Litigation & Disputes Bulletin: Q1 2021

In This Issue:

• Maryland Commits to Daubert for Evaluating Admissibility of Expert Testimony
• Calculating Fair Value, Court Uses Experts’ Income Analyses but Adjusts for Inconsistencies
• Court ‘Sympathizes’ With Businesses Claiming COVID-19-Related Losses but Finds No Coverage Under Policy
• Partnership Statute Precludes Use of Minority Discount in Buying Out Dissociated Partner
• Solvency Opinion Based on Management Projections Faces Daubert Challenge

Maryland Commits to Daubert for Evaluating Admissibility of Expert Testimony

Rochkind v. Stevenson, 2020 Md. LEXIS 414 (Aug. 28, 2020)

In a critical move, Maryland’s highest court recently changed the standard for the admission of expert testimony when it abandoned the existing two-channel approach in favor of Daubert. The decision aligns Maryland with the majority of states that follow Daubert, but it reflects a split (4-3) court.

Effort to ‘streamline’ process: In 1923, the U.S. Supreme Court set out the Frye “general acceptance” test for the admissibility of expert testimony based on new or novel scientific principles. In 1978, Maryland’s Court of Appeals (state’s supreme court) adopted Frye in the Reed v. State decision. The test became known as the Frye-Reed standard. In 1993, the U.S. Supreme Court, in the Daubert case, held that Federal Rule of Evidence (FRE) 702 superseded Frye. For its part, Maryland adopted Rule 5-702, the counterpart to FRE 702, while holding onto Frye-Reed.

In theory, the relationship between the two standards is clear. Testimony that discusses novel scientific theories must meet the Frye-Reed standard and the Rule 5-702 requirements. Expert testimony dealing with nonscientific evidence must only meet the requirements of Rule 5-702. In practice, as the court’s majority in the recent opinion notes, “[T]he Frye-Reed standard—and its relationship to Maryland’s Rule 5-702—holds a confusing grip on Maryland bench and bar.” Since 1978, the Frye-Reed test “slowly morphed into a ‘Frye-Reed Plus’ standard, implicitly and explicitly relying on and adopting several Daubert principles,” the majority opinion states.

The court had an opportunity to move to Daubert in an involved tort case in which the plaintiff alleged physical, psychological, and economic harm from lead exposure while living in the defendant’s apartment building. At trial, the plaintiff offered medical expert testimony on causation, i.e., that she was poisoned in the defendant’s building and that the lead exposure caused her “cognitive deficits.” The defendant vigorously challenged the expert testimony, leading to four jury trials and several appeals and culminating in petitions from both sides to the Court of Appeals. The key question was whether the court should adopt the Daubert standard.

The defendant said yes and asked the court to apply Daubert to the present case and find the opposing expert’s causation opinion inadmissible under Maryland Rule 5-702. The plaintiff argued against Daubert but also claimed that, even under Daubert, the medical expert’s testimony would be admissible.

After a lengthy discussion of the existing approach, a majority of judges found it was appropriate to adopt Daubert. The current two-channel approach had led to a “duplicative analytical process” and had “muddied” the waters of admissibility, the majority said. “Instead of perpetuating a process wherein expert testimony must pass through Frye-Reed and Rule 5-702, we implement a single standard by which courts evaluate all expert testimony: Daubert.” Adopting Daubert will “streamline” the process and permit trial courts “to evaluate all expert testimony—scientific or otherwise—under Rule 5-702.” The majority opinion provides a list of 10 factors that are “persuasive in interpreting Rule 5-702,” five Daubert factors and five additional factors courts have used to determine whether expert testimony is sufficiently reliable. The court remanded for a new trial “consistent with this opinion.”

Dissent: This was not the “right case” to make the change, the three-judge dissent said, noting the issue of admissibility in this case consistently was decided under Rule 5-702, not Frye-Reed. The dissent also suggested the adoption of Daubert might benefit defendants and said any implementation of Daubert required at least a study of the impact of Daubert on minority groups and “people of limited financial means as potential litigants.” No such study was performed here.

