Case Law Update

Posted date: April 24, 2019 In: Case Law, QuickRead Top Story

April 2019

In the first quarter of 2019, there were no reported U.S. Tax Court cases involving either business, estate, or FLP valuation issues. Notwithstanding the above, there were several cases that valuation and litigation support professionals will want to consider. In this article, five recent cases are discussed. One of the leading cases circulating amongst the business valuation community is Kress v. U.S., Case No. 16-C-795 (U.S.D.C. Eastern District of Wisconsin), it has received considerable attention, especially by business valuation professionals. The Veriton Partners Master Fund Ltd. v. Aruba Networks, Inc. (April 16, 2019), a Delaware Supreme Court case is also discussed in detail since the case will impact how statutory fair value cases in Delaware are presented … if at all. Next, In re: CIL Limited, LaMonica v. CEVA Group PLC (Bankr. S.D.N.Y. April 8, 2019); Hoyd v. Trussway Holdings, LLC (Del. Ch. February 28, 2019); and Zayo Group, LLC v. Latisys Holdings, LLC (Del. Ch. November 26, 2018) are discussed since procedural issues involving damages cases are presented and worth considering.

[su_pullquote align=”right”]Resources:

Current Update in Valuations

Business Valuation Reporting And Challenges In The Litigation Environment

Best Practices in Business Valuation and Litigation Services

Common Sense and the S Corp Value Question—A Reality Check

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Kress v. U.S., Case No. 16-C-795 (E.D. Wis. March 25, 2019)

Facts: Plaintiffs brought a refund action against the U.S. government to recover the overpayment of gift taxes and interest related to Plaintiffs’ gift of minority-interest stock in Green Bay Packaging, Inc. (GBP) to their children and grandchildren. These gifts, S corporation shares, were made between 2007–2009 and represented a minority interest in GBP.

The corporate bylaws contained restrictions regarding any subsequent sale by any trust or beneficiary that was gifted shares by Plaintiffs, who were founders of GBP.

The IRS challenged the amounts reported on Plaintiffs’ 709s and issued Notice of Deficiency for the separate tax years. The IRS concluded that the share value was substantially higher than that reported by Plaintiffs.

Plaintiffs in the case attempted to present exhibits at trial; there were letters from the IRS conveying to Plaintiffs that the stock was undervalued, and an internal IRS memorandum analyzing Plaintiffs’ position and explaining the agency’s consideration and determinations regarding the issues presented in valuing GBP’s stock. The IRS’s objections under FRP 401, 402, and 403 were sustained. The court held, with respect to the latter, “Courts do not evaluate the procedure and evidence used in making tax assessments but rather conduct de novo review of the correctness of the assessment.”

The IRS also objected to Plaintiffs request for the court to take judicial notice of newspapers and website articles on matters ranging from the state of the economy on various dates to market conditions. On this matter, the court observed that while it is unusual to take judicial notice of newspapers and website information, it is permissible provided “the facts of the article are either ‘(1) generally known within the territorial jurisdiction of the trial court or (2) capable of accurate and ready determination by resort to sources whose accuracy cannot reasonably be questioned’ as required under Rule 201(b) of the Federal Rules of Evidence.” The court indicated it was open to taking judicial notice as requested.

As for the valuation of stock, Plaintiffs’ experts were John Emory and Nancy Czaplinski. The IRS retained Francis Burns. The experts used different valuation methods to arrive at their opinions. The court first reviewed Burns’ conclusions, then that of Plaintiffs’ experts.

Burns used the Market and Income Approaches and assigned a weight to each to arrive at his conclusion. Under the Market Approach, Burns identified 19 to 20 companies that were in the same business as GBP; he narrowed the comps to two. He then derived a set of multiples by looking at enterprise value to EBITDA and P/E and applied the multiples to the relevant GBP financial data. Burns applied an S-corporation tax premium to account for GBP’s tax advantages as an S corporation and added back the non-operating assets to reach an indicated value for GBP’s common stock.

Under the Income Approach, Burns completed a capitalized cash flow analysis, rather than a discounted cash flow analysis because GBP did not prepare any long-term forecasts and he would be required to speculate under that method. He applied an effective tax rate to GBP as if it were a C-corporation and then applied an adjustment to reflect the value of GBP as an S-corporation. Burns also reduced GBP’s value by $5.8 million per year based on GBP’s capital expenditures, assumed a 4.9% perpetuity growth rate, and then added back the S-corporation premium to account for the tax advantages associated with the S-corporation status and non-operating assets.

