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Damages Expert’s ‘Before/After’ Lost Profits Analysis Bolsters Plaintiff’s Defamation Case

Mem’l Hermann Health Sys. v. Gomez, 2019 Tex. App. LEXIS 7199 (Aug. 15, 2019)

In a defamation and business disparagement case involving a cardiovascular surgeon and his solo practice, a Texas appeals court recently upheld the jury’s liability findings and damages awards. The plaintiff’s expert’s lost profits analysis focused on the number of surgeries the plaintiff performed and the nature of the plaintiff’s practice before the wrongful conduct took place and after. The defendant’s attacks on the expert failed, where the expert had considered, and convincingly ruled out, alternative reasons for a decline in business and presented to the jury a range of damages based on various scenarios and supported by evidence.

Backstory. The plaintiff (appellee), a cardiovascular (CV) surgeon, and his business entity, sued the defendant health system for defamation, business disparagement, tortious interference with prospective business relations, and restraint of trade. In essence, the plaintiff asserted the defendant used misleading data related to the plaintiff’s performance and engaged in a “whisper campaign” to eliminate competition.

The defendant was one of the largest not-for-profit health systems in southeast Texas. The plaintiff started working for one of the defendant’s hospitals, Memorial Hermann/Memorial City hospital (MH/MC), in 1989 when the leading heart surgeon was looking for a partner. For a decade, the plaintiff’s practice was successful. He was known for performing robotic surgery, which was good for MH/MC’s business, and patients the plaintiff treated seemed to be doing well. The plaintiff had referrals from other doctors who thought him to be “an excellent surgeon.” (The plaintiff also started a vein clinic while working at the defendant’s hospital.)

However, in 2008, leadership at MH/MC changed. At the same time, another healthcare provider, Methodist Health System, planned to open a new hospital, Methodist West Hospital. The plaintiff indicated that he wanted to perform heart surgeries at both hospitals. The defendant seemed concerned that the plaintiff’s plan would cause its hospital, MH/MC, to lose business.

In the first half of 2009, while Methodist negotiated its future contract with the plaintiff, an employee of the defendant told a physician liaison with Methodist West that there was talk that the plaintiff’s work was of “bad quality” and his mortality rates were high. The liaison later testified that she believed what the source of the rumor had said because “[i]t was in the ether, it was out there,” and she recommended that Methodist West carefully vet the plaintiff.

Also, in early 2009, the defendant decided to initiate a data-driven review of various programs, including the CV surgery program. The standard process was to measure the outcome of certain procedures, including cardiovascular surgery, by adjusting for risk.

However, the defendant’s data analysis focused on the mortality rates of individual surgeons and was not risk-adjusted. The MH/MC executive in charge of the review claimed some cardiologists were concerned that the mortality rate in the program was too high. The hospital had four CV surgeons, including the plaintiff.

In fall 2009, Methodist West, while it was still building its CV surgery program, decided to hire the plaintiff as an independent contractor. He also was to hold an administrative position, co-directing that hospital’s cardiovascular robotics institute, and was to serve as senior advisor for cardiovascular surgery service development.

Around the same time, the plaintiff’s surgery partner at MH/MC told him the hospital had data that showed the plaintiff’s mortality rate for patients treated was high. The plaintiff later testified that this statement essentially meant: “I was a bad surgeon.” The plaintiff was informed he would be suspended or proctored. He testified that “proctored” meant he would be subject to supervision while performing services. He said it would be impossible to keep this status secret. Everyone, doctors and nurses, will “know that you’re a suspended doctor, a proctored doctor. And so basically your reputation is ruined.”

At a September 2009 meeting including MH/MC medical and administrative leadership, a slide presentation claimed two CV surgeons, out of the total of four, were “the primary drivers in the unfavorable mortality rate.” The surgeons were only identified by a number. One surgeon’s mortality rate was said to be 40%, and the other’s mortality rate was 11.1%. Another slide, “Risk Adjusted Observed to Expected Ratio” (O/E ratio), showed that two surgeons had performed better than the performance marker and two had performed worse.

In a follow-up meeting with the chairman of the cardiovascular peer review committee, the leader of the review process said the plaintiff was one of the two CV surgeons whose performance was subpar. The chairman was concerned about the statements in the slide presentation and the process for analyzing the data and began a review of all surgical cases from which the raw data came. That review took several months and ended with the conclusion that there was no “quality of care issue with any of the four surgeons that had their data presented.” There was no need for “any proctoring or changing of privileges.” The chairman later also testified that sharing “raw” surgeon mortality data was “absolutely not” the right thing to do, as it would “hinder referral patterns, damage reputations.” The committee chairman recommended against this practice.

Although he informed the four surgeons that the review process was closed, the evidence showed that, going forward, the leadership at MH/MC continued to create and use individual surgeon mortality rates, including in public presentations.

When the plaintiff confronted the leadership over the use of the contested data, he said he was told that “we needed to be a transparent organization, that this was a safety issue.” He said he was told the data had been shown to other cardiologists and physicians who normally referred patients to him, ostensibly to allow the latter to make informed decisions about whether or not to refer patients to the plaintiff.

A former colleague of the plaintiff testified that, while doctors had a high opinion of the plaintiff before 2009, “there was eventually a ‘general consensus’ that ‘Dr. Gomez has a high mortality rate.’” This witness said there was a “whisper campaign” that influenced other cardiologists when deciding whom to choose as a surgeon.

The hospital later instituted a “hiatus” for marketing the services of the plaintiff. A witness testified that questioning someone’s surgical abilities and putting marketing efforts on behalf of a physician on pause was “a big deal.”

In April 2012, the plaintiff resigned his privileges at the defendant’s hospital and moved his practice to Methodist West.

