Only a few months after it issued its controversial opinion in a fair value proceeding, the Zelouf court offers a crisp and unequivocal defense of its earlier decision, saying the guiding standard was fairness, not “formalistic and buzzwordy principles.”
No DLOM: Among the New York fair value cases that transfixed the valuation community late last year was the court’s ruling in the Zelouf case, which centered on a family feud over the management of a very successful textile business in New York. The controlling shareholders orchestrated a freeze-out merger to render the minority shareholder, Nahal, powerless to pursue derivative claims against them, alleging corporate waste and self-dealing. When Nahal rejected the company’s buyout offer, a statutory fair value proceeding went forward.
What created buzz was the trial court’s ruling that the facts of the case militated against the application of a discount for lack of marketability (DLOM). If the reasoning behind a DLOM is that the recovery of a frozen-out, minority shareholder should be less to account for the difficulty of selling a closely held company as compared to a publicly traded company, it did not apply here because it was unlikely that the company would or could ever be sold, said the court. A liquidity risk in this situation was “more theoretical than real.” Applying a DLOM would “artificially depress Nahal’s recovery due to a hypothetical sale that will never occur,” the court found.
The parties swiftly filed post-trial motions seeking to modify or vacate aspects of the decision. The controlling shareholders particularly objected to the court’s no-likelihood-of-sale rationale. New York appellate courts have regularly applied DLOMs even where there is little likelihood of sale, they claimed. “This is because New York law is unambiguous in requiring the appraising court to assume a hypothetical sale; the willingness of the owners to sell is irrelevant.”
No retreat: The court did not retreat from its earlier position. First, it said with emphasis, “no New York appellate court has ever held that a DLOM must be applied to a fair value appraisal of a closely held company.” It reiterated that to apply a DLOM in this case would be the economic equivalent of imposing a minority discount, which New York law prohibits.
Indeed, it is the tension between the application of a DLOM, which is done in most cases but is not legally required, and the practical effect of a DLOM here serving as a minority discount, repugnant to New York courts and never allowed, that drives the court’s ruling.
According to the court, its ruling did not mean that a DLOM was never legally acceptable, which would contravene existing precedent. Rather, the decision of whether to apply a DLOM depended on what was fair under the unique facts of a case. Sound valuation principles ought to guide the court’s analysis and in this case did, but “the gravamen of the court’s valuation is fairness, a notion that … requires contextualizing the applicable valuation principles to the actual company being valued,” the court emphasized.
The question of whether there was a rationale for DLOM in fair value proceedings has become “an area of heated debate in the legal and valuation communities,” the court observed. “[M]ore compelling appellate resolution of these issues would surely be welcomed by all.”
Takeaway: This decision shows how much New York trial courts are engaging in an internal debate over the justification for a DLOM in fair value proceedings. For example, the court in Zelouf uses the AriZona ice tea case to say that liquidity risk concerns do inform a court’s DLOM analysis in contrast to what the controlling shareholders say. In AriZona, the court, in turn, used the Zelouf case to distinguish the facts of the case in front of it and justify the use of a DLOM by pointing to evidence of the company’s illiquidity illustrated by two prior expressions of interest from potential buyers.
Find an extended discussion of Zelouf International Corp. v. Zelouf, 2014 N.Y. Misc. LEXIS 5595 (Dec. 22, 2014), in the February issue of Business Valuation Update; the court’s opinion will be available soon at BVLaw. The earlier decision, Zelouf International Corp. v. Zelouf, 2014 N.Y. Misc. LEXIS 4341 (Oct. 6, 2014), is also available at BVLaw.