In prior posts, we have explained various valuation concepts, including the discounted cash flow (DCF) and comparable company analyses. In this post, we examine how those concepts can be applied for tax purposes. Like an appraisal in Delaware, when determining the fair market value of a closely held corporation or ownership interest in a corporation for tax purposes, tax courts consider a broad array of factors and methods. Pursuant to Treasury Revenue Rule 59-60, factors to consider include a company’s worth, its revenues, industry information, and, in the case of a minority interest, the degree of corporate control enjoyed by the interest. In Estate of Gallagher v. Commissioner, No. 16853-08, 2011 Tax Ct. Memo LEXIS 150 (T.C. June 28, 2011), the Tax Court was asked, by way of notice of deficiency in federal estate tax, to determine the fair market value of membership interests in a Kentucky limited liability company included in the decedent’s gross estate. The Tax Court considered both a DCF analysis and a comparable companies analysis from two competing experts. Given the lack of comparable companies, the court relied exclusively on the DCF method. The experts also debated over the projections and growth rate of the subject company and various discounts to reflect the company’s status as an S corporation, the minority interest position, and lack of marketability. The court took parts of both experts’ analyses, but calculated its own discount rate and applied both a minority discount and a lack of marketability discount. The court ultimately concluded that based on a DCF analysis, the fair value of the shares as of the valuation date was $32,601,640, or $8,212 per share.

** Lowenstein Sandler LLP thanks Anish Patel, a student at Seton Hall Law, for his contribution to this blog.

Texas recently forayed into appraisal by applying its statute to a corporation’s plan of merger. Subchapter H of Chapter 10 of the Texas Business Organizations Code provides that a voting shareholder of a for-profit corporation who dissents to a plan of merger is entitled to “obtain the fair value of [its] ownership interest through an appraisal.” TEX. BUS. ORGS. CODE ANN. § 10.354(a)(2).

In Am. Bank, N.A. as Tr. of Lisa Marie Buckley Tr. v. Moorehead Oil & Gas, Inc., 2018 WL 6219635, at *1 (Tex. App. Nov. 29, 2018), there was an additional wrinkle – the dissenting shares from the corporation’s plan of merger had been bequeathed to the trusts. Section 10.361(g) provides that a “beneficial owner of an ownership interest subject to dissenters’ rights held in a voting trust or by a nominee on the beneficial owner’s behalf” may file a petition for a valuation in that situation.

In Moorehead, the trusts had inherited a 3.8 percent stake in the oil and gas company Moorehead. Shortly thereafter, Moorehead finalized plans to reorganize itself, through a merger, to become a limited liability company, whereby the trusts’ shares would be canceled and converted into cash. The beneficiaries of the trusts objected to Moorehead’s valuation of $7.30 per share and filed an action seeking appraisal and recovery of the fair market value of their shares. Moorehead filed a motion for summary judgment on the grounds that (1) the petition was untimely because the original petition failed to correctly name the trustees of the trusts, and (2) several of the plaintiffs lacked standing.

The Court applied the doctrine of misnomer and found that the amended petition related back to the date of the timely filed petition. However, the Court dismissed the claim in part based on lack of standing. While the bank plaintiff had capacity to sue as trustee, the Court held that the beneficiaries of the trusts lacked standing as beneficial owners because the shares were never held in a voting trust or by a nominee, as is required pursuant to Section 10.361(g).

Chief Justice of the Delaware Supreme Court Leo Strine has announced he will retire this fall. Readers of the blog will recognize that Chief Justice Strine has been involved in numerous appraisal decisions including Aruba and others and has spoken about the appraisal remedy at length.

The Chief Justice was previously a Vice Chancellor, before his elevation to the Delaware Supreme Court.

According to the Cape Times, South African real estate investment trust Hospitality Property Fund (“HPF”) was recently ordered by the South African High Court to reinstate certain shareholders and pay them a dividend as the result of an appraisal rights action under Section 164 of the South African Companies Act – that country’s appraisal regime.  HPF has combined two classes of its shares, which, under South African law, apparently triggered appraisal rights. A subset of HPF shareholders dissented and an appraisal proceeding has been working its way through the Courts. Whether this will be the end of the appraisal proceeding is unclear. South Africa remains a regular source of appraisal news, as we’ve covered before.

