Valuation Services Bulletin: Q3 2020
In This Issue:
- Discounts Inappropriate in Valuing Minority Interest in Mandatory Buyback, Appeals Court Rules
- Tax Court Spurns IRS’ Gift Tax Valuation Theory and Methodology
- New DOL Process Agreement Confronts Control Issue in ESOP Valuations
- Lack of Valuation Credentials Does Not Disqualify Expert, but Failure to Perform Valuation Does, Court Finds
- IRS Private Letter Ruling on Whether to Consider Pending Merger in Gift Tax Valuation
When a minority shareholder in an Indiana company was terminated as a director and officer, a dispute arose over whether, under a buyback agreement, the use of discounts for lack of control and marketability was permissible in valuing his shares. The trial court said yes, but the appeals court, citing case law, reversed.
Compelled buyback: The plaintiff was a founder as well as a director and officer of a company that fabricated and installed natural gas and pipeline equipment. He owned a 17.77% interest in the business. When he was terminated (involuntarily), his departure from the company triggered a provision in the controlling shareholder agreement requiring the company to buy back his shares. The valuation was to be based on the “appraised market value of the last day of the year preceding the valuation, determined in accordance with generally accepted accounting principles by a third party valuation company within the twenty-four months preceding the transfer of shares.”
The retained outside appraiser said it was engaged “to estimate the fair market value of the property…. This valuation was performed solely to assist with the valuation requirement in a shareholder agreement due to a triggering event involving [the plaintiff].” The appraiser found the plaintiff’s interest was worth about $3.5 million but applied discounts for lack of control (DLOC) and marketability (DLOM) and concluded the final value was $2.4 million.
The plaintiff sued, and the company countersued. Both sides filed motions for summary judgment. The issue for the trial court was whether, as a matter of law, under the buyback provision, the valuation could include discounts. The trial court found for the company and granted its motion.
The plaintiff appealed the decision. The gist of the plaintiff’s argument to the Court of Appeals was that, under the controlling case, Wenzel v. Hopper & Galliher, discounts were inappropriate because the transaction involved a compulsory sale. Further, the language of the shareholder agreement regarding the appraisal method precluded the use of the fair market value standard because the sale of the contested shares did not take place in the open market and the buyer already controlled the company.
Avoid windfall: The appeals court found Wenzel was applicable to the situation at hand. In Wenzel, the Court of Appeals rejected discounts in the context of a law firm’s purchase of a departing partner’s interest in the firm. The case was brought under the state’s professional corporation act. The court differentiated between fair value and fair market value and rejected the use of minority and marketability discounts in fair value cases where a controlling interest holder buys back the stock. Minority and marketability discounts were “open market concepts” that did not apply where a shareholder is compelled to sell to the majority, the court found. The use of discounts would mean a “windfall” to the buyer.
In the instant case, in rejecting the company’s argument that using the fair market value was consistent with the shareholder agreement, the court said:
The Shareholder Agreement itself recognizes that the mandated buyback of shares to the Company differs from a sale to a third party on the open market and thus, different interests must be recognized by implementing an appraised market value rather than the open-market valuation method of fair value or fair market value.
The appeals court concluded the trial court erred as a matter of law when it allowed the discounts.
A digest of Hartman v. BigInch Fabricators & Construction Holding Co., Inc., 2020 Ind. App. LEXIS 183 (May 5, 2020), and the court’s opinion, will be available soon at BVLaw. A digest and the court’s opinion in Wenzel v. Hopper & Galliher, 779 N.E.2d 30 (Ind. Ct. App. 2002), are available to BVLaw subscribers.
In a gift tax dispute, the U.S. Tax Court recently found for the taxpayer when it rejected the unusual reasoning and methodology the Internal Revenue Service’s trial expert proposed to keep low the discounts applicable to the nonvoting membership units in two limited liability companies (LLCs).
