Valuation Services Bulletin: Q3 2021
In This Issue:
- Expert’s Failure to Review Debtor’s Reorganization Plan Results in ‘Defective’ Hotel Appraisals
- Indiana Supreme Court Rejects Blanket Rule Against Discounts in Compulsory, Closed-Market Share Buyback
- Tax Court Allows for ‘Slight’ Discount for Lack of Control for Majority Interests in Real Estate Holding Companies
- Goodwill Analysis Ignoring Specifics Crumbles on Appeal
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 Rejects Blanket Rule Against Discounts in Compulsory, Closed-Market Share Buyback
Hartman v. BigInch Fabricators & Construction Holding Co., Inc., Indiana Supreme Court, Case No. 20S-PL-618 (Jan. 28, 2021) (Hartman II)
In 2020, the Indiana Court of Appeals overturned the trial court and found for the selling shareholder when it decided discounts were inappropriate in any compulsory, closed-market sale. The court did not think it mattered that there was a shareholder agreement that specified a buyout based on certain valuation terms, which a third-party appraiser interpreted as fair market value. In a recent decision, the state Supreme Court vacated the appeals court’s decision, finding a blanket rule disallowing minority and marketability discounts in closed-market transactions regardless of the shareholder agreement would violate the freedom to contract principle. Here, the agreement unambiguously allowed for discounts, the high court said.
‘Appraised market value.’ The plaintiff was one of the founders of a closely held company. He also held a minority interest in the company. In 2006, all the shareholders agreed to a contract that included a buyback clause. Under the clause, the company was required to buy back a shareholder’s interest if he or she were involuntarily terminated by the company. The buyback clause specified the company would buy out the shareholder at “appraised market value” as determined by a third-party valuation company in accordance with generally accepted accounting principles.
In 2018, the plaintiff was terminated without cause. To determine the value of his interest, the company retained an outside valuation firm. The appraiser applied the fair market value standard of value and discounted the plaintiff’s shares for lack of control and lack of marketability.
The plaintiff asked the trial court for a declaratory judgment that discounts were inapplicable because the shareholder agreement here did not “contemplate a fair market value standard.” Ruling on the parties’ motions for summary judgment, the trial 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 trial court ruled for the company.
The Court of Appeals reversed, finding, under controlling case law, discounts were inappropriate because the transaction involved a compulsory sale. Discounts could not apply to any closed-market sales, the appeals court decided. The Court of Appeals agreed with the terminated shareholder that one case in particular, Wenzel v. Hopper & Galliher, P.C., was controlling.
In Wenzel, the Court of Appeals rejected discounts in the context of a law firm’s purchase of a departing partner’s interest. This case arose under a statute. The court found that “fair value” did not equate with “fair market value.” See 779 N.E.2d 20 (Ind. Ct. App. 2002) (available at BVLaw).
Among other things, the court in Wenzel described minority and marketability discounts as “open market concepts.” A minority discount adjusts for lack of control over the corporation based on the notion that a minority interest does not have the same value to a third party as a majority holding. A marketability discount adjusts for lack of liquidity as to the stock because of a limited number of purchasers for the stock.
The Wenzel court said applying a minority discount was inappropriate in a compulsory buyout because “a sale to a majority shareholder or to the corporation simply consolidates or increases the interest of those already in control.” The discount “would result in a windfall to the transferee.” A marketability discount was inappropriate because there was a ready-made market for the shares.
In the instant case, the Court of Appeals found cases following Wenzel have affirmed that discounts are not applicable in compelled transactions to a controlling party. Further, the court rejected the company’s argument that Wenzel and related cases were not applicable to this case because they involved a fair value determination under the statute, whereas the instant case necessitated a value determination in accordance with the shareholder agreement.
A digest of the Court of Appeals opinion in Hartman v. BigInch Fabricators & Construction Holding Co., Inc., 2020 Ind. App. LEXIS 183 (May 5, 2020), and the court’s opinion are available to BVLaw subscribers.
Parties’ freedom to contract. The company petitioned for transfer of the case to the state Supreme Court. The petition was granted, and the Court of Appeals decision was vacated.
