Delaware Chancery Case on Shareholder Dissent Likely to Raise Eyebrows

A recent opinion from the Delaware Court of Chancery, In Re Cellular Tel. P’ship Litig., 2022 Del. Ch. LEXIS 56 (Cellular), is likely to raise eyebrows within the business valuation profession. In this shareholder dissent suit, which the court described (appropriately) as a “squeeze-out,” the minority partners in various partnerships received from the court about three times the value they received in the forced transactions that created the squeeze-outs. Subscribers to Business Valuation Update will see a well-written article on this case from Gil Matthews soon.

The Cellular decision is quite long, so it covers a lot of facts and a log of concepts as it meanders its way to a conclusion.  Along the trail, issues are raised that could be of concern to the business valuation profession. I am hopeful that the case will be appealed, if for no other reason than to get a second view from a tribunal on some of the issues presented in the opinion.

Not in any way wishing to intrude on Mr. Matthews excellent in-depth analysis, this commentary will focus on a couple of specific issues from the decision. First is the issue of whether to tax affect the income in the income approach. The partnerships were, of course, pass-through entities for tax purposes. This issue is certainly not new to the business valuation community. The Gross[1] case started the ball rolling in a public way in 1999, though it had been broiling for several years before that. Most of us know that the Gross case did not allow any deduction for taxes from the cash flows used to determine the value of a business in a capitalization of earnings or discounted cash flow methodology. This results in a “premium” to the value of 67%!

After the Gross case the issue began to be litigated in many tax and nontax forums. The Delaware Chancery Court itself adopted a position in valuing minority interests in a pass-through entity that moved away from the questionable result in Gross. In Delaware Open MRI [898 A.2d 290, 330 (Del Ch. 2006)] (MRI), the court developed a “synthetic tax rate” of 29.4% to recognize, appropriately, that someone or some entity would eventually pay tax on the income that had passed through the entity. While I still do not agree with the concept of a premium on the value of a minority interest in a pass-through entity[2],[3], the MRI case at least advanced a somewhat tolerable theory of modifying tax affecting for a pass-through entity.

Even the Tax Court had followed a more restricted methodology than Gross in some subsequent cases. But, just when we thought the Gross case methodology was fading from the litigation landscape, it has revived itself in some recent cases.  The Tax Court in the Michael Jackson estate (Estate of Jackson v. Commissioner, T.C. Memo 2021-48) opened up the Gross wound once again by not tax affecting the cash flows in determining the value of the estate.

Now comes the Cellular case, where the court decided not to follow the MRI Delaware Chancery Court decision and did not allow any tax affecting of the cash flows. While the court in Cellular recited a lengthy discussion on the matter, including that tax affecting would result in a double taxation because the suit results in the awarding of damages, the ultimate result is a reversion to caveman days on this issue. There is simply no rationale that allows up to a 67% premium for a pass-through entity interest. It simply defies logic.

The other issue for our discussion is also a tax-affecting issue, but one of more nuance. It relates to the determination of the weighted average cost of capital (WACC) method of determining a value under the income approach. This methodology determines the value of the invested value of a company instead of the equity value. The equity value is then determined by deducting the interest-bearing debt of company from the invested capital value. To determine a WACC rate of return, it is necessary to determine both a cost of capital rate and a debt rate and allocate the two appropriately. The debt rate is normally determined on an after-tax basis, which is appropriate if the valuation also tax affects the cash flows. In the Cellular decision, the court adopted a WACC rate to determine the value of the partnership. However, it tax affected the debt rate despite not tax affecting the earnings. This had the effect of increasing the value incorrectly if the cash flows were not otherwise tax affected.

We will wait to see what might happen if the decision is appealed.

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[1] Gross v Commr, TC Memo 199-254. (It is hard to believe this ultimately important case was a memorandum decision.)

[2] Note that the Trump tax cuts virtually did away with pass-through premiums. 

[3] The author has never believed in a premium for a control interest in a pass-through entity.