Nonmarketable, noncontrolling interest: In late 2013, as part of his estate plan, the taxpayer transferred his 99.8% interest in an LLC called Rabbit to a grantor retained annuity trust (GRAT) and his 99.8% interest in another LLC, Angus, into an irrevocable trust. The GRAT transfer was structured to avoid gift tax liability. The taxpayer’s 99.8% interest in both LLCs represented class B nonvoting units. A management entity that belonged to the taxpayer’s daughter solely owned the remainder 0.2% interest. This interest represented class A voting units. Both LLCs held securities, investments, and promissory notes. Neither of the two entities’ class B membership units were ever offered for sale or sold since the transfers.
The taxpayer filed a Form 709 gift tax return with valuations an appraisal firm had performed. In January 2018, the Internal Revenue Service (IRS) issued a deficiency notice, finding the taxpayer had understated the FMV of both companies’ class B units.
The taxpayer petitioned the Tax Court for review. The court was presented with three valuations, including those attached to the tax returns, valuations from the petitioner’s trial expert, and valuations from the IRS’ trial expert.
To account for the noncontrolling, nonmarketable aspects of the class B units, the firm preparing the original appraisal applied discounts for lack of control (DLOC) of 13.4% and 12.7% and a 25% discount for lack of marketability (DLOM) for both companies. The taxpayer’s trial expert prepared his own valuations and applied slightly higher DLOCs.
The IRS’ expert proposed a theory of what the hypothetical buyer and hypothetical seller would do under the facts, which aimed to minimize the applicable discounts. Per the expert, a reasonable buyer of the 99.8% interest made up of class B units would try to maximize the buyer’s economic interest by acquiring the remainder 0.2% interest consisting of class A units. Doing so would consolidate control of the respective company and further increase the value of the class B units by decreasing the discount a hypothetical buyer would pursue. To buy the class A units, the hypothetical buyer would have to pay a “reasonable” premium, which the expert determined to be 5%. Basically, he subtracted the premium amount from the undiscounted net asset value of the LLCs. The result was a significantly higher valuation for each company than those the taxpayer’s appraisers offered.
The Tax Court, citing Estate of Giustina, in which the very court had cautioned against “imaginary scenarios as to who a purchaser might be,” found the IRS expert’s approach was not supported by facts, case law, or among peers. “We are looking at the value of class B units on the date of the gifts and not the value of the class B units on the basis of subsequent events that, while within the realm of possibilities, are not reasonably probable, nor the value of the class A units,” the Tax Court said.
For Rabbit, the court adopted the NAV to which the parties stipulated. For Angus, it adopted the NAV the original appraiser calculated.
The Department of Labor recently settled ESOP litigation with the trustee Farmers National Bank of Danville (FNB). The settlement incorporates a process agreement that contains noteworthy directives instructing the trustee on handling controlling interest acquisitions and indemnification matters.
This is the sixth such process agreement the DOL has made with defendant trustees. Ostensibly the agreements only bind the parties to it, here FNB. At the same time, the agreements have come to serve as guideposts to the ESOP community as a whole regarding the issues the DOL prioritizes in scrutinizing ESOP transactions and the positions the DOL takes on the issues. The crux long has been that the DOL has failed to issue final regulations that provide legal guidance and certainty to actors in ESOP transactions.
Control provision: The control provision in the FNB agreement applies only “when the ESOP intends to buy a controlling interest in the company whose stock it intends to acquire.” It speaks to the question whether the ESOP, in purchasing 100% of the stock of a company, has acquired actual control over the company such that it is appropriate to include a control premium in the valuation underlying the transaction. This issue was heavily litigated in the two key cases arising in the 4th Circuit, Brundle and Vinoskey. In both cases, the courts sided with the DOL in finding the ESOP did not in fact acquire control of the company and a control premium was not justifiable.
