The last post on this blog began a discussion of Friedman v. Beway, a 1995 New York Court of Appeals (First Department) decision.  Beway is considered by many New York attorneys to be the leading New York case on statutory fair value determinations in New York. In this post, we examine the trial court decision for help in understanding what happened at the Court of Appeals.

As always, I examine cases from business and valuation perspectives.

Net Asset Value is a Beginning Point

At trial in the Beway matter, the Supreme Court (the lower court in New York) held one session in which the net asset values of nine family-owned asset-holding companies were determined to total $128.2 million. The combined net asset values of petitioners’ shares totaled $15.2 million, as seen below.¹

Fair Value is Determined

The second session of the Beway trial addressed the determination of fair value for each entity and in total. The agreed upon combined net asset value was $128.2 million. The petitioners owned the interests indicated in the exhibit above, which was developed in the McGraw Report.

The petitioners’ expert concluded that the fair values for each of the interests were the net asset values of their percentage interests. He concluded the combined fair value was to be $15.2 million. Unfortunately, from my perspective, while his opinion was ignored, it was the “right” conclusion.

The Company’s expert, McGraw (identified as such in Beway), determined the fair value of the nine interests to be $5.9 million through a multi-tiered process of discounting. This conclusion represented a total discount of 61% to the combined net asset value of $15.2 million determined in the first court session.

The McGraw Report provided three methods in arriving at its preliminary conclusion:

• A net asset value method that examined the prices at which a number of publicly-traded REITs were trading. The average REIT discount was 9.8%, but the McGraw Report increased that to 25.0%. There was no discussion of what caused the increase from the 9.8% REIT discount to the concluded 25.0% discount. The indicated values summed to $11.4 million.
• The second method was a closed-end fund analysis. McGraw concluded that the appropriate discount to net asset value was 20% and reached an indicated value of $12.2 million.
• The third method was an investment value analysis. McGraw looked at several publicly traded real estate-oriented companies and used their metrics to apply to the Beway entities. The conclusion with this method was $9.5 million, or a 38% discount to the net asset value.

These three methods were then weighted 40% (net asset value using REITs), 20% (closed end fund analysis), and 40% (investment value method). The concluded value of all nine entities was $10.8 million, or a 29% discount to the net asset values of the nine entities.

This value was then discounted by an additional 45% based on an analysis of several restricted stock transactions (30.4%) and an incremental discount of 14.6% to reflect restrictions on transfers in the various operating agreements.

The Supreme Court evidently discounted a good bit of the discounting in the McGraw Report, accepting only its 30.4% restricted stock discount reduced by a 9.4% REIT discount (the actual discount was 9.8%, but the court used 9.4%), yielding a 21% marketability discount. The Supreme Court’s conclusion relative to that of the McGraw Report as shown below.

The Supreme Court did not accept McGraw’s REIT discount (neither the 9.8% nor the 25%). The Supreme Court did not accept McGraw’s closed-end fund analysis or his investment analysis, either. The Supreme Court’s 21% net discount was applied to the net asset values of the entities.

The Court of Appeals believed that reducing the restricted stock discount of 30.4% by 9.4% (actually 9.8%) was a “double counting” of the reduction for the REIT discount.

There was some confusion in the Supreme Court. The Court of Appeals remanded the matter back to the Supreme Court to address that confusion and to reach a conclusion based on a better understanding of the evidence. Following remand, the concluded marketability discount in Beway remained at 21%, as discussed in our prior post.

Having read the trial transcript of the Supreme Court’s valuation trial and the McGraw Report, it is clear to me why things were unclear there.

Perspective Based on Trial Court and Appeal

We observe the following from this analysis of Beway from business and valuation perspectives:

• The decision affirmed the conclusion that minority interest discounts are not applicable in New York fair value determinations.
• A significant portion of the Court of Appeals decision addressed the kind of value that fair value should be in a New York fair value determination.
• Based on my understanding of the case, any marketability discount should be applicable at the company level and not relate to the shareholder level of value.
• Importantly for a discussion of marketability discounts in 2022, we should note that all of the market evidence cited in the McGraw Report pertained to discounts for minority interests and did not pertain to company-level discounts. We will gain a better understanding of this confusion in the further discussion of the levels of value below.

The major valuation adjustments used in the McGraw report were based on:

• Closed-end fund analysis
• REIT discount analysis
• Restricted stock discount analysis

All of these “discounts” reflect shareholder-level discounts and are not applicable to the nine companies in Beway as whole companies. In other words, the discounts employed in the McGraw Report all pertained to moving from the middle level of the chart below to the bottom level and to developing the values of illiquid minority interests in the subject companies.

