The Continuing Debate About Brown: What Constitutes “Extraordinary Circumstances”?

By Charles F. Vuotto, Esq. and Scott A. Maier, CPA/ABV

(With Special Thanks to Daniel M. Serviss, Esq.)

2003

 

As authors of another article about Brown[i], we were concerned that the reader would dismiss this discussion as another in the ongoing debate over what standard of value is appropriate for asset valuation in the matrimonial dissolution context.  This is not the purpose of this article!  Rather, we intend to explore a part of the decision which, to this day (as a concept in both Brown, as well as Brown’s sister cases in the realm of oppressed/dissenting shareholder law in New Jersey), remains largely undefined and unexplored.  Specifically, what facts constitute “Extraordinary Circumstances” which would give rise to the application of valuation discounts in business valuations? 

Obviously there have been a plethora of articles and treatises written about this case celeb during recent months which have attempted to probe the Court’s innermost thoughts and ulterior motives in terms of setting a new standard of value for experts to use in fixing business (and possibly other assets’) values for the purposes of equitable distribution under the New Jersey statute[ii].  Surprisingly, though, the research done by the authors of this article reveals a prominent lack of discussion relating to this seminal issue.

It is our opinion that to resolve valuation issues for equitable distribution under the precedent set forth in Brown (until the standard of value itself is crystallized in subsequent cases), understanding the meaning of “Extraordinary Circumstances” will become essential.

To understand why this concept is so central and why an understanding of this issue is so essential to the practitioner, we must examine the background of the concept and how this question became relevant in the matrimonial arena.

THE GENESIS OF THE VALUATION CONCEPTS UTILIZED IN BROWN

To begin this part of the analysis, one must understand the central theme set forth by Judge Wecker’s opinion in terms of which standard of value was deemed appropriate for use in determining equitable distribution.  In Brown, the Court pulls from general corporate law and, more specifically, New Jersey’s Oppressed and Dissenting Shareholder statutes[iii] as well as the related case law to reach its conclusions.  TheBrown Court stated in its opinion “The general rule we deduce from Lawson and Balsamides is that in a statutory appraisal for purposes of determining the fair value of shares owned by a dissenting shareholder under N.J.S.A. 14A:11-1 to –1 (as in Lawson), or for valuing shares in a court-ordered buy-out resulting from an oppressed shareholder situation under N.J.S.A. 14A:12-7 (1) (c) (as in Balsamides), neither a [lack of] marketability nor a minority [interest] discount should be applied absent extraordinary circumstances.”

To state the concept of Fair Value simplistically, as utilized within the oppressed/dissenting shareholder litigation context, we set forth the following analysis:

1.      The remedy in a shareholder dispute matter where one or more of the shareholders are found to be “oppressed”[iv] will, more than likely, be for the Court to order a sale of one (or more) of the shareholder’s ownership interests to the other shareholder(s).

2.      In order to determine the price to be paid for the transferred ownership interest(s), the statute requires the use of “fair value.”

3.      Fair value is a statute/case law driven concept.  In other words, fair value can be defined differently in different jurisdictions or even within the same jurisdiction depending upon the purpose for which the subject appraisal is being utilized.  Further, fair value can and often does include attributes found in other generally accepted standards of value, such as Fair Market Value (which we will discuss in detail below) or Investment Value/Value to the Holder.

4.      New Jersey case law, specifically the seminal cases in this area of law, Lawson[v] and Balsamides,[vi] define fair value in oppressed shareholder matters generally as the fair market value of the entity exclusive of valuation adjustments such as discounts or premia (which we also discuss in detail below in the section regarding Fair Market Value).  Specifically,Balsamides states, “In this case, the key question is whether Perle received “fair value” for the shares of stock he was judicially ordered to sell to Balsamides.  Specifically, whether the trial court in calculating the “fair value” of his shares should have applied a discount reflecting the lack or marketability or non-marketability of those shares.”

