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In Buyout Dispute, ‘Downward Bias’ Sinks Expert’s Fair Value Determination

Ryan Trust v. Ryan, 308 Neb. 851 (April 9, 2021)

In a bitter buyout dispute involving a successful private family business and featuring two veteran appraisers, the Nebraska Supreme Court recently affirmed the district court’s decision to unreservedly credit the valuation testimony of the expert for the late majority shareholder. In contrast, the district court found the company’s expert’s valuations under various methods showed a “downward bias” that made the expert’s value conclusion unreliable.

Oppression claim: Streck Inc. was a worldwide industry leader in developing and manufacturing cell stabilization technology for use in hematology, immunology, and molecular diagnostics. Sales were strong and increasing every year since its creation, and it had no product recalls in the past 25 years. The company had long-lasting relationships with large customers and a valuable portfolio of intellectual property. Its financial performance surged in recent years, and it expected more growth in future years.

Streck was founded by Dr. Wayne Ryan, who, at the relevant time, owned over 52% of the company’s stock by way of a trust (RRT). However, one of his daughters came to own two-thirds of the company’s voting shares, enabling her to appoint a majority of the members of the board of directors. In September 2013, she replaced her father as CEO. She encouraged her father to retire. Dr. Ryan did not object to her becoming CEO as long as the company was sold. In 2014, the CEO took steps to sell the company.

According to a trial industry expert for RRT, the sales process was “flawed and failed.” Despite the company’s ongoing solid performance and a growing healthcare life sciences market, bids solicited by an investment banker on behalf of Streck were relatively low, which the expert found was due to growth projections that were too conservative and not properly explained to prospective buyers. The industry expert said the investment banker lacked experience in the appropriate market. Further, the company decided to exclude the highest bidder in the first round.

Dr. Ryan complained he was not listened to and could not approve the sale. The board and his daughter, as CEO, abandoned the process. RRT, representing Dr. Ryan (who died before trial), sued the daughter and Streck, alleging oppression and breach of fiduciary duty and asking for judicial dissolution of the company. Ultimately, Streck elected to buy RRT’s shares under the applicable statute, which triggered a fair value determination by the district court.

‘Dysfunctional’ sales process: Both sides’ experts were highly experienced appraisers and used the discounted cash flow (DCF) approach in combination with the guideline publicly traded company (GPTC) and guideline merger and acquisition (GMA) methods to determine the fair value of Dr. Ryan’s shares. In adopting RRT’s 74-page proposed findings verbatim, the district court wholly adopted the testimony of RRT’s industry and valuation experts. Regarding the DCF, the court said the appraiser’s revenue and income projections aligned with the company’s projections and prospects for growth; his growth rate was reasonable as were the selected company-size risk premium and company-specific risk premiums. Further, the expert, who applied a 14% S corp premium, “credibly and convincingly testified” that no rational company would convert from an S corp to a C corp prior to a sale. In contrast, the company’s expert gave “misleading and not credible” explanations for his projections and “double-counted” the same risks to justify his projections and company-specific risk premium, the court said. It noted this expert arrived at the same 14% S corp premium but decided to half it to account for the risk of the company becoming a C corp in the future. The district court found this adjustment was “arbitrary” and said it reflected the expert’s “downward bias.”

The company appealed, and, based on the parties’ request for bypass, the case went in front of the state Supreme Court, which affirmed. The high court said its de novo review of the record led to the conclusion that the district court’s valuation was reasonable and based in fact and principle.

A digest of Ryan Trust v. Ryan, 308 Neb. 851 (April 9, 2021), as well as the court’s opinion will be available soon at BVLaw.

Iowa Supreme Court Allows Reduction in Value for Transaction Costs but Refuses to Allow a Reduction for Built-In Capital Gains Tax

Guge v. Kassel Enters., Supreme Court of Iowa (June 18, 2021)

Summary. This case was decided, on appeal, under the Iowa “election-to-purchase-in-lieu-of-dissolution statute.” The Iowa Supreme Court decided that, because the parties experts had “both included transaction costs in their valuations under a net asset approach, the district court’s failure to reduce the asset values to account for the costs to liquidate the corporation’s assets warranted reversal.” Additionally, since there was no evidence of an intention to liquidate the company or its assets, the court declined to adjust for the built-in gains tax consequences the majority shareholder urged.

