Demystifying Statutory Fair Value Webinar 06 28 11 Z. Christopher Mercer

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Demystifying Statutory Fair Value

Z. Christopher Mercer, ASA, CFA, ABAR

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Z. Christopher Mercer, ASA, CFA, ABARStatutory Fair Value

My first three testimonies were in statutory fair value determinations (1981, 1983)

20% of testimonies, at deposition or trial, have been on statutory fair value matters over the last 30 years (testified at trial 16 times in 10 different states)

» 16 times for shareholders

» 7 times for companies

» Court-appointed three times

Very little written on Statutory Fair Value in Business Appraisal Literature

Series on Statutory Fair Value on blog: www.ValuationSpeak.com

Please ask me to connect with you on LinkedInwww.linkedin.com/in/zchristophermercer

http://www.valuationspeak.com/

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Deposition and trial testimony

Z. Christopher Mercer, ASA, CFA, ABAR

Fair Value Matters

TRIAL TESTIMONY

Alabama

Arkansas

Colorado

Kansas

Minnesota

Mississippi

Missouri

New York

Tennessee

Texas

Alabama (Arbitrator)

DEPOSITION TESTIMONY

Alabama

Arkansas

Colorado

Georgia

Kansas

Illinois

Minnesota

Mississippi

Missouri

Nevada

Tennessee

Texas

West Virginia

OTHER FAIR VALUEENGAGEMENTS

Florida

Kentucky

Delaware

Ohio

Oklahoma

New Jersey

?

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Section 1

» Introduction to Statutory Fair Value

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What is a “standard of value”?

A standard of value provides a foundation for constructing an appraisal

ASA Business Valuation Standards Glossary

» Standard of Value. The identification of the type of value being used in a specific engagement; e.g. fair market value, fair value, investment value.

Standards of value include, among others, fair market value and fair value

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Fair Market Value is the price…

Expressed in terms of cash equivalents, at which property would change hands between

A hypothetical willing and able buyer and a hypothetical willing and able seller,

Acting at arm’s length

In an open and unrestricted market,

When neither is under compulsion to buy or sell

And when both have reasonable knowledge of the relevant facts.

(Note: In Canada, the term "price" should be replaced with the term "highest price")

ASA Business Valuation Standards Glossary

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Standard of Value Levels of Value

» “Level of value” concept defines the kind of value for appraisals

» Fair value determinations must be rendered in the context of the appropriate “level of value”

Necessary to define an appraisal

Provides framework for organizing an appraisal of securities consistent with the assignment

Provides basis for selection of valuation methods that reach a value consistent with the selected level of value

» Fair value ultimately defined in relationship to the “levels of value” Premiums and discounts mentioned in many court cases are (direct and indirect) references to the

“levels of value” used by appraisers

Appraisers can provide opinions of fair value consistent with the specified level(s) when specified

Differing interpretations re level of value can create wide swings in conclusions of appraisers

Court ultimately must decide on appropriate level of value

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Traditional Levels of Value

The control value refers to the value of the enterprise as a whole

The marketable minority interest value refers to the value of a minority interest that lacks control but enjoys the benefit of liquidity as if it were freely tradable in an active market

The nonmarketable minority interest value refers to the value of a minority interest that lacks both control and market liquidity

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Traditional Levels of ValueAppraisers refer to valuation discounts and premiums,

which are based on relationships between the levels of value

The control premium is the additional amount that an investor would pay to acquire control of a firm versus a publicly traded minority interest in that company

The minority interest discount is the decrement to value owing to the fact that the holder of a minority interest cannot exercise control over the firm

The marketability discount relates to the decrement to value, versus the marketable minority interest value, that arises because no liquid trading market (such as the NYSE) exists for the subject firm’s shares

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Levels of Value» The appropriate level of value in a fair value matter

involves a legal interpretation

Legal counsel should provide guidance

Appraisers tread on shaky ground if they attempt to interpret what fair value “should be” in any particular state

» i.e., expressing opinions regarding whether particular valuation discounts or premiums “should” apply

» Pueblo experience

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A More Modern View

Levels of Value

Source: Business Valuation: An Integrated Theory, 2nd Edition | Mercer & Harms (John Wiley & Sons, 2007)

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Section 2

» How is Statutory Fair Value Defined in Various Jurisdictions?

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Statutory Fair Value Defined – DelawareSection 262 Delaware General Corporation Law

» Subsection (h) of that statute sets forth the relevant parameters for determining value,

In appraisal proceedings the Court of Chancery:

» shall appraise the shares, determining their fair value exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with a fair rate of interest, if any, to be paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into account all relevant factors.

