Federal Court Fashions Unique Pricing Remedy in Shareholder Oppression Case

Kaplan v. First Hartford Corp., 2009 WL 737681 (D. Me.)(March 20, 2009)

An oppressed minority shareholder sought judicial appraisal of the First Hartford Corporation, a company that managed and developed real estate through several subsidiaries, with several attributes that made it unique. Although thinly traded on the Pink Sheets financial service, First Hartford acted more like a closely held company.It held investment properties for
long-term income potential, but it differed from a real estate investment
trust (REIT) in its structure, tax status, development strategy, and profit
distribution. In a word, the U.S. District Court (Maine) observed, this
is a difficult business to value.

Three very experienced experts differed by a factor of five. At a bench
trial, the parties presented three qualified experts to value First Hartford. Not surprisingly, the court noted, they disagreed with each others opinions and methodologies. In fact, the court cited a wry observation from the Delaware Chancery that in shareholder oppression cases, it is not unusual for the opinions of the experts to differ by a factor of ten. In this case, perhaps I should consider myself fortunate, since the experts...vary by a factor of only about five.

1. Plaintiff's expert.
The plaintiff retained the CEO of a private venture capital firm that invested in early stage companies. Although he had no credentials in business valuation or prior expert witness experience, [h]is work requires him to utilize discounted cash flow methodology to value business entities and real estate, the court said. Earlier in the proceedings, the defendants challenged the expert's qualifications under Daubert, but the court admitted his testimony, finding that any mistakes or analytical weaknesses went to the weight of his conclusions.

To value First Hartford, this expert used an investment approach that relied
on a discounted cash flow (DCF) model. He separated the company into its two component businesses: a portfolio of stable, income-producing properties; and a construction/development business. For the first, he adopted the conclusions of independent real estate appraisals that First Hartford obtained for its properties during the ordinary course of business (to
secure financing), within one year of the valuation date. These appraisals,
he said, had already done DCF for him. Only one property (the North
Adams parcel) was missing an appraisal, so he used three comparables to
estimate its DCF value at just under $2 million.

For the second component, the plaintiff's expert collected income/expense
data from First Hartford financials for three years prior to the valuation
date, projected net income forward for ten years, and applied a 14% discount
rate, which reflected the riskier nature of its development business, he
said. He then took the two component values, added miscellaneous items (a
pending contract for sale, excess cash, a tax shield from a net operating
loss carry-forwards) reduced by the capitalized cost of its corporate
center. He did not subtract income taxes, however, because the company had not paid federal income tax for the prior seven years and maintained the
large loss carry-forward. Ultimately, he arrived at a fair value for the
company of $48.3 million.

2. Defendants' lead expert.
First Hartford retained a well-known, credentialed business valuation expert with over 20 years' experience. She used three traditional approaches (asset, market, income) to value the company:

(a) Net asset value (NAV) approach. The defendants' expert was given the
same independent real estate appraisals that the plaintiff's expert used,
but after a third party adjusted them to reflect circumstances as of the
valuation date. (The court notes some concern that First Hartford declined
to present this third party as a witness to offer direct evidence supporting
the adjustments at trial.) Drawing on this unintroduced evidence, the
defendants expert assessed the risks associated with each property
(vacancies, cost of regulatory compliance, etc.) and adjusted for lack of
cash flows from other risks (recession, interest rates, non-core
investments). She subtracted capital gains taxes, transaction costs, and
defeasances costs that a third party buyer would incur on selling the
company, and concluded a NAV of $13.3 million.

(b)  Income approach. Once again, the defendants expert began with the
adjusted real estate appraisals. Unlike the plaintiff's expert, she used
their net operating income information rather than their bottom-line values,
adjusted for entity-level expenses (such as debt) and eliminated
non-recurring items (such as proceeds from a lawsuit). For the North Adams
property, she relied on management statements and its outstanding debt to
assign it a zero value. After, adjusting executive pay upward to reflect
fair market value, she found that First Hartford was worth only $7.6 million
under the income approach, largely due to its significant debt.

(c)  Market approach. Using comparable REITs in her guideline company
analysis, the defendant¹s expert concluded a $10 million dollar value,
acknowledging that it depended in part on data from minority stock transfers
of the publicly traded comps. She did not correct for any minority or
marketability discount, however, citing BV authority (Valuing a Business,
5th edition, by Shannon Pratt and Alina Niculita in support of this
method.

She also noted that comparable sales clearly [reflected] entire controlling
interests and some exuberance in the market at the time of the valuation,
leading to a $9.6 million value under her guideline transactions analysis.
Finally, she reviewed the sales of the company's stock (minority interests)
on the Pink Sheets to reach a $10 million value, also without factoring out
any implied minority or other discounts.

