Discounts on Closely Held Corporate Shares

In last month's issue, we discussed the necessity, in divorce cases as well as in various business-related proceedings, of applying a discount to the value of shares in closely held corporations because of these assets' lack of liquidity. We looked at the leading New York case on the issue, Friedman v. Beway Realty Corp., 87 NY2d 161 (1995), in which the Court of Appeals instructed a lower court to determine the appropriate discount for unmarketability of the petitioner's shares and a recalculate their fair value when applying that discount “to the proportionate net asset value” of the petitioner's stockholdings.

However, not all of our courts have applied the discount in the same manner. The Appellate Division, Second Department, has interpreted Friedman in a more restrictive way than was suggested by the Court of Appeals. Is the Second Department's interpretation the correct one?

In the Second Department

Despite this clear mandate from the state's highest court, the Second Department appears to have adopted a narrower application of the lack of marketability discount, one that is at odds with Friedman and the fundamental nature of stock ownership. In two cases, the Second Department held that the discount should only be applied against the value of a corporation's good will.

In Cinque v. Largo Enterprises of Suffolk County Inc., 212 AD2d 608 (2d Dept. 1995), the panel reviewed the trial court's calculation of the petitioner's interest in Largo Enterprises of Suffolk County Inc. From the court's decision, it appears that Largo's sole assets were shares in another corporation, 133-135 Main Street Realty Corporation, which owned income-producing property. The court held, in unmistakable conflict with Friedman, that the judicial hearing officer properly refused to discount the value of petitioner's shares in Largo Enterprises due to their lack of marketability since “[s]uch a discount should only be applied to the portion of the value of the corporation that is attributable to goodwill. Here, the value of the corporation is attributable solely to real property and cash” (citation omitted). Cinque, 212 AD2d at 609-10. Unfortunately, the Second Department made no effort to distinguish Cinque from the Court of Appeals' decision in Friedman.

A Similar Case

Similarly, in Whalen v. Whalen's Moving & Storage Co. Inc., 234 AD2d 552, 554 (2d Dept. 1996), the Second Department determined that the Supreme Court should not have discounted the value of the corporation for lack of marketability of the shares. Citing Cinque as support for its conclusion, the court held that “[s]uch a discount should only be applied to the portion of the value of the corporation that is attributable to goodwill.” The Second Department's analysis appears to be premised upon the notion that there is always a market for tangible items, such as real estate, but there is no corresponding market for goodwill. See Hall v. King, 177 Misc.2d 126, 134 (NY Sup Ct. 1998), aff'd, 265 AD2d 244 (1st Dept. 1999). Therefore, tangible assets, unlike intangible ones, do not need to be discounted for a lack of marketability.

Stock Ownership

While this reasoning has a certain superficial appeal, it is based upon a fundamentally incorrect view of stock ownership. A shareholder in a privately held corporation, or any corporation for that matter, does not have an ownership interest in any of the corporate assets. One's ownership of a corporation, and the corporation's ownership of its assets, require separate valuation analysis. The assets owned by the corporation are distinct from its shares. (See Sealy v. Clifton LLC, 68 AD3d 846, 846 (2d Dept. 2009), holding that a member in an LLC does not have standing in his individual capacity to seek partition of property owned by the LLC.)

So for example, in the corporate dissolution setting where the corporation elects to purchase the petitioner's interest to avoid dissolution, title to the corporate assets will always remain in the name of the corporation. Title does not change to reflect the departure of the petitioner in the same way title to real property would change to reflect the sale of a joint tenant's interest.

Lessons from Lis Pendens Cases

The distinction between stock ownership and ownership of the corporation's asset, such as real estate, is highlighted in the line of cases addressing the propriety of a lis pendens.

The case of 5303 Realty Corp. v. O&Y Equity Corp. involved a transaction related to a sale of stock in a corporation that happened to own realty. The propriety of the plaintiff's lis pendens was at issue. The Court of Appeals stated as follows: “It is well settled that the property interests of a shareholder and the corporation are distinct. '[T]he corporation in respect of corporate property and rights is entirely distinct from the stockholders who are the ultimate or equitable owners of its assets ' even complete ownership of capital stock does not operate to transfer the title to corporate property and ' ownership of capital stock is by no means identical with or equivalent to ownership of corporate property.' To allow plaintiff here to have its notice of pendency would run counter to the Brock rule and muddle an otherwise clear concept.” 5303 Realty Corp. v. O&Y, 64 NY2d 313, 323 (1984) (alterations in original), quoting Brock v. Poor, 216 NY 387 (1915).

Because of this clear distinction, courts have not permitted a plaintiff to file a lis pendens where the primary transaction is related to the sale of stock in a corporation that owned real estate. Actions relating to the sale of stock involve personal property, not title to real estate. See Id; Chambi v. Navarro, Vives & Cia, Ltd., 95 AD2d 667 (1st Dept. 1983); Whittemore v. De Pasquale, 8 AD2d 793 (1st Dept.), app den, 9 AD2d 616 (1st Dept 1959).

