Last week’s post gave the factual and procedural background of the Zelouf case, summarized Justice Kornreich’s decision awarding the 25% dissenting minority shareholder $2.2 million for the fair value of her shares and another $2.2 million damages for her “quasi-derivative” claims, and then focused on the court’s rejection of a discount for lack of marketability. If you haven’t already read last week’s post, I recommend you do so before continuing with this one.
In this Part Two, I’ll highlight a number of other, interesting issues addressed in Zelouf of importance both to business divorce lawyers and business appraisers.
Court Adopts ”No-Burden” Approach
Justice Kornreich’s decision at pages 6-9 offers a useful summary of the legal standard for determining fair value in a dissenting shareholder appraisal proceeding under Section 623 (h) of the Business Corporation Law, including a brief discussion of burden of proof. Noting that New York’s highest court never has addressed the issue, the court adopted the “no-burden” approach proposed by the parties and supported by former Justice Stephen Crane’s analysis in Matter of Cohen, 168 Misc 2d 91 [Sup Ct, NY County 1995], aff’d, 240 AD2d 225 [1st Dept 1997], under which, as Justice Kornreich put it, “the court will consider the parties’ expert testimony as persuasive evidence of fair value, but, at the end of the day, and even if the court finds neither expert to be persuasive, it is the court’s burden to make a fair value determination.” As to the quasi-derivative claims for corporate looting and waste, however, Justice Kornreich stated that the dissenting shareholder, Nahal, “still has the burden of proof . . . but the impact of such claims on the value of the company, if proven, will be decided by the court under the no-burden approach.”
Court Adopts Neutral Evaluator’s Report
The typical fair value proceeding features a battle of the experts in which each side presents its own, full-blown appraisal report. More often than not, and particularly in cases involving owner-operated sales and service companies, the competing appraisals use different approaches and different assumptions to arrive at grossly disparate conclusions of value — what’s been referred to as the Dr. Pangloss/Mr. Scrooge appraisal phenomenon.
Zelouf is somewhat atypical, not because the opposing experts didn’t arrive at disparate valuation conclusions — they did — but because the two sides agreed to use as a baseline valuation the appraisal report prepared by a neutral appraiser named Kevin Vannucci who was jointly engaged for purposes of a mediation that ultimately failed shortly before the freeze-out merger in August 2013. The appraisal proceeding and the trial testimony of the parties’ experts therefore focused on each side’s disagreements and/or proposed adjustments to the Vannucci Report.
So, too, did Justice Kornreich’s decision in which, at page 10, she found the Vannucci Report “to be a comprehensive and reliable indicator” of the company’s value and also noted the parties’ “lack of substantial disagreement over the Vannucci Report’s findings” before going on to address the specific areas of disagreement and adjustments. As described at pages 10-11 of the decision, the Vannucci Report solely relied on the capitalization method under the income approach to value the company based on its normalized net income reflecting adjustments to the gross profit margin and income add-backs for excessive officer salary, auto expense and litigation costs. The decision also cited the Vannucci Report’s calculations of a 4.3% sustainable EBITDA margin and a 3% long-term growth rate after adjusting for inflation. The Vannucci Report reached alternative conclusions of value of about $8.9 million without a marketability discount and about $6.2 million with a 30% marketability discount. As detailed in Part One, the court’s decision rejected the marketability discount and adopted the higher figure.
Tax-Affecting Rejected
Zelouf International is a pass-through entity due to its S corporation tax status, i.e, like a partnership it pays no income taxes at the corporate level. The Vannucci Report, at the direction of counsel, utilized a tax-affecting method known by its acronym, SEAM (S Corporation Economic Adjustment Multiple), which, starting with an assumed corporate income tax rate of 40% against projected earnings and then applying a number of other factors, computed an adjustment that increased the company’s equity value by about 18%. At the same time, the Vannucci Report cautioned at page 9 footnote 21 that “inclusion of a pass-through entity adjustment is most appropriate for valuations assuming a minority level of value under the assumption that a controlling owner would be able to change the corporate structure to maximize shareholder value.”
Justice Kornreich’s decision at pages 11-12 agreed with the cautionary note and rejected the SEAM adjustment, stating that “New York law does not permit an independent valuation of the minority’s equity, which would entail a separate valuation methodology and which might warrant a SEAM premium.” (Readers interested in the subject should compare the “hybrid” approach to tax-affecting developed by the Delaware Court of Chancery in the MRI Radiology dissenting shareholder appraisal case.)
Control Premium Rejected
At pages 15-16 of the decision, immediately following her discussion rejecting a marketability discount, Justice Kornreich gave short shrift to the position advocated by one of Nahal’s experts for a 24% control premium predicated on Danny’s post-merger acquisition of a super-majority interest (see pages 7-11 of expert report). “A control premium is improper,” she wrote, “because the company is being valued as a whole. . . . The level of control that Danny gained over the company after the freeze-out merger, therefore, is irrelevant.”
Adjustment Rejected for Post-Report Financials
The Vannucci Report, prepared in August 2013, valued the company’s equity as of December 31, 2012. Under BCL § 623 (h) (4), the valuation date in a dissenting shareholder appraisal proceeding is the day before the date on which the shareholders authorize the merger, in this case, August 29, 2013. Nahal argued that the company’s performance as reflected in its financial statements for the first six months of 2013, which were not available at the time of the Vannucci Report, warranted a 23% increase ($2.1 million) in the company’s value over the Vannucci Report’s conclusion of value.