Overall, defendants' first expert accorded little weight to the net asset
approach, but gave one-quarter weight to each of the remaining values
(income-based and three market values) to reach a fair value for First
Hartford of $9.3 million.

3. Defendant's second expert.
The defendants also retained a professor of
Real Estate and Urban Land Economics who taught real estate finance and
investment. This expert also used a net asset approach, employing the same
third-party adjusted real estate appraisals and then deducting taxes payable
on liquidation to reach a value of $15.5 million. Notably, he then applied a
25% minority discount‹because he believed that to be his assignment to
reach a $11.66 NAV. He did not apply any discounts for lack of
marketability.

Under the investment approach, he relied on data from public REITs, adjusted
for taxable gains and losses and other expenses, and found a value of $9.4
million‹which included a built-in minority discount, he said, because it was
based on data derived from comparable sales of minority interests. A review
of Pink Sheets sales led to a $10 million stock market value, which also
incorporated an implicit minority discount. He then accorded 10% weight to
both the NAV and investment methods, and 80% weight to the market value, to reach an overall fair value for First Hartford of $9.8 million. Factoring
out the 25% minority discount raised that value to $13.07 million.

The court found concerns with each expert. My search here is for what a
third party would pay for this entire company, the court began. Applicable
case law required the court to determine the best price that a single
buyer would pay, without minority or marketability discounts. With this
standard in mind, it turned to the expert evidence:

1. Plaintiff's expert spent too little time.
Although he had abundant
experience conducting business valuations in real-world settings, the
plaintiff's expert presented the court with many difficulties.  In particular, he treated the real estate appraisals of First Hartford properties as full-blown DCF analyses, thus avoiding doing his own but ignoring their basis on a combination of income, comparable sales, and cost analysis. The court was also skeptical of the expert's $1.9 million appraisal for the North Adams property, noting the lack of real comparables. The plaintiff's expert also made several errors, including accounting for lawsuit proceeds as a recurring item, double counting the company¹s tax loss carry-forwards, and a $3 million error in cash distributions.

Finally, plaintiff's expert did not adequately consider the director's personal guarantees which a prospective buyer might not be willing to match,
and in his ultimate conclusion, he gave no weight to the NAV or stock market
value (court¹s emphasis). In sum, [plaintiff's expert] spent precious little time on valuing this complex corporation, his first time as an expert witness.

2. Defendant's lead expert was the most thorough. Overall, the defendant's
first expert performed the most through valuation among the three. Nevertheless, the court was troubled that her going concern value ($9.3
million) was so much lower than NAV ($13.3 million). For a company like
this, dependent heavily on real estate, the ability to liquidate some of it
holdings could play an important part in how much a third party would pay,
even for the business as a going concern.

The court was also troubled that the expert's stock value ($10 million) was
so much higher than her income-based value ($7.6 million), perhaps because
the latter assumed no future sales of the properties. Although the plaintiff's expert may have overestimated future sales, they cannot be ignored altogether, the court said. Defendants¹ expert also declined to adjust her Pink Sheets value for an implicit minority discount. Finally, the court had no way to assess the reliability of her reliance on the adjusted real estate appraisals, and questioned her ready acceptance of management statements that the North Adams property had no value when cross-examination revealed that leasing was ongoing and the mortgage debt was $3 million less than its financing.

3. Defendants' second expert gives the court pause.The defendants' second
expert supported his heavy if not exclusive weight on Pink Sheets pricing
with substantial academic backing. However, he seemed to believe that his
assignment was to value a minority interest, which makes me question the
rest of his instructions, the court said. (Apparently, these instructions like the adjustments to the real estate appraisals‹came from a third party whom First Hartford declined to present at trial.) First Hartford also informed its second expert about a $4 million error the morning of his deposition, but he did not disclose it, and only communicated the error to plaintiff¹s attorney on the eve of trial. Further, his report did not show any account for the company's tax loss carry forwards, although the expert insisted at trial that he included them.

Market value and minority/marketability discounts become the main focus. The plaintiff urged the court to discount any reliance on Pink Sheets pricing,
because the stock was too thinly traded on an unreliable exchange, and it
hugely undervalue[d] the oppressing control by the majority shareholder.

First Hartford was thinly traded, but its prices did not necessarily undervalue the business, the court found. Nor had any shareholder oppression led to thinner trading. To be sure, the stock suffered from modest lack of marketability, as evidenced by Lehman Brothers inability to move a large
block (35,000) of shares just one week after the valuation date. These
factors did not make stock market value irrelevant.

