Chancery Court Rejects 'Inconceivable' Value in Shareholder Buyout

Posted by Jay McDaniel on November 01, 2011

Sometimes an expert valuation opinion, however well documented, leads to a conclusion that just doesn’t square with reality.  That was the case with an expert opinion in Rughani-Shah v. Noaz, Docket No. A-4943-08T2 (Sept. 16, 2011) that valued a one-third interest in a medical practice at just $25,000.  The trial court’s decision was affirmed by the Appellate Division of New Jersey Superior Court. 

The trial judge didn’t buy it – not when the practice was grossing $1.7 million a year and not when the buy-in for the shareholder seeking the buyout had been eight times that amount.  Common sense said the number was just too low, and the expert’s opinion was rejected.

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Book Value is Not Fair Value in Partnership Buyout

Posted by Jay McDaniel on August 19, 2011

PartnerAgreement.jpgSocialite’s Family Partnership Interest

Book value can have a few different meanings. The best definition is simply the value of assets and liabilities that a company carries on its books. Is it different than the “fair value” standard applied in statutory buyouts?  Yes– a lot different.

There are many partnership agreements and corporate buy-sell agreements still in effect with a book value buyout provision. They tend to be older entities, often involving family businesses, and I cringe whenever I look at the agreement and see the term applied to the company’s value.

 

Book Value Used to Buy Socialite’s Interest

A recent decision involving the estate of socialite Claudia Cohen demonstrates why. Estate of Claudia Cohen v. Booth Computers, et al., Docket No. A-0319-09T2. Estate of Cohen App Div.pdf. (Thanks also to Peter Mahler’s NY Business Divorce blog for finding the trial decision. Cohen Chancery Div.pdf.) In that decision, the Cohen’s estate argued that the book value of a successful business was just less than 2 percent of its fair value – $ 178,000 as opposed to $11.526 million – and sought to reform the partnership agreement. The effort failed and the Appellate Division affirmed the trial court’s enforcement of the agreement. The disparity between book value and fair value was not, in the court’s opinion, reason to alter an otherwise unambiguous document.

The result was a windfall for the last surviving partner, Claudia’s bother James, and the same result is likely to occur in most agreements that set the value of the business at book value rather than fair value.

The Cohen case involved a partnership formed by the late Robert Cohen, an entrepreneur who amassed a considerable fortune through various entities including the Hudson News Group. He had three children – Claudia, Michael and James. Claudia, well known in Manhattan and Hamptons social circles, was also an editor of Page 6 of the New York Post and the ex-wife of entrepreneur Ronald Perelman. 

The estate, with Perelman as executor, brought suit against Booth Computers and Claudia’s brother, James, after Claudia’s interest in a family partnership was valued at a fraction of the fair value of the partnership’s holdings.

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Oppressed Shareholders Avoid Key Person Discounts

Posted by Jay McDaniel on May 27, 2011

keyperson.jpgThis case goes into the “be careful what you say” category – particularly when it’s under oath, and particularly when you are involved in an oppressed shareholder action, or any other type of business divorce, for that matter.

 

Oppressed Shareholder Litigation

Oppressed shareholder actions almost invariably involve the purchase of the interests of some of the principals based upon valuations prepared by experts. One of the issues that the valuation expert will consider is whether a discount (or reduction in value) should be applied for the loss of a key person.

The inclination of the oppressed shareholder  is to insist that they were absolutely critical to the success of the business, while the controlling shareholders insists that the shareholder who was forced out or frozen out was of no use anyway.

There is no bonus for being important to the business in valuation proceedings. In fact, the opposite is true. It runs contrary to the emotions of the parties and is completely counterintuitive to non-lawyers. For example, the big rainmaker who accounts for 80 percent of his professional firm’s business, but has somehow gotten frozen out of the enterprise, should keep his opinion about the extent of the contribution to himself or herself.  The fact is that the enterprise is worth a lot less without them around, and that decrease in value may be reflected in a lower price for the purchase of their interests.