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Statutory Fair Value Defined – New York§ 623. Procedure to enforce shareholder's right to receive payment for shares

§ 623 (h) (4).» The court shall determine whether each dissenting shareholder, as to whom the corporation

requests the court to make such determination, is entitled to receive payment for his shares. If the corporation does not request any such determination or if the court finds that any dissenting shareholder is so entitled, it shall proceed to fix the value of the shares, which, for

the purposes of this section, shall be the fair value as of the close of business on the day prior to the shareholders' authorization date. In

fixing the fair value of the shares, the court shall consider the nature of the transaction giving rise to the shareholder's right to receive payment for shares and its effects on the corporation and its shareholders, the concepts and methods then customary in the relevant securities and financial markets for determining fair value of shares of a corporation engaging in a similar transaction under comparable circumstances and all other relevant factors. The court shall determine the fair value of the shares without a jury and without referral to an appraiser or referee. Upon application by the corporation or by any shareholder who is a party to the proceeding, the court may, in its discretion, permit pretrial disclosure, including, but not limited to, disclosure of any expert's reports relating to the fair value of the shares whether or not intended for use at the trial in the proceeding and notwithstanding subdivision (d) of section 3101 of the civil practice law and rules.

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Statutory Fair Value Defined – FloridaF.S. §607.1302, Right of Shareholders to Appraisal

» “Fair value” is defined as the value of the corporation’s shares determined:

(a) Immediately before the effectuation of the corporate action to which a shareholder objects.

(b) Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable to the corporation and its remaining shareholders.

(c) For a corporation with 10 or fewer shareholders, without discounting for lack of marketability or minority status.

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Statutory Fair Value Defined – Florida

Distinction Between Corporations with More Than 10 Shareholders and 10 or Less Shareholders — Although clearly providing that fair value is to be determined without discounting for lack of marketability or minority status, §607.1301(4)(c) arbitrarily limits this provision to corporations with 10 or fewer shareholders. This creates the inference that those discounts would be applied in appraisal proceedings brought by shareholders in corporations that have more than 10 shareholders. A recent commentator has argued that this distinction is illogical because there is often no market for a private corporation’s shares, regardless of whether the corporation has 10, 11, or 50 shareholders. Instead, as the commentator argues, the appropriate distinction should only be whether there is an established market for a corporation’s shares. If there is an established market, there is no need for an appraisal remedy; if there is no established market, then discounts for lack of control or lack of marketability should not apply. The courts have not yet addressed the issue.

Rebecca C. Cavendish and Christopher W. KammererFlorida Bar Journal, September 2008

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Statutory Fair Value Defined – MississippiSection 79-4-13.01 Mississippi Code of 1972 (effective July 1, 2000)

» (4) "Fair value" * * * means the value of the corporation's shares determined:

(i) Immediately before the effectuation of the corporate action to which the shareholder objects:

(ii) Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; and

(iii) Without discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to Section 79-4-13.02(a)(5)

Note: The Mississippi statutory definition of fair value does not apply to publicly traded companies or those with 2,000 or more shareholders, and notes other exceptions as well in elaborating sections (makes more sense than current Florida statute)

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Section 3

» What “should” statutory fair value be in any particular state?

» Example from a “real life” report…

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Engagement DefinitionClient Name Name1, Name2, Name3, Name4, PC

Business Name Company Name

Type of Entity C Corporation

State of Organization Alabama

Principal Business Location Somewhere, Alabama

Business Interest Under Consideration Shares of Stock Subject to a Recent Reverse Stock Split

State of ValueFair Value. Fair value is to be determined pursuant to Alabama Code §10-2B-13.01. Definitions (4).

Level of Value See further discussion below regarding Standard of Value

Effective Date December 31, 2003

Purpose & Intended Use

We understand that our appraisal will be used as a basis for determining the fair value of 20.873 shares of common stock of Company Name in connection with litigation related to a reverse stock split that was effective as of December 31, 2003. We further understand that our appraisal will be submitted in connection with this litigation and that Z. Christopher Mercer, ASA, CFA, CEO of Mercer Capital, may be requested to provide deposition and/or trial testimony related to the opinions in this appraisal.

