Opinion
Civil Action No. 18462.
Date Submitted: June 26, 2003.
Date Decided: April 22, 2004.
Steven L. Caponi, Esquire and Elizabeth A. Wilburn, Esquire, of BLANK ROME LLP, Wilmington, Delaware; Attorneys for Plaintiff.
David J. Teklits, Esquire, of MORRIS, NICHOLS, ARSHT TUNNELL, Wilmington, Delaware; Of Counsel: Richard P. Weiss, Esquire, of Law Offices of Richard P. Weiss, Wayne, New Jersey; Attorneys for Defendant.
MEMORANDUM OPINION
The Petitioner, Harry Ng, was a minority shareholder of Heng Sang Realty Corporation, a Delaware Corporation ("Heng Sang" or "the company") until he was removed as a shareholder in a freeze-out merger that took place on July 12, 2000. In the merger, Ng received $93,500 for each of his Heng Sang shares. Ng then sought appraisal of his shares under 8 Del. C. § 262. This appraisal action was tried on November 27, 2002 and January 13, 2003. Following post-trial briefing, oral argument was held on June 26, 2003.
The sole issue is the fair value of Heng Sang on the date of the merger. That determination requires the Court to resolve three discrete sub-issues: (i) what is the appropriate tax rate for projected future tax expenses in the discounted cash flow ("DCF") analysis; (ii) was it proper to include in the fair value calculation certain undocumented selling, general and administrative ("SGA") expenses furnished orally to the company's expert; and (iii) can "net asset value" properly be used as a valuation method where it is not the exclusive method of valuation being employed? This is the Opinion of the Court, after trial, on the merits of Ng's appraisal action.
The issues of fee shifting and the form of interest were determined in a bench ruling issued by the Court after oral argument on June 26, 2003.
I. THE FACTS
Heng Sang was formed in the early 1980's as a joint venture among three families to purchase and manage a five-story commercial building in the SoHo section of Manhattan, New York City. Petitioner Harry Ng and his family owned 20% of Heng Sang's common stock. Members of the Fung and Liang families owned the remaining 80% interest.
From its inception until the mid-1990's, Heng Sang generated very little profit. As a result of the New York real estate boom beginning in the mid-1990's Heng Sang's profit picture changed. During that period, Heng Sang began to generate substantial profits as a result of the dramatic appreciation in the SoHo real estate market. In 1997, because of the increased profits and the resulting increase in the company's tax burden, Heng Sang's board of directors began to consider converting Heng Sang, which was then a "subchapter C" corporation, into a "subchapter S" corporation. An important effect of that conversion would be to "cap" the company's tax rate at approximately 11%, rather than for the company's tax rate to increase on a graduated basis.
See 26 U.S.C. § 301 et seq.
See 26 U.S.C. § 1361 et seq.
Ng was the corporate Secretary of Heng Sang until he was replaced at a board of directors meeting in 1997. From that point through the date of the merger, See Yee Fung was Heng Sang's President; his sons, William Fung and Steve Fung, were the Secretary and Treasurer of the corporation; and Liang Liang was the Vice President.
In 1997, See Yee Fung approached Ng with an offer to buy out his shares in the company. Ng refused several offers by Fung. Mr. Fung testified that he also had several meetings with Ng and his mother, all designed to convince Ng to consent to converting Heng Sang to a subchapter S corporation. Ng denied that he was ever approached about the subchapter S conversion, but the Court finds as fact that on several occasions Fung did discuss converting Heng Sang to a subchapter S corporation with Ng, and that Ng refused to consent to the conversion.
Fung's repeated offers to purchase Ng's shares made Ng suspicious, because at about that same time, Ng received information about what (he had been informed) was management's inappropriate use of Heng Sang funds. Ng also perceived that Fung had become increasingly secretive in operating the business. For 1997, Ng received a single dividend of $13,400, while during that same year (Ng later learned), the company's officers received salaries totaling nearly $300,000. Ng requested access to the company's books and records, first individually and then through his attorney, but the company refused to accede to that request.
After failing in his attempts to gain access to Heng Sang's books and records, Ng filed a shareholder action in a New York state court to gain access to the company's books and records. A. The 1998 and 1999 Shareholders' Meetings
PX 53. The record does not disclose the outcome of this action.
