Closely Held Corporate Shares Require a Discount

In several locations, the Business Corporation Law (BCL) speaks of determining the “fair value” of a shareholder's interest. For example, in corporate dissolution proceedings based upon alleged oppression of a minority shareholder by the majority, BCL ' 1118 allows the corporation to avoid dissolution by buying the petitioning minority's interest. If the corporation and the petitioner are unable to agree on the price, BCL ' 1118(b) requires the court to “determine fair value of the petitioner's share.”

Similarly, a shareholder who objects to some action the corporation is about to take may withdraw as a shareholder and receive “fair value” for his interest. See NY BCL ' 623(e) (McKinney's 2010).

What Is 'Fair Value'?

Unfortunately for the courts and litigants, neither the legislature nor professional valuation standards have defined “fair value.” Courts have filled in the gap and defined it as the price that “a willing purchaser, in an arm's length transaction, would offer for the corporation as an operating business.” See In re Pace Photographers, Ltd., 71 NY2d 737, 748 (1988), quoting Matter of Blake v. Blake Agency, 107 AD2d 139, 146 (2d Dept. 1985). This broad definition leaves the courts with significant discretion to determine the value based upon the nature of the transaction and its effects on the corporation, valuation methodologies for determining fair value of similar corporations, and “all other relevant factors.” BCL ' 623(h)(4).

Factoring In the Discount

One of the “other relevant factors” that has produced a significant amount of litigation is whether the court should discount the value of an interest in a closely held corporation to reflect the lack of a public market on which the shares can be sold. This discount reflects the illiquidity of the shares as compared with shares of similar companies that are traded over the NYSE or NASDAQ. Matter of Seagroatt Floral Co. Inc., 78 NY2d 439, 445-446 (1991).

Since a shareholder cannot easily find a buyer to purchase the shares for cash, an owner of shares of a closely held corporation may be forced to hold the shares for longer than she desires. A reasonable investor would consider this extended holding period in determining the price to pay for the shares. Therefore, the Court of Appeals has held that “fair value” determinations “must take into consideration inhibitions on the transfer of the corporate interest resulting from a limited market ' .” Amodio v. Amodio, 70 NY2d 5, 7 (1987).

In Friedman v. Beway Realty Corp., 87 NY2d 161 (1995), the Court of Appeals reviewed the trial court's application of the marketability discount to calculate the petitioner's interests in nine closely held corporations, which each had a single piece of real estate as its sole asset. Thus, the corporations at issue in Friedman had only tangible assets, but no intangible assets such as good will.

The court remanded the case to the Supreme Court “for a new determination of the appropriate discount for unmarketability of petitioner's shares and a recalculation of fair value when that discount is applied to the proportionate net asset value of petitioner's stockholdings in the nine corporations.” (Emphasis added). Id. at 171

In the world of shareholder valuation proceedings and lack of marketability discounts, Friedman is significant because it clearly holds that the discount should be applied against the net asset value, regardless of the nature of the assets, and should be applied even where the only asset owned by the corporation is real property. (The Court of Appeals' decision in Friedman is noteworthy for another reason, not directly applicable to this article. In another part of its decision, the court definitively held that a minority shareholder's interest should not be discounted for the additional reason that it represents a minority interest that is incapable of exercising any control over the management of the corporation.)

Conclusion

In next month's newsletter we will see how the Second Department has more narrowly defined those corporate assets that may be discounted when valuing a closely held corporation, and we will discuss why the Court of Appeals should resolve the issue.

Douglas A. Cooper is a senior partner in the litigation department at Ruskin Moscou Faltischek in Uniondale, and also serves as the firm's co-managing partner. Matthew F. Didora is an associate in the litigation department. This is a slightly modified version of an article that first appeared in the New York Law Journal, an ALM sister publication of this newsletter.

In divorce, it is sometimes necessary to value shares of a closely held corporation. Of course, we all know that ascertaining the value of shares in a publicly traded company, such as Google or Coca-Cola, is a simple undertaking. MSNBC, CNN and the Internet are among the numerous sources available to investors that provide nearly real-time quotes of the latest prices for shares traded over public exchanges like the New York Stock Exchange or NASDAQ. The presence of these national exchanges enables stockholders to immediately liquidate their shares for cash in a matter of minutes through a few clicks of a mouse or a single phone call.