Calculating Fair Value, Court Uses Experts’ Income Analyses but Adjusts for Inconsistencies

Anderson v. A & R Spraying & Trucking, Inc., 306 Neb. 484 (July 17, 2020)

In a buyout dispute, the Nebraska Supreme Court recently upheld the trial court’s fair value determination based on the income approach. The trial court was presented with testimony from experienced valuators who offered earnings-based value conclusions but either “strayed from” the income approach in parts of the analysis or ultimately rejected the income approach over the asset approach. The trial court decided to adjust both income analyses and averaged the valuations. The appeals court found this approach was reasonable.

Failure to agree on ‘fair price.’ In 1999, two men (Anderson and Rafert) started a trucking and crop-spraying business, A & R Spraying & Trucking. The company was organized as a C corporation but functioned more like a partnership than corporation. There were no corporate bylaws, no formal meetings, and no agreement as to how to proceed in the event of a buyout. Both owners had an equal, 50% interest.

When Anderson died in 2015, his wife (the plaintiff) inherited Anderson’s interest. By 2017, it was evident that the plaintiff and Rafert, the surviving founder (and defendant), could not agree on anything and deadlock ensued.

The plaintiff filed for dissolution of the company under the applicable state statute. Rafert indicated he was “ready, willing, and able” to buy the plaintiff out, but the parties could not agree “on a fair price.” The defendant filed a formal request with the court to buy the plaintiff’s shares instead of dissolution and offered $40,000 for the plaintiff’s ownership interest.

A bench trial followed in which both parties offered expert testimony as to the value of the company. Both experts had decades of experience as CPAs and were credentialed business valuators. Both experts discussed the three valuation methods: income approach, asset approach, and market approach. And both experts found the market approach was inappropriate because there were no truly comparable companies serving as peers.

Disagreement over use of asset approach. The buying shareholder’s expert (defendant’s expert) based her valuation on the income approach, specifically a discounted cash flow (DCF) model. The expert rejected the asset approach, finding it was only appropriate if the company’s assets would be sold. Here, it was clear that the surviving partner would continue the company’s operations. Also, the defense expert noted that the company used a cash-based accounting system.

An April 2017 appraisal of the company’s assets, including trucks, trailers, spraying equipment, other vehicles, and tools, produced a valuation of about $1.3 million.

The defense expert considered the company’s income tax returns from 2013 to 2016, internal depreciation schedules, and a financial statement from the company’s accounting firm for the first quarter of 2017. She normalized cash flow and concluded the company generated $220,000 in 2013, $240,000 in 2014, $305,000 in 2015, and $138,000 in 2016.

She found that, on average, the company’s annual after-tax income was about $114,000. She assumed a 2% growth rate, capitalized the income using a 20% rate, and reached a value of about $678,000. She found this amount represented the company’s free cash flow.

In a final step, the defense expert subtracted all of the company’s debt, about $1.2 million, as well as an income payment that was due from the earlier value. The result was a negative valuation for the company, specifically -$498,000.

An analysis under the asset approach, on which the defense expert did not rely, produced a value of $142,000, to which the expert applied a 15% discount for lack of marketability.

The plaintiff’s expert submitted two reports. Her initial valuation was based on a hybrid of the income and asset approach (no further details in the court’s opinion). She determined the company’s weighted cash flow was about $123,000 per year. Using a “capitalization of benefits” analysis, she valued the company at about $753,000.

However, at the beginning of trial, after testimony from the opposing expert, the plaintiff’s expert submitted a revised report in which she relied solely on the asset approach, explaining it was the appropriate method as the company was an asset-heavy business. The plaintiff’s expert found the adjusted book value of the company was about $573,200. Considering back wages payable, interest, and the April 2017 appraisal of the company’s trucks, vehicles, and spraying equipment, the plaintiff’s expert concluded the company was worth between $720,000 and $1 million.

Expert’s analysis ‘hard to understand.’ The court agreed with the defense expert that the income approach was the correct method with which to value the company to determine the fair value of the plaintiff’s interest.

The court noted this was a going concern and the company used a cash-based accounting system. But the court disagreed with the defense expert’s decision to subtract 100% of the debt ($1.2 million) from the achieved value ($678,000). “[A] business, as a going concern, is not required to pay back all of its debt on a lump sum basis,” the court said. At the same time, the court agreed with the expert that it was appropriate to subtract an interest payment that was due ($23,000). The court’s adjustment to the defense expert’s valuation generated a positive value of $655,000 for the company.

