Smith v. Smith: A Closer look at Equitable Distribution and the Valuation of Closely Held Businesses
Kary C. Watson
Law & Valuation
The North Carolina courts have given family law attorneys little guidance on the appropriate way to value a spouse's interest in a closely-held corporation. The courts have been generally willing to accept a wide variety of valuation methods and techniques. Not only have the courts allowed various methods in different cases, but also they have often allowed for a mixing of methods within the same case. This mixing of methods creates the impression that the courts are result driven; that they choose the expert and the method that leads to the result that they want.
The lack of direction by the courts on this issue appears to be the product of several factors. First, in North Carolina the trial court is only required to arrive at a value that reasonably approximates the net value of the business interest.(1) In addition to this wide grant of discretion, many trial court judges are not familiar with the sophisticated valuation techniques that are being presented to them. In fact, one trial court judge even admitted the following in an equitable distribution judgment: "this court lacks the kind of expertise to revise the discount rates chosen by the expert witnesses and to choose the appropriate comparables . . ."(2)
It is the combination of these two factors that have produced the muddy state of the law in this area. Many hoped that the because of the complexity of the businesses at issue in the Smith(3) case, the court would embrace the opportunity to lay out some clearer rules. For the most part this did not happen. Although the North Carolina Court of Appeals did announce in Smith that the use of an "industry standard" approach was acceptable when valuing a car dealership, the court did not express an opinion as to which method of valuation is generally preferred for the closely-held corporations involved.(4)
Before examining the Smith case in detail, it will be helpful to quickly look at the law of equitable distribution in North Carolina.
In 1981 North Carolina enacted its Equitable Distribution Act, abandoning the old title theory as the appropriate way to divide assets upon divorce.(5) Although North Carolina now refers to itself as an "Equitable Distribution" state, in reality it is a "marital property" state. If the North Carolina act was intended to be pure equitable distribution then the judge would have the freedom to distribute all of the property owned by the divorcing couple. The North Carolina act does not go quite this far.
Chapter Fifty of the North Carolina General Statutes describes the process the court must follow in an equitable distribution case. Specifically, the Act requires that the court, when undertaking a property division, follow a six step procedure:(1) classify all property of the parties as separate or marital, (2) value the separate property and assign it to the appropriate party, (3) value each item as marital property, (4) classify the debts of the parties as marital or separate and value them, (5) apportion or distribute the marital debts in an equitable manner, and (6) distribute the marital property equitably.(6)
The second and third steps of this process are where valuation techiniques and issues come into play. Specifically, the statute requires that after calssifying the propety as either marital or separate the trial judge must ascertain the net value of the property as of the date of separation.(7) Net value is not defined in the statute, but the North Carolina courts have consistently interpreted it to mean fair market value. Fair market value is defined as "the price which a willing buyer would pay to purchase the asset on the open market from a willing seller, with neither party being under any compulsion to complete the transaction."(8) Unfortunately, N.C.G.S. § 50-20 represents all the guidance that the legislature has given in the area of valuation and equitable distribution. It is left up to the trial judge to determine what the actual fair market value of an asset is.
Smith V. Smith:
The parties involved were married on June 6, 1972 and subsequently separated on June 24, 1988.(9) On July 13, 1988 the plaintiff, the wife in this matter, filed a complaint seeking several forms of relief including child support and post-separation support.(10) These issues were heard over a five week period of time from November to Decemeber 1990.(11)
The trial was lengthy due to the large size of the marital and separate estates in question. In addition to having many investments, the defendant, Mr. Bruton Smith, was part owner of Sonic Financial Corporation, a holding company comprised of various assets, including several car dealerships and the Charlotte Motor Speedway.(12) At the end of the trial, Judge Brown entered an order for distribution of the marital property which included a finding that the net value of the marital property was $44,183,807. Moreover, Judge Brown found that an equal distribution of the property was not equitable, and distributed 69% to Mr. Smith and 31% to Mrs. Smith. The judgment was appealed by both parties. Although there were several issues on appeal, this paper will focus on the defendant's appeal of Judge Brown's valuation of the Charlotte Motor Speedway.