 

Key Person Discounts

There is surprisingly little case law on this topic in either New York or New Jersey and I am surprised that the issue does not come up more often between feuding principals. Yet you can have the unexpected situation in which a controlling shareholder fires key sales people and then asserts that they were absolutely critical – i.e., “key persons” – to the success of the business.

That was the case recently when the Supreme Court of New York County reviewed an application of this discount, which revealed an interesting point of the very personal nature of business divorce.  Matter of Abraham (Elite Techonology NY, Inc.), 2010 NY Slip Op 33225(U) (Sup. Ct. NY County Nov. 10, 2010), (opinion here) (Thanks to Peter Mahler’s NY Business Divorce blog for finding the decision and publishing the referee’s report).

The key person discount, in the context of business valuation, is defined by....

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LLC Does Not Distribute Clients on Dissolution

Posted by Jay McDaniel on April 12, 2011


LLCdissolves.jpg

When a limited liability company dissolves, it pays its creditors and distributes the remaining assets in the winding-down process. Many professional practices are organized as LLCs, and their principal assets are the clients they serve.  That does not mean, however, that the professional limited liability company in dissolution has to divide up the clients.

This is an important holding for lawyers, accountants, doctors and other professionals that are practicing in New Jersey as a limited liability company. According to a New Jersey appeals court, the clients that the professionals, such as an accountant, bring to the LLC represent personal goodwill that belongs to the individual professional, rather than goodwill belonging to the enterprise.  Thus, clients of professional limited liability companies are not considered assets of the LLC and on dissolution are not subject to distribution.

Accountants Seek Dissolution of Firm

The decision, Michael Gaines v. John Luongo (copy of opinion here) involved an accounting firm that was formed under the New Jersey Limited Liability Company Act, N.J.S.A. 42:2B-1. The Operating Agreement of the limited liability company gave Gaines a 70 percent majority but provided that the two members would share profits and losses equally.The Operating Agreement provided for dissolution of the limited liability company under various conditions, including any event that made it "impossible, unlawful or impractical" to continue operating the business of the limited liability company. The Operating Agreement also provided that in distributing assets to members at the time of dissolution, if the LLC's assets could not be sold, they were to be valued on the company's books for the purpose of distribution to the owners.

The Operating Agreement of the limited liability company also contained a restrictive covenant that prohibited Luongo, the defendant, from competing with the firm for one year and within a 10-mile radius. The relationship between the partners deteriorated within a few years of the formation of the LLC. The litigation arose out of the fact that the partners disagreed about whether they had agreed to dissolve or whether the majority had locked the plaintiff out of the business.

Dissolution of LLC Subject of Dispute

Defendant Luongo claimed that the two partners had decided that the LLC would be dissolved and that each would keep their own clients. Luongo claimed that he arranged for new office space and they divided up the furniture and agreed that each would keep their clients. Gaines denied any agreement to dissolve, said he had continued to operate the firm and that his partner had cleaned out the bank account and frozen him out of the business.

Although the firm was organized as a limited liability company, Gaines filed suit as an oppressed minority shareholder under N.J.S.A. 14A:2-7, seeking an injunction, appointment of a fiscal manager and an order determining the fair value of his interest - including the value of the clients of the firm as assets to be distributed on dissolution of the limited liability company. He sought to compel judicial resolution. (See our prior post on court-ordered distributions of assets in an involuntary dissolution here.) He also sought to enforce the restrictive covenant.

The trial court held that the parties had, in fact, agreed to dissolve and that the clients were not part of the assets to be distributed. In affirming the lower court's decision, the Appellate Division agreed with the trial court's finding that the company's clients were never carried on the books as an asset, no value was ever assigned to them on the company's balance sheets, and that they were free to remain as clients of either partner, or neither.

Clients of Profession Are Personal Goodwill Not a Business Asset

Each of the accountants simply took their clients with them after the LLC had been dissolved. An in-kind distribution when the LLC was dissolved was "inconsitent wit the nature of professional clients, whose value is found in personal goodwill." The court used the "working definition of personal goodwill" as the "part of increased earning capacity that results from the reputation, knowledge and skills of an individual person and is not transferrable or marketable." Which is simply to say that clients hire accountants (or lawyers or doctors) not firms.

