Opinion
CV146050218
08-25-2016
R.D. Clark & Sons et al. v. James Clark et al
August 30, 2016, Filed
UNPUBLISHED OPINION
MEMORANDUM OF DECISION
Joseph M. Shortall, Judge, Trial Referee.
In 1984 Robert D. Clark and his sons formed R.D. Clark & Sons, Inc. (corporation), an " S corporation, " to engage in the business of transporting petroleum products and other freight. While he was alive and in good health, Robert Clark was in charge. As his son, James, testified, he didn't have meetings. Robert Clark owned one-third of the shares of stock; his twin sons John and James each owned another one-third and worked in the business. His daughter Carolyn also worked in the business, beginning in 2009. After her father's death, Carolyn came to own his one-third interest.
" An S corporation is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation . . . What makes the S corporation different from a traditional corporation . . . is that profits and losses can pass through to [the shareholder's] personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed." sba.gov, Starting and Managing a business.
Robert Clark died in May of 2011. After his death, John, Carolyn and James soon fell out over management of the corporation. In September 2011 John as president and Carolyn as treasurer fired James from his position as a driver and occasional dispatcher. At present John, Carolyn and James continue to own a one-third interest in the corporation. John and Carolyn are directors and officers and continue to work in the business.
James was an officer and director until he resigned from those positions in February 2012.
Claims were made by John and Carolyn in the complaint that began this action that, after they fired him, James used proprietary and confidential information of the corporation in order to start a competing business, solicit the corporation's customers and interfere with and undermine the corporation's business. In his counterclaim James accused John and Carolyn of freezing him out of the corporation's management and misusing the corporation's assets for their personal purposes. He sought a dissolution of the corporation, pursuant to General Statutes § 33-896(a)(1), and appointment of a receiver to manage the corporation's affairs, pursuant to General Statutes § 33-898(a). He also sought damages for the alleged wrongful termination of his employment by John and Carolyn.
On November 21, 2014 the corporation elected to acquire James' one-third interest in lieu of dissolution of the corporation, as provided for in General Statutes § 33-900(a). Docket entry #116. That statute goes on to provide that, if the corporation and the shareholder who sought dissolution cannot agree on the " fair value and terms of purchase" of the latter's shares, the court shall determine the " fair value" of the shares. § 33-900(c) & (d).
" In a proceeding . . . to dissolve a corporation, the corporation may elect . . . to purchase all shares owned by the petitioning shareholder at the fair value of the shares."
The corporation and James having failed to agree on the fair value of James' interest, a trial for the purpose of determining that value began before this court on December 8, 2015 and continued on December 9, 22 & 23, 2015 and February 23, 24 & 25, 2016. On February 23, 2016 the parties agreed to the following changes in the pleadings to reflect the limited scope of the issues to be decided by the court. The plaintiffs' complaint was withdrawn in its entirety. Docket entry #173. The defendant James Clark filed a second amended counterclaim containing a single count seeking dissolution of the corporation. Docket entry #172. In that amended counterclaim James alleged that the corporation had a practice for many years of providing shareholders with funds to pay the federal income tax liabilities incurred by them as a result of the pass-through of the corporation's profits to them. The counterclaim goes on to claim that James has not received any such payments from the corporation for the years 2012, 2013 and 2014 although he remains a shareholder of the corporation. The denials of those payments was " illegal, oppressive and fraudulent, " the counterclaim alleges. Because James is a minority shareholder, he claims that this oppressive conduct toward him by the majority shareholders, John and Carolyn, precludes any discount to the fair value of his shares in the corporation, as determined by the court, based on his minority status (minority discount) or on the limited marketability of shares in a closely-held family corporation such as this one (marketability discount).
See footnote 1, supra .
These changes in the pleadings, which had the practical effect of abandoning multiple claims that the parties had made against each other in the original pleadings, were the subject of a stipulation placed on the record by counsel, in the presence of the parties, with each counsel affirming that the changes were being made with the agreement of their respective clients. See Partial transcript of proceedings, February 23, 2016, pp. 4-5.
Thus, the questions to be decided by the court are (1) what is the " fair value" of James' one-third interest in the corporation and (2) should the amount that the corporation must pay him for the " fair value" of his shares be subject to either a minority or a marketability discount?
" A minority discount adjusts for the fact the shares represent a minority interest in the corporation and thus lack control of it. A marketability discount adjusts for lack of liquidity of the shares of a closely held corporation in the open market." (Citation omitted.) DeVivo v. DeVivo, Superior Court, judicial district of Hartford, Docket No. CV 98 0581020, p. 6, 30 Conn.L.Rptr. 52, 2001 WL 577072.
