Resources

News

First | Prev | Page 1 / 21 | Next | Last

Litigation Services Bulletin: Q3 2020

Posted 1:00 PM by

In This Issue:

 

Plaintiff’s Overbroad Damages Calculation Prompts Court Not to Grant Award for Proven Wrongdoing

Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLP, 2020 Del. Ch. LEXIS 76; 2020 WL 948513 (Feb. 27, 2020)

The Delaware Court of Chancery recently decided damages in a case in which the buyer sued in tort and contract after the subject company lost in value post-acquisition. In a tactical misstep, the plaintiff submitted an expert damages calculation at the liability phase and adhered to it even though the court ended up substantially limiting the scope of liability. The expert’s theory and calculation were not sufficiently tailored to the wrongdoing the plaintiff was able to prove, the court found. Vice Chancellor Glasscock said, “[H]arm is in itself insufficient for a damages award if I have no basis to make a ‘reasonable estimate’ of damages.” The court therefore declined to award any damages for certain established misrepresentations. This case shows that it is not cost-effective for a litigant not to submit an updated, on-point expert report.

Backstory. The case arose over the acquisition of a company, Plimus, that functioned as a “reseller” between small online retailers and consumers. Its success depended on having good working relationships with payment processors. Two of them were critical for Plimus: PayPal and Paymentech. Typically, Plimus would “acquire” products from the retailer and receive payment for that retailer from the payment processor. The payment processor in turn had relationships with credit card companies and their banks.

Problems in the process would arise whenever the retailer’s product was not satisfactory to the consumer and credit card companies had to cancel debt the consumer incurred for fraudulent or mispresented products known as “chargebacks.” In the event of a chargeback, the credit card company imposed a fine on the payment processor, which, in turn, contacted the reseller (e.g., Plimus). In sum, retailers whose products resulted in excessive chargebacks put a strain on the reseller and the payment processor.

The plaintiff (related private equity firms) acquired Plimus by way of merger in 2011. The sale price was based on due diligence, management projections, and representations in the parties’ merger agreement. The merger closed on Sept. 29, 2011. The merger price was $115 million. Shortly after the merger, PayPal terminated its business relationship with Plimus, placing Plimus on the “MasterCard Alert to Control High-Risk Merchant” list (MATCH list). Plimus then entered into an agreement with another payment processor. But, in January 2012, the new partner also terminated Plimus.

In its annual report ending Dec. 31, 2011, the buyer/plaintiff stated that “Plimus was the only portfolio company to experience decline in valuation, as the company removed a number of high-risk clients from its payment platform, resulting in a negative short-term impact.” Plimus’ removal of high-risk customers, its purging of some 500 higher-risk merchants in early 2012, and its giving more scrutiny to new vendors meant a decline in processing volume relative to expectations. The buyer said it therefore expected a lower sale volume into 2012. In August 2012, the buyer fired the CEO of Plimus. The buyer also made what it claimed were many millions in additional investments in Plimus. In 2014, Plimus changed its business model and began to operate as a payment facilitator. This role required it to show more transparency as to its vendors and as such was preferable to model processors and acquiring banks.

The buyer eventually sued the principals, including the CEO, and stockholders of Plimus in the Delaware Court of Chancery, claiming breaches related to the representations and warranties the defendants made in the merger agreement as well as various acts of fraud and fraudulent inducement related to the merger.

The court, in the instant opinion, noted that the litigation was “large,” as concerns the scope of allegations, the cast of defendants, and the damages claims. The court decided to bifurcate the proceedings into a liability phase and a damages phase. In the liability phase, the court rejected most of the plaintiff’s claims.

The damages findings are the subject of the court’s instant decision.

Surviving claims. Based on the liability proceedings, the court found the plaintiff was able to prove two instances of fraudulent misrepresentation, one involving Plimus’ former CEO, as well as several breaches of contractual representations by other defendants.

As for the fraud claims, before the merger closed, Plimus was put on notice by PayPal that it had to terminate one vendor in particular, GoClickCash. This vendor was involved in a “get rich quick” scheme that resulted in high chargebacks. Once Plimus had notice from PayPal, it terminated the account and performed an internal review that resulted in terminating another 16 potentially compromising vendors. About a week before the merger closed, Plimus received notice that PayPal would impose a $200,000 fine related to GoClickCash.

The court found, prior to closing, the buyer had organized a “bring down call” with Plimus’ management to discuss changes in the business that might require amending the disclosure schedule accompanying the initial merger agreement. Internally, Plimus’ CEO noted the fine was a business issue, but he chose not to disclose it to the buyer at that call or before the closing of the merger.

Further, the court found that, in early August 2011 and numerous times after that, PayPal informed Plimus that the latter had incurred excessive chargebacks and that PayPal might issue a 30-day termination notice and end its relationship with Plimus. On the date of closing, PayPal had not yet decided whether or not to terminate Plimus.

The court found that, while the CEO likely disclosed to the buyer that Plimus had some dispute with PayPal, he did not disclose the extent of the problem or the threat of PayPal’s terminating the relationship. Nondisclosure of PayPal’s threats and the GoClickCash fine were false representations, the court found, where Plimus principals stated that the company followed credit card network rules and that no suppliers of goods or services had threatened termination.

The court specifically noted that Plimus’ CEO “intended” for the buyer to rely on these false representations to induce the buyer to go ahead with the merger, recognizing that the PayPal problems could negatively affect the merger. Plimus knew that the loss of PayPal would mean a major disruption of its business, the court noted. In contrast, the buyer relied on representations by Plimus, and its reliance was reasonable where due diligence related to the merger was completed before PayPal made termination threats and Plimus had a contractual obligation to disclose the information. The court noted Plimus’ CEO later testified that he did not believe PayPal would go through with its threats to terminate. Although the court believed the testimony was truthful, it found problematic the CEO’s awareness of the threats and said he “fraudulently concealed them” from the buyer.

As for liability related to contractual breaches, the court noted Plimus had stated in the merger agreement that it followed the rules of the card systems, payment card industry standard, the National Automated Clearing House Association, regulations applicable to the credit card industry, and its member banks. At the same time, Plimus had received numerous violation notices from its two major payment processors, Paymentech and PayPal. The defendants conceded a number of breaches related to excessive chargeback issues.

Further, the defendants’ vouching in the merger agreement that there were no suppliers of products or services that had notified Plimus of an intent to terminate their business relationship with the company was misrepresentation.

Damages calculation submitted. All told, the court “greatly circumscribed” liability for Plimus in the first phase of the proceedings. It found that “the bulk of [the plaintiff’s] wide-ranging allegation were unproved” and could not support damages.

The court noted that, regardless of the limited scope of liability, the plaintiff entities “were content” to rely on a damages report and testimony that they had presented at trial based on their “generously-proportioned allegations.”

In post-trial damages oral argument, the plaintiff said it did not think additional damages evidence was necessary (i.e., a revised expert report) considering the court’s findings that there was fraud regarding PayPal. According to the plaintiff, all of its fraud claims ultimately “built to the PayPal fraud,” which “was always the main issue. It’s also where we tracked the damages from. And when that was the fraud that was found, we thought we could move forward on that basis.” The court found the plaintiff’s argument problematic.

The plaintiff’s overriding damages theory was that the alleged breaches and wrongdoing by the various defendants lead to the diminution in the fair value of the plaintiff’s equity interest in Plimus.

The plaintiff’s damages expert found damages consisted of: (a) the difference between the $115 million sale price and the value of Plimus as determined by him on the merger date (the difference being about $90.3 million); (b) $31.5 million representing the additional investments the plaintiff had made in Plimus post-merger; and (c) about $212,300 in preclosing fines.

The expert noted the plaintiff had arrived at its $115 million sale price based on multiples of 2011 actual Q2 run rate EBITDA and 2011 estimated Q4 and yearly EBITDA. The expert thought it was appropriate to adhere to the same methodology. He used the 2011 Q4 EBITDA multiple of 10.1x, which, he said, was the valuation metric the plaintiff used for its valuation of Plimus.

The expert first calculated the 2011 Q4 EBITDA using Plimus’ actual 2011 Q4 EBITDA. He then significantly downward adjusted the actual Q4 EBITDA to arrive at what he considered “the full extent of the harm.” The projected Q4 EBITDA was about $11.4 million, which, based on a multiple of 10.1x, resulted in the $115 million merger price. In contrast, the actual Q4 EBITDA was about $5.1 million, which would have resulted in a fair value of about $51.3 million. Importantly, however, the plaintiff’s expert did not use the difference between those two figures as his damages figure.

Rather, he adjusted the actual Q4 2011 EBITDA by eliminating revenues from “transactions attributable to the lost volume to Plimus’ decision to terminate the relationship of customers with chargebacks in excess levels allowed by the payment processors or other risk concern.” He justified this adjustment by noting “the full effects of the fraud were not felt until 2012 and beyond … [t]hat is, the actual EBITDA results still included the benefit of profits from clients that were shortly lost or terminated as the fallout from the fraud continued.”

In essence, he backed out from the company’s actual Q4 2011 EBITDA revenue from any client (court’s emphasis) whom Plimus terminated a few days after the closing of the merger, in October 2011, and throughout June 2012. The expert maintained that making this adjustment resulted in a “conservative estimate of the harm” the plaintiff incurred. By the expert’s calculation, Plimus’ adjusted 2011 Q4 EBITDA was only $2.45 million. Applying the 10.1x multiple, the expert arrived at a fair value determination of about $24.7 million (rather than $51.3 million based on actual Q4 EBITDA). The difference between the price the buyer paid and the $24.7 million was the diminution in business value, the expert found.

He then added to this amount the $31.5 million he said the buyer had invested in Plimus in fall 2012 and December 2014 and the fines.

Limited scope of damages. The court found certain defendants were liable for certain chargeback fines, and Plimus’ CEO was liable for the $200,000 in fraud damages for the PayPal GoClickCash fine.

The more important issue was what damages were available to the plaintiff related to Plimus’ nondisclosure of PayPal’s termination threats where PayPal did terminate its relationship with Plimus immediately after the merger.

Damages could be based on tort or contract, but the damages resulting from this liability were identical, the court explained. “Both contract and tort law thus conceive of damages as the pecuniary consequences of the breach or tort. This requires an identification of the conduct for which a defendant is liable and an isolation of the harm occurring therefrom.”

The task here was to “separate the non-disclosure of PayPal’s termination threats—and the harm occurring therefrom—from all other fraud and breach allegations,” the court explained. It observed that damages must “represent the difference between what the Plaintiffs expected—Plimus with PayPal as a processor—and what they got—Plimus sans PayPal.”

Specifically, the plaintiff had a right to damages “consequent to the loss of the PayPal relationship which meant the inability to use PayPal’s services, and the resulting reputational damage.” At the same time, the court cautioned that the plaintiff was not entitled to damages going back to the underlying reasons as to why PayPal terminated its relationship with Plimus, such as Plimus’ excessive chargebacks, lack of risk monitoring, and illegitimate vendors. The record showed the buyer knew of these problems at the time of the merger, the court explained.

The plaintiff had to prove damages related to the PayPal termination with “reasonable certainty,” the court noted.

The court found the plaintiff’s expert offered a damages calculation that was not sufficiently linked to the harm to the plaintiff from the nondisclosure of PayPal’s termination threats. Rather, the calculation managed to “throw everything in the hopper: all amounts by which Plimus missed [the plaintiff’s] projections for Q4 2011 EBIDA, all revenue and volume from vendors terminated in the 9 month period after the Merger, and all amounts [the plaintiff] invested in Plimus in the years after the Merger.”

In his testimony, the expert himself said his calculations failed to filter out damages from the wrongdoing the plaintiff was able to prove at trial, which, the court noted, “are a rather small subset of its allegation.” Notwithstanding the court’s liability findings, the plaintiff “elected to stand” on its expert report, submitted before the court’s liability findings were made, the court noted.

It said the plaintiff’s expert offered no mechanism to segregate out the decrease in Q4 2011 EBITDA attributable to the loss of PayPal. Also, in terms of the claimed post-merger investment, the plaintiff failed to segregate what portion of the investment was necessary because of the loss of PayPal. Further, the plaintiff did not show how the latter damages were not already covered in the plaintiff’s fair value estimate, the court noted.

Based on the record, the court said it was unable to assign damages caused by the loss of PayPal as a payment processor. Doing so would be “mere speculation or conjecture because the Plaintiffs failed to tie any portion of their damages estimate to the loss of the PayPal as a processing service provider.”

Accordingly, even though the court found the plaintiff suffered harm from the loss of the PayPal relationship, the court declared itself unable to award fraud or contract damages related to the misrepresentations regarding the PayPal termination threats. The plaintiff was entitled to recover about $212,300 related to fines only.

 

Plaintiff Fails Panduit Test Where Lost Profits Analysis Includes ‘Far More’ Than Value of Patents

Sunoco Partnership Mktg. & Terminals L.P. v. U.S. Venture, Inc., 2020 U.S. Dist. LEXIS 14994; 2020 WL 469383 (Jan. 29, 2020)

In this patent infringement case, which featured a protected system for blending butane and gasoline, the plaintiff claimed over $30 million in lost profit damages resulting from the defendant’s misconduct. The court rejected the claim, noting the plaintiff failed to satisfy the four-factor Panduit test, and instead awarded a significantly lesser amount in reasonable royalty. The court found the plaintiff expert’s damages analysis was flawed in that it did not capture the value of the patented invention only. The court also observed that the same expert earlier had been excluded under Daubert in a different suit involving the same plaintiff for offering a similarly problematic analysis. One takeaway for experts is that courts and the opposing party keep track of an expert’s testifying history, including Daubert exclusions.

Backstory. The plaintiff owned five patents related to an automated system for blending butane into gasoline at the last point of distribution, i.e., before tanker trucks move the gas to retail gas stations. Butane is more volatile than gasoline and blending it into gasoline allows cars to start up consistently in colder weather. Because butane is lower in price than gasoline, commercial sellers have an incentive to blend as much of it into gas as possible. However, gas with higher volatility contributes to smog, causing the Environmental Protection Agency (EPA) to impose limits on the level of volatility allowed in gasoline. The plaintiff’s patented system was able to blend to the permitted degree by way of an automated system that did not require human involvement.

The inventors first assigned the patents to a company called Texon in early 2000. In 2010, the plaintiff in this suit, Sunoco Partnership Marketing & Terminals LP (Sunoco), bought Texon’s butane blending business for $140 million.

The defendant owned gasoline terminals in various states that stored and shipped gasoline and diesel. In 2008, the defendant began research on the development of an automated blending process. When it learned of the Texon system, the defendant negotiated with Texon to provide blending services to one of the defendant’s facilities. However, the parties were not able to reach a deal. The defendant then continued to explore alternatives and recruited a different company, Technics (no longer a party to the litigation), to design and install a blending system. By the defendant’s own admission, the goal always was to develop an automated way of blending butane into gasoline. Automation was a key feature in the plaintiff’s patented system.

During the infringement period (April 2012 to April 2017), the defendant used its infringing system in seven of its terminals. Notably, in 2015, after the plaintiff filed suit in federal court alleging infringements of four patents related to the blending system, the defendant extended the use of its automated blending system from three facilities to seven. The plaintiff later successfully argued to the court that the defendant’s conduct showed the infringement was willful and that the plaintiff was entitled to treble damages.

In April 2017, the defendant modified its system in a way that required a human operator to assist with the blending. The merit of the modified system in relation to the plaintiff’s protected system also was an issue in the litigation, especially regarding the calculation of damages.

Much of the trial centered on the validity of certain patent claims, the question of whether there was infringement, and the extent and nature of damages available to the plaintiff.

Lost profits. The plaintiff sought lost profit damages based on expert testimony that professed to calculate the profit the plaintiff would have made had the defendant not infringed its patents. The expert claimed the total amount of lost profits was about $31.6 million.

This figure was based on the premise that the plaintiff would have signed a butane supply agreement with the defendant and the two sides would have split the profits made from the sale of gas blended with butane. The expert explained that the profit margin was the difference between the price of the extra gasoline that could be sold because it was blended with butane and the cost related to buying, transporting, and blending the butane.

The defendant’s expert criticized the plaintiff’s analysis, noting that the plaintiff’s butane supply agreements did not reflect the value of the patent.

Applicable law. Under the applicable law, a plaintiff seeking lost profit damages must satisfy the four-factor Panduit test. Specifically, the plaintiff must show: (1) demand for the patented product; (2) an “absence of acceptable noninfringing alternatives”; (3) “manufacturing and marketing capability to exploit the demand”; and (4) “the amount of profit it would have made.” See Panduit Corp. v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152 (6th Cir. 1978).

The Federal Circuit has noted that it is difficult to prove damages under Panduit and that the second factor “often proves the most difficult for patent holders.” See Mentor Graphics v. EVE-USA, Inc.,851 F.3d 1275 (Fed. Cir. 2017).

In this case, the parties’ disagreement in fact centered on Factor 2, specifically on the issue of whether the defendant’s modified blending system (requiring a human operator) represented a noninfringing alternative to the plaintiff’s automated system. The defendant argued it did, but the court found this argument “not a compelling one.” The court noted that automation was a critical aspect of the plaintiff’s protected system and a feature the defendant had, for years, tried to replicate in its own infringing system. The court noted that the defendant’s own damages expert stated the modified system cost the defendant 10% more than the automated system; moreover, the modified system required human intervention, which increased the risk of error related to blending. There was testimony that the defendant’s human operators asked the company to “scrap[]” the modified system for the automated one.

The court found automation was the “particular feature[] available only from the patented product,” which meant the modified system was not “acceptable.” Accordingly, the plaintiff was able to show that there was no acceptable noninfringing alternative to its patented system.

However, the court noted the plaintiff was not able to meet Factor 4 of the Panduit test, i.e., establish the amount of profit it would have made but for the infringement. The court agreed with the defendant’s expert that the plaintiff expert’s calculation based on butane supply agreements failed to separate out the value of the patented system. “But the problem with this analysis is that neither butane nor blended gasoline is the patented invention,” the court said. It also noted that neither butane nor blended gasoline constituted a “functional unit,” such that the plaintiff would be entitled to the entire market value of the patented and unpatented parts. And the court noted that, under the agreements Sunoco made, it did not require blending partners to use the butane Sunoco provided.

The $31.6 million figure, which the plaintiff said represented lost profits, included much more than just the damage to the plaintiff from the defendant’s infringement, the court noted.

It went on to say that “[t]his court is not the first to identify such problems with [the plaintiff expert’s] analysis.” According to the court, a magistrate judge presiding over another suit Sunoco brought and featuring testimony by the same damages expert granted the defendant’s Daubert motion to exclude the same expert’s testimony for failure “to apportion the value of the patented system in comparison to the value of the butane supply agreements.”

The court in the instant case concluded the plaintiff was not entitled to lost profits because it did not meet all the requirements under Panduit.

Reasonable royalty. Under the applicable statute and case law, if a plaintiff proves infringement, it is entitled to no less than a reasonable royalty. See 35 U.S.C. § 284; Panduit.

The court here looked to the common method for determining a reasonable royalty, which is premised on a “hypothetical negotiation” between the parties prior to infringement to achieve an agreed-upon royalty. This approach looks to the Georgia-Pacific factors for calculating the reasonable royalty.

The plaintiff’s expert determined a reasonable royalty was between $17.1 million and $25.7 million. He estimated that, at the time of infringement, the defendant could expect to make a profit of between .40 to .60 per gallon of blended butane. Because the plaintiff typically negotiated a 50-50 profit share agreement, these numbers would be half, the expert assumed. He multiplied them by the 85.7 million gallons of butane the defendant blended during the five years in which it infringed to arrive at the proposed total numbers.

In contrast, the defendant’s expert proposed royalty damages in the amount of $2 million only. He came to this figure by finding that, using the modified system, the defendant would blend about 10% less butane than if it used the plaintiff’s protected system. Moreover, the modified system required a human operator to whom the expert assigned a $200,000 annual salary. During the five-year infringement period, the defendant would have lost about $4.6 million and would have had to pay a total salary of about $1 million to the extra operator, the defense expert calculated. He proposed that $5.6 million was the highest amount the defendant would pay to use the plaintiff’s patented system. According to the expert, the parties would have agreed to a $2 million license for the plaintiff’s system.

The plaintiff countered that this figure was too low considering the plaintiff bought the patented system for $140 million in 2010, two years before the infringement began.

The court rejected the plaintiff’s reasonable royalty for a number of reasons. It said the expert’s calculation was based on the same flawed analysis as the expert’s lost profits analysis—relying on the plaintiff’s butane supply agreements, where these agreements covered much more than the value of the patents. Similarly, the court found the $140 million price the plaintiff paid for the butane blending business, included the patents and the existing butane blending contracts, according to testimony from one of the inventors of the patented system.

Because the butane supply contracts included “far more than just patent licenses,” the court said it was “difficult to identify how much of that $140 million actually concerned the patents as opposed to Texon’s profit sharing agreements.”

Finally, the court noted that, when the plaintiff acquired the patents and the rest of Texon’s blending business, Texon retained a contract with one terminal. The plaintiff then granted Texon a license for the “Blending Patents” for use in Texon’s ongoing relationship with the terminal. Texon paid the plaintiff .02 per gallon of each gallon it blended for the terminal. Using the .02-per-gallon amount with the 87.5 million gallons of butane the defendant blended during the infringement period results in $1.7 million, the court noted. It suggested this figure was close to the reasonable royalty the defense expert proposed.

The court said it was more persuaded by the defense expert’s analysis and awarded the plaintiff $2 million in reasonable royalty.

Enhanced damages appropriate. In addition, the court found enhanced damages were justified because there was sufficient evidence that the defendant willfully infringed the plaintiff’s patented system. Under the applicable statute, if a court finds there was infringement, it “may increase the damages up to three times the amount found or assessed.” Accordingly, here, the plaintiff was entitled to $6 million plus prejudgment interest, the court said.

 

Court Decides Daubert Exclusion of Expert Testimony for Failure to Apportion Is Premature

Pawelko v. Hasbro, Inc., 2020 U.S. Dist. LEXIS 738; 2020 WL 42451 (Jan. 3, 2020)

An inventor of a Play-Doh-like substance brought suit against Hasbro, the toy company, for misappropriation of a trade secret and breach of contract. The company unsuccessfully sought to exclude both of the plaintiff’s damages experts under Daubert. Two observations by the court stand out. The court found an expert’s reasonable royalty was not fatally flawed simply because the expert did not analyze every Georgia-Pacific factor, where the expert used an accepted industry standard royalty. Further, the court found a damages determination was not automatically inadmissible where the expert did not apportion. Rather, the court said, it was for the jury to hear all the evidence and damages theories and then determine the experts’ credibility as to the reasonable royalty in this case.

Backstory. The plaintiff created “Liquid Mosaic,” an “arts and craft play system … that made it easy and fun for children to create art projects and decorate by using a unique craft gun. ” She signed a nondisclosure agreement with the defendant, Hasbro, a multinational conglomerate that owned toy, board games, and media assets, and made a presentation to generate interest for her product. Hasbro was not interested in a deal but later came out with two product lines, Play-Doh Plus and DohVinci, which, the plaintiff claimed, incorporated components of her “Liquid Mosaic.”

The plaintiff claimed Hasbro misappropriated the plaintiff’s confidential information and breached the nondisclosure agreement. Hasbro countered that there was no legally protectable trade secret and sought summary judgment on this issue. The court rejected Hasbro’s summary judgment motion, finding these were fact-intensive issues that had to be presented to the trier of fact. In other words, the issue should go to trial.

In pretrial motions, including a motion under Federal Rule of Civil Procedure 720 and Daubert, the defendant argued that the plaintiff’s two damages experts should be precluded from testifying.

Court looks to industry standard. The plaintiff’s Expert 1 presented two opinions. In one opinion, she essentially testified that the plaintiff’s invention qualified as a trade secret even if elements were already known to the public (and Hasbro) before the plaintiff’s meeting with Hasbro if those components in a new form gave the final product a competitive advantage.

