Litigation & Disputes Bulletin: Q4 2020
In This Issue:
- Indiana and South Carolina Courts Issue Key Discount Rulings
- Court Finds Use of Industry Licensing Data Reasonable and Relevant to Expert’s Reasonable Royalty Opinion
- Expert’s Damages Calculation Based on Extensive Experience in Field Is Reliable, Court Finds
- Court Rejects FMV Appraisal of Dissociated Member’s Interest in Statutory Buyout
Indiana and South Carolina Courts Issue Key Discount Rulings
Hartman v. BigInch Fabricators & Construction Holding Co., Inc., 2020 Ind. App. LEXIS 183 (May 5, 2020)
Clark v. Clark, 2020 S.C. LEXIS 69 (May 13, 2020)
In a crucial decision on the use of discounts when valuing a spouse’s minority interest in a closely held business, a majority of the South Carolina Supreme Court rejected a bright-line rule, noting it would limit the flexibility family courts must have in apportioning marital assets. Other considerations also militated against a fixed approach, the majority explained. The opinion triggered a dissent.
Disagreement over DLOM: During the marriage, the husband came to own 100% of the stock in a family business. Most of it was found to be a gift from his father and not marital property. In 2009, the husband transferred a 25% equity interest in the business to the wife. A stock agreement contained a transfer restriction. In 2012, the husband filed for divorce. The flashpoint was the valuation of the wife’s 25% interest.
The husband’s expert applied a discount for lack of marketability and lack of control. She explained the DLOM by noting a closely held company was less marketable and less liquid than a publicly traded business. She also pointed to the transfer restriction. A minority discount was appropriate as the interest holder would not have control over the company.
The wife’s expert initially used a DLOM, but, upon learning that the husband did not intend to sell the company, found it was inappropriate. He valued the entire company and divided the result by four.
The family court credited the husband’s expert. Acknowledging a “debate as to whether … discounts should apply in a divorce setting as the business is not actually sold,” the court noted the applicable standard, fair market value, which assumed a hypothetical sale between a willing buyer and a willing seller.
The Court of Appeals reversed on the DLOM. It said the marketability discount was based on the fiction of an anticipated sale, which, under the applicable law, was no longer recognized when there was no evidence of an intent to sell the business, as was the case here. Also, the stock restriction was of no consequence where one spouse intended to retain ownership. The court relied on Moore v. Moore, a pivotal Supreme Court decision that primarily dealt with goodwill. In Moore, the state’s high court found the facts of the case did not justify a DLOM, while declining to make a bright-line rule as to whether DLOM was ever appropriate in divorce proceedings.
The Court of Appeals upheld the use of the minority discount.
Emphasis on FMV: On review with the state Supreme Court, a majority of justices emphasized that FMV was the applicable standard of valuation. The majority also noted a longstanding tension between “proper business valuation principles” and a trial court’s goal of apportioning marital assets “fairly and justly.”
Certainly, if we value flexibility in how the family court apportions the parties’ marital assets—which we clearly do—we should consider that court’s decision when it has chosen to accept the parties’ expert testimony that a marketability discount applies and when the court has found one party’s expert more credible.
Not to do so, the high court’s majority suggested, would mean imposing a bright-line rule that the high court earlier had rejected. The majority said Moore was clear that the use of DLOM required a case-by-case analysis. Here, the Court of Appeals “effectively established a bright-line rule disallowing this discount,” the court’s majority said. Doing so was error. The facts of the case supported the trial court’s use of a marketability discount. Further, minority status “certainly affects an asset’s fair market value, and therefore, it is proper for courts to consider the propriety of this discount.”
Dissent: The dissent agreed that Moore did not create a bright-line rule as to the DLOM. But the facts here were “not meaningfully different from the facts in Moore,” the dissent said. In both cases, a minority interest, by order of the court, was transferred to the spouse owning the entire remaining interest, and, in both cases, the owner-spouse had no intent to sell the business. Likewise, under the facts of the case, use of a minority discount was inappropriate, the dissent said. Writing for the dissent, Justice James noted he was not abandoning the FMV but, “when facts and common sense dictate, courts should avoid an approach that results in a fictional value being assigned to the asset.”
