DLOM Dilemma – Defendants’ Bad-Faith Behavior Precluded Marketability Discount
In Sipko v. Koger, Inc., the New Jersey Supreme Court affirmed the trial court’s holding that a buyout of the plaintiff’s interests was the appropriate remedy in a shareholder dispute. The court also reversed the appellate court’s ruling, which remanded the case to the trial court to determine whether a discount for lack of marketability (DLOM) should apply when valuing the plaintiff’s interests. It found that a DLOM was inappropriate, noting the “defendants’ bad-faith behavior throughout this 15-year litigation.”
Family Dispute Leads to Business Divorce
This case involved several related family businesses owned by a father and his two sons. The father established Koger in 1994, gifting 1.5% interests to each son. In 2002 and 2004, respectively, he formed two subsidiaries — Koger Distributed Solutions (KDS) and Koger Professional Services (KPS) — with each son owning 50% of each company’s shares.
A family disagreement led to one son resigning in 2006 and relinquishing his 50% interests in both KDS and KPS. He sued the company, his father and his brother, alleging that he was an oppressed shareholder. He also claimed that he’d signed the documents transferring his KDS and KPS stock under duress.
Defendants Behaved Badly
After the litigation commenced, the defendants transferred several contracts from the subsidiaries to Koger. According to the trial court, the transfers were “part and parcel of a strategy to render [the plaintiff’s] interests in KDS and KPS zero.” They also backdated the transfer of stock in KPS, the more valuable of the subsidiaries, from February 2006 to December 2004. This move was designed to deprive the plaintiff of his interests in lucrative contracts he negotiated in 2005.
As this case worked its way through the New Jersey courts, the appellate court and supreme court agreed that the plaintiff’s transfer of KDS and KPS stock was void for lack of consideration. The higher courts also reversed the trial court’s finding that the subsidiaries lacked independent value. Although the supreme court upheld the trial court’s finding that the plaintiff failed to demonstrate shareholder oppression, it noted that New Jersey’s statute “does not limit the equitable power of the courts to fashion remedies appropriate to an individual case.”
On remand, the trial court determined that a buyout of the plaintiff’s KDS and KPS stock was an appropriate remedy. It accepted the plaintiff’s expert’s valuation of his interests, as of the date the complaint was filed, at approximately $18 million. Significantly, though the trial court invited the defendants to present their own expert to value the two subsidiaries, they declined.
Sidebar: Is a DLOM Appropriate for a Controlling Interest?
It’s widely accepted, among the courts and valuation experts, that a discount for lack of marketability (DLOM) is often appropriate for a noncontrolling interest in a privately held company. But what about a controlling interest? Many valuation practitioners apply such discounts, even when valuing a 100% interest in a business, and some courts have accepted them. Generally, DLOMs for controlling interests, if applicable, are much smaller than those for noncontrolling interests. However, the issue remains controversial.
In practice, the DLOM usually reflects two distinct, but related, components:
- Marketability. This refers to the ability to sell an asset in a readily available market at minimal cost.
- Liquidity. This component generally refers to the speed at which an asset can be converted into cash.
Publicly traded stock is marketable (it’s readily sold on a stock exchange) and liquid (it can be converted into cash in a matter of days). Minority interests in private companies are generally both unmarketable (there’s no readily available market) and illiquid (they can’t be converted to cash quickly). The DLOM for such interests is often quantified using restricted stock studies and IPO studies, which measure differences in value between marketable, liquid shares and unmarketable, illiquid shares.
Proponents of DLOMs for controlling interests in private companies note that these interests are marketable but illiquid. Opponents argue that marketability and liquidity issues are already reflected in the risk component of the rate of return used to convert expected cash flows to present value. Even if a DLOM is appropriate, quantifying it can be a challenge. The restricted stock and IPO studies involve minority interests, and there are no similar empirical studies to quantify DLOMs for controlling interests.
The defendants did, however, file an appeal. In due course, the appellate court upheld the buyout remedy but rejected the trial court’s acceptance of the plaintiff’s expert’s valuation. In particular, the appellate court determined that the trial court had failed to determine whether a DLOM should be applied to the value of his interests in KDS and KPS.
The supreme court reversed. “The guiding principle in such cases,” the court explained, “is that a [DLOM] cannot be used unfairly by the parties whose misconduct and bad faith caused the corporate split to benefit themselves to the detriment of the injured parties.” Pointing to all of the defendants’ conduct to strip the plaintiff’s rightful interests of value, the supreme court found that “equity cannot abide imposing a discount to the benefit of defendants.” The court deferred to the trial judge’s broad discretion to accept or reject expert testimony, “particularly because the trial judge handled this matter for over a decade, presided over the bench trial, heard testimony, asked questions, and had, by far, the best feel for the case.”