Later, in 2012, the plaintiff and his business entity, which he used for billing, accounting, and liability purposes, filed suit against the defendant. The plaintiff’s defamation and disparagement claims alleged the use of misleading individual surgeon mortality rates and a damaging whisper campaign.

Expert testimony on lost profits. The plaintiff offered expert testimony, from a forensic accountant, on the financial impact of the defamation and disparagement on the plaintiff individually and on his business. The expert’s damages calculation focused on lost profits related to the decline in the plaintiff’s CV surgical activity. The expert said she did not consider the plaintiff’s vein practice in calculating damages because it “can also be done by a physician assistant or nurse practitioner” and it was “not the core of [the plaintiff’s] practice or what he went to school to do.” The expert explained that doctors often had cosmetic “side” businesses and were able to maintain two practices (the main practice and the cosmetic side practice) at once.

The expert compared the CV practice, i.e., the number of surgeries the plaintiff performed, before and after the disparagement. She used the plaintiff’s records and reviewed tax returns, affidavits, as well as records of procedures the plaintiff performed at his new workplace, Methodist West, and other materials. She also considered the plaintiff’s training in robotic surgery. And she undertook research “to get an idea of what the market for cardiothoracic surgery was, what people were saying in the industry about the surgery, about the number of surgeons out there, about what the demand was.” She said she wanted to “get an indication of what the overall environment was.”

The expert said she treated the business the same as she treated the plaintiff because he was a solo practitioner and the two were “more or less … the same person.”

Looking at data from 2004 through 2016, the expert was able to extrapolate what the plaintiff’s practice would have looked like “had it been able to continue from 2008 on.” In other words, to calculate expected profits, the expert determined what the plaintiff would have earned “but for” the defendant’s actions as well as the related costs. She then subtracted the actual profits from the estimated profits.

According to the expert, the plaintiff would be able to perform 258 surgeries per year “given the fact that a lot of the procedures would be robotic which can be faster and he also has a broad range of surgical procedures that he can perform.” The expert found that, in 2004, the plaintiff undertook 288 surgeries. Between 2005 and 2007, the number declined because the plaintiff was training to perform robotic surgeries and building his vein clinic. Between 2009 and 2010, when the rumors against the plaintiff started and gained traction, the expert saw a significant decline in the number of procedures the plaintiff performed and in revenue. The expert used 2010 as the starting point for calculating lost profits.

For future lost profits, the expert said she calculated a range of damages because “we don’t exactly know what the lingering effects of the damage to [the plaintiff’s] reputation are and will be in the future.”

She also said there was no indication that the practice had begun to recover; rather, “there continues to be a decline.” The expert developed various scenarios to calculate damages, including: (1) projecting no growth for the practice; and (2) projecting 4.6% growth based on the assumption that there would be some recovery in the future. Adopting a more conservative approach, the expert also assumed the plaintiff could not achieve the 258 surgeries per year even if the defamation had never occurred. The expert’s various scenarios resulted in a range of damages from $2 million to $5.6 million.

The expert said she considered other causes that might have led to a decline in business, including market conditions and the plaintiff’s own actions. But the expert ruled all other causes out, noting that, while the CV surgeons at MH/MC had similar numbers of procedures until 2009, two of the four surgeons experienced an increase in numbers since 2009. At that time, the plaintiff’s numbers began to decline.

The expert further explained that the plaintiff’s vein practice, and any income the plaintiff earned from it, were not of consequence to the damages calculation because the vein practice would not have cut into the CV practice had he been able to increase CV activities. The plaintiff could have turned the vein practice over to a nurse practitioner, the expert reasoned. Also, the vein practice was not as susceptible to the defamation because it did not rely on the same referral sources as the CV surgery.

Economic and nonpecuniary harm. The jury found for the plaintiff on the defamation and business disparagement claims. It rejected the restraint-of-trade claim.

As economic damages, the jury awarded the plaintiff damages for past injury to his reputation based on one person’s defamatory statements and on the mortality rate data. In addition, the jury awarded damages for probable future injury to the plaintiff’s reputation based on the same statements and data.

The defamatory statement referred to remarks, in the first part of 2009, by one of the defendant’s employees to a physician liaison with Methodist West, in which the employee said there was talk that the plaintiff’s work was bad and his mortality rate was high. The contested data referred to the defendant’s repeated use of the individual surgeon’s mortality rate, unadjusted for risk factors related to a patient’s case.

Moreover, the jury awarded the business entity past and future lost profits for disparagement related to the whisper campaign and use of the contested data.

Finally, the jury awarded damages for past mental anguish related to the defamation. It also determined there was malice related to the mortality data and therefore awarded exemplary damages. The total amount of damages was over $6 million.

The trial court accepted the jury’s verdict and issued its final judgment.

Plaintiff proves causation of damages. The defendant appealed the damages with the state Court of Appeals arguing, among other things, the plaintiff had failed to establish causation for the defamation and business disparagement claims. The plaintiff did not link either the contested statements or the mortality data to any harm to his reputation or lost profits, the defendant said.

The Court of Appeals disagreed, finding the defendant “misrepresent[ed] the nature of the evidence presented at trial.”

The court explained: “Actionable defamation requires (1) publication of a false statement of fact to a third party, (2) that was defamatory concerning the plaintiff, (3) with the requisite degree of fault, and (4) that proximately caused damages.” (citation omitted)

As to lost profits, state Supreme Court case law says, “The amount of the loss must be shown by competent evidence with reasonable certainty.” What constitutes “reasonable certainty” is a “fact intensive determination.” Estimates of lost profits “must be based on objective facts, figures, or data from which the amount of lost profits can be ascertained.” However, “it is not necessary to produce in court the documents supporting the opinion or estimates.”

The court noted the liaison for Methodist West to whom the defamatory statements were addressed specifically testified that the statements affected her opinion of the plaintiff. This witness expressly said she “absolutely did believe” the statements and had “witnessed that happening and heard it from multiple physicians.” The witness also said she had recommended extra vetting of the plaintiff.

