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LLC Buyout at Fair Value Poses ‘Conundrum’ for the Court

Finkel v. Palm Park, Inc., 2020 NCBC 84 (Nov. 18, 2020)

In allowing LLC members to buy out a departing member to avoid the dissolution of the company, a court had to determine the fair value of the departing member’s interest in a holding company. The court, in large part, relied on the fair market valuation the remaining members’ BV expert performed, which was premised on an orderly liquidation of the company.

The plaintiff and the defendants owned a limited liability company (TONG). The plaintiff owned 37.5%, whereas the defendants owned 62.5%. TONG’s only asset was its 100% stock ownership in another holding company, Palm Park, which owned three properties. Neither TONG nor Palm Park were involved in managing the properties.

The plaintiff sued the defendants for constructive fraud and judicial dissolution. The court initially concluded TONG should be dissolved as a matter of law. But, in an amended final judgment, the court, under the applicable state statute, found the defendants had the option of buying out the plaintiff’s membership interest.

Net asset value approach: Both parties agreed the net asset value approach was appropriate to determine the fair value of the plaintiff’s interest in TONG. Only the defendants offered a valuation from a BV expert, who said he was retained to “determin[e] the Fair Market Value of a 37.5% Membership Interest in [TONG] on a control marketable basis” as of the valuation date. The expert’s fair market value determination was based on a hypothetical “orderly liquidation” of TONG, including the sale of Palm Park. Under the orderly liquidation premise, the expert accounted for capital gain taxes related to the various transactions and other obligations a liquidation would trigger. He concluded that the fair market value of the members’ equity in TONG was worth almost $3.1 million and the plaintiff’s 37.5% interest was worth a little less than $1.2 million.

The plaintiff objected that the liquidation premise made no sense where the defendants elected to purchase Horizon’s interest in TONG instead of having the company be liquidated so that the defendants could continue to benefit from the investment in TONG and Palm Park “as a going concern.” Therefore, the court should not give any weight to the expert’s valuation.

The court disagreed. It noted that “there is no dispute that the orderly liquidation premise is an accepted method for determining the fair market value of holding companies” (referencing IRS Rev. Rul. 59-60). Further, the court said, fair market value was concerned with a hypothetical sale involving a hypothetical buyer and a hypothetical seller. It “is not determined by deciding the price that would be arrived at by the specific buyer and seller involved in the particular transaction under consideration.” The likelihood of liquidation was not a proper consideration for determining the FMV of the plaintiff’s interest in TONG “and is not a basis for refusing to consider [the expert’s] valuation report.” However, acknowledging that the case did present “something of a conundrum,” the court said it would consider the fact that there would not be an actual dissolution when assessing the equities of the case. At the same time, “it would be a sad end to the unfortunate story underlying this case” if the buyout would jeopardize the continued existence of Palm Park. In an effort to conclude the lawsuit quickly and enable the parties to get on with their respective business lives, the court found the fair value of the plaintiff’s interest was $1.65 million.


Sufficiently Comparable License Obviates Further Apportionment for Reasonable Royalty

Vectura v. GlaxoSmithKline LLC, 2020 U.S. App. LEXIS 36393; __ F.3d__; 2020 WL 6788757 (Nov. 19, 2020)

The Federal Circuit, in ruling on this patent infringement case involving two major pharmaceutical companies, clarified the apportionment requirement. The court found the plaintiff based its reasonable royalty calculation on a comparable license that closely covered the value of the patent in the instant case and made further apportionment unnecessary. The Federal Circuit acknowledged that the case featured unusual circumstances, while upholding the district court’s finding that the prior license guiding the royalty determination was sufficiently comparable.

Background. The plaintiff, Vectura Ltd., owned a patent that covered “composite active particles” for use in dry-powder inhalers. The active ingredient produces the intended chemical or biological effect, whereas specific additive particles help the dispersion and delivery of the active ingredient into the lungs upon activation of the inhaler. The patent discussed various additive materials, including magnesium stearate, that promoted pulmonary dispersion.

The defendant, GlaxoSmithKline LLC (GSK), made certain inhalers that Vectura said contained composite active particles that violated its patent. The case went to trial in which Vectura won on the issues of validity, infringement, and willful infringement.