Overview. This case resulted in two holdings:

  1. Because both parties’ experts included transaction costs on their valuation “under a net asset approach,” the District Court’s failure to reduce the asset values for those costs warranted a reversal. The record lacked detail to allow the court to determine the appropriate amount of such a reduction.
  2. There was no evidence of any actual or contemplated liquidation of assets by the majority shareholder’s election.

Factual and procedural background. Founders Lawrence and Georgia Kassel ultimately left all of the stock of their farming corporation, Kassel Enterprises Inc. (Kassel), to their three children. “At the time this lawsuit arose, Susan and Peggy each owned 23.75% of the corporation’s shares and Craig the remaining 52.5%.” Susan and Peggy filed suit seeking judicial dissolution of Kassel for “illegal, oppressive, or fraudulent” conduct.

“Five additional claims, counts II through VI, sought money damages based on claims for breach of fiduciary duty, fraud, breach of contract, third-party beneficiary rights, and civil conspiracy.” The defendants denied the claims and filed three counterclaims.

Kassel elected to purchase Susan and Peggy’s shares for fair value in lieu of a judicial dissolution of the corporation. The parties failed to agree on the fair value of the shares within the statutory 60 days. “Susan and Peggy voluntarily dismissed all of their claims against the defendants in counts II through VI except for part of their breach of fiduciary duty claim in count II against Craig and his wife.” Craig and his wife dismissed one of their claims.

The District Court used an asset-based method to determine the fair value, set at $6,826.87 per share (847 shares). Susan and Peggy each owned 201.165 shares, or $1,373,327 each. Attorney and expert fees were also awarded.

The claims for wrongdoing by Craig and his wife were deemed to be derivative claims against Kassel Enterprises. The requirements for derivative claims had not been met. Craig argues that the District Court erred in not allowing a reduction in the fair value for transaction costs and built-in gains.

Determination of fair value. The election to purchase the shares having been made, the court noted that the code determines fair value “[u]sing customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal” and “[w]ithout discounting for lack of marketability or minority status.” The experts in this case both agreed on a net asset approach because an overwhelming proportion of Kassel’s value rested in its farmland and not in any income generated from ongoing operations. Fully $5.6 million of the $5.8 million value of Kassel’s assets were attributable to the farmland. Craig contended that the value of his sisters’ shares should include a deduction for theoretical transaction costs in a potential sale of the assets and potential capital gains tax liability on the corporation’s assets.

Deduction of transaction costs. The District Court reasoned that, in determining fair value, transaction costs in a liquidation are not components of a corporation’s value as a going concern without some evidence that the liquidation is contemplated. However, both experts agreed that a deduction for transaction costs based on a hypothetical liquidation of Kassel’s assets should have been included, but they disagreed on the amount. The difference largely reflected a disagreement as to the hypothetical commission rate for a hypothetical sale of the farmland. The Supreme Court found that the District Court’s failure to account for the costs to liquidate the assets of Kassel warrants reversal. Since the court felt it did not have sufficient information with which to determine the correct amount of liquidation costs, it remanded that decision to the District Court for it to determine.

Deduction of built-in gain tax. Craig urged that the District Court should have deducted the built-in gain tax in determining the fair value. The assets Kassel holds, especially the farmland, have increased in value since the election in 2007 by Kassel to be an S corporation. As such, the taxes that Susan and Peggy would already pay for the S corp pass-through income would result in a “double tax of sorts” on Susan and Peggy (conceded by Craig’s expert). Craig testified the corporation had no intention of selling any farmland. The weight of authority on the issue of tax deductions in fair value determinations leans sharply in the direction that courts should not discount for tax consequences where no liquidation triggering those consequences are contemplated.