Yes, in sum. The two terms are often used interchangeably in the literature. Certain countries or jurisdictions have a stronger tradition of referring to these important shareholder rights as either appraisal rights – focusing on the remedy – or dissenters rights – focusing on the entitlement. Arguably, dissenters rights may be thought of as broader than appraisal rights since dissenters rights can encompass remedies other than appraisal. And the appraisal remedy, through quasi-appraisal, may be available to those who do not dissent. But these somewhat philosophical distinctions are less relevant than common usage, and in common usage, dissenters rights and appraisal rights are the same.

Is the “go shop” still an effective tool for ensuring the maximization of business value? Maybe not – according to recent research by Prof. Guhan Subramanian of Harvard Business School. A “go shop” provision, in short, is when a seller comes to agreement with a buyer, but then there is a post-agreement process where the seller seeks out alternative, better, deals (or ‘shops’ the company). If no higher bidder is found – so the logic goes – than the original deal must have been a value maximizing one. A 2008 study of go shop provisions was positive: using a small samplesize, the study found that go-shops were yielding a topping bidder a significant amount of the time, and were resulting in increases in value to shareholders.

Does newer data continue to show evidence of the efficacy of go shops?  Not so much, say the authors. In the new data set – now focused on deals from 2010 to 2018, go shops resulted in a higher bidder only 6% of the time, and then only 2.5% of the time in 2015-2018. And what explains this (setting aside that the n of the original study may have been too small to be meaningful)? One option, which the authors discount, is that the go shop provisions themselves got worse – shorter periods, higher termination fees, etc. But the second option, which the authors focus on, does not bode well for shareholders who look to a go shop as protective: modern go shops have introduce are structured in ways to make a topping bid unattractive while giving the window-dressing of a go shop process – i.e., match rights, short windows in large deals (as opposed to in smaller deals as before), and technical changes to the proposal to require a topping bidder to launch a full-blown acquisition during the period  – all leading to the authors view that merger participants, including management and the investment banks have conflicts of interest when it comes to the go-shop. From an HLS Forum blog post on the article: “Conflicts of interest for management also hinder the effectiveness of go-shop processes. CEO’s often have a financial incentive to keep the deal price down, which means discouraging potential third-party bids during the go-shop process. And in some instances, CEOs have undisclosed qualitative reasons for discouraging third-party bids.”

Are go shops still working? Well, the authors have this to say: “At the highest level, the story of the go-shop technology over the past ten years is one of innovation corrupted: transactional planners innovate, the Delaware courts signal qualified acceptance, and then a broader set of practitioners push the technology beyond its breaking point.”

Appraisal is a remedy for shareholders who believe a merger is being consummated at below fair value. Appraisal is also a check on management and boards of directors – specifically, providing a ‘backcheck’ on whether the shareholder fiduciaries are achieving fair value for the company. Management buyouts are an acute case of mixed incentives for company insiders, and accordingly are a place where the appraisal remedy is particularly critical.

Enter a recent paper from the Journal of Financial Economics analyzing MBOs and freezeouts. Analyzing MBOs and other mergers from 1980 forward, the authors find evidence that MBOS and freezeout transactions are timed to take advantage of industry-wide under valuations. In other words – the insiders, with the most industry knowledge, are sometimes able to purchase companies on the cheap from existing shareholders when the overall industry is being undervalued by the market. This allows the buyer (management) to “capture the value” between the target’s value and the bid price in a time of industry undervaluation.

It is worth noting that the authors evidence applies to the “average” MBO – i.e., MBO’s in general – and not to any particular MBO. Management does not time its bid to industry undervaluation in every instance, or in any particular instance, but there is evidence that management does so across the aggregate of MBOs.

Data like this highlights the importance of the appraisal remedy. When MBOs are able to accrue value to the bidder, and not shareholders, shareholders need a remedy (like appraisal) to check the buyer (in this case – management’s!) gains. The data also highlights that appraisal may be particularly relevant in MBOs or other instances where the buyer has superior information to the market at large – something that was seen in Dell and other appraisal cases.

