The 2005 Jelke v. Commissioner decision has been described as “poor” for the taxpayer (by Shannon Pratt in the BVU) and frustrating for the appraiser. The Tax Court declined to follow the leading case, Estate v. Dunn (5th Cir. 2002), and adopt a dollar-for-dollar discount for a holding company’s built-in capital gains tax liability. After receiving the disappointing result in Jelke, the taxpayers almost did not want to appeal, according to their original appraiser, Will Frazier (see BVWire #62-3). “Their advisors and I had to beg them.”
But they ended up hiring attorney John Porter (Baker Botts, Houston), “a good choice on their part,” Frazier said. (Porter led the reversal of McCord v. Comm’r by the Fifth Circuit in 2006.) The effort evidently paid off, as the Eleventh Circuit opinion provides an exhaustive but excellent review of precedent in support of its decision. We’ve abstracted the case in some detail to give appraisers a full understanding of the context for the Jelke decision and its ultimate findings.
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While there is a general consensus that liquidity is an important component of asset-pricing, there is a wide divergence of views regarding an appropriate discount for lack of liquidity. Precise measurement of the impact of block size, asset size, trading speed, and trading cost—as of a given valuation date—has been difficult. The valuation community is being challenged to provide empirically supportable evidence for fact-based, case-specific levels of discounts for lack of liquidity (DLOL).
Quantifying liquidity can be elusive
Valuation practice relies heavily on data from public equity markets to estimate the underlying parameters for the appraisal of closely held businesses, by way of required rates of return, market multiples, or size premiums. In the past, the “gold standard” of liquidity has been described as “call the broker and receive your funds in three days.” While this conveniently assumes that blocks of all sizes for all publicly listed (marketable) firms are equally liquid—in practice, liquidity can be quite elusive. The apparently large volume of shares trading daily on U.S. equity markets represents less than 1% of all listed (marketable) shares eligible for trading. Further, public equity markets show varying degrees of liquidity across a spectrum of both time and size.
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Litman v. United States, 2007 U.S. Claims LEXIS 273 (August 22, 2007)
Not since the Estate of Gimbel v. Commissioner (2006) [usual format] has a federal court taken such a close and comprehensive look at the calculation of marketability discounts for large blocks of restricted stock. But in Gimbel, the issuer’s repurchasing option played a significant role in reducing the risk and the applicable discount for a 13% block of shares in a publicly traded, steel and aluminum company. By contrast, Litman considered an emerging Internet company’s transfer of nearly 10 million shares to insiders (about 33% more than the public float) on the eve of its IPO, with the stock subject to considerable contractual and non-contractual (SEC) restrictions, as well as market, industry, and company risk.
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