The proposal to convert Heng Sang to a subchapter S corporation first surfaced formally at the 1998 stockholders meeting. Ng did not attend that meeting (on the advice of his attorney) because he was opposed to a subchapter S conversion. At that meeting, those in attendance were presented with information about corporate finances and the proposed conversion. The minutes of the 1998 shareholders' meeting disclose that Ng was informed about the conversion proposal, but refused to consent to it.
DX 18.
Ng did not attend the 1999 shareholders' meeting either. The minutes of that meeting reflect that the directors again discussed converting Heng Sang to a subchapter S corporation and that Ng again refused to consent. Sometime thereafter, the remaining stockholders (and the board members) concluded that the only way to resolve the impasse was to remove Ng as a stockholder of Heng Sang in a cash-out merger intended specifically for that purpose. The board then took steps to effectuate that merger.
DX 19.
B. The Merger
In connection with the contemplated merger, Landauer Realty Group ("Landauer") was engaged to perform a real estate appraisal of the building, which was Heng Sang's only asset. Using income and sales comparison valuation approaches, Landauer appraised the building at $21,900,000 as of May 1, 2000.
The directors also retained Empire Valuation Consultants ("Empire") to value Heng Sang as a going concern. Using the Landauer valuation as a starting point, Empire arrived at a going concern value of Heng Sang of $9,350,000 ( i.e., $93,500 per share) as of June 1, 2000.
On July 12, 2000, the company's directors unanimously approved the merger, as did the stockholders other than Ng. On that same day, the merger was formally consummated, for the specific purpose of eliminating Ng, the sole non-consenting shareholder, so as to enable Heng Sang to be converted to an S corporation. Ng received $93,500 for each of his shares, for a total of $1.87 million.
Ng formally demanded an appraisal of his shares on August 18, 2000. On October 26, 2000, Ng filed this appraisal action, in which he also asserted breach of fiduciary duty claims. During the discovery phase of this case the fiduciary duty claims were later dismissed with prejudice, leaving only Ng's appraisal claim for trial and ultimate resolution.
At the trial, Ng's expert, J. Mark Penny of Hempstead Co., valued the company at $21.7 million as of July 31, 2000. On that basis, the appraised value of Ng's 20% interest would be $4.3 million. To arrive at that value, Penny performed two valuations: a DCF analysis in which he arrived at a fair value of $20 million; and a separate "adjusted net asset value" analysis that resulted in a fair value of $23.4 million. In his DCF valuation analysis, Penny assumed an effective tax rate of 11% of Heng Sang's net operating income, which was the maximum tax rate for a subchapter S corporation. Because the two values were close, Penny then weighed each value equally, and determined that Heng Sang's ultimate fair value was the average of those two values, i.e., $21.7 million.
PX 9A.
Id.
Id.
The company's trial expert, Roger Grabowski ("Grabowski") of Standard Poors Corporate Valuation Consultants, employed a DCF analysis to arrive at a fair value of $7.8 million — $1.7 million less than the Empire $9,350,000 valuation that served as the basis for the actual merger price. On that basis, Ng's 20% interest in Heng Sang would be worth $1.56 million. To arrive at his $7.8 million valuation, Grabowski utilized the statutory subchapter C corporate tax rate, which resulted in an effective tax rate of over 25% of gross revenue. Grabowski also adjusted Heng Sang's annual revenue projection by deducting annual rental of $70,000 from the Landauer revenue projection, to account for the fact that Heng Sang occupies 2500 square feet of its own building. Grabowski further reduced the cash flow projections to account for certain corporate level office expenses and professional fees. Those latter expenses and fees were not contemporaneously documented in records kept in the normal course of business, but, rather, were based on information provided orally to Grabowski by Fung during a single telephone conversation.
Empire was not called as a witness to defend its valuation at the trial.
