Valuation discounts can and often do play an outsized role in contested appraisal proceedings involving the valuation of equity interests in closely held business entities for which there is no public market. This is certainly true in appraisal contests applying the fair market value (FMV) standard generally used in gift and estate tax matters and matrimonial cases, under which accredited business appraisers must consider applicable discounts including the two most common and potentially largest discounts for lack of control (a/k/a minority discount a/k/a DLOC) and lack of marketability (a/k/a marketability discount a/k/a DLOM). See ASA Business Valuation Standards BVS-VI, Part IV; Statements on ASA Business Valuation Standards, SBVS-1, Part VI, SBVS-2, Part VI; ASA Procedural Guidelines PG-2.
In most states, the merger statutes granting appraisal remedies to dissenting equity owners and the judicial dissolution statutes authorizing buyouts dictate the use not of the FMV standard but, rather, the legislative construct known as the fair value (FV) standard. At the risk of oversimplification, the difference between FMV and FV is that, unlike FMV, the FV standard either statutorily or under judge-made law prohibits DLOC and DLOM, although New York’s version of FV prohibits DLOC and allows (but does not compel and sometimes disallows on a case-by-case basis) DLOM. The philosophy underlying the disallowance of one or both DLOM and DLOC under the statutory FV standard was expressed as well as anywhere by the Delaware Supreme Court in its 1989 ruling in the Cavalier Oil case, where it wrote:
Discounting individual share holdings injects into the appraisal process speculation on the various factors which may dictate the marketability of minority shareholdings. 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.
The seemingly neat distinction between the application of DLOC and DLOM, on the one hand, under the FMV standard derived from appraisal doctrine in non-statutory appraisal proceedings (allowed) and, on the other hand, the FV standard derived from legislative/judicial edict in statutory buyout proceedings (generally not allowed), came under attack in a recent California intermediate appellate court’s 2-1 decision in Pourmoradi v Gabbai.
The case involves an LLC judicial dissolution proceeding in which the respondent 50% member elected to purchase the interest of the 50% petitioning member in lieu of dissolution, as permitted by the governing statute. The two-judge majority reversed the trial court’s valuation insofar as it rejected aggregate DLOC/DLOM discounts of 25% proposed by the respondent’s appraiser and 20% proposed by a court-appointed neutral appraiser. The dissenting judge would have upheld the trial court’s determination on fairness grounds reminiscent of those articulated in Cavalier Oil. Let’s take a closer look.
California’s LLC Buyout Statute
In 2012, California amended its Corporations Code to adopt the Revised Uniform LLC Act (RULLCA). RULLCA as promulgated by the Uniform Law Commission merely provides in § 701(b) that, in dissolution cases based on oppressive, fraudulent, or illegal acts by the LLC’s managers or controlling members, “the court may order a remedy other than dissolution.” The section’s official comment clarifies that, “[i]n the close corporation context, many courts have reached this position without express statutory authority, most often with regard to court-ordered buyouts of oppressed shareholders” and that § 701(b) “saves courts and litigants the trouble of re-inventing that wheel in the LLC context.” Section 701 and its comment says nothing about the standard of value or discounts.
California’s version of RULLCA goes much further than § 701, mimicking in large part the elective buyout provision in § 2000 of the California Corporations Code governing judicial dissolution proceedings involving closely held corporations. Under that statute the court appoints three disinterested appraisers to ascertain and fix the “fair value” of the shares held by the complaining shareholder. But there’s one big difference between § 2000 and its RULLCA counterpart in § 17707.03 of the Corporations Code: under the latter provision, the court appoints three disinterested appraisers to ascertain and fix the “fair market value” of the membership interest of the complaining member.
Apparently, the reference to FMV in § 17703.03 carried over from California’s original LLC Act adopted in 1994. I have no clue why the original Act used FMV instead of FV. It would be pure speculation on my part to suggest that it derived from California partnership law. Likewise, and against the flow of LLC legislative “corporatization” that kicked in after check-the-box came into effect in the late ’90s, why FMV was retained in the 2012 RULLCA instead of aligning with § 2000’s use of the FV standard, I also have no clue.
The Trial Court’s Valuation in Pourmoradi
Pourmoradi involves a realty-holding LLC with two 50% members who deadlocked over whether to restructure a secured loan or sell the property. After the plaintiff filed for dissolution, the defendant elected to purchase the plaintiff’s interest under § 17703.03. The trial court appointed two party-nominated appraisers and a third, neutral appraiser to appraise the FMV of the plaintiff’s membership interest.
The three appraisers agreed on a valuation of the real property but could not agree on the definition of FMV. The plaintiff-seller’s attorney advised the appraisers that FMV as used in § 17703.03 was the equivalent of FV as used in § 2000 for close corporations and therefore excluded DLOC/DLOM. The defendant-buyer’s attorney advised the appraisers that the definition of FMV was as set forth in IRS Revenue Ruling 59-60 and the ASA Business Valuation Standards and therefore allowed DLOC/DLOM. The three appraisers agreed that the (undiscounted) FV of the plaintiff’s membership interest was a little under $5 million. The defendant’s appraiser and the neutral appraiser respectively concluded FMVs of approximately $4 million and $4.25 million, respectively applying combined DLOC/DLOM discounts of 25% and 20%.
