Counsel is presented with an opportunity to represent a petitioner (or a respondent) in a corporate dissolution proceeding. As petitioner’s counsel, a petition under N.Y. Business Corporation Law (“BCL”) § 1104 cannot be filed as the client does not own at least one-half of the votes of all outstanding shares of the corporation. However, as the client owns an excess of 20% of such shares, she is permitted to file under BCL § 1104-a. Respondent’s counsel receives the petition and has two choices: (1) defend on the grounds that a dissolution is not legally viable under § 1104-a or under “common law”; or (2) within 90 days after the filing of the petition, the respondent can elect to purchase the shares owned by the petitioner at their fair value “upon such terms and conditions as may be approved by the court” under BCL § 1118.
Why even consider opting to purchase the minority’s shares if respondent believes that dissolution should not be granted? There are a number of factors that can play into this decision. First, considering the fact that under BCL § 1118 the valuation will be as of the date of the filing of the petition, this may inure to the respondent’s benefit. Respondent may expect a marked change in the success of the company subsequent to the date of the filing of the petition now that the dissatisfied shareholder may no longer be involved in day-to-day operations. Respondent may also believe that, notwithstanding her fervent belief that dissolution is unwarranted, by electing to purchase the shares she removes the uncertainties that any litigation engenders and avoids the costs associated with fighting the aggrieved shareholder who has requested to exit the corporate entity. One of those risks is that if the dissolution is granted, there will be even more costs and court intervention as the company winds down its operations for the purpose of liquidating its assets to effect a distribution to petitioner and any other shareholders. This is a costly and risky proposition for any ongoing concern and may result in a diminution of the value of those assets throughout the dissolution process. Finally, respondent may have no interest in having to deal with the almost constant haranguing that an aggrieved shareholder may engage in – even if his initial attempt at dissolution was unsuccessful.
A decision is made to go the BCL § 1118 route, so what is next?
For either petitioner or respondent’s counsel what comes next is fairly formulaic. The matter is a special proceeding whose procedural aspects are governed by the provisions of Article 4 of the CPLR.[i] There will be an exchange of relevant financial documents which will eventually lead to a hearing where the court will determiner “fair value.” Where the BCL does not define “fair value,” courts are in agreement that “fair value” is the price which a hypothetical “willing purchaser, in an arm’s length transaction, would offer the corporation as an operating business.”[ii] Fair value is not ascertaining the value of an interest in the “throes of liquidation.”[iii] In such a proceeding, neither side has a burden of proof. Rather, it is the court that determines fair value based upon the evidence presented at the hearing, usually through the testimony of experts.[iv] Both sides also know that the date of valuation, as stated above, is the date prior to the date on which the petition was filed.[v] So how do the respective sides begin to determine “fair value,” and what other considerations are there for each side as they try to convince the court that their valuation is more accurate?
There should be no doubt that expert assistance in this matter is essential. Professional appraisers understand the valuation techniques regularly accepted in the industry and by the courts. While a lawyer involved in this line of work should have some working knowledge as to how a business is appraised, no lawyer can be expected to have the level of knowledge that a professionally-certified business appraiser has acquired over years of study. In addition, no matter what skills an attorney may have at cross examination of a business valuation expert, the court is going to want to have a competing valuation to compare and contrast against the valuation of the other side.
With that said, it is time to engage the services of an expert. What should counsel look for when hiring a business valuation expert? Certainly the expert should be “certified.” There are a number of organizations which require appraisers to go through a certification process. Some of the accrediting organizations are USPAP, NACVA, IBA and ASA.[vi] One should also look to an expert who has specific knowledge of the industry which she will be evaluating. The more the expert knows about the particular industry the better.
The expert should be engaged by counsel for their respective parties rather than the parties themselves.[vii] Unlike the attorney-client privilege, the client-accountant communication privilege is limited. However, when an attorney retains an accountant for his expertise to assist in client representation, the privilege will apply to attorney-accountant communications. In this “Kovel Letter,” the attorneys engage the accountant, specifying that the expert is assisting in representation of his specific client under the attorney’s direction, the expert is reporting directly to the attorney, all communications between the expert and the client and between the attorney and the client are privileged for the purpose of assisting the attorney, and that the attorney has ultimate control of the expert’s work and without written permission by the attorney the expert cannot disclose that to anyone.[viii]
There are essentially three predominant methodologies to determine fair value, to wit, (1) net asset value; (2) investment value; and (3) market value.[ix] Net asset value is an asset-based approach focusing on the balance sheet of the company and more appropriate for holding companies with significant tangible assets, i.e., family limited partnerships. Investment value is also known as the “income approach” which is to determine a value that is equal to the present value of future benefits such as revenues, operating profits and cash flow. This involves a capitalization of a single benefit stream or discounting multiple benefit streams. Finally, there is the generally-recognized market approach or market value. Market approach is determining value by observing transactions in the market place that are similar in nature thus ascribing value to the transaction at issue. For most closely-held corporations, it will be difficult to establish a market value approach because of the uniqueness of the company’s operations irrespective of the industry in which the company is involved. Moreover, there may not simply be enough comparables that are similar enough to warrant reliance on such an approach.