Once the court has decided those issues, it will hear the parties on the terms and conditions of the purchase and whether James Clark, as the shareholder petitioning for dissolution, is entitled to payment of the reasonable fees and expenses of his counsel and of his expert witness.
" Upon determining the fair value of the shares, the court shall enter an order directing the purchase upon such terms and conditions as the court determines appropriate . . . (I)f the court finds that the petitioning shareholder had probable grounds for relief under [§ 33-896(a)(1)], it may award to the petitioning shareholder reasonable fees and expenses of counsel and of any experts employed by him." § 33-900(e).
I
Neither the Connecticut Supreme Court nor the Appellate Court has addressed the legal issues that arise when majority shareholders seek to buy out a minority shareholder who has sought dissolution of a corporation pursuant to § 33-896. Fortunately, the court has available the scholarly and comprehensive decision of Judge Robert Satter in DeVivo v. DeVivo, Superior Court, judicial district of Hartford, Docket No. CV 98 0581020, 30 Conn.L.Rptr. 52, 2001 WL 577072 (May 8, 2001), to guide its consideration of these questions:
1. What is the meaning of the " fair value" of the corporation as that term is used in § 33-900?
2. When should the court apply either a minority discount or a marketability discount to the " fair value" of the minority shareholder's interest in the corporation?
After reviewing the legislative history of § 33-900 and court decisions from around the country construing its counterparts in other states, all of which are based on the Model Business Corporation Act, Judge Satter concluded that " fair value, as used in § 33-900, is not synonymous with fair market value." 2001 WL 577072 *4, Rather, " the proper method to determine 'fair value' of the shares of a petitioning shareholder under § 33-900 is to ascertain the value of the corporation as a whole and allocate value to the shares of the petitioning shareholder in proportion to the percentage interest they represent in the corporation." Id. at *5.
Both parties here have approached the determination of fair value of the corporation in this fashion.
Turning to the second issue, whether or not to discount the shares in a closely-held corporation, Judge Satter first distinguished the two forms of discount. " A minority discount adjusts for the fact that the shares represent a minority interest in the corporation and thus lack control of it. A marketability discount adjusts for lack of liquidity of the shares of a closely held corporation in the open market." Id.
Minority discounts " are almost universally denied, " Judge Satter found from his review of the cases considering buyouts by majority shareholders. Id. at *6. " (W)hen the [minority] shares are to be purchased by someone who is already in control of the corporation . . . it can hardly be said that the value of the shares are (sic) less to the purchaser because they are noncontrolling." Brown v. Allied Corrugated Box Co., 91 Cal.App.3d 477, 154 Cal.Rptr. 170, 176 (Cal.App.2d Distr. 1979). Id. at *7.
The same is true where the minority shareholder's petition to dissolve the corporation is based on " oppressive" conduct on the part of the majority. See § 33-896(a)(1)(B). " The rationale for such a rule is clear. Where a dissenting shareholder petitions for relief due to oppressive conduct of the defendants, she should not be punished by reducing the value of her stock that she would not otherwise have wanted to sell. Put another way, defendants who engage in oppressive conduct should not be rewarded for that conduct by being permitted to purchase the dissenting shareholder's shares at a fraction of their value." Booth v. Waltz, Superior Court, judicial district of Hartford, Docket No. X 04 CV 10 6011749, 2012 WL 6846552, *22 (Dec. 14, 2012).
The approach of courts to the allowance of marketability discounts is not as uniform. See, e.g., Raskin v. Walter Karl, Inc., 129 A.D.2d 642, 514 N.Y.S.2d 120, Appellate Div., 2d Dept. (1987). " However, absent extraordinary circumstances, the majority of the courts reject marketability discounts in deadlock, or oppressed shareholders' actions." DeVivo v. DeVivo, supra, 2001 WL 577072 *8. The cases reveal three reasons for disallowing both minority and marketability discounts: (1) they deny petitioning shareholders the full value of their shares; (2) they unfairly enrich majority shareholders by allowing them to purchase the minority's interest for less than its true value; (3) they penalize the petitioning shareholder for taking advantage of the appraisal statute like § 33-900. Id. In DeVivo, however, Judge Satter did apply a marketability discount to the petitioning shareholder's interest based on his finding of " extraordinary circumstances": the " fair value" of the minority shareholder's interest was so much greater than the net worth, operating cash flow and net income of the business that payment of the full value would place unreasonably burdensome demands on the business. Id. at *11.
