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THE JUDGE WOULDN’T IGNORE THIS “ROUNDING ERROR”

June 2017 | Issue 86 Background Constellis Group,  Inc. is a private security firm.  In December 2013, the Company formed an Employee Stock Ownership Plan (“ESOP”), which purchased 100% of Constellis’s voting stock.  Wilmington Trust NA was named Trustee of the ESOP.  Less than a year after the ESOP was created, the ESOP sold all […] More...

NEW JERSEY COURT USES VALUATION DISCOUNT TO PUNISH “BAD BOY”

March 2017 | Issue 85 Introduction Richard and Steven Parker are brothers who ran a flower business in Scotch Plains, New Jersey.  Richard is the President of Parker Interior Plantscapes (“PIP”), which installs and services plants and flowers in commercial settings.  Steven is the President of Parker Wholesale Florists (“PWF”), which is a garden center.  […] More...

Dell Appraisal Spawns a Multitude of Valuation Approaches

February 2017 | Issue 84 Introduction A Delaware Chancery appraisal case involving computer company Dell Inc. gave rise to a multitude of valuation measurements.  It is instructive to see how the court sorted through them in coming up with its final appraisal conclusion.  The case is In re Appraisal of Dell Inc., 2016 Del. Ch. LEXIS […] More...

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Tax Court Uses Dribble-Out Method to Value Restricted Stock

January, 2007 | Issue 13

In a recent U. S. Tax Court opinion, Gimbel v. Commissioner (2006 T.C. Memo LEXIS 274, December 19, 2006), the Court used the “dribble-out” provisions of Rule 144 to calculate the fair market value for estate tax purposes of a large block of restricted stock in a public company.

Large Block Held
Georgina T. Gimbel, at the date of her death, June 5, 2000, owned in trust 3,548,450 shares of common stock of Reliance Steel and Aluminum Company, a New York Stock Exchange listed company. These shares represented approximately 13% of the 27,786,030 shares of Reliance common stock outstanding. The average public trading price of the company’s stock on the date of death, which was the valuation date, was $ 20.8125 per share.

Because of the large size of decedent’s holdings in Reliance, she was considered an “affiliated person” under Federal securities laws. Consequently, the Reliance shares were restricted as to resale. Without registering the shares, the Estate was permitted under SEC Rule 144 to sell no more than 278,000 of its restricted shares to the public in any three month period. Thus, to sell the Estate’s restricted Reliance shares pursuant to Rule 144 would take more than three years.

Estate Claims Discount
The Estate, in its Federal estate tax return, valued the Reliance stock at $16.50 per share. This was calculated by applying a 20.72% discount representing lack of marketability and liquidity to the freely-traded valuation date value of $ 20.8125.

On audit, the IRS determined that the shares should be discounted from the valuation date trading price, but only by 8 %, producing a value of $19.15 per share.

Judge Considers Liquidity Alternatives
In his analysis, Judge Swift considered the various means that would be available to the Estate to liquidate this holding of restricted stock. He concluded that it would not be likely that Reliance would file a registration statement with the SEC to sell the shares, because the company was in the midst of confidential negotiations on a large acquisition.

The Judge ruled out a private sale of the shares, first, because the company’s investment banker had tried without success to find a private placement buyer, and secondly, because a private buyer would, after a purchase, find itself in the same restricted stock position as the Estate.

Another possible alternative was sale of the stock to the company itself. This was considered, and the Court concluded that the company had the financial capacity to purchase no more than 20 % of the block.

Dribble-Out Method Selected
Finally, the Judge considered various Rule 144 dribble-out scenarios. Three valuation experts presented analyses of value based on this method of sale. The Estate’s first expert calculated a gross cash flow over the dribble-out period, based on the valuation date public trading price, of $73,200,000. He then discounted this to $65,800,000 using a risk-free rate of return. He then calculated a $10,500,000 cost to purchase put options that would allow the Reliance shares to be sold at no less than the valuation date price throughout the entire dribble-out period. This cost was subtracted from the sale proceeds, resulting in a net value of $55,300,000, reflecting a 24.5 % discount from the valuation date trading price.

The Estate’s second expert followed a similar approach, however he added an estimated $1,100,000 in dividends expected to be paid on the Reliance stock during the dribble-out period. He then discounted the sales proceeds at a discount rate of 13.2 %, which was the expected rate of return on Reliance’s equity. He did not factor in the cost of a put option. His approach produced a 17.4 % discount from the valuation date trading price.

Cashless Collar Considered
The IRS expert made a dribble-out calculation in which he assumed that the shareholder would enter into a hedging contract such as a “cashless collar” or “prepaid variable forward contract” to protect against a market decline. He estimated that such a hedge would cost the equivalent of a 5 % discount from the valuation date trading price.

After reviewing the evidence, the Judge concluded that the hedging contracts posited by the experts would not have been available to a holder of the block of stock in question. He believed that an active market for such non-standard non-traded put options did not exist. Similarly, he believed that the hedging contracts put forth by the IRS expert would not exist for such an illiquid block of stock.

Court Decides
Having ruled out both approaches involving hedging contracts, the Court deemed the approach used by the second Estate expert to be the most reasonable. After adjusting for the assumed purchase of 20 % of the block by Reliance, he ended up with an overall valuation discount of 14.4 %, producing a value of $17.86 per share.