R.D. Clark and Sons, Inc., et al. v. James Clark, et al.

Connecticut Appellate Court Affirms Trial Court’s Decision Not to Tax-Affect Earnings

In a dispute over the buyout of the minority shares in a family business, the Connecticut appellate court addressed several important valuation issues. Notably, the appellate court upheld the trial court’s decision not to tax-affect the company’s earnings in determining the fair value of the shares, even though both the plaintiffs’ and defendants’ experts had done so. The appellate court also upheld the trial court’s findings that (1) the company engaged in shareholder oppression and, therefore, the value of the minority shareholder’s interest would not be subject to a minority interest discount, and (2) the value of the minority interest should not be reduced by a discount for lack of marketability. This article summarizes this state court decision.

In a dispute over the buyout of the minority shares in a family business, the 2019 Connecticut appellate court addressed several important valuation issues. Notably, the court upheld the trial court’s decision not to tax-affect the company’s earnings in determining the fair value of the shares, even though both the plaintiffs’ and defendants’ experts had done so. The appellate court also upheld the trial court’s findings that (1) the company engaged in shareholder oppression and, therefore, the value of the minority shareholder’s interest would not be subject to a minority interest discount, and (2) the value of the minority interest should not be reduced by a discount for lack of marketability.

The appellate court downplayed the impact of its decision on future rulings. Emphasizing that valuation is a factual determination, the court limited its analysis “to the holdings of the trial court and the corporation’s specific challenges to them”.

Facts of the Case

R.D. Clark and Sons, Inc., was formed in 1984 in Connecticut by Robert D. Clark (Robert D.) to operate a specialty freight trucking business. The company was organized as an S corporation owned in equal one-third shares by Robert Clark and his two sons, John Clark (John) and James Clark (James). When Robert D. died in 2011, his daughter, Carolyn Manchester, assumed his shares. The three siblings served as officers and directors of the company until they had a falling out in late 2011. James was terminated from his position as a driver and occasional dispatcher. James then resigned in February 2012 from his positions as officer and director.

In 2014, the company and its other shareholders brought an action against James and his new business, Smart Choice, for breach of fiduciary duty, alleging that James had improperly used proprietary information to start a competing venture. The complaint was withdrawn in February 2016 when the company elected to purchase James’s shares at fair value in lieu of dissolution of his new venture, pursuant to Connecticut law.

At the same time, James filed an amended counterclaim alleging that the company had a practice for many years of providing shareholders with funds to cover their pass-through shares of company’s income tax liabilities. James had not received such payments for the years 2012, 2013, and 2014. James claimed that this conduct was oppressive.

The parties were unable to agree on the shares’ fair value or the purchase terms; the matter was presented to the trial court. The court determined the company’s value as of December 31, 2014, was $2,356,719 and the fair value of James’ shares was $785,573. The court also ruled that (1) the company’s majority shareholders had engaged in oppressive conduct, hence the value of James’ shares was not subject to a minority interest discount; (2) the shares’ value should not be reduced by a marketability discount; and (3) James was entitled to statutory attorney and expert witness fees, expenses, and post-judgement interest.

In June 2017, the court awarded James $983,028.09, including fees and expenses, plus post-judgement interest at 2.25 percent, payable over ten years.

Appellate Court’s Analysis

The plaintiffs challenged the court’s valuation of James’s interest, claiming the court erred by:

• Not tax-affecting the company’s earnings,
• Not applying a minority interest discount, and
• Not applying a discount for lack of marketability.

Tax-Affecting

Expert witnesses for both sides valued the company with an income approach decreasing the corporation’s normalized earnings reflecting a pass-through tax rate. The plaintiffs’ expert applied a 25 percent tax rate and the defendant’s expert applied a 12.6 percent tax rate. The court declined the tax-affecting adjustment. The company argued on appeal that this artificially inflated the company’s value.

The appellate court noted that no Connecticut law mandates a specific approach to tax-affecting. The court concluded that the trial court did not commit a reversible abuse of discretion by not tax-affecting, for several reasons:

1. The approach has considerable support in tax cases.
2. The trial court was to determine fair value, not fair market value.
3. The issue of tax affecting continues to be a subject of debate among experts.
4. This case “seems particularly ill-suited to tax affecting earnings,” given the company’s continuing practice of extending loans to shareholders to cover their tax liabilities and then retiring those loans through the payment of bonuses.