The court rejected the market-based analysis the plaintiff’s expert proffered, noting it was “hard to understand” and “not helpful.” However, it considered the expert’s initial income-based value determination, making some adjustments.

In general, the trial court found that both experts “generously included” assumptions and conditions in their valuations.

The trial court decided to average the experts’ adjusted income-based value conclusions and arrived at a value of about $640,000 for the company. Accordingly, the plaintiff’s 50% interest was worth about $320,000, the trial court concluded.

The defendant (buying shareholder) challenged various aspects of the trial court’s findings, including the valuation of the company with the state Supreme Court (bypassing the state’s Court of Appeals).

The Supreme Court noted that neither party argued the trial court used the wrong valuation method. “[T]he sole issue presented is whether the district court’s valuation is ‘unreasonably high,’ considering the experts’ reports and supporting testimony regarding the income approach.”

The defendant particularly objected to the trial court’s decision not to subtract the full amount of debt.

Applicable legal principles. At the outset of its analysis, the reviewing court noted that, under the applicable statute, in a judicial buyout action, the court shall “determine the fair value of the petitioner’s shares.” See Neb. Rev. State. § 21-2.201(d).

The Nebraska Model Business Corporation Act’s provisions governing appraisal rights say “fair value” represents the value of the corporation’s shares “[u]sing customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal.” See § 21-2.171(3)(ii).

Case law says that the “real objective is to ascertain the actual worth of that which the dissenter loses because of his unwillingness to go along with the controlling stockholders, that is, to indemnify him.” The value determination is to be based on “all material factors and elements” affecting value. The factors include “the nature of the business and its operations, its assets and liabilities, its earning capacity, and the future prospects of the company.” The valuation rests on the assumption that the company will continue as a going concern and will not be liquidated.

Reasonable valuation. In finding the trial court’s decision was reasonable and had a basis in fact and principle, the Supreme Court observed that both experts agreed, under the income approach, the business was valued as a going concern. The asset approach values the company’s assets and liabilities as if the business were to be sold and liquidated, the high court noted.

The evidence showed the business continued after the plaintiff’s husband had died and “there have been no efforts to liquidate,” the high court said. It agreed with the trial court that “subtracting 100% of the debt from the valuation estimate of the business does not comport with the overall theory of the Income Approach because a business, as a going concern, is not required to pay back all of its debt on a lump sum basis.”

The high court said the defense expert “contradicted her own testimony when she strayed from the income approach by subtracting all of the corporation’s debt.” The trial court was not speculating when it rejected the expert’s “blending of the income and asset methods as unpersuasive,” the state Supreme Court said.

Further, the evidence showed the company consistently generated significant cash and the company’s personal banker testified the company paid its loans on time. This witness also said the accounts receivable was collectable.

The high court found the trial court carefully considered the expert testimony and identified aspects in each valuation that were inconsistent with the income approach. Accordingly, it adjusted each opinion and based its valuation on the average of the two, adjusted, valuations.

The trial court’s valuation was not error, the state Supreme Court concluded.

Court ‘Sympathizes’ With Businesses Claiming COVID-19-Related Losses but Finds No Coverage Under Policy

Diesel Barbershop, LLC v. State Farm Lloyds, 2020 U.S. Dist. LEXIS 147276; 2020 WL 4724305 (Aug. 13, 2020)

COVID-19-related damages cases are making their way through state and federal courts. Plaintiffs typically are businesses that have suffered economic losses because of various mandatory shutdowns. They file claims with their insurance agency, which frequently denies coverage for business interruption losses. However, more often than not, courts have sided with the defendant insurance company and dismissed the plaintiff’s case or ruled against the business owner. In the instant case, a number of barbershops operating in Texas challenged the insurance company’s rejection of their claims under policies that were essentially identical. The court agreed with the insurer that the policies, which included a virus exception, did not provide coverage for loss caused by COVID-19 or other causes related to the excluded event, i.e., COVID-19.

