A Proposed Standard for Valuing Closely Held Corporations in Divorce
By Member, Frank A. Louis, Esq.
“Before you can value a company, you must know the purposes for which you need the valuation. Different purposes will provide differing values and different valuation methods”. Paul B. Barren, When You Buy Or Sell A Company, rev. ed. (Meriden, CT: The Center For Business Information, Inc. 1983) pp. 8-9, cited in Pratt Valuing Small Businesses And Professional Practices. Shannon P. Pratt, Robert F. Reilly, Robert P. Schweihs (McGraw Hill) (1998, 3rd ed.) p 52
“We further recognize that valuation principles that are appropriate for appraisal actions are not necessarily useful in other contexts such as valuation of stock for tax and equitable distribution purposes. Lawson Mardon Wheaton, Inc. v. Smith, 160 N.J. 383, 399 (1999).
INTRODUCTION
Traditionally, the Symposium has been a laboratory for the advancement of new legal theories which are then tested in the cauldron of intellectual debate, discussion and critical analysis. Many initiatives advanced have been ultimately incorporated in our law or Rule Amendments. It is against this historical backdrop that I propose a Standard to value a closely held business subject to equitable distribution under N.J.S.A. 2A:34-23.1. I believe Fair Market Value, a standard predicated on a sale, is incorrect and potentially subverts the policies underpinning our Equitable Distribution Statute. Any standard should be consistent with the policy underpinning the Equitable Distribution statute and assure that the end result is not only fair to both parties, but solidly grounded in economically realistic facts. Utilizing a standard that is directly contrary to the facts of a particular case is poor law and poor policy. Selection of a standard is not only an implementation of policy, but the wrong standard has the potential to undermine the important systemic goal that participants in a Justice System believe they are treated fairly. Using hypotheticals predicated on sales that are not occurring and which have little or nothing to do with the facts of a case to determine the substantial financial obligations arising from marriage inevitably lead to disrespect of the law. This, in turn, undermines the integrity of our system and contributes to non-compliance. Principles which govern marital obligations in divorce must not only be fair, but must be perceived to be fair – and logically linked to the reality of the parties’ lives. People may disagree with the end result, but nevertheless it is important they respect the process. Justice Brandeis, in his landmark Law Review Article, “The Living Law”, made this precise point:
“When Montenegro was admitted to the family of nations, its Prince concluded that, like other civilized countries, it must have a Code Of Law. Bogigish’s fame had reached Montenegro – for Ragusa is but a few miles distant. So the Prince begged the Czar of Russia to have the learned jurist prepare a Code for Montenegro. The Czar granted the request; the Bogigish undertook the task. But instead of utilizing his great knowledge of laws to draft a Code, he proceeded to Montenegro, and for two years literally made his home with the people, studying everywhere their customs, their practices, their needs, their beliefs, their points of view. Then he embodied in law the life which the Montenegrins
lived. They respected that law; because it expressed the will of the people”. (emphasis added)
Louis, Brandeis: The Living Law (Illinois Law Review) Volume X (February 1916) Number 7.
Thus, selection of the correct standard is important on multiple levels yet selection of a standard should not be done in a vacuum. As Shannon Pratt observed in his classic treatise Valuing Small Businesses and Professional Practices, a ’Standard Of Value’ is the definition of the type of value being sought”. Pratt at 38. (Pratt, Reilly and Schweihs) McGraw-Hill (3rd ed. 1998). The “type of value” may well change given the purpose of the appraisal. Fair Market Value is not the “type” of value that should be applicable in a divorce when addressing a closely held business that will continue to operate.
The desirability of having a uniform Standard Of Value is self-evident. This is an issue in virtually every case where an interest in a closely held business is being valued. The systemic interest of applying the same rules in valuing assets will assist settlement and normalize the judicial analysis. It is astonishing after forty years of Equitable Distribution history disputes still exist on a foundational aspect of our practice: the standard for valuing closely held business assets under N.J.S.A. 2A:34-23.1. Elimination of disputes on such a fundamental issue can only benefit the system and the individuals getting divorced; it will have the beneficial impact of reducing fees, advancing settlements, afford uniformity and, in the final analysis, provide a more accurate standard to implement the public policy embodied by our divorce statutes.
As Jay Fishman, (“Fishman”) perhaps our foremost evaluator and theorist noted: “a clear understanding of the assumptions in the Standard Of Value used in estimating the value of a closely held business in connection with a marital dissolution matter is critical to the appraisal process”. Fishman and O’Rourke: Value: More Than A Superficial Understanding Is Required – Journal Of The American Academy Of Matrimonial Lawyers (Vol. 15) (1998) at p. 315. This article’s goal is to propose a new standard that will be fair, economically realistic and which will implement the policies in N.J.S.A. 2A:34-23.1 – and eliminate the uncertainty in our law that unfortunately presently exists.
That a new standard is needed because of the lack of clarity as well as confusion that presently exists as revealed by an excerpt from a trial in which I was cross-examining Jay Fishman who perceptively noted the problem.
Question: And Fair Value in New Jersey, does it assume the business will continue to be operated in the manner in which it had been?
Answer: It’s ambiguous.
Question: The term is ambiguous.
Answer: As it applies to New Jersey matrimonial cases. It ranges from it being Fair Market Value without regard to discounts because in reality the business is not being sold. That is one end of the spectrum. The other end is its Investment Value or Intrinsic Value that is value to the holder because it is not being sold. (emphasis added)
The two ends of the spectrum are vastly disparate and highlight the problem. One involved value predicated on a sale, but without discounts, while at the other end it is value calculated as if the entity was not being sold. Let us never forget one central fact: the business is not being sold and basing our analysis of the value of a closely held entity on a falsehood is simply wrong when there is a viable other option.
A significant problem is the “spectrum” is not a continuum. The two positions involve analysis which takes place in two vastly different factual scenarios. Fair Value does not allow “Discounts” because the property isn’t actually being sold, but if only Discounts are eliminated the remainder of the analysis remains to be done under Fair Market Value – predicated on a willing buyer and a willing seller (Fair Value = Fair Market Value – Discounts). What Fishman refers to as Investment or Extrinsic Value (and what I call Equitable Distribution or Divorce Value) captures the value to the business owner in the future without considering a sale – which is precisely what is happening. The Giants and the Yankees are both long established New York sports teams, yet what they do is fundamentally different. Both Value To The Holder, which assumes no sales and Fair Value, which assumes a sale, may be on the same spectrum, but applying the two disparate standards to the same facts may well result in different results.
Fishman, in his testimony, was clearly correct; the law in New Jersey is uncertain or ambiguous as to the standard to be utilized – and the differences are vast. People who are divorcing need clarity – not uncertainty or ambiguity. Judges need to know what is the standard – so do lawyers and litigants. Settlement is more difficult when lawyers and accountants cannot even agree on what the law is; the facts are difficult enough. This ambiguity is unfair to the litigants and harmful to the system. People’s lives should not turn on ambiguities.
The Proposed Standard
While courts have repeatedly addressed the public policy underpinning our Equitable Distribution statutes, surprisingly there has never been a clear and definitive discussion of whether the Standard Of Valuing actually implements that policy. Nor, interestingly, did the Legislature ever provide direction when it enacted, and thereafter amended, our Equitable Distribution Statute. N.J.S.A. 2A:34-23.1 does not contain a Valuation Standard. By default, the determination of the Valuation Standard has been left to the courts. Yet, the Supreme Court, which addresses policy, has never adopted or even commented upon whether Fair Market Value is the correct standard. This article will address the historical evolution of the existing Standard, the policy underpinning Equitable Distribution and why there should be a linkage between that policy and any standard while simultaneously proposing a new standard to provide clarity, certainty and economic realism to our law. The proposed standard is straight forward and firmly rooted not only in the facts of the particular case but in fairness and importantly what the statute itself intended to achieve. The proposed standard is:
IN VALUING A CLOSELY HELD ENTITY FOR DISTRIBUTION UNDER NJSA 2A:34-23.1, THE NON-TITLED SPOUSE SHOULD BE COMPENSATED FOR THE ECONOMIC BENEFITS THE TITLED SPOUSE WILL RECEIVE IN THE FUTURE.
This is not a new concept. It was the subject of an earlier Article for the 2006 Symposium entitled “Equitable Distribution Value”. Family Law Symposium (2006, pg. 169). Even in 2006, the need for an appropriate valuation standard was not a novel idea. Barry Sziklay, a well known valuation expert respected both in New Jersey and nationally, prepared an Article for the Family Advocate, a publication of the American Bar Association in which he proposed, as long ago as 2003, Divorce Value, as the appropriate standard. Gary R. Trugman, another New Jersey expert, for years argued Fair Market Value was inappropriate, suggesting instead Divorce Value be utilized. In May, 2004 Alan S. Zipp at the AICPA Conference in Las Vegas similarly recommended a “Divorce Standard” for valuing a business. His Article is also attached. (Ex. A) Zipp, along with all of the other critics of Fair Market Value, proposed measuring the value of the business “to its present owners, and hence to the marital community and not in terms of the value to a willing buyer”. Zipp at S1-15. Zipp reasoned, as I do, the correct standard should be linked to the actual facts – not a hypothetical sale which has nothing to do with the case before a Court.
Zipp’s standards are excerpted below and mirror my definition:
1. The value of the business interest shall be determined using customary and current valuation concepts and techniques generally employed for similar businesses.
2. The business interest shall be valued at its intrinsic worth to its present owners, and not at its value to an outside hypothetical willing buyer.
3. The business shall be valued as a going concern.
4. If the interest being appraised is less than the entire business the value of the interest shall be determined as
considered appropriate by the appraiser either as:
(a) A pro rata share of the enterprise value; or
(b) The present value of the expected future benefits from the interest.
5. Absent extraordinary circumstances, the value of the interest being appraised shall be determined without discounting for Lack of Marketability or for Minority Status. ¹
(emphasis added)
If the Appellate Division in Brown v. Brown, 348 N.J. Super. 466 477 (App. Div. 2002) noted “careful analysis on a case by case basis is required with sensitivity and adjustments for particular circumstances”, (emphasis added) why not have a Standard which requires such an analysis be governed by the “particular circumstances” – not hypothetical unrelated to the circumstances. Only by deciding cases on the facts presented (as Brown suggested and actually did) will the law satisfy Justice Pashman, who sagaciously noted a legal standard would “abysmally” fail if the approach was based on the “allure of legal niceties incomprehensible to the public” as opposed to the test of “common sense” based on the “realities of the commercial and consumer world”. Vornado Inc. v. Hyland, 77 N.J. 347, 365 (1978). While Vornado was not a Family Part case his wisdom accurately made the point and did so in terms everyone should understand. Common sense, like a Judge’s robe, should accompany them to the bench.