The FNB agreement obliges FNB, when acting as trustee in an ESOP transaction, only to approve a transaction in which the ESOP pays for a control premium if FNB ensures the ESOP acquires a host of specific rights that, in the DOL’s view, reflect true control over the company. “Control,” under the agreement, means having “all of the unencumbered rights” a controlling shareholder normally would have as well as the rights normally vested in the company’s board of directors and top executives. ESOP practitioners have chafed at this expansive definition of control.
Moreover, if the transaction imposes restrictions on the ESOP’s ability to control the company or the ESOP does not acquire “the degree of control of the company commensurate with the ownership interest it is acquiring,” FNB as trustee must ensure the purchase price reflects the ESOP’s lack of control. In these circumstances, FNB has to ensure that the valuation does not only include a control premium but includes “an appropriate lack of control discount [DLOC], to the extent that the ESOP’s rights of control are diminished.”
Open questions are whether the list of rights the DOL provides here is now applicable in all ESOP transactions to show the ESOP has acquired actual control, whether a transfer of rights short of those on the list requires an adjustment in the form of a DLOC, and how one calculates the “appropriate” lack of control discount.
Indemnification provision: Also important is a provision that says FNB cannot request indemnification by an ESOP or “ESOP-owned company (irrespective of whether the ESOP owns some or all of the company’s stock)” for liability and losses from breach of fiduciary duty claims or other ERISA violations. FNB, as defendant, also cannot ask for the advancement of legal fees “unless an entirely independent third-party determines that there has been no breach of fiduciary duty.” Even then, there has to be “a prudent arrangement” that guarantees a refund of advanced fees or costs if a court later determines there was a fiduciary breach.
As legal exposure particularly for ESOP trustees has increased, who bears the cost of defending against DOL action has become a critical issue. This provision suggests an effort by the DOL to tighten restrictions on the defense-related assistance available to ESOP trustees.
Hat tip to James F. Joyner (Integra Valuation Consulting LLC) for alerting us to this case.
Lack of Valuation Credentials Does Not Disqualify Expert, but Failure to Perform Valuation Does, Court Finds
Eurochem North America Corp. v. Ganske, 2020 U.S. Dist. LEXIS 26539; 2020 WL 747008 (Feb. 14, 2020)
This tangled business dispute included a Daubert challenge to an expert who had no business valuation credentials but was retained to value the plaintiff’s company for purposes of a before-and-after damages calculation. The court found that the expert was qualified based on decades of experience. But the expert’s testimony was inadmissible under the unreliability and relevance prongs. Since the expert had not actually performed the value determination, he could not credibly vouch for the reliability of the decisions and data that went into the calculations. The testimony was irrelevant where the plaintiff’s damages model failed to account for other factors contributing to the claimed losses. The expert’s testimony was part of the plaintiff’s flawed methodology and would not assist the jury, the court found.
Background. EuroChem (plaintiff and counterdefendant) sued a couple (Kent and Julie Ganske) and their company over more than $14 million in unpaid invoices for delivered goods. The Ganskes and their company disputed the debt and also filed a third-party complaint against EuroChem, alleging various business torts. An arbitrator found for EuroChem on the debt dispute, and the federal court confirmed the arbitration award. The court also rejected the Ganskes’ claim that their personal guarantees to pay their company’s debt were unenforceable because of fraud and lack of consideration
The Ganskes’ third-party claim was headed for trial. In essence, they claimed that EuroChem, through trickery, managed to obtain confidential business information, which it used to contact the Ganskes’ customers and vendors to lure them away with cheaper products and by defaming the Ganskes and their company. In terms of remedy, the Ganskes tried to introduce into evidence an expert report and testimony to show “business devaluation” damages of approximately $24 million.
EuroChem attacked the admissibility of the Ganskes’ expert testimony under Federal Rule of Evidence 702 and Daubert and its progeny.
Applicable legal principles. Rule 702 provides that a witness may be qualified as an expert by “knowledge, skill, experience, training, or education.” An expert may testify whether his or her knowledge will help the trier of fact (jury or judge) to understand the evidence or a disputed fact; whether the expert testimony is based on sufficient facts or data; whether the testimony is the product of reliable principles and methods; and whether the principles or methods have been reliably applied to the facts of the case.