James Clark's counterclaim asserts that he has been the victim of oppressive conduct on the part of John and Carolyn. The court will address that issue, as well as the appropriateness of a minority or marketability discount, after it has found what is the fair value of James' one-third interest in the corporation.
II
The parties agree that the value of the corporation should be determined as of December 31, 2014. Accordingly, the court adopts December 31, 2014 as the valuation date.
" . . . (T)he court . . . shall . . . determine the fair value of the petitioner's shares as of the day before the date on which the petition [for dissolution] was filed or as of such other date as the court deems appropriate under the circumstances." § 33-900(d).
Each party retained a qualified expert to value the corporation as of that date, and both experts used the commonly-accepted income-based approach in arriving at their respective estimates of the present value of the corporation.
The income-based approach to business valuation requires a projection of future cash flow for the business based on past and present earnings, " normalized" to account for what the evaluator considers anomalies in its past or present operations or expenses. The concept here is to eliminate these anomalies; e.g., inflated salaries, unnecessary or one-time expenditures, in order to see what the corporation's " normal" cash flow would be without them.
The experts retained in this case have used the terms " cash flow, " " net profit" and " net earnings" interchangeably to identify the figure that represents their projections of the corporation's financial performance in the future. The court will use the term " cash flow" for that purpose.
Once future cash flow has been projected, that amount is converted into the estimated present value of the corporation by applying to it a " capitalization rate" (cap rate). The cap rate is a prediction of the rate of return on his investment an investor would desire if he were to buy into the corporation, adjusted to take into account the debt/equity ratio attributable to the investment and the predicted growth in the corporation's income stream.
The parties' experts disagreed as to both the " normalized" cash flow of the corporation and the cap rate. As a result they arrived at vastly different estimates of the fair value of the corporation.
James' expert, Richard Royston, estimated the cash flow of the corporation at $1,197,341 annually. He used a cap rate of 20.9% to arrive at a fair value, after deduction of the corporation's debt as of December 31, 2014 and addition of the amount due to the corporation from John, James and Carolyn on that date, of $4,861,117. James' one-third share of the corporation, therefore, would be valued at $1,620,000. On the other hand, John Kramer, the expert retained by John and Carolyn, estimated the corporation's cash flow at only $142,445 annually and applied a cap rate of 6.03%, thus arriving at a fair value, after the same adjustments as those made by Mr. Royston and addition of an amount due to the corporation from a related corporate entity, of $1,655,000. James' one-third share of the corporation, therefore, would be valued at $551,612.
See pp. 31-32, below.
The amount of the average cash flow annually is divided by the cap rate to arrive at the fair value of the corporation.
III
Both experts in this case started with the corporation's actual operational and financial experience for the five-year period 2010-2014, as reflected in its statements of income and expenses for each of those years. Where the expert has several years of financial data available to him, as was the case here, he must also decide which of those years are more predictive of what the company's financial performance in the future will be. From the years he has selected the evaluator must compute an average cash flow that the corporation will likely experience in the future. If the evaluator considers one or more of the years he has chosen more typical of what the corporation's future earnings will be, he may " weight" those years more heavily in computing his average.
A
Richard Royston, the expert retained by James Clark, excluded 2010 and 2011 from his projections. In 2010 the corporation lost its single major customer, making that year's financial results unrepresentative of future performance. Mr. Royston eliminated 2011 because he understood that the corporation underwent a change in management upon the death of Robert Clark. The evidence heard by the court, however, established that, in the years leading up to his death, Robert Clark had played an increasingly minor role in the corporation, with his daughter Carolyn taking on more of his management duties. The result was that, upon his death, the corporation did not experience a major management change that affected its financial performance. Therefore, the court considers that 2011s financial results should be included in a projection of the corporation's future performance. John Kramer, the expert retained by John and Carolyn, did include 2011 in his projections.
Mr. Royston " normalized" the financial results for 2012, 2013 and 2014 by reducing expenditures in several ways:
1. He reduced the salaries and benefits paid to John and Carolyn to what he considered levels more commensurate with their actual duties, as described to him by James.
2. He reduced the legal fees expended by the company over that period to what he considered a more " normal" level going forward.
3. He eliminated all fees paid to a consultant who had been acting as the corporation's chief financial officer for many years, based on James' advice that the consultant's duties could be performed by existing staff.
4. He reduced the rent paid in 2014 to Jean Clark, Robert Clark's widow, who owns the premises out of which the business is run, to the average of the rents paid in 2012 and 2013.