DISCOUNTS DEFINED IN THE CONTEXT OF FAIR MARKET VALUE

Having presented a synopsis of the law in the area, let us briefly review some valuation theory and definitions which give rise to the results in cases such as Lawson and Balsamides:

·         Fair Market Value (“FMV”) is derived from a tax-law driven concept that was developed early in the twentieth century.  A detailed discussion of the development and use of fair market value is set forth in the IRS Code in Revenue Ruling 59-60.  As a side note, prior to the Brown decision, it was generally recognized that FMV, even though sometimes a bit corrupted, was the applicable standard of value in New Jersey divorce dissolution for the purposes of determining equitable distribution.  Fair market value is defined as follows:

The amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and both have reasonable knowledge of the relevant facts.

·         As indicated by the above definition, FMV is based upon a hypothetical sale between some willing buyer and willing seller, both of which represent an amalgam of real buyers and sellers which make up the hypothetical freely traded markets;

·         To arrive at a FMV value for a business under the market or income approaches utilized within FMV valuations, most appraisers utilize (and adjust from) data, in their calculations, derived from public markets.  In most matrimonial (and oppressed/dissenting shareholder) cases in which the authors are involved, the resulting value can be termed a “marketable interest”;[vii]

·         Because of this use of public market information, the appraiser who is doing an appraisal under FMV would normally consider applying a discount to the interest being valued for lack of marketability or liquidity (“DLOM”), that is the inherent cost of not being able to sell a closely held business’s ownership interest in a matter of days, as one could accomplish with a share of publicly traded stock;

·         We also assume, for the purposes of this article, that we are initially calculating the entire ownership interest (i.e., 100 percent of the common stock) in the subject company and then, from there, calculating what a specific percentage ownership interest in the entity is worth;

·         Therefore, if an appraiser were appraising a minority ownership interest (which carried with it a prominent lack of control over the subject company) for an oppressed shareholder using the FMV standard of value (presumably for a Court Ordered buyout of a shareholder interest by another shareholder), the appraiser would more than likely have applied a DLOM and a discount for lack of control to get to the valuation conclusion for the minority shareholder’s piece of the pie.

As touched on above, Lawson and Balsamides, which most would agree are the seminal cases utilized by practitioners in the shareholder dispute area, both specifically state that for equity purposes the valuation of ownership interests for transfer between shareholders is proscribed, in most cases, from containing either of the above mentioned discounts which are lynchpins of the FMV calculation. 

The generally accepted reasoning for this as to each discount follows:

DLOM – The Court, in its remedy of transferring the ownership interest, is creating a market for the interest being transferred and therefore no lack of marketability exists.  This remedy might very well, in certain instances, value the shareholder’s ownership interest at an amount which would be higher than the actual realizable value which would be realized in a real world sale of that ownership interest.

Balsamides is the exception to this rule.  As is apparent in our discussion of the case below, the issue became whether or not the lack of discount would penalize the oppressed shareholder at a future time.  The Court felt it appropriate to allow the discount, as the company would be illiquid and without a ready market immediately after the transaction, in effect, forcing the oppressed shareholder to fully suffer the effects of any marketing difficulties.

As an aside, we should note here that the Balsamides Court further punished the oppressing party by allowing a discount to be calculated on a value which, by definition, did not require discounting.  The appraisal which was ultimately accepted by the Court in this matter was completed based upon the use of the formula approach to valuation (IRS Rev. Proc. 68-609).  This methodology was created specifically to be utilized to calculate value for closely held businesses’ ownership interests.  Therefore, no further discounting is necessary to account for the difference in liquidity between a freely traded interest and a closely held interest.  However, the Court indeed allowed a lack of marketability discount to be applied to the value as calculated under this approach.  This decision created a windfall to the oppressed shareholder in the matter.  We, as practitioners in this area, should be careful to avoid this error in future matters.

Discount for lack of control – The Court would be remiss to allow the oppressing shareholder to benefit from the oppression that the shareholder created.  If the Court were to allow a discount for lack of control, this would be punitive to the dissenting/oppressed shareholder and, indeed, an undeserved advantage to the oppressors.  It can further be stated that a dissenting stockholder should receive their pro rata share of a control value of the company in order to compensate them for the compulsory nature of the transaction, and for the fact that, if they were not oppressed, it may have been their will to continue as a minority shareholder of the company and reap the related benefits.

Therefore, the Courts, both in oppressed and dissenting shareholder litigation and in the matrimonial arena (through Brown), have been directed not to apply such discounts except in “Extraordinary Circumstances.”  This brings us to the crux of our discussion.