Court Finds Use of Industry Licensing Data Reasonable and Relevant to Expert’s Reasonable Royalty Opinion
J&M Industries, Inc. v. Raven Industries, Inc., 2020 U.S. Dist. LEXIS 76881 (May 1, 2020)
In this ongoing patent litigation, the court ruled on a number of motions to exclude expert testimony under Daubert and Federal Rule of Evidence 702. The plaintiff argued the reasonable royalty opinion of the defendant’s damages expert disregarded core principles of patent law. For example, in performing a Georgia-Pacific analysis, the expert improperly considered licensing data from the general industry in which the parties operated without showing comparability to the technology at issue. Therefore, the expert’s opinion was unreliable. The court found most of the testimony was admissible.
Background. The plaintiff was a Louisiana company that designed and manufactured a storage system for covering bulk material such as grain. The plaintiff had a patent for tarps with an internal strapping system. The defendant sold covers for temporary grain storage systems. According to the plaintiff, some of the defendant’s covers violated the plaintiff’s patented technology. The plaintiff asked for damages and injunctive relief and claimed the infringement was willful and therefore entitled the plaintiff to increased damages.
At this point in the litigation, the parties filed motions to exclude various experts. The plaintiff said the defendant’s expert opinion as to what a reasonable royalty for this situation would be was inadmissible under Daubert and Rule 702. The expert used the Georgia-Pacific framework that is premised on a hypothetical negotiation between the parties that takes place immediately prior to the infringement and in which both sides determine a reasonable royalty.
In essence, the defendant’s expert found damages to compensate for the defendant’s alleged infringement should be in the form of a running royalty. The rate should be 9%, applied to the appropriate royalty base, which represents the revenue generated by the infringement. The defendant’s expert contended the 35% royalty the plaintiff’s expert proposed was “extremely high” and did not align with licensing rates in the related agricultural industry (i.e., agribusiness).
The plaintiff claimed the defendant’s expert failed to perform proper apportionment as required under one of the Georgia-Pacific (G-P) factors. Further, he relied on licensing data without knowing or verifying that the licenses he considered for his analysis were similar to the business and technology at issue in this case.
Applicable legal principles. Two sets of legal principles are in play in this dispute. One concerns the law covering the admissibility of expert testimony. The other concerns the law applicable to damages in patent infringement cases.
Admissibility. Rule 702 of the Federal Rules of Evidence requires that a witness who seeks to testify as an expert must be qualified “by knowledge, skill, experience, training, or education.” The testimony must help the trier of fact understand evidence or determine a fact in issue. The testimony must be based on sufficient facts or data, must be the product of reliable principles and methods, and the expert must have reliably applied the principles and methods to the facts of the case.
Further, under Daubert and its progeny, the testimony must be reliable and relevant. Under Daubert, the district court performs a gatekeeping function as to the admissibility of the expert’s opinion. Rejection of expert testimony is the exception rather than the rule. However, the court may decline to admit opinion testimony that is “connected to existing data only by the ipse dixit of the expert” and may exclude testimony if “there is simply too great an analytical gap between the data and the opinion offered.” See General Electric Co. v. Joiner, 522 U.S. 136 (1997).
Infringement damages. A patent holder may be compensated for infringement either in the form of lost profits and a reasonable royalty the patent holder would have negotiated in an arm’s-length transaction Under the applicable statute, damages for infringement must be no less than a reasonable royalty for the use of the invention by the infringer.
One way to determine a reasonable royalty is the Georgia-Pacific framework, which sets forth 15 factors to ascertain a royalty on which the parties would have agreed in a hypothetical negotiation. However, the Federal Circuit, a special U.S. court of appeals that handles appeals in patent cases, has held that an expert testifying to damages in patent cases need not use any or all of the G-P factors. If the expert decides to use them, he or she must do more than merely recite the factors or offer conclusory remarks related to their impact, the Federal Circuit has said.
To arrive at a running royalty, the classic way is to multiply the royalty base, i.e., the revenue generated from the infringement, by the royalty rate, i.e., the percentage of revenue that is owed to the patent holder.
Apportionment. One of the Georgia-Pacific factors addresses the need for apportionment of damages. Under Federal Circuit case law, the apportionment principle requires that a reasonable royalty only compensate the patent holder for the incremental value that the patented invention adds to the end product. Under G-P Factor No. 13, the value of nonpatented features in a product must be apportioned out when determining a reasonable royalty.