EQUITABLE DISTRIBUTION POLICY
The theory of Equitable Distribution was clearly enunciated by Judge Mountain in Rothman v. Rothman, 65 N.J. 219, (1974), wherein he stated:
The public policy select to be served is at least two-fold. Here after, future financial support for a divorced wife has been available only by grant of alimony. Such support has always been inherently precarious. It ceases upon the
death of the former husband and will cease or falter upon his experiencing financial misfortune disabling him from continuing his regular payments. This may result in serious misfortune to the wife and in some cases will compel her to become a public charge. An allocation of property to the wife at the time of the divorce is at least some protection against such an eventuality. In the second place, the enactment seeks to right what many have felt to be a grave wrong. It gives a recognition to the essential supportive role played by the wife in the home, acknowledging that as a homemaker, wife and mother she should clearly be entitled to a share of family assets accumulated during the marriage. Thus, the division of property upon a divorce is responsive to the concept that marriage is a shared enterprise, a joint undertaking, that in many ways it is akin to a partnership. Only if it is clearly understood that far more than
economic factors are involved, will the result in distribution be equitable within the true intent and meaning of the statute. (emphasis added)
Thus, Equitable Distribution is a policy driven statutory scheme dividing assets on equitable principals arising from a view marriage is a “joint enterprise” which is akin to a partnership”. It was a rejection of the former practice of dividing property based on tracing title, Tucker v. Tucker, 121 N.J. Super. 539, 545 (Ch. Div. 1972). This clear policy was emphasized by the 1988 amendment creating a rebuttable presumption “each party made a substantial financial or non-financial contribution to the acquisition of income and property while the party was married”. N.J.S.A. 2A:34-23.1.
In Gibbons v. Gibbons, 174 N.J. Super. 107, 114 (App. Div. 1980), another case highlighting the policy the Appellate Division stated:
“The function of Equitable Distribution is to recognize that when the marriage ends each of the spouses based on the
totality of the contribution made to it, has a stake in and a right to a share of the family assets accumulated
while it endured, not because that share is needed but because those assets represent the capital product of what was essentially a partnership entity.” Id. at 114.
WHERE FAIR MARKET VALUE CAME FROM
The first pronouncement on the statute by the Supreme Court was in Rothman vs. Rothman, 65 N.J. 219 (1974) where a three step Equitable Distribution process was proposed. Rothman at 232. The Court, (using outdated sexist language) noted in the second step “he (the trial court) must determine an asset’s value “for purposes of such distribution”. The Court never addressed what it meant by “value” or a standard by which it would be calculated. Fair Market Value may have been assumed, but it was never discussed; that the subject of the appeal in Rothman. Nor did the Supreme Court in Rothman, or in the remainder of the Painter trilogy, discuss policy and valuation – except to select the filing date as the Valuation Date. That selection was done for systemic management reasons – not because it implemented the policy of the statute. In fact, the impact of using Fair Market Value on the policy of Equitable Distribution has never truly been considered in any reported case – let alone our Supreme Court. It has simply been accepted over the years without critical comment.
It is surprising that in 2012 an article is being written questioning adherence to Fair Market Value when a unanimous Supreme Court in 1975 observed that the “customary” result to “market value” might no longer be utilized and that “some other method of determining worth must be employed”. Yet, we continued to use Fair Market Value for over thirty-five years. As the Supreme Court said in Stern:
“Placing a precise or even an approximately accurate value upon an interest in a professional partnership, when the partner whose interest in question intends to continue as a member of the firm is no easy matter. Circumstances
preclude our customary resort to market value. Some other method of determining worth must be employed”.
Stern v Stern, 66 N.J. 340, 345 (1975).
The Fair Market Value standard seemingly emanated from Lavene vs. Lavene, 162 N.J. Super. 187, 192 (Ch.Div.1978), on remand from 148 N.J. Super. 267 (App. Div. 1977), where the Court comprehensively reviewed the methodology utilized in determining the “Fair Market Value” of an asset. The Court assumed a hypothetical buyer and seller, the traditional method by which Fair Market Value had always been established. The Court noted:
“The valuation of the stock of a closely held corporation calls for an attempt to fix a Fair Market Value for the stock – that is, the price at which the property would change hands between a willing Buyer and a willing Seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having a reasonable knowledge of the relevant facts. It is assumed that the hypothetical Buyer and Seller are able, as well as willing, to trade and to be informed about the property and the market for such property.” Lavene, 162 N.J. Super. at 192-193. (emphasis added)
This definition is virtually the same as the definition of Fair Market Value in Revenue Ruling 59-60 (Ex. B) which, notably, deals with death not divorce. It is virtually the same as the definition used by the American Society Of Appraisers (ASA). Yet, the court did no analysis; it simply assumed Fair Market Value was the correct standard. It was an impermissible “Net Opinion” by the Appellate Division.
Yet, a careful review of Rev. Ruling 59-60, by its literal language undercuts its use as a Standard. The Revenue Ruling also provided for the following:
01. A determination of Fair Market Value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases. Often, an appraiser will find wide differences of opinion as to the Fair Market Value of a
particular stock. In resolving such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”
In an interesting observation, the Revenue Ruling indicates that Fair Market Value is “a question of fact” that will “depend upon the circumstances in each case” which is precisely my point – it depends on the facts or the economic reality of the case. The Revenue Ruling then suggested for there to be a “sound” valuation, it must be based not only upon “all the relevant facts but the elements of common sense and informed judgment and reasonableness”. All of this suggests using a Revenue Ruling for a divorce case predicated on death ignores the “relevant facts”, has none of the “elements of common sense” and does not reflect use of “informed judgment”.
Lavene acknowledged that determining the Fair Market Value of an interest in a closely held corporation “always presented difficulties”; Lavene at 193, and determined that Revenue Ruling 59-60 set forth an “approach, method and factors” which were “equally applicable here” Lavene at 193. In selecting Fair Market Value, the court did not review the statute or any policy considerations; nor did it explain why Revenue Ruling 59-60 dealing with death was “equally applicable” to divorce or why a definition for Fair Market Value taken from the Estate Tax Regulations was so readily accepted as the divorce standard.
Neither Lavene, nor any subsequent case, discussed what should have been perhaps the first question asked – does it make sense as our divorce standard? The unfortunate observation of comparing death and divorce has created innumerable problems and fundamental unfairness for over a quarter of a century. The most obvious distinction, which is directly linked to the policy implicit in N.J.S.A. 2A:34-23.1, is that in divorce, the business which is not being sold will continue to be operated by the titled spouse. Clearly when the title owner passes away, he or she is no longer operating the business. This distinction seemingly was lost on the Appellate Division in Lavene. It is particularly problematical in valuing a professional or personal service business where the continuation of the owner in the business is what creates the value. For some reason, that obvious distinction has never been factored into the analysis of whether Fair Market Value is or should be the appropriate standard; it was rationalized by assuming the sale was hypothetical.
In the seminal days of Equitable Distribution, using an existing Revenue Ruling seemed reasonable. After all, the asset had to be valued and using Fair Market Value seemed to be a reasonable approach. Yet, why have we as lawyers, let alone our Courts, blindly accepted a statement equating death and divorce? How can they possibly be “equally applicable”. What statutory equitable distribution policy is advanced by equating the two? What public policy reflecting marriage as a partnership is served by treating the asset as being sold when it is not? It is self-evident in death the business owner is no longer present to operate the enterprise. In contrast, divorce does not necessarily change the operation of a business – or the value to the owner – a point emphasized in Brown. See Brown at 489. The Supreme Court in Dugan made the same point when it observed that “After divorce, the law practice will continue to benefit from that goodwill as it had during the marriage”. Dugan v. Dugan, 92 N.J. 423, 434 (1983). Yet, for over thirty years we have equated death and divorce, or as someone might sarcastically note, operated as if we were in Alice In Wonderland with up being down, black being white, being accepted as valid truisms.
Lavene properly rejected an approach to Book Value primarily because it was inconsistent with not only basic economic theory in determining value while also being inconsistent with the purposes of equitable distribution. The analysis was done primarily from an economic – not a divorce standpoint:
“Close corporations cannot be realistically evaluated by a simplistic approach which is based solely on book value, which fails to deal with the realities of the good will concept, which does not consider the investment value of a business in terms of actual profit and which does not deal with the question of discounting the value of minority interest.” Lavene, 148 N.J. Super. at 275. (emphasis added)
That the “reality” of good will mandated an approach other than Book Value suggested the Court wanted the valuation to be economically realistic; since good will had value and the business owner would continue to enjoy the benefit of the good will the non-titled spouse was entitled to fair compensation for the benefits the owner was continuing to receive. That the owner continued in the business was, in the language of Rev. Ruling 68-609, the “relevant fact”. Basing an opinion on what actually would occur seemingly would be a valuation based on the “relevant facts” and on “common sense”.
Why didn’t the “reality” of a divorce suggest using a standard linked to the facts that a divorce was occurring? Inevitably, and without question, other courts followed the Lavene approach. Fair Market Value, almost without questioning by courts, lawyers, or commentators was accepted and utilized. By virtue of inertia, not analysis, Fair Market Value now becomes the standard. Yet, is it consistent with the Legislative purpose in equitably distributing assets in a divorce context? Certainly, it is not difficult to point out the differences between divorce and death; yet, that is the precise standard our courts now apply.
What is the logic or fairness of utilizing a methodology that might be appropriate in the market place in a different context but was never analyzed to see if it was consistent with the legislative policy and purposes in sharing assets when people divorce? What is troubling about Fair Market Value in the divorce context is that it permits lawyers and experts, quite properly within the framework of that methodology, to raise questions that are perfectly permissible, logical and air but may be irrelevant or of minimal importance in a divorce. For instance, Lavene referred to a “Minority Discount”.
There are other discounts: “Lack Of Marketability”, “Key Man”, all of which have legitimate support in the literature, tax law cases and Revenue Ruling 59-60 itself. They generally result in a reduction in value because they logically consider what a willing buyer would pay. But what do they have to do with a divorce if there is no buyer and no sale?
POLICY V. ACCOUNTING METHODOLOGY:
HOW THE CONFLICT HAS BEEN RESOLVED
It is useful to examine the instances where Courts have addressed the conflict between accounting principles and the public policy relating to matrimonial cases. Both legislatively and judicially, government has recognized that abstract, but nonetheless, legitimate market based accounting principles, must nevertheless give way when they conflict with implementing the broader divorce related policy considerations. That should be the case here as well.