Scope of Work Appraisal

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Role of Appraiser in Statutory Fair Value Determinations» Quoting from the text of the appraisal…

The purpose of this appraisal is to provide our opinion of the fair value of shares of Company, Inc. as of December 31, 2003, the date of a reverse stock split. Fair value is to be determined pursuant to Alabama Code §10-2B-13.01. Definitions (4), which defines fair value as follows:

» (4) “Fair Value,” with respect to a dissenter’s shares, means the value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.

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This statutory definition of fair value in Alabama, like the related definitions in the statutes of most other states, does not provide a description sufficient to provide guidance to appraisers regarding the type, or level of value, intended by the legislature. As a result, appraisers must typically make reference to the relevant fair value case law when developing fair value opinions.

Mercer Capital typically requests that counsel provide a legal interpretation of the relevant case law. Such interpretations in some jurisdictions suggest what appraisers call a controlling interest conclusion of fair value. Other jurisdictions have been interpreted to allow the use of minority and/or marketability discounts in fair value determinations.

Counsel for Company, Inc. has indicated to Mercer Capital that the precedent case law regarding the determination of fair value in the type of case currently in litigation is unclear as to judicial interpretation. Consequently, counsel has requested that Mercer Capital provide three opinions of fair value:

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Conclusion 1. Fair value is interpreted as a controlling interest level of value. As seen in the chart below, this value reflects the value of shares and no minority interest or marketability discounts are employed.

Conclusion 2. Fair value is interpreted as a marketable minority interest level of value. This value is also an enterprise value, but considers an appropriate minority interest discount. No marketability discount is employed.

Conclusion 3. Fair value is interpreted as a nonmarketable minority level of value. This value begins with the overall enterprise value and employs appropriate minority interest and marketability discounts based on the facts and circumstances of the case.

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The following “levels of value” chart provides a conceptual illustration of the interpretation of each of the three levels of value noted above in valuation terms

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In rendering these three opinions of fair value, neither Mercer Capital nor Z. Christopher Mercer, ASA, CFA is rendering any opinion regarding which interpretation of fair value is appropriate under Alabama law. These opinions are provided to counsel and to the Court for consideration in the context of the legal interpretation of fair value.

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Discounts for Lack of Marketability

» Pointing out the obvious…

The use of discounts for lack of control and lack of marketability can have a significant impact on the buy-out price of a minority shareholder’s interest in a closely held corporation. Thus, it is important for an attorney dealing with an appraisal or dissolution case (or the decision to bring such an action) to have an understanding of this issue and the relevant Florida statutes and decisions, as well as the significant decisions from around the country, in order to be prepared to address the potential arguments regarding the use of the two discounts.

Rebecca C. Cavendish and Christopher W. KammererFlorida Bar Journal, September 2008

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Section 4

» Defining statutory fair value in terms of fair market value at a particular level of value

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A More Modern View

Levels of Value


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New York Matter of Giaimo

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“Marketability Discount – The Problem» While the use of a “marketability discount” is stated in Beway, there is no

economic rationale for its application by appraisers

» The base valuation in New York is definitely, or so it seems based on business and valuation perspectives, definitely a financial control concept

» There is no economic rationale for applying a “marketability discount” to a controlling interest in a business

Remember the definition of fair market value

Hypothetical transaction between arm’s length parties occurs on the valuation date.

» If a hypothetical transaction occurred, it occurred at the price concluded in the appraisal at the financial control level

» Exposure to market has already occurred (or is assumed to have occurred in the hypothetical negotiation between the parties)

Reference to restricted stock studies and pre-IPO studies to validate a so-called “marketability discount” for a controlling interest makes no economic sense

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Assignment Definition

Client Name Robert T. Giaimo

Business Name1. EGA Associates, Inc. (“EGA”)2. First Ave. Village Corp. (“FAV”)

Type of Entity C Corporation

State of Organization New York

Principal Business Location New York, New York

Business Interest Under Consideration 100% of the Common Stock

State of Value Fair Value. Fair value in Accordance with New York Business Corporation Law §623

Level of Value Controlling Interest Basis

Effective Date August 1, 2007

Purpose & Intended UseLitigation Concerning the Petition of Robert T. Giaimo, as Co-Executor of the Will of Edward P. Giaimo, Jr. Deceased for the Judicial Dissolution of EGA Associates, Inc.

Scope of Work Appraisals

Premise of Value Going Concern

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» Quoting from the text of the appraisal…

Mercer Capital is not a law firm and Z. Christopher Mercer is not a lawyer. We therefore offer no opinions regarding the legal interpretation of the definition of fair value from a valuation perspective. We have requested that Mr. Giaimo’s legal counsel provide a legal interpretation of the relevant case law.