In determining the applicable royalty rate, Expert 1 said the general industry standard royalty rate in the toy industry is 5%. That rate drops to 3% for co-branded products. Initially, in her report, the expert said the applicable rate was 5% for Play-Doh Plus. But, at her deposition, the expert changed the rate to 3% after finding out this product was a co-branded product.

Hasbro claimed this testimony was inadmissible because it was not based on an acceptable methodology and was speculative in that the expert did not follow the Georgia-Pacific 15-factor framework.

The court disagreed. It explained that, under Rule 702, an expert may testify if his or her “scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue.”

Under Daubert, a court must determine whether the testimony represents specialized knowledge and whether this knowledge is relevant such that it will help the jury make factual determinations. Daubert also provides a list of factors to determine the reliability and relevance of the expert’s specialized knowledge, including whether the expert’s theory can be tested, has been subject to peer review, and has been generally accepted within the relevant community.

In the instant case, the court found the expert based her opinions as to the applicable royalty rate on standards that were generally acceptable in the toy industry. Therefore, the opinions “pass muster under Rule 702.”

Hasbro further argued the testimony was unreliable because the expert did not “expound on every Georgia-Pacific factor in her report.” The court said this failure did not “doom” the expert’s opinion. “Because there is an established toy industry standard royalty rate, the Court finds that the fact that [Expert 1] did not focus specifically on Georgia-Pacific factors to render her opinions does not make those opinions inadmissible.” The court added that cross-examination by Hasbro and the presentation of opposing evidence were the traditional methods for attacking “shaky but admissible evidence.”

The plaintiff also offered testimony from a second damages expert (Expert 2) who said the royalty base here was made up of the total net sales of all of Hasbro’s products in the DohVinci subbrand and the total net sales of all products sold with the Play-Doh compound. According to this expert, net sales were the gross earnings Hasbro made from the sale of each product line minus returns or discounts. Expert 2 calculated damages to the plaintiff of about $255 million. This calculation included profits from some 25 products that Hasbro sold with Play-Doh as well as all products sold under the DohVinci subbrand earned or to be earned from 2014 through 2023.

The products included elements that Hasbro, not the plaintiff, had invented. According to Hasbro’s damages expert, damages to the plaintiff were at most $261,000.

Entire market value claim. Hasbro also contended that the failure by both of the opposing experts to apportion to the invented product made the testimony inadmissible.

The plaintiff argued that both of Hasbro’s offending product lines derived from the plaintiff’s invention. The invention was the basis for customer demand. Therefore, under the applicable law, the entire market rule exception to apportionment applied. “For the entire market value rule to apply, the patentee must prove that ‘the patent-related feature is the basis for the customer demand.’” See Lucent Techs. v. Gateway, Inc., 580 F.3d 1301 (Fed. Cir. 2009).

The court noted that “apportionment in trade misrepresentation cases is a potentially important tool that the parties can give the jury if the jury finds liability and determines that the plaintiff suffered damages.” Citing to Ericsson, Inc. v. D-Link Sys., Inc., the court acknowledged that “the ultimate reasonable royalty award must be based on the incremental value that the patented invention adds to the end product.” See 773 F.3d 1201 (Fed. Cir. 2014) (available at BVLaw).

But the court went on to say that “this is a determination that a jury must make after hearing all the documentary and testimonial evidence.” The court said it could not, at this early stage in the litigation, determine that the decision of the plaintiff’s experts not to apportion was fatal for admissibility of their testimony. There was an assumption that the jury would hear evidence to support the plaintiff’s claim that the entire market value rule exception applied, the court said. Also, the experts might explain how they selected their royalty rate and royalty base to support their damages opinions, the court said. The parties must “equip the jury with reliable and tangible evidence to decide which numbers are more consistent with that evidence and which experts are more credible,” the court said.

The court rejected the defendant’s motion to exclude the plaintiff’s damages experts under Daubert and Rule 702.

 

Court Affirms Plaintiff’s Showing of Loss of Income Pursuant to Business Interruption Policy

Binghamton Precast & Supply Corp. v Liberty Mutual Fire Insurance Co., 2020 NY Slip Op 02214 (April 9, 2020)

Filing a business interruption claim has become one of the first remedies businesses suffering from the economic consequences of COVID-19 look to in an attempt to mitigate the damage to their operations. But the process is hardly trouble free, as this pre-COVID-19 case illustrates. Insurers often deny claims, and the case winds up in court, often going to appeal, as happened here. The instant case is helpful in explaining the applicable legal principles underlying the theory of business interruption and making it clear that the success of a claim depends entirely on the individual policy. The issue in litigation often becomes how to interpret the policy. Here, the business owner was able to show a loss of income pursuant to the terms of the policy, the court found.

Backstory. The plaintiff made precast concrete products for the construction industry. Sales were based on custom orders for specific products, not from inventory. Once orders came in, the plaintiff manufactured them based on a tight production schedule subject to contractual deadlines and limited capacity.

The plaintiff had a policy with the defendant insurance company for equipment breakdown. In June 2015, one of the plaintiff’s concrete mixers broke down and caused an interruption in production until the mixer was repaired and was able to resume operation two days later.

In the event of an equipment breakdown, the plaintiff’s policy provided coverage for “actual loss of Business Income during the Period of Restoration” and extra expenses incurred by operating the business during the restoration period. The parties agreed that the restoration period began with the breakdown of the concrete mixer and ended 30 days after repairs were complete.

The policy also provided that the insurer would “consider the experience of your business before the ‘Breakdown’ and the probable experience you would have had without the ‘Breakdown’ in determining the amount of our payment.” According to the policy, “business income” meant “Net income (Net Profit or Loss before income taxes) that would have been earned or incurred” and normal operating expenses.

The plaintiff filed a claim with the defendant insurer for lost profits resulting from the two days of lost production. The plaintiff explained that, because construction work was seasonal, the plaintiff had to operate its plant close to full capacity in summer. Having the breakdown occur in June meant the plaintiff lost two days of production that it could not make up in summer, resulting in lost profits.

The plaintiff provided the insurer with evidence of the lost production and an explanation of how it calculated lost profits.

The insurer denied the claim, arguing the plaintiff failed to show specific lost sales resulting from the breakdown during the short period following the breakdown.

The plaintiff sued in the New York Supreme Court (trial court) for breach of contract. Both parties then filed summary judgment motions. The court granted the plaintiff’s motion, finding the plaintiff established actual loss of business within the meaning of the policy.

‘Reasonable expectation of the parties.’ The insurance company appealed the ruling to the New York Supreme Court’s appellate division, reviving its argument about the need to show specific sales lost as a consequence of the concrete mixer’s breakdown.

The court’s appellate division disagreed with this interpretation of the policy at issue. Under case law, “[a]n insurance policy must be interpreted to give clear and unambiguous provisions their plain and ordinary meaning.” The appellate division found the policy expressly included profits and losses in its broad definition of business income. However, said the court, neither term (“profits” or “losses”) referred to specific sales or showed an intent to limit coverage under the policy in the way the insurance company argued. The court added that the policy also did not refer to specific sales in setting out the methodology for determining the amount of the insurance holder’s lost business income.

The court noted that, in calculating lost profits, the plaintiff followed the methodology the policy prescribed, i.e., demonstrating production before, during, and after the equipment breakdown and applying its profit margin during the relevant period to the lost production.

In addition, the court noted that, under New York law, the touchstone in interpreting a business interruption policy is the “reasonable expectation of the parties.” The court found the policy “cannot reasonably be interpreted as the defendant argues.”

To impose a requirement that an insured cannot recover for lost business income under defendant’s policy unless it can demonstrate that an equipment breakdown caused a loss of specific sales during the relatively brief restoration period immediately after the breakdown would, in effect, prevent recovery under the policy by an insured whose business—like plaintiff’s—consists of fulfilling contracts after they have been made, rather than upon sales following production.

The court also rejected the defendant’s late objection that the plaintiff’s claim was not covered under a policy exclusion, noting the defendant had not ever advised the plaintiff this exclusion affected coverage or made this argument in front of the trial court. Rather, the record showed the defendant never argued denial of coverage but, instead, argued the plaintiff had failed to show actual loss of business income.

Moreover, the court dismissed the defendant’s argument that the plaintiff suffered no loss of profits because it was able to reschedule any lost production in the next few working days. The court noted the plaintiff showed that rescheduling work meant displacing work the plaintiff would otherwise have performed on those days and having to fit that work into a schedule that was tight due to contractual deadlines, limited capacity, and the short duration of the summer season.

However, the court found the trial court erred in granting summary judgment to the plaintiff on the issue of the amount of damages. Whether the plaintiff mitigated its losses as required in the policy was an issue for trial, the court found. It added that mitigation requirements in business interruption policies also were controlled by and enforceable under the terms of the individual policy.

 

Business Interruption Claim Raises Triable Issue as to Viability of New Business, Court Finds

Optical Works & Logistics, LLC v. Sentinel Ins. Co., 2020 U.S. Dist. LEXIS 53987 (March 26, 2020)

As the impact of the COVID-19 crisis on business activity has come into relief, business owners struggling to keep companies operating have turned to business interruption insurance to stay afloat. The instant pre-COVID-19 case shows what happens when the insurer denies the claim and the case proceeds to court. This case also points to opportunities business interruption disputes present for damages and valuation professionals, particularly on the plaintiff’s side. Ideally, financial experts become involved in the early stages of a case, where they can provide analysis in support of a damages claim and increase the chance of keeping the claim alive.

Claim denied. The plaintiff was a fledgling Rhode Island optical media company that made replicas of DVDs and CDs for the education and healthcare markets. The company had invested in expensive, specialized machinery and ultrasensitive equipment by setting up a special room (“clean room”) in a building the company rented. There were unpaid construction bills and rent payments as the company tried to make a go of it. The company had an all-risk property and business interruption policy with the defendant insurer.

The company began operations in July 2011 and August 2011. One month later, Hurricane Irene as well as Tropical Storm Lee hit the area, resulting in roof damage and water leakage into the company’s clean room. The water damaged equipment and documents. The company tried to mitigate the damage and hired a company to fix the roof. Ultimately, the business owners decided they had to move the equipment off-site. In the end, the company concluded it could not stay in the building and moved operations.

The plaintiff claimed it had notified the business interruption insurer almost immediately, but the insurer disputed this, arguing it received late notice. The insurer only sent an adjuster in October 2011 who informed the company by letter that the insurer was investigating various coverage issues, including the cause of the water damage and whether conditions were sufficiently bad for the company to leave the property. The insurer sent three consultants to determine the cause of the loss to the building, the clean room, the equipment, and documents. Ultimately, the insurer denied the claim.

The plaintiff filed suit for breach of contract and bad faith on the insurer’s part. The defendant filed for summary judgment. The plaintiff contended that, while losses could have been limited to between $50,000 and $75,000 had the insurance company provided prompt coverage, damages rose to over $4 million and ultimately resulted in the company’s insolvency.

The insurer in essence claimed there was no breach of contract because the company did not suffer the kind of damage covered under its business interruption policy. The insurer also argued the company did not make a proper claim as required under the terms of the policy.

Question as to normal operating expenses. The court found summary judgment in favor of the defendant was inappropriate because the case raised too many issues of material fact that “are better left for a trier-of-fact to decide.”

“The purpose of business interruption coverage is to ensure that a business has the financial support necessary to sustain its business operation in the event disaster occurred,” the court said, citing case law. (internal citation omitted)

The court then looked at the plaintiff’s individual policy to determine the coverage the company had. Coverage included “continuing normal operating expenses incurred” after and because of the event causing the loss; physical damage to the property; extra business expenses incurred as a result of the loss; and damage to valuable papers, computers, and media.

The court noted the policy provided coverage during the restoration period, i.e., from the date of the direct physical loss or physical damage until the date when the property should be repaired or replaced with reasonable speed and similar quality or when business was resumed at a new permanent location.

The court said there was a factual dispute between the parties as to whether the post-storm investigation the insurance company performed was proper.

As to the continuing normal operating expenses the company claimed, the court noted the insurer made various assertions that the company was new and was not a viable business even before the storm. There was no evidence of expenses incurred before the storm, the insurer said, and, therefore, the company was not entitled to coverage of continuing operating expenses.

In contrast, the plaintiff maintained its consulting expert projected what expenses it would have incurred had the insurer paid the benefit under the policy and the company been able to successfully continue its operations. Because the insurer denied the claim, the company had to shut down its business, the plaintiff claimed.

According to the court, determining when and whether the company could have resumed normal business operations raised “the type of murky factual question” that was best resolved by a trier of fact.

There were other disputed issues, the court said, including some related to expert witnesses. For example, there were questions as to what operating expenses such as rent and utilities and what extra expenses the plaintiff had incurred. The court noted the plaintiff had submitted financial evidence from its expert as to how much money it would need to replace business property, equipment and machinery, and documents.

The court concluded that cross-examination was the best way to vet the disputed facts and opinions and that the trier of fact should decide which testimony was most credible and supported by facts. “The Court is sufficiently convinced that a trier-of-fact should decide the outcome of this case.”

About Ron
Ron Lenz is the partner-in-charge of KSM’s Litigation Services Group.  He advises clients and attorneys in matters of financial litigation and often challenges assumptions to help clients obtain the best possible litigation outcome. Connect with him on LinkedIn.
 

About Jay
Jay Cunningham is a director in KSM’s Litigation Services Group. Jay counsels clients faced with litigation or other disputes through forensics and commercial damage analyses, often serving as an expert witness. Connect with him on LinkedIn.

link

Valuation Services Bulletin: Q3 2020

Posted 3:00 PM by

In This Issue:

 

Discounts Inappropriate in Valuing Minority Interest in Mandatory Buyback, Appeals Court Rules

When a minority shareholder in an Indiana company was terminated as a director and officer, a dispute arose over whether, under a buyback agreement, the use of discounts for lack of control and marketability was permissible in valuing his shares. The trial court said yes, but the appeals court, citing case law, reversed.

Compelled buyback: The plaintiff was a founder as well as a director and officer of a company that fabricated and installed natural gas and pipeline equipment. He owned a 17.77% interest in the business. When he was terminated (involuntarily), his departure from the company triggered a provision in the controlling shareholder agreement requiring the company to buy back his shares. The valuation was to be based on the “appraised market value of the last day of the year preceding the valuation, determined in accordance with generally accepted accounting principles by a third party valuation company within the twenty-four months preceding the transfer of shares.”

The retained outside appraiser said it was engaged “to estimate the fair market value of the property…. This valuation was performed solely to assist with the valuation requirement in a shareholder agreement due to a triggering event involving [the plaintiff].” The appraiser found the plaintiff’s interest was worth about $3.5 million but applied discounts for lack of control (DLOC) and marketability (DLOM) and concluded the final value was $2.4 million.

The plaintiff sued, and the company countersued. Both sides filed motions for summary judgment. The issue for the trial court was whether, as a matter of law, under the buyback provision, the valuation could include discounts. The trial court found for the company and granted its motion.

The plaintiff appealed the decision. The gist of the plaintiff’s argument to the Court of Appeals was that, under the controlling case, Wenzel v. Hopper & Galliher, discounts were inappropriate because the transaction involved a compulsory sale. Further, the language of the shareholder agreement regarding the appraisal method precluded the use of the fair market value standard because the sale of the contested shares did not take place in the open market and the buyer already controlled the company.

Avoid windfall: The appeals court found Wenzel was applicable to the situation at hand. In Wenzel, the Court of Appeals rejected discounts in the context of a law firm’s purchase of a departing partner’s interest in the firm. The case was brought under the state’s professional corporation act. The court differentiated between fair value and fair market value and rejected the use of minority and marketability discounts in fair value cases where a controlling interest holder buys back the stock. Minority and marketability discounts were “open market concepts” that did not apply where a shareholder is compelled to sell to the majority, the court found. The use of discounts would mean a “windfall” to the buyer.

In the instant case, in rejecting the company’s argument that using the fair market value was consistent with the shareholder agreement, the court said:

The Shareholder Agreement itself recognizes that the mandated buyback of shares to the Company differs from a sale to a third party on the open market and thus, different interests must be recognized by implementing an appraised market value rather than the open-market valuation method of fair value or fair market value.

The appeals court concluded the trial court erred as a matter of law when it allowed the discounts.

A digest of Hartman v. BigInch Fabricators & Construction Holding Co., Inc., 2020 Ind. App. LEXIS 183 (May 5, 2020), and the court’s opinion, will be available soon at BVLaw. A digest and the court’s opinion in Wenzel v. Hopper & Galliher, 779 N.E.2d 30 (Ind. Ct. App. 2002), are available to BVLaw subscribers.

 

Tax Court Spurns IRS’ Gift Tax Valuation Theory and Methodology

In a gift tax dispute, the U.S. Tax Court recently found for the taxpayer when it rejected the unusual reasoning and methodology the Internal Revenue Service’s trial expert proposed to keep low the discounts applicable to the nonvoting membership units in two limited liability companies (LLCs).

Nonmarketable, noncontrolling interest: In late 2013, as part of his estate plan, the taxpayer transferred his 99.8% interest in an LLC called Rabbit to a grantor retained annuity trust (GRAT) and his 99.8% interest in another LLC, Angus, into an irrevocable trust. The GRAT transfer was structured to avoid gift tax liability. The taxpayer’s 99.8% interest in both LLCs represented class B nonvoting units. A management entity that belonged to the taxpayer’s daughter solely owned the remainder 0.2% interest. This interest represented class A voting units. Both LLCs held securities, investments, and promissory notes. Neither of the two entities’ class B membership units were ever offered for sale or sold since the transfers.

The taxpayer filed a Form 709 gift tax return with valuations an appraisal firm had performed. In January 2018, the Internal Revenue Service (IRS) issued a deficiency notice, finding the taxpayer had understated the FMV of both companies’ class B units.

The taxpayer petitioned the Tax Court for review. The court was presented with three valuations, including those attached to the tax returns, valuations from the petitioner’s trial expert, and valuations from the IRS’ trial expert.

To account for the noncontrolling, nonmarketable aspects of the class B units, the firm preparing the original appraisal applied discounts for lack of control (DLOC) of 13.4% and 12.7% and a 25% discount for lack of marketability (DLOM) for both companies. The taxpayer’s trial expert prepared his own valuations and applied slightly higher DLOCs.

The IRS’ expert proposed a theory of what the hypothetical buyer and hypothetical seller would do under the facts, which aimed to minimize the applicable discounts. Per the expert, a reasonable buyer of the 99.8% interest made up of class B units would try to maximize the buyer’s economic interest by acquiring the remainder 0.2% interest consisting of class A units. Doing so would consolidate control of the respective company and further increase the value of the class B units by decreasing the discount a hypothetical buyer would pursue. To buy the class A units, the hypothetical buyer would have to pay a “reasonable” premium, which the expert determined to be 5%. Basically, he subtracted the premium amount from the undiscounted net asset value of the LLCs. The result was a significantly higher valuation for each company than those the taxpayer’s appraisers offered.

The Tax Court, citing Estate of Giustina, in which the very court had cautioned against “imaginary scenarios as to who a purchaser might be,” found the IRS expert’s approach was not supported by facts, case law, or among peers. “We are looking at the value of class B units on the date of the gifts and not the value of the class B units on the basis of subsequent events that, while within the realm of possibilities, are not reasonably probable, nor the value of the class A units,” the Tax Court said.

For Rabbit, the court adopted the NAV to which the parties stipulated. For Angus, it adopted the NAV the original appraiser calculated.

 

New DOL Process Agreement Confronts Control Issue in ESOP Valuations

The Department of Labor recently settled ESOP litigation with the trustee Farmers National Bank of Danville (FNB). The settlement incorporates a process agreement that contains noteworthy directives instructing the trustee on handling controlling interest acquisitions and indemnification matters.

This is the sixth such process agreement the DOL has made with defendant trustees. Ostensibly the agreements only bind the parties to it, here FNB. At the same time, the agreements have come to serve as guideposts to the ESOP community as a whole regarding the issues the DOL prioritizes in scrutinizing ESOP transactions and the positions the DOL takes on the issues. The crux long has been that the DOL has failed to issue final regulations that provide legal guidance and certainty to actors in ESOP transactions.

Control provision: The control provision in the FNB agreement applies only “when the ESOP intends to buy a controlling interest in the company whose stock it intends to acquire.” It speaks to the question whether the ESOP, in purchasing 100% of the stock of a company, has acquired actual control over the company such that it is appropriate to include a control premium in the valuation underlying the transaction. This issue was heavily litigated in the two key cases arising in the 4th Circuit, Brundle and Vinoskey. In both cases, the courts sided with the DOL in finding the ESOP did not in fact acquire control of the company and a control premium was not justifiable.

The FNB agreement obliges FNB, when acting as trustee in an ESOP transaction, only to approve a transaction in which the ESOP pays for a control premium if FNB ensures the ESOP acquires a host of specific rights that, in the DOL’s view, reflect true control over the company. “Control,” under the agreement, means having “all of the unencumbered rights” a controlling shareholder normally would have as well as the rights normally vested in the company’s board of directors and top executives. ESOP practitioners have chafed at this expansive definition of control.

Moreover, if the transaction imposes restrictions on the ESOP’s ability to control the company or the ESOP does not acquire “the degree of control of the company commensurate with the ownership interest it is acquiring,” FNB as trustee must ensure the purchase price reflects the ESOP’s lack of control. In these circumstances, FNB has to ensure that the valuation does not only include a control premium but includes “an appropriate lack of control discount [DLOC], to the extent that the ESOP’s rights of control are diminished.”

Open questions are whether the list of rights the DOL provides here is now applicable in all ESOP transactions to show the ESOP has acquired actual control, whether a transfer of rights short of those on the list requires an adjustment in the form of a DLOC, and how one calculates the “appropriate” lack of control discount.

Indemnification provision: Also important is a provision that says FNB cannot request indemnification by an ESOP or “ESOP-owned company (irrespective of whether the ESOP owns some or all of the company’s stock)” for liability and losses from breach of fiduciary duty claims or other ERISA violations. FNB, as defendant, also cannot ask for the advancement of legal fees “unless an entirely independent third-party determines that there has been no breach of fiduciary duty.” Even then, there has to be “a prudent arrangement” that guarantees a refund of advanced fees or costs if a court later determines there was a fiduciary breach.

As legal exposure particularly for ESOP trustees has increased, who bears the cost of defending against DOL action has become a critical issue. This provision suggests an effort by the DOL to tighten restrictions on the defense-related assistance available to ESOP trustees.

Hat tip to James F. Joyner (Integra Valuation Consulting LLC) for alerting us to this case.

 

Lack of Valuation Credentials Does Not Disqualify Expert, but Failure to Perform Valuation Does, Court Finds

Eurochem North America Corp. v. Ganske, 2020 U.S. Dist. LEXIS 26539; 2020 WL 747008 (Feb. 14, 2020)

This tangled business dispute included a Daubert challenge to an expert who had no business valuation credentials but was retained to value the plaintiff’s company for purposes of a before-and-after damages calculation. The court found that the expert was qualified based on decades of experience. But the expert’s testimony was inadmissible under the unreliability and relevance prongs. Since the expert had not actually performed the value determination, he could not credibly vouch for the reliability of the decisions and data that went into the calculations. The testimony was irrelevant where the plaintiff’s damages model failed to account for other factors contributing to the claimed losses. The expert’s testimony was part of the plaintiff’s flawed methodology and would not assist the jury, the court found.

Background. EuroChem (plaintiff and counterdefendant) sued a couple (Kent and Julie Ganske) and their company over more than $14 million in unpaid invoices for delivered goods. The Ganskes and their company disputed the debt and also filed a third-party complaint against EuroChem, alleging various business torts. An arbitrator found for EuroChem on the debt dispute, and the federal court confirmed the arbitration award. The court also rejected the Ganskes’ claim that their personal guarantees to pay their company’s debt were unenforceable because of fraud and lack of consideration

The Ganskes’ third-party claim was headed for trial. In essence, they claimed that EuroChem, through trickery, managed to obtain confidential business information, which it used to contact the Ganskes’ customers and vendors to lure them away with cheaper products and by defaming the Ganskes and their company. In terms of remedy, the Ganskes tried to introduce into evidence an expert report and testimony to show “business devaluation” damages of approximately $24 million.