Under the entire market value rule (EMVR), recovery of damages based on the value of the entire product is permissible only if the patented feature is the sole driver of customer demand or substantially creates the value of the component parts.
The court found that the defendant’s expert considered all the applicable principles in calculating a reasonable royalty to compensate for the alleged infringement of the plaintiff’s patent.
The plaintiff argued the tarp body (grain storage cover) was a patented feature, and the opposing expert improperly apportioned out the value related to it. The court rejected this argument. It noted the defense expert explained that grain storage covers without the patented internal straps were commercially available and sold by both parties. Therefore, the nonstrap grain storage covers represented the nonpatented components for which the plaintiff should not be compensated. In contrast, the patented internal straps represented the incremental value added to the end product, the grain storage cover. The expert determined the value of the internal straps (the patented invention) by comparing the pricing of the grain storage with the straps with the grain covers sold without the straps. The expert expressly considered apportionment principles in his reasonable royalty analysis, the court concluded.
Comparable licenses and royalty rates. G-P Factor No. 12 relates to the profit or selling price “that may be customary in the particular business or in comparable businesses to allow for the use of the invention or analogous inventions.”
The defense expert considered this factor for his opinion while acknowledging he was unable to identify licenses for comparable technologies. However, he used the ktMINE database to review royalty rates in agribusiness and found the rates ranged between 1% and 7.5%. He agreed that these rates were not directly applicable to the royalty rate here but said the information was relevant “in helping assess the reasonableness of an already determined royalty rate.” Also, the overview was useful in that it showed the plaintiff expert’s 35% rate was too high.
Moreover, the defense expert cited a 2012 KPMG study that showed the relationship between royalty rates and profitability across all industries. The expert used formulas from this study to predict royalty rates between 4% and 9.1%, with an average of 6.1%, based on the defendant’s profit margins.
He concluded these results aligned with the ktMINE results and again showed that the opposing expert’s 35% royalty rate was “out of line with actual observed license agreements.” The defense expert also used this analysis to conclude most royalty rates related to agribusiness and related industries were between 2% and 9% of revenue.
The court agreed with the plaintiff that the defense expert’s opinion as to the KPMG study or its effect on calculating a reasonable royalty was inadmissible. The court noted that this study dealt with a wide range of industries and was not tailored to businesses that were “comparable in any way to the temporary grain storage industry.” There was not a sufficient connection to the facts of the case, the court said.
However, the court admitted into evidence the expert’s opinion related to licensing data for the agribusiness. The court noted the expert acknowledged the difference between the data specific to the contested technology and data used in the broader market. He explained how the latter data were relevant. He did not use it to determine a royalty rate applicable in this case but to confirm the reasonableness of his opinion as to what a proper royalty rate here was.
The court said the method the expert used “in this regard” was both reasonable and sufficiently tied to the facts of the case “at least insofar as data related to agribusiness licensing is concerned.”
In conclusion, the court allowed into evidence most of the defense expert’s testimony on damages, i.e., what a reasonable royalty would be to compensate the plaintiff for the defendant’s violation of the plaintiff’s patented technology.
Expert’s Damages Calculation Based on Extensive Experience in Field Is Reliable, Court Finds
Geiger v. Creative Impact Inc., 2020 U.S. Dist. LEXIS 106332 (June 17, 2020)
Both parties in this damages case centering on allegations of misappropriation of the plaintiffs’ images by defendant strip club owner raised Rule 702/Daubert challenges to the opposing expert testimony. The court’s opinion offers noteworthy observations on the admissibility of surveys and the expert qualification requirement under the federal rules of evidence and case law.
Allegations. Several women who previously worked or currently work as models sued the defendant strip club owner (and the club) alleging he had posted images of plaintiffs in flyers online, via social media, without their consent. The images were from prior photo shoots. The defendants’ flyers referred to activities occurring at the strip club. The plaintiffs contended the use of their images improperly implied that they were strippers at the club or affiliated with or promoting it.
The plaintiffs filed suit in federal court. They claimed false light invasion of privacy and misappropriation of likeness under state law (Arizona) and false association and false advertising under federal law, i.e., the Lanham Act.