EXTRAORDINARY CIRCUMSTANCES IN THE CONTEXT OF DIVORCE LITIGATION

 

Assumptions

As we stated at the beginning of this article, this is not going to be another debate about which standard of value is or is not appropriate as a result of Brown.  Therefore, for the purposes of our discussion and in the context of the explanations presented above, we assume the following scenarios:

·         The doctrine set forth in Brown is the ongoing precedent in this area for the foreseeable future;

·         As such, the stated standard of value to be used in valuing closely held businesses for the purposes of equitable distribution is fair value, as described in relevant oppressed/dissenting shareholder case law;

·         Fair Value for these purposes (as well as this article) is defined as FMV without the application of discounts, unless extraordinary circumstances exist.

What we know does constitute Extraordinary Circumstances

The substantial research completed by the authors has yielded only two clear examples of an Extraordinary Circumstance justifying the application of discounts. 

In Advance Communication Design, Inc. v. Follett, 615 N.W.2d 285 (Minn. 2000), the Minnesota Supreme Court addressed whether to apply a lack of marketability discount when an oppressing shareholder is ordered to buy-out the oppressed shareholder.  This case involved a dispute between a one-third owner of a closely held corporation and the husband and wife in control of the corporation.  The defendant, an employee of Advance Communication Design, Inc. and one-third owner sought to terminate his working relationship with the company.  When no agreement could be reached, he resigned, retaining his stock.  Defendant requested the Court to either dissolve the corporation or provide other equitable relief.  The plaintiff corporation exercised its option to repurchase the defendant’s shares pursuant to the Buy-Sell Agreement and offered the defendant what it determined to be the appropriate value for the outstanding shares owned.  When the defendant declined, the company sought an appraisal of the shares and amended its Complaint requesting that the Court require the defendant sell his shares at the value determined by the plaintiff’s appraisal pursuant to the Buy-Sell Agreement. 

            The trial court ordered the plaintiff to purchase the defendant’s shares for fair value.  In setting fair value, the trial court refused to apply the lack of marketability discount, reasoning that while the discount may be appropriate in a sale to a third party, this was a court ordered sale to a corporation whose only remaining shareholders had acted in an oppressive manner towards the selling shareholder.  Under these circumstances, the trial court concluded that applying a lack of marketability discount would interfere with the statutory purposes of protecting minority shareholders and insuring that court ordered buy-out be fair and equitable to all parties. 

            The Court of Appeals affirmed this decision citing Balsamides and Wheaton, agreeing that a lack of marketability discount was inappropriate because it would allow the controlling shareholders to benefit at the expense of an oppressed minority shareholder. 

            The Minnesota Supreme Court reversed and remanded the case, ordering the trial court to apply lack of marketability discount.  The Court, in remanding the case, listed a number of factors relevant to fair value which should be taken into account to achieve maximum flexibility in the application of the extraordinary circumstances exception to avoid an unfair wealth transfer.  The Court suggested that the following be considered:

1.            whether the buying or selling shareholder has acted in a manner that is unfairly oppressive to the other or has reduced the value of the corporation;

2.            whether the oppressed shareholder has additional remedies…; or

3.            whether any condition of the buy-out, including price, would be unfair to the remaining shareholders because it would be unduly burdensome on the corporation.

Id. at 292-93.

            When weighing these factors, the Court reminded that “the overarching policy however, is to insure that buy-out is fair and equitable to all parties.”  Id. at 293.

            In Advanced Communication Design, the Minnesota Supreme Court provided guidance to practitioners defining the “extraordinary circumstances” which would allow for lack of marketability and minority interest discount.  According to the Minnesota Supreme Court, extraordinary circumstances clearly exist when there would be an unfair wealth transfer were a discount not applied.  The Court expounded on this notion by providing specific factors to consider in applying the extraordinary circumstance exception, including: whether there has been oppression or harm done to the corporation; whether additional remedies are available to the oppressed shareholder; whether the price, absent a marketability discount, would be unfair to the other shareholders because it would be unduly burdensome on the corporation.