Even though Methodist West did eventually hire the plaintiff, this did not mean that his reputation did not suffer harm from the statement and extended vetting process, the court noted. Further, being only employed by Methodist West meant the plaintiff performed fewer cardiovascular surgeries “for which he had trained and which he had developed a highly marketable technique prior to the defamatory statements made about him.”

The plaintiff testified that he had not intended to quit practicing at the defendant’s hospital but felt compelled to resign his privileges there. The nature of his practice also changed in that many of the procedures he currently performed required less skill than the surgeries he had performed before the defamation was published.

Moreover, although there was evidence that some people still had a good opinion of the plaintiff, this did not mean he suffered no harm to his reputation, the court said. There was testimony that the whisper campaign was real and affected the plaintiff’s reputation and business.

The court also said the defendant ignored the expert testimony the plaintiff offered. The damages expert presented detailed facts as to the nature of the practice before and after the alleged defamation. She supported her conclusions with data on the plaintiff’s surgical referrals and the number of surgeries performed before and after the wrongful conduct.

The court rejected the claim that the plaintiff failed to connect his lower surgical numbers to particular instances of defamation. There could have been multiple reasons for this loss, the defendant argued, calling the plaintiff’s theory of recovery “wildly speculative.”

In contrast, the court observed the plaintiff’s damages expert showed there was a decline in referrals and CV surgeries and she quantified damages for this decline. The expert testified that, when the individual surgeon mortality rate data first came into use, in 2009 and 2010, a noticeable decrease in the volume of the plaintiff’s practice occurred. The expert testified the low volume continued for years and the plaintiff’s practice never fully recovered.

The jury was entitled to believe the witnesses who said there were doctors who believed the plaintiff was a bad surgeon having high mortality rates. The jury also had “latitude” to award damages resulting from the harm to the plaintiff’s reputation among fellow professionals, the court said.

Damages based on sufficient evidence. In a related argument, the defendant claimed the evidence to support the damages the jury awarded was “legally insufficient.” The defendant specifically attacked the damages expert’s calculation.

Besides claiming the expert failed to rule out reasons for the decline in business other than the defamatory statements and misleading data, the defendant tried to attack the expert’s method and data. None of the arguments had traction with the Court of Appeals.

The court noted the expert in fact testified she had considered other factors that might have contributed to the decline in the plaintiff’s CV surgery business, including “market-driven” factors, the plaintiff’s personal life, and his involvement with the vein clinic. However, the expert concluded none of these reasons explained the decline. She pointed to data showing the plaintiff’s fellow surgeons experienced growth in their practices during the time the plaintiff experienced a decline. Further, the vein clinic did not prevent the plaintiff from maintaining a full surgical practice. Also, the plaintiff said he would have preferred to devote more time to CV surgery but lacked the referrals to make a full practice.

The appeals court noted the trial court had found the expert qualified and her methodology followed the legal principles applicable to lost profits. She presented a range of damages to the jury, with supporting data. She considered data specific to the plaintiff’s practice and also looked at comparable practices in the area and at general market conditions, the appeals court noted.

The defendant claimed the number of procedures the expert said the plaintiff could perform per year (258) was unsupportable. But, the appeals court, noted the expert found there was a year before the defamation began in which the plaintiff had performed more than 258 surgeries . Also, other surgeons performed as many surgeries. “But for” the defamation, the plaintiff could have performed as well, particularly given his experience in robotic surgery, the expert believed.

The court also noted the expert developed damages based on a number of scenarios. The jury was entitled to credit the evidence supporting any one of the expert’s representations. The defendant took issue with the conclusions the expert drew, the court observed. However, this objection went to the weight of the evidence and its resolution was left to the jury.

Finally, the court found there was no double recovery. The plaintiff presented evidence of lost profits of up to $5.6 million related to defamation and damage to his reputation. The award for lost profits related to the entity was slightly over $5 million. This was within the range of evidence for lost profits and reputation damages, regardless of whether the plaintiff lost as an individual or as a one-person, the court said. The jury had a right to apportion the damages the expert presented among different damages theories, the court said.

The Court of Appeals affirmed the trial court’s damages findings.

Expert’s Reasonable Royalty Properly Captured Value Added by Plaintiff’s Invention

Simo Holdings, Inc. v. H.K. uCloudlink Network Tech. Ltd., 2019 U.S. Dist. LEXIS 146702 (Aug. 28, 2019)

The defendants sought to vacate the jury award to the plaintiff, claiming the plaintiff had based damages on a theory of lost profits disguised as a reasonable royalty and violated law that did not allow for lost profits in the circumstances present. The defendants also took aim at the plaintiff’s expert testimony, arguing the royalty rate the expert proposed was suspiciously close to the plaintiff’s profit margin and was based on numerous wrong assumptions. In an opinion that reviews several key principles applicable to damages in patent infringement cases, the court denied the defendants’ post-trial motions.

Backstory. The plaintiff sued the defendants for infringing the plaintiff’s patented technology related to data roaming. The defendant and its American subsidiary, uCloudlink, sold a line of mobile Wi-Fi hot spot devices and a mobile phone that enabled users to access data services during travel abroad without incurring the high roaming fees telecommunications companies typically charged. The plaintiff sold its patent-practicing products through its wholly owned subsidiary, Skyroam. The plaintiff claimed Skyroam and uCloudlink were direct competitors, as they were the only companies that provided both the hardware and the data in one package. Skyroam’s president testified what the companies offered customers was different from what other businesses offered. For example, manufacturers of mobile hotspots typically did not sell data services. On the other hand, carriers such as AT&T offered roaming services that were “very expensive” and not comparable to Skyroam’s products.