At this stage in the proceedings, both parties sought to exclude the rivaling expert testimony under Rule 702 of the Federal Rules of Evidence and Daubert and progeny.
Plaintiffs’ survey-related testimony. The plaintiff offered testimony from two experts. One expert presented a survey he had done to “explore possible confusion among consumers exposed to [Defendant’s] advertising in terms of what they understood about the women’ [sic] appearances in the Internet advertising material.”
The defendant did not question the expert’s qualifications but contended the survey was unreliable and also was irrelevant. The court rejected both arguments.
The court first explained the legal principles applying to the issue of admissibility of expert testimony in federal court.
Under Rule 702, an expert must be qualified “by knowledge, skill, experience, training, or education” and the expert’s knowledge must “help the trier of fact to understand the evidence or to determine a fact in issue.” Further, the testimony must be based on sufficient facts or data, must be the product of reliable principles and methods, and the expert must reliably apply the principles and methods to the facts of the case.
Under Daubert and related cases, the court serves as gatekeeper, ensuring the testimony is both reliable and relevant. The focus of the Rule 702 assessment is “solely on principles and methodology, not on the conclusions that they generate.”
As for survey evidence, the court noted the principal requirement was that the survey “was conducted according to accepted principles.” Objections regarding technique or methodology go to the weight to be accorded the survey (a question for the fact-finder) but do not make the survey inadmissible.
Here, the court noted, the expert stated that he had conducted the survey in agreement with principles in the field and with the aim of ensuring “survey trustworthiness.”
The court found all of the defendant’s objections to the expert’s survey were related to survey methodology and did not require exclusion of this evidence.
For example, the defendant argued the expert did not use a control group and did not control for prior exposure to the flyers. The court noted the defendant did not cite to law that a survey must be precluded as unreliable where there is no control group. This is a claim of technical inadequacy, which goes toward weight, not admissibility, the court said. The prior-exposure-to-the-flyers argument also concerned survey methodology and therefore went toward weight, not admissibility.
Likewise, the court dismissed claims that the way in which the plaintiffs’ expert framed questions was “problematic as it is more likely to yield biased responses.” This objection, too, “has to do with an asserted technical inadequacy,” the court said. Challenges to formatting and wording of questions are related to survey methodology and don’t affect admissibility.
In concluding the testimony was admissible, the court noted the expert was qualified and his report included a detailed description of the methodology he used and how the methods conformed with accepted principles in the field.
The only “possible indicium of unreliability” was the expert’s awareness that the survey was for litigation, the court said. But, even if some courts think it is “ideal” if a surveyor is unaware of the purpose of the survey, knowledge of the purpose “does not render the survey necessarily unreliable as some level of attorney involvement can be required to ensure the survey is ‘legally and factually relevant,’” the court stated (citation omitted)
The court went on to say (in a footnote) that its case law research has not revealed a single case where any expert was precluded from testifying “solely due to knowledge of the litigation prior to drafting the survey.” The court also said that insisting on the “ideal,” i.e., no knowledge of the litigation, was itself problematic in that “it potentially trades reliability for relevance.” Some degree of involvement by the attorney “may be desirable rather than objectionable,” where the goal is “a legally and factually relevant survey.”
A challenge related to the expert’s knowledge of the litigation before developing his survey would go to the weight of the survey evidence, not admissibility, the court said.
The court also found the survey was relevant to the issues of the case. It noted the evidence would at a minimum be relevant to the question of whether the flyers implied what the plaintiffs claimed the flyers implied: the plaintiffs’ promoting the strip club or being associated with it.
The plaintiffs’ survey evidence was admissible under Rule 702 and Daubert, the court concluded.
Plaintiffs’ damages testimony. The defendant also sought to exclude the plaintiffs’ damages expert, arguing essentially the expert had used an unreliable methodology.
The expert, who had worked as “an agent in the [m]odel and [t]alent industry” for the past 30 years, explained he based damages on “the hypothetical negotiated price that Defendant would pay each of the Plaintiffs to use their respective image.” The price was based on a “day rate,” compensating for a model’s time on the day of the shoot. The expert, referring to The White Book: A Guide to Model Fees, explained the day rate depended on a number of factors including a model’s desirability, work history, “the embarrassment factor,” the type of exposure, and usage. “Usage,” the expert noted, included “the way and method of use and distribution of images including but not limited to advertising, social media, third party promotion, branding, [b]illboard displays, coupons and more.”