Concepts Counsel Should Be Aware Of
Although unquestionably the attorneys in a fair-value proceeding will be relying significantly on their experts, an understanding of several concepts that impact an expert’s valuation will be of great assistance to counsel. For example, but for petitioner forcing this issue through the initial filing for dissolution, it is highly unlikely that petitioner’s shares were readily marketable, and, more likely than not, there are significant restrictions in place preventing transfer of those shares. Nevertheless, under New York law there is no “minority discount” that may be applied in a BCL § 1118 valuation hearing to compensate the other shareholders for the minority shareholders’ lack of control. The rationale is a minority discount would deprive minority shareholders of their proportionate interest in a going concern which would result in minority shares being valued below that of majority shares, thus violating the courts mandate of equal treatment of all shares of the same class in minority stockholder buyouts.[x] However, a “marketing discount” or, as it is commonly known, a “discount for lack of marketability” (DLOM) may be applied to compensate for the lack of a ready market for the shares. However, note that no New York court has ever held that DLOM must be applied in a § 1118 proceeding, although courts have indeed recognized a DLOM.[xi] Also, DLOM is not designed to discount the value of the corporation or any particular asset, i.e., goodwill, but rather is to reflect the lack of marketability of the shares of the corporation.[xii]
Next, counsel should be aware of the possibility that the existence of an embedded capital gains tax or “B.I.G.” may be used to reduce the value of the corporation. The theory is that corporate holdings appreciate in value. As such, an event such as a dissolution could result in the liquidation of a particular asset or assets owned by the corporation, and, thus, a large capital gains tax will result upon the sale of such assets. In New York, it is recognized that embedded capital gains tax assets held by a C corporation will affect what a hypothetical willing purchaser with reasonable knowledge of the underlying facts will pay for the corporate stock. Universally, New York courts have consistently held that a hypothetical willing buyer will insist on a B.I.G. deduction.[xiii]
It has also been held that interest is payable to the petitioner from the date of the filing of the petition. As for the rate of interest, courts generally award an “equitable” rate of interest. In most cases, courts have determined that the “equitable” rate of interest should be the statutory rate of nine percent.[xiv] This is an easy default, but it can be challenged. The court may fix interest at a rate other than the statutory rate if the court finds “such deviance is warranted by the equities” and the court is provided with specifics as to why this should be done.[xv] In today’s low-interest environment, one may argue that nine percent interest is unwarranted coupled with other facts to support that position. There is also the question of whether the petitioner’s cost expenses in attorney’s fees can be awarded by the court. BCL § 1118 makes no provision for the imposition of court costs and disbursements. However, in Blake, it was determined that such awards are discretionary with the court.[xvi]
One factor that the lawyer can add to the expert-driven proceeding, and which may prove detrimental to either parties’ claim in terms of how much interest is awarded (or at all) or whether costs are assessed, is potential “bad faith” by either one of the litigants. Bad faith may be found in connection with one of the shareholders’ actions before the petition was filed or during the fair value proceeding.[xvii] If the court makes a determination that petitioner has acted in bad faith, it could affect the petitioner’s ability to receive prejudgment interest.[xviii]
In sum, notwithstanding the seemingly mechanical process by which value may be determined, the lawyer still has the ability to use his or her talents to affect the outcome.
[i] See In Re WTB Prop., Inc., 291 A.D.2d 566 (2d Dept. 2002); see also In Re Quail Aero Serv., Inc., 300 A.D. 2d 800 (2d Dept. 2002).
[ii] Matter of Pace Photographers (Rosen), 71 N.Y.2d 737, 748 (1988); Matter of Penepent Corp., 96 N.Y.2d 186, 193 (2001); and Matter of Seagroatt Floral Co., Inc. (Riccardi), 78 N.Y.2d 439, 445 (1991).
[iii] Matter of Seagroatt Floral Co., Inc., 78 N.Y.2d at 445.
[iv] Matter of Cohen, 636 N.Y.S.2d 994 (Sup. Ct., N.Y. Co. 1993), aff’d 240 A.D.2d 225 (1997).
[v] See BCL § 1118.
[vi] Uniform Standards of Professional Appraisal Practice (USPAP), National Association of Certified Valuation Analysts (NACVA), Institute of Business Appraisers (IBA), American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA): CFA Institute (CFAI): Chartered Financial Analyst (CFA).
[vii] The engagement letter should specify that the expert will solely look to the client for payment of all invoices.
[viii] U.S. v. Kovel, 296 F.2d 918 (2d Cir. 1961).
[ix] Matter of Friedman v. Beway Realty, 87 N.Y.2d 161, 167 (1995).
[x] Matter of Friedman, 87 N.Y.2d at 170.
[xi] Seagroatt, 78 N.Y.2d at 442.
[xii] Ferolito v. Arizona Beverages USA, 2014 WL 5834862, *18-19 (Sup. Ct., Nassau Co. 2014).
[xiii] Giaimo v. Vitale, 101 A.D. 3d 523 (1st Dept. 2012).
[xiv] See Giaimo, 101 A.D.3d at 526 (the court awarded prejudgment interest at the “equitable rate” of four percent).
[xv] Rodriguez v. Estevez, 19 Misc.3d 1116(A) (Sup. Ct., N.Y. Co. 2008).
[xvi] Blake v. Blake Agency, Inc. 107 A.D.2d 139, 151 (2d Dept. 1985).
[xvii] McDaniel v. 162 Columbia Heights Housing Corp., 25 Misc.3d 1024 (Sup. Ct., Kings Co. 2009); Hall v. King, 177 Misc.2d 126 (Sup. Ct., N.Y. Co. 1998); Ferolito, 2014 WL 5834862 at *22.
Reprinted with permission by the Nassau County Bar Association.