5. He eliminated charitable contributions paid by the corporation because such contributions are a totally discretionary expense.
These " normalizing" reductions in the corporation's annual expenditures had a dramatic effect on the corporation's bottom line for all three years. The cash flow for 2012 increased from $228,115 to $492,956; for 2013 the increase was from $295,163 to $541,720. Cash flow for 2014 more than doubled, from $805,864 to $1,626,847. See exhibit DD, schedule 3.
And, when non-operational allowances such as depreciation of equipment, amortization of debt and interest expense are added back to these figures, the corporation's " normalized" earnings from operations for each of those years, according to Mr. Royston, are as follows:
See exhibit DD, schedule 2.
2012
$839,228
2013
$863,477
2014
$2,032,647
Deciding that the corporation's " most recent results are more likely to reflect future performance than those from earlier years"; exhibit DD, p. 1; Mr. Royston used a weighted average in calculating the corporation's annual cash flow. The result: an estimate of annual cash flow for the corporation of $1,444,021. Id.
Mr. Royston assigned a weight of 3 to earnings for 2014, 2 to earnings for 2013 and 1 to earnings for 2012.
Employing an annual growth rate in those earnings of 3%, Mr. Royston's projected earnings for the corporation would be $1,487,341 for 2015. Id. Reducing that figure by $290,000, an amount Mr. Royston allotted for the purchase of 2 1/2 trucks in that year, results in an estimate of cash flow for 2015 of $1,197,341. Id.
B
As mentioned earlier, John Kramer, the expert retained by John & Carolyn, used a four-year window into the financial operations of the corporation, which the court considers a more realistic approach. He also " normalized" the corporation's financial results for those years:
1. He set the compensation paid to John and Carolyn, as president and vice president of operations respectively, at rates he considered more reflective of their duties in managing a company of this size in the Hartford region, based on his review of the Economic Research Institute's (ERI) " Salary Assessor" publication. This resulted in significantly higher compensation than allowed for by Mr. Royston.
2. He eliminated legal expenses related to this litigation and made no other changes in that line item.
3. He eliminated discretionary expenses paid by the corporation for the benefit of John and Carolyn; e.g., automobile expenses, heating oil and maintenance.
4. He adjusted the rent expenditures to what he concluded to be market rates, based on a 2014 real estate appraisal of the property owned by Jean Clark.
5. He, too, eliminated charitable contributions.
These adjustments seem to the court more realistic than those of Mr. Royston. Perhaps that is to be expected because Mr. Royston's principal informant as to the corporation's operations was James Clark, who has been divorced from the corporation's management for almost five years. In addition, Mr. Kramer's adjustments for compensation and rent are based on sources, an ERI publication and a real estate appraisal, that carry more weight with the court.
Mr. Kramer's adjustments, of course, affect the bottom line from the corporation's operations. The corporation's operations for 2011 generated a loss of $12,189; with Mr. Kramer's adjustments that loss would have been $63,219. In 2012, 2013 and 2014 the cash flow from operations changed as follows: 2012, from $282,158 to $207,014; 2013, from $370,836 to $274,726; 2014, from $849,500 to $1,212,680. See exhibit 1, p. 33.
Mr. Kramer, although he affirmed that earnings of an S Corp. " are not subject to taxation at the entity level but rather are taxed to the individual shareholders"; exhibit 1, p. 15; nevertheless decreased the corporation's normalized earnings further by applying a pass-through tax rate of 25% to them. Id. In doing so Mr. Kramer relied on the case of Delaware Open MRI Radiology Assoc., P.A. v. Kessler, 898 A.2d 290 (Del.Ch. 2006). The court's decision in Kessler, however, was at odds with a prior decision of the Court of Chancery and decisions of the U.S. Tax Court that declined to " tax affect" the earnings of an S Corp. Those cases recognized that an S corporation structure can produce a material increase in economic value for a stockholder and should be given weight in a proper valuation of the stockholder's interest." Delaware Open MRI Radiology Assoc., P.A. v. Kessler, supra, 898 A.2d at 327. The way to do that, those cases held, was to ignore tax completely. Id., 328.
In re Radiology Assocs., 611 A.2d 485, 495 (Del.Ch. 1991).
Adams v. Comm. of Internal Revenue, T.C. Memo 2002-80, 2002 WL 467235 (U.S. Tax Ct. 2002); Heck v. Comm. of Internal Revenue, T.C. Memo 2002-34, 2002 WL 180879 (U.S. Tax Ct. 2002); Gross v. Comm. of Internal Revenue, T.C. Memo 1999-254, 1999 WL 549463 (U.S. Tax Ct. 1999).