The court said the expert was qualified based on this extensive experience in the modeling industry. (The defendant did not challenge the testimony on qualification grounds.) “Lack of peer review, publication, or general acceptance of the expert’s methodology is not dispositive when an expert’s opinion is based on the application of extensive experience, as the expert’s opinion is the product of the expert’s experience—not science,” the court said.
The defendant also objected that The White Book was not reliable as it was a U.K. publication and did not include any data or method for determining valuations. The court rejected this argument, noting it was not properly developed. And, even if the court considered the merits of this claim, the claim would fail given the expert’s extensive experience in the field, the court said. “An expert may rely on a publication that is a reliable authority in the expert’s field,” the court said.
The court dismissed the defendant’s objections as a disagreement over assumptions and calculations, which were based on the expert’s experience and his review of the facts. The methodology was sufficiently reliable for purposes of admissibility, the court concluded.
Defendant’s expert testimony. The plaintiff sought to exclude the defense expert under all three prongs of Rule 702 and Daubert—qualifications, reliability, and relevance. This attempt also was not successful.
First, the plaintiff claimed the opposing expert was unqualified as he “has never negotiated a modeling or talent contract in his life.” The plaintiffs called the expert’s analysis “naïve and foundationless,” which only a person “who lacks the most fundamental comprehension of the modeling industry and how contracts are negotiated, and valuations arrived at,” would offer.
The court found this objection, as worded, overwrought (“bluster”) and baseless. It noted the expert had about 19 years of experience providing valuation services in a number of industries, including in the areas of intellectual property, media, entertainment, etc. The expert’s curriculum vitae said he had been involved in “lawsuits involving over 135 models who have alleged right of publicity claims for unlawful use of their image” and he had published on these issues. The expert was qualified, the court found.
As for the plaintiffs’ challenge based on reliability, the court noted “the crux” was “that Plaintiffs do not agree with [the opposing expert’s] methodology.” Particularly, they disagreed with the assumption that damages are equal to the amount a plaintiff could get for selling a license to a particular image taken at a photo shoot. This objection goes toward the weight of the expert’s opinion, not admissibility, and must be decided by the trier of fact, the court said.
The court likewise dismissed the plaintiffs’ contention the defense expert’s testimony was not relevant. For testimony to be relevant, it must be “sufficiently tied to the facts of the case that it will aid the jury in resolving a factual dispute,” the court noted. Here, the plaintiffs did not explain why the opposing expert’s damages analysis was irrelevant. There was a disagreement between the parties over how to value the plaintiffs’ damages, the court observed, and the defendant had a right to offer an opinion on the issue. The plaintiffs were free to test this opinion on cross-examination.
The testimony was admissible as it would aid the trier of fact in determining damages in the case, the court found.
The court admitted all proffered expert testimony.
Court Rejects FMV Appraisal of Dissociated Member’s Interest in Statutory Buyout
Flynn v. Maschmeyer, 2020 IL App (1st) 190784 (June 25, 2020)
Two members in a limited liability company sued a third member alleging the defendant’s wrongful conduct harmed the company. The court awarded damages and also ordered the company to buy out the defendant (dissociated) member for the fair value of his interest in the company. The plaintiffs’ expert provided a fair market valuation that was substantially lower than opposing expert’s valuation, which did not apply discounts and included other changes. The court adopted the valuation of the defense expert with adjustments, finding the plaintiffs claimed a significant amount of debt the company allegedly incurred that it could not substantiate. The appeals court affirmed.
Backstory. In 2009, one of the plaintiffs and the defendant formed a business that designed, landscaped, and constructed outdoor living spaces such as decks and roof tops. The company was organized as a limited-liability company, and both members owned 50%. In March 2013, the two members admitted a third person (also a plaintiff) as a member and awarded him a 15% interest. The founding members then each owned 42.5% of the company.
Under the company’s 2009 and 2013 operation agreements, the founding member plaintiff was the CEO of the company and had responsibility over all financial matters. The defendant was the sales agent and designer and brought in a substantial part of the business.