The defendant appealed the trial court's judgemnt as to the value of his interest in the holding company Sonic. In order to determine if the trial court commited error in valuing this piece of the marital estate, the court had to reexamine the value of its parts, which includes the Charlotte Motor Speedway.(13) The court recognized that the Charlote Motor Speedway ("CMS") was by far the most valuable asset held by Sonic.(14) Defendant contended that the trial court erred in its valuation of CMS in that: (1) the trial court failed to use a sound valuation methodology; and (2) the evidence presented at trial did not support the findings made or the methods used by the court in valuing the asset.(15) In order to determine the validity of defendant's claims, the Court of Appeals reviewed carefully the evidence presented at trial and the judgment entered by the trial court.
During the trial, the court was presented with several approaches to valuing CMS. The expert for the plaintiff, Mr. Nicholson, used an income approach. In addition, Nicholson used a market multiple approach as a test of the reasonableness of the values he reached through his primary income approach.(16) The defense rejected both of these methods and instead presented the court with a valuation of CMS based on the excess earnings approach.(17)
The court found that the while the market multiple approach did not produce a reasonable value for CMS, both the income and excess earning approaches were reasonable and accurate methodologies for valuing CMS.(18) Although the court found both methods acceptable, the trial judge disagreed with the experts' application of them. Judge Brown rejected the method used by the palintiff's expert, Mr. Nicholson, for several reasons including a defect in the beta multiple that he selected.(19)
However, the primary reason for the court's rejection of the income method had little to do with the method itself. The court was uncomfortable with Nicholson's lack of familiarity with the type of asset involved. Specifically, the court noted that Nicholson had nominal contacts with CMS's officers and employees.(20) Moreover, he never even bothered to visit the speedway himself.(21) The court felt that this lack of experience was problematic in that the level of expertise of the expert is criticially important to the accuracy of any valuation.(22) Since Judge Brown felt that the expert was in essence not qualified, he dismissed the method Nicholson suggested with little or no discussion as to its effectiveness or appropriateness as a valuation method for CMS.
The court also rejected the value of CMS presented by the defense expert, Mr. Beck, citing several problems with Beck's valuation. Primarily, the court was concerned about the large amount of risk that the defense claimed was involved in an investment in CMS, and the capitalization rate that reflected this perceived risk.(23)
In the end, the trial court chose to determine the value of CMS himself using the excess earnings method.(24) The North Carolina courts have recognized the authority of a trial judge to arrive at a value of his own as long as the value is based upon appropriate factors to be considered in the valuation process and the evidence presented.(25) The trial court here appears to have complied with these requirements.
Judge Brown chose the excess earnings method over the income approach because he felt that it allowed sufficent flexibility for him to correct the mistakes that Beck had made.(26) In essence, the internal structure of the excess earnings method allowed the trial court to reach a valuation for CMS based on the evidence presented, making it unnecessary for him to go through the entire valuation process himself. Keeping the method used by the defense allowed Judge Brown to simply build on what the defendant had already done.
The excess earnings method, as used by the Smith court, determined the net value of CMS (the fair market value) by adding the following three things: (1) the net value of the facilities; (2) the capitalized excess earnings currently realized by its operational activities; and (3) CMS's book value excluding the appraised value of its facilities.(27) The trial judge accepted the defense's expert values for the first and third components but challenged the expert's calculation of the capitalized excess earnings.
The trial court rejected the value presented by the defense for several reasons. Specifically, the trial judge found that Beck's analysis contained the following defects: (1) the degree of risk inherent in a capital investment in this particular racing enterprise; (2) lack of care in key data compulations; (3) computation of CMS's weighted average income; and (4) his capitalization rate.(28) The court recognized that these factors vary in their degree of importance, but stressed the fact that a problem with any one of them would cause the court to reject the expert's valuation.