This three-level chart was generally understood by 1995 when Beway was decided, although it was not published until 1990. At the time, the application of marketability discounts to move from the marketable minority (middle) level to the nonmarketable minority (lowest) level was common. The McGraw Report applied minority interest marketability discounts to the corporation as a whole, which would now be viewed as inappropriate by most business appraisers.

We learned in the 1990s that the Control Value on the chart above related to strategic acquisitions of companies. As a result, it is inappropriate to use control premium information to infer minority interest discounts.

Marketability Discounts Applicable to Companies, Not Shares

The bottom line is that the “marketability discount” based on restricted stock analysis and the REIT and closed-end fund discounts employed by McGraw and accepted by the Supreme Court were discounts for the minority nature of small ownership interests, contrary to the confused guidance of Blake and Beway. I say confused because it is confusing from business and valuation perspectives.

Beway references the 1985 appellate level decision of Blake, stating:

However, a discount recognizing the lack of marketability of the shares of Blake Agency, Inc., is appropriate, and, under the circumstances of this case, the amount of the discount should be 25%. A discount for lack of marketability is properly factored into the equation because the shares of a closely held corporation cannot be readily sold on a public market. Such a discount bears no relation to the fact that the petitioner’s shares in the corporation represent a minority interest (citations omitted, emphasis added).

Reading this guidance carefully, a marketability discount can be considered “because the shares of a closely held corporation cannot be readily sold on a public market.” The inference is that all the shares of a closely held company cannot be readily sold on a public market. Reinforcing this, the quote goes on to say that a marketability discount “bears no relation to the fact that the petitioner’s shares in the corporation represent a minority interest.” If not, then any applicable marketability discount must exist because a corporation itself is not marketable, and its shares cannot be offered to the public markets.

The direct inference is that any marketability discount must be applicable at the level of the corporation itself rather than applicable to minority shares themselves. This is an important inference.

It follows that evidence reflecting comparisons of (minority interest) publicly-traded shares with restricted stock offer prices is irrelevant for marketability discounts in fair value determinations. These studies relate two different minority interest prices, the public price, and the placement price. They bear no relation to the marketability of any company at all.

Nevertheless, there is a failure to recognize this distinction in a number of New York fair value cases.

We look now at a levels of value chart applicable to asset holding entities to clarify these relationships. There is no concept of strategic control for asset holding entities, so now there are only three levels of value, the financial control/marketable minority value and the nonmarketable minority value.

Any Discount to NAV is “Unfair”

It is generally recognized today that the marketable minority and financial control levels of value coexist. The minority interest discount is generally considered to be very small or nil.

For asset holding entities, net asset value (market value of all assets less liabilities) is the financial control value. In practice, there is no minority interest discount. In New York fair value, there is no minority interest discount.

It should be clear that the imposition of a marketability discount takes the financial control value to the nonmarketable minority level of value, which is not the level of the enterprise.

There is no logic for the application of marketability discounts to entire companies, so the application of any marketability discount is really a disguised minority interest discount and creates “unequal treatment of shares of the same class of stock.”

The example below is similar to an example in our last post.

We look at the illustration “by the numbers.”

1. A corporation or LLC is owned by the controllers and the dissenters at 80% and 20%, respectively.
2. There are 100,000 shares outstanding, so shares are allocated pro rata to ownership.
3. The net asset value (NAV) of the entity has been determined by the appraisal to be $50 million.
4. NAV per share is, therefore, $500 per share, with $40 million apportioned to the controlling owners and $10 million to the dissenters.
5. A marketability discount of 16%, as in Giaimo, is applied.
6. The dissenters’ shares are devalued by $1.6 million. Where does that value go? To the controlling owners.
7. The controlling owners experience an increase in value to $41.6 million, and the dissenters realize a loss of $1.6 million ($10 million to $8.4 million).
8. Value per share for the controllers is now $520 per share, up 4% in Column 9, and the dissenters’ value falls to $420 per share, a reduction of 16%.

The math works the same whether a discount is called “minority interest” or “marketability.” Any discount from NAV for asset holding entities or otherwise determined fair value (financial control) results in a transfer of value from the dissenters to controllers.

This result is contrary to my understanding of guidance from Beway. And, it does not make sense from business and valuation perspectives to forbid a minority interest discount because it is “unfair” to dissenters,” and yet to allow a marketability discount through pained logic which is equally as “unfair.”

We will have one or two more posts related to Beway in the near future.

In the meantime, please comment on the blog below or to me personally.

Be well,

Chris

 

¹ Mercer Capital obtained the transcript of the Supreme Court trial in the Beway matter. We also obtained the valuation report prepared by Kenneth W. McGraw on behalf of Patricof & Co. Capital Corp (“the McGraw Report.”) The table below is excerpted from Exhibit 2 of the McGraw Report.