The founding members did not receive any salaries but received distributions at the discretion of the plaintiff. Between January 2009 and June 2014, the defendant received nearly $977,000 in distributions. The plaintiff received about $775,000.
By June 2014, the two plaintiff members found the defendant had deposited checks made out to the company and/or himself for work performed into his personal bank account. They confronted the defendant and unsuccessfully demanded that he make a capital contribution of $850,000 to the company. The defendant did not do this. Instead, the defendant and his wife set up a competing company.
The plaintiffs filed suit in July 2014, to disassociate the defendant from the company pursuant to the state’s limited liability company act. Eleven days later, the plaintiffs informed the defendant that he was removed as a member and manager of the company and current and past distributions owed to him were “void.” Instead, the plaintiffs allocated the defendant’s 42.5% interest to themselves, leaving the founding member plaintiff with a 63.75% interest and the other plaintiff with a 36.25% interest.
In their court complaint, the plaintiffs argued the defendant had breached his fiduciary duty to the company by usurping business opportunities that should have gone to the company, wrongfully depositing company checks into his personal bank account, and using company assets for his own projects. They also filed a claim for dissociation, asking the court to order the defendant expelled as a member of the company
The defendant filed counterclaims. He also sought to have his interest purchased at fair value under the provisions of the act’s then-applicable dissolution and dissociation articles (805 ILCS 180/35-60 and 180/35-65).
The case went to trial and both parties offered expert testimony on the value of the defendant’s interest.
Under a provision in the act that was in effect at the time, but has since been repealed, the court, in determining the dissociated member’s distributional interest, would consider all relevant evidence of the value of the company as a going concern, agreements among members as to the buyout price or a formula for determining the value of the departing member’s interest, and recommendations by appraisers appointed by the court, as well as legal constraints on the company’s ability to buy back the interest.
Questionable debt claims. The plaintiffs’ expert did not testify, but his report was in evidence because the parties stipulated to the admissibility of both expert reports.
The report of the plaintiffs’ expert said the expert had performed a “fair market value” analysis of the defendant’s ownership interest in the LLC. The expert explained FMV was “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having knowledge of the relevant facts.”
The expert used an income approach, specifically the discounted cash flow analysis. Future cash flow was based on five-year projections.
The expert noted he assumed, but did not independently verify, the accuracy and completeness of all information, including all financial data, the plaintiffs had provided. The expert concluded the defendant’s ownership interest was worth $28,225.
Specifically, the expert used internally prepared financial statements from 2011 through 2014, including historical balance sheets, and relied on plaintiff statements claiming the company had “outstanding long-term debt” of about $1.1 million. The expert report said the appraiser understood this amount to represent noninterest-bearing obligations to various vendors and subcontractors for inventory and work performed. The report also noted the company said it had an additional $946,000 in debt that was not reflected in the balance sheets. The expert subtracted the debt amounts in his value determination.
He calculated a 19.8% weighted average cost of capital and a 16.8% capitalization rate. Further, since this was a privately held company, a 20% discount for lack of marketability was appropriate, the expert explained. He found that, as of the valuation date, the C corporation equivalent nonmarketable, noncontrolling value of the company’s total equity was $51,520. Since the company was not a C corp, the expert applied a 1.2890 “S corporation equity adjustment multiple” to reflect the status of a pass-through entity. Doing so increased the “fair market value of total equity on a nonmarketable, noncontrolling ownership interest basis” to about $66,400. The defendant’s 42.5% interest therefore was $28,225, the plaintiffs’ expert concluded.
The defendant’s expert used the opposing expert’s report but made adjustments to it. Instead of internally prepared financial statements, this expert considered the company’s corporate tax returns from 2011 through 2013. She determined the difference between the two sets of financial documents averaged $393,000 over the three years. She used this difference to calculate an upward adjustment of $1.5 million to the opposing expert’s valuation. The defense expert found the total invested capital value was about $3.3 million. She said there was not enough information as to the $946,000 “off balance sheet liability” and that it should not be included in the valuation. Further, under USPAP, this liability was an “extraordinary assumption” that should be excluded from the analysis, the expert explained. She did subtract the $1.1 million long-term debt from the total invested capital, as the opposing expert had done.