II. THE PARTIES' CONTENTIONS AND THE ISSUES PRESENTED
In this appraisal the parties have resolved all disputes except for three. The first is which tax rate — the subchapter S or the subchapter C rate — is appropriate. Ng contends that Heng Sang's projected future tax liability cannot be based solely on the subchapter C statutory rate, because historically Heng Sang never paid taxes at the level projected by Grabowski, and there is no persuasive evidence that it ever would. For the period 1993 through 2000, with one exception, Heng Sang's historical tax rate ranged between 1% and 9.5% of gross revenue. Ng claims that whether Heng Sang is assumed to be a subchapter C or a subchapter S corporation, Penny's 11% tax rate was appropriate, because Penny properly took into account Heng Sang's long history of actively managing its tax liability and assumed that the company would take appropriate steps to continue that tax-minimizing practice into the future.
The company disagrees. It contends that Penny's valuation rationale was that Heng Sang would be a subchapter S corporation after the merger, and that Penny projected an 11% of gross revenues tax rate solely because he assumed that Heng Sang would be an S corporation. That assumption, the company urges, was impermissible as a matter of law, because the company could not enjoy the benefit of subchapter S status unless and until after Ng was eliminated as a stockholder.
The second dispute concerns certain SGA expenses. Ng claims that the SGA expenses that Grabowski included in his DCF analysis are improper because they are unsupported by any evidence of record. It is undisputed (and Ng emphasizes) that Grabowski's projected architect fees and attorney's fees were "created," without any documentary support, during a telephone conversation between Grabowski and See Yee Fung. The company counters that the SGA expenses were, nonetheless, all valid corporate level expenses that were essential to conduct the operations of the corporation. Thus, they were properly included in Grabowski's forecasted expenses.
The third, and final, issue flows from the company's claim that Penny's valuation should be stricken in its entirety because Penny used a liquidation value which, the company urges, is impermissible under Paskill v. Alcoma. Ng responds that Paskill prohibits only the use of a liquidation valuation as the sole method of determining fair value, and that here, Penny also used the DCF valuation method and properly accorded equal weight to each of his resulting values to arrive at an overall fair value.
747 A.2d 549 (Del. 2000).
Thus, the three issues that must be resolved to determine the fair value of Heng Sang are: (i) what is the appropriate tax rate for projecting Heng Sang's future tax expenses in the DCF analysis, (ii) were the undocumented SGA expenses that were provided orally to the company's valuation expert appropriately included in the fair value calculation, and (iii) did Penny use an impermissible valuation method in determining the corporation's going concern value in these particular circumstances? These issues are now addressed.
III. ANALYSIS
A. Preliminary
An appraisal proceeding is a limited statutory remedy, whose purpose is "to provide equitable relief for shareholders dissenting from a merger on grounds of inadequacy of the offering price." Underlying a Delaware statutory appraisal is the assumption that the dissenting shareholders would be willing to maintain their investment position had the merger not occurred. Therefore, the corporation must be valued as an operating entity, and on that basis this Court must determine the value of what has been taken from the shareholder, namely, the shareholder's proportionate interest in the going concern.
Paskill Corp. v. Alcoma Corp., 747 A.2d 549 (Del. 2000) citing Cede Co. v. Technicolor, Inc., 684 A.2d 289 (Del. 1996).
Id., citing Cede Co. v. Technicolor, Inc., 542 A.2d 1182, 1186 (Del. 1988).
Cavalier Oil Corp. v. Harnett, 564 A.2d 1137, 1145 (Del. 1989).
Id., citing Tri-Continental Corp. v. Battye, 74 A.2d 71, 72 (Del. 1950).
In determining going concern value, this Court must consider the factors articulated by the Supreme Court in Tri-Continental Corp. v. Battye:
In determining what figure represents this true or intrinsic value, the appraiser and the courts must take into consideration all factors and elements which reasonably might enter into the fixing of value. Thus, market value, asset value, dividends, earning prospects, the nature of the enterprise and any other facts which were known or which could be ascertained as of the date of merger and which throw any light on future prospects of the merged corporation are not only pertinent to an inquiry as to the value of the dissenting stockholders' interest, but must be considered by the agency fixing the value.
B. The Tax Rate Issue
Tri-Continental Corp. v. Battye, 74 A.2d at 72.
Tri-Continental Corp. v. Battye, 74 A.2d at 72.