Once Burns calculated the preliminary minority share value, he then applied marketability discounts of 10.8% for tax year 2007, 11.0% for tax year 2008, and 11.2% for tax year 2009. He determined the discount by considering restricted stock studies, the costs of going public, and the overall academic research on the topic.

Issues: Whether the IRS’s expert’s conclusion of value are correct?

Held: No. The IRS’s expert overstated the value of the minority-held shares. The court faulted his analysis for 1) “not adequately account[ing] for the 2008 recession”, 2) relying on an outlier using the Market Approach, 3) not properly valu[ing] the non-operating asset, 4) group life insurance policies, and 5) two GBP private airplanes. Further, Burns’ report was critiqued for having too low marketability discounts. With respect to the latter, the court noted that the discounts used here were far lower than those he used in another case. As for the S corporation premiums, the court found:

GBP’s subchapter S status is a neutral consideration with respect to the valuation of its stock. Notwithstanding the tax advantages associated with subchapter S status, there are also noted disadvantages, including the limited ability to reinvest in the company and the limited access to credit markets. It is therefore unclear if a minority shareholder enjoys those benefits.

The court gives less weight to Burns’ conclusions as a result.

As for the Emory report, Emory used the Market Approach and “incorporated concepts of the Income Approach assessment.” Emory did not add the non-operating assets reasoning that a minority shareholder cannot realize the value of those assets, and only considered them in conjunction with GBP’s book value. As for the discounts for lack of marketability, Emory considered restricted stock studies, which evaluated identical stocks. He also consulted the Pre-IPO studies. Emory did not apply an S-corporation premium and determined that a 30% marketability discount was proper.

Czaplinski was retained as an expert since the IRS criticized Emory’s report for not having employed the Income Approach. Czaplinski used the capitalized economic income method and discount dividend method and applied three sensitivities to the method, resulting in six valuations. She “also accounted for GBP’s subchapter S status under both methods” by adjusting the discount rate.

The court found Emory’s report and testimony most persuasive and noted that he “spent ample time with the company and management, and truly understands GBP’s business.”

As for the 2703(a) restrictions, which the IRS asserted was a device also not a bona fide business arrangement, the court ruled that the restriction was bona fide. The court observed that 2703(b) requires that evidence be produced that the arrangement is common amongst unrelated parties dealing at arms’ length. No such evidence was produced and as result, the court reduced the Emery discounts three basis points for 2007 and 2008 and five basis points for 2008. Practitioners will want to be cognizant the share restriction, if unproven—which is often the case—did not materially reduce the discount for lack of marketability.

Veriton Partners Master Fund Ltd. v. Aruba Networks, Inc., (Del. April 16, 2019)

Facts: In August 2014 Hewlett-Packard (HP) approached Aruba Networks (Aruba) to discuss a merger. After several months of negotiations between the two companies, the Aruba board decided to accept HP’s offer of $22.67 per share. News leaked and Aruba’s stock price jumped from $18.37 per share to $22.24 per share. The next day, after the market closed, Aruba released its quarterly results which beat analysts’ expectations. The stock jumped to $24.81 per share. The Boards approved the transaction and announced a $24.67 per share price.

On August 28, 2015, Veriton Partners Master Fund Ltd. (Veriton) filed an appraisal proceeding in the Court of Chancery asking the court to appraise the “fair value” of shares. Veriton maintained Aruba’s fair value was $32.57 per share and Aruba contended it was either $19.75 per share (before trial) or $19.75 per share (after trial). In its post-trial answering brief, Aruba contended that its “deal price less synergies” value was $19.10 per share.

Post-trial arguments were scheduled for May 17, 2017, but the Court of Chancery postponed the hearing once it became clear that the Delaware Supreme Court’s forthcoming decision in DFC [Global Corp. v. Muirfield Value Partners, LP] likely would have a significant impact on the legal landscape. Supplemental briefs were submitted in this case.

In its brief, Aruba abandoned the deal price minus synergies as its main benchmark and argued for the first time that its preannouncement stock price was “the single most important mark of its fair value.” On February 15, 2018, the Court of Chancery issued its port-trial opinion finding that the fair value under section 262 was $17.13 per share. In its opinion, the Court of Chancery considered three different valuation measures; first, the “unaffected market price”; second, the deal price minus portion of the synergies left with the seller; and third, two expert witnesses’ valuations which were based primarily on discounted cash flow (DCF) models. The Court of Chancery did not accord any weight to the DCF reports.