When assets are sold, a taxable event occurs creating a liability for payment of capital gains taxes by the selling party. Yet, that broad based principle was not applied to divorces. Rather, the policy determination was made it is inappropriate to tax people who are selling assets to each other Aincident to a divorce@. To implement this societal determination that people should not be taxed when they divide their assets in a divorce, Section 1041 of the Internal Revenue Code was adopted. That provision provides that sales, denominated as Atransfers@, between spouses are not taxable events so long as they are Aincident to a divorce@. This emphasized the principle that as long as the sale or transfer between spouses was “related to the cessation” of the marriage, public policy considerations preclude treating such transactions as taxable events. Thus, if a transaction between former spouses occurs, even if it is the byproduct of a divorce, but nonetheless was not “related to the cessation of the marriage” the safe harbor provisions of Section 1041 do not apply. Certain time limits were established which were quite liberal to distinguish between transactions “related to the cessation of the marriage” or merely which might occur between former spouses. If the transfer occurs within six years and is provided for in the divorce instrument, it is presumed to be “related to the cessation of the marriage”. See TEMP. TREAS.REG. SECTION 1.1041-1T; Q/A 7. If the transfer is more than six years after the divorce, it is presumed not to be related to the cessation of the marriage.²
This policy determination was implemented in the Deficit Reduction Act of 1984 where Congress overruled the 1962 decision in United States v. Davis, 370 U.S. 64 (1962). Davis held a transfer of property from one spouse to another incident to a divorce required recognition of gain or loss. By enacting Section 1041, Congress made it clear for tax purposes, no gain or loss will be recognized by the parties when there was a transfer of properties Aincident to a divorce@. The policy determination to provide spouses special treatment is also exemplified by gift law, which is philosophically related to the Section 1041 transfers; in each instance spouses may make unlimited gifts to each other without gift tax consequences. Even children are not treated so liberally since parental gifts are subject to gift tax rules. Only spouses have the unrestricted freedom to gift as they please. That determination flows from the status of marriage as a fundamental societal institution which policy considerations mandate marital transactions be treated differently than commercial contracts.
Another illustration of divorce law trumping accounting principles was the provision in the regulations relating to Section 71 of the Internal Revenue Code (AIRC@) permitting parties to designate otherwise taxable income, i.e. alimony, as non-taxable income. As with divorce related property transfers, the determination was made that in transactions involving spouses, there was no public policy reason to have a bright line rule that all alimony must be deductible by the payor and includable in the recipient=s income. This distinction is particularly significant; it emphasizes that divorce related transactions have traditionally been treated differently than other accounting transactions. For example, even if a person was an employee of a charitable organization, e.g. Mother Theresa, regardless of the societal benefits of the employer, the employee must report their salary as part of their gross taxable income. Only if people marry do they have the right to designate income as tax free income. See Reg. 1.71(T) Q8. A related, but different, area is child support income. It is an obvious policy determination to designate that child support payments have no tax consequence.
In fact, the alimony deduction itself is yet another example of policy dictating law. Until 1942 alimony was neither taxable to the recipient nor deductible by the payor. Gould v. Gould, 245 U.S. 151 (1917). In that year to relieve the financial hardship imposed on the payor of paying alimony with after-tax income Congress amended the Revenue Act to provide for deductibility. This provision was ultimately embodied in IRC Sec. 71 (215). Policy, and the fairness it reflected, dictated the result.
Marriage and what it means to our society, coupled with simple concepts of fairness, have always trumped accounting principles developed for use in a commercial setting. Yet, another example involves theoretical taxes. According to the American Institute of Certified Public Accountants (AAICPA@) accountants are required to treat theoretical taxes in a certain fashion on personal financial statements. Audited financial statements must include provisions providing for theoretical taxes as a liability. From an accounting standpoint, the logic is clear and compelling; as a potential liability, accountants are required, in applying Generally Accepted Accounting Principles, to reflect the theoretical tax.
Yet, Orgler analyzed the issue from the standpoint of policy not accounting, thus highlighting the salutary approach taken by courts. Orgler v. Orgler, 237 N.J. Super. 342 (App. Div. 1989) Confronted with the conflict between unambiguous accounting principles and the policy reflected by Equitable Distribution, the Court declined to follow the AICPA ruling. Orgler was a triumph of policy driven statutory construction over accounting principles; it reaffirmed the principle that if reality and Equitable Distribution policy was the standard, equity, if not a sound dose of common sense, eant the AICPA mandated subtraction of theoretical costs from value when the asset was not being sold made no sense.
Brown reached the same conclusion as did the Appellate Division in both Orgler and Wadlow. Wadlow v. Wadlow, 200 N.J. Super. 372 (App. Div. 1985). (A real estate commission not being incurred is not to be deducted from the calculation of gross distributable proceeds).
Another example of the disparate treatment between matrimonial and accounting law are rules governing the Passive/Active dichotomy. For tax purposes, unless a taxpayer is engaged in the Atrade or business@ of owning and investing in real estate, (See IRC 469(C)(7)) the investment is deemed passive. As a consequence of it’s passive treatment, losses generated are not available to the taxpayer for use in the year they are incurred unless they are offset by similar gains. Yet, in matrimonial law, the legal consequences of a real estate asset being passive and active is different; they are bottomed upon disparate public policy considerations. The IRS’s concern was to minimize deductibility and increase tax collections; the divorce related concern is to fairly compensate the non-titled spouse for appreciation caused by the active efforts of the party which created the value during the marriage. Given that goal, it was immaterial whether the titled owner was engaged in the Atrade or business@ of real estate or simply had one piece of property purchased for investment. It is yet another example of policy determining the legal standards to be applied.
Similarly, there is a substantial difference when addressing issues of depreciation. For tax purposes, a commercial real estate investment property, for example, may have it’s book value decreased because the owners utilize depreciation, which reduces the book value. Yet, in a divorce case, where the goal is to fairly compensate spouses who acquire assets during a marriage, the depreciated value is not binding; rather, it is the actual value. Thus, the same asset may for tax purposes have it=s value decreased; yet, for marital purposes, it’s value increases, once again linking the policy implicit in N.J.S.A. 2A:34-23.1 with a result directly contrary to the result achieved when applying strict accounting principles.
Yet, another example is the treatment of cash flow. In applying strict accounting principles, monies paid under an Accumulated Adjustment Account in a Sub-Chapter S Corporation (the AAA Account) or repayment of an Officer Loan would have no effect on taxable income; it would nonetheless be highly relevant in a matrimonial setting. Once again, the conflict between accounting principles where the cash flow effectively does not exist since it is not reported as taxable income, and the matrimonial setting where not only does it exist but must be considered by the Court, is patent. It is a reflection of the differing public policy considerations involved mandating different results.
THE DIFFERENT STANDARDS OF VALUE
There are a number of different types of Value whose meaning can change depending upon the context in which the term is used. Jay Fishman’s articles printed in Financial Valuation: Business and Business Interest, Ed. James H. Zukin (1990) Sec. 2.1(2). There is, of course, Fair Market Value which Fishman, in a fairly traditional definition, explained was:
“The amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts”.
In their excellent book, Standards Of Value: Theory And Applications, Jay Fishman, Shannon Pratt and William Morrison make a salient point about Fair Market Value by doing the unusual – looking at the exact words. They point out that by inclusion of the word “Market”, this is almost by definition a standard predicated on the value an asset would have in a market – whether that market was real or hypothetical. It is predicated on what accountants characterize as “Value In Exchange” or what we commonly refer to as a sale. Fair Market Value by definition and use assumes the asset is being sold. This precept illustrates my fundamental disagreement with Fair Market Value as our Standard since it is predicated upon a set of facts not occurring.
Shannon Pratt also identified various Standards Of Value that could be utilized in a divorce. He first listed Fair Market Value as defined by Revenue Ruling 59-60. A second was Investment Value (sometimes also referred to as Intrinsic Value) which he characterized as similar to Value To The Holder or the Standard proposed in this article. Pratt characterized Investment Value as: “the value of a small business (or business interests) or a professional practice to a specific owner”. Unlike the Fair Market Value Standard, this standard considers (1) the specific owner’s expectation of rates; (2) the potential synergy associated with ownership of the subject business; and (3) the specific earnings and expectations resulting from the specific ownership. “Unless a sale is imminent, an assumption as to a hypothetical sale is irrelevant (unlike fair market value, where there always is the assumption of a sale.” Shannon Pratt and Alina V. Niculita, “The Standard of Value Is Critical in the Valuation of a Business in Divorce”, Family Lawyer Magazine, October 25, 2011. As Pratt describes it, this approach more accurately reflects economic reality. It is consistent with the Standard proposed here; it attempts to capture the value of the enterprise to the owner, as opposed to the value of the enterprise to a hypothetical buyer, in a sale which is not occurring. Pratt, Valuing Small Businesses and Professional Practices, Third Edition, pg. 41.
Fishman, even more so than Pratt, accurately explained “Intrinsic or Investment Value” believing the best way to understand this type of value is appreciate that it is the Value As A Going Concern to a particular owner without consideration of a sale. If you capture the value to the owner, then the court’s role would be to calculate how that value – received in the future – would fairly be allocated to the owner’s spouse in the present. Capturing and calculating the value to the owner after a divorce is philosophically and jurisprudentially consistent with determining how to fairly compensate the non-titled spouse for the asset both spouses created during their marriage – and which the titled spouse will continue to receive. To illustrate, Fishman drew an analogy between Stock Options or Professional Licenses – neither of which can necessarily be transferred and thus have no value in exchange, but nevertheless have substantial Intrinsic Value to the holder. Fishman at 320. He perceptively understood the value was not realized by a sale – but by the precise opposite – the continued use of the asset by the owner. The transfer or sale does not create value – it is the ongoing use that measures value, and that is precisely what happens in most divorces which is why our law should use that as our standard.
FAIR VALUE
Fair value is not an appraisal term and was introduced into our practice by Brown v. Brown, 348 N.J. Super. 466, 484-486 (App. Div. 2002). It is established legislatively or judicially and to implement a specific policy. As used in Oppression and Dissenter’s Rights cases, it is not explicitly defined as is Fair Market value – It has been defined by the American Bar Association’s Model Corporate Business Act and later the revised Model Corporate Business Act, and by the American Law Institute’s Principles of Corporate Governance (“ALI”). The most recent definition of the revised Model Corporate Business Act in 1999 essentially states that there will be no discounts for minority status, no discount for lack of marketability (absent an extraordinary circumstance) and that the valuation will be performed using customary and current valuation concepts and techniques employed for similar businesses.
