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Forensic Files - May 2015

 

Marketability Discounts on Display in New York Supreme Court

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In October 2014, the New York Supreme Court decided two cases in which discounts for lack of marketability played a significant role.These cases were Zelouf International Corp. v. Nahal Zelouf ( “Zelouf”) and John M. Ferolito and JMF Investments Holdings, Inc. v AriZona Beverages USA LLC, AZ National Distributors LLC, AriZona Beverage Company LLC and AriZona International, LLC ( “AriZona Entities” collectively “AriZona”).

For those a bit fuzzy on the terminology, discounts for lack of marketability are reductions in the value of an investment due to the inability to freely transfer an interest. In many situations, valuation professionals will apply a marketability discount when valuing interests in privately-held companies.This is because recognition must be given to the fact that the fair market value of an ownership interest in a privately held company is not equivalent to its underlying economic worth in the public marketplace, since there is a lack of liquidity in the ownership interest, which detracts from its value to a potential investor. It is this lack of liquidity that gives rise to a discount for lack of marketability.

Zelouf (Decided 10/6/2014)1

One of the issues in Zelouf was determining the fair value of Nahal Zelouf's ownership interest in an entity formerly known as Zelouf International Corporation (“ZIC”) under New York Business Corporation Law (“BCL”) � 623. ZIC was merged into a new entity, effectively “freezing out” Nahal Zelouf.

In reaching its decision, the Court discussed a number of factors which it considered.These factors tended to agree with a Court-appointed neutral valuation expert's “reasoning” that although a hypothetical condition regarding the application of a discount for lack of marketability was utilized in his report, a discount for lack of marketability should not be applied.Specifically, the Court agreed with the expert's reasoning that “the assumptions behind the DLOM [discount for lack of marketability] and its calculation, such as hypothetical impediments to sale and the actual likelihood that Old ZIC would be sold, are entirely irrelevant to the determination of the fair value of Nahal's shares, which is based on her pro rata share of the value of the entire company on a controlling basis.”

The Court also reasoned that since the company would always be under the control of the Zelouf family, even without the ownership of Nahal and her family, the company's illiquidity was irrelevant, “mooting the concern for which a DLOM accounts” because the other Zelouf family members will never pay a price for the company's theoretical illiquidity. Therefore, artificially depressing Nahal's recovery for a hypothetical sale that will never occur was unfair. According to the Court, imposing “such a cost on Nahal is tantamount to levying the very sort of minority penalty that New York law prohibits..”For that reason the Court concluded that “the fair value of Nahal's shares should be based on the true value of owning the company that Nahal would have enjoyed had she not been mistreated while a shareholder and forced out when she complained..”

In its analysis, the Court held that “the purpose of a DLOM is to account for 'risk associated with the illiquidity of the shares” and that “liquidity risk only manifests into real cost in an actual sale and should not be imposed here where there will never be a sale and, thus no real cost.” According to the Court, “risk, of course, is a function of probability times the threatened harm..” While the Court acknowledged that “the threat of harm here (a lower net purchase price due to illiquidity costs) is undisputed,,” it held that that risk did not warrant a discount for lack of marketability because “the probability that such a threat will actually occur is negligible..”

For these reasons and others, the Court determined that no discount for lack of marketability was applicable to the subject interest in this matter.

AriZona (Decided 10/14/2014)

Decided just eight days after Zelouf, AriZona provides another insight into discounts for lack of marketability.This case related to the ultimate buyout of John Ferolito's ownership interest in the AriZona Entities under BCL � 1118.

In reaching its conclusion on the discount for lack of marketability to be applied to the AriZona Entities, the Court focused on two primary factors: an agreement between the owners and past offers made to purchase the AriZona Entities.

The owners of the AriZona Entities entered into an Owners' Agreement which placed significant transfer restrictions on the ownership interests.In a vacuum, these significant restrictions may give rise to a discount for lack of marketability.According to the Court, “such a conclusion is appropriate here, as the Owners' Agreement itself readily demonstrates that the current owners of the company cannot easily liquidate their shares.”

The owners of AriZona had received offers to purchase the AriZona Entities from buyers such as Tata and Nestle Waters, N.A. These offers were made under the presumption that the buyer would conduct a thorough due diligence after any offer was accepted. However, the negotiations with these potential buyers were stopped prior to advancing to the due diligence process.The Court ultimately rejected Mr. Ferolito's contention that the success of the AriZona Entities and the fact that other companies had expressed an interest in purchasing all or part of the AriZona Entities meant that no discount for lack of marketability was warranted.The Court reasoned that “the expressions of interest, which never manifested into a bona fide offer, do not refute the difficulties any of AriZona's present shareholders have had, or will have, as they attempt to liquidate their shares. Indeed, the fact that those expressions did not bloom into offers may well further support for the view that a DLOM is appropriate.”

For these reasons and others, the Court determined that a discount for lack of marketability should be applied to the AriZona Entities and that the discount amount should be 25 percent.

These two landmark New York Supreme Court decisions point to one significant issue that all attorneys and valuation experts must consider – that the facts and circumstances of each case should dictate the applicability and the size of any marketability discount calculation. As the Zelouf case shows, the fact that a closely held interest is being valued does not automatically give rise to a discount for lack of marketability.

Both of the abovementioned cases also demonstrate that Judges will view the acts of the parties both prior to the dispute and after the commencement of the lawsuit. In both the cases, the assumptions, valuation calculations and testimony of the valuation professionals and other experts were key to the Judges' rulings.For these reasons, parties who engage a valuation expert should expect a thorough analysis of the subject interest, which requires the cooperation of all parties on both sides and the availability of reliable and complete financial and operational information.

1 The authors of this article were involved in the Zelouf matter. This article is meant only to discuss the facts surrounding this case and the Court's rationale behind the discounts as stated in the Court's opinion.
 
 
 
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