The U.S. Supreme Court’s Daubert decision requires the federal district court to act as gatekeeper to ensure expert testimony is based on a reliable foundation and is relevant to the proceedings.
Put differently, the court must assess the expert’s qualifications, the reliability of his or her methods, and the relevance of the expert’s testimony. In assessing admissibility, courts are not concerned with “the ultimate correctness of the expert’s conclusions.” Under the controlling case law, courts have “great latitude in determining not only how to measure the reliability of the proposed expert testimony but also whether the testimony is, in fact, reliable.”
Here, EuroChem challenged the admissibility of the Ganskes’ expert under all three prongs.
The expert was retained to provide a valuation for the Ganskes’ before-and-after damages model. Specifically, the expert, a business broker who typically worked with sellers to market their businesses to prospective buyers, offered a valuation of the business before the alleged misconduct by EuroChem took place. For this purpose, the Ganskes sought to introduce a 25-page business report the expert’s company had prepared in late 2016 or early 2017, which valued the company at $36 million, as well as the expert’s testimony. The Ganskes themselves claimed the “after” value of their company was about $11 million. The litigation strategy was to persuade the jury to attribute the loss in value solely to EuroChem’s alleged conduct.
Qualifications challenge. EuroChem first argued the expert was not qualified under Rule 702 because he lacked business valuation experience and credentials. He was not familiar with the standards governing business valuations, EuroChem claimed. It noted the expert had only taken two one-day classes to become a “Certified Business Intermediary” from the International Business Brokers Association.
The court found qualification was not a problem for admissibility purposes. It observed that the expert had been a business broker for more than 40 years and, throughout his career, had valued and sold many businesses and performed more than 1,000 business valuations. He was qualified by experience.
Reliability challenge. However, the court found the testimony did not meet Daubert’s reliability requirement.
Under the applicable 7th Circuit case law, courts testing for reliability may consider a nonexhaustive list of factors that ask whether the proffered theory can be tested or has been tested, whether it has been peer-reviewed, whether it has been accepted in a given scientific community, whether the testimony flows “naturally and directly” from research that the expert conducted independent of the litigation or whether it was litigation-driven, and whether the expert adequately accounted for “obvious alternative explanations.” See Gopalratnam v. Hewlett-Packard Co., 877 F.3d 771 (7th Cir. 2017).
The court found significant problems with the methodology underlying the expert’s valuation. For one, the expert did not actually prepare the report, the court noted. Rather, the report was prepared by an employee, who, the expert said in deposition, “does all of our valuations in-house.” He said he typically reviewed valuation reports when they were completed, and he also reviewed the underlying information when it came into the office, including tax returns. At the same time, he admitted that he had not supervised the production of the contested report.
The court found the expert’s testimony on the methodology his firm had used to create the report was inadmissible hearsay. There was no way to properly cross-examine him regarding its preparation, the court said.
Further, the expert admitted that the Ganskes did not retain him to prepare an independent determination of the company’s value. He, or his firm, used the data the Ganskes provided for the express purpose of coming up with a valuation that would maximize the value of the business to prospective buyers.
Moreover, the expert said his firm did not prepare a valuation but “an estimate of value for marketing purpose.”
Most importantly, there was no showing that the actual methods used to arrive at an estimate of value were reliable, the court found. The expert’s firm used three income approaches (multiple of seller’s discretionary income, multiple of EBITDA, and multiple of gross revenue). The multiple of gross revenue approach yielded a result that was about 20 times greater than the result achieved with the other two methods, the court noted. The expert conceded it was appropriate to disregard an outlier, and he could not explain why, in this case, the very high result was given equal weight in the final estimate of value. Not having prepared the calculation, he did not know what sources were used to produce various multiples that were used for the estimate. The court noted the expert “simply presumed the figure was reliable.”