Not so stocks in the thousands of privately held companies throughout New York whose shares are not traded on the NYSE or NASDAQ. These companies often have only a handful of shareholders, many of whom are family members or close friends. Since shares in these companies are not routinely sold each day, there is no market to consult to determine the value of any one shareholder's interest. As a result, a unique form of litigation exists in New York whose purpose is to determine the fair value of an interest in a closely held corporation. Such proceedings are referred to as appraisal proceedings or shareholder valuation proceedings. They are necessary not only in divorce actions, but also in other cases, including dissenting shareholder cases and shareholder dissolution proceedings in which the corporation elects to avoid dissolution by purchasing the petitioning shareholder's interests. In all these cases, the valuation equation is complicated by this fact: There is likely no ready market for the shares at issue. So, should the asset's value be discounted?

Assigning Value

In several locations, the Business Corporation Law (BCL) speaks of determining the “fair value” of a shareholder's interest. For example, in corporate dissolution proceedings based upon alleged oppression of a minority shareholder by the majority, BCL ' 1118 allows the corporation to avoid dissolution by buying the petitioning minority's interest. If the corporation and the petitioner are unable to agree on the price, BCL ' 1118(b) requires the court to “determine fair value of the petitioner's share.”

Similarly, a shareholder who objects to some action the corporation is about to take may withdraw as a shareholder and receive “fair value” for his interest. See NY BCL ' 623(e) (McKinney's 2010).

What Is 'Fair Value'?

Unfortunately for the courts and litigants, neither the legislature nor professional valuation standards have defined “fair value.” Courts have filled in the gap and defined it as the price that “a willing purchaser, in an arm's length transaction, would offer for the corporation as an operating business.” See In re Pace Photographers, Ltd. , 71 NY2d 737, 748 (1988), quoting Matter of Blake v. Blake Agency , 107 AD2d 139, 146 (2d Dept. 1985). This broad definition leaves the courts with significant discretion to determine the value based upon the nature of the transaction and its effects on the corporation, valuation methodologies for determining fair value of similar corporations, and “all other relevant factors.” BCL ' 623(h)(4).

Factoring In the Discount

One of the “other relevant factors” that has produced a significant amount of litigation is whether the court should discount the value of an interest in a closely held corporation to reflect the lack of a public market on which the shares can be sold. This discount reflects the illiquidity of the shares as compared with shares of similar companies that are traded over the NYSE or NASDAQ. Matter of Seagroatt Floral Co. Inc., 78 NY2d 439, 445-446 (1991).

Since a shareholder cannot easily find a buyer to purchase the shares for cash, an owner of shares of a closely held corporation may be forced to hold the shares for longer than she desires. A reasonable investor would consider this extended holding period in determining the price to pay for the shares. Therefore, the Court of Appeals has held that “fair value” determinations “must take into consideration inhibitions on the transfer of the corporate interest resulting from a limited market ' .” Amodio v. Amodio , 70 NY2d 5, 7 (1987).

In Friedman v. Beway Realty Corp. , 87 NY2d 161 (1995), the Court of Appeals reviewed the trial court's application of the marketability discount to calculate the petitioner's interests in nine closely held corporations, which each had a single piece of real estate as its sole asset. Thus, the corporations at issue in Friedman had only tangible assets, but no intangible assets such as good will.

The court remanded the case to the Supreme Court “for a new determination of the appropriate discount for unmarketability of petitioner's shares and a recalculation of fair value when that discount is applied to the proportionate net asset value of petitioner's stockholdings in the nine corporations.” (Emphasis added). Id. at 171

In the world of shareholder valuation proceedings and lack of marketability discounts, Friedman is significant because it clearly holds that the discount should be applied against the net asset value, regardless of the nature of the assets, and should be applied even where the only asset owned by the corporation is real property. (The Court of Appeals' decision in Friedman is noteworthy for another reason, not directly applicable to this article. In another part of its decision, the court definitively held that a minority shareholder's interest should not be discounted for the additional reason that it represents a minority interest that is incapable of exercising any control over the management of the corporation.)

Conclusion

In next month's newsletter we will see how the Second Department has more narrowly defined those corporate assets that may be discounted when valuing a closely held corporation, and we will discuss why the Court of Appeals should resolve the issue.

Douglas A. Cooper is a senior partner in the litigation department at Ruskin Moscou Faltischek in Uniondale, and also serves as the firm's co-managing partner. Matthew F. Didora is an associate in the litigation department. This is a slightly modified version of an article that first appeared in the New York Law Journal, an ALM sister publication of this newsletter.