Judge Brown focused his critique on the defense's emphasis on the riskiness of the racing business and on the capitalization rate selected by Beck. First, the court noted that the defense focused on several contingencies that would affect the future income of CMS. These contingencies included rain, sanctioning of races held at CMS, possible legislation that would restrict advertising, and a potential government-imposed ban on auto racing during the war with Iraq or some future world war.(29)
The court found that the likelihood of these factors is best measured by the actual history of the racing industry, and, in particular, CMS.(30) Throughout the judgment, the court stressed the need to look at the actual history and events surrounding this business. Several times, the trial judge noted that the excess earnings method rested on many assumptions and hypothetical situations, and that this was only compounded by the type of 'special purpose' facility involved in this valuation. Therefore, it was critical to keep the actual history of CMS in mind as much as possible.
After carefully considering all of the evidence presented about the actual history and productivity of CMS, the court held that the risk invloved in the successful operation of CMS was nominal at best. Specifically, the court found that any risk of NASCAR sanctions was nominal; that any risk of rain was both nominal and temporary; that any fear of a ban due to war was nothing more than mere conjecture; and that in reality the corporate sponsorship of both CMS and the races that are held there was strong.(31) Finally, the court determined based upon evidence of the expansion of CMS by the defendant, and his recent acquisition of the Atlanta International Speedway, that the Defendant was in fact confident about the future of the racing industry and CMS. Moreover, the defendant's investing in the auto racing industry had not been stifled by any fear of risk.(32)
The court's rejection of the risk analysis presented by the defense lead to its rejection of the capitalization rate used by the defense. The court noted that in applying the excess earnings method, the capitalization rate is the single facor which most affects the final value.(33) The defense's expert, Mr. Beck, selcted a capitalization rate of thirty-three percent. The trial judge commented that he had never seen such a high capitalization rate selected.(34) During the trial, Beck cited only one reason for choosing this rate, stating that the basis for the rate was the volitility of earnings of CMS.(35)
Here again, the court dismissed the position of the defense because it did not logically follow from the evidence presented. The court found that an examination of CMS's corporate earnings did not reveal this type of volatility. Specifically, the court noted that since 1984 the records indicated a consistent upward trend. In fact, although some components of CMS may have experienced a loss in a given year, there was no evidence presented that CMS, as a whole, ever suffered a loss.(36)
Once again, the defense had simply overstated the risk involved in owning and operating CMS. After examining all of the evidence presented, including evidence of CMS's earnings, its expansion, and the continuing popularity of NASCAR events, the court found the proper capitilization rate to be sixteen percent.(37)
As noted earlier the court's selection of the sixteen percent capitalization rate was challenged by the defense on appeal. The Court of Appeals in reviewing this issue also noted the importance of the capitilzation rate to a correct application of the excess earnings method.(38) The court noted that the rate is intended to reflect the amount of risk involved in an investment. Specifically, the court stated "the capitalilzation rate represents the rate of return a prudent investor would expect annually on his investment given current interest rates and the relative risk involved in the type of business in question."(39)
In reviewing the lower court's rejection of the defense's thirty-three percent rate, the Court of Appeals relied on the findings of the trial court, specifically citing portions of the original judgment which included the finding that the defense's rate "overstates risk, and indicates a degree of investment risk the finanical history of this corporation simply does not substantiate."(40) The appellate court's reliance on the trial court's findings is appropriate in the review of valuation issues. As stated earlier, the appellate courts need only find that the value arrived at "reasonably approximates" the net value of the business.(41)
Moreover, the Court of Appeals held that the trial judge was not bound to pick either of the capitalization rates presented by the parties. A trial judge is free to arrive at a value on their own as long as it is supported by the evidence and not arbitrarily chosen.(42) The court reviewed the extensive findings of fact and judgment of the trial court, finding that the value chosen by the trial judge was amply supported by evidence and was not arbitrarily chosen.(43) On these grounds, the Court of Appeals upheld the trial court's valuation of CMS without thoroughly discussing the validity of the excess earnings method to determine the value of a closely-held corporation in an equitable distribution action.