A jury awarded Vectura a reasonable royalty of 3% of GSK’s $2.99 billion in sales for the infringing inhalers. The award was nearly $90 million.

GSK challenged the award in post-trial motions, including asking for a new trial on infringement and damages. It argued that Vectura’s damages theory was fatally flawed and that Vectura’s counsel and expert made comments during trial that were prejudicial to GSK and affected the jury’s decision on damages. The district court denied the motions, which prompted GSK to appeal the judgment with the U.S. Court of Appeals for the Federal Circuit, asking again for a new trial on damages

Contested damages expert testimony. Regarding the damages challenges, the Federal Circuit noted that the parties had a “licensing history.” Most relevant for this litigation was a 2010 nonexclusive, worldwide license Vectura had granted GSK related to more than 400 patents, covering certain GSK respiratory therapeutics. This license centered on a now-expired Vectura patent that covered additive material similar to that in the contested patent. Also, the 2010 license had a nonassert clause that included the application for the contested patent.

Under the 2010 license, GSK agreed to pay a tiered royalty: 3% on the first 300 million British pounds in sales, 2% on sales between 300 million pounds and 500 million pounds, and no additional royalties for sales above 500 million pounds. The 2010 license expired in 2016.

At trial in the instant case, Vectura’s damages expert, in determining a reasonable royalty, used the 2010 license’s 3% (first tier) rate as the royalty rate. She used the 2010 license’s royalty base, which consisted of total sales of licensed products for the royalty base. The expert did not adopt the 2010 royalty cap, saying circumstances had changed by the time a hypothetical negotiation would have occurred, around July 2016.

GSK’s damages expert relied on a different theory, which also used the total revenue resulting from the licensed products, but applied a lower royalty rate, 0.0187%. The GSK damages expert acknowledged that the 2010 license was “a very close comparable, much closer than you ever find in a patent case.”

At trial, Vectura offered evidence that the key part of the 2010 license covered the contested invention and that the 2010 license and the hypothetical negotiation dealt with “roughly very similar technology.” Also Vectura argued, successfully, that the principles of apportionment were “baked into” the 2010 license. Therefore, it was not necessary to perform further apportionment. The district court agreed, noting that, where a party relied on a sufficiently comparable license, it could adopt that license’s royalty rate and royalty base without further apportionment or proving that the infringing features drove the entire market value of the accused product.

On appeal, GSK argued there was insufficient evidence to support the jury’s damages. GSL said Vectura’s expert improperly used total sales of the accused inhalers as her royalty base. To be able to use the entire market value of the infringing inhalers, Vectura needed to show that the patented mixture of particles drove consumer demand, GSK said. Without this showing, the expert needed to apportion the royalty base to exclude the value of the noninfringing components.

The Federal Circuit noted that, in ordinary circumstances, using the entire market value as the royalty base is only permissible if the plaintiff can show the patented feature created the basis for consumer demand or substantially created the value of the component parts. If this is not the case, then apportionment was required.

However, the Federal Circuit went on to say that the court’s case law provides that, if the reasonable royalty is based on a sufficiently comparable license (or comparable negotiation), further apportionment is not necessary. The idea is that the comparable license has a “builtin apportionment.” (citing Commonwealth Sci. & Indus. Rsch. Organisation v. Cisco Sys., Inc., 809 F.3d 1295 (Fed. Cir. 2015))

“Built-in apportionment effectively assumes that the negotiators of a comparable license settled on a royalty rate and royalty base combination embodying the value of the asserted patent,” the Federal Circuit said.

This was the situation here, the Federal Circuit said, noting that GSK’s own damages expert acknowledged how close and comparable the 2010 license was to covering the value of the patent giving rise to the suit.

The Federal Circuit dismissed GSK’s objection that the 2010 license covered other patents, saying this fact did not “fatally undermine [Vectura’s expert’s] theory of compatibility.”

GSK’s also objected that the 2010 license imposed a royalty cap, which was integral to the 2010 license but was absent in the damages theory of Vectura’s expert. This argument also had no traction with the Federal Circuit, which noted that Vectura’s expert had explained that a hypothetical negotiation assumed validity and infringement, among other changed circumstances, which supported not applying a cap on royalty. The court noted that, by 2016, the infringing inhalers were hugely successful, “which would have increased Vectura’s leverage in the hypothetical negotiation.” The jury was free to credit the expert’s testimony and award damages without a cap, the Federal Circuit said.