The appellate court emphasized that its decision was based on the facts of the case and “we discern no bright-line rule in this area.”

Minority Interest Discount

In arm’s-length transactions, the value of a minority interest is typically discounted because a willing buyer would pay less for a non-controlling interest in a closely held business. In this case, the trial court declined to apply a minority interest discount (and attorney and expert witness fees were awarded) because James had been subjected to oppressive conduct by majority shareholders.

The oppression founded on the basis that after James’s termination, while he remained a shareholder, he was excluded from the company’s long-standing policy of providing shareholders with funds to cover their pass-through tax liabilities. The company challenged the trial court’s finding of oppression on several grounds:

• Customary practice extends loans to officers and directors, not to shareholders.
• The decision to extend those loans was made by the company’s advisory board.
• The defendant failed to establish his tax obligations for the years in question.
• Any alleged oppression occurred only after the defendant petitioned for the company’s dissolution because any tax assistance the defendant may have received for his 2014 tax obligations would not have been awarded until after the valuation date.

The trial court rejected all of these arguments because they contradicted the evidence in the record or based on testimony by witnesses found not to be credible.

Marketability Discount

The company argued that the trial court’s disallowance of a marketability discount was erroneous and imposed an “undue financial burden” on the company. The appellate court disagreed. The court explained that the marketability discount application is generally disfavored when determining fair value versus fair market value of shares in a closely held corporation when the shares are for purchase in lieu of dissolution with no actual sale of shares in the open market.

Although Connecticut law is silent on marketability discount appropriateness in valuing a dissenting shareholder’s interest, some courts apply this discount under “extraordinary circumstances” in order to “promote fairness and equity to all parties”. The trial court noted that extraordinary circumstances have been found to exist when “the full value of a buyout greatly exceeded certain measures of the corporation’s financial condition,” but that was not the case here. The trial court acknowledged that the company had been struggling financially but found “the way to deal with this issue is in setting the terms and conditions of purchase, not in applying an arbitrary percentage discount.”

The appellate court found after an examination of the company’s relative finances and the defendant’s shares, that the trial court had not abused its discretion by determining there were no extraordinary circumstances warranting a marketability discount. The trial court addressed the financial burden of its judgment on the company with a 10-year payment plan to satisfy the judgment. Per the appellate court, the company cannot successfully claim an unfair financial burden merely because it might have trouble in making the payments.

Conclusion

The Connecticut appellate court’s decision in R.D. Clark and Sons, Inc., et al. v. James Clark et al., addresses important issues regarding the application of tax affecting plus minority and marketability discounts in buyout-related valuations. Although the decision offers little in the way of bright-line rules or other objective guidance for future courts or litigants, it highlights the fact-based nature of many valuation issues.

As the appellate court explains:

Valuation is a factual determination. In assessing the value of…property…the trier arrives at [its] own conclusions by weighing the opinions of the appraisers, the claims of the parties, and [its] own general knowledge of the elements going to establish value, and then employs the most appropriate method of determining valuation…The trial court has the right to accept so much of the testimony of the experts and the recognized appraisal methods which they employed as [it] finds applicable; [its] determination is reviewable only if [it] misapplies, overlooks, or gives a wrong or improper effect to any test or consideration which it was [its] duty to regard… In determining whether the trial court reasonably could have concluded as it did on the basis of the evidence before it, we will give every reasonable presumption in favor of the correctness of [its] action. (Citation omitted; internal quotation marks omitted.)

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Kimberly Tavares, CVA, is the founder of PacWest Accounting, Inc., a full-service accounting/litigation support firm that provides outsourced CFO advisory services as well as business valuation and forensic accounting services. She has served as an expert witness in San Diego and Orange counties in California and has over 18 years of experience preparing valuations in numerous industries, including technology, construction, healthcare, professional services, trucking, and manufacturing. Ms. Tavares graduated from California State University Fullerton with a BA in Accounting. She is CFO of the Newport Beach Chamber of Commerce Board of Directors, a 2016 NACVA/CTI 40 Under Forty honoree, and a nominee for the Connected Women of Influence 2018 President’s Award, and the 2016 and 2018 Orange County Business Journal Women in Business Award.

Ms. Tavares can be contacted at (949) 873-3126 or by e-mail to kim@pacwestaccounting.com.