Addition of wasted or misapplied corporate assets. Susan and Peggy requested these additions orally during the fair value hearing. The District Court orally ruled on it, thus preserving it for appeal. Susan and Peggy argued that they have a claim for damages under this theory and not that the corporation has such a claim. Craig argued that, if the corporation does not have a claim, it should not be included in increasing the value of the corporation’s assets. Shareholders don’t normally have a claim unless it is a derivative claim. Susan and Peggy failed to complete the statutory and other requirements for bringing a derivative action. “Susan and Peggy’s expert didn’t include any legal claims the corporation might possess against Craig among the list of the corporation’s assets in his expert report.” The District Court did not err in its determination that Susan and Peggy made these claims on their own behalf and not on behalf of the corporation (i.e., as a derivative).

Award of attorney and expert fees and expenses. “Craig argues that the district court erred in requiring the corporation to pay Susan and Peggy’s fees and expenses.” “But the statute speaks in terms of both waste and misapplication of corporate assets, so even a finding that no ‘waste’ of corporate Assets took place doesn’t bar a finding that ‘misapplication’ of corporate assets occurred.” The District Court found, among other things, that Craig misapplied corporate assets by renting farmland to his own entities at below-market rates. The court noted that, in most cases of this type involving a controlling shareholder (as here) acting through and on behalf of the corporation in committing the misconduct triggering the fee award, “[w]e hold that the district court properly applied section 490.1434(5)” in making the fee award.

Disposition. “We reverse the district court’s ruling as to the transaction costs and remand for the district court to determine and apply a discount to the value of Kassel Enterprises’ assets as part of the fair-value determination of Susan and Peggy’s shares. We otherwise affirm the district court’s rulings in all respects.”

Oxley and McDonald Jr. concurring specially. These justices concurred only in the judgment as it relates to the issue of the capital gains deduction. Only entity-level adjustments are allowed for fair value valuations. The majority made the mistake of determining whether a sale was actually contemplated (instead of the normal consideration of a hypothetical sale in the case of a fair value determination). “If the majority agrees with the experts that hypothetical liquidation transaction costs should be deducted because those are entity-level deductions under a net asset valuation, it should have applied that same analysis to the capital gains issue and affirmed on the basis that any capital gains taxes would not be at the entity level, stopping its analysis of the capital gains issue.”

Tax Court Resists Tax Affecting in Michael Jackson Case

Estate of Michael J. Jackson v. Commissioner, T.C. Memo 2021-48 (May 3, 2021)

Although the U.S. Tax Court recently handed the Michael Jackson estate a decisive victory regarding the estate’s tax liability, the court did not side with the estate on tax affecting, an issue that has preoccupied valuators, many of whom are proponents of the practice, for a long time.

Estate of Jones is distinguishable: Michael Jackson died in 2009. The tax dispute was over the fair market value of three contested assets at Jackson’s death: the value of Jackson’s name and likeness and the value of his interest in two music publishing assets. Each of the assets was held by a pass-through entity (PTE), “which means the Code imposes no tax on the income that these assets produce.” Rather, the income passes through to the owners, who pay tax on it at their individual rates. C corporations, on the other hand, are subject to entity-level taxes and investor-level taxes. Tax affecting seeks to reflect the tax implications to a hypothetical buyer.

At trial, the estate engaged four experts, two of whom collaborated on valuing the image and likeness asset. The Internal Revenue Service presented testimony from a single expert. As the court noted, the estate’s experts took tax affecting into account in their discounted cash flow analyses but all applied different tax rates. For example, the lead valuator of the image and likeness asset used a 35% rate based on the then-applicable corporate rate. For its part, the IRS objected to tax affecting.

The court noted that, “in the past, we’ve shied away from tax affecting because of these practical problems.” It noted that proponents of the practice have often pointed out that many potential buyers of PTEs, including S corporations, are C corps that would tax affect (at C corp rates) in calculating income to decide how much to pay for the asset. Opponents of the practice have claimed tax affecting produces an appraisal that gives no value to the benefit of S corp status.