EuroChem attacked the admissibility of the Ganskes’ expert testimony under Federal Rule of Evidence 702 and Daubert and its progeny.

Applicable legal principles. Rule 702 provides that a witness may be qualified as an expert by “knowledge, skill, experience, training, or education.” An expert may testify whether his or her knowledge will help the trier of fact (jury or judge) to understand the evidence or a disputed fact; whether the expert testimony is based on sufficient facts or data; whether the testimony is the product of reliable principles and methods; and whether the principles or methods have been reliably applied to the facts of the case.

The U.S. Supreme Court’s Daubert decision requires the federal district court to act as gatekeeper to ensure expert testimony is based on a reliable foundation and is relevant to the proceedings.

Put differently, the court must assess the expert’s qualifications, the reliability of his or her methods, and the relevance of the expert’s testimony. In assessing admissibility, courts are not concerned with “the ultimate correctness of the expert’s conclusions.” Under the controlling case law, courts have “great latitude in determining not only how to measure the reliability of the proposed expert testimony but also whether the testimony is, in fact, reliable.”

Here, EuroChem challenged the admissibility of the Ganskes’ expert under all three prongs.

The expert was retained to provide a valuation for the Ganskes’ before-and-after damages model. Specifically, the expert, a business broker who typically worked with sellers to market their businesses to prospective buyers, offered a valuation of the business before the alleged misconduct by EuroChem took place. For this purpose, the Ganskes sought to introduce a 25-page business report the expert’s company had prepared in late 2016 or early 2017, which valued the company at $36 million, as well as the expert’s testimony. The Ganskes themselves claimed the “after” value of their company was about $11 million. The litigation strategy was to persuade the jury to attribute the loss in value solely to EuroChem’s alleged conduct.

Qualifications challenge. EuroChem first argued the expert was not qualified under Rule 702 because he lacked business valuation experience and credentials. He was not familiar with the standards governing business valuations, EuroChem claimed. It noted the expert had only taken two one-day classes to become a “Certified Business Intermediary” from the International Business Brokers Association.

The court found qualification was not a problem for admissibility purposes. It observed that the expert had been a business broker for more than 40 years and, throughout his career, had valued and sold many businesses and performed more than 1,000 business valuations. He was qualified by experience.

Reliability challenge. However, the court found the testimony did not meet Daubert’s reliability requirement.

Under the applicable 7th Circuit case law, courts testing for reliability may consider a nonexhaustive list of factors that ask whether the proffered theory can be tested or has been tested, whether it has been peer-reviewed, whether it has been accepted in a given scientific community, whether the testimony flows “naturally and directly” from research that the expert conducted independent of the litigation or whether it was litigation-driven, and whether the expert adequately accounted for “obvious alternative explanations.” See Gopalratnam v. Hewlett-Packard Co., 877 F.3d 771 (7th Cir. 2017).

The court found significant problems with the methodology underlying the expert’s valuation. For one, the expert did not actually prepare the report, the court noted. Rather, the report was prepared by an employee, who, the expert said in deposition, “does all of our valuations in-house.” He said he typically reviewed valuation reports when they were completed, and he also reviewed the underlying information when it came into the office, including tax returns. At the same time, he admitted that he had not supervised the production of the contested report.

The court found the expert’s testimony on the methodology his firm had used to create the report was inadmissible hearsay. There was no way to properly cross-examine him regarding its preparation, the court said.

Further, the expert admitted that the Ganskes did not retain him to prepare an independent determination of the company’s value. He, or his firm, used the data the Ganskes provided for the express purpose of coming up with a valuation that would maximize the value of the business to prospective buyers.

Moreover, the expert said his firm did not prepare a valuation but “an estimate of value for marketing purpose.”

Most importantly, there was no showing that the actual methods used to arrive at an estimate of value were reliable, the court found. The expert’s firm used three income approaches (multiple of seller’s discretionary income, multiple of EBITDA, and multiple of gross revenue). The multiple of gross revenue approach yielded a result that was about 20 times greater than the result achieved with the other two methods, the court noted. The expert conceded it was appropriate to disregard an outlier, and he could not explain why, in this case, the very high result was given equal weight in the final estimate of value. Not having prepared the calculation, he did not know what sources were used to produce various multiples that were used for the estimate. The court noted the expert “simply presumed the figure was reliable.”

The Ganskes failed to show the methodology their expert used was sound and reliable, the court noted. It also said that, in a “post-hoc affidavit,” the expert asserted that his firm had relied on sources “that I know to be reliable and the information that we gathered is of a type reasonably relied upon by experts in my field.” The court declined to consider the affidavit but noted that, even if it did, this statement would not show reliability because it was nothing but the expert’s “say-so.”

Relevance challenge. The court said it had “serious concerns” that the testimony was even relevant. It was fair that the Ganskes wanted to introduce the expert report and testimony to support the “before” part of their before-and-after damages model, the court said. But the model as such was flawed because the Ganskes failed to account for other factors that might have led to business losses, such as changes in market conditions, i.e., factors unrelated to the alleged disparagement by EuroChem.

“[A] valid damages model in a case alleging unfair business competition must account for factors not attributable to the defendants’ misconduct that might have caused the plaintiff’s financial losses,” the court noted. Under the applicable 7th Circuit case law, “a simple before-and-after theory is too imprecise,” the court noted. The Ganskes’ contention that the entire decline in the value of their business was attributable to EuroChem’s smear campaign was “untenable” under common sense and the facts of the case, the court noted with emphasis.

The record showed that before the alleged defamation campaign, the Ganskes had $23 million in customer liabilities and owned EuroChem millions more, the court emphasized. The expert failed to account for this debt in his estimate of value.

Insofar as the expert’s testimony was to be the starting point of the Ganskes’ flawed method, it was not helpful to the jury, the court said.

The court concluded the expert report and testimony were inadmissible under Rule 702 and Daubert.

 

IRS Private Letter Ruling on Whether to Consider Pending Merger in Gift Tax Valuation

Office of Chief Counsel Internal Revenue Service Memorandum, POSTF-111979-17, Number 201939002, Release Date 9/27/2019

Valuation experts working on gift and other tax-related matters will want to be familiar with a recent private letter ruling by the Internal Revenue Service on the issue of when a fair market value determination would consider a pending merger for gift tax purposes. Even though private letter rulings are not precedent, they can provide guidance to financial experts and attorneys on how the agency analyzes issues and what positions it may be expected to take in an audit or litigation setting.

Facts provided. The memo does not provide a lot of facts. Here is what we know.

The donor of the gifted property was a co-founder and chairman of the board of a publicly traded company (Corporation A).

On Date 1, he transferred shares to a grantor retained annuity trust (GRAT) for a certain number of years. (The memo does not state the number of years.) After that period, the remainder of the trust would be distributed to his children.

Following Date 1, on Date 2, the donor’s company announced a merger with another company (Corporation B).

Before Date 1, i.e., the transfer of shares, Corporation A had engaged in negotiations with multiple parties.

Also, before the transfer of shares, Corporation A had held exclusive negotiations with Corporation B. These negotiations eventually culminated in the merger.

After the merger was announced (the IRS memo does not state how many days later), the value of Corporation A stock “increased substantially, though less than the agreed merger price.” The memo does not state when exactly the merger closed.

Issue presented. The memo answered the question of whether, under these facts, a hypothetical buyer and a hypothetical seller of shares in a publicly traded company would consider the pending merger in determining the value of the shares for gift tax purposes.

In other words, given these circumstances, should a fair market value determination for gift tax purposes account for the pending merger?

Short answer. Chief counsel said yes.

Applicable legal principles. If a gift is made in property, the value of the property on the date of the gift represents the amount of the gift. In other words, the valuation date is the date of transfer (date of gifting).

The value of the transferred property is “the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the facts.”

In other words, the applicable standard of value is fair market value (FMV).

Under the FMV, the willing buyer and the willing seller are hypothetical, meaning they are not the specific donor and donee.

Further, the FMV assumes that the aim of both the hypothetical willing buyer and the hypothetical willing seller is to maximize their economic advantage.

Also, there is a presumption that the hypothetical willing buyer and willing seller ready to engage in a transaction have “reasonable knowledge of relevant facts” as to the property at issue. This presumption applies “even if the relevant facts at issue were unknown to the actual owner of the property.”

There is a presumption that both the hypothetical buyer and hypothetical seller made reasonable efforts to investigate the relevant facts.

Besides looking to publicly available facts, this principle assumes reasonable knowledge of “those facts that a reasonable buyer or seller would uncover during the course of negotiations over the purchase price of the property.”

There is a presumption that a reasonable buyer would have asked the reasonable seller about information that is not publicly available. In other words, the reasonable buyer would act in a prudent manner.

If a stock or bond is publicly traded, “the mean between the highest and lowest quoted selling prices on the date of the gift is the fair market value per share or bond.”

If it is found that the value based on the bid and asked price does not represent fair market value, there may be “some reasonable modification” of the trading price. Alternatively, “other relevant facts and elements of value shall be considered in determining fair market value.”

Valuation is a question of fact. In practice, this principle means the trier of fact (e.g., the U.S. Tax Court) has broad discretion and is accorded great deference by the appeals court.

Law on subsequent events. As a general rule, the valuation hinges on the valuation date (date of gifting) “without regard to events happening after that date.”

But, to the extent subsequent events are “relevant to the question of value,” they may be considered.

Further, a subsequent event may be considered “if the event was reasonably foreseeable as of the valuation date.”

Chief counsel’s memo goes on to say that “even if unforeseeable as of the valuation date,” an event occurring after the valuation date may be “probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date.” (citing Estate of Gilford v. Commissioner, 88 T.C. 38 (1987))

To support an argument in favor of accounting for the post-valuation date merger, the chief counsel cites a 1974 Tax Court case, Silverman v. Commissioner. According to the memo, in Silverman, the Tax Court rejected the taxpayer expert’s testimony because it “failed to take into account the circumstances of the future public sale.”

Editor’s note: More precisely, in Silverman, the taxpayers, who were controlling shareholders in a corporation, reorganized the company with a view toward a stock sale in a public offering. The first step was to create two classes of stock, nonvoting and voting stock. The taxpayers then gifted nonvoting stock to trusts benefitting their children. Afterward, they reorganized the corporation a second time to create a single class of voting stock. This resulted in one share of voting stock receiving seven shares of a new common stock and one share of nonvoting stock receiving 6.5 shares of a new common stock. The Tax Court found the 65-70 ratio provided a “yardstick with which to measure the value” of the gifted nonvoting stock. In doing so, the court found for the IRS in determining the value of the gifted nonvoting stock. The 2nd Circuit Court of Appeals affirmed, finding the Tax Court’s valuation was conclusive and not clearly erroneous. See Silverman v. Commissioner, T.C. Memo. 1974-285, aff’d 538 F.2d 927 (2d Cir. 1976).

In the IRS memo, chief counsel also cites a 9th Circuit case, Ferguson v. Commissioner, in which the Court of Appeals affirmed a Tax Court ruling in favor of the IRS that taxpayers were liable for gain in appreciated stock that later was transferred to various charitable organizations. However, this case centered on the anticipatory assignment of income doctrine. The court found the taxpayers had not completed the contributions of appreciated stock before it had ripened from an interest in a viable corporation to a fixed right to receive cash via an ongoing tender offer or pending merger agreement. See Ferguson v. Commissioner, 174 F.3d 997.

Application to instant case. Chief counsel’s memo maintains that the instant case had “many factual similarities with Ferguson” and that, even though Ferguson dealt “exclusively with the assignment of income doctrine, it also relies upon the proposition that the facts and circumstances surrounding a transaction are relevant to the determination that a merger is likely to go through.”

Chief counsel’s memo notes that, here, the board made a targeted search for merger candidates, there were exclusive negotiations with Corporation B before the final agreement, and an agreement was “practically certain” to go through. A hypothetical willing buyer and willing seller would have knowledge of all relevant facts, including the pending merger, the memo says. “Indeed, to ignore the facts and circumstances of the pending merger would undermine the basic tenets of fair market value and yield a baseless valuation.”

About Dan
Dan Rosio is the partner-in-charge of Katz, Sapper & Miller's Valuation Services Group. Dan advises clients on valuation, succession planning, and transaction matters, often serving as an expert witness and helping find solutions to unique challenges. Connect with him on LinkedIn

 

About Andy
Andy Manchir is a director in Katz, Sapper & Miller's Valuation and ESOP Services Groups. Andy helps clients understand the value of their business and advises them on succession planning options, including ESOP, third-party sales, or family transitions. Connect with him on LinkedIn.

link

Litigation Services Bulletin: Q2 2020

Posted 8:45 PM by

To better serve you during the coronavirus pandemic, the Q2 Bulletin has been adapted to provide business content relevant to the current state of disruption. If you have any questions related to valuation or litigation matters, please contact us using this form, and we will be in touch as soon as possible. Whatever your needs, we are here to help you navigate this unprecedented time.

In This Issue:

** Articles appear in recent issues of BVWire’s ezine.

 

Legal Avenues for Businesses Coping with COVID-19 Disruption and Damages

Issue #211-1 (April 1, 2020)

In Franchising in the Time of COVID-19, an ABA panel recently discussed the scope of the disruption the pandemic has caused for franchisees and franchisors as well as legal doctrines on which franchisees/franchisors might rely to deal with the monetary damages to their businesses.

This excellent webinar took place on March 23, and the speakers were Kristin Lawrence Corcoran (Franchise World Headquarters LLC), Michael R. Gray (Lathrop GPM), Nicole Liguori Micklich (Urso, Liguori & Micklich), and Tao Xu.

Business interruption insurance: In an effort to stem losses resulting from the pandemic, businesses may consider filing a business interruption claim with their insurance. What losses are covered depends entirely on the individual policy, the speakers say. Consequently, while policies may be similar, they may include different riders and endorsements. Many policies have virus exclusions. Check yours.

The speakers note that, to make a valid claim, a business usually has to show that it suffered a “direct physical loss or damage to property.” Earlier this month, a restaurant in Louisiana filed a case arguing it suffered direct physical damage to the property in that employees who proved to have the virus actually contaminated the workspace, requiring the restaurant to shut down for decontamination. The insurance company should be liable for the cost of deep cleaning as well as loss of income.

The premise of the claim is that health experts know the virus can survive on surfaces up to 28 days. Further, health professionals have acknowledged the waiting times to test potentially affected persons and obtain test results. This delay allowed the virus to linger and contaminate the physical space, the argument goes.

The speakers note that insurance companies are much less likely to entertain arguments for “presumed contamination,” i.e., injury based on the general knowledge (assumption) that the virus is omnipresent. The speakers also note that some insurance policies may cover government-ordered closures; others may not. Again, the language of the individual policy controls the claims businesses can file. Diligently document all losses, file claims, and await the response from the insurance company, the speakers advise. They note that responses to claims and the development of claims are evolving.

Force majeure clauses: In this unrivaled crisis, franchise owners and holders may try to invoke force majeure (FM) clauses to escape certain contractual obligations. This French term, which means “superior force,” generally refers to events beyond the control of a party to the contract that make it impossible to perform under a contract. The ABA panelists note that there is no standard legal definition for FM. The language of a specific contract explains what events may allow a party to abandon the contract. Often, FM clauses in contracts expressly exclude health crises. It is not clear whether federal, state, or local orders that prohibit or make difficult movement, the performance of certain services, and access to certain supplies qualify as FM. The panelists caution that parties to a contract cannot escape performance just because doing so has become too expensive. Anyone thinking of pursuing this avenue must pay close attention to notice deadline requirements, the panelists advise.

 

IRS Discusses Tax Implications of COVID-19 Legislation

Issue #211-2 (April 8, 2020)

In an excellent ABA webinar that summarized and analyzed the COVID-19-related legislation Congress passed to alleviate the economic harm on businesses and persons, IRS Chief Counsel Michael Desmond spoke to some of the efforts the agency is making to achieve implementation. Here are a few takeaways from this item-packed discussion.

The presentation took place on April 2 and also included leaders from the ABA Tax Section: Sheri Dillon, Jennifer Breen, Lisa Zarlenga, as well as Anne Gordon (Tax Counsel, U.S. Senate) and Sunita Lough (IRS deputy commissioner services and enforcement).

CARES Act: This legislation was signed into law on March 27 and includes relief for small and large business through loans, guarantees, and other investments. Of particular note are provisions to provide qualifying employers with a refundable payroll tax credit of up to $5,000 for each employee’s wages paid from March 13, 2020, through Dec. 31, 2020. To qualify, a governmental shutdown order must have fully or partially suspended an employer’s operations during the COVID-19 crisis or the employer must have experienced a drop in gross receipts by more than 50% compared to the same quarter in 2019.

Further, the legislation seeks to make available additional cash flow and ensure liquidity by temporarily repealing the 80% of taxable income limitation on using the net operating loss carryovers that the 2017 TCJA imposed. Specifically, for a taxable year beginning before Jan. 1, 2021, a taxpayer can fully offset taxable income in that year with NOLs from prior taxable years. Also, taxpayers may carry back NOLs arising in 2018, 2019, and 2020 to their prior five taxable years. (This is the Tax Code § 172 provision.) Speakers noted that, if you are thinking of carrying back five years to offset prior income and get a refund, you may also have to amend state tax filings.

A key question was how quickly taxpayers could monetize their losses and get refunds. Chief Counsel Desmond said this issue was top of the list and two sets of guidance were coming soon, one addressing substantive issues and one procedural issues.

IRS notices: IRS Notice 2020-18 provides for an extension of the federal income tax filing date from April 15, 2020 (whether due date or extension) to July 15, 2020. The extension is automatic. Taxpayers may defer any amount of federal income tax payments until July 15, 2020. Note that this notice does not address payments due for other quarters or fiscal year taxpayers. Taxpayers with a different filing or payment due date other than April 15 must abide by the original date as of now. This may create a situation where Q2 estimated income tax payments are due on June 15, 2020, while Q1 estimated income tax payments are postponed from April 15, 2020, to July 15, 2020. IRS Notice 2020-20 provides the most up-to-date guidance and augments the relief by including Gift Tax and Generation-Skipping Transfer Tax returns.

IRS representatives also noted that, in the spirit of the “People First Initiative,” the agency is trying to “help people and businesses during these uncertain times.” The agency “generally” will not start new audits but will work on refunds “where possible,” without in-person contact. For audits in the works, the IRS will continue the work, the idea being that most taxpayers want the audit over with. Also, IRS appeals will continue to work cases. Taxpayers are encouraged to promptly respond to requests for information in these cases.

Note that the IRS continues to process tax returns and to issue refunds and seeks “to help taxpayers through its self-serving tools.”

 

What Family Law Practitioners Need to Know About COVID-19-Related Legislation

Issue #211-3 (April 15, 2020)

In a recent webinar, hosted by the American Academy of Matrimonial Lawyers (AAML), high-caliber presenters examined provisions in the mammoth COVID-19 federal legislation that are of particular significance to family law practitioners (attorneys and business valuators).

The discussion took place on April 9, and the speakers were Michelle F. Gallagher (Adamy Valuations), a nationally recognized BV expert, and Brian C. Vertz (Pollock Begg), a divorce attorney specializing in complex child support issues, business valuations, and other divorce-related issues.

No double dipping: In broad strokes, the Families First Coronavirus Response Act (FFCRA) provides emergency paid-leave benefits for employees who work for an employer that has fewer than 500 employees and who are unable to work because they are sick with the virus, care for someone with COVID-19, are in quarantine or self-isolation, or have children who cannot go to school because of mandatory school closures.

Employers affected by the employee’s absence may apply for refundable tax credits (from payroll taxes) to offset the cost of this extra paid leave. The FFCRA provisions apply to wages paid beginning April 1, 2020, and ending on Dec. 31, 2020.

Specifically, if an employee cannot work because he or she has COVID-19, the employer may get a refundable credit at the employee’s regular pay, up to $511 per day, for a total of 10 days. For other employees, including those caring for someone with the disease, an employer can claim up to $200 per day for up to 10 days. Gallagher notes that the IRS is still working on the forms an employer has to submit to get reimbursed.

The CARES Act includes an employee retention credit provision that says an employer may qualify for a refundable tax credit of up to $5,000 for each employee’s wages paid from March 13, 2020, through Dec. 31, 2020. To be eligible, an employer’s operations must have been fully or partially suspended because of the crisis by a shutdown order from a governmental entity or because gross receipts dropped by more than 50% in comparison to the same quarter in 2019.

Michelle Gallagher points out that there is no double dipping in the sense that, if an employer uses wages to qualify under the FFCRA, it cannot also use the same wages to secure benefits under another provision, i.e., the employee retention credit.

Employers struggling to pay employees and stay in business may be eligible for SBA loans that may be forgiven in part or even entirely. Under the paycheck protection program (PPP), smaller businesses (those with less than 500 employees), sole proprietors, independent contractors, and self-employed workers may apply. The SBA will forgive loans if the employer keeps the same headcount of workers and wages for eight weeks after disbursement of the loan. For full forgiveness, only about 25% of operating costs may go to nonpayroll costs, including rent. Under recent SBA guidance, lenders must disburse the loan proceeds within 10 days of loan approval. The eight-week count for the employer begins with the first disbursement of the loan.

Gallagher notes there is also no double dipping as concerns the PPP loan. An employer who wants to take advantage of the loan cannot also receive an employee retention credit.

Valuation considerations: Both speakers note that it’s important to consider the impact of the various remedies available to business owners and individuals in a business valuation or in calculating income for spousal support purposes for divorce purposes. Find out what the effect of the crisis has been on cash flow and what legal remedies a business has taken advantage of. Consider whether the PPP loan might be a windfall for the business owner. Consider the valuation date, Gallagher says. If, in an ongoing case, the most recent valuation was for Dec. 31, 2019, it may make sense to alert the attorney on the case to explore the possibility of doing an updated valuation. Note that different states have different valuation date requirements (date of separation, date of trial), but that courts, in this extraordinary situation, may allow for an updated valuation (which means more work for the valuator).

 

AICPA Issues a Subsequent Event Toolkit

Issue #211-4 (April 22, 2020)

In a prior issue of BVWire, we presented one valuation expert’s way of dealing with the coronavirus in valuation reports before it was known or knowable. In an appendix to her report, she considered the coronavirus a subsequent event as of the valuation date (Dec. 31, 2019), explained why she did so, and stated that the determination of value does not consider the effects of the virus. She also cited the language of the standards she was following, namely, the AICPA’s Standards on Valuation Services (SSVS No. 1 VS Sec 100, paragraph 43). This treatment is essentially consistent with the recently released AICPA VS Section 100 Subsequent Event Toolkit, a helpful resource that includes frequently asked questions and sample disclosure language. The Toolkit reminds valuers who adhere to VS 100 that the disclosure of a subsequent event is not required—it is up to the analyst to decide whether or not it is appropriate to make the disclosure.

VISIT THE KSM COVID-19 RESOURCE CENTER

About Ron
Ron Lenz is the partner-in-charge of KSM’s Litigation Services Group.  He advises clients and attorneys in matters of financial litigation and often challenges assumptions to help clients obtain the best possible litigation outcome. Connect with him on LinkedIn.
 

About Jay
Jay Cunningham is a director in KSM’s Litigation Services Group. Jay counsels clients faced with litigation or other disputes through forensics and commercial damage analyses, often serving as an expert witness. Connect with him on LinkedIn.

link

Valuation Services Bulletin: Q1 2020

Posted 6:15 PM by

In This Issue:

 

Calculation Engagements Receive Mixed Reactions From Courts

If the appraisal profession is conflicted over the validity of calculation engagements, so are courts, as a brief review of court decisions on the BVLaw platform shows. Courts have responded in different ways to questions about the reliability and usefulness of calculation engagements depending on the circumstances of the case. The cases do not offer a brightline rule that appraisers can follow; acceptance seems to be situational.