Justice Kornreich disagreed at pages 16-18 of the decision, finding that “Nahal has not submitted any evidence that the value of the company materially increased in the intervening eight months.” The company’s financials, she wrote, “do not actually show improvements to the company’s fundamentals, nor did Nahal’s experts contend that the company’s performance improved.” Justice Kornreich also described as “problematic for many reasons” Nahal’s experts’ “mathematical exercise of plugging in the 2013 numbers and applying various weighting schemes.”
Damages Awarded for Quasi-Derivative Claims
Under normal circumstances, once someone loses shareholder status, whether due to a voluntary sale of shares or a freeze-out merger, that person no longer has standing to bring or maintain a shareholder derivative action. In her discussion of the applicable legal standards at page 9 of the decision, Justice Kornreich referred to Nahal’s claims in the prior, discontinued shareholder’s derivative action, which were carried over into the appraisal proceeding, as post-merger “quasi-derivative” claims. She further noted that “New York courts have not developed a system for dealing with quasi-derivative claims” the viability of which “remains an unsettled issue in New York.” She then concluded, however, that she need not “rule on the viability of quasi-derivative claims because the parties agreed to have Nahal’s derivative claims evaluated in this appraisal proceeding.” (Compare the Delaware Chancery Court’s recent decision in Zutrau v Jansing, also a dissenting shareholder proceeding that came amidst a pending derivative action alleging corporate waste, in which, rather than awarding a percentage of excessive compensation as damages, the court directed normalizing adjustments to the appraiser’s discounted cash flow analysis.)
Justice Kornreich’s determination of the quasi-derivative claims, found at pages 18-28 of the decision, broke them down into two categories: (1) corporate waste, including excessive compensation to the controlling shareholders, Danny and Rony, a no-show salary for Danny’s mother, leasing of luxury cars, and the diversion of certain customers to Danny’s separate business, and (2) Danny’s and Rony’s misappropriation of millions of dollars in cash by manipulating or falsifying inventory records and the company’s financial statements.
As to the waste claims, Justice Kornreich found insufficient Nahal’s showing with respect to Danny’s and Rony’s salaries, which rose to over $1.7 million and $400,000, respectively, and their taking of no-interest loans. While their salaries “may have been excessive,” Justice Kornreich wrote, “Nahal provides no proof that their salaries were disproportionate to the benefit they conferred” on the company. She also noted that the Vannucci Report’s normalizing adjustments for officer salaries “are not proof that seemingly excessive salaries are legally wasteful.” She also found “immaterial” the value of the avoided interest on loans.
Nahal’s remaining waste claims did get onto the scoreboard, including payments totaling almost $1 million to Danny’s mother for a no-show job, which Justice Kornreich called “a textbook example of corporate waste”; the company’s leasing of luxury cars for employees’ personal use or use by by non-employees; and Danny’s diversion of sales to his separate company called Zelouf West. The decision awarded Nahal damages for 25% of the mother’s salary payments and 25% of the leasing expenses, totaling about $220,000. It did not give a separate damage award for the diverted sales which already were factored into the Vannucci Report’s valuation.
Nahal’s misappropriation claim, which was based on a forensic examination of the company’s inventory tracking database, established to the court’s satisfaction that the company’s financial statements omitted over $14 million in gross profits in the period 2004 through 2010. Key to the forensic examiner’s conclusion was his assumption of a 25% profit margin based on benchmark profitability margins for similar companies as reflected in data compiled by the Risk Management Association. Justice Kornreich also found support for the assumed profit margin and the cash misappropriation in the fact that, after Nahal filed her derivative action in 2009, the company reported higher profit margins during a recessionary period and Danny’s salary doubled. Because the statute of limitations precluded Nahal’s recovery for amounts misappropriated before 2007, Justice Kornreich awarded her $2 million in damages representing 25% of the amounts “plundered” by Danny from 2007 through 2010 computed at an average rate of $2 million annually.
Attorneys’ Fees and Interest Awarded
As I noted in Part One, the court’s 2013 ruling permitting the freeze-out merger to proceed on the eve of trial of the prior shareholder’s derivative action was conditioned on the company’s stipulation to include in the subsequent appraisal proceeding Nahal’s derivative claims for corporate waste and looting including statutory entitlement to recover her legal fees. It’s understandable, therefore, that the parties devoted tremendous effort to the fight over Nahal’s claim for almost $7 million in attorneys’ fees and expenses in the derivative action plus another $1.5 million in the appraisal proceeding. (Read here, here, and here the post-trial briefs addressing only the issue of fees.)
In her decision at pages 29-30, Justice Kornreich awarded Nahal her reasonable attorneys’ fees in the prior derivative action and in the appraisal proceeding based on Nahal having proven that the fair value of her shares materially exceeded the company’s offer, with the amount of the fees to be determined by a Special Referee subject to a number of specific directives spelled out in Justice Kornreich’s decision.
Finally, Justice Kornreich awarded pre-judgment interest at the statutory rate of 9% from the date the appraisal proceeding was commenced on the difference between her $2.2 million fair value award and the lesser amount tendered by the company as merger consideration, and from January 1, 2009, on the $2.2 million damages award for the quasi-derivative claims, that date being a “reasonable intermediate date” in the 2007-2010 claims period.