 

 

 

 

MICHAEL GAINES, Individually and as a Shareholder of Gaines, Goldenfarb and Luongo,LLC, Plaintiff-Appellant, v. JOHN LUONGO, Defendant-Respondent. Docket No. A-3600-09T3f, from Superior Court of New Jersey, Chancery Division, Middlesex County, Docket No. C-276-08. Tobia& Sorger, LLC, attorneys for appellant (Ronald L. Tobia and JillTobia Sorger, on the brief). HarwoodLloyd, LLC, attorneys for respondent (Michael B. Oropollo, of counseland on the brief).

Flickr Credits: Independent Picture Service

Alessandro Bianchi, an associate of the firm, helped with the preparation of this post.

Court Defers to Management's Liquidation Value in Dissenting Shareholder Value

Posted by Jay McDaniel on January 24, 2011

forsalesignflickr.jpg

Is a shareholder who dissents to the sale of a business stuck with the terms of the sale as the measure of the fair value of their interest?  That seems to be effect of an appellate division opinion affirming a trial court’s decision to apply the business judgment rule in deciding that the “arms length” transaction on which the dissenter’s payment was based was a fair measure of the company’s value.

But there is a potential flaw lurking in the court’s reasoning, one that could haunt future shareholders who refuse to go along with a plan to sell a closely held business.  If the court is going to defer to the majority’s judgment under the business judgment rule, as this trial court did, is it really applying an objective fair value standard?  Seems to me that the answer is no, and the appellate court made a mistake.

 

Dissenters Rights 

Shareholders have a right to dissent from certain extraordinary corporate acts, such as a merger or sale of substantially all the assets of a business, and demand payment for fair value of their interest.  When they do dissent, their rights as a shareholder are immediately terminated and converted into a claim to be paid the fair value of the shares.  Fair value is supposed to an objective measure and typically it requires the court to decide between different values proposed by the parties’ experts.

Meanwhile, the business judgment rule provides a corporations board of directors with the ability to exercise their judgment, in good faith, without being second guessed by shareholders of the courts.  In the absence of self-dealing or other misconduct, the board’s decision is presumed to be valid.  Judges, realizing their knowledge is better used in the courtroom than the boardroom, will generally not second-guess a decision of the board.  

The issue then, is if the majority owners of a business decide to sell and a minority shareholder dissents, the court may just look at the deal as the best possible evidence of the value of the business and not consider if the deal was smart or an accurate reflection of fair value.  The dissenting shareholder has nothing to win, just their cut of the purchase price.

 

Determination of Fair Value

This was precisely the issue in a lawsuit that arose from an unusual decision by a board of directors in Holiday Medical Center, Inc. v. Weisman, Docket No. A-5198-08T2 (App. Div. November 17, 2010)(copy of opinion here).  The deal was an odd one in that, in deciding to sell the business, the board also decided to donate most of the purchase price back to the seller, a non-profit, apparently for the tax deduction.

First of all, you have to assume that the tax deduction was legitimate.  (The IRS probably would not look very kindly on a sale price inflated to generate a big tax deduction)  So it is not surprising that one of the shareholders who dissented from the action and demanded to be paid fair value was unhappy when the company tried to pay her the net (after donation) share of the proceeds.

The board of Holiday Medical Center, Inc. (“HMC”), facing significant operation losses and decided to sell a nursing home facility it owned “while the assets retained some value.”  HMC voted to sell the nursing home to a private school for $8 million and donate back any net proceeds in excess of $2 million.  As the deal was ultimately structured, $3.3 million went to pay off the existing mortgage on the facility, $2.9 million as a charitable donation back to the school, and $2 million to HMC.  

Plaintiff, a 5 percent shareholder, argued that her fair value should be based on either the going concern value of $5.54 million or the liquidation value of $7 million. The trial court accepted the argument that a going concern measure should be applied, but then decided that the sale transaction, with all its wrinkles, was the best indication of the actual value of the business.  When the plaintiff, objected, the court fell back on the business judgment rule.