After a hearing and further instruction by the court, the appraisers came back with a unanimous report concluding a FV of about $5 million after applying a 5.5% discount for liquidation costs and a FMV of about $4.5 million.
The trial court ultimately entered a decree ordering a buyout of almost $5.3 million based on the appraisers’ FV conclusion without the 5.5% discount for liquidation costs. As quoted in the appellate court’s majority opinion, the trial court explained its decision as follows:
Here the company is made up of only two partners. The sale of one partner’s interest to the other partner would give the purchasing partner total control over the entire company. As such, a reduction for lack of control or lack of marketability would serve no purpose under this scenario. Such a reduction would only make sense if plaintiffs were selling their shares to some third-party purchaser who lacked control over the business affairs of the company. Accordingly, this court declines to apply the 15 percent reduction in value for lack of control and marketability. In fixing and setting the amount in the alternative decree, the court finds the purchase amount to be $5,278,865 without any percentage reduction therefrom. All other analyses, calculations, and conclusions of the unanimous report are well thought out and supported by the extensive research of the appraisers, and except as noted herein, are hereby approved without further offset, reduction or alteration.
The Appellate Majority Reverses
Defendant’s appeal contended that the trial court erred in fixing the value of plaintiff’s membership interest by applying a FV standard instead of the FMV standard required by the statute. Two of the three judges of the Court of Appeals agreed with the defendant, reversed the lower court’s decree, and remanded the case for further proceedings consistent with the majority opinion.
The majority launched its analysis with presumptions of statutory construction. First, it presumed that “when the Legislature used the term ‘fair market value’ in the Act, rather than ‘fair value’ from section 2000, it intended to change that standard of valuation for LLC dissolutions.” Second, it presumed that “the Legislature was aware of prior judicial constructions of the term ‘fair value,’ as precluding valuation discounts for lack of control.” From those presumptions, the majority concluded,
it follows that the Legislature, in enacting the original LLC Act, intended to depart from the ‘fair value’ standard and its liquidation value definition and utilize instead a market-based definition that included valuation discounts based on the amount a hypothetical willing and able buyer would pay for the interest in the marketplace.
The majority then wasted few words finding that the lower court misapplied the FMV standard of value. Here’s the gist of its discussion on that point:
[I]n explaining that it would not apply a reduction in value for lack of control and marketability, the trial court observed that “[s]uch a reduction would only make sense if plaintiffs were selling their shares to some third-party purchaser.” By refusing to consider how much “some third-party purchaser” would pay for plaintiffs’ interest, the court declined to apply the fair market value standard, which is based on the hypothetical willing and able buyer, and not the actual buyers in this instance, defendants. . . . By awarding, in essence, the liquidation value of plaintiffs’ interest, the trial court ignored the Legislature’s command to use a market-based standard and instead focused on the relationship of the parties to the dissolution proceeding. The court therefore defaulted to the wrong statutory valuation standard, even if it did not expressly acknowledge that it was utilizing that standard.
The dissenting judge wrote that majority was using “an entirely artificial manner of analysis” in determining whether a hypothetical third-party “market participant” buying a 50% interest in the LLC would demand a discount due to “not [being able] to take action alone when the other 50 percent owner disagrees.” Rather, where the defendant as purchaser “will end up with 100 percent control of the company,” he urged,
[t]here is no legal or practical justification for applying a lack of control or marketability discount in that circumstance. Indeed, if such a discount were applied, that would allow the purchaser to reap a windfall: the buyer need only pay the court-ordered, discounted price to obtain full control of the company and then, once in possession of full control and the premium it is worth, immediately turn around and sell the company to a third party at a higher price—laughing all the way to the bank to pocket the difference. The trial court understood that makes no good sense. As I read the record, the court believed some consideration of the equities was necessary to avoid an outcome in this particular factual scenario that the Legislature may not have foreseen but could not have intended.
The Meaning of “Fair” in FMV and FV
I find it hard to criticize the majority opinion in Pourmoradi for reading and applying § 17703.03 as written based on the legislature’s presumed awareness of the difference between FMV and FV when it adopted the original LLC Act and its RULLCA replacement. Whether the California legislature made the right choice as a matter of policy, and whether it should amend the statute to harmonize it with its close corporation counterpart, are questions outside the judicial realm.
As I see it, the FMV standard of value derives from experiential, empirically-based appraisal doctrine whereas the FV standard derives from normative legal doctrine layered on top of appraisal doctrine. And while both standards include the word “fair,” I think the word has different meanings under each. I read “fair” in FMV as a modifier of “market value,” meaning a value that replicates as close as possible what would occur in an arm’s-length transaction, with neither buyer nor seller under a compulsion to buy or sell, and both with reasonable knowledge of the facts. I read “fair” in FV less as a modifier of “value” than as a self-contained principle conveying a sense of what reasonable people would think is just and proper under the particular circumstances of the case and, in a common-law environment, that which would not incentivize others to engage in socially undesirable or economically inefficient behavior.
Finally, contrary to any misimpressions others may draw from these musings, as a lawyer who represents both buyers and sellers in appraisal proceedings, I am agnostic when it comes to valuation standards including discounts. My job is to advocate using the statutorily and judicially formulated law to the maximum advantage of my client, whether buyer or seller, and to refine the law also where advantageous to my client. Nothing more. Nothing less.