Pratt observes that Fair Value is “an excellent example of ambiguous terminology” noting that to understand what the expression truly means, you must understand the context of its use. In most states, as Pratt observes, Fair Value is the statutory valuation standard. In New Jersey, Fair Value is in actuality a statutory term utilized initially under N.J.S.A. 14A:11 and the term N.J.S.A. 14A:12 was explained in Balsamides v. Protameen Chemicals, 116 N.J. 352, 374 (1999). Until 1968 and the adoption of the New Jersey Business Corporation Act (N.J.S.A. 14A:1-1 et. seq.) dissenting shareholders in appraisal actions were to be paid “full market value”; however, that was changed. As both Balsamides and Lawson Mardon Wheaton, Inc. v. Smith, 160 N.J. 383 (1999) indicate, Fair Value is not synonymous with Fair Market Value. The general distinction is whether or not discounts (Marketability and/or Minority) are to be utilized – and the use of discounts is governed by whether the discount furthers or subverts the statutory policy sought to be implemented. That is, of course, the basic premise of this article – policy dictates the Standard.
Today, it is common practice for appraisers in divorces to reference Fair Value as the standard to be utilized because of an extensive discussion by Judge Wecker in Brown, where she discussed Lawson and Balsamides. What is critical to understand is that in Brown the issue was not as broadly phrased as it is in this article. Rather, it was a limited issue but one, nevertheless, with broader implications albeit not discussed since it wasn’t necessary for the decision. In rejecting Marketability Discounts, (the issue in the case) Brown referred to Lawson and Balsamides and other corporate cases in New Jersey and in Delaware. Whether the reference to Fair Value in Brown was dicta, or central to the holding nonetheless, it has been interpreted as establishing Fair Value as the standard. Most experts, based on Brown, today say Fair Value equals Fair Market Value but without a Marketability Discount. Fishman, however, who is particularly perceptive, more accurately captured the issue as evidenced by his testimony referenced earlier. Is it Value In Exchange (a sale) or Value To The Holder (as proposed herein).
Since the primary issue in Brown was the issue of discounts, the absence of the broader discussion was appropriate. Brown clearly stands for a simple salutary principle: when a Standard for appraisals conflicts with statutory policy – policy must triumph. Since the business in Brown was not being sold there was no policy justification for reducing the distributable value for a discount which only involved a sale (Marketability Discount). The facts and policy dictated the result.
THE HYPOTHETICAL
The following hypothetical provides a framework for analysis of the issue presented. Assume there is a professional practice consisting of three partners, two of whom are getting divorced simultaneously. The practice is a C Corporation and each shareholder owns one-third of the outstanding shares. The parties’ accountants have agreed the total valuation of the Practice is $900,000.00. Dr. Hymerling, who is 55 years old, however, earns $300,000.00 because he started the practice. He always earned more because of that fact, yet each doctor more or less generates the same annual revenues for the practice. Dr. Sobel, who is 40 years old, earns $100,000.00 annually. The other doctor, Dr. DeBartolo, earns $100,000.00.
The experts agree Reasonable Compensation for each of the doctors is the same – $100,000 annually. Since this is my hypothetical, and to prove a point, assume the doctors – Sobel and DeBartolo – are truly appreciative of Dr. Hymerling, both professionally and personally, for what he has done for them, however unlikely that may be in the real world. Thus, there is no reasonable likelihood they will seek to readjust his salary downward to reflect his Reasonable Compensation. Loyalty, albeit an outdated concept, in this particular practice exists. Therefore, going forward the financial arrangements will continue as they have historically – and disproportionately.
The Partnership does not have a Buy/Sell Agreement. Applying Fair Market Value methodology, (which assumes a sale) one-third of $900,000.00 would equal $300,000.00, i.e. if the Practice were sold each doctor would receive $300,000 ($900,000 divided by 3 = $300,000). Should $300,000 be the value for distribution under N.J.S.A. 2A:34-23.1 for both Dr. Sobel and Dr. Hymerling? If the standard is Equitable Distribution Value, defined as the economic benefits Dr. Hymerling will continue to enjoy after the divorce, would those greater annual benefits (300,000 v. 100,000) translate to a higher value under N.J.S.A. 2A:34-23.1. Thus, the issue is whether the values should be the same since they each own the same percentage or should Dr. Hymerling’s interest be valued at a greater amount because the economic benefits he receives (and will continue to receive) are three times what Dr. Sobel and Dr. DeBartolo will receive? Phrased otherwise, why should Mrs. Sobel and Mrs. Hymerling receive the same distributable share, if the benefits their husbands will receive in the future are disproportionate?
If you change the facts the fairness of the proposed standard is even clearer. If Dr. Hymerling practiced by himself and is not 55 but 40, should that not affect the result? He would thus receive the benefits of his compensation above what is deemed reasonable for a longer period of time – shouldn’t that impact the amount his wife receives?
SHOULD FAIR MARKET VALUE, WHICH ASSUMES A SALE, BE THE STANDARD APPLIED WHEN DETERMINING THE VALUE OF AN ASSET FOR DISTRIBUTION UNDER N.J.S.A. 2A:34-23.1.
Equitable Distribution is a statutory creation the Legislature has reviewed twice – once in its initial formulation and again in 1988 when the statute was amended. Each time the Legislature declined to determine how an asset subject to distribution is to be valued. In 1988, the second time the Legislature reviewed the topic, the statute was amended to include factors. The statute required courts to “consider” the recently enacted itemized factors “in making an equitable distribution of property”. These factors have been interpreted to be “Distribution” factors unrelated to establishing asset value; rather, they affect the percentage the non-titled spouse is to receive. Thus, the Legislature did not adopt Fair Market Value; in fact, legislatively it has never been adopted, sanctioned or even mentioned as the appropriate valuation standard. The only reference to value is in factor K of 2A:34-23.1 where Courts were directed to consider the “present value” of an asset in effectuating a distribution. That was not and could not be a Valuation Standard for two reasons: (1) Value is not defined; (2) the “present value” is the value of the asset at trial – not the sanctioned valuation date which is the filing date. This factor was simply a recognition that a party’s assets (and their value) could bear on the fairness of a distribution, i.e. the percentage received by the non-titled spouse.
Fair Market Value has judicially been created, and without a great deal of reflection, from an economic or policy standpoint, of its impact. It seemed, in retrospect, a perfectly logical and fair method to value an asset; it was, after all, the way assets traditionally had been valued. Yet, sometimes the simple answer is just too simple – particularly when the selection was unaccompanied by detailed analysis – or even thought whether Fair Market Value was the optimum standard to value. No one asked is Fair Market Value the correct standard to implement the policy of N.J.S.A. 2A:34-23.1. More specifically, is it appropriate in a divorce to value an asset as if it is being sold when it is not being sold or, in contrast, valuing the asset in the hands of the owner who would continue to operate the business.
Brown touched on the issue but never went beyond eliminating Marketability Discounts. Judge Wecker recognized divorce did not affect the economic benefits the husband was receiving; therefore, applying a Marketability Discount was patently unfair since there was no economic nexus between the reduction in value caused by the difficulty in selling an asset which, in reality, was not being sold. A Marketability Discount is the adjustment made for the difficulty in selling an asset. Brown at 483. As she noted:
“While there is no ready market for the shares and consequently no Fair Market Value of Florist, James’s shares in the going concern have value to him and to his co-owners that does not depend upon a theoretical sale to an outsider and has not changed as a result of the divorce complaint or judgment”.
Brown at 489. (emphasis added)
One may read Brown as rejecting Fair Market Value as a Standard because of Judge’s Wecker’s belief it was inappropriate to determine distributable value in a divorce case because the asset was not being sold but most do not read it that broadly. Certainly, that was the standard she used and as she noted, unlike cases under Title XIV (The New Jersey Business Corporation Act) there was “no actual transfer of shares” “involved in this equitable distribution case. Since there was no contemplated sale in the foreseeable future, a Marketability Discount should not be used. Brown at 489. Yet, she did not say – and “I also meant by the way” any other aspect of Fair Market Value that has nothing to do with a sale also should not apply. It is inferred – but not said. Thus, many experts in New Jersey believe Brown should be read to be interpreted as suggesting that distributable value should be determined not as if the asset were being sold, relying on Brown, but as an attempt to calculate the value to the particular owner. In other words, value is determined not by a value in exchange, i.e. a sale, but what is the asset worth to the individual. However, many read Brown narrowly – it is Fair Market Value but only without a Discount for Marketability – and some incorrectly believe – Minority Discounts – as well. Hence, the problem.
THE EXISTING LAW CONCERNING BUY SELL AGREEMENTS IS CONSISTENT WITH THE PREMISE THAT VALUATION OF A CLOSELY HELD CORPORATION SHOULD BE DETERMINED BY ACTUAL ECONOMIC REALITY AND NOT HYPOTHETICAL FACTS UNRELATED TO THE CASE.
Whenever one proposes a change in how legal issues are to be determined, it is useful to see, in addition to examining whether the proposal is consistent with policy, but how the law has been applied in similar areas. Is the proposed change logically consistent with existing law or at variance thereof. In many closely held corporations, owners enter into Buy-Sell Agreements which govern their rights, duties and obligations. Yet, practically speaking, in many cases that Agreement – absent a likely triggering event is not conclusive.
In Bowen v. Bowen, 96 N.J. 36 (1984) the Supreme Court was confronted with the difficulty in valuing a spouse’s minority interest in a closely held corporation. The specific issue in Bowen was whether a Court, faced with that difficulty in determining value, would direct the shareholder retain ownership but award the spouse an equitable interest therein, which would be accompanied with all the associated issues of entanglement going forward. The Supreme Court, quite properly, held that when confronted with difficult valuation questions, the Court must nonetheless decide the issue and not leave divorcing spouses in an ongoing commercial partnership when their personal partnership was unsuccessful.
In reaching the conclusion, the Supreme Court made certain observations pertinent to my proposal. Importantly, Justice O’Hern observed the Buy-Sell Agreement in Bowen should not control value “because it did not contemplate the circumstances when the Husband’s status with the corporation and his fellow stockholders would remain the same”. He rejected granting the Buy Sell Agreement conclusive effect because it failed to “recognize the realities of the present situation: the shareholder will not sell the stock and, one hopes, will not die”. In other words, the Buy Sell Agreement had little or nothing to do with the factual or economic reality of the case and the owner will continue to experience the benefits of being a 22% shareholder and employee – which is precisely the premise of my entire approach. Since virtually all Buy-Sell Agreements between partners expressly do not consider good will, (and most are not regularly updated) and since good will is a distributable asset, Stern’s approach is effectively negated by the single inevitable concession, easily obtained in any case, that good will was not contemplated by the Agreement; therefore, the formula utilized was not “reflective of true value” and thus not binding.