Here, the estate’s experts argued that a C corp would be the only likely buyer for the assets. For example, in valuing Jackson’s image and likeness, the estate’s appraiser pointed out that any buyer would have to spend considerable money to rehabilitate the asset and defend its value. C corps historically have bought the image and likeness of other celebrities, he said. But the court said it was not convinced that a C corp was the more likely buyer. The same appraiser valued this asset at $3 million, which “is not a sum so large as to make it likely that only a C corporation would be able to buy it,” the court said. It noted there now exist many different (less restrictive) types of PTEs that have many of the same benefits as C corps when it comes to raising capital while avoiding double taxation. The court suggested the “gap between C corporations and other entities has narrowed over time.” The estate’s experts did not “persuasively explain” why those new PTEs wouldn’t be a suitable buyers, the court aid.

The court noted there seemed to be only one case where the Tax Court allowed tax affecting in a valuation, the 2019 Estate of Jones case. However, that case was distinguishable in that both parties’ experts agreed that a hypothetical buyer and seller would take into account the corporate structure. The parties only disagreed over how to account for this effect. Here, the estate’s experts themselves used inconsistent tax rates and they were met with opposing IRS testimony that, “at least on this very particular point,” was persuasive considering Tax Court precedent, the court said.

“This all leads us to find that tax affecting is inappropriate on the specific facts of the case,” the court said.

Kentucky Appeals Court Explains State’s Goodwill Law

Maginnis v. Maginnis, 2021 Ky. App. Unpub. LEXIS 378 *; 2021 WL 2483877 (June 18, 2021)

An unpublished opinion from the Kentucky Court of Appeals provides important insight into the court’s thinking as to the goodwill analysis trial courts must perform under the applicable state law when valuing business entities. Under controlling Kentucky law, only enterprise goodwill is a marital asset subject to marital distribution.

Scope of Gaskill: During the marriage, the ex-spouses started a chimney business. The husband worked as a chimney sweep, and the wife performed other tasks, including bookkeeping. The valuation of the company was important both for marital distribution purposes and determining alimony to the wife.

The wife relied on expert testimony from a CPA whose testimony and expert report included statements that 70% of the company’s value was personal goodwill and 30% was enterprise goodwill. The trial court accepted this expert’s overall valuation. At the same time, in determining the value of marital assets for property distribution’s sake and calculating income for alimony’s sake, the trial court disregarded the expert’s goodwill allocation.

The husband appealed the court’s findings on a number of grounds, including assigning error to the trial court’s decision to ignore the opposing expert’s goodwill analysis.

The Court of Appeals sided with the husband. The reviewing court first noted that the controlling case is the state Supreme Court’s Gaskill v. Robbins decision, which involved the valuation of an oral surgery practice that was organized as a sole proprietorship. In Gaskill, the high court adopted the distinction between enterprise and personal goodwill. Under the facts of Gaskill, the court found: “[T]here can be little argument that the skill, personality, work ethic, reputation, and relationships developed by [the owner spouse/doctor] are hers alone and cannot be sold to a subsequent practitioner.” Further, “[t]o consider this highly personal value as marital would effectively attach [the owner’s] future earnings, to which [the nonowner spouse] has no claim.”

In the instant case, the Court of Appeals invalidated the trial court’s judgment on this ground.

Moreover, the Court of Appeals dismissed the wife’s argument that Gaskill did not apply here because Gaskill dealt with a professional business whereas the contested business was a nonprofessional entity. The appeals court said it knew of no authority that definitively addressed whether Gaskill applied to valuing professional and nonprofessional business entities alike.

But, according to the appeals court, “though the issue may more often arise when valuing a professional entity, we conclude that Gaskill also applies to valuing nonprofessional entities.” Here, ignoring the expert’s unrebutted goodwill conclusions resulted in an approximately $200,000 increase in the marital portion of the company’s value, the Court of Appeals noted. In remanding, the appeals court ordered the trial court either to accept the expert’s goodwill conclusions and make the requisite apportionment of value or reject the goodwill analysis and provide a good explanation for doing so.

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