The Second Department's refusal to apply the lack of marketability discount to tangible assets because a market always exists for those assets ignores the distinction between ownership of the corporation and ownership of its assets, and ignores the fact that stock ownership does not carry with it ownership of the corporation's assets. The Second Department's enunciation of the law incorrectly views the corporate shareholder as possessing an interest in the corporation's assets.

Shareholder valuation proceedings, whether under BCL ' 1118 or ' 623, involve the transfer of personal property, i.e., corporate stock. In Friedman, the Court of Appeals properly focused on the value of the shares rather than the value of the corporation's real estate holdings. In doing so, the court upheld the trial court's rejection of the petitioner's calculation of fair value that simply applied the petitioner's percentage interest to the aggregate value of the corporations' real estate holdings. Friedman, 87 NY2d at 165. The court held that this methodology incorrectly viewed the shareholders as joint tenants in the real property rather than corporate shareholders. Id.

The Friedman court adhered to its earlier decision in 5303 Realty Corp., holding that a shareholder does not have an ownership interest in the corporation's property. All the shareholder has is a stock certificate. Once the analysis is directed at the correct asset being valued, the shares, it is clear that the lack of marketability discount must be applied to the net asset value.

In Hall v. King, a decision extremely critical of the Second Department's holdings in Cinque and Whalen, Justice Stephen G. Crane applied the lack of marketability discount to the net asset value of all assets, tangible and intangible alike. Hall v. King, 177 Misc2d at 134. Correctly focusing on the corporate shares, Justice Crane held that the lack of marketability discount reflects the “'risk associated with illiquidity of the shares,'” not any of the corporation's assets. Id. Justice Crane's decision in Hall was upheld by the First Department, creating a conflict between the First and Second Departments.

Higher Guidance Needed

It is clear that the Court of Appeals needs to take a case dealing with the correct application of the marketability discount in order to resolve the differences of opinion, settle New York law on this topic and permit divorcing parties and others to know how these assets should be valued. When it does, the court should rely upon its prior decisions in Friedman and 5303 Realty and focus its analysis on the corporation's shares, not the assets owned. Viewed in the proper light, it is clear that the lack of marketability discount must be applied against the shares of all closely held corporations, regardless of the assets that the corporation owns, because there is no readily available market over which shares in those companies may be sold to others and converted to cash.

Douglas A. Cooper is a senior partner in the litigation department at Ruskin Moscou Faltischek in Uniondale and also serves as the firm's co-managing partner. Matthew F. Didora is an associate in the litigation department. This is a slightly modified version of an article that first appeared in the New York Law Journal, an ALM sister publication of this newsletter.

In last month's issue, we discussed the necessity, in divorce cases as well as in various business-related proceedings, of applying a discount to the value of shares in closely held corporations because of these assets' lack of liquidity. We looked at the leading New York case on the issue, Friedman v. Beway Realty Corp. , 87 NY2d 161 (1995), in which the Court of Appeals instructed a lower court to determine the appropriate discount for unmarketability of the petitioner's shares and a recalculate their fair value when applying that discount “to the proportionate net asset value” of the petitioner's stockholdings.

However, not all of our courts have applied the discount in the same manner. The Appellate Division, Second Department, has interpreted Friedman in a more restrictive way than was suggested by the Court of Appeals. Is the Second Department's interpretation the correct one?

In the Second Department

Despite this clear mandate from the state's highest court, the Second Department appears to have adopted a narrower application of the lack of marketability discount, one that is at odds with Friedman and the fundamental nature of stock ownership. In two cases, the Second Department held that the discount should only be applied against the value of a corporation's good will.

In Cinque v. Largo Enterprises of Suffolk County Inc. , 212 AD2d 608 (2d Dept. 1995), the panel reviewed the trial court's calculation of the petitioner's interest in Largo Enterprises of Suffolk County Inc. From the court's decision, it appears that Largo's sole assets were shares in another corporation, 133-135 Main Street Realty Corporation, which owned income-producing property. The court held, in unmistakable conflict with Friedman, that the judicial hearing officer properly refused to discount the value of petitioner's shares in Largo Enterprises due to their lack of marketability since “[s]uch a discount should only be applied to the portion of the value of the corporation that is attributable to goodwill. Here, the value of the corporation is attributable solely to real property and cash” (citation omitted). Cinque, 212 AD2d at 609-10. Unfortunately, the Second Department made no effort to distinguish Cinque from the Court of Appeals' decision in Friedman.

A Similar Case

Similarly, in Whalen v. Whalen ' s Moving & Storage Co. Inc. , 234 AD2d 552, 554 (2d Dept. 1996), the Second Department determined that the Supreme Court should not have discounted the value of the corporation for lack of marketability of the shares. Citing Cinque as support for its conclusion, the court held that “[s]uch a discount should only be applied to the portion of the value of the corporation that is attributable to goodwill.” The Second Department's analysis appears to be premised upon the notion that there is always a market for tangible items, such as real estate, but there is no corresponding market for goodwill. See Hall v. King , 177 Misc.2d 126, 134 (NY Sup Ct. 1998), aff'd, 265 AD2d 244 (1st Dept. 1999). Therefore, tangible assets, unlike intangible ones, do not need to be discounted for a lack of marketability.