The district court did not abuse its discretion when it denied GSK’s motion for a new trial on this ground, the Federal Circuit concluded.

Sales-related statements. In another line of attack, GSK argued that, during trial, Vectura had made improper references to GSK’s $3.8 billion sales in the U.S. and that its expert made an improper “it’s just pennies on the dollar, so what’s the big deal” argument. Those remarks were prejudicial and may have influenced the jury in determining damages against GSK. Under controlling case law, this conduct required a new trial, GSK contended.

The Federal Circuit noted that, during trial, GSK did not consistently object to references to U.S. sales by Vectura’s counsel and witnesses. GSK only objected during the testimony of Vectura’s damages expert, arguing then it was improper “to give an opinion on the entire market value of the product” without apportioning to the infringing features.

GSK’s counsel also claimed it was “inflammatory to put billion dollar numbers in front of juries, and that should be avoided if at all possible.” In later testimony, Vectura’s damages expert referred to GSK’s U.S. sales and GSK did not object to those references or demonstratives that showed the dollar amount of U.S. sales.

The district court noted that sales should only be emphasized to the extent it was necessary under the law. At the same time, the court said, in this case, “there was no smallest salable patent-practicing unit, and the total revenue was an appropriate base that the jury needed to hear to understand Plaintiff’s damages expert’s analysis.” Referencing the total revenue figure was not so prejudicial as to require overturning the damages verdict, the district court found in ruling on GSK’s motion for a new trial.

The Federal Circuit found references to U.S. sales were not objectionable. Under Vectura’s damages theory, which asked the jury to multiply the royalty rate (3%) by the royalty base, Vectura’s expert needed to reference GSK’s total sales. The expert’s royalty base was the total sales of the infringing inhalers, the court noted.

It said the expert also properly referenced the sales figures when she analyzed the comparability of the 2010 license and the 2016 hypothetical negotiation. This analysis was critical to Vectura’s theory of built-in apportionment, the Federal Circuit noted.

The Federal Circuit said that the district court’s decision that Vectura’s remarks on total sales were not so prejudicial that they required a new trial would be given considerable weight. “We find no basis to second-guess the judgment of the experienced trial judge in this regard.” The Federal Circuit upheld the district court’s decision to deny GSK’s motion for a new trial on this ground and upheld the nearly $90 million award to Vectura.


Proper Damages Measure Is Lost Profits Calculation, Not DCF-Based Loss Analysis

Precision Kidd Acquisition, LLC v. Pass, 2020 Pa. Super. Unpub. LEXIS 3103 (Oct. 1, 2020)

This Pennsylvania appellate court decision (unpublished) includes an informative discussion of how to measure damages arising out of a merger in which the seller allegedly failed to inform the buyer during negotiations that one of its bigger customers had terminated a supply contract. The buyer (appellant) argued the proper measure of damages was the difference between what the company was worth as represented by the seller and what it actually was worth upon the purchase. The trial court found the buyer’s damage determination was not credible and awarded lost profits based on the seller’s expert testimony.

Backstory. The seller (appellee) manufactured and shaped steel. Between 2010 and 2013, one of its key customers was Snap-On (SO). Annual sales to SO accounted for about 10.5% of the seller’s annual sales. SO and the seller had a nonexclusive supply arrangement under which the seller agreed that, if SO ordered products from the buyer, SO would pay a price to be agreed upon annually. There was no requirement that SO buy anything from the seller. The agreement was for one year, with annual renewals. Either party could terminate it 120 days before renewal; immediately, if the other party were acquired; or at any time, for any reason, upon 120 days’ notice.

In January 2014, SO informed the seller that it would terminate the agreement. However, SO continued to be a customer of the seller through individual purchase orders. The seller was able to retain 20% of SO’s business.