The first issue concerns the appropriate tax rate. At trial and in post-trial briefing, Ng's assumed tax rate posited that the corporation could be valued as an S corporation on the merger date. That assumption is incorrect, because without Ng's consent, that corporate form was unavailable to Heng Sang on the merger date. Ng's refusal to consent to the conversion made subchapter S status unavailable to Heng Sang until after the merger in which Ng was eliminated as a stockholder.
Although Ng adheres to his position that Heng Sang should be valued as a subchapter S corporation, he also advances the alternative contention that even if Heng Sang were valued as a C corporation, a tax rate of 11% of gross revenues is still appropriate. Ng bases this contention upon Heng Sang's history and past practice of actively managing its tax liabilities to keep them at a low level. The company disagrees. It argues that any valuation which assumes that Heng Sang would remain a subchapter C corporation post-merger, and that therefore assumes tax liabilities of only 11% of gross revenues, can be achieved only if the Court validates Ng's breach of fiduciary duty claims that the salaries paid to Ng's executives were improperly high. Such a challenge is impermissible, the company argues, because Ng has now dismissed his breach of fiduciary duty claims with prejudice.
The company further argues that Heng Sang's historical low tax rates are not an appropriate measure for projecting its future tax liabilities, because before 1997, Heng Sang was never profitable and its officers chose to not take any salaries. Those circumstances, urges the company, would no longer exist after the merger. Even though the tax rates before the merger were kept low by progressive salary increases, such steep increases could not continue indefinitely. Accordingly, the company concludes, it was proper for Grabowski to assume that officers' salaries would flatten out and that, with increasing gross revenues, the tax rate would continue to increase. It therefore was reasonable to assume a tax rate of 25% of gross revenue.
I agree that Heng Sang's history as a marginally profitable enterprise and its performance in the early 1990's are not especially relevant predictors of the company's future prospects. Nonetheless, the company's tax rate argument is fatally flawed. Heng Sang's "turnaround" began with its acquisition of two major long-term leases in 1997. As a result, gross revenues jumped from $1.2 million in 1997 to $1.4 million in 1998, and officers' salaries jumped from slightly over $10,000 to $339,000 during that same period. In 1998, Heng Sang paid out a much larger percent of its gross revenues than it did in any other year — 18.9%, which was far below the 25% corporate tax rate projected by Grabowski. Heng Sang's financial performance during the following two years further evidences its ability to manage its tax liability. In 1999, gross revenues rose to $1.7 million, officers' total salaries rose to $535,500, and Heng Sang paid 3.4% of gross revenues in taxes. In 2000, when gross revenues reached $2.7 million, Heng Sang paid out only 4% of those revenues in taxes. Clearly, Heng Sang's practice of controlling its tax liability was not limited to the period before the company became profitable — this practice continued thereafter. At no time did Heng Sang ever come close to paying taxes at the rate of 25% of net revenue. Grabowski's 25% tax rate assumption is, therefore, unreasonable.
In determining fair value, this court cannot consider speculative future tax liabilities. A liability is speculative if it is not part of the company's operative reality or known or capable of proof on the date of the merger. I agree with the company that Ng's valuation assumption that Heng Sang would be a subchapter S corporation on the merger date was inappropriate. Under Allenson v. Midway Airlines Corp. Heng Sang's conversion to an S corporation cannot be considered for valuation purposes, because without Ng's consent it was not possible for Heng Sang to convert to subchapter S status before the merger, and Ng never granted his consent.
Paskill Corp. v. Alcoma Corp., 747 A.2d 549, 552 (Del. 2000).
Id., see also Cede Co. v. Technicolor, Inc., 684 A.2d 289 (Del. 1996).
789 A.2d 572 (Del.Ch. 2001).
But, the company's projections of future tax liability at a 25% of gross revenue order of magnitude are also unreasonable, because they are unsupported by the record. An analysis of Heng Sang's performance during the most recent nine years that Heng Sang functioned as a subchapter C corporation establishes that Heng Sang paid, on average, 5.6% of gross revenues in taxes. Accordingly, the Court determines that even where Heng Sang is valued as a subchapter C corporation, the 11% tax rate is the more reasonable.
C. The SGA Expense Issue
The second issue concerns the propriety of Grabowski's deduction (for DCF purposes) of additional SGA expenses for officer compensation, professional fees, office rental ("opportunity cost of management space"), and office expenses from the revenues projected in the Landauer real estate valuation.
