Ever since the Appellate Division, Second Department’s 1985 landmark decision in the Blake case (107 AD2d 139), it has been fairly well settled that courts apply a discount for lack of marketability — but not for lack of control — in stock valuation proceedings under Section 1118 of the Business Corporation Law. That’s the statute that permits the majority stockholder to elect to purchase for "fair value" the shares of an "oppressed" minority shareholder who seeks judicial dissolution of a close corporation under BCL Section 1104-a.
The discount for lack of marketability (DLOM) typically is the single largest downward adjustment to stock value, and therefore tends to be the most heavily contested in valuation proceedings. DLOM essentially reflects the greater time and expense of selling shares of a close corporation versus shares for which there exists an efficient public market. The cases generally reflect DLOM percentages ranging from 10% on the low end to 35% on the high end, with 25% being most frequent. Of course, every case is different and it is up to the expert appraiser to do a proper analysis taking into account all relevant factors.
The biggest, open controversy concerning DLOM concerns whether it should be applied to the entire enterprise value or only to the company’s intangible assets, i.e., goodwill. The answer may depend on which court you’re in.
In the Second Department (which covers all of downstate New York including Long Island and the lower Hudson Valley but excluding Manhattan and the Bronx), the prevailing rule appears in two appellate decisions from the mid 1990’s holding that DLOM applies only to goodwill. In the first case, Matter of Whalen, 204 AD2d 468 (2d Dept 1994), which decided several issues in advance of the valuation hearing, the court declared without further elaboration that "the discount [for lack of marketability] should only be applied to the portion of the value attributable to goodwill", citing the Blake case. A year later, in Matter of Cinque, 212 AD2d 608 (2d Dept 1995), the court affirmed a lower court decision insofar as it refused to apply DLOM in valuing the shares of a real estate holding company, stating:
Such a discount should only be applied to the portion of the value of the corporation that is attributable to goodwill. Here, the value of the corporation is attributable solely to real property and cash.
Later that same year, the Whalen case was back before the Second Department on a post-valuation appeal (234 AD2d 552) in which it found improper the lower court’s application of a 20% DLOM where "the operating value of the corporation is attributable solely to tangible assets."
Precedent in the First Department, which covers Manhattan and the Bronx, points in the opposite direction. In Hall v. King, 177 Misc.2d 126 (Sup Ct NY Co 1998), aff’d, 265 AD2d 244 (1st Dept 1999), the trial court confirmed a referee’s report valuing shares of a closely held corporation dealing in high quality reproduction antique furniture and accessories. The referee used a net asset approach but also added a goodwill value by computing the amount of business a buyer could expect to retain after purchase of the corporation in the absence of a non-compete clause. The referee then applied a 25% DLOM to the sum derived by adding goodwill to the adjusted net asset value.
In an extended discussion the trial judge in Hall explicitly disagrees with the Second Department’s Whalen and Cinque decisions. He criticizes those decisions’ reliance on Blake in which, he says:
It just so happens that the calculation in that case applied this discount only to goodwill. There was no discussion of this limitation in the application of the lack of marketability discount anywhere else in the opinion. Indeed, in one of the authorities Blake cited in approving use of such a discount, Lyons and Whitman, Valuing Closely Held Corporations and Publicly Traded Securities with Limited Marketability: Approaches to Allowable Discounts from Gross Values (33 Bus Law 2213), there is not the slightest hint that the discount is restricted to goodwill.
Hall then takes aim at the analytical foundation for the Second Department’s rulings, stating:
The conceivable basis for the restriction, though not discussed in Whalen or Cinque, is that the tangible assets of the corporation are readily saleable but not so its goodwill or other intangibles. Not only does such an explanation fly in the face of controlling language in opinions of the Court of Appeals, it rests on a faulty foundation. Goodwill is certainly a vendable asset. Indeed, goodwill is subject to the same fluctuations in value as are tangible assets. Thus, the line of Second Department cases limiting the unmarketability discount appears to lack any valid theoretical underpinning. [Citations omitted.]
The Hall decision was appealed to the Appellate Division, First Department, which affirmed the lower court’s valuation determination in a short memorandum decision finding "appropriate" the "application of a 25% lack of marketability discount to all of the corporate assets in light of the absence of a noncompete clause between the parties."
However economical its language, the First Department’s affirmance in Hall clearly signals a parting of the ways with its sister court’s Whalen and Cinque decisions. I was hoping in the years following Hall that the Second Department would revisit the issue in another Section 1118 valuation case, particularly after the trial judge in Hall, Stephen Crane, joined the Second Department where he sat as an appellate judge from 2001 through 2007. Not only has my wish not been granted, but in a matrimonial equitable distribution case decided in 2001 called Cohen v. Cohen (279 AD2d 599), the Second Department repeated that DLOM "should only be applied to the portion of the value of the corporation that is attributable to goodwill". You can probably guess which cases the Cohen opinion cites: Blake, Whalen and Cinque. Take that, First Department!
With locked horns in the two downstate appellate departments, and no decisions on the subject from the two upstate appellate departments, it’ll likely take some yet-to-be-born big-money valuation case to wend its way up to New York’s highest court, the Court of Appeals, before we get a definitive answer.