The Importance of Carefully Defining What is Being Valued

The Importance of Carefully Defining What is Being Valued

      I am currently working on updating a publication of the American Bar Association addressing buy-sale agreements. In the course of that work I stumbled upon a 2018 bankruptcy decision that stands for an important rule, namely that it is crucial to define what is being appraised in determining a buyout value. In re Stebnitz (Dubis v. Daniel J. Stebnitz and Gary C. Stebnitz), 586 B.R. 289 (Bankr. E.D. Wis. 2018). 

      Daniel J. Stebnitz, the debtor in bankruptcy, was a one-third member in an LLC along with his two brothers David and Gary. That LLC, Spirit Valley Camp, LLC, was governed by a written operating agreement signed by each of Daniel, David and Gary. The opinion suggests, but does not state explicitly, that the property held by the LLC was a vacation home. As such it did not generate income. The operating agreement provided for per stirpes descent of the membership interests amongst the three family groups and is well addressed voluntary withdrawal from the LLC (¶ 20.B), providing: 

If a Membership Group wishes to withdraw from the LLC, it shall give the remaining Membership Groups written notice. The remaining Membership Groups shall purchase said departing Membership Group interest within 120 days of receipt of such notice. The purchase price shall be one-third (1/3) [of] a formal appraisal, obtained and paid for by the departing Membership Group. If the remaining Membership Groups object to said appraisal, they have the option of requiring a second appraisal, at the departing Membership Group’s cost. If an agreement cannot be reached, the Membership Groups shall obtain a third appraisal, at the cost of the departing Membership Group and the purchase price shall be the average of the three. If the departing Membership Group fails to obtain and/or pay for the appraisal, that Membership Group shall be considered in default. 586 B.R. at 293.

The opinion noted that the agreement did not define the term “appraisal.” Id. 

      After an adversary proceeding in which the trustee recovered to the estate Daniel’s interest in the LLC after he had transferred it pre-bankruptcy filing, the trustee gave notice of his intent to withdraw from the LLC, requiring the redemption of Daniel’s interest for $80,000. That notice included an appraisal valuing the LLC’s property at $240,000. Well within the 120 day period for closing on the put option, David and Gary’s attorney returned to the trustee a valuation of a one-third interest in the LLC. After utilizing a 15% discount for lack of control and a 20% discount for lack of marketability, valued Daniel’s interest in the LLC at $40,800. That amount was further reduced for a variety of expenses, yielding a final offer price of $25,000. 586 B.R. at 293-94. It does not appear that the third appraisal provided for in ¶ 20.B. of the operating agreement was ever sought. Rather, the trustee brought this adversary proceeding and requested summary judgment, arguing that “the [operating] Agreement’s plain language requires a formal appraisal of the Property, not a valuation of the LLC.” As the court would further note, “The problem with Paragraph 20.B is that it requires a ‘formal appraisal’ but does not specify what is to be appraised.” 

      The court would accept the trustee’s argument that the appraisal should be of the LLC’s property in part because the LLC, beyond holding the property, did not have a “business purpose” evidenced by, for example, renting the property or regularly buying and selling other parcels of property for profit. Ergo, the court would conclude that the “appraisal” provided for in ¶ 20.B of the operating agreement should be of the underlying asset, that being the real property. As such, the court granted the trustee summary judgment on its claim that the judgment debtor’s interest in the LLC should be redeemed by the other members for $80,000. 

      For myself, I find this decision entirely unsatisfactory. The court ignored the fact that the debtor did not have any ownership interest in the property. Rather, he held a one-third interest in the LLC. Ownership of an LLC does not convey to the member any ownership interest in the LLC’s property. This point was not, however, even in passing, acknowledged in the decision.

Further, in justifying its decision, the court wrote: 

The defendants do not offer a reasonable interpretation of the contract provision to counter the Trustee’s reading. As noted above, the Agreement shows an intent to keep the LLC (and the Property) in the family, with interests equally apportioned between the families of the defendants and the debtor. The Agreement describes this as an intent “to provide for the transition to future generations [of the initial members] without diluting their respective ownership percentages” and instructs that the Agreement “shall be interpreted with this goal in mind.” This goal is apparent in the transfer of a member’s interest to only tow other categories of individuals: (1) the member’s designated beneficiaries; and (2) the other membership groups.

Given this stated intention, it is unreasonable to read the buy-out price of “one-third (1/3) a formal appraisal” to mean instead a valuation of an individual one-third share in the LLC that factors in deductions or discounts for “lack of control” or “lack of marketability,” as the defendants propose. The purpose of the buy-out provision in Paragraph 20.B is to allow the remaining membership groups to retain their investment positions in the family-owned property, and to allow the existing member to recapture his investment, in shares proportionate to the value of the LLC’s assets-currently, the Property. Applying any kind of discount for lack of control or similar considerations is inconsistent with the Agreement’s stated purposes, and would allow the remaining membership groups to purchase one-third of the LLC’s assets for less than one-third their appraised value, reaping a windfall at the expense of the existing family member. A discount for lack of marketability is likewise inappropriate when the Agreement obligates the remaining membership groups to purchase the existing member’s interest. In sum, the defendants’ reading of the contract is unreasonable, and therefore does not render the contractual provision ambiguous. 586 B.R. at 296-97 (citations to record and footnote omitted).

      Except that happens all the time. Again, the debtor held only a minority interest in the LLC itself. He had no control over the LLC’s property; as recited in the opinion, ordinary course transactions require the approval of two-thirds of the members, with extraordinary transactions requiring unanimous approval. Rather, the application of discounts for lack of control and marketability are common in the valuation methodologies employed in operating agreements and are to be expected in the event of a voluntary withdrawal from a venture. A point made by the court, namely that minority and lack of control discounts are not permitted in corporate dissenter rights actions may be true, but is also irrelevant. The facts of this case were a voluntary withdrawal from the LLC, not a compulsory of redemption as is the case in a dissenter rights action.

      Again, the only thing the debtor in bankruptcy could sell was an interest in the LLC, and the agreement should have specified that the appraisal would be of that intangible. The operating agreement’s failure to be specific as to that point allowed this decision to turn out as it did.