FMV

The Colorado Supreme Court, in Marriage of Thornhill (June 1, 2010), held that it would not mandate the “fair value” standard for valuation of business in divorce proceedings. The husband in Thornhill operated an oil and gas service company that was valued at $1.625 million after applying a 33% marketability discount as part of an FMV valuation for divorce purposes. The wife argued on appeal that the marketability discount should not be applied, citing a Colorado precedent in which marketability discounts were prohibited in minority shareholder oppression cases. The Supreme Court affirmed the trial court’s refusal to prohibit marketability discounts in divorce cases. The Supreme Court noted that the “fair value” standard was required under the state’s shareholder oppression statute but not under the state’s divorce statute.

This decision contains a good explanation of the reasons why “fair value” is not necessarily appropriate to divorce cases. The wife argued that divorce cases are similar to shareholder oppression cases because a divorce involves an involuntary divestiture of a party’s interest in the business. The Colorado Supreme Court explained that valuation discounts are prohibited in shareholder oppression cases to discourage majority shareholders from engaging in oppressive behavior. In other words, the prohibition of marketability discounts in shareholder oppression cases forces the majority shareholders to pay more than fair market value as a penalty for their conduct. Imposing the fair value standard in divorce cases would not serve the same purpose.

The Colorado Supreme Court did not go as far as prohibiting the fair value standard in divorce cases. Instead, the court held that marketability discounts must be considered on a case-by-case basis. It is conceivable, under certain circumstances, that marketability discounts might not be applied in divorce cases. It would not be appropriate, however, to impose the fair value standard in every divorce.

Texas has once again proven itself to be a haven for the affluent divorcee. In Mandell v. Mandell, 2010 WL 1006406 (March 18, 2010), the Texas Court of Appeals held that a professional spouse’s 25% interest in a medical corporation was limited under the terms of a buy-sell agreement to a nominal fixed price payable to shareholders upon divorce. The decision was summarized at BVLaw Blog as follows:

In a case of first impression, the Texas Court of Appeals considered a buy-sell agreement that purported to bind shareholders and their spouses in the event of divorce. As a further complication, the husband had signed an employment agreement with the private medical association—but neither he nor his wife had signed the shareholders’ agreement.  This unsigned agreement limited the value of a divorcing shareholder’s interest to the equity buy-in price (in this instance, a mere $11,000 for a 25% share in a business with an estimated $3 million to $5 million book value).

I share BVLaw Blog’s incredulity, but my analysis is somewhat different.

In the opinion, the Texas appeals court emphasized that the doctor, who signed the stock purchase agreement during the marriage three years before separation, tendered a check for his buy-in but never signed the shareholders agreement (which was referenced in the stock purchase agreement); and his shares were never issued. After separation, the corporation returned the shareholder’s fixed buy-in payment. At that point, the trial court  might have held that the shares were never acquired, and only the buy-in payment itself was community property.

Yet, during the pendency of the divorce litigation, the wife filed motions compelling her husband and the corporation to complete the transaction. The doctor returned the fixed sum to the corporation, and the corporation issued the shares. When the wife attempted to introduce expert testimony to prove the fair market value of the shares, she was met with a motion in limine, which was granted. The trial court held that the wife was bound by the terms of the agreements.

In Texas, the fair market value of a business is presumed to be zero if the shareholders are contractually obligated to sell back their shares upon retirement, death or divorce. A divorcing spouse may present evidence of book value or comparable sales to rebut the presumption, but in this case, the court held that the net asset value was the property of the corporation, not the shareholders.

It might be signficant that Texas is a community property jurisdiction. Since the marital community exists throughout the marriage in those jurisdictions, it could be said that the doctor’s wife was in privity with her contracting husband when he signed the stock purchase agreement. Furthermore, property in Texas apparently cannot be owned simultaneously by one legal entity (a corporation) and another legal entity (the marital community). These principles might not apply in common law (marital property) states, such as Pennsylvania, where it might be argued that the spouses were neither in privity nor intended third party beneficiaries of such contracts, and where marital property is merely a fictitious estate rather than a legal entity.

The current economic recession has had a profound adverse impact on many businesses. So, in cases where we are asked to value businesses on a valuation date prior to the recession, how can we ignore what we know will happen? One of my favorite lecturers, Mel Abraham, answered this question in the BVResources newsletter this month by recalling an interaction he had with a California judge a few years ago. In that case, the business had lost its largest (60%) client six months after the valuation date, and Abraham had factored the risk of client loss into his discount rate and DCF calculations. When the judge argued that this was a subsequent event, Abraham agreed but countered, “The loss of the client was definitely a subsequent event, but the risk of losing the client was known and knowable as of the date of valuation.” Looking back to valuation dates, particularly in mid-2008, you cannot include loss of revenues or other damages that actually occurred as the result of this current economic downturn, he added. However, conditions known as of the valuation date (like heavy leverage, declining assets, or other high-risk indicators) could, should, and would have been known or knowable even prior to the stock market meltdown.

The Alabama Court of Appeals recently issued an opinion in Grelier v. Grelier, holding that the parties’ agreement to employ the fair market value standard in a divorce case precluded wife from arguing on appeal that the trial court should not have applied marketability and minority discounts.

In Grelier, the parties appointed a neutral expert to determine the value of the husband’s business, a retail and commercial real estate development company. The husband owed a 25% interest; his father, brother and college roommate owned the other interests. The consent order appointing the expert specified that he would determine the fair market value of the business. Husband and Wife each hired independent experts to offer their opinions of value as well.

The court-appointed expert testified that marketability and minority discounts should not be applied to the husband’s interest in the real estate business, but the opinion does not reveal why. Wife’s expert testified that the court-appointed expert’s valuation was flawed because it relied on out-dated appraisals and verbal statements of value but agreed that discounts should not be applied. Husband’s expert testified that a minority interest discount was appropriate because the wife had not proven that the husband had a right to act independently from the majority stakeholders; and that a marketability discount was standard practice when determining the FMV of close corporations. Husband’s expert suggested a 25% minority discount and 25% marketability discount, but the trial court reduced the combined discounts to 40%.

On appeal, the wife argued that the trial court should have utilized the fair value standard instead of FMV; and that the minority interest and marketability discounts should not have been applied. The Alabama Court of Appeals held that the wife’s argument was waived for failure to raise it in the trial court, where she had consented to a FMV standard in the order appointed the expert. Moreover, the appellate court held that the trial court had not abused its discretion in applying the discounts to arrive at FMV.