Background. The plaintiffs owned barbershops. The defendant insurance company, State Farm Lloyds (State Farm), issued policies to insure the plaintiffs’ properties. As the provisions in the policies that were relevant to this litigation were essentially identical, the court did not analyze each plaintiff’s policy separately.

On Feb. 11, 2020, the World Health Organization announced a new disease called COVID-19 that was caused by the most recently discovered coronavirus. The virus spread rapidly and has resulted in a global pandemic.

In the United States, the outbreak, in its early stages, caused many local and state governments to shut down nonessential businesses to limit the spread of the virus. In Texas, where the instant case is being litigated, county and state officials issued multiple executive orders in March 2020 and April 2020 that required certain businesses, including the plaintiffs’ barbershops, to remain closed to protect the health of the community. The authorities did not consider barbershops essential businesses or businesses exempted from the shutdown orders.

The plaintiffs suffered loss of income due to the mandatory shutdowns and filed claims with State Farm seeking coverage for business interruption losses. State Farm, without investigating the claims, denied the plaintiffs’ requests. Its denial letter stated the policies included a virus exception that precluded coverage of “loss caused by enforcement of ordinance or law, virus, and consequential losses.” Further, State Farm said, under the policy, there had to be “physical damage to the property, within one mile of the described property.” Also, the damage had to be “the result of a Covered Cause of Loss.” Under the virus exception, a virus is not a covered cause of loss, State Farm argued.

The plaintiffs then filed suit in state court to contest the insurer’s denial of coverage. The claims were breach of contract, noncompliance with the Texas Insurance Code, and breach of the duty of good faith and fair dealing. The defendant succeeded in removing the case to federal court, which, at this stage in the proceedings, ruled on the defendant’s motion to dismiss the plaintiffs’ case.

Relevant policy provisions. The parties argued over the language in several policy provisions.

In the “Covered Causes of Loss” section, State Farm said it would “insure for accidental direct physical loss to Covered Property” unless the loss was excluded.

The policies contained an express exclusion for “[v]irus, bacteria or other microorganism that induces or is capable of inducing physical distress, illness or disease.”

The policies also included lead-in language to the virus exclusion that said State Farm would not insure for a loss regardless of “whether other causes acted concurrently or in any sequence within the excluded event to produce the loss.”

Finally, the policies had a “Civil Authority” provision that applied to a “Covered Cause of Loss” and provided payment for actual “Loss of Income” caused by an order of civil authority that prevented or prohibited access to the insured’s property as a result of physical damage to property in the proximity of the insured’s property.

Applicable legal principles. This breach of contract case was subject to Texas law. It required the court to interpret the policies under the applicable contract interpretation standards. Citing case law, the court noted the “paramount rule is that courts enforce unambiguous policies as written.” Further, a court must “honor plain language, reviewing policies as drafted, not revising them as desired.”

In asking the court to dismiss this case, State Farm said coverage under this policy was only available if: (1) there were an accidental direct physical loss to the insured property; and (2) the loss were not excluded.

Here, there was no direct physical loss because the plaintiffs based their business interruption claim on the shutdown orders. The plaintiffs did not show their businesses were “tangibly ‘damaged’ per se,” the insurer said. Even if the plaintiffs were able to show this type of damage, their claim would not be covered under the virus exclusion, which was unambiguous and was added to the policies in response to the SARS pandemic in the early 2000s, State Farm contended.

The plaintiffs countered the language in the policies did not require tangible and complete physical loss. It allowed for partial loss of the properties, including the loss of use resulting from the governmental orders. Moreover, to circumvent the virus exclusion, the plaintiffs argued the orders, not the virus, caused the direct physical loss. Further, they said the exception did not apply because there was no virus present on the premises. Also, the Civil Authority provision applied because various governmental entities issued the orders to protect public health and welfare.

Ahead of its analysis, the court said it “sympathizes with Plaintiffs’ situation” but had to grant the defendants’ motion to dismiss the case.