The language in Bowen was consistent with earlier language of the Supreme Court in Stern v. Stern, 66 N.J. 340 347 (1975) where the Supreme Court found that a partnership agreement might be established to some presumptive validity. The Supreme Court noted:
“Once it is established that the books of the firm are well kept and that the value of the partners’ interest are in fact periodically and carefully reviewed, then the presumption to which we have referred should be subject to effective attack only upon the submission of clear and convincing proofs”.
Given the absence of a sale, the Court rejected the Buy-Sell Agreement, at least in part, because there was not going to be a transfer contemplated by the Agreement. Put differently, both Justice O’Hern in Bowen, and Judge Wecker in Brown, recognized the distinction between basing value on a set of hypothetical facts that were not going to occur, as contrasted with the economic reality of the business owner continuing to operate their enterprise. They each chose to base their decision on the facts of the case before them – hardly an unrealistic or unfair approach.
In each instance, the Supreme Court and the Appellate Division chose to base their decision on the existing economic reality. Since there was not to be a sale occurring, or implementation of a Buy-Sell Agreement, it would not be determinative. What would control their decision was the actual reality of what would happen to this business in the hands of the owner. As Judge Wecker correctly observed, the divorce would not affect Mr. Brown in the operation of the business. As Justice O’Hern observed, Mr. Bowen would continue to experience the benefits of being a 22% shareholder and an employee.
That there is symmetry between the existing law and the proposal is important and helps provide the analytical framework for selection of a standard of value. Our Courts must only be concerned about the reality of what is occurring in cases before them, as opposed to attempting to establish values based on someone dying (Revenue Ruling 59-60), a business being sold (Fair Market Value) or an implementation of a Buy-Sell (Bowen)³ – none of which are occurring.
In evaluating the usefulness of utilizing a Buy/Sell Agreement in a divorce case, one must recognize why such Agreements are prepared. Aside from establishing a mechanism to resolve potential disputes with a withdrawing partner, a Buy/Sell Agreement has, at least in part, a goal to enhance the value of the entity by creating a disincentive for the withdrawing owner. This is true because generally such Agreements do not include all elements of value, such as good will or any other intangible aspects and therefore they generally reflect a lower value. That lower value creates a disincentive to leave. Thus, its very purpose is not necessarily to capture the economic benefits the spouse will continue to receive, or even the Fair Market Value of the spouse’s interest at any particular point in time.
PROBLEMS FAIR MARKET VALUE CREATES
One of the inherent problems in Fair Market Value is that a sale or Value In Exchange presupposes all underlying assumptions built into the definition of Fair Market Value remain viable which means the remainder of the analysis is done assuming a hypothetical sale. While New Jersey has already carved out certain exceptions to Fair Market Value, such as Marketability Discounts (Brown v. Brown) and latent tax consequences, (Orgler v. Orgler) because they are inconsistent with divorce policy all other attributes of a Fair Market Value sale arguably still apply until some Court holds they do not – or a Court adds the one sentence Brown omitted. There are so many aspects to Fair Market Value that contradict divorce policy. Instead of having a policy that is linked to divorce policy we face years of litigation on multiple issues continuing to carve out exceptions as we have done, for example, with Marketability Discounts. Why not utilize the correct policy as opposed to revising Fair Market Value on a case by case basis to fit. A round peg is better for a round hole as opposed to trying to cut a square peg to fit. I will identify multiple conflicts between Fair Market Value and the policy in divorce.
THE QUANDARY OF FAIR MARKET VALUE: KNOWN OR KNOWABLE
One of the more interesting aspects of the Lavene definition, which is inextricably linked with the willing buyer and a willing seller, (Fair Market Value) is the factual predicate that “both parties having a reasonable knowledge of the relevant facts”. Revenue Ruling 59-60: Section 2 (.02) This aspect of Fair Market Value has enormous significance in our practice since an application of Fair Market Value as the standard means neither the buyer nor the seller could be aware of any facts or circumstances that occurred after the valuation date, except if they were “known or knowable” as of the valuation date. The preceding example illustrates the problem. Fishman believes the standard seems to be what was “discernible and predictable at the valuation date”. Fishman: Whose Fair Market Value Is It Anyway” 41 Valuation 92 (June 1997). Therefore, changes in value were theoretically excluded as a matter of law if they occurred, for any reason, subsequent to the filing date of the Complaint and were neither known or knowable when the Complaint was filed. Yet, when you have a valuation date that by definition must be before settlement, and support is determined by cash flow, not as of the valuation date but at settlement or trial and Factor K in N.J.S.A. 2A:34-23.1 requires a Court consider present financial information, the very information Fair Market Value says you cannot consider is available to the parties and the courts – and must be considered. The Judge must look at present information for support and to evaluate Factor K for distribution but cannot consider the same information – unless it was known or knowable. Are these the rules we want when people divorce or do we want our judges to have both eyes open to all the evidence?
MANAGEMENT PROJECTIONS: HOW ARE THEY TREATED
One of the more interesting cases I had which emphasized the very issue this Article addresses concerned the issue of “Known Or Knowable”. It highlighted whether Fair Market Value should continue to be the Valuation Standard. The precise issue was the propriety of using management’s projections as a basis for establishing value. Many businesses, particularly those with substantial revenues, have future revenue projections prepared by Management. They are predicated on what management knows as of a certain date.
In my mediated matter, the non-titled spouse’s expert, quite reasonably, relied upon management’s revenue projections. Yet, because of the complexity of the case, substantial time passed from the valuation date to the mediation. Thus, the actual revenues were available and they were markedly lower than the projections. The Wife’s appraiser argued he was following the “rules” and formulated his opinion on the projections because that was what was the only reliable information that was “known or knowable” as of the valuation date. He argued the present revenues could not be considered since they were not “known or knowable” as of the valuation date – and that was, he contended, the rules he had to follow when using either Fair or Fair Market Value. Needless to say the business owner’s accountant, since we had the actual numbers, argued how could a distributive scheme be based on revenues that never were received but which materially enhanced value. He pleaded I could not “close” my eyes to the “real numbers”. He further argued the actual revenues were utilized for support since that analysis is done as of the present. Since there were two different cash flows I sarcastically asked whether I should only use one eye in my analysis. I noted if there was a valuation change caused by passive reasons – acknowledged by all to have taken place – but which was not known or knowable as of the valuation date, does everyone close both eyes? Importantly, what must not be forgotten is the economic reality involved – is it fair or appropriate policy to require a spouse to pay real dollars based on a cash flow everyone acknowledges does not exist? This is not a theoretical exercise; courts make judgments that affect people’s lives. The law must require such judgments be made on evidence – not a theory inconsistent with the actual facts.
Here, the conflict between Fair Market Value and the overriding Equitable Distribution policy of assuring the end result be fair, stood in stark contrast. We must never forget Justice Pashman’s observation in Kikkert v. Kikkert, 88 N.J. 4, 10 (1981) that “fairness after all, is the prime concern of equitable distribution” or the Appellate Division’s Comment of Goldman v. Goldman, 275 N.J. Super. 452, 457 (App. Div. 1994) that it is the ultimate “obligation” of a court to assure the distribution was “equitable to both parties”. It was my opinion then, as it is now, using the rigid formulaic approach required by Fair Market Value should not be followed when it conflicted with the most important goal in any divorce – achieving a fair and equitable result which is economically realistic. Using management’s projection because that was all that was “known or knowable” is yet another instance when Fair Market Value conflicts with the Equitable Distribution policy. As it did in Orgler and Brown, policy must triumph over strict appraisal methodology.
APPRAISERS AND POST FILING EVENTS
One of the major problems in developing a Standard Of Value are the requirements pursuant to which appraisers must complete their reports. There is understandable concern in the valuation community about liability. Thus, there is a direct conflict between the standards utilized and my view that an appraiser must be permitted to consider events that occurred post-filing.
There are at least two applicable standards for preparation of an expert report – each addresses events that occur after the valuation date. The Appraisal Standards Board of the Appraisal Foundation develops, interprets and amends U.S.P.A.P. Compliance with U.S.P.A.P. is required when the appraiser is obligated to comply (1) by law or regulation or (2) by agreement with a client.
USPAP provides professional valuation guidance regarding subsequent events for retrospective appraisals (appraisals in which the effective date of the appraisal is prior to the report date). According to USPAP:
“A retrospective appraisal is complicated by the fact that the appraiser already knows what occurred in the market after the effective date of the appraisal. Data subsequent to the effective date may be considered in developing a retrospective value as a confirmation of trends that would reasonably be considered by a buyer or seller as of that date. The appraiser should determine a logical cut-off because at some point distant from the effective date, the subsequent data will not reflect the relevant market. This is a difficult determination to make. Studying the market
conditions as of the date of the appraisal assists the appraiser in judging where he or she should make this cut-off. In the absence of evidence in the market that data subsequent to the effective date were consistent with and confirmed market expectations as of the effective date, the effective date should be used as the cut-off date for data considered by the appraiser”.
Based on USPAP, it is reasonable for a valuation analyst to consider data subsequent to the valuation date but only to confirm historical trends and market expectations as of the valuation date.
AICPA SSVS-1
AICPA members and other CPA’s are required to comply with SSVS-1 when they perform engagements to estimate value that culminate in the expression of a conclusion of value or a calculated value. SSVS-1 provides professional valuation guidance regarding subsequent events. According to SSVS-1:
“The valuation date is the specific date at which the valuation analyst estimates the value of the subject interest and concludes on his or her estimation of value. Generally, the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date. An event that could affect the value may occur subsequent to the valuation date; such an occurrence is referred to as a subsequent event. Subsequent events are indicative of conditions that were not known or knowable at the valuation date, including conditions that arose subsequent to the valuation date. The valuation would not be updated to reflect those events or conditions. Moreover, the valuation report would typically not include a discussion of those events or conditions because a valuation is performed as of a point in time – the valuation date – and the events described in this subparagraph, occurring subsequent to that date, are not relevant to the value determined as of that date. In situations in which a valuation is meaningful to the intended user beyond the valuation date, the events may be of such nature and significance as to warrant disclosure (at the option of the valuation analyst) in a separate section of the report in order to keep users informed (paragraphs 52(p), 71(r) and 74). Such disclosure should clearly indicate that information regarding the events is provided for information purposes only and does not affect the determination as of the specific valuation date.” Uniform Standards Of Professional Appraisal Practice, 2010-2011, Edition (Washington, D.C.: The Appraisal Foundation, 210) Statement On Appraisal Standards III, p. U-84. (emphasis added)
Based on SSVS-1, CPA valuation analysts are not required to disclose subsequent events. However, CPA valuation analysts may disclose subsequent events in a separate report section for informational purposes.