Counsel for Mr. Giaimo has indicated to Mercer Capital that the precedent case law regarding the determination of fair value in the type of case currently in litigation is clear as to judicial interpretation of minority discounts and counsel notes that New York court decisions uniformly hold that no minority discount be applied.

Counsel also indicates that case law holds that a marketability discount is applicable only to “good will” and several cases, including a 2008 holding for the First Department, explicitly state no discount for lack of marketability is to be applied when a company’s sole assets are cash and real estate.

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The cases we have been shown and legal counsel’s interpretation of fair value would suggest that our appraisal conclusion should reflect a controlling interest level of value, though without a control premium, and that we should apply neither a minority interest discount nor a marketability discount in this appraisal.

In rendering this opinion of fair value, however neither Mercer Capital nor Z. Christopher Mercer, ASA, CFA is rendering any opinion regarding the interpretation of fair value under New York law.

This valuation opinion is provided to counsel and to the court for consideration in the context of the legal interpretation of fair value.

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To complete this discussion relating fair value to the fair market value standard of value, let’s refer back to the “Assignment Definition.”

We noted that fair value would be determined on a controlling interest basis. Then, based upon legal instruction, in the “Fair Value Considerations in New York” section, we further refined that assignment for each of the Companies to determine fair value at the financial control level of value.

From an appraiser’s viewpoint then, fair value, as interpreted above in New York, can be described as the valuation equivalent of fair market value at the financial control level of value.

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“Marketability Discount” in New York What’s an Appraiser to Do?

» Beway, the leading appellate level case in New York, indicates: Going concern valuation as if arm’s length parties negotiated a sale of the company Then, consider (?) or apply (?) a “marketability discount”

» No economic basis or rationale for it» No help from the underlying data relied upon by the experts (and the court) in Beway

» If there is a “marketability discount” it must be quite small, since the risks associated with illiquidity (i.e., exposure to market) in the hypothetical transaction involving the company has already occurred

» Beway says to ignore contractual restrictions on voluntary transfer (because transfers are necessitated by actions of the majority)

» Call the application of a “marketability discount” an “implied minority discount” that New York courts will have to figure out in future cases when provided with appropriate economic and valuation evidence

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“Marketability Discount” in New York What’s an Appraiser to Do?


If applicable, economics suggest nil or smallIf applicable, economics suggest nil or small

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Stockholder’s Proportionate Interest… Trye-Continental vs. Battye (1950 Del. LEXIS 2)

» The basic concept of value under the appraisal statute is that the stockholder is entitled to be paid for that which has been taken from him, viz., his proportionate interest in a going concern.

» By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true or intrinsic value of his stock which has been taken by the merger.

» In determining what figure represents this true or intrinsic value, the appraiser and the courts must take into consideration all factors and elements which reasonably might enter into the fixing of value. Thus, market value, asset value, dividends, earning prospects, the nature of the enterprise and any other facts which were known or which could be ascertained as of the date of merger and which throw any light on future prospects of the merged corporation are not only pertinent to an inquiry as to the value of the dissenting stockholders’ interest, but must be considered by the agency fixing the value.

» The basic concept of value under the appraisal statute is that the stockholder is entitled to be paid for that which has been taken from him, viz., his proportionate interest in a going concern.

» By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true or intrinsic value of his stock which has been taken by the merger.

» In determining what figure represents this true or intrinsic value, the appraiser and the courts must take into consideration all factors and elements which reasonably might enter into the fixing of value. Thus, market value, asset value, dividends, earning prospects, the nature of the enterprise and any other facts which were known or which could be ascertained as of the date of merger and which throw any light on future prospects of the merged corporation are not only pertinent to an inquiry as to the value of the dissenting stockholders’ interest, but must be considered by the agency fixing the value. (emphasis added)

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The IMD Stated in Caselaw

» The concept of the “implied minority discount” is based on the premise that guideline company analysis:

“…produces an equity valuation that inherently reflects a minority discount, as the date used for purposes of comparison is all derived form minority trading of the comparable companies. Because that value is not fully reflective of the intrinsic worth of the corporation on a going concern basis, this court has applied an explicit control premium in calculating the fair value of the equity in an appraisal proceeding.”