Direct physical loss hurdle. The court said the policies were explicit in their requiring an accidental, direct physical loss to the property. The court agreed with the plaintiffs that there was case law from various state and federal courts that found physical loss even when there was no tangible destruction to the property. However, the court said it found more persuasive the line of cases that required the plaintiff to show tangible injury to the property. “It appears that within our Circuit [5th Circuit], the loss needs to have been a ‘distinct, demonstrable physical alteration of the property.” (citing Hartford Ins. Co. of Midwest v. Mississippi Valley Gas Co., 181 F. App’x 465 (5th Cir. 2006))

The plaintiffs did not plead a direct physical loss to their buildings, the court concluded.

Virus exclusion hurdle. The court agreed with the insurer that, even if the plaintiffs had shown direct physical loss to their properties, they still would not prevail on their claims because of the virus exception contained in the policies.

The court noted that the parties “vehemently” disagreed on how to read the lead-in language to the virus exception. The court found the language “unambiguous and enforceable.” The plaintiffs pleaded that COVID-19 was “in fact” the reason for the shutdown orders and was the underlying cause of the plaintiffs’ alleged losses, the court said. “While the Orders technically forced the Properties to close to protect public health, the Orders only came about sequentially as a result of the COVID-19 virus spreading rapidly throughout the community.” The presence of the virus was “the primary root cause” of the temporary closures of the plaintiffs’ businesses, the court noted.

The lead-in clause to the virus exception excluded coverage of the plaintiffs’ losses, the court concluded. Further, the Civil Authority provision, which applied to a “Covered Cause of Loss,” was not applicable, the court said.

“While there is no doubt that the COVID-19 crisis severely affected Plaintiffs’ businesses, State Farm cannot be held liable to pay business interruption insurance on these claims” under the plain language of the insurance contract between the parties, the court decided.

Editor’s note: A companion case is Turek Enterprises, Inc. v. State Farm Mutual Automobile Insurance Co., 2020 U.S. Dist. LEXIS 161198 (Sept. 3, 2020), which arose in the Eastern District of Michigan and had facts similar to those in the instant case as well as an almost identical business insurance policy from a State Farm Insurer. A digest of Turek and the court’s opinion are also available at BVLaw.

Partnership Statute Precludes Use of Minority Discount in Buying Out Dissociated Partner

Boesch v. Holeman, 2020 U.S.P.Q.2D (BNA) 11062; 2020 Tenn. App. LEXIS 410; 2020 WL 5537005 (Sept. 14, 2020)

The central issue in this entangled business dispute involving both a partnership and a limited liability company was whether to apply partnership or LLC law valuing the dissociated partner’s one-third interest. The appeals court said the complicated facts implicated the law on partnerships. That said, the trial court erred in adopting an expert opinion that applied a discount for lack of control (as well as a discount for lack of marketability) where the statute required valuing the entire partnership as a going concern. Because the trial court’s valuation determination did not align with the applicable law, the appeals court remanded.

Partnership or LLC? In 2014, three people, including the plaintiff (dissociated partner), formed a partnership to build a flavored-moonshine and whiskey business called Tennessee Legend. There was no written partnership or other agreement specifying who owned what and how the company would be operated. Trial testimony indicated the plaintiff and a second partner (defendant) were to contribute “sweat equity,” whereas the third partner (defendant) was to finance the operation.

The plaintiff had experience in the industry and provided the formulas for mixing the various products. In his suit against the two remaining partners, he claimed the formulas were trade secrets that the defendants misappropriated when they continued to use them after his dissociation and without his consent.

Within a year, relations between the plaintiff and one of the partners deteriorated, resulting in the plaintiff’s dissociation in December 2015. The parties disputed whether the plaintiff left voluntarily or was expelled. After the plaintiff’s departure, the business carried on and, in time, grew.

In May 2016, the plaintiff sued the remaining partners, raising a variety of claims, including fraud and violation of the Uniform Trade Secrets Act. Alternatively, he accused the defendant partners of breaching their fiduciary duties by terminating him and stealing his trade secrets. The defendants counterclaimed but acknowledged that they had a business arrangement with the plaintiff related to Tennessee Legend.