In Rohling v. Rohling, an Alabama divorce case that centered on the valuation of the husband’s dental lab, only the wife offered expert testimony from a certified valuation and financial forensics analyst. The expert worked pursuant to a calculation engagement. The trial court rebuffed the husband’s efforts to discredit the testimony, noting the expert was well qualified to provide an opinion based on the requirements of a calculation engagement as well as a valuation engagement and he used “methods recognized and accepted by [the] accounting industry for accountants conducting ‘calculation engagements.’” Importantly, “the Husband did not employ his own expert or pay the increased fee to [the expert] to conduct the more rigorous ‘valuation engagement.’” The appeals court affirmed.

In an article in the November 2019 BVU, Michael Paschall (Bannister Financial), a critic of the use of calculation engagements, says, “[T]he case does not represent a legitimate victory for calculation engagements as much as a win by forfeit.” He warns, however, that it “represents further evidence of ‘calculation creep’ in the business valuation field.”

In Surgem, LLC v. Seitz, a 2013 New Jersey appellate ruling on a buyout dispute, the court rejected the defendant expert’s calculation of value. The expert testified that the defendant had not provided the materials necessary to perform a valuation and said “more work should have been done” to prepare a fair valuation of the company. Importantly, the plaintiff offered countervailing expert testimony. The plaintiff’s expert said the opposing expert’s per-share price was an “arbitrary amount” based on unreliable projections. The trial court noted that, by the defense expert’s own account, the work fell far short of an “actual fair valuation of [the company].” Upholding the trial court’s ruling, the appellate court said the lower court had given sound reasons for rejecting the calculation of value.

In contrast, in Hipple v. SCIX, LLC, a 2014 case litigated in federal district court, the former wife sued her ex-husband and his business for fraudulent transfer of the company’s assets and the proceeds of the assets. She offered expert testimony on the value of the company’s assets. The expert had done a calculation of value, explaining that he had limited information about the company’s financials and therefore was not able to do a full appraisal. The defendants filed a Daubert motion to exclude the testimony, which the court denied. It found the AICPA approved of both calculation and valuation engagements and there was no reason to prevent the trier of fact from hearing the expert’s testimony. The expert explained why he did not perform a full valuation. Questions about the specifics of the testimony went to weight not admissibility, the court decided.

Finally, in A.C. v. J.O., a 2013 New York divorce case, the husband offered a preliminary report from a financial expert who had done valuations of the wife’s professional practice at the beginning of the divorce proceedings, while the wife still cooperated with the expert. The expert explained that he never had been authorized to do work beyond the initial report. Had he prepared a final report, he would have audited the spouses’ books and records to confirm the accuracy of the earlier information.

When the wife contested the validity of the preliminary appraisal, saying it was only a “calculation report,” the trial court noted the expert was qualified and his work was preliminary because the wife had decided to stop cooperating. Her uncooperative attitude should be held against her interests, not the husband’s, the court found.

Digests of the cases discussed above and the courts’ opinions are available at BVLaw.

 

BV Expert Shows How to Produce a Viable Valuation With Little Financial Data Available

Kvinta v. Kvinta, 2019 Fla. App. LEXIS 10172 (June 28, 2019)

BV expertise matters, as a recent Florida divorce case shows in which the parties’ experts faced the challenge of valuing a company that once operated abroad but was sold a decade before the divorce trial. Only the owner spouse’s experienced valuation expert produced a defensible valuation, the trial court found. The state Court of Appeal affirmed.

This baroque marital dissolution case began in 1995, when the wife filed for legal separation and later for divorce in Ohio. In 2009, the wife asked a Florida court to determine and distribute marital assets and award her spousal support. The Florida case was tried in 2016. There was no transcript of the trial court testimony. The issue was how to value a company in which the husband obtained an ownership interest in 1991, while being overseas, which he sold in 2006 for nearly $2.4 million. The company operated in the Middle East.

Coverture fraction method: For purposes of calculating the marital value of the company, the valuation date was 1995. The husband’s expert used a coverture fraction method. As the numerator, he used the number of months during which the asset was marital in nature, and, as the denominator, he used the total length of ownership. The coverture fraction was 23.3%, which he then applied to the 2006 sales price. The husband’s expert arrived at a marital value of the asset, as of 1995, of almost $556,000. The former wife’s share was almost $245,000, considering her share of taxes paid by the former husband on the sale.

The wife’s expert used an income approach even though both experts apparently said it was “very difficult” to come up with accurate estimates of an “interim value” where no “normal” financial records were available given the passage of time and location of the business. The trial court adopted the approach of the husband’s expert.

On appeal, the wife argued the trial court should have credited her expert’s valuation. Rejecting the argument, the appellate court noted the wife’s expert “was a CPA with no business valuation credentials” who used an income approach “despite having essentially no financial documents reflecting the cash flow, liabilities, assets, and so forth of the company.”

In contrast, the Court of Appeal said, the trial court found the husband’s expert was “experienced in valuing businesses and offered a reasonable approach” to valuing the company “despite having little financial data beyond the ultimate price for which Former Husband sold his interest.” The appellate court also observed that, when there is no transcript of the trial court testimony, an appellate court should give “utmost credence to [the trial court’s] fact findings.”

Considering these factors, the state Court of Appeal upheld the trial court’s value determination.

 

Court Says Corrected DCF Still Supports Original Fair Value Determination

In re Appraisal of Jarden Corp., 2019 Del. Ch. LEXIS 994 (Sept. 16, 2019)

The Delaware Court of Chancery’s recent decision to use the unaffected market price as fair value prompted the petitioners to file a motion for reargument. In its original opinion, the court, as part of its comprehensive analysis, reviewed the opposing experts’ discounted cash flow calculations and, finding neither entirely convincing, created its own DCF model. The court said the DCF value corroborated its decision to rely on the market price. The petitioners subsequently argued the court’s DCF included multiple errors and the corrected DCF model did not substantiate the fair value determination. While the court conceded errors, it found the corrected analysis still supported its earlier holding.

Backstory. This dissenting shareholder action arose out of the acquisition of Jarden Corp. (Jarden) by Newell Rubbermaid Inc. (Newell) for cash and stock yielding a merger price of $59.21 per share. Both companies were major consumer products companies. The sale process started in 2015, and the merger closed in April 2016.

The driving force behind the sale was Jarden’s CEO, who, when learning of Newell’s interest in a possible transaction, began negotiations without notifying Jarden’s board of directors. Without the board’s authorization, Jarden’s CEO proposed a financial framework that guided the sale process. Focusing singularly on a deal with Newell, the CEO also negotiated for himself change-in-control payments without prior approval from Jarden’s board. Once the board was in the know, it did not discuss the possibility of a market check and did not reach out to potential strategic partners or financial sponsors.

Before the companies announced the merger, on Dec. 14, 2015, The Wall Street Journal reported on the parties’ discussions about a deal. In response, the trading price of both Jarden and Newell went up. The unaffected market price, on Dec. 4, 2015, was $48.31 per share. Newell structured the deal to reflect $500 million in annual cost synergies. The companies’ joint proxy statement reflected this synergy estimate.

Dissenting shareholders petitioned the Delaware Court of Chancery for a fair-value determination under the state’s appraisal statute (8 Del. C. § 262). The petitioners’ expert, using a market multiples analysis and a discounted cash flow (DCF) analysis, arrived at a value of $71.35 per share. Jarden’s (respondent’s) expert analyzed market evidence (unaffected market price, deal price minus synergies) and prepared valuations based on the comparable companies method and DCF method. He arrived at a fair value determination of $48.01 per share.

At trial, Jarden also offered expert testimony that said the synergy estimate was conservative and the value was taken by Jarden’s stockholders. Moreover, the expert said the decision by Jarden’s board not to hold an auction was reasonable.

In adjudicating the case, Vice Chancellor Slights noted that the statute required the court to give fair consideration to “proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.” He said that the parties argued in favor of “nearly every possible indicator of fair value imaginable.”

The court found the deal-price-minus-synergies metric was not reliable here because the sale process (“if one can call it that”) was problematic in light of the conduct of Jarden’s CEO and the failure to provide for a post-signing market check.

Regarding the value of synergies, the court noted there was no real expert analysis of the synergies that were realized because the experts assumed the $500 million estimate was accurate. Further, expert analysis as to whether Jarden’s stockholders received the value of the anticipated synergies “raised more questions than it answered.”

The court found Jarden’s argument in favor of using the unaffected stock trading price as fair value was persuasive. The court credited evidence Jarden’s expert presented to prove the stock traded in a semistrong efficient market. This evidence included an event study that showed how the company’s stock in the two years before the merger had responded “quickly and appropriately” to earnings and other performance-related announcements. The court also found that certain internal valuations Jarden had done in other contexts showed at a minimum that the company and the market saw Jarden’s value “well below what Petitioners seek here.”

As for “traditional” valuation approaches, the court rejected the experts’ comparable companies value conclusions. Regarding the experts’ DCF analyses, the court noted the experts arrived at “fantastically divergent conclusions.”

The court, drawing on inputs from both experts, performed its own DCF analysis as a check against the unaffected market price. It arrived at a value of $48.13 per share. The unaffected market price was $48.31. The DCF value corroborated the unaffected market price, the court concluded. (A digest of In re Appraisal of Jarden Corp., Consol. C.A. No. 12456 (Del. Ch. July 19, 2019), 2019 Del. Ch. LEXIS 27, and the court’s opinion are available at BVLaw.)

Court convinced DCF ‘not reliable here.’ The petitioners then filed a motion for reargument in which they claimed the court’s DCF model included structural and mathematical errors. The revised model produced a range of values that was significantly higher than the court’s original DCF result and therefore did not corroborate the court’s fair value determination, the petitioners contended.

The court conceded it had made errors that required correction. But it disagreed that the corrected DCF yielded a value of between $61.59 and $64.01 per share, as the petitioners claimed. The court did not change its earlier ruling.

In a footnote, Vice Chancellor Slights suggested it was a mistake to conduct his own DCF after finding “the evidence did not support certain aspects of both of the competing experts’ DCF valuations.” Noting the experts’ inability to agree on certain inputs, the vice chancellor said he was “more convinced than ever … that the DCF is not reliable here, particularly given the presence of a reliable ‘market-based metric.’” (quoting In re Stillwater Mining Co., 2019 Del. Ch. LEXIS 3020 (Aug. 21, 2019)) (available at BVLaw).

Vice Chancellor Slights also said he should have left it “at that” rather than “parse through the inputs and hazard semi-informed guesses about which expert’s view was closer to the truth” (quoting Stillwater). However, having performed his own DCF, the vice chancellor said he would “see that process through to the bitter end by engaging in the revised DCF presented here.”

Errors identified and corrected. The court agreed with the petitioners that it was necessary in the calculation of free cash flows to add back depreciation and subtract Jarden’s yearover-year increase in net working capital.

The court admitted that, in calculating WACC, it had adjusted for tax twice by making tax adjustments to the after-tax cost of debt. It agreed that omitting the second tax adjustment was necessary.

In the corrected and original versions, the court used the capital asset pricing model (CAPM) to calculate the cost of equity. In the corrected version, it calculated after-tax cost of debt by multiplying the pretax cost of debt by (1 - tax rate). To calculate WACC, the court multiplied the cost of equity by the equity to total capitalization, multiplied the after-tax cost of debt by the debt to total capitalization, and added the two numbers together. WACC was 7.29%.

The petitioners noted the court’s DCF mistakenly did not use terminal year 2021 net operating profit after tax (NOPAT) ($1.273 million) but did use unlevered free cash flows ($939 million) to calculate the terminal value. In their correction, the petitioners used the court’s original 27.75% terminal investment rate (TIR), terminal FY21 NOPAT, and the capitalization factor to determine the final terminal value. The court’s original opinion had noted that the parties’ experts disagreed over the TIR and the disagreement accounted for 87% of the gap in their DCF valuations. The court arrived at a 27.75% TIR by averaging the respondent expert’s 33.9% terminal investment rate (from the McKinsey formula for TIR) and the company’s 21.6% historical five-year average.

In correcting the terminal value, the court said it agreed with the respondent that maintaining 27.75% as TIR did not make sense. The original opinion had stated that “the return on new invested capital should equal the company’s WACC.” However, given the court’s corrected WACC (7.29%), the court’s initial TIR “improperly departs from this principle.” The court opted for a “straightforward application of the McKinsey formula” to calculate TIR.

The court originally treated year 2016 as a full year, including all of that year’s unlevered free cash flows in its calculation. The petitioners pointed out that the merger closed in April 2016, requiring an adjustment to reflect the partial year. The court adopted the methodology the petitioners’ expert used, multiplying the full-year 2016 forecasted unlevered free cash flows by the portion of the year that remained after the merger.

The court agreed that it was necessary to account for tax savings that Jarden expected to receive from the amortization of intangible assets and used the respondent expert’s amortization tax shield. The court also agreed that an adjustment for pension and postretirement liabilities was necessary when calculating the value of equity.

Correcting for the errors the petitioners had identified and revising the TIR based on the McKinsey formula, the court arrived at a corrected DCF value of $48.23 per share, in contrast to the $48.13-per-share price in the original opinion.

No change in outcome. The court concluded the value resulting from the corrected DCF still corroborated the court’s original fair value determination based on the unaffected market price ($48.31 per share).

 

Novel Issue of Law Raised in ESOP Case That Pits Trustee Against Appraiser

Remy v. Lubbock Nat’l Bank, 2019 U.S. Dist. LEXIS 133421 (Aug. 8, 2019)

A fairly routine ESOP case that is being litigated in the 4th Circuit has raised a novel legal issue in this jurisdiction as to the financial liability of co-fiduciaries and nonfiduciaries, including the ESOP appraiser.

The plaintiffs in the main case sued the defendant, Lubbock National Bank (Lubbock), over its role as trustee in a 2011 transaction. They claimed Lubbock breached its fiduciary duties under ERISA when it caused the plan to overpay for company stock. Lubbock engaged Stout Risius Ross (SRR), an experienced ESOP appraiser, to serve as independent financial advisor. Among other things, the plaintiffs claimed SRR, when valuing the company and providing a fairness opinion in connection with the transaction, relied on projections that had been manipulated to maximize the sale price. Lubbock, as trustee, knew or should have known that the projections that SRR used were unreliable and the sale price was unsupportable “given the unreliability of the financial projections.”

Trustee’s third-party complaint: In defending against the suit, Lubbock filed a counterclaim as well as a third-party complaint against SRR and the seller of the company shares. Lubbock sought indemnification, contribution, and/or apportionment in the event Lubbock were found liable in the main case. In response, SRR filed a motion to dismiss Lubbock’s claims. SRR claimed it was not a fiduciary under ERISA and ERISA did not provide a right to contribution against a nonfiduciary.

The court stayed discovery in the principal case pending a resolution of the third-party motions. (The seller also filed a motion to dismiss.) The question whether ERISA provides for a right of contribution or indemnity by a fiduciary against a co-fiduciary or nonfiduciary was a legal issue that had not yet been decided in the 4th Circuit, the court said.

It noted that ERISA does not have specific provisions that grant a right of indemnification or contribution among fiduciaries. The U.S. Supreme Court has not addressed this specific issue, and different circuits have split on it. Some circuits have rejected the idea of a right of contribution, whereas others have found that, since ERISA has a foundation in trust law, which allows for a cause of action for contribution and indemnification, courts should be able to allow for a claim of contribution. District courts in the 4th Circuit also have come to a different conclusion on this issue, the court noted.

The court adopted the position of courts “holding ERISA provides for a right of indemnification or contribution among fiduciaries.” At the same time, the court found “the significant weight of authority” has rejected claims for contribution or indemnity against nonfiduciaries. The court pointed out that other courts have observed that “extending the threat of liability over the heads of those who only lend professional services to a plan without exercising any control over … plan assets will deter such individuals from helping fiduciaries navigate the intricate financial and legal thicket of ERISA.” It was undisputed that SRR was not a fiduciary, the court said. Accordingly, it granted SRR’s motion and dismissed the trustee’s claim for contribution against SRR.

About Dan
Dan Rosio is the partner-in-charge of Katz, Sapper & Miller's Valuation Services Group. Dan advises clients on valuation, succession planning, and transaction matters, often serving as an expert witness and helping find solutions to unique challenges. Connect with him on LinkedIn

 

About Andy
Andy Manchir is a director in Katz, Sapper & Miller's Valuation and ESOP Services Groups. Andy helps clients understand the value of their business and advises them on succession planning options, including ESOP, third-party sales, or family transitions. Connect with him on LinkedIn.

link

Litigation Services Bulletin: Q4 2019

Posted 7:18 PM by

In This Issue:

Court Rejects Double-Dip Claim, Emphasizing Owner’s General Earning Capacity

Callahan v. Callahan, 157 Conn. App. 78 (May 5, 2015)

Double counting (often called “double dipping”) was one of the key issues the Connecticut appellate court discussed in this contentious divorce proceedings involving several financial consulting companies that the ex-spouses had established. The husband said the trial court’s order to pay the wife a significant sum of money in alimony per month was impermissible double dipping because the alimony was income from the very companies of which the court had awarded the wife a portion. The wife countered there was no double dipping as the alimony calculation was based on the husband’s general earning capacity. The appellate court agreed with the wife.

Husband’s earnings capacity. During the marriage, in 1995, the husband and wife created three related companies that provided financial and investment consulting. The companies were structured so that the wife owned 51% of each of the three companies and the husband the remaining 49%. Further, the husband owned 100% of a fourth related company. In 2009, the wife resigned formally from the positions she held at the companies and the spouses separated. The wife then filed for divorce.

Before the husband worked for the couple’s companies, he had held positions on Wall Street and had worked in London.

During the divorce proceedings, in the spring of 2012, the wife’s forensic valuation expert arrived at a combined value of the companies of not less than $11.7 million. The expert noted that comparable compensation for the husband, as a key person working on Wall Street, would be in the $1 million-to-$2 million range annually. The wife’s expert attributed 50% of the pretax profits to the husband. For 2010, the adjusted compensation was nearly $2 million. As of the completion of the second quarter of 2011, adjusted compensation attributable to the husband was nearly $685,000, the expert said. The husband did not offer contradicting evidence.

In its May 2012 memorandum of decision, the trial court called the valuation methodology of the wife’s expert, and the adjustments he made, “a sound and reasonable approach to valuation” and adopted the expert’s conclusions.

Both parties came to agree that the companies should be sold. The trial court ordered the wife to transfer to the husband the titles and all rights to the companies. And it ordered the husband to sign a promissory note for $6 million payable to the wife at $1 million per year for six years. If the husband were to sell the companies within six months, he was to pay the wife 55% of the sale proceeds; the wife was to receive no less than $4 million from the sale, the trial court ordered.

Further, the court awarded the wife $60,000 per month in alimony until the death of either party, the remarriage of the wife, “or as determined by the court.” The court said it based alimony on “earnings, including member distributions to the defendant up to $2,0000,000 per year.” The court particularly noted the statement from the wife’s expert regarding the husband’s ability to make at least $1 million to $2 million per year, operating as a key person on Wall Street. The court said: “Accordingly, finding earnings attributable to the defendant in the amount of $2,000,000 gross is conservative, the court adopts it as a finding of fact as to the present earning capacity of the defendant at [the companies].”

The husband subsequently filed various motions in which he asked the trial court to reopen the dissolution judgment and related financial orders. In November 2012, the trial court granted the husband’s motion and ordered an evidentiary hearing related to the husband’s claims that the wife had appropriated funds from the companies and engaged in conduct that negatively affected the value of the businesses. At an evidentiary hearing, the parties presented expert testimony as to the husband’s value-related claims.

The trial court concluded that the “deleterious conduct” of the wife undermined the husband’s ability to operate the companies and caused the value of the companies to drop from $11.7 million to $6.3 million. Finding a new trial was not necessary, the court issued substitute financial orders in which it reduced the amount the wife would receive for her interest in the companies from $4 million to $3 million.

Both parties appealed various aspects of the trial court’s findings.

Challenge to alimony. The husband claimed the trial court’s alimony determination was error because the court considered income generated by the companies while also awarding the wife a portion of the value of the companies. The trial court double dipped, the husband argued.

In a related argument, the husband contended the trial court did not make a finding as to the husband’s general earning capacity but only as to the husband’s earning capacity at the companies. Further, if the trial court had found the husband’s earning capacity was independent of the income he earned at the companies, the trial court erred because it did not have evidence that the husband had earnings from an independent source of $2 million per year. Nor did the court have evidence of the husband’s earning capacity. The husband’s argument was based on a claim that the trial court had stricken testimony from the wife’s expert as to potential earnings on Wall Street for procedural reasons.

The wife contended the trial court based its decision on the husband’s general earning capacity. She argued the trial court referenced the husband’s educational background, experience, and qualification when finding earning capacity of at least $1 million to $2 million, “irrespective of his income from the companies.” Moreover, under case law, it was not improper for the trial court to use a spouse’s income derived from a closely held business as some evidence of the spouse’s general earning capacity, the wife said. This was what the trial court did here.

The state appellate court agreed with the wife. It first noted the general principle that “a court may not take an income producing asset into account in its property division and also award alimony based on that same income.”

The appellate court found the trial court here made fact findings as to the husband’s earning capacity “independent of his employment at the companies.” The trial court both determined that the husband’s “present [gross] earning capacity” at the companies was $2 million per year. But, according to the appellate court, there also was additional evidence that the trial court considered in fashioning its order for alimony. The reviewing court pointed to the trial court’s crediting the approach the wife’s expert used for the valuation and the expert’s comment as to the husband’s earning capacity on Wall Street. In addition, the appellate court said, the trial court had evidence regarding the husband’s educational background and his employment prior to working for the companies, “which included various positions on Wall Street and in London.”

Therefore, there was evidence to support the trial court’s finding as to the husband’s general earning capacity, “independent of his position [at the companies],” the appellate court said. It concluded the trial court did not engage in improper double dipping.

Improper post-judgment revaluation. The wife challenged the trial court’s decision to revisit the dissolution judgment and change its earlier financial orders based on the husband’s allegations of post-judgment misconduct by the wife.

The appellate court agreed with the wife that the trial court did not have the authority to undertake a do-over. In a nutshell, as the appellate court explained, under the controlling law, the circumstances in which a court may reopen or set aside a judgment are limited because of the important principle of achieving finality in judgments. Basically, a court may open a judgment if a motion is filed within four months following the judgment date and where there is “a good and compelling reason for its modification or vacation.”

The husband had filed the motion within four months of the judgment. But the wife contended, and the appellate court agreed, that a post-judgment change in the value of a marital asset was not a valid reason to revisit a judgment. Under case law, the trial court’s decision to reopen a judgment must relate to prejudgment conduct, the wife said.

The appellate court noted that the trial court improperly considered post-judgment withdrawals by the wife. “Neither party has identified precedent wherein the trial court opened a marital dissolution judgment to revalue an asset subject to equitable distribution on the basis of post-judgment conduct by one of the parties,” the court said. It went to on say that the applicable statutes did not “vest[] the trial court with authority to revisit a judgment dividing marital property where post-judgment conduct, conditions, or changes affect the value of a marital asset.”

The appellate court reversed the modified judgment of the trial court and reinstated the trial court’s original financial orders “in their entirety.”

 

Court Admits Unjust Enrichment Damages Based on Profit Projections

Grove US LLC v. Sany America Inc., 2019 U.S. Dist. LEXIS 32125 (Feb. 28, 2019)

This Daubert case, which arose out of the plaintiff’s claim that the defendant misappropriated the plaintiff’s trade secrets, includes an important discussion of unjust enrichment damages. A key issue was whether, in the context of misappropriation of a trade secret, the plaintiff’s damages expert may consider expected future income to the defendant from the offending product, as the plaintiff’s damages expert did. The defendant said only the actual profits to the defendant may be used and that the opposing expert’s calculation was based on speculation. The plaintiff argued that use of future profit projections may be appropriate to determine the market value of the trade secrets. The court found the testimony was admissible.