There are three general approaches to valuation: income, asset based, and market comparable.(44) Included within the income approach are the methods used by both experts in Smith: the capitalization of discounted cash flow (plaintiff) and the capitalization of excess earnings approach (defendant).(45) The excess earnings method was the method eventually used by the trial court in reaching a fair value for CMS. The court in its judgment does not describe the operation of this method in any detail. However, it is useful to see what process the defense expert and trial judge were actually engaged in.
The excess earnings method originated as IRS Revenue Ruling 68-609. The ruling puts forth a formula that first values the net tangible assets of a business, then determines the "goodwill" value of the business by capitalizing any earnings in excess of a reasonable return on the net tangible assets.(46) Specifically, under this formula the fair market value of of a closely-held company is determined by executing the following computations(47):
(1) Determine the average net earnings, excluding reasonable officers' compensation, of the business for not less than five years. Abnormal years whether below or above the average should be eliminated.
(2) Determine the average annual value of the tangible assets used in the business for a representative number of years immediately preceeding the valuation date.
(3) Determine a fair percentage return on tangible assets computed in (2).
(4) Deduct (3) from (1). This is the amount of average earnings attributable to good will or excess earnings.
(5) Capitalize the average earnings attributable to goodwill or excess earnings computed in (4) and an appropriate percentage.
Although the Smith court did not follow the above formula precisely, the three components used by both the defense's expert and the trial judge are all contained within the formula. Under the excess earnings method as used by the court, the net value (fair market value) of CMS was determined by adding: (1) the net value of CMS's facilities; (2) the capitalized excess earnings currently realized by its operational activities; and (3) CMS's book value excluding the appraised value of its facilities.(48) The Smith court appears to have consolidated parts of the formula contained in 68-609. In particular, the court chose to outline the way to determine the excess earnings of CMS in more detail than step (4) of 68-609 does. Recognizing again the peculiar nature of the business being valued in this case, the trial court defined the excess earnings of CMS as "the net income from operations in excess of a normal return on value from a net lease of the real property owned by CMS; or, stated differently, "the amount by which expected net income from operations would exceed the expected rental income."(49) In essence, this formula, as the court describes it, gives you the same or similar value that step (4) of the formula in Revenue Ruling 68-609 would.
A. Selection of the Capitalization Rate
The excess earnings method has become the method of choice for valuing assets in equitable distribution cases.(50) However, this method also provides the most opportunity for abuse.(51) In fact, the IRS stated that the method should only be used as a 'last resort' when other, better methods are unavailable.(52) Much of the criticism of this method is based upon the difficulty in choosing an appropriate capitalization rate.(53) The rate is supposed to represent the amount of risk involved in a particular business.(54) However, it seems that determining the amount of risk is little more than pure speculation.
The problems inherent in the selection of this rate were the primary grounds for the defense's appeal in Smith. As noted above, at trial, the plaintiff, the defense and the judge each selected varying capitalization rates. The plaintiff suggested that the amount of risk invloved in investing in a company like CMS was twelve percent, while the defense argued that it was over double that--thirty-three percent.(55) After discarding the value presented by the defense as too high, the trial judge found that the appropriate capitalization rate to be sixteen percent.(56) Although this rate falls within the traditonal range of 15 to 20 percent(57), there is little discussion in the record of why the court settled on sixteen percent.