 

The Business Judgment Rule

The business judgment rule cloaks the directors and officers in a presumption that favors the disputed decision.  In order to strip this presumption, a shareholder must first show that the officers or directors engaged in “fraud, self-dealing, or unconscionable conduct.”   If the shareholder is successful in making this showing, the burden shifts to the directors and officers to show that the decision was fair to the corporation.  In re PSE&G Shareholder Litigation, 173 N.J. 258, 276-277 (2002).  Courts will analyze every decision that aggrieves a shareholder through the lens of the business judgment rule.

 

            Holiday Medical reflects the reluctance of courts to undo a board’s decision absent a clear showing of misconduct by the directors.  Even in this unorthodox sale in which a significant portion of the proceeds was donated back to the buyer, presumably for preferable tax treatment, the business judgment rule barred the trial court from questioning this move with no evidence of “bad faith, self-dealing or fraud.”  If a shareholder seeks to upend a board decision, the evidence of some misconduct must be clear and convincing.  

 

But here’s the rub: shouldn’t the statutory fair value of a dissenting shareholder’s interest be the same, regardless of whether the deal the board wants to make turns out be smart or unwise.  That is the whole point of dissent, fair value is judged from a point before the disputed transaction (merger or sale).  If the court is just going to look at the actual transaction as the value, using the lens of the business judgment rule, what’s the point?  The dissenter’s rights are completely elusive.

 

Attorneys Fees and Tricky Arithmetic       

One of the other issues on appeal was the trial court’s denial of attorney’s fees.  In the end, plaintiff’s net result was an increase of the payment she would receive from $80,000 to almost $100,000.  Reading between the lines, it appears that on her best day, she was probably entitled to no more than another $25,000 if had she prevailed in her principal argument.  

Two trials and two appeals.  You have to question the math.  Plaintiff sough an award of attorney’s fees, available under the statute, but not surprisingly it was rejected by the court.  No doubt the litigation costs long ago exceeded the potential return (unless the fee award was granted).

Bonnie C. Park an associate of the firm, has helped in the preparations of this post.

An Early Cost-Benefit Analysis in Business Breakups Will Keep Dispute in Perspective

Posted by Jay McDaniel on August 13, 2010

When one or more of the owners of a business think it is time to get divorced, the decision in invariably accompanied by hard feelings.  As most clients ultimately learn, the courts are incapable of resolving emotional issues.  But they deal pretty well with money – which is why it makes sense to find out how much is at stake in the fight that is likely to ensue.  Save the emotions for therapy; money is what the case is about.

The Pitfalls of Misinformation

My experience is that most clients are pretty thoroughly misinformed about the “fair value” of their business as well as their individual interests.  Not infrequently, clients will presume that the high price-to-earnings ratio that one may find in the market of publicly traded stocks will apply equally to their closely held business.  Not so.  Others will fail to recognize the effect that the unusually high salaries paid to the owners will likely have in inflating the value of the business.

Lawyers, meanwhile, have a tendency to assume that their client knows the real value of the business and may make judgments and assessments without enough information.  And as we discussed in a recent post, the most confident of us at the bar are also the most likely to overestimate the return that we can secure for our client.  Thus, objective, even if incomplete, information about the value of a business is critical to effective decision making.

There are any number of variables that are unique to the process of formally valuing a business.  These are ordinarily well beyond the expertise of the accountant who prepares the tax returns or audits the books, so it makes sense to bring in a consultant early to do an informal valuation.  Doing so lets lawyer and client make informed judgments about the resources that should be devoted to this dispute.

Making an Educated Investment

Once we know the value of company, we can make some intelligent decisions about how to proceed to maximize the return.  We take a hard look at the costs of the litigation, direct and indirect: attorney’s fees, expert’s fees, disbursements, lost productivity or income.  With this information, a client can make informed choices about the litigation strategy.