Prior ITC ruling against defendant. The parties had a history of litigation. The plaintiff is a leading crane manufacturer and initially sued the defendant (related companies), alleging patent infringement and misappropriation of trade secrets related to crane technology. The U.S. International Trade Commission (ITC) started its own proceedings against the defendant, alleging tortious interference with contract. The ITC found the defendant had violated the Tariff Act by misappropriating the plaintiff’s protectable trade secrets and infringing one patent. On appeal, the Federal Circuit affirmed the ITC’s ruling.

Meanwhile, in the instant case, the plaintiff amended its complaint by asserting only claims of state law misappropriation of trade secrets and tortious interference with contract. The defendant filed counterclaims. In its summary judgment motion, the plaintiff asked the court to adopt the ITC ruling. Although the court found the defendant liable for violating the plaintiff’s trade secrets under state law, the court allowed the defendant to asset certain counterclaims against the plaintiff.

At this stage in the proceedings, both parties filed Daubert motions asking the court to exclude the opposing expert damages testimony.

Applicable law. Under Rule 702 of the Federal Rules of Evidence and Daubert, a witness who is qualified by knowledge, skill, experience, training, or education, may testify if: (1) the expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue; (2) the testimony is based on sufficient facts or data; (3) the testimony is the product of reliable principles and methods; and (4) the expert has reliably applied the principles and methods to the facts of the case. A district court functions as a gatekeeper and has broad discretion in determining the reliability and relevance of the proposed testimony. There is a preference for admissibility in case of doubts as to the usefulness of the expert testimony.

Recovering benefit to the defendant. The ITC, in its investigation, determined that the defendant used the plaintiff’s trade secrets to build a crane that allowed the defendant to enter the U.S. wind energy market. Without the plaintiff’s technology, the defendant did not have cranes that were suitable for this market and it would have had to adapt two of its own crane models and incur substantial development costs.

The plaintiff’s expert calculated unjust enrichment damages and actual damages.

Regarding unjust enrichment, the plaintiff claimed it had a right to recover the amount by which the defendant was unjustly enriched by misappropriating the plaintiff’s trade secrets. The plaintiff’s expert found unjust enrichment damages included research and development costs the defendant avoided by not having to adapt its own cranes; research and development costs the defendant saved by using the plaintiff’s trade secrets to build the violating crane; and the incremental profit the defendant anticipated it would generate at the time closest to the misappropriation.

For the incremental profit determination, the plaintiff’s expert relied on an analysis one of the defendant’s employees had done projecting future sales and profits to the defendant from the offending crane; this was called the “Economic Value Added” (EVA) analysis.

In total, unjust enrichment damages ranged from almost $74 million to $112 million, the plaintiff’s expert calculated.

The defendant attacked the plaintiff expert’s assessment of unjust enrichment, saying it was based in part on “hypothetical future profits” and was an “irrelevant, unreliable, and inappropriate measure of damages for unjust enrichment.” Unjust enrichment damages must not be based on estimated profits, the defendant claimed. It asked the court to preclude the opposing expert from testifying to or relying on the defendant’s EVA analysis.

The court explained that the issue here was one of substantive law rather than determining the merits of the plaintiff expert’s methodology. Two principles are at work. Under the applicable case law, “damages in an unjust enrichment claim are measured by the benefit conferred upon the defendant.” See Ramsey v. Ellis, 484 N.W.2d 331 (Wis. 1992).

For claims of misappropriation of trade secrets, courts look “to the time at which the misappropriation occurred to determine what the value of the misappropriated trade secret would be to a defendant who believes he can utilize it to his advantage, provided he does in fact put the idea to a commercial use.” See Univ. Computing Co. v. Lykes-Youngstown Corp., 504 F.2d 518 (5th Cir. 1974).

The plaintiff argued its expert used the defendant’s EVA analysis to determine the fair market value of the trade secrets at the time of the misappropriation. Parties may use future profit projections to determine the value of trade secrets, the plaintiff said. It went on to argue that the plaintiff could recover the value of trade secrets even if the defendant obtained no actual profit from the misappropriation, citing to the comments of section 51 of the Restatement (Third) of Restitution and Unjust Enrichment. Comment d, in particular, says that, “[s]o long as benefits wrongfully obtained have an ascertainable market value, that value is the minimum measure of the wrongdoing defendant’s unjust enrichment, even if the transaction produces no ascertainable injury to the claimant and no ascertainable injury to the defendant.”

The court concluded the plaintiff expert’s opinion on the value of the trade secrets, relying on the EVA analysis, was admissible. The defendant was free to challenge the expert’s valuation of the trade secrets by arguing the projections in the EVA analysis were speculative and unreliable and did not provide a reasonable measure of the fair market value of the trade secrets. Also, the defendant could point out that the actual profit it received from the use of the trade secrets was less than $2 million; moreover, the defendant could say that the value of the trade secrets was reduced because of the remedies the plaintiff had already obtained as a result of the ITC ruling. However, the court said, the defendant had not shown that it was improper or economically unsound for the plaintiff’s expert to consider the likely income from the use of the trade secrets.

Actual damages. The plaintiff’s expert broke the actual damages to the plaintiff down into three categories. First, he calculated incremental “Performance Improvement Programs” (PIPS) expenses. The argument was that, once the defendant introduced its offending crane into the market, the plaintiff had to accelerate the development of its two new cranes, which increased PIPS expenses due to work necessary to correct design flaws and other mistakes that were not caught during the accelerated product development, before the cranes were delivered to customers.

The plaintiff relied on a document that one of the plaintiff’s employees had created, tracking expenses related to the new cranes in comparison to two older crane models. Working with these numbers, the plaintiff’s expert found incremental PIPS expenses for the two cranes amounted to $4.5 million.

The expert also prepared an itemized summary of legal expenses related to the earlier ITC action, which he said were recoverable as money spent to mitigate damages. The total of these expenses was nearly $7.4 million. Further, the plaintiff’s expert calculated incremental security expenses, related to what the plaintiff claimed were additional security improvements it had to make because of the defendant’s misappropriation. Expenses in this category amounted to over $1 million.

The defendant first claimed this testimony was inadmissible because the plaintiff’s expert merely served as a mouthpiece for the plaintiff. He did not do an independent analysis of the accuracy and reliability of the data the plaintiff’s employees provided to the expert.

The court noted that the defendant did not challenge the opposing expert’s qualifications and said the expert brought more to the case than simple repetition of the plaintiff’s calculations. Given the expert’s background in valuation and financial consulting, he would be able to explain to the jury the effect of the misappropriation on the plaintiff’s business and the value of the misappropriation to the defendant. “A general knowledge of how businesses operate, i.e., the importance of trade secrets, the way businesses conduct research and development into new products, the costs of such research and development, performance improvement plans, and similar topics will help the jury understand the nature and basis of the damage claims [the plaintiff] is asserting,” the court said.

It also noted that questions as to the sources of an expert’s testimony went to the weight of the opinion, rather than admissibility, and should be left for the jury to decide. However, the court excluded the expert’s testimony as to irreparable harm resulting from the defendant’s misconduct. It said it would suspend its determination regarding equitable relief until after the jury resolved the issue of damages.

In sum, the court found the plaintiff expert’s testimony as to actual damages and unjust enrichment damages was admissible.

No legal conclusions. The defendant’s expert provided rebuttal testimony and his own assessment of damages related to the misappropriation of trade secrets.

In trying to exclude this testimony, the plaintiff first contended the expert, at various points, improperly offered an opinion as to what legal standard the jury should use. For example, the defendant’s expert said, “[T]he ‘anticipated’ economic profits based on forecasts that never materialized is not proper, and are not a measure of unjust enrichment.”

The defendant countered its expert did no more than explain his understanding of the applicable law.

The court disagreed with the defendant, finding the defense expert expressed an opinion on a legal question, that is, which factors or evidence the jury could consider in determining unjust enrichment. As such, the expert’s opinion “encroach[ed] on the court’s authority to instruct the jury on the law to be applied to the facts of the case.” Merely telling the jury what result to reach is not helpful to the jury, the court noted, striking this legal conclusion from the expert’s report.

At the same time, the court noted the defense expert was allowed to point out that the anticipated profits did not materialize and he was able to challenge the opposing expert’s opinion on the fair market value of the misappropriated trade secrets on the grounds that the relied-upon EVA analysis was “speculative, unreliable, and not a true measure of the value of the trade secrets.”

The plaintiff also claimed the defense expert improperly offered an opinion on causation. For example, in critiquing the plaintiff expert’s testimony on accelerated development of two cranes and increased PIPS expenses, the defense expert claimed the opposing expert did not independently analyze the premise of causation. He simply assumed that the defendant’s conduct was the only cause for the accelerated development of the two cranes, rather than also take into account market conditions, competition, staffing, and business management factors.

The court found this was proper rebuttal evidence. Simply because the defense expert used different assumptions and methods to calculate the various expenses did not justify the exclusion of his testimony.

Moreover, the plaintiff argued the defense expert was not permitted to offer an opinion that contradicted the findings of the ITC investigation. For example, the ITC found that, without the plaintiff’s trade secrets to build the defendant’s offending crane, the defendant would have had to adjust two other models for the U.S. market. By misappropriating the trade secrets, the defendants avoided “what likely would have been a developmental dead end.”

The defendant’s expert disputed these findings, saying the record was clear that the defendant would have rejected, and did reject, the idea of adapting the two cranes and, therefore, any development costs related to the two cranes were irrelevant to measuring unjust enrichment, i.e., measuring the benefit to the defendant. The defense expert found the only additional development costs the defendant avoided because of the misappropriation ranged from $1.3 million to $1.5 million.

The court said the defendant was not allowed to use an expert to contradict the ITC’s factual findings. The expert was precluded from making statements that were inconsistent with the ITC’s findings because this opinion would not be helpful to the jury but would cause jury confusion.

The plaintiff objected to the defense expert critique that there was no reliable basis for the plaintiff expert’s actual damages calculation because the plaintiff didn’t show lost sales resulting from the misappropriation. According to the defense expert, many factors could have played a role in the plaintiff’s failure to meet sales projections as to one of the cranes it developed in response to the defendant’s offending crane. The defense expert suggested the opposing expert should have considered the boom-bust cycle of the wind power market, oil prices varying between the time the plaintiff forecast sales for its crane and the sales date of the crane, flaws in the crane’s design, and poor forecasting on the part of the plaintiff’s employees.

The court found these statements by the defense expert were admissible testimony. The plaintiff would be able to challenge the correctness of the defense expert’s conclusion in cross-examination or by introducing contrary evidence.

In sum, the court precluded the defense expert from presenting legal conclusions and making statements that contradicted the findings of the earlier ITC proceeding (in favor of the plaintiff). Other defense expert opinions as to the causal link between the misconduct and the plaintiff’s claimed damages and claimed lost sales were admissible, the court concluded.

In Florida Divorce, Expert's 'With-and-Without' Valuation Withstands Appeal

Muszynski v. Muszynski, Case No. 2013-DR-18828-O, Final Judgment of Dissolution of Marriage, Circuit Court of the Ninth Circuit, Orange County, Fla. (Oct. 4, 2017), Bob Leblanc (Circuit Judge), aff’d per curiam Muszynski v. Muszynski, 2019 Fla. App. LEXIS 9913 (June 25, 2019)

In a nasty Florida divorce case, an appellate court recently upheld the trial court’s valuation findings concerning the husband’s 50% interest in a successful company that operates in the waste disposal industry. The trial court adopted the valuation of the wife’s expert, which included the value of certain intangibles belonging to the company but excluded the value of the husband’s personal goodwill. In Florida, enterprise goodwill is a marital asset, but personal goodwill is not.

Separating out personal goodwill: During the marriage, the husband set up a business, soon selling a 50% ownership interest to a third party. The husband had sole ownership over the remaining 50%. The company facilitated waste removal in that it had relationships with companies that generated waste and those that hauled it away. Apparently, the company did not, itself, remove the waste.

A few years before filing for divorce, the husband sold a 45% interest (nonvoting stock) to a trust but retained a 5% interest that represented 50% of the total voting rights in the company. Ostensibly, he did so for estate planning purposes. But the trial court noted that, at that time, the parties’ marriage was breaking down and that the wife was not properly informed of the sale and its implications.

The trial court first determined that the totality of circumstances suggested the sale “did not serve a valid marital purpose and was unconscionable.” The transaction was the husband’s “unilateral decision” and did not change the classification of the husband’s interest from a marital asset to a nonmarital asset. The value, for purposes of equitable distribution, was the full 50% of the company’s stock (not the retained 5% interest), the trial court decided.

The parties’ experts prepared fair market value determinations but disagreed on how to value the husband’s interest. The husband’s expert proposed a net asset valuation, noting, however, that the company had no significant assets as it didn’t produce anything or own much. According to this expert, all intangible value was linked to the husband’s (and his business partner’s) client relationships and therefore was not a marital asset. This value represented nothing more than the husband’s future earning capacity, which must not be considered in dividing marital property in a divorce proceeding, the expert said.

The wife’s expert valued the company’s assets and teased out the value of all identifiable intangibles which, he explained, belonged to the enterprise (including workforce, trade name, employees’ noncompetes, and customer relations). Proceeding from the premise that a buyer would not buy the company without having a noncompete for the husband in place, which evidences personal goodwill, he used the with-and-without method to determine the value of the husband’s noncompete and subtracted this value from the overall valuation.

In crediting this expert’s testimony, the court emphasized that the valuation did not include any personal goodwill of the husband. The court said it accepted the wife’s expert’s “methodologies for separating out any value related to Husband’s personal goodwill.” A state court of appeal recently affirmed the trial court’s decision per curiam, without issuing an opinion.

 

In Misappropriation Case, Expert’s ‘Head Start’ Damages Calculation Survives Appeal

Sabre GLBL, Inc. v. Shan, 2019 U.S. App. LEXIS 19983 (July 3, 2019)

This damages case, which centered on an employee’s breach of fiduciary duties and other misconduct toward her former employer, and which went to arbitration, includes an informative discussion of the difference between head start damages and saved development costs. Both the federal district court and 3rd Circuit Court of Appeals found the head start award was based on a valid damages theory and methodology for calculating the benefit to the wrongdoer as a result of her misconduct.

Background. The employee worked for nearly two decades for Sabre in the United States and China. Sabre was a technology provider to the travel and tourism industry. In 2013, the employee became a consultant for the company and entered into an employee intellectual property and confidentiality agreement (EIPC agreement). The contract forbade her to disclose or use the company’s confidential information for her own benefit or the benefit of a third party.

The EIPC agreement also included a noncompete clause and restricted the employee’s ability to interfere with the company’s relationships with customers, employees, and contractors for a period of time, both during and after her employment with the company.

In violation of the agreement, the employee, while still employed, started a competing Chinese company and also began to recruit Sabre employees and to solicit Sabre customers. The employee ultimately owned a 68% stake in the company, through a holding company she had formed to acquire shares in the Chinese competitor. The employee then resigned from Sabre and returned to China to work for the Chinese competitor.

More than a year later, Sabre sued the employee in New Jersey (where she had worked as a contractor) for breach of the EIPC agreement and breach of her fiduciary duties to Sabre. The employee was able to remove the lawsuit to federal court and compel arbitration. An arbitrator ultimately found for the company on a number of claims and awarded the employer two types of damages. The employee was required to disgorge $200,000, representing the salary she had received from Sabre during the period in which she had been disloyal to the company. Under the “head start” measure of damages, the arbitrator awarded the company nearly $1.2 million in damages. In a nutshell, this award represented the benefit to the employee derived from her misconduct based on her equity interest in the Chinese competitor.

However, the arbitrator rejected recovery under another category of damages for saved development costs, finding the evidence Sabre provided was too speculative.

The arbitrator also found the employee liable for breach of contract and other violations but did not award any additional damages related to the additional claims. The district court confirmed the arbitration award.

The employee then appealed the district court’s confirmation of the arbitration award with the 3rd Circuit Court of Appeals, arguing, in essence, that the arbitrator “manifestly disregarded” various aspects of the applicable Texas law when it awarded the damages. The 3rd Circuit disagreed.

Calculation of head start damages. The flashpoint was the head start damages award. The arbitrator accepted the calculations of the company’s damages expert, which were premised on the theory that the employee’s breach of fiduciary duty to Sabre (acquiring and using the company’s confidential information and trade secrets and, improperly, recruiting its personnel), gave the Chinese competitor a two-year head start, which that company would not have had but for the employee’s misconduct. In other words, the head start damages quantified the benefit to the Chinese company and to the employee who held an equity stake in it as a result of the employee’s misconduct.

The expert first computed the incremental value of the head start to the Chinese company by valuing the company with and without the head start and determining the difference between the two valuations. He then multiplied this figure by 68%, representing the employee’s ownership in the Chinese competitor.

For his valuation of the company with the head start, the expert relied on a transaction in which an actual outside investor was willing to buy a 20% interest in the company for a certain amount. The expert then discounted the resulting valuation to calculate the value of the company without the head start, showing that, but for the employee’s misconduct, the company would not have achieved this valuation for an additional two years.

The expert determined that the incremental value to the Chinese company was over $1.7 million, whereas the incremental value to the employee was about $1.2 million. The arbitrator, in adopting the expert’s damages determination, found this was “an accepted and credible approach” with which to calculate the benefit to the employee from the misconduct.

Among the numerous arguments the employee made to contest the damages, she claimed the head start damages calculation was flawed because it was based on Sabre’s erroneous assumption that head start damages and saved development costs are “the same thing.” The employee then contended the arbitrator mistakenly allowed Sabre to recover saved development costs, without there being any evidence of those costs.

The appeals court rejected the argument. It noted that, in his report, Sabre’s expert made clear that head start damages and saved development costs were separate damages theories that sought recovery for two different benefits the wrongdoer received as a result of the misconduct. Head start damages, the appeals court said, reflected the benefit to the employee from the increase in the Chinese company’s value “as a result of the company’s being two years further along than it otherwise would have been in developing and commercializing its products and services.”

Saved development costs, on the other hand, capture the benefit to the employee from the Chinese competitor’s ability to avoid certain research and development costs by misappropriating Sabre’s trade secrets and confidential information. In other words, the Chinese competitor did not have to develop this knowledge and information on its own.

The 3rd Circuit noted that, in the instant case, the arbitrator found that Sabre failed to prove saved development costs and, instead, awarded head start damages based on Sabre’s expert’s damages calculation.

The argument that the expert’s valuation was precluded under Texas case law also had no traction with the 3rd Circuit. Rather, the reviewing court found there was no ruling “that shareholder equity is categorically an impermissible method of establishing the value of a company.”

Moreover, the court dismissed the employee’s claim that Sabre’s expert wrongly assumed that all or most of the Chinese company’s value as of the valuation date was attributable to products that were traceable to the employee’s misconduct. The employee claimed that other products unrelated to her misconduct also were in development as of the valuation date. However, the 3rd Circuit found the employee did not provide a basis for concluding the expert’s assumption was incorrect.

The 3rd Circuit Court of Appeals concluded that, despite many assertions of legal error, the employee failed to identify a governing legal principle in Texas law that the arbitrator knew of but chose to ignore when it awarded the former employer head start damages. There was no evidence to conclude the damages “were awarded in manifest disregard of the law,” the 3rd Circuit said. It confirmed the head start damages award.

 

High Court Approves of Trial Court’s Rejection of Discounts in Fair Value Determination

Puklich v. Puklich, 2019 ND 154; 2019 N.D. LEXIS 153; 2019 WL 2641017 (June 27, 2019)

A buyout dispute between siblings who owned several businesses generated a noteworthy decision from the North Dakota Supreme Court on the use of valuation discounts. Reviewing the applicable case law, the high court found the trial court, in determining the fair value of one sibling’s minority share in a closely held corporation, did not err in refusing to apply a minority discount. The trial court was authorized to use the value finding to account for the majority shareholder’s wrongful conduct, the high court found. Also, case law from other states supported the decision not to apply a minority discount under the circumstances, the state Supreme Court found. It also concluded the trial court’s decision not to use discounts in the context of the dissolution of a partnership also was not clear error.

Background. Two siblings held ownership interests in three businesses. One company was a closely held corporation that operated an automobile dealership. The other was a limited partnership that owned the real estate on which the dealership was located and leased it to the dealership. A third company, also a closely held business, operated a reinsurance business that was related to the dealership.

The siblings’ relationship broke down, leading the sister to ask the court to dissolve the partnership. In response, the brother, who was the minority shareholder in the dealership, asserted various breaches of fiduciary duty by the sister and ultimately asked the court to order the sister to buy out his interest in the dealership and award damages for the breaches.

The trial court dissolved the partnership and ordered the sister to pay $2.9 million to the brother for the value of his partnership interest. Further, the court compelled the sister to buy the brother’s 19% minority interest in the automobile dealership for $2.6 million.

As to the partnership, the court found the sister had breached her duty in winding up the partnership without notifying the brother, who was the co-owner. As to the dealership, the court found the sister had breached her duties of good faith and fair dealing by trying to oppress the brother as a minority shareholder in an attempt to buy his shares at below fair market value. The trial court found the sister limited the funds flowing to the brother and did not provide him with timely information about the business.

Liquidation of partnership assets. At trial, the parties presented expert testimony as to the value of the partnership and the automobile dealership. The trial court adopted the valuations of the brother’s expert.

On appeal to the state Supreme Court, the sister claimed the trial court’s valuation findings were erroneous. She particularly challenged the trial court’s rejection of the use of valuation discounts as to both entities.

Regarding the partnership, which owned the real estate, the sister claimed one of the brother’s experts mistakenly valued the real estate as a fee simple estate rather than a leased fee estate. She contended the expert ignored the leases that allowed the dealership to use the property. She also claimed that the brother’s other expert used the allegedly wrong real estate value when valuing the partnership.

Under the law, valuation is a question of fact, the state Supreme Court noted. The trial court’s valuation findings are only reversed if they are clearly erroneous. Moreover, the trial court’s valuations are presumed to be correct, “and a valuation within the range of evidence presented to the court is not clearly erroneous.”

The state’s high court observed that the trial court here was aware that the real estate appraiser had not considered the leases allowing the dealership to use the property. However, the high court said, there was evidence that the leases were not arm’s-length leases and that the rent payable under the leases could be increased. The brother’s expert considered the amount of rent that a lease reflecting market value could generate. This expert testified that, “if the leases reflected market value, the leased fee estate and fee simple estate would be equal.” Given this evidence, the trial court’s valuation of the real estate owned by the partnership was not clearly erroneous, the high court found.

The sister also claimed that the trial court erred in not applying a minority discount and a lack of marketability discount (DLOM) when valuing the partnership interest.

The high court, referencing a tax court decision, first noted that the two discounts were “conceptually distinct.” It explained that the minority discount deals with the interest owner’s inability to force liquidation and realize the owner’s respective portion of the net asset value. On the other hand, the marketability discount reflects the lack of a ready market for the ownership interest. See Estate of Fleming v. Commissioner, 74 T.C.M. (CCH) 1049 (T.C. 1997). Questions regarding the use of discounts and their rates are questions of fact, the high court noted.

It pointed out that the applicable state statute for winding up a partnership’s business (N.D.C.C. § 45-2-07) called for the liquidation of the business’s assets. Doing so required liquidating the assets of the business, paying its debts, and distributing the remaining funds to partners based on their ownership interests. Considering that the dissolution of the partnership here resulted in the liquidation of its assets, it was not clear error for the trial court to reject the use of discounts, the state Supreme Court found. It affirmed the trial court’s valuation of the partnership.

However, the high court struck down a damages award of $300,000 to compensate the brother for the sister’s breach of fiduciary duties with respect to the partnership, finding the trial court offered no explanation as to how it arrived at this sum.