In essence, Skyroam buys a certain number of megabytes of data from a carrier and then packages the data and sells them in a “Daypass” to a retailer, for a higher price.

A jury found the defendants liable for willful infringement and, based on the plaintiff’s expert testimony as to what a reasonable royalty would be, awarded nearly $2.2 million in damages. The court enhanced the amount by 30% because of the jury’s finding of willfulness.

The defendants filed post-trial motions for judgment as a matter of law and for a new trial. Among other things, they challenged the plaintiff’s damages theory as well as the expert’s calculation of a reasonable royalty. The court found the defendants failed to meet the high standard that would allow the judge to overturn the jury award.

At the outset of its analysis, the court noted that, under federal rule of civil procedure 50(b) and the applicable case law, judgment as a matter of law is appropriate only if there is “a complete absence of evidence.” The burden on a party filing a Rule 50 motion “is particularly heavy after the jury has deliberated in the case and actually returned its verdict.”

Plaintiff’s damages theory is sound. The defendants’ principal argument was that, even though the plaintiff claimed to pursue a reasonable royalty, it actually tried to recover lost profits. The court noted that the defendants had made this argument in various ways during the litigation and the court had consistently rejected it.

Based on the premise that the plaintiff had sought lost profits, the defendants in their recent challenge argued that, under case law from the Federal Circuit, a parent company may not recover the lost profits of a subsidiary except if it can show that the subsidiary’s profits “flow inexorably up to the parent.” See Mars, Inc. v. Coin Acceptors, Inc., 527 F.3d 1359 (Fed. Cir. 2008), mandate recalled and amended, 557 F.3d 1377. The plaintiff was the parent company and did not sell the products featuring the protected technology directly but through its subsidiary, Skyroam. Under the applicable rule, therefore, the damages awarded to the plaintiff were based on the wrong theory, the defendants said.

The court noted the defendants stated the law correctly, but the rule did not apply because the plaintiff did not seek lost profits but a reasonable royalty. The court, once again, rejected the argument that damages were based on lost profits.

In a similar vein, the defendants claimed it was categorically impermissible to use the subsidiary’s profit margin in determining a reasonable royalty. By doing so, the plaintiff automatically made the damages theory one of lost profits instead of a reasonable royalty.

The court noted a reasonable royalty analysis seeks to “reconstruct what the parties would have agreed to in a hypothetical negotiation.” According to the court, there was little doubt that, in the “but-for” world in which the parties would have negotiated, the plaintiff would have considered the profit margins of its wholly-owned subsidiary. “It seems unreasonable to suggest otherwise.”

The court said it was not persuaded that it was impermissible to consider the subsidiary’s profit margins or “that doing so automatically made the damages theory one of ‘lost profits’ instead of reasonable royalty.”

In addition, the court pointed out that, in the converse situation, a suit by a subsidiary, the Federal Circuit “has expressly approved including the impact on a related company in the reasonable royalty analysis.” The Federal Circuit has found that, in any hypothetical negotiation, the economic impact on the parent company would “weigh heavily in all decisions.” See Union Carbide Chemicals & Plastics Tech. Corp. v. Shell Oil Co., 425 F.3d 1366 (Fed. Cir. 2005), overruled on other grounds.

Expert testimony holds up. The defendants also argued the expert testimony supporting the award was compromised. For one, the expert simply “plugged in Skyroam’s lost profits and called it a day.” The defendants noted that the reasonable royalty rate, $3.00 per Daypass, was almost identical to Skyroam’s profit margin per Daypass.

The court said this argument misunderstood the expert testimony and evidence. It did not appear that the plaintiff was “simply smuggling in lost profits under the guise of a reasonable royalty.” For one, Skyroam’s profit margin per Daypass was $3.00 at the wholesale price but was more like $7.00 at the retail price.

The plaintiff’s expert explained that Skyroam bought the data for $2.00 and sold the data packaged in a Daypass form for about $5.00 to a retailer. The difference reflected the “value” Skyroam had added through the use of its patented system.

The court said that, while this calculation might be “somewhat crude,” the defendants had failed to explain why it was not a reasonable proxy for quantifying the value Skyroam added.

The defendants alleged the expert was wrong in describing the relationship between Skyroam and uCloudlink as “zero-sum.” There were other competitors in the data roaming area.

First off, the court noted this argument was only relevant if the damages reflected lost profits, which was not the case here. “In any event,” the court said, there was testimony that the plaintiff and defendant entities were the only competitors for a specific pool of customers. They both supplied data and hardware and aimed their products at consumers that wanted both data and hardware in one package.

Other competitors might sell data services only, or they might sell stand-alone mobile hot spots.

In addition, the defendants argued the expert calculated the royalty incorrectly by basing the rate on the number of data packages (Daypasses) sold. The expert should have used the infringing devices for the royalty base.

The court called this “a curious argument” considering the defense expert (who was excluded for unrelated reasons) had also used the number of Daypasses to calculate a reasonable royalty. The court said doing so made good sense because, as the plaintiff’s expert explained, Skyroam profited from the sale of data accessed with its devices, not from the sale of the hardware itself.

The defendants’ argument that basing the royalty on the sales of Daypasses failed to limit damages to the infringing feature also had no traction. The court noted that the value of the defendants’ devices was not the hardware itself. Instead, it was “the fact that the products permit convenient global mobile network access. The devices are useful only insofar as they serve as ‘gateways’ to the data or mobile network.”

The defendants infringed the patented technology by “the manner in which uCloudlink devices provide roaming services,” the court noted. The plaintiff’s expert explained the value the plaintiff’s invention added as “the ability to provision mobile roaming services.” The court concluded that the defendants’ suggestion that a reasonable royalty had to be based on the infringing devices rather than the data accessed through infringement of the patented technology “is simply to ignore economic reality.” The plaintiff’s expert was not required to “subtract[] any unpatented elements,” the court said.