The defense expert explained that the fair value standard of value, which did not use discounts, was more appropriate here than the “fair market value standard” and therefore rejected the 20% marketability discount. In this regard, she also noted that the company’s historical cash flows represented those available to the controlling shareholder “due to the equivalent nature of the two equal 42.5% shareholder’s [sic] involvement and management of the Company.”
The defense expert adopted the S corp adjustment multiple the opposing expert proposed. She also added to the company’s value a litigation asset of about $1.1 million related to the company’s instant claim against the defendant. In total, the defense expert found the company’s equity ownership was worth $4.4 million, making the defendant’s interest worth about $1.9 million.
‘Hopelessly unreliable’ financial records. The trial court found the defendant had breached his fiduciary duty to the company for taking opportunities that belonged to the company. The court said it also was undisputed that the defendant had deposited checks to the company into his personal bank account. The court awarded the company the gross revenue resulting from the contested projects as part of the damages, noting the defendant had failed to show what expenses he had incurred in undertaking the projects (these amounts could have been subtracted from the plaintiffs’ award).
The court also found that, because of his wrongful conduct, the defendant had forfeited two-thirds of the distributions the company had made to him while he was breaching his fiduciary duty, i.e., about $651,000. This amount represented punitive damages.
At the same time, the court found the defendant was entitled to the fair value of his interest in the company.
As for the valuations the experts proposed, the court first took issue with the $2.1 million debt the plaintiffs claimed the company had incurred. The court noted the company’s financial books and records were “hopelessly unreliable,” and it observed this was “odd” considering the founding member plaintiff who was in charge of the books had a master’s degree in finance and substantial experience in business. The court found there was no contemporaneous evidence substantiating the claimed debt to contractors and vendors and none of the company’s income tax records reflected the “off-balance sheet” liabilities. In fact, the $1.1 million long-term liability appeared first on the company’s 2013 tax return, which the plaintiff prepared and filed after the defendant had been removed from the company. The 2012 tax return showed long-term debt of only $395,000, the court observed. It pointed out the plaintiff had submitted a different version of the 2013 tax return to financial institutions (for loan applications) that did not show the same amount of indebtedness and showed more income than the company had reported to the Internal Revenue Service. Ultimately, the court found the $2.1 million in claimed debt should not be considered in determining the fair value of the defendant’s interest.
The court found the defense expert’s methodology “persuasive” but made several other adjustments, including increasing the amount of the litigation asset, which represented an asset to the company, to $2 million. At the same time, the court excluded the forfeiture amount it had assessed against the defendant to prevent the defendant from recapturing this money in the fair value determination.
The plaintiffs challenged many of the trial court’s findings, including the fair value determination, with the state’s appellate court.
Deference on valuation findings. In considering the plaintiffs’ arguments, the appellate court noted, under the standard of review, it would defer to the trial court’s judgment as to property valuation “unless the trial court’s decision was against the manifest weight of the evidence.”
The plaintiff said the litigation asset, i.e., the judgment against the defendant (exclusive of the punitive damages), should not be considered in calculating the value of the defendant’s interest.
The appellate court disagreed, noting the amount of judgment represented the company’s assets. Its inclusion was necessary to reflect the company’s full value. The defendant was asked to pay back to the company money he improperly earned by doing jobs the company should have had an opportunity to do, the court said. If that amount were excluded from the company’s value, the plaintiffs would in effect receive the same amount twice. Also, because the trial court awarded the company the gross revenue the defendant received (as he could not substantiate the expenses related to the work done), the trial court actually awarded the company more than the defendant received from the jobs, the appellate court observed. Including these funds in the value determination was not improper.
The plaintiffs also claimed the trial court’s failure to consider the $1.1 million long-term debt in the valuation was error as both experts included this amount.
The appellate court dismissed this argument, noting the trial court did not find plaintiff testimony in support of the debt claim credible. The trial court found the witness “evasive” and the evidence “not convincing,” the appellate court noted. “[T]here is a plethora of plaintiff’s evidence that the trial court did not find credible, and we will not second-guess the trial court’s credibility determinations.”
The state appellate court affirmed the trial court’s fair value determination of the defendant’s 42.5% interest in the company.
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