Minority interest in auto dealership. The sister also challenged the valuation of the auto dealership, arguing the trial court improperly used the valuation of the brother’s expert to penalize her for the breach of fiduciary duty. She also claimed the court improperly rejected the use of valuation discounts.

The state’s high court disagreed. It first noted that the trial court had found the sister had taken “calculated steps to force the brother to sell his interest to her and reduce any funds owing to [the brother] from the business.” The trial court went on to say it would not discount the brother’s interest, as the sister’s expert had recommended.

The state Supreme Court noted that the reviewing court gives great deference to a trial court’s credibility determinations. According to the Supreme Court, the trial court here was not only making a credibility determination between the rivalling experts or deciding how much weight to give to each expert’s testimony. Rather, the trial court “adjusted its finding on the value of [the dealership] to account for [the sister’s] breach of fiduciary duty with respect to [the dealership].” Instead of awarding damages for the breach of fiduciary duty, the trial court decided to adopt the valuation of the brother’s expert, which did not apply discounts, the state Supreme Court noted.

It went on to explain that, in circumstances in which persons in control of a closely held corporation have acted in a wrongful manner toward the company’s shareholders, the trial court is authorized either to dissolve the corporation or “grant any equitable relief it deems just and reasonable under certain specified conditions.” The purchase price must be the fair value of the shares, unless there exists a controlling shareholder agreement. See N.D.C.C. § 10-19, 1-115(4)(a).

The state Supreme Court noted that the trial court here acted in accordance with the statute. The trial court used a value that favored the brother, “as an equitable remedy for [the sister’s] breach of fiduciary duty.” What’s more, the trial court selected a value for the company that was within the range of evidence. The trial court’s ruling did not reflect an erroneous view of the law, the high court found and upheld the valuation of the auto dealership.

In discussing the appropriateness of valuation discounts, the high court cited decisions from other state courts that have rejected the application of discounts when valuing a minority interest in the context of a corporate dissolution, where the buyer is the corporation or its controlling shareholder, as well in dissenting shareholder cases requiring a determination of the fair value of the dissenter’s interest.

“We agree a trial court ascertaining ‘fair value’ of minority shares under the Business Corporation Act should not automatically discount their value,” the state Supreme Court said. It concluded that the trial court’s rejection of discounts “was consistent with our case law.”

About Ron
Ron Lenz is the partner-in-charge of KSM’s Litigation Services Group.  He advises clients and attorneys in matters of financial litigation and often challenges assumptions to help clients obtain the best possible litigation outcome. Connect with him on LinkedIn.
 

About Jay
Jay Cunningham is a director in KSM’s Litigation Services Group. Jay counsels clients faced with litigation or other disputes through forensics and commercial damage analyses, often serving as an expert witness. Connect with him on LinkedIn.

link

Litigation Services Bulletin: Q3 2019

Posted 12:00 PM by

In This Issue:

In Gatekeeper Role, Court Trains Attention on Expert Methodology, Not Conclusions

Acosta v. Wilmington Trust, N.A., 2019 U.S. Dist. LEXIS 9246 (Jan. 18, 2019)

In this ESOP litigation, both parties tried to exclude the opposing side’s valuation expert testimony under Rule 702 and Daubert. The court noted that, at this stage in the proceedings, its focus was on whether the experts applied reliable principles and methods, not on the experts’ conclusions. This case serves as an important reminder to attorneys and experts that the role of the court as gatekeeper is different from its role as evaluator of the sufficiency of the evidence (as the court in another case, Washington v. Kellwood Co., explained so well). Put differently, simply because the expert opinion is admissible does not mean it will hold up in terms of the ultimate outcome of the case.

Questioning ESOP valuation. The U.S. Department of Labor (DOL) sued the defendant trustee (and others) alleging the trustee violated its duties under ERISA by causing an employee stock ownership plan (ESOP) to purchase the outstanding stock in a graphite processing company (Graphite Sales Inc.). According to the DOL, the purchase was for greater than fair market value, which meant the trustee caused the ESOP to overpay by approximately $6 million. At the time of the transaction, an independent valuation firm appraised the company. As part of the transaction, the sellers received stock warrants that amounted to an 18% equity stake in the company. Also, two officers received stock appreciation rights, representing a 10% equity interest. Further, an investor received rights to a 7% equity stake in the company.

The crux of the case was the valuation of the company. The DOL offered expert testimony that called into question the ESOP valuator’s contemporaneous appraisal. The defendant trustee presented its own trial expert to testify and rebut the opinion of the DOL’s expert. Both parties challenged the opposing testimony under Rule 702 of the federal rules of evidence and under Daubert and its progeny. Further, the DOL argued the opposing expert opinion was inadmissible under Rule 403, which provides for exclusion of relevant evidence on various grounds (unfair prejudice, confusing the issues, misleading the jury, etc.). The court’s discussion focused on Rule 702 and Daubert.

In a nutshell, Rule 702 and Daubert provide for testimony by a qualified expert whose “scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue.” The testimony must be based on sufficient facts and data and must be “the product of reliable principles and methods.” In assessing the testimony, a court considers whether the testimony “has been tested, is the subject of peer review and publication, has a permissible error rate, follows established standards, and receives ‘general acceptance’ within a ‘relevant scientific community.’”

“At this gatekeeping stage,” the court in the instant case said, the court’s focus is “on principles and methodology, not the conclusions that they generated.”

Objections to DOL expert testimony. In trying to exclude the DOL’s expert, the defense broadly claimed the expert’s value opinion was nothing more than ipse dixit, or “I say so.” This argument, the court found, was based on the expert’s statement during his deposition that he “could not speak for the entire industry.” In other words, he suggested different valuation experts might interpret certain facts differently.

“Of course, [the expert’s] concession … does not mean that his own interpretation is made up,” the court said, dismissing the defendant’s argument.

The defendant also attacked the expert’s methodology on specifics. For example, it took issue with the DOL expert’s statement that the ESOP appraiser should have used multiples of revenue and EBITDA, not multiples of EBIT and EBITDA, in valuing the company. The defense claimed the DOL expert’s view conflicted with a cited treatise that said the expert’s proposed approach was applied most frequently to startups and service businesses, neither of which the subject company was.

“The defendant is wrong,” the court said. It noted the treatise “explicitly contemplates” use of the expert’s approach “in circumstances other than start-ups and service companies.”

Secondly, the defendant objected to the DOL expert’s claim that the ESOP appraiser erred by using the exit multiple method rather than the Gordon growth model for its discounted cash flow analysis. The defendant said the expert’s critique was wrong because treatises permit the use of either method.

“Even if true,” the court said, the defense argument does not affect admissibility because it simply contests the DOL’s expert choice among accepted valuation methodologies.

Thirdly, the defendant claimed it was improper for the expert to consider the stock warrants and appreciation rights when valuing the company. The defendant noted that the expert, in deposition testimony, “admitted” that the warrants could be considered part of financing the transaction.

The court noted that, in the same testimony, the expert pointed to another “motivation” for the warrants: They were “a form of contingent consideration” and should have been added to the purchase price, he said.

The court said that the defendant would have a chance to probe this issue at trial. However, in terms of admissibility, the defendant failed to show the expert’s view was based on insufficient facts or conflicted with accepted principles and methodologies.

Moreover, the defendant raised questions related to the DOL expert’s application of the principles and method to the facts of the case. For example, the expert criticized the ESOP appraiser’s projections. The defendant, in turn, claimed the expert failed to give proper consideration to the management projections and ignored various other pieces of financial evidence.

The court noted that none of “these purported errors” showed the DOL expert “made up” his revenue projections or used unsound methods. The defendant failed to show that accepted valuation principles compelled the expert to weigh the evidence differently or consider certain evidence, the court said.

Another defense objection was to the expert’s criticism of the ESOP appraiser’s selection of guideline companies and the latter’s choices related to the application of the guideline company method. The defense claimed the expert’s criticism contradicted the expert’s own analysis on other topics. The defendant said there was no reason to use the expert’s preferred method.

According to the court, the defendant’s objection went toward the weight of the opposing opinion, but it did not “even remotely suggest” the opposing expert’s opinion was based on an unsound methodology.

Similarly, the DOL’s expert criticized the ESOP appraiser’s use of a 10% control premium to the guideline companies’ stock. The defendant suggested that the DOL expert’s analysis of control was wrong and made his calculation wrong.

The court disagreed again, noting that this type of application error “would not show that [the expert’s] views are inadmissible.

Objection to defense expert testimony. The court quickly dismissed the DOL’s claim that the defense expert’s testimony was inadmissible because he improperly proposed a damages methodology when doing so was the role of the court.

The court noted the defense expert’s approach—comparing what the ESOP paid for the stock with the fair market value of the stock on the date of the transaction—was the same approach the DOL expert used. Further, this analysis was a legally approved methodology.

In general, the court suggested that the parties mostly quarreled over the opposing expert’s conclusions but failed to show the conclusions were unscientific—the requisite inquiry for purposes of determining admissibility of expert testimony.

Both expert testimonies were admissible in their entirety, the court found.

Editor’s Note: A digest of the above-mentioned case, Washington v. Kellwood Co., 2016 U.S. Dist. LEXIS 92309 (July 15, 2016), and the court’s opinion are available at BVLaw.

 

Economic Damages Culminate Suit Over War Journalist's Extrajudicial Killing

Colvin v. Syrian Arab Republic, 2019 U.S. Dist. LEXIS 14641 (Jan. 30, 2019)

A civil suit arising out of the “deliberated” killing of a well-respected American war correspondent illustrates that valuation and damages issues play a critical role in most litigation. The loss of income analysis in this case will be of particular interest to appraisers specializing in personal injury cases.

Marie Colvin was an acclaimed American war journalist who worked for over 25 years for the British paper, The Sunday Times. In February 2012, Colvin, who was a special target of the Syrian government, was killed in a concerted artillery attack in the Syrian city of Homs. Afterwards, members of the Syrian military and intelligence celebrated. Based on evidence, they said: “Marie Colvin was a dog and now she’s dead. Let the Americans help her now.”

Colvin’s youngest sister, Cathleen, and Colvin’s niece and nephew sued the Syrian government under the Foreign Sovereign Immunities Act (FSIA), alleging the reporter’s death was an extrajudicial killing. The plaintiffs sought damages under two legal theories: wrongful death and emotional distress. The court found there was copious evidence (almost 1,000 pages of exhibits, detailed affidavits, declarations, and expert reports) to support a finding that Colvin was the victim of a “deliberated killing” by the Syrian government.

Under the wrongful death theory, all plaintiffs were entitled to monetary damages for the loss of prospective income, benefits, and retirement pay as shown by a reasonable estimate from an expert that was based on well-founded assumptions. The plaintiffs’ damages expert was highly qualified, the court noted. She held a Ph.D. in economics and had worked in valuation for over 10 years, participating in “hundreds of valuation-related projects around the world.” The testimony met the requirements of federal rule of evidence 702, the court found.

To calculate the economic loss resulting from the reporter’s premature death, the expert decided to take a conservative view. In determining the expected income, the expert did not include professional earnings beyond Colvin’s employment with The Sunday Times, believing “it was not possible” to quantify with “a reasonable degree of certainty” any future book deals or film contracts that Marie Colvin could have received.

The expert also adjusted the total amount of lost wages for the risk inherent in the journalist’s job (“probability of survival”) and the time value of money and found the economic loss was $2.37 million. The court credited the expert’s opinion but said that, under the relevant case law, the calculation had to be adjusted for consumption costs. Therefore, the court asked for an updated expert report before making a final determination as to the exact amount of loss of income.

The court also awarded Colvin’s sister $2.5 million to compensate for the pain and suffering resulting from the journalist’s death, and it awarded punitive damages of $300 million. However, this is a default judgment against the Syrian government. How much of the award the plaintiffs will ever see remains unclear.

Extra: A well-received movie based on Marie Colvin’s life came out in 2018. It’s called A Private War.

 

Divorce Court Finds No Personal Goodwill Value in Single-Owner Business

Stephanos v. Stephanos (In re Marriage of Stephanos), Case No. 502013DR007061XXXXSB, Circuit Court of the Fifteenth Judicial Circuit, Palm Beach County, Florida, J. Samantha Schosberg Feuer, Final Judgment (Dec. 28, 2018)

A Florida divorce case is noteworthy for its multifaceted goodwill analysis, which included an examination by the court of which party had the burden of establishing that goodwill was either enterprise or personal in character and was either a marital asset or not. The nub of the problem was that the husband, who held sole title to the contested company, had a damaged business reputation but still claimed any goodwill existing in the business should be attributed to him. The wife, through expert and lay testimony, was able to show all of the goodwill was enterprise goodwill. The husband was not vital to the company’s continuing existence and success. Further, the court found a noncompete analysis (or “real world transaction”) would not change the goodwill attribution.

Owner’s problems with the law. The parties first filed for divorce in 2003. They then reconciled and dropped their divorce petitions. Ten years later, in June 2013, the husband filed another petition for divorce, which, in November 2013, prompted a counterpetition from the wife. The husband was active in the hormone replacement industry. At one point, he and a business partner equally owned a company, Palm Beach Rejuvenation (PBR). However, in 2007, during the reconciliation period with the wife, the husband and his brother became targets of a federal investigation and were indicted by the state of New York. PBR was raided. The events were on the cover of Sports Illustrated in 2007.

The husband pled guilty to a third-degree felony in the state case and was found guilty, placed on probation, and prohibited from ever providing human growth hormone services to anyone in New York state. The wife gave financial support for the husband’s defense and also provided funds for the creation of a separate entity, Nationwide Synergy Inc. (NSI), which operated in the hormone replacement industry but was not a professional practice. The valuation of NSI was a flashpoint during the divorce proceedings.

The parties also argued over whether PBR morphed into NSI or essentially stopped functioning because of the husband’s legal problems. The trial court ruled that NSI was mostly a separate entity, even though the businesses shared similarities and the husband had bought PBR’s assets and opened NSI in an effort to rebrand. Besides those two entities, between 2007 and 2013, the spouses, and the husband’s brother, also created other businesses involved in hormone replacement therapy.

Importantly, the NSI stock was in the husband’s name alone. The court noted the reason for this arrangement was strategic, to protect the wife from potential legal exposure in light of the husband’s past problems regarding PBR.

The husband was CEO, and the wife served as the CFO of NSI. The evidence showed she made an initial contribution of approximately $850,000 of her nonmarital assets and dealt with the company’s financial activities. She also supervised employees and assisted in creating an important database, and she worked on developing a reputation for NSI and the other entities.

In the company’s beginning, the husband recruited salespersons and put in place people who were key to generating cash. But, once the company grew, other employees became key persons, including the spouses’ son and another employee. The latter two developed a network of physicians who performed clinical valuations of potential customers who wanted to buy the company’s products over the internet. This medical assessment became federal law in 2008. NSI’s key employees established the necessary protocol at the company.

Between 2007 and 2016 (the valuation date), the value of the company went from about zero to $5.3 million and $5.7 million, according to the valuations the parties’ highly qualified experts offered at trial.

Equitable distribution principles. The overriding issue was for the court to determine whether NSI was a marital asset that was subject to equitable distribution.

The applicable statute (Fla. Stat. § 61.075) provides for a three-step process. In essence, the court first has to classify the assets and liabilities as marital or nonmarital. Next, the court has to value the “significant” marital assets based on “competent, substantial evidence.” Under case law, a court must not simply “split the difference” between the values the parties proposed but has to “cite to specific evidence or lack thereof in the record to arrive at its conclusions.” Finally, the court must distribute the assets and liabilities under a presumption in favor of equal distribution, “unless there is a justification for an unequal distribution based on all relevant factors.” Also, under the statute, all assets a couple acquires after the date of marriage that are not specifically established as nonmarital assets are presumed to be marital assets and liabilities. This presumption may be overcome by showing that the assets are nonmarital assets.

Residual method. The court’s inquiry focused on whether there was goodwill value in the company. The question was how to calculate the goodwill value and how to determine whether it was personal or enterprise goodwill.

The applicable statutory provision (Fla. Stat. § 61.075(3)(b)) and case law require a valuation based on the fair market value standard of value.

The clearest method would be the fair market value approach, which is best described as what would a willing buyer pay, and what would a willing seller accept, neither acting under duress for a sale of the business. The excess over assets would represent goodwill. See Thompson v. Thompson, 576 So. 2d 267 (Fla. 1991) (available at BVLaw).

The court explained that Thompson was the controlling case on the issue of business goodwill in the divorce context. Thompson says that enterprise goodwill is value attributable to the company/entity as opposed to value related to the reputation or continued presence of a particular person (“the marital litigant”). In Florida, enterprise goodwill is a marital asset, whereas personal goodwill is not.

The court noted that, when it came to the overall valuation of NSI, the parties’ experts achieved a fair market value determination that was remarkably close. The difference was less than $250,000. The wife’s expert found the company was worth $5.3 million, and the husband’s expert determined it was worth $5.7 million.

The more contentious issue was the goodwill calculation. The court noted the husband’s expert suggested he was unable to extrapolate any goodwill value from the fair market value. Although it respected the expert’s opinion, the court found the claim somewhat “dubious” given the expert’s “extensive expertise and knowledge in the area of business valuation and goodwill.”

In contrast, the wife’s expert used the residual method to determine the value of goodwill, which the husband’s expert allowed was a proper approach. By subtracting the net asset value from the entity’s FMV, the expert achieved a residual value (goodwill) of $2.2 million.

Burden of proof issue. The court noted that it found no reported cases that addressed which party had the burden of establishing the value of enterprise goodwill. Here, the husband claimed that all of the goodwill at the company was personal, whereas the wife claimed personal goodwill in the company was nonexistent or negligible. Accordingly, the husband contended the wife should have the burden of showing all of the goodwill was enterprise goodwill, while the wife argued the burden was on the husband to show he was entitled to the goodwill value as he claimed it was personal to him. Both parties cited cases to support their positions. The court concluded that, since the wife claimed there was goodwill, it was appropriate that she had the burden of showing that enterprise goodwill existed—”through competent and substantial evidence”—and that, therefore, the goodwill was a marital asset.

The court rejected the husband’s position that it was impossible to extract the value of personal goodwill from the residual value. Instead, the court relied on testimony from the wife’s expert as to the purchase price allocation approach and on other testimony and factors to come to the conclusion that there was no personal goodwill attributable to the husband.

The court specifically noted that the husband was a convicted felon who was “unable to compete in certain markets”; his reputation was blemished. He could not point to any customers his efforts brought in. He had no role in developing the database or sales force, both of which were critical parts of the business. He had no relationships with the company’s physician affiliates. Further, all employees of NSI had signed noncompetes and, therefore, were precluded from aligning themselves with the husband in a similar business. In addition, members in the physician affiliate network were bound by noncompetes and confidentiality agreements to protect NSI’s intellectual property. The physicians in the network had relationships with the two key employees, not the husband. The company’s advertising did not mention the husband because the company specifically determined that, if his affiliation with the company were known, it could hurt the business. Most of the company’s revenue stream was generated by website sales; the website in turn was managed by another employee, not the husband. Any web domains and phone numbers belonged to the company and would transfer in the event of a sale.

Company employees spoke of the husband’s limited role and said they did not know what he actually did there. One key employee said that, if the husband were to leave for a year, the company would continue to function as it always had. Also, as of 2016, the husband had limited his role in the company. He was rarely in the office and only communicated sporadically via email.

There was no credible evidence that showed the husband was key to the company, the court found. It decided that the entire residual value was enterprise goodwill. This amount was a marital asset, subject to equitable distribution.

Noncompete goodwill theory. That said, the court also considered the husband’s alternate theory in support of his position that the goodwill was personal to him. He and his expert contended that, in the real world (i.e., in an actual, as opposed to a hypothetical, transaction), a buyer would only be willing to purchase NSI’s stock if the husband executed a noncompete agreement.

The court noted, however, that the ASA’s business valuation standards do not require consideration of a noncompete when calculating fair market value. The court also noted it was not aware of any precedent “from any substantive authority in this State wherein the specificities regarding value and methodology address the criteria to value a covenant not to compete in a ‘real world’ situation.” In other words, there was no specific appellate opinion addressing the valuation of a noncompete.

The wife’s expert proposed looking to Internal Revenue Service guidelines for the purpose of valuing a noncompete. The nine factors included:

  1. The seller’s ability to compete;
  1. The seller’s intent to compete;
  1. The seller’s economic resources;
  1. The potential damage to the buyer the seller’s competition posed;
  1. The seller’s business expertise in the industry;
  1. The seller’s contacts and relationships with customers, suppliers, and others in the business;
  1. The buyer’s interest in eliminating competition;
  1. The duration and economic scope of the covenant; and
  1. The seller’s intention to remain in the same geographic area. See Langdon v. Commissioner, 59 Fed. Appx. 168 (8th Cir. 2003) (citing Lorvic Holdings, Inc. v. Commissioner, 1998 Tax Ct. Memo 283 (1998).

The court said it would rely on the analysis of the wife’s expert for the calculation of value (assuming there was any) of a noncompete. Several case-specific facts were critical, including the fact that all 16 sales force members of the company had executed noncompete, nonsolicitation, and confidentiality agreements, as did the 14 “non-sales force” employees.

Further, all 32 physicians in the company’s physician affiliate network were bound by noncompetes. The company had established a proprietary database related to customers. And there was an established relationship between the entity and the patients/customers the company served.

Considering all the restrictions in place, the court found a real-world transaction analysis that centered on the existence or nonexistence of the husband’s noncompete also would not change the outcome as to personal goodwill. Under either continued presence or noncompete analysis, the goodwill value personal to the husband was nonexistent or negligible, the court concluded.

In the final analysis, the court awarded the company to the husband. For equitable distribution purposes, the court adopted the $5.3 million valuation the wife’s expert had proposed as well as this expert’s determination that goodwill in the company was about $2.2 million and was enterprise goodwill that was subject to marital distribution.

Editor’s note: Hat tip to Josh Shilts (Villela & Shilts LLC) for alerting us to this important goodwill decision.

 

Court Chooses DCF to Determine Fair Value in ‘Straightforward’ Appraisal Case

Kendall Hoyd & Silver v. Trussway Holdings, 2019 Del. Ch. LEXIS 72, 2019 WL 994048 (Feb. 28, 2019)

Several standard valuation methods were in play in a statutory appraisal case arising out of the minority shareholder’s petition to the Delaware Court of Chancery for a fair value determination. Neither the aborted sales process nor the market approach produced reliable indicators of fair value, the court found. Instead, it relied on a discounted cash flow (DCF) analysis and, in so doing, discussed and resolved disagreements between the parties’ experts over various inputs, including management projections, beta, and residual value. As the subject company was not a public company, the Delaware Supreme Court’s Dell and DFC Global decisions did not guide the Court of Chancery’s analysis.

Nine-year projections. The dispute related to the conversion of a corporation into a limited liability company. Trussway Holdings Inc. (Trussway) had a wholly owned subsidiary, Trussway Industries Inc. (TII), that was the leading manufacturer of prefabricated trusses and other components for the multifamily housing market. TII was the company whose value was in dispute. It had six manufacturing facilities in the U.S. and approximately 930 employees.

In mid-2016, TII contemplated a sale and hired an investment firm to develop a valuation of the company. The financial adviser came up with a value range of $202 million to $298 million. It contacted over 75 parties. At the end of 2016, TII made presentations to seven interested parties. The focal point was nine-year projections (2017 to 2025). The projections envisioned revenue for 2016 to be $218.2 million, increasing in 2017 to $235.9 million. Afterward, revenue was expected to grow from 2.2% to 14.9% annually through 2025. These numbers were very optimistic compared to the numbers appearing in internal management projections for 2015 and 2016. For example, the 2015 projections anticipated an increase from $196 million in 2015 to $204 million in 2016 and an annual decline thereafter, to $132.76 in 2019. The record showed one board member foresaw declines in multifamily housing starts. Internal five-year projections for 2016 also anticipated a decline in revenue through 2020.

