Fair Value: Extraordinary Circumstances and the Discount for Lack of Marketability

Appraisal proceedings and shareholder disputes that involve court ordered buyouts will value the interest to be purchased at its "fair value." Fair value as the standard of value is a legal concept and generally different from the more familiar standard of value: fair market value.

Previewing all of the differences between the two standards of value can be a lengthy discussion. However, one of the primary differences is whether the determination and conclusion of value includes a discount for lack of a market for the interest. Since the market place values the ability to sell an interest and obtain liquidity, the lack of a market and ability to dispose of an interest brings with it a discount in the value. This discount is called the discount for lack of marketability or DLOM.

For example, if the court found that the tentative value of a minority shareholders interest was $100 a share, the application of the DLOM could result in that value being reduced by an amount that could range from 15% to 50%. Because of the dramatic effect of the DLOM, the potential application and amount is significant in any valuation proceeding. In fact, it could be one of the most important considerations in an appraisal proceeding.

Whether and how a court would consider the application of the DLOM is a matter of the law of the particular jurisdiction. A variety of answers exist, however, a frequently stated rule in several states (such as Arizona, Illinois, New Jersey and Minnesota as a few examples) is that the DLOM would be applied only in "extraordinary circumstances."

What constitutes "extraordinary circumstances" in these several jurisdictions has not been the subject of many court opinions. As a result, the occasion of an appellate decision discussing the application of it is note worthy. 

In an unpublished opinion, the appellate division of the Superior Court of New Jersey, applied the discount to a minority shareholder's interest where the minority was found to be the 'oppressing shareholder." Wisniewski v. Walsh, 2013 N.J.Super. Unpub (April 2013).

The case involved three siblings in multiple claims against each other. Eventually, original defendant brother, Norbert, was ordered to sell his interest to his sister. The third sibling, Frank, out of jail and by the time of the decision deceased, was found to have previously been the key person in the profitability of the business.

Rather than order Norbert to buy out Patricia, Norbert was ordered to sell out to her and Frank's estate.

As an important note, many assume that remedy against the "defendant" as the oppressing party is to be required to buy the innocent parties interest. However, the courts in oppression actions have equitable authority. That is, the court has the ability to fashion a remedy that it feels fits the circumstances. In this case, rather than ordering Norbert to buy, he was ordered to sell. Forcing Norbert to buy would have given him either a majority (if only buying Patricia's interest) or complete ownership (with both Patricia and Frank's interests).

With a valuable and growing enterprise, the court was not going to create a result that one sibling (the "oppressor") could gain the advantage of control and benefit from bad conduct. Especially true in this case where the estate was not claiming oppression and a buy-out remedy might otherwise have existed only in respect of Patricia's interest.

As for the DLOM, the court applied the marketability discount to Norbert's shares. The "extraordinary circumstance" was the fact that the oppressing shareholder was being forced to sell to the innocent shareholder, and not the other way around.

Not discounting Norbert's interest, the court felt it would have left the risk and cost of the lack of marketability on the "innocent" party. In effect, this would reward the oppressor with "the undiscounted proportional value" and left Patricia with the burden of any discount in a future sale.

Norbert was not allowed to avoid a DLOM that he might otherwise have faced in a sale of his interest to a third party.