In 2013, the seller’s majority shareholders decided to sell the company. The company engaged an investment bank, which contacted the eventual buyer. Months of negotiations ensued during which the buyer was not informed that SO had terminated its agreement with the seller. The buyer later also claimed that, during due diligence, while it had access to the seller’s important financial and legal documents, it was not made aware of SO’s terminating letter. The buyer claimed this document was not part of the data room. At the beginning of August 2014, the seller and buyer signed a letter of intent that stated a purchase price of $11.5 million (based on the seller’s EBITDA and eventually lowered to $11.4 million). The buyer claimed, at that time, it was not informed of the cancellation of SO’s contract and that it was precluded from contacting any of the seller’s customers until the end of 2014. The merger closed in early January 2015.

The buyer sued the representative of the selling shareholders for breach of contract and contractual indemnification regarding the merger. The buyer alleged the seller’s failure to disclose the termination of the contract with SO arguably made the company less profitable and less valuable. The buyer asked for indemnification of damages under the terms of the merger.

A nonjury trial followed in which the trial court found there was a breach of contract and awarded the buyer $36,000 in damages (and over $384,000 in attorney’s fees).

At trial, both sides offered expert testimony as to how to determine damages in the case and what the amount should be.

Problematic risk analysis. The buyer’s expert said the “principal concept of [his damages] analysis” was the value of the seller with the SO agreement intact minus the value of the company without the SO agreement in place. He said the best indicator of value with the SO agreement was the agreed-upon final purchase price, $11.4 million.

He said he used a discounted cash flow analysis to determine the value of the company without the SO agreement, which he found to be $9.3 million. By his measure, damages were $2.1 million.

In explaining the DCF analysis, he said he “took advantage of the fact that we had a purchase price that had been negotiated between arm’s length third parties, and at the same time, we had a deal model that had forecasted cash flows that were prepared contemporaneous with the closing of the transaction.” He said he used the DCF to estimate “what I call the discount rate or [internal rate of return] IRR.” He said he used this rate and, in “Step 2,” adjusted cash flows “based on the materially reduced level of sales” to SO.

He said that, once “you have new cash flows, you can apply the same discount rate that I developed in Step 1 to the new cash flows to arrive at the corrected purchase price or the value of the company ex[-]Snap-[O]n.”

The seller’s expert found there were multiple flaws in the opposing expert’s analysis whose conclusion “significantly overstated” the damage to the buyer as a result of the termination of the SO contract. The seller’s expert disagreed about the amount of costs to the seller related to the SO business. He also noted the opposing expert only used one common valuation method to value the seller. He said he had not seen evidence that the buyer performed a DCF analysis when it assessed the seller company before committing to the purchase.

He said the opposing expert’s analysis was marred in that it treated the risk associated with the SO contract the same as the risk associated with the entire enterprise. On direct, the seller’s counsel noted that this was one contract that did not come with an obligation to buy anything. At the same time, this was an enterprise with multiple parties, contracts, and relationships. The seller’s expert said the opposing expert “end[ed] up with a disproportionate … value related to Snap-[O]n compared to Snap-[O]n’s contribution to the business.”

The seller’s expert agreed with counsel that the opposing expert improperly “treated this contract the same as this whole enterprise in terms of risk and the value of that contract.”

The seller’s expert also noted that the buyer did not actually pay $11.4 million, but only $7.4 million because the merger consideration was reduced by $4 million for an underfunded pension liability account.

He said, for his analysis, he considered that the assets were greater than the purchase price and this did not change with the termination of the SO contact. He found there was no way to determine a decrease in value because of the SO relationship and, therefore, looked at a “simple lost[-]profits calculation.”

He presented to the court three alternative analyses that found the company had lost profits incrementally from $36,000 to $109,000.

The trial court said it did not find the testimony of the buyer’s expert credible. The plaintiff (buyer) was unable to prove $2.1 million in damages with reasonable certainty “where it solely relies on incredible expert testimony.” The court said it “will not rewind the clock to determine what [the buyer] would have paid for the Company based on [its expert’s] overstated valuation.”

But the court said it recognized that SO was able to terminate its contract within 120 days of notice. “Assuming [the buyer] knew of the termination at the time of the transaction, [the buyer] would be entitled to 120 days of profit[s] from its business with Snap-On.” The court said it would award $36,000 in damages based on the seller’s expert’s lost profits analysis. This amount, the court said, was a “fair and reasonable estimate of lost profits suffered by [the buyer] for those 120 days.”