The lawsuit expanded when another entity, Crystal Falls Spirits LLC, entered the case. The exact relationship between the LLC and the partnership was never clear, as the appeals court noted. The court said the LLC, which was created by one of the defendants and of which the plaintiff never was a member, “acted as a sort of conduit through which the partnership operated.” In deposition testimony, the defendant who had formed the LLC said there was an intent that all three business partners would be LLC members. However, there was no writing to this effect and no writing clarifying the relationship between the LLC and the partnership. In the lawsuit, the LLC claimed it owned the formulas for the Tennessee Legend products.

When the case went to trial in December 2018, one of the most contested issues was the value of the plaintiff’s one-third interest in the business. Both parties presented expert testimony.

The plaintiff’s business valuation and accounting expert used August 2017 as the valuation date, even though the plaintiff’s dissociation from the partnership was in December 2015. The expert said he was asked to determine a one-third interest in the LLC. He said he was not given a valuation date, but “we do need to try to assess the December 2015 date to see what a value was then.” He said the information available to him allowed him to prepare an estimate of value as of August 2017, “and then I discounted to come up with a 2015 value or estimate.” On cross-examination, the expert admitted that he did not directly determine the value of the plaintiff’s interest as of December 2015.

The plaintiff’s expert estimated the plaintiff’s interest was worth $258,300.

The defense expert valued the plaintiff’s interest at $23,000. She said she applied a discount for lack of control and discount for lack of marketability. She was vague about the specific rates. “So we could argue how much is lack of control, how much is lack of marketability.” She said, “Rather than getting into the semantics, combine them together … it’s a third interest, you don’t have control and you don’t have market, what’s the total haircut, the total discount you take off a hundred percent interest value.”

The trial court adopted the defense expert’s value determination, awarding the plaintiff $23,000 against the defendants and the LLC for his one-third interest “in the partnership and business venture.”

The court dismissed the plaintiff’s other claims. It said the plaintiff failed to prove violation of the state trade secrets act, unreimbursed expenses, labor charges, and royalties. (In total, the plaintiff asked for a judgment of $750,000 against the defendants.)

On appeal to the state Court of Appeals, the plaintiff, representing himself, challenged a number of the trial court’s rulings. One objection was that the trial court’s valuation for purposes of determining the plaintiff’s buyout price was error.

Sale of entire business as a going concern. The Tennessee Court of Appeals rejected all of the plaintiff’s assignments of errors, except for the plaintiff’s claim that the valuation was flawed as it was based on the defense expert’s calculation, which did not comport with the applicable law. Specifically, under the Tennessee Code’s provision dealing with the purchase of a dissociated partner’s interest (Tenn. Code Ann. § 61-1-701), it was improper for the expert to apply a discount for lack of control discount.

The appeals court noted there was uncertainty at trial as to whether the law on partnerships or on LLCs applied in the present circumstances. “In the end, the valuation proceeded without a definitive answer,” the appeals court said. It added there was no dispute on appeal as both sides described the business arrangement as a partnership. “Thus, the law on partnerships is implicated.”

The court said, in the present circumstances, where one partner is dissociated but the partnership is not wound up, the statute provides:

The buyout price … is the amount that would have been distributable to the dissociating partner under § 61-1-807(b) if, on the date of dissociation, the assets of the partnership were sold at a price equal to the greater of the liquidation value or the value based on a sale of the entire business as a going concern without the dissociated partner and the partnership were wound up as of that date.

The court noted that The Uniform Law Comment to the applicable statute says that liquidation value “is not intended to mean distress sale value.” Under general principles of valuation, the price in either case is the price a willing and informed buyer would pay a willing and informed seller, with neither being under compulsion to deal. “The notion of a minority discount in determining the buyout price is negated by valuing the business as a going concern.” The comment goes on to say: “Other discounts, such as for a lack of marketability or the loss of a key partner, may be appropriate, however.”

The Court of Appeals said the parties agreed that liquidation value was inappropriate. Accordingly, the important language in the statute was “the value based on the sale of the entire business as a going concern without the dissociated partner and the partnership were wound up as of that date.”

The trial court relied on the defense expert’s valuation, which, while “thorough and detailed,” also included a discount for lack of control and for lack of marketability. Although, in her trial testimony, the expert tried to minimize the importance of the distinction between the two types of discounts, the distinction mattered pursuant to the applicable statute, the appeals court said.