» Boruso v. Communications Telesystems Int’l, 753 A.2nd 451, 458 (Del. Ch. 1999)

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The Implied Minority Discount (IMD)in Delaware

» The “implied minority discount” in Delaware

Actually a “control premium” designed, according to the Delaware Chancery Court, to eliminate any discount from “intrinsic worth” found in the share prices of even very actively traded companies

Reflects the belief that the public markets consistently undervalue public company shares relative to their pro rata going concern value

This belief not generally shared by thought leaders in the business valuation profession

» Creates problems for appraisers and courts across the nation

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IMD – Texas Arbitration Shootout» Arbitration panel looked to Delaware

» Bank’s counsel and appraiser argued that a minority interest discount should apply (and marketability discount, too!)

Appraiser actually argued that discounts “should” apply because the interest in question was a minority interest

» Tried to call the “implied minority discount” a discount

» Shareholder’s counsel and appraiser noted (correctly) that the IMD is actually a premium and estimated the portion of control premiums that might be caused by expected synergies at time of announcements of bank transactions

» Wide difference in value created

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IMD – Texas Arbitration Shootout

One appraiser considered the implied minority discount by estimating the extent of expected merger synergies in typical bank change-of-control transactions, splitting the difference between financial and strategic control

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Marketable Minority

Cash flow expectations drive

transactional pricing relative to the

marketable minority pricing

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Conceptual Math Relationships Value Implications

CFe(c,s) ≥ CFe(c,f)

Gs ≥ 0 Ve(c,s) ≥ Ve(c,f)

Rs ≤ Rmm

CFe(c,f) ≥ CFe(mm)

Gf ≥ 0 Ve(c,f) ≥ Vmm

Rf = Rmm (+/- a little)

Gv = Rmm - Div Yld

CFsh ≤ CFe(mm)

Gv ≤ Rmm - Div Yld Vsh ≤ Vmm

Rhp ≥ Rmm

Vmm is the

benchmark for the other levels

MarketableMinority Value

CFe(mm)

Rmm - Gmm

NonmarketableMinority Value

CFsh

Rhp - Gv

Strategic Control Value

CFe(c,s)

Rs - [Gmm + Gs]

Financial Control Value

CFe(c,f)

Rf - [Gmm + Gf]

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How can all public companies be trading at less than their “intrinsic worth”?

Harkens back to the Nath hypothesis in 1990

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IMD Conclusions What’s an Appraiser to Do?» The Implied Minority Discount in Delaware statutory fair

value

Actually a Premium (to eliminate the “implied minority discount”)

Strategic Control premium – excluding synergies

Requires analysis for which there is little or no relevant market evidence

If the Delaware Courts want to say statutory fair value in Delaware includes an implied minority discount

» Need to just say so and define it

» Or consider relevant analysis and comment

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Fair Market Value vs. Fair Value in Transactions (and Fairness Opinions)» Many transactions involve the purchase of minority interests of companies (through recapitalizations,

going-private transactions, etc.)

» The fair market value of individual minority interests might appropriately be determined at the nonmarketable minority level of value

» However, in transactions that give rise to the right to dissent and to receive fair value, is it “fair” if the transaction calls for minority shareholders to receive discounted values?

» In other words, if the transaction invokes fair value, does the standard of value for assessing fairness of a transaction shift from that of fair market value to that of statutory fair value?

Answer: Likely yes, absent specific legal opinion stating otherwise

Why? If statutory fair value calls for an enterprise, undiscounted value, and that value is available through dissent, is it “fair, from a financial point of view” to offer a discounted value in a transaction?

Do I know I am answering my question with a question?

» What’s an investment banker/financial advisor to do?

Fair value disputes are often triggered when corporations engage in transactions giving rise to the right of dissent and to receive fair value – but they attempt to transact at nonmarketable minority prices

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Statutory Fair Value and Buy-Sell Agreements


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What is the appropriate value in most negotiated buy-sell agreements to determine price when trigger events occur?


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Wrapping Up We’ve addressed a few critical questions

» How is statutory fair value defined?

» What “should” statutory fair value be in a particular state?

» What is “fair value” in: New York? Delaware? Elsewhere?

» What are the appropriate roles for legal counsel and business appraisers in fair value matters?

» How can statutory fair value and fair market value differ? And how can this impact fairness opinions in transactions?

» Why is it appropriate (or necessary?) for appraisers to define statutory fair value in terms of fair market value at a particular level of value?

» Is what’s “fair” for buy-sell agreement negotiations applicable to statutory fair value determinations?

Demystifying Statutory Fair Value Webinar 06 28 11 Z. Christopher Mercer

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Transcript of Demystifying Statutory Fair Value Webinar 06 28 11 Z. Christopher Mercer