Issue: Whether the Delaware Chancery Court abused its discretion arriving at Aruba’s stock price instead of the deal price minus synergies?

Held: Yes, the Chancery Court abused its discretion. The Court held “the Court of Chancery shall enter a final judgment for the petitioners awarding them $19.10 per share, which reflects the deal price minus the portion of synergies left with the seller as estimated by [Aruba Networks] in this case.”

Significantly, the Court wrote a stinging opinion regarding the procedures not employed and role of the judge. The Court wrote:

By relying exclusively on the 30-day average market price, the Court of Chancery not only abused its discretion by double counting agency costs but also injected due process and fairness problems into the proceedings. As Verition argued, the Vice Chancellor’s desire not to award deal price minus synergies could be seen—in light of his letter to the parties and the overall tone of his opinion and reargument decision—as a results-oriented move to generate an odd result compelled by his personal frustration at being reversed in Dell. Indeed, the idea of awarding the stock price came into the proceedings from the Vice Chancellor himself after requesting supplemental post-trial briefing on the matter. Prior to that point, neither party argued for that figure as the fair value under § 262. Because the Vice Chancellor introduced this issue late in the proceedings, the extent to which the market price approximated fair value was never subjected to the crucible of pretrial discovery, expert depositions, cross-expert rebuttal, expert testimony at trial, and cross examination at trial. Instead, the Vice Chancellor surfaced Aruba’s stock price as an appropriate measure of fair value in a way that is antithetical to the traditional hallmarks of a Court of Chancery appraisal proceeding. The lack of a developed record on whether the stock price was an adequate proxy for fair value buttresses our holding that the Court of Chancery abused its discretion by awarding the 30-day average unaffected market price of $17.13 per share.

These procedural issues relate to substance in an important way. The reason for pretrial discovery and trial is for parties to have a chance to test each other’s evidence and to give the fact-finder a reliable basis to make an ultimate determination after each side has a fair chance to develop a record and to comment upon it. The lack of that process here as to the Vice Chancellor’s ultimate remedy is troubling. The Vice Chancellor slighted several important factors in choosing to give exclusive weight to the unaffected market price. Under the semi-strong form of the efficient capital markets hypothesis, the unaffected market price is not assumed to factor in nonpublic information. In this case, however, HP had signed a confidentiality agreement, done exclusive due diligence, gotten access to material nonpublic information, and had a much sharper incentive to engage in price discovery than an ordinary trader because it was seeking to acquire all shares. Moreover, its information base was more current as of the time of the deal than the trading price used by the Vice Chancellor. Compounding these issues was the reality that Aruba was set to release strong earnings that HP knew about in the final negotiations, but that the market did not. As previously noted, Aruba’s stock price jumped 9.7% once those earnings were finally reported to the public. None of these issues were illuminated in the traditional way, and none of them were discussed by the Court of Chancery in a reasoned way in giving exclusive weight to a prior trading price that was $7.54 below what HP agreed to pay, and well below what Aruba had previously argued was fair value.

This multitude of concerns gives us pause, as does the evident plausibility of Verition’s concern that the trial judge was bent on using the 30-day average market price as a personal reaction to being reversed in a different case. In a reargument decision addressing the petitioner’s argument to this effect, the Vice Chancellor denied that this was the case. We take him at his word. However, so too do we take him at his word that he viewed an estimate of deal price minus synergies as compelling evidence of fair value on this record, but that he could not come up with a reliable estimate of his own because he wanted to double count agency costs, and also lacked confidence in his underlying synergy deduction. Nevertheless, fixing the double counting problem and hewing to the record developed by the parties themselves, leaves a reliable estimate of deal price minus synergies, which is the one that Aruba advanced until the Vice Chancellor himself injected the 30-day average market price as his own speculative idea. Of course, estimating synergies and allocating a reasonable portion to the seller certainly involves imprecision, but no more than other valuation methods, like a DCF analysis that involves estimating (i) future free cash flows; (ii) the weighted average cost of capital (including the stock’s beta); and (iii) the perpetuity growth rate. But here there is no basis to think Aruba was being generous in its evaluation of deal price minus synergies. And, as any measure of value should be, Aruba’s $19.10 deal price minus synergies value is corroborated by abundant record evidence.

The Vice Chancellor himself concluded that because the HP-Aruba transaction involved enormous synergies, “the deal price … operates as a ceiling for fair value.” That conclusion was abundantly supported by the record. Aruba’s estimate of $19.10 resulting from that method was corroborated by HP’s and Aruba’s real-time considerations and Aruba’s DCF, comparable companies, and comparable transactions analyses.