Both S.S.V.S.-1 and U.S.P.A.P. circumscribe and limit the use of subsequent events in determining the value as of an earlier date, which is the case in every Family Part case in New Jersey. The failure to address the concerns of the appraisers in developing a standard will only create problems. It will lead to inconsistent results while simultaneously creating conflicts between lawyers and their own experts. Only with a clear definitive statement of law that appraisers can rely upon in preparing their reports can this problem be eliminated. That clear statement would have to allow appraisers to consider post-filing events not to confirm their opinion, but on the substantive valuation issue itself. Then appraisers can say they are following the substantive law. At present we have no clear cut legal principle and known or knowable is a persistent problem.
The issue of whether a court should consider post-filing events in determining value is not only a legal and accounting question, but one that goes to the very essence of our practice. My view is simplistic; premised upon what I understand to be a foundational principle of Family Law: the end result must be fair. In deciding issues involving spousal relationships and children, injecting commercial law principles is simply incorrect. The underlying policy is different, the individuals involved are not the same and, in the Family Law matters, the over-riding public policy assuring the end result is fair is paramount. From a societal standpoint, dissolving a family is not the same as dissolving a business partnership. To achieve a fair result courts must keep their eyes open – not shut because of technical appraisal rules which directly contravene the need, in the language of Rev. Ruling 59-60, for the valuation to be based upon “all the relevant facts, but the elements of common sense, informed judgment, and reasonableness”.
Judges Carchman and Lihotz, two of our Appellate Division Judges with the most extensive experience in the Family Part, recently authored an unreported opinion that speaks to the philosophical issue whether Family Courts should consider all available information in their decision making. In Savini v. Triestman, decided July 15, 2010 (App. Div. A-3085-08T1), the issue was the propriety of a trial judge’s denial of a post-judgment motion seeking a declaration that a change in circumstance had occurred. The husband has filed one motion which was denied. That decision was affirmed by the Appellate Division. Thereafter, he filed a series of new motions which essentially mirrored the first set. However, in the second submission, he included information that had been available but was not included in his first application. When the second motion was denied the trial judge noted, among other reasons for the denial, that he had not considered the information that had been available previously but was not submitted.
When the Appellate Division affirmed the second denial, it observed “under the facts and circumstances presented in this particular case” the judges’ determination not to consider the information that could have been supplied was “a proper exercise of discretion and not error”. Savini at pg. 6 (slip opinion). Yet, in language that bears on a court closing its eyes to what was not “known or knowable” as of the valuation date, but nonetheless known to the parties, and the court, thereafter, Judges Carchman and Lihotz significantly observed:
“There are circumstances, however, where previously known facts and information, properly established and relevant to such issues as child support, are brought to the attention of the court and they should not, as a matter of law, be barred or disregarded. Family Part decisions, including support, must be equitable and just and ultimately, properly documented information should as a general rule be considered when brought to the Court’s attention”. (emphasis added) Savini at 6, slip opinion.
Thus, in language that mirrors the basic approach taken by this article, the Appellate Division has established a broadly based philosophical principle that Family decisions not only must be “equitable and just”, but it is the obligation of a court to consider “properly documented information”. Thus, information that arose subsequent to the valuation date that was neither “known or knowable”, but nonetheless is relevant on the issue of valuation and is “properly documented” must be considered. If it is the obligation of the court to consider this information what is the appraiser to do? Does Savini apply to equitable distribution? May an expert ignore the standards in his profession? We have these issues because we operate under an incorrect standard. Use the proposed standard and all these issues disappear.
Under Savini, this new information should be brought to the court’s attention, since to do anything other than that might lead to a result that was neither “just” or “equitable”. Simply put two of our most respected and experienced jurists make a simple, yet nonetheless critical point – in New Jersey, we want the right result and to reach that plateau the actual facts must be considered .4
By analogy, the Appellate Division also reached a similar conclusion almost a quarter century ago about filing late papers. In Tyler v. N.J. Auto. Full Ins., 228 N.J. Super. 463, 468 (App. Div. 1988) a non-matrimonial case where the principles, if anything, are stricter than in a Family case, the Appellate Division observed that:
“It is a mistaken exercise of judgment to close the courtroom doors to a litigant whose opposition papers are late but are in the court’s hands before the return date for the motion which determines the meritorious outcome of a consequential lawsuit”. (emphasis added)
Thus, there are two Appellate Division decisions emphasizing the importance that judicial determinations be made on the evidence presented. To suggest in a Family Part case that an evidence of consequence not be considered because it might violate a technical appraisal rule is not simply inconsistent with the law, it is poor policy and inevitably will create an unfair result. As attorneys, we have the obligation to do whatever we can to assure that the law is interpreted in such a way to promote justice – not injustice – and to assure that fairness – not unfairness – is achieved. Do not simply accept known or knowable as the law. Before Brown, Marketability discounts existed but now no longer have any legal viability in a divorce.
In further support of this position at an earlier Symposium, I argued that when there was a conflict between the substantive law and a matter of procedure, the substantive law had to prevail.5 The issue presented was when there was a conflict between what a temporary change in circumstance which rendered enforcement of a spousal support obligation unfair and inequitable, the court should and could not enforce an unfair Agreement or Order. Here, the choice is even clearer. When there is a conflict between the substantive obligation and responsibility of a court to render a judgment that is fair and equitable but which conflicts with an accounting procedural rule, the substantive obligation to assure fairness in a divorce case must triumph.
THE CASH SALE
There is a little known aspect of Fair Market Value which is essentially ignored in our practice but which is viable and problematical. According to the IRS, the definition of Fair Market Value assumes a cash sale with the full price being paid at the time of transfer. IRS Valuation Guide for Income Estate and Gift Tax Purposes, pp. 1-5 (1994) Commerce Clearing House, Inc. cited in Fishman at 317: (Footnote 5 & 6 Value: More Than A Superficial Understanding Is Required) (“The correct standard for valuation for our purposes is the amount the property would bring in a cash sale”). As Fishman goes on to note, this cash payment is:
“particularly relevant in the valuation of Smaller businesses because very often the buyer does not pay the full purchase price at closing but rather there is a payout over time and, at times, this payout is without interest. In addition, the payout may be contingent upon future events such as client retention”.
Yet, as Pratt observed, “most sales of small businesses and professional practices are consummated on terms other than cash” which is precisely the situation in very many divorce settlements. Pratt went on to note:
“The majority of small businesses and Professional practice sales include a cash down payment, typically 20 to 40 percent of what we will call the transaction value, with the balance on a contract to be paid over some period of time, usually a few years. The contracts for the balance of the transaction price are usually interest-bearing contracts, but the rate of interest is frequently below a market rate. In other words, third-party lenders would generally charge higher rates on loans that have comparable collateral and the same terms as those in the contract for the balance of a transaction price. Consequently, the Fair Market Values of such contracts in terms of cash or cash equivalents accepted as part of the consideration in a sale are usually less than their face values” (emphasis added)
If Fair Market Value contemplates such a cash sale, how does one reconcile Shannon Pratt’s observation that in defining Fair Market Value there is “general agreement that the definition applies that the parties have the ability as well as the willingness to buy or sell”. That ability is not always present and a payment over time implicates the terms. Glenn Desmond pointed out in his Handbook, On The Sales Of Businesses, “there is substantial evidence that the terms of sale of a small business have a significant impact on the price”. Glenn M. Desmond, Handbook Of Small Business Formulas And Rules Of Thumb, 2d. Ed. (Camden, ME; Valuation Press, 1993, p. 20). IRS Valuation Guide For Income And Estate And Gift Taxes – 58 (1994)
If the expert has used Fair market Value then he or she has presumably assumed a cash sale, but what are the consequences in where there isn’t an ability to pay the full price cash? In most cases there is not an ability to pay the full purchase price in cash. If there is financing, as Pratt & Desmond confirm, that directly affects value. Therefore, the expert has rendered a valuation opinion, that on the very facts of the case, is predicated upon a set of facts that does not exist.
If there is not a cash sale, the appraisers value is also arguably too high. Fishman made this same point in discussing Morris v. Comm. Of IRS, 761 F. 2d 1195 (6th Cir. 1985).
“The Tax Court case Morris v. Commission Internal Revenue 761 F.2d 1195, 56 A.F.T.R.2d 85-6485, 85-1 USTC P 13, 617 (6th Cir., 1985). addressed the issue of financing arrangements, opining that the effect of favorable or unfavorable
financing should be considered in the estimation of Fair Market Value. In this case the expert used comparable sales that were reflective of owner financing. Since owner financing was lower than third party financing the price reflected in the comparable sales was inflated. The court criticized the expert for not adjusting the multiples produced from the
comparable sales downward to reflect their overstatement due to owner financing.
In Fair Market Value, the interest rate utilized for any deferred payment, the security provided, the number of years over which the balance of the purchase price would be paid, therefore directly impact the value of the transaction. That is economic reality; a court arguably under Fair Market Value would have to consider each of these variables before concluding what the value was. Is any of this necessary – or needed? It certainly is not done. That may no longer be true after this Symposium as lawyers arguably have the obligation to raise these issues – injecting more uncertainty in an already uncertain practice.
Despite a cash payment being a required element in the Fair Market Value analysis, this requirement is almost universally ignored. Eliminating a strict application of Fair Market Value would eliminate the disputed issue of how the terms of the buyout would impact the value. Wouldn’t it be preferable not to have to deal with these types of issues which really have little to do with the case by doing away with Fair Market Value? Why not decide the case on the actual facts, not theories that only create confusion and disagreements?
RESTRICTIVE COVENANTS AND FAIR MARKET VALUE:
PERFECT TOGETHER?