Unfortunately, the Court of Appeals does little more to clarify this issue on appeal. The court refers to the trial judge's finidngs of fact which included a statement that the trial judge was not persuaded that an investment in CMS had the high degree of risk presented by the defense.(58) In addition to this particular reference, the Court of Appeals generally noted that there was extensive evidence presented to the trial judge on the issue of the valution of CMS and particularly on the amount of risk involved.(59)
The Court of Appeals did not have to go any farther into the issue because of the accepted standard of review applicable in valuation cases. As noted earlier, in reviewing the valuation of an ongoing closely-held business made by a trial judge in an equitable distribution case, the court need only find that the value chosen reasonably approximates the net value of the business.(60) In determining whether a reasonable approximation has been reached, the reviewing court need only determine that there is credible evidence to support the trial court's valuation.(61)
Under this standard of review, it is clear why the Court of Appeals simply brushed over the process used by the trial court to arrive at the sixteen percent capitalization rate. Looking closely at the Court of Appeals' review of this issue, it is clear that this low standard of review has led to trial judges having great freedom in their valuation of businesses. In particular, it leaves them free to select a capitalization rate with little or no explanation. Only reviewing the selection of the rate to see if it produced a reasonbale value permits exactly the type of abuse that the critics of the excess earnings method are concerned about. In particular, it allows a trial judge to not only reject the rates presented by the parties, but also to choose one of their own that may be as speculative.
B. Consideration of Future Earnings as Problematic
There is a more fundamental problem with the use of the excess earnings method in equitable distribution cases like Smith: the formula used to determine excess earnings requires that future income be considered. In fact, all income approaches are based upon a projection of future earnings discounted to present value.(62) Specifically, the theory that underlies a capitalization formula like the one contained in Revenue Ruling 68-609 is that a "future flow of income has a present value and its value can be computed to an equivalent lump sum payment."(63)
The problem with considering future income in the equitable distribution context is that it could constitute a post-divorce division of income.(64) Specifically, the problem is that after a divorce is final, a spouse is not supposed to share in the income of the ex-spouse, unless it is through an alimony payment. This being the case, the excess earnings method is an inappropriate method to be used in the equitable distribution context in that it considers "income that is to be earned after the marriage."(65)
Courts should recognize this problem and seek to find better methods to value closely held corporations that are at issue in equitable distribution cases. One possibility might be to rely on an asset based approach where the value of the company is derived from its adjusted book value.(66) For example, the court could have chosen to value CMS by looking to what the actual cost of CMS was. This historical approach has been criticized because it does not take into consideration the time value of money--it looks to the past not to the future.(67) However, in an equitable distribution case this may be exactly what we want a valuation method to do. It is interesting to note that even though in Smith, Judge Brown used the excess earnings approach to value CMS he was constantly checking the evidence and values against the actual historical data of CMS. Maybe Judge Brown was also weary of relying on future income in valuing an asset that was to be divided at divorce.
Both the trial court and the Court of Appeals were faced with a wonderful opportunity in Smith to clarify the issues surrounding the valuation of closely-held businesses in equitable distribution actions and unfortunately failed to do so. The trial court's choice of both the excess earnings method and its specific capitalization rate were easily affirmed on appeal because of the low standard of review imposed by the Court of Appeals. This left all those who were hoping for a little more clarity still in the dark.
The Smith decision makes it clear that the court is willing to overlook the problems inherent in using the excess earnings method in equitable distribution cases. As long as use of the excess earnings method reasonably approximates the fair market value of the asset in question, then its use will be upheld. The courts do not seem to be concerned with the potential abuses that arise from the sheer guessing involved in choosing a capitalization rate. Nor are they bothered that the excess earnings method forces them to consider future income in spite of the very purpose of divorce and equitable distribution. In the end, the Smith case shows us that a trial court can choose any method and any value for any asset they want, as long as it is reasonable in light of the evidence presented.