A company representative said in his deposition that the nine-year projections were adjusted downward during the sales process “because the business wasn’t performing as was anticipated.”

Importantly, the nine-year projections added to the base case projected costs, revenue, and EBITDA related to four strategic initiatives. The effect was an increase in revenue and EBITDA. By 2025, the initiatives accounted for 39% of revenue and 43% of EBITDA in the nine-year projections.

In December 2016, Trussway’s board of directors approved a merger that transformed Trussway and its subsidiaries, including TII, into LLCs. The transaction was driven by one majority shareholder that owned about 95% of the company’s stock. Two minority shareholders held roughly 5% of the company’s stock and did not vote on or consent to the merger. Instead, the minority shareholders filed for statutory appraisal under section 262 of the Delaware appraisal statute.

While the merger went forward, the negotiations over the sale of TII were ongoing. In February 2017, one offer emerged. The bidder offered $170 million. It later withdrew the offer, and the sale went nowhere.

The parties agreed to the value of the corporate assets and liabilities but did not agree on the value of TII. Ultimately, one minority shareholder settled in principle with Trussway (the respondent). The other shareholder’s petition went to trial in the Delaware Court of Chancery.

Both the petitioner and the respondent offered expert valuation testimony.

Applicable law. Section 262 of the Delaware appraisal statute entitles dissenting shareholders to petition the Delaware Court of Chancery for a determination of the fair value (intrinsic value) of their shares as of the merger date. The fair value determination must exclude “any element of value arising from the accomplishment or expectation of the merger.” The court “should first envisage the entire pre-merger company as a ‘going concern,’ as a standalone entity and assess its value as such.” Under the statute, the court must undertake a case-by-case analysis that considers “all relevant factors.” Both parties have the burden of proving their valuation positions.

Court rejects market approach. In a nutshell, the petitioner’s expert determined the petitioner’s interest in Trussway was $387.82 per share, which was made up of the value of TII, plus the agreed-upon value of the corporate assets, minus the agreed-upon amount of liabilities.

The company’s expert (respondent’s expert) arrived at a fair value of $225.92 per share.

The petitioner’s expert performed a DCF analysis to which he assigned 60% of the weight, a comparable companies analysis that he weighted at 30%, and a precedent transactions analysis that he weighted at 10%.

The company’s expert relied on the results of two DCF analyses. One analysis was based on the nine-year management projections. In a second analysis, the expert modified the nine-year projections to become five-year projections. He assigned a 25% weight to the DCF using the nine-year projections and a 75% weight to the DCF based on the five-year projections.

Neither party claimed that the unsuccessful sales process revealed a value that represented fair value. The court said the one bid emerging during the sales process, $170 million, and other indications of interest, at best, served as “a very rough reasonable check.”

The court agreed with the company’s expert that the petitioner expert’s comparable companies analysis did not generate a meaningful value indicator because the companies used as comparables were insufficiently similar to the subject company in regard to size, public status, and products. The company further contended that the court should disregard the result of the opposing expert’s precedent transaction analysis since that analysis was based on only one reliable transaction. The court agreed and used the DCF for its determination of fair value.

DCF disagreements. Here, the experts used a similar methodology to perform their DCFs but had consequential disagreements over a few key inputs, the court noted.

Projections. The issue was how reliable the nine-year management projections were. The petitioner’s expert used them in their entirety, finding they were based on “the best currently available estimates and judgments of the management of the company.”

The company argued that a valuation should use only the base projections, thus ignoring the strategic initiatives. Alternatively, if the strategic initiatives were part of the analysis, the valuation should assign greater weight to the first five years of company projections, as the company’s expert had done.

In discussing the reliability of the nine-year projections, the court noted the company “routinely” created projections. The projections were done in the course of business and, in this instance, the company intended to use them in the context of a sales, the court observed. Sales considerations generated optimistic projections, the court noted. It also found the projections were longer than the common five-year projections. One explanation for the extended period was that the multifamily housing industry was cyclical. The longer projections aimed to correct “cyclic distortion,” the petitioner argued.

The court agreed that the projections were “the best predictor” of the subsidiary’s performance. Moreover, it found that the strategic initiatives were part of TII’s “operative reality” and should be considered in valuing the company as a going concern. “TII had the unilateral choice to pursue the initiatives, and projected that they would do so,” the court noted.

The court acknowledged there was “a degree of huckster’s optimism in these predictions” and noted that the petitioner’s expert seemed to acknowledge as much by adding a 1% risk premium to account for the uncertainty surrounding the forecasts. However, there was no basis for the 1% risk premium adjustment, the court found. It adopted a modified version of the approach the company’s expert took regarding the projections. The court weighted the results of the two DCF-generated values equally. One value resulted from using the nine-year projections and the other from using the same projections but beginning the terminal period after five years. The court said its analyses applied the calculation the company’s expert made from the nine-year projections of management’s projected annual cash flows and expected debt and equity levels.

WACC and beta. Although the experts largely agreed on how to calculate WACC, they disagreed over beta. The petitioner’s expert used adjusted beta, assigning two-thirds of the weight to raw beta and one-third weight to a mean beta of 1.0. The company’s expert used historic beta.

Further, the petitioner’s expert used the Hamada method to unlever and relever beta. In contrast, the company’s expert used the Harris-Pringle method. The methodologies differ in their treatment of debt, which can result in “notably disparate beta calculations,” the court noted.

The petitioner’s expert obtained a WACC of 13.4%, whereas the company’s expert calculated a WACC of 15.4%.

The court disfavored the use of an adjusted beta “for this small, private corporation.” It also said that any error in using a historic beta would be minimized because the court assigned a 50% weight to a DCF that used the nine-year projections with very optimistic growth forecasts.

Also, since the court leaned heavily on the DCF analysis of the company’s expert, it accepted his use of the Harris-Pringle model. The difference in the approaches was de minimus, the court said. The court’s beta was 1.74, and its WACC was 15.4%.

Residual value. To calculate the terminal value, both experts used the Gordon growth model. However, the plaintiff’s expert also used the exit multiples approach, which the opposing expert said doing so improperly increased the residual value. The company’s expert used a 2.3% growth rate, which the petitioner claimed was too low.

The court said use of the exit multiples approach with its high-growth-rate assumptions was inappropriate considering the court already used the optimistic nine-year forecast. Therefore, the court decided to use the Gordon growth model and a 2.3% growth rate.

The court’s inputs generated two values. A DCF analysis based on the nine-year forecast resulted in a value for TII of $197,800. A DCF analysis based on the first five years of the projections resulted in a valuation of $168,800. Weighting each result equally, the value of the company was about $183,300. Adding the other agreed-upon values for assets and liabilities and dividing the result by the shares outstanding, the court obtained a per-share value for Trussway Holdings of $236.52—thus a value close to the fair value calculated by the company’s expert.

Based on its DCF analysis, the court decided the fair value of the company as of the merger date was $236.52 per share.

About Ron
Ron Lenz is the partner-in-charge of KSM’s Litigation Services Group.  He advises clients and attorneys in matters of financial litigation and often challenges assumptions to help clients obtain the best possible litigation outcome. Connect with him on LinkedIn.
 

About Jay
Jay Cunningham is a director in KSM’s Litigation Services Group. Jay counsels clients faced with litigation or other disputes through forensics and commercial damage analyses, often serving as an expert witness. Connect with him on LinkedIn.

link

Valuation Services Bulletin: Q3 2019

Posted 12:00 PM by

In This Issue:

Tricks of the Trade in Detecting Rigged Valuations

Did you ever read a business valuation report where you knew the valuation was rigged to obtain a higher or lower value? Unfortunately, some valuation analysts manipulate the process in order to please their client and/or win at all costs. This can often happen in contentious divorce engagements.

Where to look: One place to look for evidence of rigging is in the discount rate, which has several inputs susceptible to manipulation. The size premium is one input that appears to be a good candidate for abuse. However, the size premium differs depending on the data breakdown you use and the historical time frame of the data, which can explain the difference. But where the discount rate can be manipulated the most is in the company-specific risk adjustment, which is based purely on the judgment of the expert. This is a prime area where opponents will try to detect valuation bias and try to discredit the analysis.

 

In Gatekeeper Role, Court Trains Attention on Expert Methodology, Not Conclusions

Acosta v. Wilmington Trust, N.A., 2019 U.S. Dist. LEXIS 9246 (Jan. 18, 2019)

In this ESOP litigation, both parties tried to exclude the opposing side’s valuation expert testimony under Rule 702 and Daubert. The court noted that, at this stage in the proceedings, its focus was on whether the experts applied reliable principles and methods, not on the experts’ conclusions. This case serves as an important reminder to attorneys and experts that the role of the court as gatekeeper is different from its role as evaluator of the sufficiency of the evidence (as the court in another case, Washington v. Kellwood Co., explained so well). Put differently, simply because the expert opinion is admissible does not mean it will hold up in terms of the ultimate outcome of the case.

Questioning ESOP valuation. The U.S. Department of Labor (DOL) sued the defendant trustee (and others) alleging the trustee violated its duties under ERISA by causing an employee stock ownership plan (ESOP) to purchase the outstanding stock in a graphite processing company (Graphite Sales Inc.). According to the DOL, the purchase was for greater than fair market value, which meant the trustee caused the ESOP to overpay by approximately $6 million. At the time of the transaction, an independent valuation firm appraised the company. As part of the transaction, the sellers received stock warrants that amounted to an 18% equity stake in the company. Also, two officers received stock appreciation rights, representing a 10% equity interest. Further, an investor received rights to a 7% equity stake in the company.

The crux of the case was the valuation of the company. The DOL offered expert testimony that called into question the ESOP valuator’s contemporaneous appraisal. The defendant trustee presented its own trial expert to testify and rebut the opinion of the DOL’s expert. Both parties challenged the opposing testimony under Rule 702 of the federal rules of evidence and under Daubert and its progeny. Further, the DOL argued the opposing expert opinion was inadmissible under Rule 403, which provides for exclusion of relevant evidence on various grounds (unfair prejudice, confusing the issues, misleading the jury, etc.). The court’s discussion focused on Rule 702 and Daubert.

In a nutshell, Rule 702 and Daubert provide for testimony by a qualified expert whose “scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue.” The testimony must be based on sufficient facts and data and must be “the product of reliable principles and methods.” In assessing the testimony, a court considers whether the testimony “has been tested, is the subject of peer review and publication, has a permissible error rate, follows established standards, and receives ‘general acceptance’ within a ‘relevant scientific community.’”

“At this gatekeeping stage,” the court in the instant case said, the court’s focus is “on principles and methodology, not the conclusions that they generated.”

Objections to DOL expert testimony. In trying to exclude the DOL’s expert, the defense broadly claimed the expert’s value opinion was nothing more than ipse dixit, or “I say so.” This argument, the court found, was based on the expert’s statement during his deposition that he “could not speak for the entire industry.” In other words, he suggested different valuation experts might interpret certain facts differently.

“Of course, [the expert’s] concession … does not mean that his own interpretation is made up,” the court said, dismissing the defendant’s argument.

The defendant also attacked the expert’s methodology on specifics. For example, it took issue with the DOL expert’s statement that the ESOP appraiser should have used multiples of revenue and EBITDA, not multiples of EBIT and EBITDA, in valuing the company. The defense claimed the DOL expert’s view conflicted with a cited treatise that said the expert’s proposed approach was applied most frequently to startups and service businesses, neither of which the subject company was.

“The defendant is wrong,” the court said. It noted the treatise “explicitly contemplates” use of the expert’s approach “in circumstances other than start-ups and service companies.”

Secondly, the defendant objected to the DOL expert’s claim that the ESOP appraiser erred by using the exit multiple method rather than the Gordon growth model for its discounted cash flow analysis. The defendant said the expert’s critique was wrong because treatises permit the use of either method.

“Even if true,” the court said, the defense argument does not affect admissibility because it simply contests the DOL’s expert choice among accepted valuation methodologies.

Thirdly, the defendant claimed it was improper for the expert to consider the stock warrants and appreciation rights when valuing the company. The defendant noted that the expert, in deposition testimony, “admitted” that the warrants could be considered part of financing the transaction.

The court noted that, in the same testimony, the expert pointed to another “motivation” for the warrants: They were “a form of contingent consideration” and should have been added to the purchase price, he said.

The court said that the defendant would have a chance to probe this issue at trial. However, in terms of admissibility, the defendant failed to show the expert’s view was based on insufficient facts or conflicted with accepted principles and methodologies.

Moreover, the defendant raised questions related to the DOL expert’s application of the principles and method to the facts of the case. For example, the expert criticized the ESOP appraiser’s projections. The defendant, in turn, claimed the expert failed to give proper consideration to the management projections and ignored various other pieces of financial evidence.

The court noted that none of “these purported errors” showed the DOL expert “made up” his revenue projections or used unsound methods. The defendant failed to show that accepted valuation principles compelled the expert to weigh the evidence differently or consider certain evidence, the court said.

Another defense objection was to the expert’s criticism of the ESOP appraiser’s selection of guideline companies and the latter’s choices related to the application of the guideline company method. The defense claimed the expert’s criticism contradicted the expert’s own analysis on other topics. The defendant said there was no reason to use the expert’s preferred method.

According to the court, the defendant’s objection went toward the weight of the opposing opinion, but it did not “even remotely suggest” the opposing expert’s opinion was based on an unsound methodology.

Similarly, the DOL’s expert criticized the ESOP appraiser’s use of a 10% control premium to the guideline companies’ stock. The defendant suggested that the DOL expert’s analysis of control was wrong and made his calculation wrong.

The court disagreed again, noting that this type of application error “would not show that [the expert’s] views are inadmissible.

Objection to defense expert testimony. The court quickly dismissed the DOL’s claim that the defense expert’s testimony was inadmissible because he improperly proposed a damages methodology when doing so was the role of the court.

The court noted the defense expert’s approach—comparing what the ESOP paid for the stock with the fair market value of the stock on the date of the transaction—was the same approach the DOL expert used. Further, this analysis was a legally approved methodology.

In general, the court suggested that the parties mostly quarreled over the opposing expert’s conclusions but failed to show the conclusions were unscientific—the requisite inquiry for purposes of determining admissibility of expert testimony.

Both expert testimonies were admissible in their entirety, the court found.

Editor’s Note: A digest of the above-mentioned case, Washington v. Kellwood Co., 2016 U.S. Dist. LEXIS 92309 (July 15, 2016), and the court’s opinion are available at BVLaw.

 

Divorce Court Finds No Personal Goodwill Value in Single-Owner Business

Stephanos v. Stephanos (In re Marriage of Stephanos), Case No. 502013DR007061XXXXSB, Circuit Court of the Fifteenth Judicial Circuit, Palm Beach County, Florida, J. Samantha Schosberg Feuer, Final Judgment (Dec. 28, 2018)

A Florida divorce case is noteworthy for its multifaceted goodwill analysis, which included an examination by the court of which party had the burden of establishing that goodwill was either enterprise or personal in character and was either a marital asset or not. The nub of the problem was that the husband, who held sole title to the contested company, had a damaged business reputation but still claimed any goodwill existing in the business should be attributed to him. The wife, through expert and lay testimony, was able to show all of the goodwill was enterprise goodwill. The husband was not vital to the company’s continuing existence and success. Further, the court found a noncompete analysis (or “real world transaction”) would not change the goodwill attribution.

Owner’s problems with the law. The parties first filed for divorce in 2003. They then reconciled and dropped their divorce petitions. Ten years later, in June 2013, the husband filed another petition for divorce, which, in November 2013, prompted a counterpetition from the wife. The husband was active in the hormone replacement industry. At one point, he and a business partner equally owned a company, Palm Beach Rejuvenation (PBR). However, in 2007, during the reconciliation period with the wife, the husband and his brother became targets of a federal investigation and were indicted by the state of New York. PBR was raided. The events were on the cover of Sports Illustrated in 2007.

The husband pled guilty to a third-degree felony in the state case and was found guilty, placed on probation, and prohibited from ever providing human growth hormone services to anyone in New York state. The wife gave financial support for the husband’s defense and also provided funds for the creation of a separate entity, Nationwide Synergy Inc. (NSI), which operated in the hormone replacement industry but was not a professional practice. The valuation of NSI was a flashpoint during the divorce proceedings.

The parties also argued over whether PBR morphed into NSI or essentially stopped functioning because of the husband’s legal problems. The trial court ruled that NSI was mostly a separate entity, even though the businesses shared similarities and the husband had bought PBR’s assets and opened NSI in an effort to rebrand. Besides those two entities, between 2007 and 2013, the spouses, and the husband’s brother, also created other businesses involved in hormone replacement therapy.

Importantly, the NSI stock was in the husband’s name alone. The court noted the reason for this arrangement was strategic, to protect the wife from potential legal exposure in light of the husband’s past problems regarding PBR.

The husband was CEO, and the wife served as the CFO of NSI. The evidence showed she made an initial contribution of approximately $850,000 of her nonmarital assets and dealt with the company’s financial activities. She also supervised employees and assisted in creating an important database, and she worked on developing a reputation for NSI and the other entities.

In the company’s beginning, the husband recruited salespersons and put in place people who were key to generating cash. But, once the company grew, other employees became key persons, including the spouses’ son and another employee. The latter two developed a network of physicians who performed clinical valuations of potential customers who wanted to buy the company’s products over the internet. This medical assessment became federal law in 2008. NSI’s key employees established the necessary protocol at the company.

Between 2007 and 2016 (the valuation date), the value of the company went from about zero to $5.3 million and $5.7 million, according to the valuations the parties’ highly qualified experts offered at trial.

Equitable distribution principles. The overriding issue was for the court to determine whether NSI was a marital asset that was subject to equitable distribution.

The applicable statute (Fla. Stat. § 61.075) provides for a three-step process. In essence, the court first has to classify the assets and liabilities as marital or nonmarital. Next, the court has to value the “significant” marital assets based on “competent, substantial evidence.” Under case law, a court must not simply “split the difference” between the values the parties proposed but has to “cite to specific evidence or lack thereof in the record to arrive at its conclusions.” Finally, the court must distribute the assets and liabilities under a presumption in favor of equal distribution, “unless there is a justification for an unequal distribution based on all relevant factors.” Also, under the statute, all assets a couple acquires after the date of marriage that are not specifically established as nonmarital assets are presumed to be marital assets and liabilities. This presumption may be overcome by showing that the assets are nonmarital assets.

Residual method. The court’s inquiry focused on whether there was goodwill value in the company. The question was how to calculate the goodwill value and how to determine whether it was personal or enterprise goodwill.

The applicable statutory provision (Fla. Stat. § 61.075(3)(b)) and case law require a valuation based on the fair market value standard of value.

The clearest method would be the fair market value approach, which is best described as what would a willing buyer pay, and what would a willing seller accept, neither acting under duress for a sale of the business. The excess over assets would represent goodwill. See Thompson v. Thompson, 576 So. 2d 267 (Fla. 1991) (available at BVLaw).

The court explained that Thompson was the controlling case on the issue of business goodwill in the divorce context. Thompson says that enterprise goodwill is value attributable to the company/entity as opposed to value related to the reputation or continued presence of a particular person (“the marital litigant”). In Florida, enterprise goodwill is a marital asset, whereas personal goodwill is not.

The court noted that, when it came to the overall valuation of NSI, the parties’ experts achieved a fair market value determination that was remarkably close. The difference was less than $250,000. The wife’s expert found the company was worth $5.3 million, and the husband’s expert determined it was worth $5.7 million.

The more contentious issue was the goodwill calculation. The court noted the husband’s expert suggested he was unable to extrapolate any goodwill value from the fair market value. Although it respected the expert’s opinion, the court found the claim somewhat “dubious” given the expert’s “extensive expertise and knowledge in the area of business valuation and goodwill.”

In contrast, the wife’s expert used the residual method to determine the value of goodwill, which the husband’s expert allowed was a proper approach. By subtracting the net asset value from the entity’s FMV, the expert achieved a residual value (goodwill) of $2.2 million.

Burden of proof issue. The court noted that it found no reported cases that addressed which party had the burden of establishing the value of enterprise goodwill. Here, the husband claimed that all of the goodwill at the company was personal, whereas the wife claimed personal goodwill in the company was nonexistent or negligible. Accordingly, the husband contended the wife should have the burden of showing all of the goodwill was enterprise goodwill, while the wife argued the burden was on the husband to show he was entitled to the goodwill value as he claimed it was personal to him. Both parties cited cases to support their positions. The court concluded that, since the wife claimed there was goodwill, it was appropriate that she had the burden of showing that enterprise goodwill existed—”through competent and substantial evidence”—and that, therefore, the goodwill was a marital asset.

The court rejected the husband’s position that it was impossible to extract the value of personal goodwill from the residual value. Instead, the court relied on testimony from the wife’s expert as to the purchase price allocation approach and on other testimony and factors to come to the conclusion that there was no personal goodwill attributable to the husband.

The court specifically noted that the husband was a convicted felon who was “unable to compete in certain markets”; his reputation was blemished. He could not point to any customers his efforts brought in. He had no role in developing the database or sales force, both of which were critical parts of the business. He had no relationships with the company’s physician affiliates. Further, all employees of NSI had signed noncompetes and, therefore, were precluded from aligning themselves with the husband in a similar business. In addition, members in the physician affiliate network were bound by noncompetes and confidentiality agreements to protect NSI’s intellectual property. The physicians in the network had relationships with the two key employees, not the husband. The company’s advertising did not mention the husband because the company specifically determined that, if his affiliation with the company were known, it could hurt the business. Most of the company’s revenue stream was generated by website sales; the website in turn was managed by another employee, not the husband. Any web domains and phone numbers belonged to the company and would transfer in the event of a sale.

Company employees spoke of the husband’s limited role and said they did not know what he actually did there. One key employee said that, if the husband were to leave for a year, the company would continue to function as it always had. Also, as of 2016, the husband had limited his role in the company. He was rarely in the office and only communicated sporadically via email.

There was no credible evidence that showed the husband was key to the company, the court found. It decided that the entire residual value was enterprise goodwill. This amount was a marital asset, subject to equitable distribution.

Noncompete goodwill theory. That said, the court also considered the husband’s alternate theory in support of his position that the goodwill was personal to him. He and his expert contended that, in the real world (i.e., in an actual, as opposed to a hypothetical, transaction), a buyer would only be willing to purchase NSI’s stock if the husband executed a noncompete agreement.

The court noted, however, that the ASA’s business valuation standards do not require consideration of a noncompete when calculating fair market value. The court also noted it was not aware of any precedent “from any substantive authority in this State wherein the specificities regarding value and methodology address the criteria to value a covenant not to compete in a ‘real world’ situation.” In other words, there was no specific appellate opinion addressing the valuation of a noncompete.

The wife’s expert proposed looking to Internal Revenue Service guidelines for the purpose of valuing a noncompete. The nine factors included:

  1. The seller’s ability to compete;
  1. The seller’s intent to compete;
  1. The seller’s economic resources;
  1. The potential damage to the buyer the seller’s competition posed;
  1. The seller’s business expertise in the industry;
  1. The seller’s contacts and relationships with customers, suppliers, and others in the business;
  1. The buyer’s interest in eliminating competition;
  1. The duration and economic scope of the covenant; and
  1. The seller’s intention to remain in the same geographic area. See Langdon v. Commissioner, 59 Fed. Appx. 168 (8th Cir. 2003) (citing Lorvic Holdings, Inc. v. Commissioner, 1998 Tax Ct. Memo 283 (1998).

The court said it would rely on the analysis of the wife’s expert for the calculation of value (assuming there was any) of a noncompete. Several case-specific facts were critical, including the fact that all 16 sales force members of the company had executed noncompete, nonsolicitation, and confidentiality agreements, as did the 14 “non-sales force” employees.

Further, all 32 physicians in the company’s physician affiliate network were bound by noncompetes. The company had established a proprietary database related to customers. And there was an established relationship between the entity and the patients/customers the company served.