For example, when the costs of litigation are factored in, the offer made by one of the parties may be more attractive.  Long-term litigation may be detrimental to the income of the principals.  In some cases, the party that will ultimately pay the purchase price will have to make some hard decisions about funding the settlement.

Sometimes both sides want to keep the business.  At other times, one person simply wants to be cashed out.  The parties may want – or need to – consider the sale of the business as a going concern or dissolution and distribution to the assets.  Even the “go-no go” decision of whether to file a lawsuit can be implicated.  If there is not much good will in the business and the operating agreement does not prohibit withdrawal, it might make more economic for a client to quit and start a new business that competes with the old.

Getting the ‘Back of the Envelop’ Appraisal

I typically recommend that clients engage a certified business appraiser very early in the case.  (You want to get someone who has the credentials to testify later if necessary.)  Appraisal has its own fact-finding procedures and standards, so you cannot expect anything approaching a final valuation report.

Nonetheless, the consultant who should be able to evaluate the assets and cash flow of the business.  The consultant typically will research the discount rate (rate of return required by a prospective purchaser) and come up with a value based on the businesses’ cash flow.  A relatively detailed description of the business provided by my client, recent tax returns and copies of income statements and balance sheets are usually sufficient for this purpose.

The question of what goes into a valuation is beyond the scope of this post.  I wrote something recently (post here).  Peter Mahler’s blog www.nybusinessdivorce.com also has some very informative posts concerning New York corporations.  Although New Jersey law is a bit different in certain respects, most of the information is of universal application.

Lawyer Confidence May Be Poor Indicator of Results

Posted by Jay McDaniel on August 11, 2010

Lawyers must evaluate cases and try to predict the most likely outcome.  To be successful, to attract and win clients, they must do so with confidence. A recent study of the accuracy of those predictions, however, reveals that lawyers are often overconfident and overly optimistic in their assessments of a client's case.

A recent study published in Psychology, Public Policy and Law revealed that the more confidence a lawyer expressed in his or her ability to achieve a possible result, the more likely he or she was to be fail to achieve those results.  You can read the full article here (Insightful or Wishful - Lawyers Ability to Predict Case Outcomes.pdf).

The lesson appears to be that clients might want to maintain some skepticism about the results that the supremely confident lawyer predicts, even as they recognize that the statistics don't tell the whole story.  The lawyer who doesn't believe in a case, or who lacks confidence will have a difficult time being the zealous advocate that is the touchstone of an effective litigator.  We may not meet our lofty goals as often, but that is not to say that we don't do better for our clients when we are confident in the cause.  In our next post, we'll take a look at predicting the outcome in a business dispute case.

How Important Is The Lawyer's Prediction?

When choosing and working with a lawyer, we all look for someone that we believe can achieve the results that we want.  And we are attracted to the lawyer who both exudes and inspires confidence.  (I look for the same thing when I have to hire a lawyer.  The fact that I have a law degree doesn't make much difference when I am the client.)  We aren't likely to be attracted to a lawyer who is equivocal and uncertain about a successful outcome.

We will make decisions based on the lawyer's assessment, important decisions. To sue or not to sue.  To settle.  To pursue the extra deposition or conduct additional discovery.  We want and need to believe in the lawyer's judgment and expertise.  It is difficult to pursue a litigation strategy when the lawyer isn't confident in its success.

Our need to believe, however, might be contrary to reality.  This study indicated that there is a negative correlation between the confidence of the lawyer and his or her ability to predict the outcome.

The Statistical Evidence

In a study taken primarily among civil litigators, the researchers found that the lawyers who were the most confident about the results they expected to achieve were also more likely to fail to achieve those results.  At the same time, those lawyers who were less confident were more to likely to exceed their expectations.  Women were slightly more accurate than men.  And, perhaps most surprisingly, years of experience did not seem to affect the results.

The researchers conducted surveys of lawyers concerning matters that were expected to be tried within 6-12 months.  They asked the lawyers to define the "win situation in terms of your minimum goal for the outcome of the case."  The lawyers where then asked to give the probabily that they would achieve the outcome.  The researchers then went back and determined the actual results of the matters to see how they compared to the lawyers' predictions.