In a traditional commercial setting involving a willing buyer and a willing seller, a Restrictive Covenant is extremely valuable to the buyer. It constitutes an economic detriment to the Seller and, when included, it is reflected in the price because it imposes a restriction on the seller’s ability to generate revenue while they nonetheless sprout the assertion the opinion was based on a willing buyer and adversely impacts their income. Yet, in our practice, virtually no expert reports address a Restrictive Covenant. On cross-examination, an expert can be confronted with questions that would make the evaluator have a very uncomfortable afternoon given the logical inconsistency of their position although at least one expert has advised me he has testified the covenant is part of the value yet, if true, that is generally not reflected in the report.
If a Restrictive Covenant is an essential element in a commercial transaction, reflecting true economic value, how can it be ignored? When the forensic expert testifies their report never mentions a Covenant but that they are aware in a commercial setting there is a direct relationship between the price paid and the existence of such a Covenant, the fallacy of Fair Market Value is revealed. The cross-examination about Covenant questions are asked only after the expert has already testified that he or she has used Fair Market Value or Fair Value without discounts. The careful cross-examiner will have already extracted a concession that Fair Market Value means the expert’s conclusion was predicated on a willing buyer/willing seller. Then the evaluator will be forced to concede the absence of a Restrictive Covenant would have an impact on value with a willing buyer.
What public policy is served by continuing to utilize a Standard that is so logically inconsistent with what truly happens in a divorce case. Just as value should not be reduced for a marketability discount when the asset is not being sold, nor should there be a valuation reduction because of the lack of a Restrictive Covenant. Covenants may well be a legitimate aspect of Fair Market Value, but the entire issue highlights why the Standard should be linked to the policy being implemented. If an asset is not being sold, valuation principals unrelated to the facts should have no consequence.
The new standard, if adopted, will eliminate what is, at best, a theoretical exercise which has no bearing on the true economic reality of what happens in a divorce case. It is yet another justification for adopting a Standard of Value that is linked to the true facts of the case and not hypothetical facts unrelated to the case.6
THE INEFFICIENT LAWYER
Another problem with the Fair Market Value test in a divorce case is illustrated by the hypothetical of the inefficient lawyer. This was an issue I addressed previously and the article is attached (Ex. C). It essentially outlines a series of hypothetical facts involving a lawyer who has operated his practice in a certain fashion where coupled with a stipulation by all concerned that his choices were reasonable, made without any divorce related considerations and represented the manner in which he would continue to operate his practice post-divorce. Yet, by firing certain overpaid staff, moving his office and doing certain other things that never would have happened had the marriage remained together, the practice could be made more profitable.
A Fair Market Value assumes a willing buyer and a willing seller. Valuation theory in this context considers the economic judgments to be made by a prospective buyer that operational efficiencies could be made thereby enhancing profit and increasing the value. It would be perfectly appropriate in a Fair Market Value analysis to suggest that an inefficiently run business has certain elements of value that an efficiently run business does not. This is simple economics: the new owner can alter the mode of operation and enhance profitability thereby increasing the cash flow in the ultimate value but does it make sense in a divorce case if it is not reasonable for a Court to find that the nature of the operation will change in the future.
DIVORCE, FAIR MARKET VALUE AND HIGHEST AND BEST USE
Utilization of the proposed standard would eliminate the troublesome disputes that can arise in determining the value of a marital asset where there is a substantial difference in value between the present use of an asset and what might be characterized under law as its “highest and best use”. The issue arises dealing with funeral homes which may have a greater real-estate value then they do based on the income generated by the homes, marinas, golf courses or any business which is operated at a location which could be sold and generate a higher rate of return then the owner receives from the present use. The conflict arises when the present use is one that has been in existence both before and during the marriage and where everyone agrees there are no plans to alter the use. The absence of such a plan may be for no other reason than the owner enjoys what he or she is doing, or it is a family enterprise that has been passed on and is intended to be passed from parent to child. There may well be circumstances where the present use has a value that is less than the theoretical value ascribed by the Highest and Best Use. Conceptually, the problem exists because of Highest and Best Use is utilized in the determination of Fair Market Value. It assumes the hypothetical willing buyer would purchase the property and then use if for its highest and best use but that theory may be only be a theory when it conflicts with the factual reality of a divorce case.
This was an issue in a recent tax court case, Boltar, LLC., Joseph Calabria, Jr. vs. Commissioner of Internal Revenue (United States Tax Court – Docket No. 25954-08 filed April 5, 2011). Boltar relied on Stanley Work and Subs vs. Commissioner, 87 TC at 402 which cited United States vs. 320 Acres Of Land, 605 F.2D 762, 781 (5 Th. Cir. 1979) noting that if the hypothetical buyer would not take into potential use then highest and best use would not be a determination of Fair Market Value.
The problem in a divorce is that we are dealing with a hypothetical and not a real buyer; thus, it is relatively simple to argue the hypothetical buyer would consider the Highest And Best Use creating an easy, if not realistic, argument for the non-titled spouse. A hypothetical circumstance is unrelated to the facts: it is always the facts and reality that ruin a good story. While there is some debate in Boltar that the Highest And Best Use must be realistic, reasonable and probable, the potential for litigation over this issue is patent and in my view unnecessary. If the parties have used this particular asset in the same fashion and the fact finder can reasonably find that that use will continue then what policy in N.J.S.A. 2A:34-23.1 is furthered by requiring the titled spouse to pay the non-titled spouse money based on a value that the titled spouse will not receive in the future. It highlights the difference between deciding cases on the facts, or on theories and hypothetical’s that have nothing to do with the facts. Adoption of the proposed standard effectively eliminates Highest And Best Use from the analysis unless, the evidence reveals the property may well be transformed and the titled spouse will enjoy an increase in value.
CONTAMINATED PROPERTY AND FAIR MARKET VALUE:
WHAT SHOULD THE LAW BE?
There are very difficult issues presented when property subject to distribution is contaminated because of contingent liabilities related to potential clean up costs. The issue arises in a hypothetical context since the parties do not want to create the very costs they assiduously avoided while married. In short, one spouse will continue to operate their business at the same location and enjoy the cash flow it generates. Generally, there is no thought of a sale. Yet, an argument can be made the property has no value in exchange because it could not economically be sold since under a Fair market analysis there must be a willing buyer – and that buyer would not bear the costs of a cleanup which might well exceed the appraised value. Many of these cases are resolved outside of the court system because to prove contamination would trigger a reporting requirement under ISRA (formerly ECRA).
There are two Supreme Court cases, which, while non-matrimonial, deal with this issue. See Inmar Associates, Inc. v. Borough of Carlstadt, 112 N.J. 593 (1998) and GAF Corp. v. Borough of Boundbrook (the two cases were consolidated). They deal with value and environmental issues but neither was a matrimonial case; rather, they were addressed in Tax Court. The Supreme Court characterized the issue as the proper method for determining the assessed value of real property subject to governmentally imposed requirements for environmental clean-up. In both cases the court held it was not proper to value the property subject to such mandatory environmental clean-ups by merely deducting the anticipated clean-up costs from the assessed valuation. Inmar at 605 . 8
Interestingly, the court found in Inmar there was a distinct “value in use” which remained unchanged so long as the owner continued to operate at that location. Inmar at 607. This is strikingly similar to Value To The Holder approach nd in direct contradiction to a value construct predicated upon a sale where the result might well be different.
Nonetheless, there are different policy considerations in tax assessment and Inmar may not therefore be dispositive. The non-titled spouse would certainly rely on the reasoning of Inmar and GAF in opposing any reduction in value because of the clean-up costs are not presently being incurred and are speculative. In contrast, the owner will argue it would be unfair to pay the non-titled spouse a value that ignores economic reality since the business will be ongoing. As Inmar notes, in “assessing property under the income approach, market reality cannot be ignored”. Inmar at 607. The likelihood of the clean-up costs being incurred, the degree to which the titled spouse continues to receive an economic benefit above and beyond reasonable compensation are factors that would seemingly bear on the issue. It seems harsh and unfair to ignore the risk associated with the environmental problem but equally unfair to suggest there is no value whatsoever. A strict Fair Market approach might well lead to a result that could fairly be characterized as uneconomically unrealistic. The 40 year old owner of a junk yard earning $500,000.00 a year will continue to enjoy the benefits of that cash flow. The standard that values the economic benefits the owner of the property will continue to receive in the future will most accurately capture the economic reality post-divorce. It is flexible enough to consider, as Orgler did, the risks associated with the property ownership and the contingent liability of clean up costs. These would be factors an appraiser would utilize in selecting a capitalization rate but might also be a factor a court might consider in determining the allocable percentage share received by the non-titled spouse. In that way, the law would be flexible enough to balance each of the parties’ competing interests and come to a result that more accurately measures the actual economic circumstances post-divorce. This is a particularly problematical area that is directly impacted by the facts and most particularly by the age of the owner who may be placed in a situation where the income stream enjoyed may not continue in the future because the asset cannot reasonably be sold without a substantial economic detriment. Phrased another way, the end result would be impacted by the factual circumstances of the parties which is precisely what the law should be.
KEY MAN DISCOUNT
Interestingly, since there is such a seemingly slavish utilization of Revenue Ruling 59-60, it is strange that an element of the Opinion is rarely argued. Revenue Ruling 59-60 (in Section IV)(Point 02)(b) provides “the loss of the manager of a so called “one man business” may have a depressing effect on the value of the stock of such business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise. In valuing the stock of this type of business, therefore, the effect of the loss of the manager on the future expectancy of the business and the absence of management succession potentialities are pertinent factors to be taken into consideration”. In non-matrimonial cases, particularly Estate cases, such a discount is neither surprising or inappropriate. See Estate of Feldman v. Commissioner, 56 Tax Ct. Mem. Dec. (CCH) 118, 130 (1988) WL93058 (1988). It has been noted a Key Man Discount is appropriate when an individual’s “continued services are critical to the financial success” of the business. Bernier v. Bernier, 449 Mass. 774, 791, 873 N.E. 2d 216 (Supreme Judicial Court, MA 20007). Yet, in Bernier, a well known case for Husband’s treatment of S Corps, rejected a Key Man Discount but not because it was a divorce; rather, it found the services were replaceable.
If there is any question as to the economic viability of the concept of a “Key Man” all one need do is examine the impact of Steve Jobs death on the price of Apple Stock. Yet, traditionally, this is not an argument advanced in a divorce case notwithstanding the fact Revenue Ruling 59-60, considers it to be an element to be considered. See Sec. 4 (02)(b) (“the loss of the manager of a so-called “one man” business may have a depressing effect on the value of the stock”). I believe the reason it is not traditionally argued is because everyone instinctively understands that we are valuing the business as if it is not sold and the Key Man is still there. Or, no one really thought about the concept. This is another clear example of where the logic and policy of equitable distribution diverts from traditional Fair Market Value – and in this instance properly so, but why must we engage in such mental gymnastics? Why not have a Standard keyed to the facts – and the policy. If not, why isn’t a Key Man Discount argued to reduce value?
