Fundamentals of BV in PA: Glosser Bros. II

This post is the second in a series dedicated to historical legal precedents on business valuation in Pennsylvania. The factual background for this case, Glosser Bros., is discussed in my post last week. This is part II:

In addition to their argument that trial court should have considered actual stock transactions, the appellants in Glosser Bros. also complained about the expert testimony given by the dissenters’ accountant, who calculated the company’s net asset value. In particular, the Company argued that the trial court should have excluded the expert’s testimony to the extent that he had relied upon an equipment appraisal prepared by an appraiser (at the Company’s request) who did not testify at trial. The Company also complained that the plaintiffs’ accountant was not qualified to determine the value of leases held by the Company.

The dissenting shareholders argued that their expert’s testimony about the equipment appraisal was admissible, despite being hearsay, because it had been relied upon by the Company in its proxy statement for the merger and considered by management in adopting a certain tax treatment of the transaction. As such, they argued, it was an adoptive admission of the Company. Furthermore, the dissenters argued, it was the type of evidence on which business valuation professionals generally rely in the practice of their profession, and thus admissible under Pa.R.E. 703.

The trial court, apparently, had repeated the refrain frequently heard by lawyers who object to the admission of evidence: that the evidence would be admitted and the court would decide what weight to assign to it. The Superior Court generally approved this ruling, noting that in non-jury trials, it might be desirable for the trial court to have as much evidence before it as possible.

The Superior Court first rejected the Company’s argument that the dissenters’ expert was not qualified to appraise the leases. Observing that the accountant had been qualified as an expert on the issue of stock valuation, the Superior Court cited Pennsyvlania’s liberal standard for qualification of an expert. The Court also noted that the Company itself had used the same methods for its own purposes. Therefore, the Superior Court refused to disqualify the dissenters’ expert on this issue.

As for the equipment appraisal on which the business valuator relied, the Superior Court agreed that it would be hearsay evidence if offered to prove the truth of the matters that it contained. The Superior Court held that the Company’s use and reliance on the equipment appraiser’s opinion did not amount to an adoptive admission. Yet, the Superior Court did not overrule the trial court’s decision to admit the testimony of the plaintiff’s valuation expert, including the portions of his testimony that relied upon the hearsay equipment appraisal.

Reviewing the development of evidentiary procedure, the Superior Court noted that the expert testimony exception to the hearsay rule had been extended beyond medical experts, to experts in other fields. See, e.g., Pittsburgh Outdoor Advertising Corp. Appeal, 440 Pa. 321, 272 A.2d 163 (1970); Steinhauer v. Wilson, 485 A.2d 477 (Pa.Super.1984). Yet, the Superior Court in Glosser Bros. placed significant weight on the fact that the equipment appraisal had been prepared for the Company itself and was not the only equipment appraisal that the plaintiff’s valuation expert had considered. The testifying expert had exercised his own independent judgment by giving greater weight to the out-of-court equipment appraisal than to another appraisal prepared by an expert who testified at trial. Finding that the equipment appraisal carried its own “circumstantial guarantee of trustworthiness,” the Superior Court refused to exclude the testimony of the plaintiff’s business valuation who relied on the hearsay evidence.

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Fundamentals of BV in PA: Glosser Bros.

This post is the first of series aimed at reviewing the historical legal decisions concerning business valuation in Pennsylvania. Since these are state court cases, most arise from shareholder disputes, divorces, and condemnation cases. Some are stale, some vital, and some questionable, but all are worth reviewing. The first installment, concerning Glosser Bros., will be presented in two parts:

One of the leading cases on business valuation in Pennsylvania is In re Glosser Bros., Inc., 555 A.2d 129 (Pa.Super.1989), a dissenting shareholder action arising from the management-led buyout of a regional chain of discount department stores, outlet stores and grocery stores. Three of the company’s shareholders filed suit against the acquirer, claiming that the share price paid by acquirer was too low and seeking an appraisal of the stock. The standard of value in such cases is “fair value” as provided by Section 515 of the Pennsylvania Business Corporation Law of 1988.