1 Offerman v. Offerman, 137 N.C. App. 289, 527 S.E. 2d 684 (2000).
2 Id. at 294.
3 Smith v. Smith, 111 N.C. App. 460, 433 S.E. 2d 196 (1994), rev'd in part, 336 N.C. 575, 444 S.E. 2d 420 (1994).
4 Id. at 496-498.
5 Clarence E. Horton Jr., Principles of Valuation in North Carolina, Institute of Government (1993).
6 Horton, supra note 5, at 1, See also Byrd v. Owens, 86 N.C. App. 418 (1987).
7 NCGS § 50-20(c)
8 Carlson v. Carlson
9 Record, Smith at 12.
11 Record at 165.
12 Record at 185-190.
13 Smith v. Smith, 111 N.C. App. 460, 487, 433 S.E. 2d 196 (1994), rev'd in part, 336 N.C. 575, 444 S.E. 2d 420 (1994).
19 Record at 264-265.
20 Record at 264.
23 Id. at 488.
24 Id. at 488.
25 Id. at 493, See also Nix v. Nix, 80 N.C. App. 110, 341 S.E. 2d 116 (1986).
26 Id. at 488.
27 Id. at 488.
28 Record at 267.
29 Record at 268.
31 Record at 268.
32 Record at 269.
33 Record at 271.
34 Record at 271.
36 Record at 272.
37 Record at 273.
38 Smith v. Smith, 111 N.C. App. 460, 490, 433 S.E. 2d 196 (1994), rev'd in part, 336 N.C. 575, 444 S.E. 2d 420 (1994).
40 Id. at 491.
41 Offerman v. Offerman, 137 N.C. App. 289, 292, 527 S.E. 2d 684 (2000), see also Poore v Poore, 75 N.C. App. 414, 331 S.E. 2d 266 (1985).
42 Id. at 493; See also Hartman v Hartman, 82 N.C. App. 167, 346 S.E. 2d 196 (1986), aff'd 319 N.C. 396, 354 S.E. 2d 239 (1987).
43 Id. at 494.
44 Doyle Early, Valuation of a Small Business, 1997 Equitable Distribution Seminar, Wake Forest University C.L.E., 299.
45 After reading both the District Court's equitable distribution judgment and the Court of Appeals opinion, it is still unclear to me why the court refers to the method used by plaintiff as the 'income method'. Plaintiff's expert should have made it clear that they were using a particular method within the income approach: the discounted cash flow method.
46 Early supra note 40, at 300.
48 Early, supra note 40, at 302.
49 Smith v. Smith, 111 N.C. App. 460, 488, 433 S.E. 2d 196 (1994), rev'd in part, 336 N.C. 575, 444 S.E. 2d 420 (1994); See also Early supra note 40, at 302.
50 Alan Palmiter, Law & Valuation § 4.5.4 (2001) <http://www.law.wfu.edu/courses/law&value-Palmiter/00/0-0.html>
51 Early supra note 40, at 302.
52 Palmiter, supra note 46, at § 4.5.4.
53 Palmiter, supra note 46, at § 4.5.4 (quoting 2 John P. McCahey, Valuation and Distribution of Marital Property, § 22.08(2), 22-103-104 (1993))
54 Smith v. Smith, 111 N.C. App. 460, 490, 433 S.E. 2d 196 (1994), rev'd in part, 336 N.C. 575, 444 S.E. 2d 420 (1994).
55 Record at 259, 271.
56 Record at 273. See earlier section describing the case for a thorough discussion of why the court disregarded the numbers presented by both plaintiff and defendant.
57 Early, supra note 40, at 301.
58 Smith v. Smith, 111 N.C. App. 460, 492, 433 S.E. 2d 196 (1994), rev'd in part, 336 N.C. 575, 444 S.E. 2d 420 (1994).
59 Id. at 493.
60 Palmiter, supra note 46, at § 6.5.
62 Early, supra note 40, at 299.
63 Fred Kennedy & Bruce Thomas, Putting a Value on: Education and Professional Goodwill, 2 Family Advocate 3, 5 (Summer 1979). Although this article discusses the valuation of goodwill in a professional practice, I felt that the criticisms of the excess earnings method that it poses were as equally applicable to the closely held corporation.
64 Palmiter, supra note 46, at § 1.3.3.
65 EEC v. EJC, 457 A.2d 688, 693 (1983), See also Fred Kennedy & Bruce Thomas, Putting a Value on: Education and Professional Goodwill, 2 Family Advocate 3, 5 (Summer 1979).
66 Early, supra note 40, at 299.
67 See The Old Man and the Tree: A Parable of Valuation, adapted by Alan Palmiter, Law & Valuation, Introduction (2001) <http://www.law.wfu.edu/courses/law&value-Palmiter/00/0-0.html>