In fact, the court started with the stock market price as the guide to fair
value, including a 100-share trade just three days before the valuation date
at $3.25 per. That number was consistent with the weighted average monthly
price of First Hartford stock for the year prior to the valuation date, which ranged from $2.00 to $3.95 per share. It also found, based on thin
trading and Lehman Brothers reverting the 10,000 shares back to the company for $2.50 per share, that a marketability adjustment was appropriate to the stock's pricing‹though none of the experts suggested a number. Only the defendant¹s second expert applied an implicit minority discount of 25%,
testifying that the relevant range for similar companies is up to 30%.

[G]iven the need to recognize both discounts, the court applied the higher
figure (30%) to the $3.25 per-share price, leading to the adjusted value of
$4.64. As there were just over 3.08 million shares outstanding on the
valuation date, the company was worth a total of approximately $14.3
million, which the court rounded up to $15 million to ensure full recognition of the necessary marketability adjustment. That number modestly exceeded the NAV of defendants' lead expert ($13.3 million) but her NAV reflected reductions for taxes and other transaction costs and also assigned a zero value to the North Adams property. The court's value was modestly below the NAV of the defendants' second expert ($15.5 million) but that was before he reduced the figure on the mistaken belief that a minority discount was appropriate.

I find net asset value to have significance for this company whose assets
largely are real estate holdings, the court added, citing two law journal
articles in support. ([R]eal estate companies are sometimes undervalued by
the stock market because they produce low reported earnings relative to
their cash flow.)  Therefore, net asset value fortifies my confidence in
the stock market value, the court said, after adjustment for minority and
marketability discounts.

The court also recognized that the market and asset values were much higher
than the numbers that the two defense experts derived from their investment
and income approaches. But they are much lower than the number plaintiff's
expert derived from his version of the same approach.  The wildly divergent income approach values helped support the court's reliance on the NAV and market values. Further, applicable law (Maine) considers investment
value a weak measure of fair value when the company's earnings are erratic
and determination of the capitalization ratio is highly subjective. Defendants' lead expert repeatedly referred to First Hartford's volatile returns; and all of the experts had to make subjective adjustments to their cap rate, given the company's unique structure and two lines of real estate
business.

After consideration of all the evidence and conducting its own extensive analysis, the court concluded a $15 million fair value for First Hartford,
derived primarily from the stock trades, corrected for the minority and
marketability discounts, and supported by the expert net asset valuations.

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What attorneys should look for when retaining financial experts and business valuation consultants
Alexandria, Louisiana-based attorney and BV insider L. Paul Hood offered simple, yet compelling, insights on how BV experts can make themselves more appealing to hiring attorneys during his informative session, Burning Issues Within the Appraisal Industry at the 2009 NACVA and IBA Consultants Conference held in Boston last week. To put your best foot forward, Hood suggested these characteristics as most important for successful financial experts:

1. Experts who can cogently make points in one or two sentences are
   prized.
2. Experts who offer access to key financial and industry information are
   the most believable, so they should bring a large group of research sources to your client's side.
3. Experts who know the field well enough to demonstrate that they can
   create appraisal reports that invite limited scrutiny. One way to do this, Hood said, is to remember what is left out is just as important as what is included in appraisal reports. For example: When preparing reports and to diffuse criticism, Hood requires that BV experts document what they did, what they did not do, and to acknowledge reasons for choosing one method over another.
4. BV experts show ongoing learning through continuing education,
   writing, and speaking. It's all about a willingness to continue to learn
   and improve, and Hood said if there's no evidence of this, the expert will be risky
5. Hood says that credentials are necessary; he expects his experts to
   have at least one of the four standard business valuation credentials (from the ASA, NACVA, IBA, or AICPA) but two is definitely better. Courts are more apt to criticize experts who don¹t have credentials.

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Are the days of the uncredentialed BV expert over?
That was just one of the many questions that U.S. Tax Court judge, the
Honorable David Laro, former national program manager of the IRS and current IBA Executive Director Howard Lewis, and principal of the American Business Appraisers in San Diego, Mike Eggers, deftly fended from attendees at last week's NACVA and IBA Consultants Conference in Boston.

"Yes, undoubtedly," Judge Laro responded, with his usual cut-to-the-quick cogency. (He was also quick to remind listeners that his opinions were his own, and not those of fellow members of the federal tax bench.) "The Congress and the Service have raised the stakes for appraisers and
appraisals that are significantly higher. Your field is extremely dynamic
and changing all the time," he added. "We need to rely on you. We need you to have education, experience, and exposure, and know how to render an opinion that is reliable and credible. Judges do not undergo the same continuing education that BV experts must, but you are helping to educate us," Laro said. "That's how we're becoming more sophisticated."

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