Illogical award? The buyer appealed the trial court’s findings on various grounds with the Superior Court of Pennsylvania (intermediate appellate court). The gist of the argument was that the trial court used the wrong measure of damages when determining the loss to the buyer. The trial court “illogically awarded damages that the Company would have been entitled to if Snap-On had breached the Snap-On Contract—but neither the Company nor Snap-On is a party to this case, nor is there any allegation that the Snap-On Contract was breached,” the buyer noted with emphasis.

It also argued that, under relevant case law, “it is the value of the loss of this relationship, and the cash flows it represented, which is the proper measure of damages here.”

The appellate court was not persuaded. It noted the trial court found that the buyer’s expert presented a damages calculation that was “inflated and flawed in multiple respects” and therefore declined to rely on the expert’s testimony. Considering the valuation evidence before the trial court, it did not err in failing to award damages based on the measure and analysis the buyer proposed, the appellate court said.

The appellate court pointed out the trial court had noted that the buyer’s expert’s analysis understated costs associated with the customer relationship, did not properly consider SO’s contractual rights in valuing the business, did not account for the company’s large size and assets, and did not properly consider how pricing competition made it difficult for the company to obtain work from SO following the acquisition.

The appellate court also rejected the buyer’s claim that the trial court should have “simply substituted” the final incremental profits number, as determined by the seller’s expert, into the analysis of the buyer’s expert. Alternatively, it could have relied on the discounted cash flow analysis of the seller’s expert. The reviewing court pointed out that, when asked whether the DCF the buyer’s expert had offered was acceptable other than the cost aspect, the seller’s expert said: “It is not my approach; it was his. I was just correcting and reflecting adjustment or corrections to his analysis.” Put differently, the seller’s expert did not recommend the opposing expert’s valuations to measure damages but instead used a lost-profits calculation, the appellate court noted.

The appellate court upheld the trial court’s damages finding, but it remanded for reasons related to the trial court’s fee award.


Expert’s Failure to Review Debtor’s Reorganization Plan Results in ‘Defective’ Hotel Appraisals

In re Kinser Group LLC, 2020 Bankr. LEXIS 3533 (Dec. 18, 2020)

The key issue in the bankruptcy proceedings involving a debtor entity that owned two hotels was the value of the hotels, which would control the amount of the main creditor’s secured and unsecured claims. The valuation date was October 2020, a point when the effect of COVID-19 was keenly felt, particularly in the hospitality industry. The court, drawing on expert opinions from both sides and straddling the value divide, found a legally sound valuation needed to be based on the premise that the debtor was planning to keep hotels in operation. Further, any valuation based on the income approach needed to be based on projections that accounted for the revenue damage caused by COVID-19.

Backstory. In 2017, the debtor entity bought two hotels in Bloomington, Ind.: the Comfort Inn and the Holiday Inn. At the time, only about 1,000 hotel rooms were available in the city. In contrast, at the end of 2020, there were about 2,900 rooms. Meanwhile, the city’s population was relatively static, as was the rate of visitors.

COVID-19-related government shutdowns in the area began in March 2020. One of the debtor’s 50% owners, who was a witness at the valuation hearing that is the subject of this court decision, testified that, before COVID-19, the debtor never missed a payment to the bank, which held perfected first liens in the amount of about $7.5 million as of August 2020. The shutdowns had serious negative consequences for the hotels’ financial performance. In October 2020, the revenue was $1.9 million lower than in October 2019, the co-owner said.

Bloomington is a college town. The evidence showed that, once COVID-19 was recognized as a global and national health threat and government orders required people to limit their social interactions, Bloomington saw students leave and pursue online education. Further, sports-related events and other college activities came to a halt for the rest of 2020. This standstill is likely to continue for a good part of 2021 until vaccination brings about a turnaround.

As for the hotels, even before COVID-19, there was a noticeable reduction in revenue (for the Comfort Inn, about 30% from 2018 to 2019) owing to the dramatic increase in the supply of hotel rooms in Bloomington.

On Oct. 7, 2020, the debtor filed for Chapter 11 bankruptcy under subchapter V. However, the court, sustaining the bank’s objection, found the debtor did not qualify for subchapter V. Instead, the case was to proceed as a standard Chapter 11 bankruptcy.