Rather than burden the parties with further proceedings, we order that a final judgment be entered for the petitioners in the amount of $19.10 per share plus any interest to which the petitioners are entitled.

Readers of QuickRead will want to take note that hedge funds were instrumental in fair value litigation and that while the 30-day moving average is clearly not an indication of fair value, a fair value may well be far less than the offer price. This logic will apply to fair value cases involving closely held companies.

In re: CIL Limited, LaMonica v. CEVA Group PLC (Bankr. S.D.N.Y. April 8, 2019)

Facts: This case involves a Chapter 7 adversary proceeding. The Chapter 7 Trustee (LaMonica) alleges that CEVA undertook a reorganization that harmed CIL. Before the restructuring transaction, CIL directly or indirectly owned 100% of the shares of CEVA. CEVA issued new shares of its stock, none went to CIL. As a result, CIL’s ownership in CEVA was reduced to .0001%. LaMonica seeks to avoid the issuance of the new CEVA shares and recover damages from CEVA. As in this type of case, one of the key issues is whether the debtor was solvent when a number of events transpired.

Here, LaMonica attempted to introduce a valuation or “Record Value Evidence” and a “Control Value Evidence” to prove CEVA’s equity value, separate and apart from the damages conclusions. CEVA filed a Motion for Rule 37 Preclusion Sanctions; defendant sought to preclude LaMonica from relying at summary judgment and, if necessary, at trial, on any and all purported damages theories and/or calculations that are not part of the Trustee’s Federal Rule 26 disclosures and the opening and rebuttal expert reports submitted by the Trustee’s valuation expert.

Defendant also sought to preclude admission of a two-page “Addendum” to the expert report.

Issue: Whether to admit the expert’s “Record Value Evidence”? “Control Value Report”? Two-page Addendum?

Held: Defendant’s motion to preclude is granted in part and denied in part.

The Court wrote:

The CEVA Defendants have established grounds under Rule 37(c)(1) to preclude the Trustee from using the Record Value Evidence and Control Value Evidence to establish or support purported damages theories and/or calculations not contained in the Trustee’s Rule 26 disclosures and the [expert’s] opening and rebuttal report at summary judgment. … The Court finds the CEVA Defendants have not established cause to so limit the Trustee’s use of the Addendum.

The takeaways in this case are that a battle of experts is not resolved through summary judgment; experts must supplement their reports and deposition testimony on a timely basis and how the Softel factors are applied when a party claims a Rule 26 violation and prejudice. See Softel, Inc. v. Dragon Me. And Sci. Commc’ns, 118 F.3d 955, 961 (2d Cir. 1997).

Hoyd v. Trussway Holdings, LLC (Del. Ch. February 28, 2019)

Facts: The case reported here involves an appraisal action arising from the conversion of a corporation, Trussway Holdings, Inc. (Trussway) into an LLC via merger. In the case, a private equity firm and Kendal Hoyd (Hoyd), owned a minority interest in Trussway. The complication in this case was that Trussway had a wholly-owned subsidiary, Trussway Industries, Inc. (TII), that owned investments in two companies, Targa and Tandem, which were not publicly-traded and held publicly traded stock in building materials.

On July 27, 2016, TII engaged Moelis and Company as its investment banker for purposes of a sale of TII. Moelis concluded that TII’s enterprise value could range from $202 million to $298 million. Moelis contacted 76 parties, of whom 27 executed non-disclosure agreements and seven expressed an interest.

In December 2016, the Trussway Board approved an Agreement and Plan of Merger between Trussway and TW Merger Sub, Inc. As a result of this plan, Trussway merged into TW Merger Sub, with Trussway LLC being the surviving entity. On the merger date, each share of Trussway was canceled and converted to common units of Trussway Holdings, LLC. The Petitioners in this case did not vote in favor of, nor did they consent to, the merger. They subsequently delivered appraisal demands.

The sale of TII, which was ongoing as of the merger date, fell through.

Issue: Whether the expressions of interest in TII have any evidentiary value? Whether a comparable company analysis could be performed to value TII?

Held: As for the first issue, the court found them “useful only as a very rough reasonableness check.” As for use of the comparable company analysis, the court agreed with Respondent “that Scheig’s (the Petitioner’s expert) supposed ‘comparable companies’ are too divergent to TII, in terms of size, public status, and products, to form meaningful analogs for valuation purposes.”