Apportionment can be done either by “careful selection of the royalty base or by adjustment of the royalty rate,” the court said, referencing Ericsson, Inc. v. D-Link Systems, Inc., 773 F.3d 1201 (Fed. Cir. 2014).

The court also found there was a basis for the plaintiff expert’s decision not to discount for noninfringing alternatives. He relied on testimony from the plaintiff’s technical expert that no acceptable noninfringing alternatives existed. Even though the defense expert disagreed, the jury was not required to credit the defense testimony over the plaintiff expert’s analysis. “Judgment as a matter of law is not an appropriate vehicle for a judge to pick sides in a battle of otherwise qualified experts,” the court said.

In concluding, the court noted that the defendants offered reasonable arguments why a reasonable royalty rate should have been lower. However, the jury rejected those arguments. “The Court cannot say that there was not substantial evidence supporting the jury’s damages calculation.”

Exclusion of defense expert testimony is justified. Finally, the court denied the defendants’ motion for a new trial.

The defendants, repeating the attack on the plaintiff expert’s method for determining a reasonable royalty, first argued the trial court should have excluded the opposing expert’s testimony. Based on its earlier analysis, the court rejected the argument.

Next, the defendants argued the trial court erred in excluding the defense expert testimony as to the appropriate reasonable royalty.

The court had found that the expert improperly “capped” the royalty rate based on uCloudlink’s profit margin for the infringing devices. Federal Circuit precedent does not allow using an infringer’s net profit margin as a cap for a reasonable royalty.

In their new motion, the defendants argued the expert did not actually cap the rate by the net profits. But the court found the expert report showed that was exactly what he had done. The expert said he was “[a]pportioning the profits attributable to the [plaintiff’s] patent.” The expert started with the profits and then whittled the number down based on a variety of factors. “This is clearly a cap,” the court said. It noted that the fact that the expert considered a great many factors to apportion the profit margin down did not save the analysis. Rather, “the problem was his starting point, and it infected every conclusion he reached.”

It was not error to exclude the defense expert’s opinion on what a reasonable royalty should be, the court concluded. It denied both post-trial motions to vacate the jury’s award in favor of the plaintiff.

Parties Fight Over Notes-Containing Expert Report: Draft or Final Version?

County of Maricopa v. Office Depot Inc., 2019 U.S. Dist. LEXIS 175695 (Oct. 9, 2019)

Several sessions at the recent AICPA conference in Las Vegas highlighted the importance of expert discovery in litigation and noted that draft reports continue to be a hot-button issue. A recent contract dispute, litigated in federal court, in which the defendant tried to exclude the opposing expert for violating federal expert disclosure requirements, is a case in point.

The plaintiff, Maricopa County, Ariz. (Maricopa), sued Office Depot, alleging the defendant had breached a pricing commitment Office Depot had made to certain state and local public agencies. Both parties presented expert testimony and tried to exclude the rivaling experts (Maricopa retained two experts) under Rule 702/Daubert. Moreover, Office Depot claimed one of the plaintiff’s experts was precluded from testifying because the plaintiff violated Rule 37 of the federal rules of civil procedure, which specifies sanctions for failure to make disclosures or cooperate in discovery, including prohibiting the expert from testifying “unless the failure was substantially justified or is harmless.”

Little guidance on what’s a draft: At his deposition, the expert said that the report he had sent to the plaintiff had a spreadsheet attached that had an extra column titled “Notes,” in which he “listed out [his] thinking and questions” regarding certain items he was asked to examine. Asked whether the “Notes” column was included in his final report, he said, “I believe so.” The plaintiff did not provide the “Notes” column in the final version of the report that went to the defendant. In its motion, Office Depot claimed the plaintiff altered the report and deprived Office Depot, the court, and the jury access to the expert’s “true opinions.” Rule 26(a)(2)(B)(i) requires that an expert report include “a complete statement of all opinions the witness will express and the basis and reasons for them.”

According to the plaintiff, the notes-containing version of the expert report was a draft and was not discoverable. Rule 26 protects as work product “drafts of any report or disclosure required under Rule 26(a)(2), regardless of the form in which the draft is recorded.”

The key issue was whether the notes-containing version of the report was a draft. “The case law, somewhat surprisingly, provides little guidance when it comes to determining whether an expert’s report was a draft or final version,” the court said. It concluded the report the plaintiff produced to Office Depot was a complete statement of the opinions the expert would express, including the reasons for his opinions. The earlier notes-containing version was a draft. The court noted that this expert did not have much experience as an expert and “it would be unusual for a final report to contain this sort of raw information.” It said Office Depot did not take issue with the “reasoning and explanation provided in the report” but simply argued it should have received the version the expert originally sent to the plaintiff. “This bolsters the conclusion that the analysis contained in the final, produced version constituted a complete expression of [the expert’s] opinions.”

Be careful: Many, but not all, states have procedural rules that align with the federal rules of expert discovery. It is critical that experts are familiar with the rules applicable in the jurisdiction in which they practice.

Keeping Gross Alive, Nimble Tax Court Accepts PTE Tax Affecting

Estate of Aaron Jones v. Commissioner, T.C. Memo. 2019-101 (Aug. 19, 2019)

In its recent ruling on an Oregon gift tax dispute, the Tax Court found a way to accept the taxpayers’ tax-affected valuations of pass-through entities (PTE) without expressly overturning Gross and related Tax Court decisions that disallowed tax affecting. This recent decision is a clean win for the taxpayers in the case. On a larger scale, it is a breakthrough for the valuation community in that the Tax Court agrees with appraisers on the importance of tax affecting to develop a more accurate appraisal of PTEs.