Stock Ownership

While this reasoning has a certain superficial appeal, it is based upon a fundamentally incorrect view of stock ownership. A shareholder in a privately held corporation, or any corporation for that matter, does not have an ownership interest in any of the corporate assets. One's ownership of a corporation, and the corporation's ownership of its assets, require separate valuation analysis. The assets owned by the corporation are distinct from its shares. ( See Sealy v. Clifton LLC , 68 AD3d 846, 846 (2d Dept. 2009), holding that a member in an LLC does not have standing in his individual capacity to seek partition of property owned by the LLC.)

So for example, in the corporate dissolution setting where the corporation elects to purchase the petitioner's interest to avoid dissolution, title to the corporate assets will always remain in the name of the corporation. Title does not change to reflect the departure of the petitioner in the same way title to real property would change to reflect the sale of a joint tenant's interest.

Lessons from Lis Pendens Cases

The distinction between stock ownership and ownership of the corporation's asset, such as real estate, is highlighted in the line of cases addressing the propriety of a lis pendens.

The case of 5303 Realty Corp. v. O&Y Equity Corp. involved a transaction related to a sale of stock in a corporation that happened to own realty. The propriety of the plaintiff's lis pendens was at issue. The Court of Appeals stated as follows: “It is well settled that the property interests of a shareholder and the corporation are distinct. '[T]he corporation in respect of corporate property and rights is entirely distinct from the stockholders who are the ultimate or equitable owners of its assets ' even complete ownership of capital stock does not operate to transfer the title to corporate property and ' ownership of capital stock is by no means identical with or equivalent to ownership of corporate property.' To allow plaintiff here to have its notice of pendency would run counter to the Brock rule and muddle an otherwise clear concept.” 5303 Realty Corp. v. O&Y , 64 NY2d 313, 323 (1984) (alterations in original), quoting Brock v. Poor , 216 NY 387 (1915).

Because of this clear distinction, courts have not permitted a plaintiff to file a lis pendens where the primary transaction is related to the sale of stock in a corporation that owned real estate. Actions relating to the sale of stock involve personal property, not title to real estate. See Id; Chambi v. Navarro, Vives & Cia, Ltd. , 95 AD2d 667 (1st Dept. 1983); Whittemore v. De Pasquale , 8 AD2d 793 (1st Dept.), app den, 9 AD2d 616 (1st Dept 1959).

The Second Department's refusal to apply the lack of marketability discount to tangible assets because a market always exists for those assets ignores the distinction between ownership of the corporation and ownership of its assets, and ignores the fact that stock ownership does not carry with it ownership of the corporation's assets. The Second Department's enunciation of the law incorrectly views the corporate shareholder as possessing an interest in the corporation's assets.

Shareholder valuation proceedings, whether under BCL ' 1118 or ' 623, involve the transfer of personal property, i.e., corporate stock. In Friedman, the Court of Appeals properly focused on the value of the shares rather than the value of the corporation's real estate holdings. In doing so, the court upheld the trial court's rejection of the petitioner's calculation of fair value that simply applied the petitioner's percentage interest to the aggregate value of the corporations' real estate holdings. Friedman, 87 NY2d at 165. The court held that this methodology incorrectly viewed the shareholders as joint tenants in the real property rather than corporate shareholders. Id.

The Friedman court adhered to its earlier decision in 5303 Realty Corp., holding that a shareholder does not have an ownership interest in the corporation's property. All the shareholder has is a stock certificate. Once the analysis is directed at the correct asset being valued, the shares, it is clear that the lack of marketability discount must be applied to the net asset value.

In Hall v. King, a decision extremely critical of the Second Department's holdings in Cinque and Whalen, Justice Stephen G. Crane applied the lack of marketability discount to the net asset value of all assets, tangible and intangible alike. Hall v. King , 177 Misc2d at 134. Correctly focusing on the corporate shares, Justice Crane held that the lack of marketability discount reflects the “'risk associated with illiquidity of the shares,'” not any of the corporation's assets. Id. Justice Crane's decision in Hall was upheld by the First Department, creating a conflict between the First and Second Departments.

Higher Guidance Needed

It is clear that the Court of Appeals needs to take a case dealing with the correct application of the marketability discount in order to resolve the differences of opinion, settle New York law on this topic and permit divorcing parties and others to know how these assets should be valued. When it does, the court should rely upon its prior decisions in Friedman and 5303 Realty and focus its analysis on the corporation's shares, not the assets owned. Viewed in the proper light, it is clear that the lack of marketability discount must be applied against the shares of all closely held corporations, regardless of the assets that the corporation owns, because there is no readily available market over which shares in those companies may be sold to others and converted to cash.

Douglas A. Cooper is a senior partner in the litigation department at Ruskin Moscou Faltischek in Uniondale and also serves as the firm's co-managing partner. Matthew F. Didora is an associate in the litigation department. This is a slightly modified version of an article that first appeared in the New York Law Journal, an ALM sister publication of this newsletter.