Valuation litigation plays out in a number of different business contexts. Readers of this blog will be well familiar with one of them: appraisal rights (a/k/a/ dissenters rights) actions brought when a public company is being acquired by another entity. But valuation disputes requiring the determination of fair value come up in many other contexts often not involving public companies, but instead private businesses. Recent discussion in the Delaware appraisal space focusing on Aruba, and its predecessor cases, discussing topics of market efficiency, “unaffected stock price”, whether the merger price is presumptively fair, etc. all presume an active, open, and at least on-first-glance well-functioning market for the stock of a company. But for private companies, there is usually no market to speak of, or, if there is one, defining it and understanding it is solely the province of economic and valuation experts. With no unaffected stock price, a ‘merger price’ almost always set by the dominant shareholder, and no real market check on value, there private valuation cases present an entirely different side to appraisal rights/dissenters rights.

This blog post details a New York dissolution proceeding where valuation was at issue. New York has a fair value statute, within its Business Corporation law, with respect to dissolution proceedings (§1118) which shares connection to New York’s appraisal rights section (§623). The post provides a blow-by-blow of a valuation dispute in New York, going through the case facts, the Net Asset Value (NAV) of the relevant entity, and then how NAV links to “fair value” (at least per the author). The post also has an extensive discussion of the application of discounts for lack of marketability (“DLOM”) in New York fair value proceedings. (For a discussion of DLOMs and DLOCs, see a guest post here.) Delaware-concerned readers may recall that Vice Chancellor Glasscock analyzed DLOMs in the case Wright v. Phillips, a deadlock case in Delaware. And we’ve written before how discounts in general come up in many fair value proceedings.

The blog post concerning New York goes through an analysis of why a DLOM (or other discounts) may not be appropriate in the dissolution case being analyzed, and notes that the opposing expert was setting out a 35% DLOM. Thus, the battlelines were set: 0% DLOM on one side; 35% DLOM on the other. Since the value at issue was in the millions, in turn, the DLOM level was worth millions (about ~$1.5MM after all was said and done according to the post).

According to the post, the matter eventually settled before trial, with a number reflecting an ‘in-between’ (though higher than 50%) of the 0% DLOM and 35% DLOM view.

The entire post is worth a read for its blow-by-blow of the valuation analysis and the underlying analysis. It bears repeating that appraisal disputes with private businesses involve an entire set of fair value considerations often different from the public-company-appraisal that captures headlines and academic attention.

For public company shareholders, a cashout merger offer (even one at a too-low price) tells you that someone wants your shares and intends to pay you cash for them. And, at least in US actions, it is the rare public-company focused appraisal case that concerns collections. Indeed, if an acquirer is paying cash for a public company, the idea of collections barely registers.

But, one bears reminding, appraisal actions are not a special breed of lawsuit where payment is somehow guaranteed. Enter In re Lee, 898 F.3d 768 (7th Cir. 2018), where we find a federal appeals court dealing with appraisal remedy related collections.

How Lee got from an Indiana appraisal case to the 7th Circuit is a tortured route, but the core facts of relevance are straightforward: a minority investor obtained a judgment under Indiana’s appraisal remedy against a corporation. The controlling majority shareholder filed for bankruptcy (and because all bankruptcy is in federal court – the federal court angle). Post-merger, the controlling shareholder “gutted” the merged company, leaving it with nothing to satisfy the appraisal judgement. The aggrieved minority shareholder sought to access the controlling shareholders personal assets. The District Court agreed with this; and the 7th Circuit affirmed. (For a more robust discussion of non-appraisal aspects of In re Lee, see this article.)

Focusing on the appraisal angle, this case highlights a couple points. Appraisal remains a potential remedy for minority shareholder oppression. While this blog, and many Delaware appraisal cases, cover billion dollar companies targeting other billion dollar companies, appraisal is not limited to such cases. An aggrieved shareholder of a small company, including a family company, may indeed have appraisal rights (depending on their jurisdiction and the facts of the case). And finally, in many instances appraisal remains part of a larger litigation environment. In other contexts (here, the bankruptcy limited the minority shareholders options), other potential litigation approaches may have possible – whether fraudulent conveyance lawsuits, or using information gleaned via appraisal in another action.

Lee, and cases like it are a useful reminder: While appraisal may be a somewhat unique remedy, it is still litigation. Appraisal can still face litigation risks (like collections), and it can be part of a larger litigation strategy than just ‘bring an appraisal.’