Backstory. The decedent, Aaron Jones, founded two closely related Oregon companies, Seneca Sawmill Co. (SSC) and Seneca Jones Timber Co. (SJTC). SSC was organized as an S corporation and was a successful lumber manufacturer. Its mills used advanced technology and produced products that could command a high price. However, SSC’s lumber was mainly used to build houses, making the company’s financial performance dependent on housing starts.

SJTC was a limited partnership. Its purpose was to invest in, acquire, hold, and manage timberlands and real property. SJTC had tree farms and practiced sustained yield harvesting. The company took care of the land, built access roads, and was engaged in efforts to protect air and water. Its land management practices often exceeded the applicable standards. As the decedent had envisioned, SJTC supplied the timber for SSC, charging the highest price SSC paid for lumber on the open market.

Timber needs to be harvested at the right time to maximize its value. SJTC typically harvested its trees when they were between 50 years old and 55 years old. The company developed projections looking 50 years ahead (assuming a 50-year growth term) to determine the annual yield.

SSC had a 10% interest in SJTC as the sole general partner and exercised broad powers to manage and control SJTC. The two companies shared a management team, and SJTC paid SSC an annual fee for administrative services. During his life, the decedent was president, CEO, and chairman of the board.

Both companies made loans back and forth between them. They were joint parties to third-party credit agreements. SSC depended on SJTC’s timber to obtain bank loans. When SSC generated revenue, it transferred the money as a loan or receivable to SJTC to repay the bank loans. On the valuation date (May 2009), SSC had a $32.7 million receivable from SJTC.

In the mid-2000s, when SSC recognized a steady shift in the market toward dry lumber and away from the green lumber SSC had been producing, SSC built a renewable energy plant to help produce dry lumber. In 2009, the decedent founded a third company, Seneca Sustainable Energy LLC (SSE), that was to own the new plant. The cost of the new plant was to be approximately $50 million. In 2009, during the global recession, banks were reluctant to make construction loans. Therefore, SSC had to borrow against SJTC’s timberlands. At the time, SJTC advanced SSC over $18.4 million, which grew to over $52 million by 2010.

The increasing weakness in the economy also affected housing starts, forcing SSC to reduce production. At the same time, SJTC reduced its timber harvest to minimize the logs it sold at depressed prices and allow unharvested timber to continue to appreciate in price.

April 2009 projections. Also, in 2009, a competitor that was concerned about its ability to satisfy loan agreements approached SJTC about a timberland exchange. In April 2009, SSC’s management team created projections for SJTC and SSC to determine the companies’ ability to comply with their own loan agreements. The team used the same process it had used to create regular, yearly financial projections. The April 2009 projections were more pessimistic than projections for 2009 and 2010 at year-end. Ultimately, SJTC agreed to the timberland exchange.

Ownership before valuation date. SSC had voting stock (class A) and nonvoting stock (class B). Before the valuation date, the decedent owned a majority of class A shares (4,900) and his three daughters each owned an equal, lesser amount of those shares (1,500 each). A third party owned 600 shares. The transfer of shares was subject to a buy-sell agreement. For example, any transfer causing the company to lose S corp status was null and void unless a majority of shareholders gave consent. Also, a transfer to a person other than a family member gave SSC the right of first refusal as to buying them. If SSC declined to do so, the individual shareholders had the option of buying. In either case, the standard of value was the fair market value (FMV) of the shares. The FMV determination required consideration of the anticipated cash distributions related to the shares and the use of discounts for lack of marketability, lack of control, and lack of voting rights.

Before the valuation date, SSC owned all of the general partner units in SJTC. The decedent owned most of the limited partner (LP) units, and the daughters owned equal minority interests. Limited partners also were subject to transfer restrictions. A transfer was invalid if it terminated the partnership for federal and state tax purposes. Also, consent of all partners was necessary to affect substitution of a transferee of partnership units as a limited partner. Limited partners were subject to a buy-sell agreement whose content mirrored the SSC buy-sell agreement.

Transfers of interests in SSC and SJTC. In May 2009, as part of his estate planning, the decedent transferred blocks of SSC shares (class A and class B shares (voting and nonvoting)) as well as SJTC limited partnership units to his three daughters by way of family and generation-skipping trusts.

He signed net-gift agreements with the daughters, assigning liability for gift and estate tax to the daughters. The IRS conceded the agreements were valid. The decedent filed a Form 709 gift tax return with valuation reports for 2009. In 2013, the Internal Revenue Service (IRS) issued a notice of deficiency of nearly $45 million. The appraisal firm valued SSC’s class A voting shares at $325 per share and the class B nonvoting shares at $315 per share. It valued the SJTC limited partnership units at $350 per unit. However, the court’s opinion notes that the estate’s reported values were different from the values the valuation firm determined.

In 2013, the Internal Revenue Service (IRS) issued a notice of deficiency, finding the SSC class A shares were worth $1,395 per unit, the class B shares were worth $1,325 per unit, and the LP units were worth $2,511 per unit. In total, the deficiency in gift tax was almost $45 million, the IRS claimed.

The decedent died a year later, in 2014, and the estate litigated the case in the U.S. Tax Court. By the time of trial, the estate had made a concession concerning the value of the SSC shares, arguing the FMV of class A shares was $390 per share and class B shares was $380 per share. The IRS, on the other hand, increased the value of the LP units for SJTC slightly.

Applicable legal principles. Under Internal Revenue Code § 2502, gift tax applies for each calendar year on the transfer of property during that taxable year. Ordinarily, the donor pays the gift tax. The value of a gift is determined on the date it is given.

Under case law, the standard of value is the fair market value of property transferred as a gift. Fair market value is “the price at which it would change hands between a willing buyer and a willing seller, neither under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” The willing buyer and willing seller are “hypothetical persons, not any specific named person.” Further, Revenue Ruling 59-60 and case law provide that, when determining the FMV of unlisted stocks for which there are no recent bids or sales, a number of factors deserve consideration.