This court will take the same approach as the latter cases and ignore the tax reductions in Mr. Kramer's computation of the corporation's normalized cash flow. See exhibit 1, p. 33.
It also appears that the court in Kessler " tax affected" that corporation's earnings " (t)o be consistent with Delaware law." Delaware Open MRI Radiology Assoc., P.A. v. Kessler, supra, 898 A.2d at 330, 327.
When non-operational allowances such as depreciation and amortization; see exhibit 1, p. 33; are added back to normalized cash flow without any deductions for taxes, the court's estimates of the corporation's earnings from operations for each of these years are as follows:
2011
$301,601
2012
$533,340
2013
$527,397
2014
$1,555,240
The difference in Mr. Kramer's approach that probably created the greatest discrepancy between his estimate of the corporation's future earnings and Mr. Royston's was the former's decision to weight equally the results of each of the four years he used in figuring the average annual cash flow. This was a sensible decision. While the general principle that more recent experience is a better predictor of future performance is sound, in this instance it does not apply. The evidence at trial revealed that the corporation's very favorable financial experience in 2014 was affected by the spike in petroleum prices and the imposition of a fuel surcharge by the corporation on its customers, two circumstances that are unlikely to recur, at least in the near term.
The corporation's sales in 2014 increased to almost $10 million from $9.3 million in 2013. Its reported net income increased 173 percent over 2013.
This simple weighting approach, in which the cash flow figure for each year is assigned a weight of one, when applied to the court's estimate of normalized earnings for 2011 to 2014, produces an estimate of annual cash flow for the corporation of $729,395, as opposed to Mr. Kramer's estimate of $627,445. Id.
Although Mr. Kramer states in his report that he used a 3% future growth rate in his estimate of the cap rate, " to reflect the Company's expected future growth patterns"; exhibit 1, p. 17; the court does not find that in his calculations of the corporation's cash flow. Compare exhibit 1, pp. 32, 33 with exhibit DD, schedule 2. Therefore, the court has applied to its estimate of annual cash flow of $729,395 the same 3% growth rate used by Mr. Royston. The result is projected cash flow for 2015 of $751,277. Reducing that figure by $456,000 for the purchase of four trucks (rather than the 2 1/2 trucks assumed by Mr. Royston), based on the advice Mr. Kramer received from the corporation's present management, and working capital of $29,000, results in an estimate of cash flow for 2015 of $266,277.
By comparison, Mr. Royston estimated cash flow for 2015 at $1,197,341. For all of the reasons stated above the court finds Mr. Kramer's approach to the corporation's cash flow, as adjusted by the court, to be a more realistic projection of what can be expected in the future. That is, the court finds $266,277 to be a more realistic estimate of future cash flow and will apply the cap rate to that figure in determining the fair value of the corporation.
IV
How can this estimate of the corporation's future stream of earnings be translated into its present value, i.e., the amount that a putative investor or, more likely in the case of a small, local, family-owned business, a potential purchaser would pay for the corporation? The commonly-accepted method, as stated previously, is by the development of a cap rate that reflects a supposed investor's/purchaser's desired rate of return on an investment in the business. Both experts employed this method in arriving at their respective opinions of the present value of the corporation.
While the method employed by the experts was the same, they reached vastly different conclusions as to the cap rate: Mr. Royston opined that 20.9% is the appropriate rate to apply to the corporation's cash flow in order to estimate its present value; Mr. Kramer, 6.03%. This court feels in the same position as the court in Kessler : " Once the experts' techniques for coming up with their discount rates are closely analyzed, the court finds itself in an intellectual position more religious than empirical, insofar as the court's decision to prefer one position over the other is more a matter of faith than reason." Delaware Open MRI Radiology Assoc., .P.A. v. Kessler, supra, 898 A.2d at 338. In such a situation the court must make a judgment as to which of the experts seemed to take a more reliable overall approach to valuing the company.
As already indicated, the court finds Mr. Kramer's estimates as to the future income and expenses of the corporation to be better informed and more realistic. The court reaches the same conclusion when it considers his calculations along the way to reaching a cap rate.