The direction of the Supreme Court’s opinion becomes clear in the opening paragraphs. 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 Supreme Court agreed with the company that Wenzel was distinguishable from the instant case because it concerned the interpretation of a statute, not a contract. The Wenzel court performed a statutory interpretation to determine the meaning of the term “fair value,” the high court noted. The statutory purpose was to ensure the shareholders would be compensated fairly. In contrast, the high court noted, here, the valuation term comes from a contract that requires the determination of the shares’ “appraised market value,” not “fair value.”
The agreement’s valuation term “unambiguously allows the discounts to apply,” the Supreme Court said. It noted that the operative term was “appraised market value,” a term the agreement did not define. However, the company, throughout the litigation, argued “market value” was synonymous with “fair market value” and the term “appraised” simply indicated who would value the stock.
In contrast, the selling shareholder (plaintiff) argued “appraised market value” and “fair market value” were not synonymous terms; the trial court improperly “injected” the fair market value standard into the agreement.
The high court disagreed with the plaintiff, finding the term “‘market value’ plainly and unambiguously refers to the shares’ ‘fair market value.’” Further, the term “‘appraised’ merely describes how to determine the shares’ market value,” the Supreme Court concluded.
The court went on to say that, while the parties agreed to a compulsory, closed-market sale, not an arm’s-length transaction, the agreement’s “plain and unambiguous language” also provides the shares be valued “as if they were sold on the open market.”
No court applying Indiana law has held that discounts are always inapplicable to a closed-market sale, “only that the discounts cannot be applied in certain situations,” the high court noted.
Here, the Supreme Court said, even if the valuation term “were somehow ambiguous, we would find ‘fair market value’ to be the appropriate standard.”
“[W]e must honor the parties’ freedom to contract and look to the terms they chose to govern the buyback of [the plaintiff’s] shares,” the court said. It noted the company does not receive a windfall from the use of discounts “because, by definition, a windfall is unexpected.” In contrast, here the parties to the company’s shareholder agreement years ago agreed to be bound by the terms of the agreement.
The high court further noted that the selling shareholder benefited from the agreement. There was a ready market for his shares as the company was obligated to buy them. Further, under generally accepted accounting principles, the use of discounts is accepted practice when determining the shares’ fair market value. The plaintiff had a right under the contract to obtain an additional appraisal from a third-party appraiser but did not do so, the state Supreme Court pointed out.
The court affirmed the trial court’s granting summary judgment for the company. There was no blanket rule against applying discounts in a compulsory, closed-end transaction. Here, under the parties’ shareholder agreement, discounts were applicable in determining the fair market value of the plaintiff’s minority interest.
Tax Court Allows for ‘Slight’ Discount for Lack of Control for Majority Interests in Real Estate Holding Companies
Estate of Warne v. Commissioner, T.C. Memo 2021-17; 2021 Tax Ct. Memo LEXIS 22 (Feb. 18, 2021)
In a gift and estate tax dispute, the estate and Internal Revenue Service agreed to apply discounts for lack of control and marketability to the majority interests in a number of real estate holding companies. The U.S. Tax Court noted that, in prior decisions, the court found no discount for lack of control applied. However, given the parties’ agreement, here the court said it would apply a “slight” or “low” discount.
Considerable power over LLCs: During her lifetime, the decedent gave fractional interests in a number of limited liability companies to family members. A family trust of which the decedent was the trustee held the majority interest in the LLCs. The LLCs held ground leases in various California properties. During her lifetime, the decedent also served as manager of the companies. Under the LLCs’ operating agreements, the majority interest holder had considerable powers, including the right, “in conjunction with the manager,” to elect to dissolve the companies.
The IRS found gift tax and estate tax deficiencies. For both the gift and estate tax calculations, the IRS determined a higher fair market value of the LLCs based on the valuations of the ground leases. In terms of the estate tax, experts for the estate valued the majority interests by applying discounts for lack of control and lack of marketability. For its part, the IRS argued a lower discount for lack of control and marketability than the estate had used were appropriate. The estate petitioned the Tax Court for review.
Both parties retained experts to analyze the appropriate discounts for each LLC. Both parties used the adjusted net asset value approach to value the LLCs, but the experts had different approaches to calculating the discounts.