The factors are the company’s net worth, earning power and dividend-paying capacity, goodwill, the economic outlook of the industry, management and the company’s position in the industry, the degree of control of the business represented in the block of stock that is to be valued, and the value of stock in similar, publicly traded companies. When valuing a partnership interest, the value of the partnership’s assets may be considered, besides considering the factors used to determine the FMV of stock.

Experts’ different approaches. Both parties offered expert valuations of SJTC. But, for SSC, the IRS only offered a rebuttal expert report.

The estate retained a highly qualified appraiser who had conducted about 100 valuations of sawmills and timber product companies. In a nutshell, this expert valued both companies as going concerns and used an income approach (discounted cash flow (DCF) method and a market approach (guideline publicly traded companies method) to value the transferred units. He found SJTC was worth $21 million on a noncontrolling, nonmarketable basis. The value per unit was $380, he found. The noncontrolling, nonmarketable value of the block of LP units the decedent transferred to each daughter was worth about $3.9 million.

The estate’s expert found SSC was worth $20 million on a noncontrolling, nonmarketable basis. The class A voting stock was worth $390 per share; the class B voting stock was worth $380 per share, after applying a 3% discount for lack of voting rights.

The IRS’ (respondent’s) expert used the net asset value (NAV) approach and a market approach to value SJTC as a going concern, on a noncontrolling, nonmarketable basis. He determined SJTC was worth over $140 million. The value of an LP unit was $2,530; the value of the block of LP units the decedent transferred to each daughter was worth nearly $26 million, this expert concluded.

The IRS used a different expert to rebut the estate expert’s valuation of SSC.

No weight to NAV approach. The focal point of the court’s very detailed opinion is the valuation of SJTC. The overriding disagreement between the parties was whether the company was an operating company that should be valued under an income approach, as the estate’s expert maintained, or a natural-resources holding company that should be valued under the net asset value approach, as the IRS’ expert proposed.

According to the court, the argument came down to whether the company sold a product or whether it simply held timber as an investment for its partners. The court also noted that companies frequently have aspects of both, operating company and holding or investment company. If so, valuation should not be limited to one approach. SJTC was such a company, the court decided. Its timberlands were its primary assets, whose value increased even if the company was not profitable on a year-to-year basis. But SJTC also was an operating company that planted, harvested, and sold timber. The company ensured its operation was efficient, and it practiced sustained yield harvesting and land management.

Use of the asset-based approach depended on whether there was a possibility that SJTC would be able to sell its underlying assets, the timberlands, the court explained. The greater the likelihood of a sale, the more relative weight should go to the asset-approach.

The court agreed with the estate that here a sale was not likely. For one, holders of LP units could not force a sale of the timberlands under the partnership agreement. SSC, as the general partner with exclusive powers to direct a sale, would not exercise its authority to do so. The court dismissed the IRS’ argument that this analysis was inappropriate as it considered specific buyers and sellers rather than the hypothetical actors the FMV required. The court said the restrictions applied to the interest and did not depend on how many limited partners SJTC had and who they were. Any hypothetical buyer and seller of an LP interest would consider the restrictions flowing from the partnership agreement and the rights SSC had over SJTC.

Moreover, the court agreed with the estate’s argument that the two companies, although separate legal entities, were in effect a single business operation. SSC’s continued operation depended on SJTC’s having ownership of timberlands. SSC, as SJTC’s general partner, would not direct SJTC to sell these assets while SSC continued as a sawmill. Considering the companies’ interconnectedness simply meant recognizing their economic relationship and the effect on their valuations, the court said. The court concluded the estate expert’s DCF analysis was the proper way to value SJTC.

Projections are reliable. The IRS voiced two objections to how the estate’s expert performed his DCF analysis. One argument was the expert used unreliable projections to determine SJTC’s cash flow.

The expert had used the company’s April 2009 projections, which were downward revisions to the projections from the most recent annual report. Management created these updated projections in the context of assessing whether SJTC was going to violate loan agreements.

According to the court, the April projections were the most current projections close to the valuation date and the company used them to make business decisions. Also, the IRS’ expert used the April projections for his market-based analysis but averaged them with the projections from the annual report. The IRS expert did not make the adjustment not because he thought the April projections were unreliable, but because, to him, they represented the worst-case scenario, the court pointed out. Use of the April projections was acceptable, the court found.

Tax affecting is appropriate. The IRS also argued the taxpayers’ expert should not have tax-affected earnings projecting cash flow. The expert used a 38% rate (proxy for federal and state taxes combined). He also calculated a 22% premium to capture the benefit to the partners from avoiding a dividend tax, by estimating the implied benefits in past years and considering an empirical study on S corp acquisitions. (He also performed a guideline publicly traded companies valuation, using the tax-affected earnings, but the metrics he used to compare the companies were pretax.)

The IRS, citing the Tax Court’s Gross decision and later cases, argued tax affecting was improper where SJTC had no tax liability on the entity level and there was no evidence the company would become a C corporation. Moreover, without a showing that two unrelated parties involved in an arm’s-length deal would tax affect, the outcome improperly favored a hypothetical buyer over the seller. This meant deviating from the required FMV.

In contrast, the estate, citing Bernier (which cited Del. Open MRI), contended using zero tax at the entity level inflated the value of an interest in SJTC. A hypothetical buyer and seller would take into account that the individual partners had to pay income tax, at ordinary levels, regardless of whether SJTC made cash distributions.

The court found that, in effect, both parties recognized that a hypothetical buyer and seller would consider SJTC’s corporate form; the parties simply disagreed over how to do this. The court observed that the IRS’ own experts “do not offer any defense of respondent’s proposed zero tax rate.” The IRS expert critiqued the estate expert’s tax affecting because he believed SJTC was a holding company and its “rate of return is closer to the property rates of return,” the court said. But he did not say tax affecting was improper because SJTC paid no entity tax, the court noted. According to the court, the argument over tax affecting was a fight between the parties’ lawyers, not the valuation experts.