Both Mr. Royston and he used the " build-up method" for estimating the cost of equity capital. Compare exhibit 1, p. 34 with exhibit DD, schedule 10. They began with the " safe rate" paid by Treasury bonds and added to it an " equity risk premium" rate, i.e., the additional rate of return available from equity investments versus investments in bonds. So far, so good: their estimates of the average market return on December 31, 2014, the valuation date, are close to identical: Mr. Royston, 9.4%; Mr. Kramer, 8.68%.
Both recognized that investments in a small company like R.D. Clark entail additional risks and add a risk premium to account for that fact. Here, however, their estimates of the degree of risk, as reflected in the additional return required by an investor, vary widely: Mr. Royston estimates the " small stock size premium" at 11.98%; Mr. Kramer, 5.78%. Here again the court finds Mr. Kramer's estimate more reasonable. Both experts drew their risk premium estimates from the same reference source; both used estimates for the smallest companies listed in that source. Mr. Royston, however, used the risk premium estimate given for the tiniest of those small companies, including companies in distressed financial circumstances. R.D. Clark has been a profitable company for most of the years for which data has been provided to the court. Therefore, the court considers Mr. Royston's estimate of the risk premium necessary to attract an outside investor or purchaser too large.
Finally, Mr. Royston adds to his estimate of the cost of equity capital both 1.5% for the trucking industry in general and 5% for R.D. Clark. While Mr. Kramer did not include a risk premium for trucking companies generally, he estimated the additional risk for investing in this corporation at 7%, due to its " dependence on economic conditions, customer concentration and increasing competition." Exhibit 1, p. 17. The net results for the two experts' estimates were, again, almost identical: Mr. Royston, 6.5%; Mr. Kramer, 7%.
Thus the only significant difference between the experts in computing the equity rate is in their estimates of a risk premium for investments in small companies. For the reasons stated, the court accepts Mr. Kramer's estimate of 5.78% and his overall estimate of 21.46% as the " cost of equity, " i.e., the rate of return it would take to interest an investor/purchaser in the corporation. But, this is the rate of return needed if all of the funds for an investment or purchase were to be from equity. Both experts cautioned the court that it must be reduced to take into account the possibility that some of the investment/purchase would be financed via debt for which the investor/purchaser would demand a lower rate of return.
Each expert reached a conclusion as to what would be the ratio of debt to equity financing in a putative investment in or purchase of the corporation. They vary dramatically: Mr. Royston gives the court a debt/equity ratio of 27%/73%; Mr. Kramer, one of 67%/33%, close to the reverse of Mr. Royston's. In other words Mr. Royston opines that an investor/purchaser would make his investment/purchase with only 27% in debt financing. Mr. Kramer says debt financing would constitute 67% of the investment/purchase.
These estimates were arrived at by a computer-aided iterative process carried out by each expert. Unfortunately, unlike in Kessler, neither provided the court with the iterations he employed to arrive at his estimates. The court's faith in the experts' process is sorely tested inasmuch as their descriptions of that process at trial seemed to the court more circular than iterative. Nevertheless, since both experts testified that their method is commonly accepted in the business valuation world and the court has no other method to substitute for it, the court will accept the debt/equity ratio estimated by the expert whose analyses, on balance, have seemed to the court to be more reliable, Mr. Kramer. This court, like the court in Kessler " does not have a store of [discounted cash flow] software available to allow us to run iterative exercises. Instead, as judges, we must do the best we can with the record the parties provide us." Delaware Open MRI Radiology Assoc., P.A. v. Kessler, supra, 898 A.2d at 341 n.138.
Delaware Open MRI Radiology Assoc., P.A. v. Kessler, supra, 898 A.2d at 341 n.137.
Moreover, the experts agreed that the principal determinant of the debt/equity ratio in their iterative processes was their respective estimates of the corporation's normalized cash flow. Since the court has accepted Mr. Kramer's estimate, with a few modifications, as closer to the mark, it follows that it should accord the same treatment to his estimate of the debt/equity ratio.
Employing his debt/equity ratio of 67%/33%, Mr. Kramer reduces the cost of equity rate of 21.46% and arrives at a " weighted average cost of capital" of 9.21%. He reduces it further by his estimate of the corporation's average growth rate of 3% and converts the result to a cap rate for December 2014 of 6.03%. See exhibit 1, p. 34.
In short, Mr. Kramer estimates that a supposed investor in or purchaser of the corporation would require a return on his investment (ROT) of 6.03%.
To arrive at the value of the corporation on December 31, 2014 that ROT must be divided into the court's estimate of the corporation's projected cash flow of $266,277. The result is a value estimate as of December 31, 2014 of $4,415,871.