While not traditionally argued, it is nonetheless a fair area of inquiry since the Key Man Discount was accepted as a reasonable factor for a trial court to consider in Warnock v. Warnock, an unreported 1985 Decision (A-5162-83T2) where the trial court accepted as a factor the loss of Mr. Warnock from the business as a legitimate reason for the distributable value of the asset to be reduced. Warnock at pg. 6. This would be irrelevant if our standard is factual – not hypothetical. A Key Man Discount may be a risk factor in selecting a Cap Rate but it should not reduce the value of virtually all privately held businesses operated by a “Key” person. The correct standard leads to the realistic result.
FAIR MARKET VALUE SHOULD NOT BE EXCLUDED IN ALL INSTANCES
SINCE A WILLING BUYER/WILLING SELLER IS APPROPRIATE FOR
CERTAIN READILY MARKETABLE ASSETS.
My criticisms of the Fair Market Value methodology for valuing assets under N.J.S.A. 2A:34-23.1 should not be read as a suggesting there be a blanket exclusion. In fact, Fair Market Value is an acceptable methodology for most real estate, personal property, publicly traded stock and other such readily marketable assets. The type of real estate best suited would be homes and commercial properties. Fractional interests in real estate have their own unique problems, particularly when accompanied with negative capital accounts. A minority ownership in a large entity coupled with sale restrictions may best be valued by some other methodology keyed to the economic benefits the owner will receive, as opposed to a Value In Exchange. The difficulty in selling, the absence of a market and the economic reality that this asset, like a professional practice, in all probability would not be sold, suggest a different approach.
This Article is primarily directed to the inappropriateness of utilizing Fair Market Value as the valuation standard for non-liquid, closely held businesses.
FAIR MARKET VALUE: A DIFFERENT WAY TO CONCEPTUALIZE THE SALE
If my standard is not accepted there is another way to view value by looking at what is being valued. Is the asset valued as if it were being sold or alternatively what someone would pay to become a partner with the owner in a continuing operation? An example utilizing a professional practice illustrates the distinction. Assume a sole practitioner who, quite naturally, argues the practice has “no real value” beyond its fixed assets because the professional is the person clients come to see and if there is a sale and the professional leaves, the practice could have no value. “They came to see me only” is the common complaint clients’ voice.
An argument like that questions the propriety of Fair Market Value which contemplates a sale, but also ignores the reality the true value of the practice is the cash flow generated by the professional which he or she will continue to receive and benefit post divorce. Under present law the appraiser would attempt to translate that future income stream into a present Fair Market Value but that never answers the quandary of the impact on the income stream if the professional, as contemplated in the Fair Market Value methodology, were to leave. The asset is valued based on the cash flow generated by the professional in the future but under the Fair Market Value approach, the person generating the income is no longer present. The theory is that the future cash flow generated by the professionals’ enhanced reputation has a certain degree of reliability which impacts on selection of a capitalization rate, the risk involved and ultimately the price to be paid by the hypothetical buyer. Yet, the approach inconsistently assumes the professional, with the enhanced reputation, remains.
Yet if what is being valued is changed some of the arguments attacking the Fair Market Value approach no longer apply if the willing buyer doesn’t purchase the entire practice but hypothetically pays to become a partner with the professional with the enhanced reputation and ultimately receives (as does the professional), the benefit of the future income stream. Then the quandary of the continuation of the income stream is eliminated because the professional never leaves. The nexus between the purpose of equitable distribution is apparent because the theory is that the non-titled spouse, through sacrifices or direct contributions, has materially contributed to the development, maintenance, and enhancement of the practice in the context of the marital partnership. That effort, which may even be non-economic, allowed the professional to develop over time the “reputation” that is translatable into the income stream and ultimately the value.
It is for that reason that the non-titled spouse, quite appropriately, is entitled to be compensated for the statutory Equitable Distribution rights. If you value what someone would pay to be a partner with the professional enjoying the enhanced reputation and not value the asset as if it were being sold that conceptually is more consistent with actual economic reality and the facts of most divorce cases. Valuing the benefits associated with the professional more accurately values what was acquired by the marital partnership, i.e. the ability to earn money in the future and the degree of risk associated with that effort. Thus, by using this standard (as opposed to an outright sale) the spouse is compensated by accurate market driven numbers – not irrelevant hypotheticals.
This “buy-in” approach presents a more logical nexus between determining value and the purposes of equitable distribution. In the buy-in the non-titled spouse is compensated for the marital effort expended to create the enhanced value. It would recognize the sacrifices made by the non-titled spouse, or the direct contributions made, that materially contributed to the development, maintenance and enhancement of the practice. In other words, what is being valued is not what is being sold but what is being maintained and continued – precisely the situation in a divorce . In short, what the professional is compensating the non-titled spouse is for a portion of the value being maintained by the professional.
A willing buyer would, arguably, pay more to join a professional practice where someone with an enhanced reputation and thus enjoy the likelihood of a consistent income stream in the future, is employed. Wouldn’t a lawyer pay more to join Gary Skoloff as a partner than to buy his practice if he was retiring to his farm and leaving the practice? However, I have rarely seen practices valued in this fashion. The standard should not be an assumption that the sale of the practice, and all of the factual and legal problems associated with a sale, but rather that the practice is continuing in its present form. It is the appraiser’s responsibility to place a present value on the economic benefits a professional will continue to receive in the future. If a hypothetical must be utilized, what would someone pay to join the practice and receive the fruits of the enhanced reputation of the professional is more logical from an economic standpoint and more directly linked to the policy of equitable distribution. That methodology is also consistent with the basic premise of this article that Fair Market Value really, in most cases, has little to do with capturing the economic reality of a divorce. Whatever benefits it has are outweighed by the detriments. Respect for the law and hence ultimate compliance by the parties is more likely enhanced by having a standard that is predicated on economic reality as opposed to a wink of the eye.
SUMMARY
After so many years of distributing closely held corporations it is time to analyze whether continued utilization of Fair Market Value, or Fair Value as the term is presently utilized, is the proper standard. It is appropriate to ask whether Fair Market Value has furthered the fundamental public policies reflected by Equitable Distribution Statute? For the reasons set forth herein I believe it is not, and for the first time in our jurisprudence we should have an open debate on what the Standard Of Value should be. As this Article argues there is ample legal support, both in law and policy, for utilizing a Standard of Value that is consistent not only with the policy implicit in N.J.S.A. 2A:34-23.1 but the facts of the case being adjudicated. A Standard that fails to implement that policy or is predicated on hypothetical facts unrelated to the particular circumstances of the individuals being divorce is not the standard our justice system should utilize.
While many inconsistent aspects of Fair Market Value have, piecemeal and overtime, been eliminated from our law, deductions for theoretical taxes and rejection of Marketability Discounts, for instance, there are a host of other aspects to Fair Market Value that are not only contrary to the goal of achieving a fair and economically realistic result, they have the potential of complicating cases, creating uncertainty, deterring settlement, and sadly, create disrespect for our law.
A standard that mandates a result which would be consistent with the facts and the policies is not only fair and appropriate but long overdue. That is what this Article has proposed and the ideas proposed should be debated, analyzed and discussed. Ultimately, the best result will be achieved by critical examination of ideas in the intellectual cauldron offered by the Bench and Bar.
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[1] Zipp and I diverge on the issue of minority discounts which is beyond the scope of this article. Minority Discounts have a duality. It may impact the value if there is a sale contemplated, but it is like a Marketability Discount absent a liquidation event. Conversely, owning a minority share may also impact the economic value to the titled owner. If it does, then it should be considered in determining the value of that person’s ownership interest. Therefore, the analysis is fact sensitive.
[2] A transfer of property is “incident to the divorce” if the transfer (1) occurs within one year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage. (IRC 1041, subd (c). Treasury Regulation 1.1041-IT(b) states that a transfer is “related to” the cessation of the marriage when the transfer is required under the divorce or separation instrument, and the transfer takes place within six years from the date of the divorce”. If the transfer is not made pursuant to a divorce or separation instrument, or occurs more than six years after cessation of the marriage, it is presumed to be unrelated to cessation of the marriage. (Treas. Regs. 1.1041-1T, A-7; see Ltr. Rul. 9306015). The presumption may be rebutted “only by showing that the transfer was made to effect the division of property owned by the former spouses” at the time the marriage ceased.
[3] Bowen certainly stands for the proposition that an updated Buy Sell can be given presumptive effect but it will not govern the parties’ rights, duties and obligations if it excludes good will – as they almost always do. Thus, it is hard to envision facts where a Buy Sell could not be avoided. As Justice O’Hern indicated, the entity in Bowen should have been valued after considering “assets of good will and other intangibles (including considerable technical expertise)” as part of the ultimate value. Since these elements of value were not included, the presumptive validity of the Buy Sell was overcome. Bowen should not be read, however, to mean the Buy Sell Agreements are irrelevant since they are a fairness factor in the overall analysis. The degree of their significance should be determined by the facts – most notably the likelihood of the Buy Sell being implemented, which turns frequently on the age of the owner. It should not be a valuation factor, but one of distribution, as a factor bearing on the fairness of the division under N.J.S.A. 2A:34-23.1. We should not compensate the non-titled spouse for a benefit the titled spouse will not receive. It simply is not fair.
[4] The Supreme Court in a different context came to a similar result. In J.D. v. M.D.F., 207 N.J. 458, 481 -482 (2011) concluded that since it was the court’s “obligation” to see “justice is accomplished” it was error for a trial court not to allow additional evidence to be admitted.
[5] I viewed this issue as somewhat different than the normal conflict between substance and procedure which was resolved by the Supreme Court in favor of procedure in Winberry v. Salisbury, 5 N.J. 240 (1950).
[6] The more interesting question is whether two people who are getting divorced are also business partners and how a Restrictive Covenant is treated in that context which is beyond the scope of this article but remains a fascinating question.
[7] Richard Norris’ excelled note on this point is attached (Ex. D) however as he has recently confirmed to me the article is somewhat out of date. IRSA has replaced ECRA and there are new Regs. Nevertheless the principle is the same on the issue presented.
[8] This approach, in some respects, is similar to Orgler v. Orgler, 237 N.J. Super. 342 (App. Div. 1989) where because the taxes on an appreciated asset were not being incurred it was error to deduct them from the value.