Most of the lawyers said they were 45-65 percent confident of achieving the outcome that they predicted.  These lawyers were generally accurate in their predictions, particularly among those where were 46-55 percent of the outcome.  But as the lawyers "confidence interval" exceeded 65 percent, the accuracy of their predictions deteriorated.  The most confident lawyers as a group failed to achieve their predictions about 20 percent of the time.

The least confident lawyers as a group did significantly better than their estimates, according to the researchers.  In fact those who were less than 50 percent confident underestimated the results as often as they were accurate.

Lawyers Are a Stubborn Lot

The researchers tried to determine whether the lawyers would be influenced by other factors.  The predictions and confidence levels of the lawyers did not change significantly as the case got closer to trial.  Nor were the lawyers likely to revise their predictions - or be significantly less confident - when asked to think through the negative aspects of their cases.

The opinions of the lawyers after the matter had been resolved also were not subject to major revisions.  Sixty-five percent of the more confident lawyers said they were pleased or very pleased with the outcome, although lawyers achieved their goals in only 57 percent of their cases.  When asked why the cases had failed to meet their predictions, the most frequently given response related to factual and evidentiary issues, the next most cited reason was "witness problems," followed by "client problems."  The least cited reason was attorney performance, including the performance of adversary counsel.

The Non-Scientific Assumptions

What is missing from the research is whether the overconfident lawyer does better for his or her clients than the lawyer who lacks confidence.  In other words, on a similar set of facts, will the client achieve a better net result with the confident lawyer or the not-so-confident lawyer.  In my opinion, the lawyer that is confident becomes a leader among the other lawyers or lawyers in the case, with the judge and with the jury.  There is a benefit to the client, however difficult it is to measure.

 

Exercise Care in Valuing Interests in New Jersey Business Breakups

Posted by Jay McDaniel on May 27, 2010

A court orders a business valuation in a matter involving an oppressed shareholder claim. The appraiser, carefully applying the standards of his profession, sends an engagement letter describing a fair market value determination.  The appraisal will value the enterprise as a whole, then apply minority and marketability discounts.  The selling shareholder is going to argue for discounts – they always do – but the report will have all the information necessary for a determination either way.

For the minority shareholder, this can be a trap. And it may be the wrong move to wait for the trial to fight out the discount issue and the battle over the definition of fair value should be fought as early in the case as possible.  Here are a few reasons why.

The appraiser is going to prepare a report based on the standards of the valuation industry and that standard is fair market value – what a willing buyer would pay a willing seller.  He is going to try to avoid the tough issue of whether any discounts should apply. The AICPA’s Statement on Standards for Valuation Services No. 1 relegates the definition of “fair value” to a single paragraph in an appendix as a matter determined by state law in judicial proceedings.  

While fair value can mean anything that the circumstances dictate, New Jersey courts will usually, but not always, interpret fair value as simply the seller’s proportionate share of the value of the whole.  In other words, no discounts.

The professional appraiser, however, will make a thorough analysis of the amounts of a minority – lack of control – and marketability – lack of a public market – for the different interests, but will not probe to whether the application of discounts creates a windfall for either party unless told to do so by the court.  And in the real world, once all of that work is placed in a professionally bound volume with charts and statistics, it is harder to argue that it should be ignored.  

Minority and control discounts, however, are reserved for the extraordinary case in which they are necessary to prevent an unfair result.  The presumption should be that the selling shareholder gets his or her proportionate share of the full value of the enterprise.  An opinion from the court-ordered expert that there is no economic unfairness in that result is going to carry a great deal of weight in the ordinary case.

There is no reason to wait for the eve of trial to go through the exercise of establishing that fair value does not require any discounts to the minority’s interest.  The seller is going to become fixed on the small number once it has been written down, making it all that much harder to resolve the case without a trial.  

Unless, of course, you're the seller.  In which case, I would just sit tight.  Maybe no one will notice.