The debtor filed a reorganization plan under which the debtor would not dispose of the hotels but would retain and operate them. Also, to determine how to treat the bank’s secured and unsecured claims under the plan, the debtor filed a valuation motion. The issue in front of the court was the fair market value of the hotels as of the valuation date. Or, as the court put it, “what would a willing buyer, under no compulsion to buy, pay for the Hotels in the condition which these Hotels existed at the Valuation Date?”

Applicable law. The valuation issue arose under 11 U.S.C.S. § 506 (“Determination of secured status”), which says:

An allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under section 553 of this title [11 USCS 553] is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor’s interest or the amount so subject to set off is less than the amount of such allowed claim.

Regarding valuation methodology, the statutory provision only says the value is to be determined “in light of the purpose of the valuation and of the proposed disposition or use of such property.”

However, under controlling Supreme Court law, the proposed disposition or use of the property “[i]s of paramount importance to the valuation question.” Where the debtor contemplated the use of the property that served as collateral, the property was to be valued under the replacement value. See Associates Commercial Corporation v. Rash, 520 U.S. 953 (1997).

Similarly, in a follow-up decision, the 9th Circuit has found that, “[w]hen a Chapter 11 debtor or a Chapter 13 debtor intends to retain property subject to a lien, the purpose of a valuation under section 506(a) is not to determine the amount the creditor would receive if it hypothetically had to foreclose and sell the collateral.” See First Southern Nat’l Bank v. Sunnyslope Hous. L.P. (In re Sunnyslope Hous. L.P.), 859 F.3d 637 (2017) (en banc).

The court in the instant case said it would equate “replacement value” with the fair market value of the hotels on the valuation date in an “as is” condition.

The court heard from valuation experts for both parties and also heard from the co-owner of the debtor. It considered all the opinions for its valuation. It also noted that all witnesses agreed that the hotel’s ability to generate net revenues for the owners was “the principal factor driving the market value of the hotel.” This is what investors focus on when buying and selling hotels, the court noted.

Key metrics. The debtor’s co-owner explained some of the principal pricing metrics in valuing a hotel. They are occupancy, average daily rate (ADR), and “RevPar,” which is occupancy times ADR.

Further, he said, the STAR report or survey provides hotel owners with information on how a hotel performs relative to its competitors. He explained that the STAR report showed that, for December 2019, the Holiday Inn had a 26.2% decline in occupancy and the Comfort Inn had a 28.5% decline in occupancy. The pre-COVID-19 decline, he said, was due to the big increase in the availability of hotel rooms and a lack of increase in the demand in Bloomington.

The debtor’s co-owner also noted the term Property Improvement Plan (PIP), which requires licensees of hotel brands to “freshen up or more fully rehabilitate a licensee’s hotel property.” The co-owner explained that neither of the subject hotels were currently contractually obligated to satisfy a PIP. A sale of either hotel also would not necessarily require a PIP for the brand to approve a buyer’s assumption of the brand’s flag.

The co-owner said the Holiday Inn license agreement was to expire in May 2022. The Comfort Inn license was to expire in 2028. Both agreements can require the debtor to perform an upgrade and/or renovations.

Under the debtor’s reorganization plan, the hotels were required to set aside capital reserves of 4% per year from 2021 through 2023. For the years 2024 and 2025, the owners would have to make a $300,000 capital contribution and to borrow $1.2 million to make capital improvements to the hotels.

The co-owner testified that there were no plans for 2021 to renovate the hotels. Renovations, such as they were planned, would not begin until 2023.

By the co-owner’s account, the Holiday Inn currently was worth about $2.4 million, whereas the Comfort Inn was worth about $1.3 million to $1.4 million. The co-owner testified that neither hotel would be able to reach 2019 RevPar levels for the next three to five years.

Debtor’s valuation expert. The debtor also offered testimony from an experienced hotel appraiser who had testified in bankruptcy and state court proceedings about 20 times.

This expert interviewed the debtor’s competitors and brokers and reviewed industry publications, particularly the STAR reports. He also visited all the competing hotels he had identified in the hotels and the subject hotels themselves. He noted the Holiday inn was a full-service hotel, whereas the Comfort Inn was a limited-service hotel.