To arrive at the true value of the corporation on that date, however, that figure must be reduced by the corporation's interest-bearing debt as of December 31, 2014 ($1,566,503), and increased by amounts due to the corporation from its shareholders on that date ($699,782) and an amount due to it from a related corporate party, Carolyn's Transport ($159,263). The result is an estimate that, on December 31, 2014, the value of the corporation was $3,708,413.
That is to say, a putative investor in or purchaser of the corporation on that date would be willing to invest or pay $3,708,413 for a 100% interest in it.
The court finds, therefore, that the fair value of the corporation on December 31, 2014 was $3,708,413. The court finds further that the value of James Clark's one-third interest in the corporation as of that date was $1,236,138.
This is the court's finding as to the value of James' interest in the corporation before any minority or marketability discount, a subject to which the court will now turn its attention.
V
James claims to be the victim of oppressive conduct on the part of the corporation, through the actions of John and Carolyn. In his second amended counterclaim, seeking dissolution of the corporation pursuant to General Statutes § 33-896(a)(1), he limits his claim of oppression to the allegation that, even though he remained a shareholder after his firing in September 2011, John and Carolyn excluded him from the corporation's long-standing policy of providing shareholders with funds to pay the federal tax liabilities they incurred as shareholders in an S corporation.
See footnote 1.
This claim of oppression is important in two respects. First, it may insulate James from the application of a discount or reduction of the value of his one-third share in the corporation because of his status as a minority shareholder and/or because of the limited marketability of shares in a closely-held family corporation. Second, it may lay the foundation for an award to James of the fees he has paid to counsel and his expert witness.
See pp. 7-8, supra .
" In a proceeding under subdivision (1) of subsection (a) of section 33-896, if the court finds that the petitioning shareholder had probable grounds for relief under said subdivision, it may award to the petitioning shareholder reasonable fees and expenses of counsel and of any experts employed by him." General Statutes § 33-900(e).
For a definition of " oppression" the court turns again to Judge Satter's decision in DeVivo . " Oppression in the context of a dissolution suit suggests a lack of probity and fair dealing in the affairs of a company to the prejudice of some of its members, or a visible departure from the standards of fair dealing and a violation of fair play as to which every shareholder who entrusts his money to a company is entitled." (Internal quotation marks and citation omitted.) DeVivo v. DeVivo, supra, 2001 WL 577072 *3. Looking to New York law for another formulation of what constitutes " oppressive" conduct in the corporate dissolution context, Judge Satter found such conduct to arise " when the controlling directors' conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner's decision to join the firm." Id.
The facts underlying James' claim are not in dispute. James testified that his father had begun the practice of making funds available to the shareholders to cover their income tax liabilities on their share of the corporation's profits right from the establishment of the corporation. Brian McAnneny, a financial consultant who has served as the corporation's chief financial officer for many years, affirmed that in 2009 John and James received approximately $60-70, 000 each from the corporation to pay federal income taxes on their share of the corporation's profits. No such payments were made to them in 2010 because the corporation lost money that year. That loss provided both John and James with a loss carry-forward for succeeding years' taxes. Mr. McAnenny estimated the amount of the carry-forward for each at $200,000.00, but he provided no documentation of those amounts. Moreover, though he assumed that both John and James enjoyed the tax benefits of those carry-forwards in 2013 and 2014, he had no first-hand knowledge. And, other evidence revealed that John received funds from the corporation in 2013 and 2014 to defray his federal income tax liabilities.
Carolyn received no funds from the corporation prior to 2011 because she did not become a shareholder until after her father's death that year. Thereafter, she received substantial payments from the corporation for her use in paying her federal tax liability on the corporation's profits.
For example, in 2014, the corporation's most successful year ever, the pass-through of corporate taxes to each of John, Carolyn and James was $233,786.00. While John and Carolyn received $180,000.00 each to defray the taxes they were required to pay, John received nothing even though, by virtue of his continuing status as a shareholder, he was liable for taxes due on corporate profits.
Mr. McAnenny told Mr. Kramer that, at the same time as John and Carolyn each received $180,000.00, the corporation credited James' " loan" account for $180,000.00, which had the effect of wiping out his balance of $92,365, converting it into an account payable to James of $87,635.00. See exhibit LL. At trial, however, Mr. McAnenny testified that this transaction, intended to treat James in an " equitable manner, " could not be consummated because the corporation lacked a " vehicle" to carry it out. So, according to Mr. McAnneny, James still owes the corporation $92,365.