1. Officer Compensation
The company contends that Ng's officer salary assumption for the base year was far too low. Landauer, in valuing the building, allotted $350,000 for base year salary and benefit expenses. Even though the Landauer report notes that "historical and budgeted amounts have been discounted because they include officers' and directors' salaries," Penny made no further adjustment to the Landauer salary and benefit expenses. Penny's reason was that Landauer's $350,000 figure plus Landauer's $62,500 per year allowance for property management, far exceeded pre-1998 staff and officers' salary figures, and were therefore sufficient. Grabowski, on the other hand, constructed a normalized base year figure for directors' compensation and staff salaries from the most recent two years' data. That figure was $610,000. Grabowski then substituted his officer and staff compensation figure and subtracted the property management fee from the Landauer DCF analysis. Grabowski's treatment of officers' and staff compensation was proper, but Penny's was not, because the salaries were part of the cost of operating the corporation (as distinguished from the building) as a going concern. Penny did not include that cost, and Grabowski did.
PX 7 at p. 40.
Grabowski then increased this number to $627,000 in his DCF analysis, but this increase is nowhere satisfactorily explained in his report.
2. Professional Fees and Office Expenses
Grabowski testified that he received information about office expenses and accounting, architect, and legal fees in a telephone conversation with See Yee Fung and company counsel, and from that information he developed "reasonable" projections for this category of future expenses. Ng challenges those expenses and professional fees on the ground that they are either completely undocumented or were recorded solely in documents created for purposes of this litigation, rather than in the regular course of business. Grabowski's office expense figures are significantly higher than the actual office expenses Heng Sang provided for the Landauer valuation.
Ng also disputes Grabowski's deduction of $70,000 per year for lost rental income for the 2500 square feet that Heng Sang occupies in the building. That deduction is excessive, Ng claims, because at least three other Fung corporations shared that same office space rent-free. The company responds that the only significance of Heng Sang's suite being listed as the principal place of business on the certificates of incorporation of the other Fung corporations, is that the suite serves as a mail drop for those corporations. Ng has furnished no evidence showing the contrary.
Ng offers only Mr. Penny's valuation as an alternative. But, Penny did not make any adjustments to the Landauer real estate appraisal for the corporate level expenses that had to be incurred to operate Heng Sang. Although Heng Sang's value is derived in large part from the value of its sole asset, the SoHo property, the value of that asset does not equate to the going concern value of its corporate owner. Appropriate adjustments must be made for the corporate expenses required for the entity that owns the income producing property to manage that property as a going concern. Those expenses must also be factually supported. In this case, the officers' compensation and the $70,000 annual rental cost are adequately supported, but the SGA expenses that were communicated orally by Mr. Fung to Grabowski and the elevated corporate office expenses are not. Accordingly, the Court determines that only the officers' and staff compensation and the $70,000 annual rental expense are properly included as deductions from the gross revenues projected by Landauer.
Trial tr. at 172, 174.
D. The Liquidation Value Issue
The third and final issue is whether Penny's "net asset value" computation can permissibly be used in any form to determine Heng Sang's fair value. The company argues that that approach is proscribed by Paskill, which prohibited the valuation of a going concern by use of a net asset value method alone.
747 A.2d 549 (Del. 2000).
The Paskill Court held that "the dissenter in an appraisal action is entitled to receive a proportionate share of fair value in the going concern on the date of the merger, rather than value that is determined on a liquidated basis." That ruling is consistent with Delaware's seminal corporate valuation case, Tri-Continental v. Battye, where the Supreme Court held that the value of the dissenting shareholder's stock in a going concern is "the true or intrinsic value of his stock which has been taken by the merger." Paskill, as Tri-Continental had before it, defined "net asset value" as "a mathematical figure representing the total value of the assets of the corporation less the prior claims." That value results in a "theoretical liquidating value to which the share would be entitled upon the company going out of business." Both of those courts differentiated between "net asset value," "full value" (which takes into account the discount inherent in a regulated closed-end investment company) and "fair asset value" (which includes "several elements of value over and above the net asset value.")
Id. at 554 (emphasis in original).
74 A.2d 71 (Del. 1950).
Id. at 72.
