Contents

• Experts Duel Over Discounts in Minority Shareholder's Divorce
• No Legitimate Business Purpose for FLP Precludes Analysis of Discounts
• Court Allows Art Collector's Estate Only 5% Fractional Interest Discount
• Damages for Lost Customer Accounts is Net Value of Lost Profits, not Fair Value
• Fair Market Value Includes Only Reasonably Foreseeable Subsequent Events
• Bankruptcy Court Cannot Just 'Split the Difference' in Divergent Discount Rates
• New FLP Case: Taxpayer's First Asset Transfer Merits Discount, But Not Second

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ESOPs as a Liquidity Event

The credit crunch and recession that the United States has endured during the past 12 to 18 months has created a difficult environment for owners of small and middle-market companies to sell their businesses. Although signs of economic recovery are on the horizon, the M&A markets remain sluggish. Despite the current market conditions, Employee Stock Ownership Plans (ESOPs) remain a viable strategy for business owners who desire either a full or partial liquidity event. An ESOP is a qualified retirement plan that primarily invests in the stock of the employer company. Thus, an ESOP can be used by a business owner to "create" an internal buyer of company stock. In addition, ESOPs can create substantial tax benefits for both the corporation and selling shareholder.

As an ESOP-owned company, SC&H has the real world experience necessary to help our clients navigate the unique aspects of an ESOP. We rely on the specialized knowledge of our professionals to serve ESOP clients nationwide, assisting selling shareholders, plan sponsors and trustees in establishing and maintaining well designed ESOPs. Our services cover both the initial ESOP transaction as well as annual compliance issues and include all of the following:

• Pre-transaction valuations
• Fairness opinions
• S Corporation tax opinions
• Annual valuation updates
• ESOP plan audits
• ESOP accounting assistance
• Company sponsor financial statement audits

If you are considering your options for a liquidity event, an ESOP may be the most beneficial vehicle to realize the highest level of after-tax proceeds. If you, or one of your clients, may benefit from considering an ESOP as an exit strategy, please contact one of our ESOP professionals by email at esopvaluation@scandh.com or call (410) 403-1500 or (800) 832-3008.

Valuations Insights, Fourth Quarter, 2009

Bankruptcy Court Cannot Just 'Split the Difference' in Divergent Discount Rates

United Air Lines, Inc. v. Regional Airports Improvement Corp., 2009 WL 1181852 (C. A. 7 (Ill))

May 5, 2009

In United Airlines' Chapter 11 reorganization, the bankruptcy court considered how much the airline owed lenders that financed the improvements to its gates at Los Angeles International Airport (LAX). The original 2004 loan amount was $60 million. According to its reorganization plan, United would have to pay the full, present value of the assets that served as security; i.e., the improved, leased space at the airport. Any excess would be unsecured debt, which the airline could write down.

Absent a liquid market for improved space at an airport, the fair market value of the property turned on the amounts that would be agreed upon by a hypothetical willing buyer and willing seller.

The appropriate rental rate.

The airline expert used $17 per square foot, the historic market rate that LAX charged to airlines, for United's leased space. The lenders disagreed, arguing that this was the rate that the airport offered prior to the 1984 Olympics for unimproved space. The trustee's expert looked at rental rates charged by a consortium of airlines that operated out of the airport's second terminal (LAX2). In 2004, the year of the loan, the consortium leased gates to other carriers at $63 per square foot. The bankruptcy court determined that an estimation of market rental rates was too speculative, and adopted the airline's $17 figure. On review, the district court agreed.

The Seventh Circuit found fault with both lower courts.

The Seventh Circuit disagreed, finding that the price was more likely somewhere between the $17 and $63, noting that, "Any potential rental price higher than $30 would make the collateral worth at least [the] $60 million [loan amount]," the court ruled, even with the discount rate that the bankruptcy court selected. That is where the court turned its attention next.

A judge must choose the right discount rate.

In its DFC analysis, the lender's expert chose an 8% discount rate, citing the rate that LAX currently paid on unsecured general revenue bonds. By contrast, United's expert selected 12% as the rate that investors would demand, given the industry's volatility. "The bankruptcy judge added the two estimates and divided by two," the Seventh Circuit explained. "An arbitrator might choose such a method, and perhaps a jury would do so behind closed doors, but a judge should choose the right discount rate rather than split the difference between the parties," it said, with emphasis.

Instead of looking at the general industry risk, it would have been more credible to look at the risks of this airport, the court added. If the airport could raise money at 8% without giving security, then secured debt investors would not demand more, and that "is all we need to know" to conclude that the discount rate could not exceed 8%.

Using the $17 per square foot rental rate, bankruptcy court projected industry-rate increases over the term of the loan (2021) to reach $146 million. Discounted by 8%, the court arrived at a present value of $46 million. Increasing the rent to $23 would make the lenders fully secured, the court held, in reversing the lower courts' judgments. "Because improved space in [LAX2] fetches almost three times the price needed to make these loans…secured, the lenders are entitled to a full recovery."

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