Glosser Brothers was a publicly-traded stock listed on the American Stock Exchange. In the months immediately preceding the merger, the shares traded around $14 per share. The stock had never traded for more than $19 per share. The company that acquired Glosser Brothers in 1985 paid $20 per share.

The Cambria County trial court did not appoint an appraiser, but took expert testimony about the methods of determining fair value, including net asset value and investment value. The trial court found the stock was worth $31 per share, which was determined by assigning 65% weight to the company’s net asset value and 35% weight to its investment value. The company appealed on several grounds, including the trial court’s refusal to consider its market share price.

The Superior Court agreed that it was an error to disregard the price at which the stock traded on the American Stock Exchange. The Court cited back to O’Connor Appeal, 452 Pa. 287, 304 A.2d 694 (1973), which required the courts in shareholder appraisal actions to consider actual market value as well as net asset value and investment value. The Court also held that the traditional “Delaware block” method of valuation (in which the court would only consider the three traditional methods of valuation, assigning a percentage weight to each) would yield to a broader consideration of generally accepted valuation techniques. (Business valuation was, at that time, a new and developing science.)

The Superior Court held that market value, while relevant, was not controlling. While it might be deemed extremely reliable in cases where there were many transactions providing extensive data, it might be less reliable in cases where the transactions were few and data scarse. Still, the Court held that market value should be totally disregarded only in cases where there was competent and substantial evidence to support the conclusion that the value at which the stock is trading is not at all reliable in gauging its intrinsic going concern value. For instance, where a high percentage of shares is held by an individual or small group, or thinly traded, the market value might be deemed unreliable.

The Superior Court in Glosser Bros. held that the trial court should not have totally disregarded the market trading price. By its ruling, the Superior Court attempted to pull away from the holding of O’Connor, in which the Supreme Court held: “[Shares of] a closely-held family corporation having unlisted stock and … no public market … [are] sold too infrequently for market value to play any part in [valuation].” In Glosser Bros., the Superior Court remanded to the trial court to consider market value among other valuation methods.

In Part II, which will be posted next week, we will discuss the other issue raised by Glosser Bros.: the expert’s ability to give opinions based upon hearsay evidence of the type ordinarily relied upon in the practice of business valuation.

Mercer Capital Publication: Buy-Sell Agreements

A recent edition of Value Matters, a periodical published by Mercer Capital Group, illustrates the reasons for having a buy-sell agreement and what options might be available. Buy-sell agreements are advisable for the same reason as prenuptial agreements: they structure the consequences of a possible future incident such as shareholder disharmony, death, or divorce.

The valuation provisions of a buy-sell agreement, which may dictate the share price in the event of partner withdrawal, death or divorce, must reconcile competing concerns. On one hand, a book value formula might be desirable in the event of divorce or the buyout of a withdrawing shareholder. On the other hand, a below-market share price may result in excessive estate taxes for the beneficiaries of a deceased shareholder. An agreement can provide different formulas for different situations, but must presumably reconcile those inconsistencies or suffer close scrutiny of the courts or IRS.

Trigger events, valuation method, and purpose are some of the important elements of a successful buy-sell agreement. Extensive details are provided, presumably, by Chris Mercer’s book, Buy-Sell Agreements.

Big Surprise: Mortgage Business Bankrupt!

In Wilson v. Wilson, 2008 WL 2312726 (Ky.App.2008), a man started a mortgage brokerage business with his high school sweetheart in 2004. Soon the business blossomed, and so did the romantic relationship between the man and his classmate, who unfortunately was not his wife. The business expanded from Kentucky to Florida and paid all of the classmate’s living expenses. Soon the business floundered, the man bought out his partner, and he filed for divorce and bankruptcy. A discharge order was entered shortly thereafter, the bankruptcy court finding that the business was insolvent and no assets existed.

In the divorce action, a court-appointed valuation professional determined the value of the business as an ongoing concern as of September 2005, one year before the bankruptcy. The trial court accepted the valuation but assigned no value to the business as marital property, since it was bankrupt and worthless a year later. The business owner’s wife appealed, arguing that it should be assigned the value given by the expert.