Further, the court found that Gross and later rulings in which the Tax Court disallowed tax affecting could be distinguished from the instant case. The court said that, in Gross, the Tax Court was presented with a stark choice: 40% or 0% corporate tax. The Gross court did not believe the 40% rate reflected the benefit to the owners from avoiding dividend tax and, “on the record of the case,” decided that a 0% rate properly reflected the savings to the owners, the court in the instant case said.

In Estate of Gallagher, the taxpayer’s expert did not justify tax affecting, but the Tax Court then acknowledged that the benefit to S corp owners regarding tax liability should be considered, the court noted.

In Estate of Giustina, the taxpayer expert’s method was faulty—he used a pretax discount rate to present value post-tax cash flow, the court noted.

The issue in those cases was not whether to account for the tax benefits flow-through entities enjoy, but how to do this, the court said. (emphasis added)

In contrast, the taxpayers’ expert took into account both the tax burden and benefit to SJTC’s owner, the court said. The expert’s “tax-affecting may not be exact, but it is more complete and more convincing than respondent’s zero tax rate.”

Market-based analysis not controversial. Both experts used the guideline public company method to value SJTC. The court noted that the opposing experts’ search for peers generated similar groups of comparable companies. Ultimately, the IRS adopted the estate expert’s valuation. The court did the same.

The expert used four measures to analyze the difference between SJTC and the peer group: (1) earnings before interest and taxes (EBIT); (2) earnings before interest, taxes, depreciation, depletion, and amortization (EBITDA); (3) revenue; and (4) adjusted tangible book value of invested capital (ATBVIC). The estate’s expert arrived at a weighted enterprise value of $107 million, on a noncontrolling, marketable basis.

Intercompany debt treatment makes sense. In valuing both SSC and SJTC, the estate expert treated intercompany debt as a clearing account or “simply two pockets of the same pair of pants.” He excluded the $32.7 million receivable SSC held from SJTC and SJTC’s payable but considered the companies’ intercompany interest income and expense as operating income and expense. The IRS contended he did this to avoid a negative value for SJTC, which would have led to an “absurd conclusion.” This receivable should have been added back into the DCF valuation at the end because it was a nonoperating asset, the IRS claimed. The receivable represented an investment in a separate company, not an investment made in the course of SSC’s business.

The court noted that SJTC would only have a negative value if one accepted the premise that the two companies were separate entities, which the court did not. SSC’s loan to SJTC was not an investment in a separate company but an intercompany clearing account that management used to move cash back and forth between the related entities, depending on need. Management assigned borrowing costs to the entity that required the cash by charging interest, the court noted. The court added that, while the interest rate was arm’s length, reflecting the rate a third-party lender would use, it was not possible for SSC to obtain a third-party loan without using SJTC and its timberland as security. But there was no evidence that SJTC could borrow from third parties in the amounts it obtained as loans from SSC. The estate expert’s treatment “captured [the companies’] relationship as interdependent parts of a single business enterprise,” the court said. It was not necessary to add back the intercompany debt into the DCF valuation.

Estate expert more persuasive on DLOM. In valuing SJTC, the parties’ experts applied discounts for lack of marketability (DLOM) whose rates were very close. The IRS expert used a 30% DLOM, while the estate’s expert used a 35% rate. The estate expert considered studies of transfers of restricted stock of publicly traded companies and private, pre-IPO sales of stock.

The IRS unsuccessfully claimed the 35% DLOM was excessive. The court said the estate expert explained the reasoning behind his DLOM rate. The models he used were common. He also used the Mandelbaum factors and considered SJTC’s unique characteristics, including the buy-sell agreement, the company’s lack of historical transfers, a potentially indefinite holding period, reported loss in the past 12 months before the valuation date, and the unpredictability of partner distributions.

In contrast, the IRS expert did not consider the buy-sell agreement transfer restrictions and admitted at trial that the restriction would increase the rate by “something like 1% or 2%.” The court called this “guessing.” The estate expert’s 35% DLOM was the proper rate, the court concluded.

SSC valuation withstands IRS’ critique. The IRS did not provide an independent valuation of SSC but used expert testimony to critique aspects of the estate expert’s valuation.

Besides objecting, unsuccessfully, to tax affecting and the treatment of intercompany debt, the IRS claimed the estate’s expert did not properly account for SSC’s general partner interest in SJTC in his DCF analysis. In valuing SSC, the expert added $350,000 in partnership income for each year in the projection period. He arrived at this amount by using the five-year and 10-year historical median distributions from SJTC.

The IRS claimed this approach undervalued the interest. The general partner interest was an outside investment granting SSC exclusive control over SJTC. Rather than looking to projected annual distributions, it was better to use 10% of the value of SJTC.

The court noted the general partner interest was an operating asset. It ensured that the two companies would remain a single business enterprise. The estate expert’s treatment of SSC’s general partner interest in SJTC was reasonable, the court said.

Taxpayer wins. The court ruled for the taxpayer on all the valuation issues. It approved of the estate expert’s use of the DCF to value SJTC, the expert’s use of the April 2009 projections, the expert’s treatment of intercompany loans, and the expert’s valuation of SSC’s general partner interest in SJTC. The court found the estate expert’s 35% DLOM was reasonable.

Importantly, the court said that the estate expert’s tax affecting was “more accurate than the respondent’s blunt zero-rate approach.”

The final values were:

Shares/units                          Value per share/units        Value of block

SSC class A (voting)                            $390                               $507,000

SSC class B (nonvoting)                     $380                            $2,073,280

SJTC LP units                                       $380                            $3,901,715

 

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