The debtor’s appraiser noted the disruption the pandemic has caused for the hotel industry. For many properties, RevPar declined by 50%, he found. However, he also noted the debtor’s hotels had shown significant revenue reduction before COVID-19, from 2018 to 2019, because of a dramatic increase in the supply of hotel rooms in Bloomington.

He also found the STAR report showed that, in December 2019, the Holiday Inn had a relatively high ADR but relatively low occupancy. This meant the hotel rooms were overpriced. He said the Comfort Inn performed better than the Holiday Inn but RevPar was down by December 2019. He said that COVID-19 devastated revenues for both hotels in 2020. He also said that industry experts expected it would take between three and five years for revenue to return to pre-COVID-19 levels.

He completely disregarded the cost approach. He found the sales comparison approach was “imperfect” because it was not possible to locate comparable sales nearby or near in time.

He decided to use the income capitalization approach. And he found RevPar was the most important metric in his valuations. A high ADR likely would push down occupancy rate and vice versa, he noted. Therefore, “RevPar is more important than artificially elevating its individual components, ADR or occupancy.”

The debtor’s expert’s valuation showed the Holiday Inn had a fair market value of about $3 million and the Comfort Inn was worth about $1.5 million. The total value of the hotels was about $4.5 million.

Bank’s valuation expert. The bank’s expert was highly experienced. He was a certified appraiser and member of the appraisal institute (MAI). He said most of his practice focused on valuing hotels. He said, in the past five years, he had appraised between 115 and 150 hotels per year, 65 in Indiana alone. However, he had never testified in litigation.

The premise of his valuation was that the hotel would be sold on the appraisal date. The sale, he assumed, would require the buyer to renovate the hotels in accordance with the terms of the applicable PIP. The total cost, he assumed, would be $3 million and would come out of the capital reserves and a capital contribution.

The bank’s appraiser agreed the income capitalization approach was the best approach. He said sales comparisons tend to be subjective, particularly when one compares different markets. Hotel buyers, this expert noted, do not generally rely on sales comparisons.

The bank’s expert agreed with the opposing expert that RevPar was the most important metric for valuing a hotel. He also noted that customers sometimes have loyalty to a hotel brand because they receive points for coming back.

This expert did not review the debtor’s reorganization plan, which discussed the debtor’s intention to keep the hotels operating.

The bank’s expert’s valuation found that the Holiday Inn on the valuation date was worth $5.5 million and the Comfort Inn was worth $2.7 million. The total value of the hotels, and therefore the bank’s collateral, was $8.2 million.

Court notes wrong base assumptions. At the beginning of its analysis, the court noted that the bank’s expert based his valuation on the mistaken premise that the hotels would be sold. Therefore, even though the expert was “imminently qualified,” his appraisals were “defective, at least for the purpose of this Court’s § 506(a) valuation.”

The debtor’s plan noted the debtor would retain and operate the hotels and case law “instructs this Court to value the Hotels at replacement value,” the court said. It went on to say that the defects in the bank’s expert’s valuation were “significant” as they lead to the assumption that the buyer would be required to spend a collective sum of $3 million to satisfy PIPs. The debtor had no capital reserves for either property and the debtor’s reorganization plan did not contemplate a capital call for years to come. The mistake carried forward in that the hypothetical buyer’s improvements pushed the expert’s occupancy and ADR numbers upwards, “thereby pushing his discounted Income Capitalization valuation all the higher.”

The court said it would give less weight to the bank’s expert’s valuation, more weight to the debtor’s expert’s valuation, and some weight to the co-owner’s valuations.

Overly optimistic projections. In performing its own valuations, first of the Comfort Inn, then the Holiday Inn, the court first considered the experts’ projections. Regarding the Comfort Inn, the bank’s expert “divines a 10-year anticipated cash flow and applies to those NOI’s a discount rate of 11.5% and a terminal cap rate of 9.5%.” The result was an “as is” valuation for the Comfort Inn of $2.7 million.

The court said the expert’s occupancy and ADR growth rates were “unconvincing and overly aggressive.” It pointed to the “dramatically increased competition in the Bloomington market,” which occurred pre-COVID-19 and the devastating effects of COVID-19 on the life of the town and the hotel industry. The court said it believed ADR and occupancy rates would not achieve stabilization for four or five years. The bank’s expert’s projections were “overly rosy.”