On appeal, the Kentucky Court of Appeals affirmed, holding the trial court did not commit an error by assigning no value to the bankrupt business. The expert and the court did not seem to violate the principle that facts not known or knowable on the date of valuation may not be considered. Rather, the date of the expert’s valuation did not appear to coincide with the date used by the court. The lesson, perhaps? Make sure the date of expert’s valuation is the same date that the court will consider at trial.

Under Pennsylvania law, the same result probably would have occurred. Under Sutliff v. Sutliff, 518 Pa. 378, 543 A.2d 534 (1988), the proper date for valuing marital assets is presumed to be the date of distribution. There are cases, however, in which the courts of Pennsylvania have adopted an earlier date, such as where there has been intentional dissipation of marital assets. See, Nagle v. Nagle, 799 A.2d 812 (Pa. Super.2002); Smith v. Smith, 653 A.2d 1259 (Pa.Super. 1995). For some reason, the Kentucky courts rejected that logic.

Credibility is King in War of the Experts

The typical “war of experts” was presented in Bussa v. Bussa, 2008 WL 2117138 (Mich.App.), a 2008 unpublished decision of the Michigan Court of Appeals. In this case, the business owner’s expert gave an opinion of value based upon the asset approach. The subject company (actually, companies) was a petroleum sub-jobber comprised of a gas station operator, a real estate holding company owning the gas stations, and a trucking company delivering fuel to the gas stations. The business owner’s expert relied on an net asset value approach and excluded the income approach because the company was involved in a highly volatile industry.

The wife’s expert considered all three approaches, including discounted cash flow, market comparables, and net asset value. In valuing the operating company, she relied primarily upon the market approach. For the trucking company, she considered all three approaches; and for the real estate holding company, the net asset approach was deemed most reliable.

The trial court rejected the opinion of the husband’s expert and slightly modified the value suggested by the wife’s expert, applying a 5% discount for lack of control (the business owner’s brother owned half of the stock) and a 10% key man discount. The opinion of the husband’s expert was rejected because of significant computational errors, an inability to cite data to support his views, and an impression of advocacy for his client.

On appeal, the Michigan court affirmed, finding that it was mostly an issue of credibility, which is best left to the trial courts to decide. It is perhaps notable that the business owner on appeal seemed to contradict his own expert, arguing that his businesses should be valued at their liquidation value (contrary to his expert’s testimony) and criticizing the discounts that were applied to the value rendered by wife’s expert (which were the discounts to which husband’s own expert testified).

Executive Compensation

An intriguing article, published recently by BVR on its BVWire blast email, reminds us that executive compensation is one of the most important components of a business valuation. The article summarizes a lecture given by Brian Brinig at the California CPA 2008 BV Conference, in which he challenged the term “reasonable compensation adjustment” as well as the methods that are commonly used to arrive at this normalization adjustment to the income statement.

Mr. Brinig would prefer the term “fair-value-of-the-owners’-services adjustment,” which is a mouthful but comes closer to describing the real objective: determining what it would cost to replace the owner with an equally qualified and competent manager. Brinig also indicates that by phrasing the question in this way, valuation professionals can avoid the mistake of valuing non-transferrable goodwill. The question is not whether a neurosurgeon is unreasonably compensated but whether another professional could be hired to replace the neurosurgeon, and at what price.

BVWire also considered whether valuation professionals, who are not generally trained or experienced in executive compensation matters, can qualify to give expert opinions in litigation on this subject. The verdict? If judges are unwilling to disqualify business appraisers from giving testimony on the subject, it must be okay to do so.

Valuation Held Preferable to Judicial Sale

In Parker v. Parker, 980 So.2d 323 (Miss.App. 2008), the Mississippi Court of Appeals held that the trial court should not have ordered a judicial sale of businesses that were marital property in a divorce action. The trial court sold the businesses because the parties failed to comply with an order directing them to obtain accurate and up-to-date business valuations. On appeal, the Mississippi court held that the trial court could have appointed a business valuation professional or divided the property in kind.