John and Carolyn seek to justify this disparity in treatment by characterizing the payments to them as " loans" from the corporation even though no notes were ever signed, no interest was ever charged, no due dates for repayment were ever specified, and the " loans" were repaid via " bonuses" they received for that purpose from the corporation. As explained by Mr. McAnenny, " bonuses" were voted by an " advisory board, " composed of Mr McAnenny and Attorneys Michael McDonald, corporate counsel, and Thomas Generis, counsel for selected corporate matters, specifically for the purpose of allowing John and Carolyn to pay down " loans" they had previously received. Funds sufficient to pay their income taxes on the " bonuses" were deducted and paid to the government by the corporation. The balance of the " bonuses" was credited to the loan account for each shareholder carried on the corporation's books. John and Carolyn received no cash from these transactions.
These " loans" were carried as receivables on the corporation's books, including those made to James prior to 2012. At the end of 2014 John's " loan" balance was $234,333.00; Carolyn's, $203,594.00. Unless and until the advisory board votes additional " bonuses" to John and Carolyn, these " loans" will remain unpaid.
In addition to the disbursements to shareholders to pay taxes, these " loan" accounts included other disbursements for the shareholders' benefit. Mr. McAnenny was unable to recall the purposes of those other disbursements.
According to Mr. McAnenny, these " loans" were made to John and Carolyn in their capacity as officers of the corporation, not as shareholders. Further, he testified, were the corporation to make such a " loan" to James, who resigned as an officer early in 2012, the IRS would have forced the corporation to treat it as a dividend, which would have triggered covenants in its outstanding loans, " probably" resulting in the loans being called. This would have been a " disaster" for the corporation, he testified.
The court places little weight on this testimony. Mr. McAnenny more than once in his testimony disavowed familiarity with IRS regulations, but he now relied on some unspecified IRS demand to explain why James could not be treated the same as his fellow shareholders. He provided no documentation to support his vague testimony that a loan to James would have triggered some unspecified covenants in the corporation's outstanding loans and what would be the effect for the corporation.
Mr. McAnenny never explained to the court's satisfaction why the corporation could not make a genuine loan to James for the purpose of defraying the potential tax liability on his share of the corporate profits in 2012, 2013 and 2014, memorialized in a promissory note, with a market interest rate and a specified payoff date. The court concludes that the corporation never seriously considered such a mechanism as a vehicle to treat James the same as John and Carolyn.
John and Carolyn also contend that they did not make the decision whether to provide funds to pay James' taxes; rather, the advisory board made that decision, just as the same board decided what salaries to pay John and Carolyn and whether to award them " bonuses" for the purpose of paying down their loan accounts. The court considers this argument disingenuous. Suffice it to say that, should John and Carolyn, as majority shareholders, be dissatisfied with any of the advisory board's decisions, such as a refusal by the board to " loan" them more money to pay their taxes, it is entirely within their authority to replace the members of the board with others who would bend to their will.
They also point to a lack of proof that James had any actual tax liability in 2012, 2013 or 2014. But, the advisory board did not " loan" John and Carolyn money only when it was satisfied that they had an actual tax liability. The board made these " loans" because John and Carolyn were shareholders who had a potential tax liability by virtue of the corporation's status as an S Corp. James occupied the same status, yet he was treated differently.
In his testimony at trial Mr. Royston did make an estimate of James' tax liability on his share of the corporation's profits in 2014.
The court finds that James has proven by a preponderance of the evidence that the corporation, through the actions of its majority shareholders, John and Carolyn, acted in an oppressive manner toward James, within the meaning of § 33-896(a)(1). The disparate treatment of James deviated from the standard of " fair dealing" to which he was entitled and " substantially defeat[ed] [his] expectation, " based on the corporation's established practice, that funds would be made available to him to defray any tax obligation he had as a shareholder in an " S corp."
VI
The court finds that the fair value of James Clark's one-third share in the corporation is $1,236,138. Because the corporation, through the actions of its majority shareholders, engaged in oppressive conduct toward him, his share will not be subject to a minority discount.
At 10:00 am on October 5, 2016 a hearing will be held at the Superior Court for the Hartford Judicial District at which the court will consider:
1. Whether there are extraordinary circumstances justifying a marketability discount of James' share.
2. The terms according to which the corporation will purchase James' share.
3. Whether James is entitled to payment of the reasonable fees and expenses of counsel and of his expert witness.
By no later than September 28, 2016 Attorney Harrington shall submit to Attorney Weinstein an itemization of his fees and expenses as well as the fees and expenses associated with Mr. Royston's services in this case.