            In New Jersey, the Supreme Court addressed the exceptional circumstances exception, adopting Comment (e) of Section 7.22(a) of the American Law Institute Principles.  In Lawson, the Court adopted the rule against the application of the lack of marketability discount to dissenting shareholders.  The Court noted that the American Law Institute (ALI) in its principles of corporate governance, supports the proposition that no discount should be applied to dissenters’ rights regarding lack of marketability.  However, the Court further noted that the ALI states that certain circumstances may arise when the proposition should be set aside.  Citing to Comment (e) in Section 7.22, the Court recognized that:

“Under a very limited exception to the principles set forth in Section 7.22(a), the court may determine that a discount reflecting the lack of marketability of shares is appropriate in ‘extraordinary circumstances.” Such circumstances require more than the absence of a trading market in share; rather the court should apply this exception only when it finds that the dissenting shareholder has held out in order to exploit the transaction giving rise to appraisal so as to divert value to itself that could not be made available proportionately to the other shareholders…[I]t would be inappropriate to apply a marketability discount … if the shareholder was dissenting to a fundamental corporate change such as a merger, rather than a relatively minor matter.” 

Id. at 403 (emphasis added). 

In the Balsamides case, the Court held that, under the specific circumstances presented, a lack of marketability discount was appropriate. The Balsamides litigation involved two 50 percent shareholders, Emanuel Balsamides and Leonard Perle. The two had been in business together for over 25 years.  Each shareholder, in turn, brought his or her respective children into the business, albeit in different capacities.  These capacities and the compensation differential between the roles, led to the troubles between the shareholders and the subsequent legal proceedings.  Ultimately, Balsamides filed suit against Perle, under the New Jersey shareholder oppression statute, N.J.S.A. 14A:12-7.

At trial, it was determined that although Balsamides was not completely without fault, Perle’s conduct was far worse and constituted oppression under the statute.  Perle was ordered to sell his shares to Balsamides at a price that reflected a lack of marketability discount of 35 percent.  This discount was upheld by the Superior Court of New Jersey, which stated, “if Perle is not required to sell his shares at a price that reflects Protameen’s (the company which they jointly owned) lack of marketability, Balsamides will suffer the full effect of Protameen’s lack of marketability at the time he sells.”  The Court goes on to state, “…fairness dictates that the oppressing shareholder should not benefit at the expense of the oppressed.  Requiring Balsamides to pay an undiscounted price for Perle’s stock penalizes Balsamides and rewards Perle.  The statute does not allow the oppressor to harm his partner and company and be rewarded with the right to buy that partner out at a discount.” The court concluded with the following: “The guiding principle we apply in this case and in Lawson Mardon Wheaton is that a marketability discount cannot be used unfairly by the controlling or oppressing shareholders to benefit themselves to the detriment of the minority or oppressed shareholders.”

As an aside, one of the authors of this article had occasion to speak with one of the valuation experts who was involved in the Balsamidesmatter.  According to that individual, the actual oppressive actions which took place were much worse than the trial record reflected (including physical attacks, vandalism of personal property, etc.).  If there was ever a case which called for the unconventional ending thatBalsamides resulted in, it was that case.  There was no way that the Court could either allow Mr. Perle to keep the company or Mr. Balsamides to not receive some bargain in the purchase of Perle’s interest in the form of discounts.  Therefore, fault of a shareholder is clearly an Extraordinary Circumstance.

What we believe does not constitute Extraordinary Circumstances

Now that we know the very limited circumstance that, until now, does constitute Extraordinary Circumstances, what definitely does not?

We think that it is safe to say that the following do not constitute Extraordinary Circumstances:

     Ordinary Business Disputes:

·         As Lawson and Balsamides both indicate in their holdings as well as their dicta, as a general matter, unless we see the specific indicia of gross oppression (i.e., substantial “fault”) by an oppressive shareholder, that regular vanilla, every day oppression (to whatever extent that concept really exists) or dissention will not warrant the application of valuation adjustments as discussed above. 

Divorcing Shareholder:

·         Brown itself makes it obvious that a divorce between husband and wife, without some further extenuating circumstances, will not constitute Extraordinary Circumstances for the purposes of valuing businesses within the subject marital estate.  However, consider the situation where the non-owning spouse’s bad acts negatively impacted the health of both the business and marriage.  Since Brownattempts to equate the non-owning spouse to a shareholder, perhaps his/her share in the business should be discounted under the clear Extraordinary Circumstances of fault in such a situation. 

