Tuesday, November 22, 2011

Valuation of a Member’s Interest in an LLC Upon Dissociation

Valuation of a Member’s Interest in an LLC Upon Dissociation
            Last Friday, the Court of Appeals, in Eddy Creek Marina Resort, LLC v. Tabor, No. 2009-CA-001608-MR, 2011 WL 5599533 (Ky. App. Nov. 18, 2011) (Not to be Published), addressed the mechanism by which the interest of a resigning LLC member should be valued. 
        Tabor was a 10% member in Eddy Creek Marina Resort, LLC.  The Court of Appeals implied, but never stated expressly, that the operating agreement afforded a member the right to withdraw from the company; in my review of the agreement I can locate no such provision.  The briefs make clear that Tabor, by some undetailed mechanism, was forced out of the company.  The Court of Appeals' opinion recites that operating agreement provided that “the dissociated member … shall be entitled to receive the fair value of the Member’s Company interest as of the date of dissociation based upon the Member’s right to share in the distributions of the Company.”  Id. at *1 (more on this point below).  The operating agreement did not, however, either define fair value or set forth the mechanism by which fair value of a dissociated member’s interest would be calculated. 

         At a bench trial, experts presented estimates of the “fair market value” of the company as ranging from $3 million to over $5 million.  Mortgages on the company assets existed in the amount of approximately $2.3 million, and Tabor testified that he was liable for a potion of that debt.  The trial court determined a company FMV of $4 million and then applied a 10% marketability discount and a 10% minority discount.  The $4 million FMV determination did not, however, incorporate the $2.3 million of debt.  Ultimately, the court concluded that Tabor’s 10% in the company was worth $324,000.  Eddy Creek appealed from the trial court’s failure to subtract the $2.3 million in debt from the $4 million FMV in determining the value of Tabor’s interest.
            The Court of Appeals held that not incorporating the LLC’s debt in the determination of company value was an error and remanded the case for further fact-finding and presumably the calculation of the adjusted amount to Tabor.
            IMHO, while the outcome of this decision is entirely correct, the basis for the ruling was, at minimum, suspicious.  The court relied upon KRS § 275.205, the default rule for the allocation “of profits and losses amongst the members of an LLC.”  The court failed to recognize that, under the principles of partnership taxation, the sharing of profits and losses is an issue of allocation (i.e., who bears tax liability for the activities of the LLC) while it is distributions by which the members receive the net profits.  An allocation, which will give rise to a tax liability to an individual member, may not be accompanied by a distribution.  Further, assuming satisfaction of the substantial economic effect test of the Internal Revenue Code, it is possible to have differing allocations of profits and losses amongst the members.  In this instance, relying upon a provision addressing tax allocations likely did no harm, it being assumed that special allocations were not in issue in this LLC, but that will oftentimes not be the case.  The court’s decision would have been stronger if they had relied upon general principles of business valuation under which the company’s debt would have to be determined in valuing the ownership interest of a member.  Many such authorities were cited to it in the briefs presented.
            There exists as well a pair of issues that, even if not issues in this case, will be relevant in the future.
            With respect to the company debt, even as the value of Tabor’s interest in the LLC is calculated net of the debt, is he, in connection with the redemption, being released thereon?  As noted by the court:
Tabor testified that he was a signatory to the mortgage and thus liable for his portion of the debt.  It would be a waste of time and resources to give Tabor the full amount he seeks for his minority interest and then later require payment of his portion of the debt.  In the interest of judicial economy, we will make no such requirement.  Id. at *2.
The value of his interest in the company will be reduced, presumably on a dollar-for-dollar basis, to account for the outstanding balance on the mortgage as of the date of the redemption.  What will be the outcome if Tabor is not released on the mortgage and the obligation goes into default?  If he ever has to satisfy the mortgage, he will, in effect, have paid that debt twice. 
           With respect to the 10% minority interest discount and the 10% marketability discount applied by the trial court, there is a question as to whether doing so was appropriate.  Minority and marketability discounts are typically applied in determining “fair market value.”  In contrast, these discounts are not applied in determining “fair value,” and the Court of Appeals stated that the Eddy Creek operating agreement called for a payment of “fair value.”  See also Shawnee Telecom v. Brown, 2011 WL 5248307 (Ky. 2011) (rejecting, in the context of a dissenter rights statute and its directive that a dissenting shareholder receive the “fair value” of their shares, the application of discounts at the owner level).  While Tabor's Brief to the Court of Appeals accepted the application of these discounts (see p. 2), in another case on similar facts such an acceptance might not be appropriate. This may, however, be a problem of the Court of Appeals simply substituting "fair value" for "fair market value"; both briefs speak in terms of "fair market value."
            It bears noting that the facts of this case are markedly different from those in the Chapman decision.  Chapman v. Regional Radiology Associates, PLLC, 2011 Ky. App. LEXIS 251 (Ky. App. Mar. 25, 2011).  In this instance, as described byt he Court of Appeals, there was a written operating agreement providing, inter alia, that upon resignation a member would be entitled to a valuation of their interest in the company and redemption at that price.  Chapman, in contrast, involved an LLC that did not have a separate written operating agreement providing for a right of redemption. 

         As for the Court of Appeals' statement that “the dissociated member … shall be entitled to receive the fair value of the Member’s Company interest as of the date of dissociation based upon the Member’s right to share in the distributions of the Company.”, it is a verbatim recitation of part of KRS 275.215 as adopted in 1994, which language was repealed in 1998 

            Practice Pointer – Terms like “fair value” do not have objectively defined meanings.  An operating agreement that calls for redemption at “fair value,” without further defining what is meant by “fair value” and defining the mechanism by which that amount will be determined, simply invites further (and typically expensive) litigation.

No comments:

Post a Comment