The Ganskes failed to show the methodology their expert used was sound and reliable, the court noted. It also said that, in a “post-hoc affidavit,” the expert asserted that his firm had relied on sources “that I know to be reliable and the information that we gathered is of a type reasonably relied upon by experts in my field.” The court declined to consider the affidavit but noted that, even if it did, this statement would not show reliability because it was nothing but the expert’s “say-so.”
Relevance challenge. The court said it had “serious concerns” that the testimony was even relevant. It was fair that the Ganskes wanted to introduce the expert report and testimony to support the “before” part of their before-and-after damages model, the court said. But the model as such was flawed because the Ganskes failed to account for other factors that might have led to business losses, such as changes in market conditions, i.e., factors unrelated to the alleged disparagement by EuroChem.
“[A] valid damages model in a case alleging unfair business competition must account for factors not attributable to the defendants’ misconduct that might have caused the plaintiff’s financial losses,” the court noted. Under the applicable 7th Circuit case law, “a simple before-and-after theory is too imprecise,” the court noted. The Ganskes’ contention that the entire decline in the value of their business was attributable to EuroChem’s smear campaign was “untenable” under common sense and the facts of the case, the court noted with emphasis.
The record showed that before the alleged defamation campaign, the Ganskes had $23 million in customer liabilities and owned EuroChem millions more, the court emphasized. The expert failed to account for this debt in his estimate of value.
Insofar as the expert’s testimony was to be the starting point of the Ganskes’ flawed method, it was not helpful to the jury, the court said.
The court concluded the expert report and testimony were inadmissible under Rule 702 and Daubert.
Office of Chief Counsel Internal Revenue Service Memorandum, POSTF-111979-17, Number 201939002, Release Date 9/27/2019
Valuation experts working on gift and other tax-related matters will want to be familiar with a recent private letter ruling by the Internal Revenue Service on the issue of when a fair market value determination would consider a pending merger for gift tax purposes. Even though private letter rulings are not precedent, they can provide guidance to financial experts and attorneys on how the agency analyzes issues and what positions it may be expected to take in an audit or litigation setting.
Facts provided. The memo does not provide a lot of facts. Here is what we know.
The donor of the gifted property was a co-founder and chairman of the board of a publicly traded company (Corporation A).
On Date 1, he transferred shares to a grantor retained annuity trust (GRAT) for a certain number of years. (The memo does not state the number of years.) After that period, the remainder of the trust would be distributed to his children.
Following Date 1, on Date 2, the donor’s company announced a merger with another company (Corporation B).
Before Date 1, i.e., the transfer of shares, Corporation A had engaged in negotiations with multiple parties.
Also, before the transfer of shares, Corporation A had held exclusive negotiations with Corporation B. These negotiations eventually culminated in the merger.
After the merger was announced (the IRS memo does not state how many days later), the value of Corporation A stock “increased substantially, though less than the agreed merger price.” The memo does not state when exactly the merger closed.
Issue presented. The memo answered the question of whether, under these facts, a hypothetical buyer and a hypothetical seller of shares in a publicly traded company would consider the pending merger in determining the value of the shares for gift tax purposes.
In other words, given these circumstances, should a fair market value determination for gift tax purposes account for the pending merger?
Short answer. Chief counsel said yes.
Applicable legal principles. If a gift is made in property, the value of the property on the date of the gift represents the amount of the gift. In other words, the valuation date is the date of transfer (date of gifting).
The value of the transferred property is “the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the facts.”
In other words, the applicable standard of value is fair market value (FMV).
Under the FMV, the willing buyer and the willing seller are hypothetical, meaning they are not the specific donor and donee.
Further, the FMV assumes that the aim of both the hypothetical willing buyer and the hypothetical willing seller is to maximize their economic advantage.
Also, there is a presumption that the hypothetical willing buyer and willing seller ready to engage in a transaction have “reasonable knowledge of relevant facts” as to the property at issue. This presumption applies “even if the relevant facts at issue were unknown to the actual owner of the property.”