The decision does discuss, in detail, the court’s view of management’s projections, the addition of a risk premium being added to the WACC, the use of adjusted beta vs. historic beta, use of beta for a company this size (close to $183m), and weighting accorded to the DCFs developed by the experts. These are issues that QuickRead readers are familiar with, but that counsel and clients are sadly unfamiliar with and need to be addressed in a report.

Zayo Group, LLC v. Latisys Holdings, LLC (Del. Ch. November 26, 2018)

Facts: In this case, an unhappy buyer of a company sued the seller for breach of contract. The seller and buyer agreed that if any of the buyer’s most valuable customers cancelled or modified their contracts with seller before the closing, the seller would disclose the facts to the buyer. The seller and buyer did not agree, however, that the seller would advise buyer if any of these customers elected not to renew one of their contracts. After the transaction closed, the seller discovered that certain major customers had elected or were electing not to renew their contracts. This litigation ensued.

Issue: Whether defendant (seller) breached the operative contract?

Held: No. Zayo, the buyer, which the court described as sophisticated, presented Latisys (Seller) an LOI that included a SPA. Although the parties redlined a small portion of the initial SPA, within two-weeks, the parties agreed to the terms of sale.

As noted above, renewals fell. In its Verified Complaint, Zayo sought indemnification for damages caused by breaches of representations, warranties, and covenants contained in the SPA. In Count II, Zayo alleged sought indemnification for continuing losses, including attorney fees. Zayo also sought specific performance directing Latisys to release funds held in an escrow account created per the SPA to cover such damages.

According to Zayo, “non-renewal is tantamount to ‘termination’ or ‘cancellation’ as contemplated by Section 4.12(b). Latisys acknowledges that it did not advise Zayo of the non-renewals but maintains that it had no obligation to do so under Section 4.12(b) or otherwise.”

The court looked at the plain language and concluded:

With two reasonable constructions in hand, I am satisfied Section 4.12(b) is ambiguous under the objective theory of contracts. Accordingly, I am now obliged to ‘look beyond the language of the contract to ascertain the parties’ intentions. In doing so, I am mindful that I must respect, ‘to the extent possible, the reasonable shared expectations of the parties at the time they contracted.’

The SPA drafting history makes it clear that Latisys made no commitment to inform Zayo if existing customers will or will not renew their expiring contract. To the contrary, Latisys expressly declined to make that commitment when Zayo proposed it during the course of negotiations. Zayo did not object and the parties executed the SPA without the ‘refuse to renew’ language in the Material Contracts representation and warranty. The fact that Zayo inserted this added language in its proposed SPA reveals Zayo, like Latysis believed that ‘refuse to renew’ had a different meaning than the language already included in Section 4.12(b)—i.e., ‘terminate, cancel, and refuse to perform.’

Caveat emptor! Buyers that are eager to acquire, need to walk away if the seller balks notwithstanding the costs incurred when the seller refuses to discuss renewals and renewals are the life-blood of the company.

In this case, it is worth noting that Gary Kleinrichert, CVA and NACVA member, was Latisys expert. The court praised Mr. Kleinrichert’s damages calculations. So, we end this article with a shout-out to Gary!

Conclusion

The Kress case will be cited as a leading and persuasive decision for when minority shares are gifted in other jurisdictions. Readers that serve as expert witnesses and tax/probate attorneys handling valuation issues will want to read the decision to discuss the strategy, advisability of asking the court to take judicial notice, and recognize that if there is no evidence, the restrictions found in the bylaws are generally agreed upon, then the 2703(b) argument in favor of greater marketability discounts is a losing argument. This is an evidentiary problem, especially since there is no local database to present evidence as to the recognized fairness of restrictions.

The Aruba decision is important too. This is a statutory fair value case and it underscores the concerns the Court had with the procedures not used and lower court’s abuse of discretion.

Roberto H Castro, JD, MST, MBA, CVA, CPVA, CMEA, BCMHV, is an appraiser of closely held businesses, machinery and equipment and Managing Member of Central Washington Appraisal, Economics & Forensics, LLC. He is also an attorney with a focus on tax, wills and trusts, business law, and succession planning with offices in E. Wenatchee and Chelan, WA. He is also Technical Editor of QuickRead and writes case law columns for The Value Examiner.

Mr. Castro can be contacted at (509) 679-3668 or by e-mail to either rcastro@cwa-appraisal.com, rcastro@rcastrolaw.com or rcastro@cwa-appraisal.com.

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The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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