Paskill at 554.
Paskill, supra, quoting Tri-Continental, 74 A.2d at 74. Tables in the lower court opinion demonstrate that the net asset value in that case was a theoretical liquidating value. See Paskill Corp. v. Alcoma Corp., 1999 Del. Ch. LEXIS 129 (Del.Ch. 1999).
Paskill, 747 A.2d at 556.
After considering these definitions, the Paskill Court held that it was error for the Chancery Court to rely on the "net asset value" as the " sole criterion" for determining the fair value of the appraised corporation, because doing that ran afoul of the mandate to value the corporation as a going concern. But the Court in that case did hold that " fair asset value" was an appropriate measure of the value of a going concern.
Id. (emphasis in original).
Paskill, supra, at 554.
In this case, Ng's valuation expert, Penny employed both an "adjusted net asset value" approach (yielding $23.4 million) and a discounted cash flow analysis (yielding $20 million). Penny then averaged the resulting values to reach an ultimate fair value of $21.7 million. The foundation for Penny's "adjusted net asset value" was the Landauer Report, which was completed on June 7, 2000 in anticipation of the merger.
PX 7. Penny testified that he identified an error in the Landauer calculation and corrected that error, which resulted in a corrected value of $26.8 million.
The Landauer valuation approach was not a "theoretical liquidating value" of the kind proscribed by Paskill. A liquidation value determines the value of the assets at liquidation, which includes the costs of an orderly sale and is often less than market value. Liabilities are then deducted from the gross sale proceeds of the assets. Here, in contrast, Landauer performed two separate valuations of the SoHo property based on commonly used approaches. First, assuming an eleven-year holding period, Landauer performed a DCF analysis and arrived at a value of $21.9 million. The DCF analysis took into account annual operating expenses, including, inter alia, payroll and benefits, utilities, building maintenance, real estate taxes, and management fees. Second, Landauer used a sales comparison approach in which it identified six comparable properties, made adjustments for their location and quality, and derived a value of $21.2 million. Landauer then reconciled these approaches, placing "less weight on [the sales comparison approach] due to the subjectivity of the adjustments," and concluded that the value of the SoHo property was $21.9 million. That 21.9 million value reflects primarily a DCF analysis, i.e., the value of the building when operated as a going concern. It does not include the costs of liquidating the asset.
The report did not assume a sale of the company or building, its stated purpose was for the buyout of a partner.
Schedule of expenses and tables at PX 7, p. 30-1, 40.
PX 7 at p. 47. Because Landauer's ultimate determination of value was the same as its DCF value, one can conclude that virtually no weight was given to the sales comparison approach.
In the disputed portion of Ng's valuation, Penny used the Landauer valuation to value the SoHo property, then adjusted for cash and other assets, liabilities, and corporate taxes to arrive at Heng Sang's "adjusted net asset value" of $23.4 million. That value does not represent a theoretical liquidating value either, because it includes consideration of Heng Sang's future income streams, corporate income taxes, and maintenance expenses associated with the building and excludes any expenses associated with the sale of Heng Sang.
As corrected by Penny, see n. 32, supra.
Even assuming, however, that some portion of Penny's ultimate valuation was based on a "net asset value" of the type described in Paskill, Penny's "adjusted net asset value" was but one element of a more comprehensive valuation of the property. In short, "net asset value" was at most a minor component, and certainly not the sole basis, for valuing Heng Sang as a going concern. Penny's consideration of "adjusted net asset value" as part of his ultimate valuation does not run afoul of the principle for which Paskill stands.
IV. CONCLUSION
For the foregoing reasons, the Court determines that (1) 11% of gross revenue is a proper tax rate assumption for DCF analysis purposes, (2) except for the professional fees, the company's SGA expenses including the officer and staff salaries assumed by Grabowski are properly included in the DCF analysis, as is the $70,000 annual rental charge for the space occupied by Heng Sang in the building, and (3) Penny's valuation approach was not inappropriate or proscribed in any respect by Paskill v. Alcoma.
Counsel for the parties shall confer and present an agreed-to form of order setting forth the fair value of Heng Sang based on the rulings made herein, and the appropriate rate of interest, as of and from and after, the merger date.