The statute requires a value based on the sale of the entire partnership business as a going concern, the appeals court emphasized. “While a discount for lack of marketability as to the entire partnership business and not as to the minority partnership may be appropriate, a discount for lack of control by the minority partnership interest is inappropriate,” the court said.

The court also pointed out that the drink formulas were assets of the partnership and their value had to be considered when valuing the entire business. Only if these values were accounted for could there be a determination of the plaintiff’s interest in the partnership, the court said.

The Court of Appeals reversed the trial court’s valuation and remanded for a calculation consistent with the statute. The appeals court also clarified that the valuation date was the date the plaintiff was dissociated, December 2015.

Solvency Opinion Based on Management Projections Faces Daubert Challenge

Official Committee of Unsecured Creditors v. Calpers Corp. Partners, LLC, 2020 U.S. Dist. LEXIS 125769 (July 17, 2020)

In a bankruptcy-cum-Daubert case that turned on solvency, a court recently rejected both parties’ claims that the opposing financial expert testimony was inadmissible. Among the myriad of attacks (all unsuccessful) against the experts was the plaintiff’s claim that the debtor’s expert had relied on management projections without scrutinizing the forecasts and examining the underlying facts or data. In contrast, the court found the expert’s deposition testimony, in particular, showed the expert assessed the reasonableness of the projections. Whether his decision to rely on the forecasts was reasonable was an issue for the jury to decide.

Failure to go behind the projections? The debtor was a pulp, paper, and tissue mill in Maine that suffered a business interruption loss and, in December 2013, received a cash settlement from its insurance company. Within six months, the board of directors authorized two distributions to a holding company that was the sole member of the debtor. Some 15 months after the last distribution, the debtor filed for Chapter 11 bankruptcy. The bankruptcy trustee appointed the official committee of unsecured creditors, i.e., the plaintiff in this case. The committee filed a lawsuit in which it tried to avoid and recover the distributions. The plaintiff argued the transfers were constructively fraudulent; the debtor was insolvent at the time of the distributions. In contrast, the debtor argued various solvency tests showed the debtor was solvent during the relevant times.

Both parties retained financial experts to support their positions, and both parties tried to exclude the rivaling expert under Federal Rule of Evidence 702 and Daubert.

The plaintiff criticized the defense expert’s solvency analysis under various tests: payment of debts test, balance sheet test, and capital adequacy test. According to the plaintiff, the expert testimony about the capital adequacy test and the income approach to the balance sheet test was unreliable, and, therefore, inadmissible, because the expert “blindly accepted mere summaries of management-prepared, EBITDA-level projections.” He did not test the reasonableness of the projections by examining the underlying facts or data or considering conflicting information, including other contemporaneous projections that were forecasting significant negative EBITDA. Also, if the expert had reviewed past financial performance against the then forecast performance, he “would have discovered that the Debtor’s prior performance was uniformly more negative than prior projections.”

‘Robust projection process’? The court found the plaintiff’s claim ignored evidence that the expert did question and analyze the reasonableness of the projections. For example, when asked during his deposition what he did to assess the reasonableness, he said he had reviewed deposition testimony of key board members and they all seemed to agree the projections included everything they knew at the time. According to the expert, the board members “talked to sales people, they talked to the operating people … So the projections were built from the ground up. It wasn’t somebody sitting in the office just making up numbers.” He said it appeared to him that the projection process was “fairly robust.” He also noted the board members “understood the business. They develop projections every year, budgets every year, reviewed financials.” He said he considered testimony from an outsider with industry expertise, who said the forecasts were reasonable. Moreover, he said, in the past, “they’ve hit $5 million of EBITDA or more.… So it’s not like they’re boldly going where no man has gone before.” Considering all of these factors “leads me to say that they’re reasonable.”

The court said the expert’s deposition testimony showed the expert (who was an accredited, experienced valuator) “applied his own expertise in assessing the reasonableness of the projections.” While the existence of opposing evidence may justify criticism of the expert’s conclusions, “that does not make his testimony inadmissible,” the court said. It added that the plaintiff could probe the reasonableness of the expert’s use of the projections through cross-examination, “and a jury can assess his response.”