Regarding the discount for lack of control, the estate’s expert used the Mergerstat Control Premium Study, which measures control premiums on transactions of publicly traded companies. The expert compared premiums paid to acquire 50.1% to 89.9% controlling interests with those paid to acquire 90% to 100% interests. He explained that the difference in premiums between the two blocks suggested a discount for controlling interests that lacked total control. He then considered factors specific to the LLCs, including the possibility of costly litigation should the majority interest holder attempt to liquidate and dissolve the companies.
In contrast, the IRS’ expert used closed-end funds classified as real estate funds to calculate the discount for lack of control. The data indicated a range of 3.5% to 15.7%, with a median discount rate of 11.9%. Comparing the funds to the subject interests, he found that closed-end funds were “minority interests and completely devoid of any control.” Therefore, a discount for lack of control for the subject interests should be at the “bottom of the range” of the closed-end discount rates. He arrived at a 2% rate.
The court noted the LLCs’ operating agreements gave significant power to the majority interest holder and the family trust held a majority interest in every LLC. Therefore, the discount for lack of control “should be low.” The court noted that it had accepted valuations of discounts based on closed-end funds for purposes of determining minority-interest discounts, not discounts for lack of control for a majority interest. Further, the closed-end funds the IRS’ expert used were too dissimilar to the subject LLCs. Therefore, the court rejected the 2% discount rate.
The court also “hesitate[d] to adopt” the estate expert’s range (5% to 8%), finding he proposed a higher rate based on the risk of potential litigation when there was no evidence in the record that minority interest holders would sue in case of dissolution. The court found a 4% discount for lack of control was appropriate.
This case also includes a discussion of the discount for lack of marketability and a charitable contribution discount. In general, the Tax Court found the estate’s experts, in valuing the various properties, presented a more reliable discount analysis.
King v. King, 2021 Fla. App. LEXIS 3170, 2021 WL 822476, 46 Fla. L. Weekly D 498 (March 4, 2021)
A divorce expert’s failure to link the facts related to a successful insurance company to his personal goodwill analysis was one of the reasons a Florida appeals court recently overturned the trial court’s valuation findings, which, the reviewing court said, were not based on competent, substantial evidence.
Principal revenue generator: During the marriage, the former spouses bought an insurance agency from the husband’s parents. The husband served as the company’s CEO, managed all aspects of the business, and was the largest generator of revenue. The wife worked as the agency’s bookkeeper.
The husband and wife initially paid $1.5 million for the business and also assumed the significant outstanding corporate debt. During the marriage, the business’s gross revenue nearly doubled. During divorce proceedings, the former spouses, relying on expert testimony, disagreed on the agency’s fair market value, the value of goodwill attributable to the husband, and the income available for alimony.
As for personal goodwill, under Florida case law, it is not a marital asset and excludable from the value of assets available for equitable distribution. Here, the husband’s expert analyzed the agency’s revenues and how much each employee generated for the business. He also considered how much business the husband could take with him if the agency were sold and the husband were not subject to a noncompete agreement. Based on this analysis, the expert concluded the value of personal goodwill in the company was about $1.6 million, which was 68% of the company’s fair market value (almost $2.1 million).
In contrast, the wife’s expert considered 30 transactions of insurance companies from the DealStats database. The transactions were not limited to Florida, and a few went back to 1997. Some of the transactions reported the value of a noncompete agreement—most assigned a value of less than 10%. The expert found the average of those values was 7.3% and used that figure to value the husband’s personal goodwill.
The trial court adopted the 7.3% value the wife’s expert proposed. The appeals court reversed, noting the expert “did not provide any specific knowledge about the particulars of the insurance businesses that reported transactions in the DealStats database.” The court said the expert did not disclose how involved the owners of the businesses he considered were in the company’s affairs, whether they sold insurance, as the husband here did, what the day-to-day operations were. The court also found it problematic that some of the analyzed transactions took place outside Florida and some were almost 20 years old. Importantly, the court pointed out that the husband here was the CEO of the company, was involved in all aspects of the company, and was its largest generator of revenue.
The testimony of the wife’s expert was not competent evidence to support the trial court’s personal goodwill value, the appeals court found. It overturned on this and other valuation issues.
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