There is a presumption that both the hypothetical buyer and hypothetical seller made reasonable efforts to investigate the relevant facts.
Besides looking to publicly available facts, this principle assumes reasonable knowledge of “those facts that a reasonable buyer or seller would uncover during the course of negotiations over the purchase price of the property.”
There is a presumption that a reasonable buyer would have asked the reasonable seller about information that is not publicly available. In other words, the reasonable buyer would act in a prudent manner.
If a stock or bond is publicly traded, “the mean between the highest and lowest quoted selling prices on the date of the gift is the fair market value per share or bond.”
If it is found that the value based on the bid and asked price does not represent fair market value, there may be “some reasonable modification” of the trading price. Alternatively, “other relevant facts and elements of value shall be considered in determining fair market value.”
Valuation is a question of fact. In practice, this principle means the trier of fact (e.g., the U.S. Tax Court) has broad discretion and is accorded great deference by the appeals court.
Law on subsequent events. As a general rule, the valuation hinges on the valuation date (date of gifting) “without regard to events happening after that date.”
But, to the extent subsequent events are “relevant to the question of value,” they may be considered.
Further, a subsequent event may be considered “if the event was reasonably foreseeable as of the valuation date.”
Chief counsel’s memo goes on to say that “even if unforeseeable as of the valuation date,” an event occurring after the valuation date may be “probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date.” (citing Estate of Gilford v. Commissioner, 88 T.C. 38 (1987))
To support an argument in favor of accounting for the post-valuation date merger, the chief counsel cites a 1974 Tax Court case, Silverman v. Commissioner. According to the memo, in Silverman, the Tax Court rejected the taxpayer expert’s testimony because it “failed to take into account the circumstances of the future public sale.”
Editor’s note: More precisely, in Silverman, the taxpayers, who were controlling shareholders in a corporation, reorganized the company with a view toward a stock sale in a public offering. The first step was to create two classes of stock, nonvoting and voting stock. The taxpayers then gifted nonvoting stock to trusts benefitting their children. Afterward, they reorganized the corporation a second time to create a single class of voting stock. This resulted in one share of voting stock receiving seven shares of a new common stock and one share of nonvoting stock receiving 6.5 shares of a new common stock. The Tax Court found the 65-70 ratio provided a “yardstick with which to measure the value” of the gifted nonvoting stock. In doing so, the court found for the IRS in determining the value of the gifted nonvoting stock. The 2nd Circuit Court of Appeals affirmed, finding the Tax Court’s valuation was conclusive and not clearly erroneous. See Silverman v. Commissioner, T.C. Memo. 1974-285, aff’d 538 F.2d 927 (2d Cir. 1976).
In the IRS memo, chief counsel also cites a 9th Circuit case, Ferguson v. Commissioner, in which the Court of Appeals affirmed a Tax Court ruling in favor of the IRS that taxpayers were liable for gain in appreciated stock that later was transferred to various charitable organizations. However, this case centered on the anticipatory assignment of income doctrine. The court found the taxpayers had not completed the contributions of appreciated stock before it had ripened from an interest in a viable corporation to a fixed right to receive cash via an ongoing tender offer or pending merger agreement. See Ferguson v. Commissioner, 174 F.3d 997.
Application to instant case. Chief counsel’s memo maintains that the instant case had “many factual similarities with Ferguson” and that, even though Ferguson dealt “exclusively with the assignment of income doctrine, it also relies upon the proposition that the facts and circumstances surrounding a transaction are relevant to the determination that a merger is likely to go through.”
Chief counsel’s memo notes that, here, the board made a targeted search for merger candidates, there were exclusive negotiations with Corporation B before the final agreement, and an agreement was “practically certain” to go through. A hypothetical willing buyer and willing seller would have knowledge of all relevant facts, including the pending merger, the memo says. “Indeed, to ignore the facts and circumstances of the pending merger would undermine the basic tenets of fair market value and yield a baseless valuation.”
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