What we believe might constitute Extraordinary Circumstances in the future

In the absence of specific guidance by the Courts in this area, what additional circumstances might one argue are “extraordinary?”  If the public policy set forth by the equitable distribution statute is to be adhered to (which presumably is that any distribution resolution should be fair and equitable to both spouses), aren’t there other situations that warrant the application of valuation adjustments?  For instance:

·         What if the company being valued is in an industry which is in dire jeopardy?

·         What if the owner of the company is two years away from forced retirement?

·         What if the company has only two customers, one of which comprises 85 percent of the company’s business?

·         What if the company cannot readily get financing?

·         What if one of the partners in the business could leave with minimal notice and there is no covenant for that partner not to compete?

These and other similar questions are asked all of the time by appraisers and attorneys in these cases.  Could some of these situations give rise to Extraordinary Circumstances?  The answer is maybe. 

When an appraiser values a business as an ongoing operating entity, the appraiser, in his/her projection of value based upon the income or market approaches must consider various “risk factors” specific to the company and/or its industry.  These factors are evident in various premia which are included in the calculation of the discount rate used, in turn, to calculate the company’s value.  In our experience, in addition to factors specific to the industry in general, the appraiser must consider some or all of the following attributes specific to the business in this assessment:

·         Depth, experience and talent level of the company’s management;

·         The financial stability of the company (i.e. the asset structure supporting the company’s operations);

·         The prospect of continued profitability of the company;

·         Competition the company faces within its industry;

·         The presence of any “key” members of management;

·         Sales or purchase concentration to one or a limited number of customers or vendors.

In our opinion, any finding relating to these “risk” factors (which would increase the risk of the company not reaching its projected earnings) would merely need to be considered in increasing the company’s discount rate and hence lowering the value of the company.  These factors would not be considered as Extraordinary Circumstances in and of themselves.

Examples of Extraordinary Circumstances Beyond Shareholder Fault

It is our belief that circumstances surrounding the owners themselves, outside of the dispute giving rise to the litigation, might very well give rise to the presence of Extraordinary Circumstances when valuing these entities for the purposes of determining a spouse’s equitable share.  Some examples follow:

 

·         Age:  What if the owner spouse is a minority owner of a business and is 64 years of age as of the date of complaint? Further, assume that an operating agreement exists calling for the spouse owner to sell back his/her interest to the business at the age of 65 at a prescribed price?  This, in our opinion, would constitute an Extraordinary Circumstancewarranting a discount to be applied to the fair market value at the date of complaint.

·         Other buy/sell provisions:  Assume the same scenario as above except that the owner is 40 years old.  However, the other partner has, pursuant to a buy/sell agreement, the right to buy the interest of the owner spouse at a prescribed price (presumably less than the fair value).  Although such agreements are not binding as to value, we believe that this may constitute an Extraordinary Circumstance (in a matrimonial Court) warranting a discount to be applied to the value.

·         Infirmity:  Assume that the owner spouse is a 40 year old individual who was diagnosed with a debilitating condition which will preclude the owner spouse from continuing to run his/her business for more than another year or so.  Would this constitute a situation which requires a DLOM?  Wouldn’t the business’ sale be quite restricted since the owner could not stay on to effectuate an orderly transfer over time?

·         Very small interest:  Consider a spouse who owns a one percent interest in a family business.  Considering that, in the real world, this interest is probably not marketable at all, shouldn’t some discount be allowed?

We could present many more examples, but we believe these samples make the point.  There are many situations that the practitioner can imagine which may realistically be considered by the Court to be an Extraordinary Circumstance.  While the Court in Brown or its progeny did not provide any details as to what an extraordinary circumstance is, there are no prescriptions in the case law either.

In summary, it is the authors’ conclusion that substantial facts that are personal to the owner, rather than industry driven, which will likely effect the future income of the business and are not addressed in the “risk factors,” should be considered “Extraordinary Circumstances.”

CONCLUSION

We believe that, assuming that the Fair Value standard as set forth by Brown, Lawson and Balsamides stands as the standard to be used in matrimonial cases for the foreseeable future, practitioners may be successful in arguing for the reasonable application of appropriate valuation adjustments (i.e., discounts and premia) by focusing on the concept of Extraordinary Circumstances in resolving these matters rather than entering the fray of the standard of value debate itself.