I am not aware of other significant costs involved in liquidating an asset-holding company. The court did not elaborate on what expenses of “marketing” might be that would add up to 16% of the net asset values of the two corporations in Giaimo. The Appellate Court went on to say:
Only respondent’s expert, Jeffrey L. Baliban, quantified what, in his opinion, would be the appropriate DLOM discount. He employed a number of studies of reported sales that bore some related characteristics to these particular corporations. He also employed a build-up method related to anticipated costs of selling the corporation that included real estate related costs and due diligence costs arising in the sale of closely held corporations. The studies and method employed reported a DLOM range of 8% to 30%, with Baliban recommending 20%. Petitioner criticizes all of the data and methods relied upon by Baliban as inapplicable. Neither the Referee nor the motion court addressed these arguments because they never reached the issue of the quantification of the DLOM. (emphasis added)
The various studies referenced by Mr. Baliban related to discounts at the shareholder level of value and not the company level. Having been present at all testimony of the business appraisers, I believe that the Special Referee did “reach the issue of the quantification of the DLOM.” He heard Mr. Baliban’s testimony and his discussion of several studies. He also heard my testimony in which I quantified the DLOM at 0%. The Special Referee then concluded that the appropriate marketability discount was no marketability discount or a 0% marketability discount, a quantified number.
The court failed to understand that 0% is a quantified discount, just like 5% or 16%.
The Appellate Division concluded:
Since the entire record is included on appeal, it is sensible and economical for us to decide this issue rather than remand the issue to the motion court for further consideration (see Wechsler v Wechsler, 58 AD3d 62, 77 [1st Dept 2008], appeal dismissed 12 NY3d 883 ). We find that the build-up method, which makes calculations based upon expected projected expenses of selling a company holding real estate, best captures the DLOM applicable in this particular case. We conclude that a 16% DLOM against the assets of both corporations is appropriate and should be applied. Since the judgments have been paid, petitioner is directed to make restitution in an amount reflecting the discount (see CPLR 5523). (emphasis added)
It may have been “sensible and economical” for the Court of Appeals to decide the issue of the marketability discount in Giaimo, but the rationale employed made no sense from business and valuation perspectives.
The “build-up method” employed by Mr. Baliban made certain calculations “based upon expected projected expenses of selling a company holding real estate.” This so-called “build-up method” is not a recognized valuation method. Based on this evidence, the Appellate Division concluded a marketability discount of 16%. Real estate commissions the real estate appraisers in Giaimo might be on the order of 1.5% to 3.0% for transactions in the range of $50 million or more and up to 5% for smaller transactions. I have personally been involved in well over 100 transactions involving businesses over the last 40 years. I have not seen transaction expenses rise to the level of 16% in any of them.
A footnote comment regarding Mr. Baliban’s “build-up method” is appropriate. There is nothing improper about “building up” a list of expenses and then totaling them. The conclusion of the build-up of expenses associated with selling a company holding real estate in the Baliban Report was apparently 20%. However, the build up has to make economic sense. The Appellate Court picked 16% as the cost of selling two corporations with very attractive Manhattan rental properties but made no comment regarding why 16% should be the appropriate discount and no comment about the reasonableness of the discount.
To put the court’s 16% marketability discount into some perspective, the combined net asset value of First Ave Village Corp. and EGA Associates was $97.1 million per the Mercer Report. At the Baliban Report’s 20% discount, the implied selling expenses are $19.4 million. At the Appellate Court’s concluded 16% discount, the implied expenses are $15.5 million. This conclusion is simply mind-boggling.
If the cost of liquidating an asset-holding entity was 16% of the net asset value, no one would put real estate into an asset-holding entity. The implied marketing expenses make no economic sense.
For further perspective, the NAV was $48.55 million for each of Janet and Robert based on my concluded NAV for the two corporations combined. Applying a 16% marketability discount lowered Robert’s value to $40.8 million, a reduction of 16%. Applying the 16% marketability discount increased Janet’s value to $56.3 million, an increase of 16%. The economic effect of the 16% marketability discount was to transfer $7.8 million of value from Robert to Janet. The shares owned by Robert and Janet were the same class of shares and identical except for the dissolution process. Nevertheless, Janet had shares worth $56.3 million upon closing, and Robert had shares worth $40.8 million for his otherwise identical shares. Janet’s shares were therefore worth 38% more than Robert’s shares.
Contrary to Beway, Robert did not get his proportionate interest a going concern and received unequal treatment relative to Janet’s shares.
From an economic standpoint, and business and valuation perspectives, applying a 16% marketability discount in Giaimo is tantamount to applying an implied or implicit minority interest discount of 16%. Whatever one calls the 16% discount, the detrimental economic impact on the selling shareholder is the same. The beneficial impact to the controlling shareholder is, dollar for dollar, equal to the detrimental impact to the selling owners.
From an economic standpoint and business and valuation perspectives, the application of a 21% marketability discount in Beway is tantamount to the application of an implied or implicit minority interest discount of 21%. Whatever one calls the 21% discount, the detrimental economic impact on the selling shareholders is the same. The beneficial impact to the controlling shareholders is, dollar for dollar, equal to the detrimental impact to the selling owners.
Recall that the combined net asset values of the nine corporations in Beway were $15.2 million. Applying a 21% marketability discount reduced that amount by $3.2 million to $12.0 million. Where did that “lost” $3.2 million go? It went directly to the controlling shareholders, as illustrated in the final figure for this post.
The first quote in the first post in the series was from the Delaware Supreme Court’s decision in Cavalier (Cavalier Oil Corp. v. Harnett – 564 A.2d 1137 (Del. 1989)
More important, to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder, a clearly undesirable result.
In the final analysis, the economic effect of applying a 21% marketability discount in Beway “…imposes a penalty for lack of control, and unfairly enriches the majority shareholders who may reap a windfall from the appraisal process…”
The same is true for the imposition of a 16% marketability discount in Giaimo.
Both results are contrary to the preponderance of guidance in Beway regarding statutory fair value determinations in New York.
In the next and likely final post in this series, we will look at the actual marketability discounts applied by New York courts in fair value determinations since about 1985. As I have alluded, the results are interesting.
In the meantime, be well! And certainly, please do comment below on this blog or to me personally.