In contrast, the debtor’s expert offered “more probable” projections. However, his 12% discount rate and 10.5% terminal cap rate were “a bit too pessimistic.” The court also rejected this expert’s sales comparison analysis, noting he made too many significant adjustments and also subtracted a “Lease-Up Discount,” which the court said he did not define or explain in the report. However, he did explain the meaning of the discount at trial.

The sales comparison approach, the court found, was not particularly useful. “RevPar is what counts and it is the components of RevPar (occupancy × ADR) which drives [the experts’ valuations] and which also drives this Court’s valuation determinations,” the court said.

The court decided the Comfort Inn was worth about $1.8 million.

The court next valued the Holiday Inn. It said it would disregard the sales comparison analyses of both experts.

Regarding the income approach, the court again found the bank’s expert offered “performance estimates” for the hotel that were overly optimistic. Occupancy rates and ADR would not be stabilized in three years, as the expert assumed, the court noted.

The debtor’s experts NOI projections for both hotels were more reasonable than the opposing expert’s projections, the court said, considering the “keen hotel competition” in the area and the “long-term revenue damage caused by the COVID-19 pandemic.”

The court concluded the Holiday Inn was worth $3.9 million. The debtor’s expert proposed a value of $3 million, and the opposing expert a value of $5.5 million. The co-owner said the hotel was worth only $2.4 million. The court noted this witness was “very knowledgeable and credible,” but his valuations were “too light.”

In conclusion, the court found the bank had failed to meet its burden to show that the hotels, collectively, were worth $8.2 million. Looking more to the debtor’s expert’s valuations, the court found the hotels’ total value was over $5.7 million.


Indiana Supreme Court Issues Key Ruling on Discounts in Compelled Buybacks

Hartman v. BigInch Fabricators & Construction Holding Co., Inc., Indiana Supreme Court, Case No. 20S-PL-618 (Jan. 28, 2021) (Hartman II)

Last year, in a compelled buyout, the Court of Appeals sided with the departing minority shareholder when it found discounts did not apply in a closed-market sale. In a freshly minted decision, the Indiana Supreme Court reversed the Court of Appeals, finding there was no blanket rule disallowing discounts in a compelled buyback. This is especially true where the parties exercised a shareholder agreement whose terms suggested the use of fair market value.

Compelled buyback: The plaintiff was one of the founders of the company and held a minority interest in it. In 2018, he was terminated without cause. Earlier, all shareholders made an agreement that specified how the buyback price of a terminated shareholder’s interest would be determined. The company would buy the interest at “appraised market value,” as determined by an independent valuator and in accordance with generally accepted accounting principles. The independent valuator applied discounts for lack of control and marketability.

The plaintiff asked the trial court for a declaration that discounts are inapplicable because the shareholder agreement here did not “contemplate a fair market value standard.” Ruling on the parties’ motions for summary judgment, the trial court essentially found that the term “market value” as used in the agreement was synonymous with fair market value. According to the trial court, the word “appraised” was an adjective modifying “market value,”

The Court of Appeals reversed, finding, under controlling case law, discounts were inappropriate because the transaction involved a compulsory sale. The company petitioned for transfer to the state Supreme Court.

Parties’ freedom to contract: The opening paragraphs in the Supreme Court opinion make the court’s preference for the company’s arguments clear. The court said, notwithstanding policy concerns that may preclude the use of discounts in certain circumstances, “we hold that the parties’ freedom to contract may permit these discounts, even for shares in a closed-market transaction” The court went on to say, that, “under the plain language of this shareholder agreement—which calls for the ‘appraised market value’ of the shares—the discounts apply.”

The court said prior case law dealing with a statutory buyout “doesn’t control” in a situation such as here, “where the valuation term comes not from a statute but from a contract that contemplates the shares’ ‘appraised market value,’ not their ‘fair value.’”

The agreement’s plain and unambiguous language shows the parties to it agreed to value their shares as if they were sold on the open market, the Supreme Court said. Further, even if “the valuation term were somehow ambiguous,” the court would still find that “fair market value” was the appropriate standard.

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