Considering all the restrictions in place, the court found a real-world transaction analysis that centered on the existence or nonexistence of the husband’s noncompete also would not change the outcome as to personal goodwill. Under either continued presence or noncompete analysis, the goodwill value personal to the husband was nonexistent or negligible, the court concluded.

In the final analysis, the court awarded the company to the husband. For equitable distribution purposes, the court adopted the $5.3 million valuation the wife’s expert had proposed as well as this expert’s determination that goodwill in the company was about $2.2 million and was enterprise goodwill that was subject to marital distribution.

Editor’s note: Hat tip to Josh Shilts (Villela & Shilts LLC) for alerting us to this important goodwill decision.

 

Pratt's Stats/DealStats Analysis Holds Up in Divorce Litigation

Hultz v. Kuhn, 2019 Md. App. LEXIS 151, 2019 WL 852109 (Feb. 21, 2019)

A Maryland divorce case illustrates the difficulties an appraiser charged with valuing a small company in the divorce context may face and how he or she may prevail in court.

The wife was the sole shareholder in a tree services business. The issue at divorce was the size of the monetary award to the husband. Initially, neither spouse offered much valuation evidence. The trial court performed a value determination based on a recent tax return that an en banc panel overturned. At the remand hearing, both parties presented expert testimony from CPAs who had valuation credentials.

The wife’s expert found the company had a value of zero. The husband’s expert explained in detail the numerous obstacles he encountered to performing a valuation. The company did not provide all of the requested financial information and the company’s tax preparer and management did not answer most of the questions the expert had asked. The company only made available four years of tax returns and a QuickBooks file, which did not “match up” from an accounting point of view. The expert also said that, from other “tax work,” he was able to see there were accounting problems. He noted “some troubling trends regarding … revenues to operating costs … as time passed.” Sales were declining, but expenses were increasing, he noted.

The expert considered all three valuation approaches but concluded here the market approach generated the only reliable indicator of value. He made it clear that he normally would prefer to do an income analysis, but he didn’t have the necessary information and the information he received was problematic. For the market approach, he used Pratt’s Stats (now DealStats) and attained a value of about $408,000, which he decided was too high for this kind of company. In light of the company’s poor performance, he applied a “very heavy discount for lack of marketability,” i.e., 50%. He recognized the significant payroll tax liability, which would make it less likely that someone would buy the business. The DLOM reduced the fair market value to $204,000.

The trial court found it difficult to reconcile the zero value with the company’s employing 11 people, paying the employee who took over the husband’s job a $65,000 annual salary, allowing the wife to pay herself $40,000 and $50,000 in 2014 and 2015, respectively, and other factors. The court credited the opinion of the husband’s expert, noting his credentials and the detailed explanation he gave of the various valuation methods and the obstacles he faced in doing the valuation.

The state Court of Special Appeals upheld the trial court’s findings.

Takeaway: Courts may be sympathetic to an expert whose work is stymied by the other side’s lack of cooperation. Therefore, talk about it!

 

Important Utah Goodwill Ruling Concerning One-Person Business

Marroquin v. Marroquin, 2019 UT App 38 (March 14, 2019)

The Utah Court of Appeals examined the nature of goodwill in a one-person business and, in so doing, expanded on the state’s goodwill jurisprudence. The appeals court upheld the trial court’s finding that there was no institutional (enterprise) goodwill in a business that entirely depended on the owner-spouse’s efforts and reputation for competency.

Personal relationships: At issue was the value of a vending machine business that operated throughout Salt Lake City. The husband owned 99% of the business (someone else owned the remaining 1%) and was the only employee. He developed and maintained the relationships with the property owners where the vending machines and kiosks were located. Most of the contracts were month-to-month, making it easy for a property owner to replace one vendor with another.

The company was a marital asset subject to division. But the parties disagreed over the nature of goodwill related to the business. Under Utah law, enterprise goodwill is a marital asset, subject to division, but personal goodwill is not.

The trial court credited the husband’s expert, a CPA and experienced business valuator, who valued the company under the net asset approach and who determined the company had no “institutional goodwill.” The expert noted that, “without the relationships that exist for the places where the vending machines are located, there is no potential for goodwill. There’s no income earning capacity that would be in excess of the value of the assets.”

“[T]he goodwill of [the company] is solely attributable to [the husband’s] work, his efforts, and his reputation for competency,” the trial court said. The goodwill was based on the husband’s “being the face of the business” and his personal relationships with the property owners that allowed him to continue to conduct business on their property on a month-to-month basis.

The wife unsuccessfully challenged this finding in a post-judgment motion and then on appeal. The Court of Appeals agreed with the trial court that the business was essentially a kind of sole proprietorship in which the wife had minimal involvement. The husband was the one who remained in contact with the entities that enabled the business to continue operating, the appeals court noted. While the wife claimed that “anybody could step into [the husband’s] shoes and carry on with the business under its name and with its assets,” she offered no evidence to support this assertion, the court said.

The appeals court found the trial court did not abuse its discretion in finding there was no institutional goodwill to be included in the company’s valuation.

Hat tip to Daniel Rondeau (Sage Forensic Accounting Inc.) for alerting us to this important decision.

About Dan
Dan Rosio is the partner-in-charge of Katz, Sapper & Miller's Valuation Services Group. Dan advises clients on valuation, succession planning, and transaction matters, often serving as an expert witness and helping find solutions to unique challenges. Connect with him on LinkedIn

 

About Andy
Andy Manchir is a director in Katz, Sapper & Miller's Valuation and ESOP Services Groups. Andy helps clients understand the value of their business and advises them on succession planning options, including ESOP, third-party sales, or family transitions. Connect with him on LinkedIn.

link

Litigation Services Bulletin: Q2 2019

Posted 2:01 PM by

In This Issue:

 

Court Says Daubert’s ‘Gatekeeper’ Role Favors Inclusion, Not Exclusion

Ferraro v. Convercent, Inc., 2018 U.S. Dist. LEXIS 209530 (Dec. 12, 2018)

This Daubert case illustrates how courts may interpret the role of “gatekeeper” differently. The dispute featured a company that provided software-based services. The defendants claimed the plaintiff’s expert was unqualified because he lacked the necessary experience valuing that type of company, but the court found the law did not require this degree of specialized knowledge. In contrast, in Weinman v. Crowley, a bankruptcy case turning on insolvency, the court, on its own accord, found the trustee’s expert, who had extensive background in international finance and some accounting experience, lacked the necessary solvency experience. The court suggested that it would have excluded the expert on this basis had the defendant argued for it. Courts also diverge on reliability when it comes to calculating damages. Here, the court said some degree of speculation is common in expert testimony. In contrast, in a recent Texas case, Cargotec v. Logan Industries, an appeals court majority found damages testimony was not admissible because the expert relied on management projections that were based on some unfounded assumptions, notwithstanding the expert’s extensive independent work on the case.

Backstory. In 1994, the plaintiff founded a company, Group Dynamics, that specialized in complex workplace investigations. The company later changed its name to Business Controls and eventually became Convercent, the named defendant. As the company developed, it expanded the services it provided. They included the traditional web-based whistleblower services as well as investigative, consulting, and training services. In 2012, Convercent was worth approximately $6 million to $8 million. The plaintiff began to look for outside investors. The company’s then-president introduced the plaintiff to the leader of a consulting company, Nebbiolo, suggesting Nebbiolo could increase Convercent’s value.

At that time, the plaintiff did not know that Nebbiolo had only just been formed and that Convercent’s president had a personal stake in it. In 2012, the plaintiff and Nebbiolo entered into a professional services agreement (PSA) under which Nebbiolo would provide services for a fee and the ability to buy equity in Convercent. As Nebbiolo lacked the funds to buy the stock outright, it persuaded the plaintiff to accept a four-year note for $1.95 million. Nebbiolo convinced the plaintiff to surrender his role as CEO of Convercent, giving verbal assurances that he could continue to work for Convercent as long as he wished. After the plaintiff’s three-year employment contract was up, Convercent declined to renew it.

In March 2017, the plaintiff sued Convercent, Nebbiolo, and two persons who he claimed had conspired against him. The claims included wrongful discharge, breach of the employment agreement, civil conspiracy, and violations of the Colorado Organized Crime Control Act (COCCA). In an earlier ruling, the court dismissed some claims but allowed others to go forward.

The defendants then filed several pretrial motions, including a Rule 702/Daubert challenge to the plaintiff’s damages expert. The court granted the defendants’ summary judgment motion as to the plaintiff’s claim for breach of the duty of good faith and fair dealing against Convercent. But the court found that there were triable issues as to the other claims.

The court also denied the defendants’ motion to exclude the plaintiff’s expert testimony.

Applicable law. Rule 702 of the Federal Rules of Evidence provides for expert testimony if the expert’s specialized knowledge assists the trier of fact and the expert’s opinions are based on sufficient facts and reliable methods properly applied to the facts. Under Daubert, the evidence must be relevant and reliable. The party offering the expert testimony has the burden of showing the testimony is admissible. The trial court serves as “gatekeeper,” assessing the expert’s reasoning and methodology and determining whether the expert opinion is scientifically valid and applicable to the facts of the case. Here, in explaining the applicable legal principles, the court noted that, being the gatekeeper “is not a role that emphasizes exclusion of expert testimony.”

Expert testimony. The plaintiff’s expert had advanced degrees in economics and professional experience working in that field. He was retained to provide a damages calculation, which included a valuation of the plaintiff’s shares in Convercent as of the end of 2017, the year in which the plaintiff filed suit.

The defendants claimed the testimony failed all the requirements of Rule 702 and Daubert: qualification, relevance, and reliability.

Qualification. According to the defendants, the expert lacked the specialized knowledge to testify to Convercent’s value because he had never valued a software-as-a-service company.

The court disagreed, finding the expert had multiple economics degrees and had been teaching and working in the field of economics for years. He also had prepared business valuations for a cannabis company and for a medical devices company. “Defendants have not stated why a business valuation of a software-as-a-service company is any different than valuing a company in the cannabis and medical devices industry,” the court said. It further noted that, under case law, an expert’s lack of specialized knowledge goes toward the weight of the testimony but does not affect admissibility.

Relevance. The defendants contended the expert testimony was not relevant because it was incongruous with the remedy available to the plaintiff. The plaintiff could only recover the projected value of the company’s shares today before the plaintiff entered into the PSA with Nebbiolo—thus, before March 2012 (when the company did business as Business Controls). The defendants argued this remedy was mandated by the plaintiff’s claim that he would not have made the PSA agreement had he known the facts about Nebbiolo.

In the alternative, the defendants said the expert should have valued the company (then doing business as Convercent) as of 2015, not 2017.

The court rejected this argument, noting that, relative to expert testimony, “relevance” meant the testimony would have to assist the jury in its damages determination. Broadly speaking, the testimony here was helpful because the average juror was unlikely to have the knowledge necessary to value a company based on market indicators, the court observed. It also found the testimony was relevant to the damages issue in the instant case.

The court noted that, under the controlling law, the court could not require the plaintiff to pursue one remedy over another. Rather, a plaintiff alleging fraudulent inducement of a contract could request rescission of the contract to restore the conditions as they existed before the parties entered into the contract or affirm the contract and claim the difference between the actual value of the benefits received and the value of the benefits the defendant had promised.

Therefore, the plaintiff here was entitled “to affirm the PSA and seek the value of his current Convercent shares,” the court said. The expert’s testimony on this point was relevant, the court found, adding it ultimately was the jury’s decision what the appropriate measure of damages here was.

Reliability. The defendants claimed the expert opinion was not reliable because the opposing expert lacked the necessary qualifications (an objection the court rejected) and also because the expert failed to consider mitigation and other pertinent facts. Therefore, his opinion was speculative.

The court dismissed these objections as well. It noted that the defendants would have a chance to challenge the data on which the plaintiff’s expert based his calculation. The plaintiff’s expert appeared to use similar facts and data as the defendants’ expert, the court pointed out. The court said it would not preclude the plaintiff’s expert from testifying “simply because the two experts have reached a different result. This is almost always the case with opposing experts.” Disagreeing with an expert’s approach or his or her reliance on certain data “does not necessarily mean an expert’s opinion is not reliable under Rule 702,” the court said.

Finally, the court noted that there was “some degree of speculation” in the plaintiff expert’s report. However, the court also observed that “there is typically some degree of speculation in expert testimony.” Performing the role of gatekeeper here, the court said its task was to ensure the expert used a reliable methodology. The expert did so by using a market-based approach, the court found.

In sum, the court found there were no grounds under Rule 702 or Daubert to exclude the plaintiff’s damages expert.

Editor’s note: Digests of Weinman v. Crowley and Cargotec v. Logan Industries, as well as the respective court opinions, are available at BVLaw.

 

Expert’s Use of Wrong Damages Methodology Results in ‘Grossly Inflated’ Damages

Zayo Group v. Latisys Holdings, LLC, 2018 Del. Ch. LEXIS 540 (Nov. 26, 2018)

A Delaware case turned on the interpretation of key provisions in the parties’ sales purchase agreement. But the case includes a damages analysis from the court that deserves attention. The plaintiff claimed the contract required the defendant to make certain disclosures that the latter did not make. The Court of Chancery found the contract was ambiguous; however, based on extrinsic evidence, the court ruled in favor of the defendant. Although the court could have ended its discussion there, it decided to analyze in detail the damages evidence the plaintiff offered. The court noted the plaintiff’s expert lacked experience in valuing going-concern businesses. This shortcoming, the court said, showed when the expert chose a methodology for calculating expectancy damages that did not fit the facts of the case, resulting in a “grossly inflated final damages number.” According to the court, even if the plaintiff had prevailed on the liability issue, it would have lost on damages for failure to present a persuasive damages analysis.

Failure to prove liability. The plaintiff, Zayo Group (Zayo), provided high-tech infrastructure, including fiber and bandwidth connectivity, colocation, and cloud services. Colocation refers to data center facilities in which businesses can rent space to operate their software and hardware. This computing real estate usually includes physical space, cooling, power, bandwidth, and physical security for the customer’s servers and other hardware. At the time of the litigation, Zayo had acquired over 40 fiber and data center companies.

The defendant, Latisys Holdings LLC (Latisys), also offered IT infrastructure services, including data center colocation. In January 2015, Zayo and Latisys executed a sales and purchase agreement (SPA) pursuant to which Zayo bought Latisys for $675 million. The transaction closed on Feb. 23, 2015. The parties later disagreed on the meaning of certain terms in the SPA.

Latisys had two kinds of contracts with its customers: master services agreements (MSAs) and service order forms (SOFs). The SOFs drove the customer relationships; they specified the services a customer bought, including rates, recurring charges, and renewal periods. Customers often had more than one SOF to cover all the services they required. The average term of an SOF was three years. When a contract expired, Latisys would provide services on a month-to-month basis. When a customer relationship had reached the “month-to-month” phase, the customer could terminate its services with Latisys within 30 days of written notice. Thirty percent of Latisys’ revenue was guaranteed only for 30 days.

The average period of Latisys’ SOFs was about four and a half years. Typically, as time went on, customers relied less on Latisys’ services and required less storage space. In negotiating a renewal for an expiring SOF, customers often were successful in extracting concessions from Latisys.

In November 2014, Zayo submitted a letter of interest to acquire Latisys, proposing “a total value in the range of $625M - $655M in cash (approximately 11 – 11.5x Q4 2014E LQA Adjusted EBITDA of $56.8M) on a cash-free, debt-free basis.” For purposes of due diligence, Latisys sent Zayo a spreadsheet that listed each customer (but not by name), the contract with the customer, expiration dates, and recurring revenue by location and product. The spreadsheet included information regarding bookings and loss from turnover (churn) for 2013 and 2014. Zayo received all the MSAs and SOFs for Latisys’ top 30 customers by monthly recurring revenue (MRR).

A Zayo’s financial analyst working on the deal developed a financial model that calculated how many months of revenue were left on the contract for each of the customers and how much revenue was guaranteed for the customers. The eventual dispute centered on five customers. Latisys initially identified them by code name but provided a key to the names in early January 2015.

Around Christmas 2014, Zayo sent a letter of intent in which it proposed a base acquisition for $655 million. Among other things, Zayo wanted to change one of the SPA provisions to include the following sentence: “No Latisys Company has received any written notice that any party to Material Contract intends to cancel, terminate, materially modify, refuse to perform or refuse to renew such Material Contract.” (emphasis added)

Latisys accepted all of the proposed language but struck the phrase “or refuse to renew” from Zayo’s draft. Zayo returned the redline to Latisys, accepting Latisys’ change. Zayo then performed a number of calculations, including a synergies analysis, which indicated significant cost saving as a result of the deal. Zayo also undertook a comparable analysis that indicated “recent comparable transactions” at “13.6 X Avg Reported LQA EBITDA Mult.” Moreover, Zayo’s financial analyst performed a 30-year discounted cash flow analysis, a net present value sensitivity analysis, and an internal rate of return analysis.

In the end, the parties settled on a price of $675 million. Latisys also agreed to indemnify Zayo for losses stemming from various breaches, assuming cumulative aggregate damages exceeded $3.375 million (the basket). The final SPA did not make representations or include warranties as to churn, churn rates, revenue, or expected revenue.

In late 2016, Zayo sued Latisys in the Delaware Court of Chancery, demanding indemnification for damages resulting from breaches of representations, warranties, and covenants included in the SPA.

Zayo claimed that Latisys failed to disclose that five customers had notified Latisys of their intent not to renew their contracts or renew the contract under different terms. Zayo contended Latisys had an obligation under the SPA to disclose this information. According to Zayo, nonrenewal of certain contracts was captured by the terms “terminate” or “cancel,” which appeared in the SPA. Latisys responded that, under the specific language of the SPA, it had no obligation to disclose the nonrenewals to Zayo.

In ruling on the liability issue, the court found the SPA was ambiguous in that both parties’ interpretations of the contractual language were reasonable. To resolve the dispute, the court then considered extrinsic evidence, including the drafting history of the SPA, the sales negotiations between the parties, and trial testimony as to the parties’ understanding of what representation Latisys would or would not have agreed to when negotiating with Zayo. A Latisys representative testified the phrase “refuse to renew” suggested an allocation of risk between the buyer and the seller. This language would make the seller liable to the buyer for undisclosed upcoming churn. According to the witness, Latisys purposefully did not include this language in the contract because it would impose on the company an unreasonable obligation to isolate and disclose potential nonrenewals. The court concluded extrinsic evidence supported Latisys’ interpretation of the SPA. Latisys did not commit a breach of contract as to any of the five customers. There was no liability.

Benefit-of-the-bargain method. The court’s liability conclusion meant the end of the plaintiff’s case. However, “for the sake of completeness,” the court also considered whether the plaintiff would have been able to prove recoverable damages.

The court explained that the standard was high: The plaintiff had to prove damages by a preponderance of the evidence. “Contract damages are not like some works of abstract art; the plaintiff cannot simply throw its proof against the canvas and hope that something recognizable as damages emerges,” the court said. It added that this case, in particular, required precise calculations because the contested SPA had an indemnification provision. Zayo would only qualify for damages exceeding the basket, i.e., the cumulative aggregate amount of $3.375 million.

The court said the plaintiff’s expert was “certainly qualified to calculate damages in the ordinary course.” However, the expert acknowledged that she had never valued a business. This lack of valuation experience “proved a disadvantage to her and ultimately rendered her opinions in this case unpersuasive,” the court said. It pointed out that the defense expert had “significant experience in benefit-of-the-bargain damages and business valuations,” including experience serving as an expert in post-transaction disputes related to representations and warranties made in sales and purchase agreements. The defense expert testified that, “to the extent the damage is derived by an alleged change in the value of what the deal should have been, then, of course, the valuation experience is pretty critical.”

The plaintiff’s expert based her expectancy damages on a multiple (14.1) of EBITDA, but this methodology was inappropriate under the facts of the case, the court said.

Expectancy (or “benefit-of-the-bargain”) damages seek to capture the difference between the as-represented value of the purchase price and the value the buyer actually received, the court explained. “The actual value the purchaser received, in turn, must assume, and account for, a diminution of the company’s earnings into perpetuity,” the court said. It further noted that the benefit-of-the-bargain methodology is only appropriate if the alleged breach causes a permanent diminution in the value of the business (lost revenues into perpetuity) and the business has been permanently impaired.

The court noted that, in deposition testimony, the plaintiff’s expert acknowledged as much. She said that this method was only appropriate where there was a loss of monthly recurring revenue “into the foreseeable future.” She defined “foreseeable future” as “one year.” At trial, she admitted that all the contested contracts expired in less than one year. She recognized that, if Zayo knew that a contested contract was in the month-to-month phase, the maximum amount a customer would be liable for would be 30 days of revenue.

The court noted that Zayo made no attempt to prove diminution of value into perpetuity; nor did its expert, by her own admission, perform a post-closing valuation of Latisys. In contrast, the opposing expert reviewed the plaintiff’s internal calculations of value and found the plaintiff, in effect, believed the value of Latisys actually increased after the deal closed. In other words, the acquisition resulted in positive returns on the plaintiff’s investment.

The court also noted there was no support in the record for the plaintiff expert’s testimony that Zayo would not have paid $675 million for Latisys had Zayo known about the renewal situation.

The court said it could “appreciate why Zayo may have avoided taking on the challenge of proving that Latisys was worth less ($22 million less to be precise) after Closing.” Zayo knew it was buying a business based on short-term contracts, with customer loyalty somewhere between four and five years, the court observed. The contested contracts expired in less than a year from the time Zayo was considering an acquisition of Latisys. If the contracts were near expiration or in the month-to-month phase at the closing of the deal, Zayo was not in a position to claim expectancy damages beyond one month of monthly recurring revenue, the court pointed out.

Additionally, the court noted that there was no evidence that Zayo based its purchase price on a multiple of EBITDA, as Zayo’s damages expert did for her calculation. Therefore, “it is difficult to understand why [the expert] would choose an EBITDA multiple as the most accurate and comprehensive metric for valuing damages.” A Zayo executive in testimony explained that the sales price was based on a number of different factors. The court said it was unsurprising that the plaintiff’s expert later struggled to explain why she selected 14.1 as the EBITDA multiple in her calculation. The damages calculation lacked any foundation in the evidence, the court found.

On the other hand, the court found the defendant’s expert proposed several damages scenarios that were credible. All the calculations showed that, under the SPA’s indemnification clause, the realized damages would not exceed the $3.375 million base amount. The court said it found most persuasive an out-of-pocket cost analysis for lost revenue through the remaining contract term of each of the contested contracts for the five customers. This defense calculation was based on the assumption that the customers would renegotiate contracts after the expiration of the existing contract based on the state of the market. The calculation achieved a total damages amount of $2.1 million, below the required $3.375 million.

The court observed that a calculation that considered damages for a period longer than the remaining terms of the contested contracts produced a total damage amount of $3.4 million, a number that was only slightly above the indemnification threshold. “[A] damages calculation that assumes Zayo would have realized revenue beyond the bargained-for SOF does not comport with the evidence of record,” the court said, pointing to market reality and the need for service companies often to offer significant price concessions to customers.

In a last-ditch effort to advocate for benefit-of-the-bargain damages, the plaintiff claimed that the AICPA Practice Aid considered those damages appropriate where “a buyer’s subjective expectation has been materially affected.”

Not so, the court said. Defense expert testimony as well as the AICPA Practice Aid confirmed that a multiples methodology for calculating damages was only appropriate “where there is a permanent impairment to the value of the business and the value the buyer receives is less than the value for which the buyer bargained.”

The Court of Chancery found that, even if the plaintiff had met its burden of proving liability, it would have been unable to prove damages. The defendant’s expert provided the only credible damages evidence, and it showed that the plaintiff had not suffered damages above the amount to which the parties had stipulated in their indemnification agreement, the court concluded.

 

Court Concludes Plaintiff Cannot Satisfy Three-Part New York Lost Profits Test

MY Imagination v. M.Z. Berger & Co., 2018 U.S. Dist. LEXIS 184346 (Oct. 29, 2018)

A contract case that was subject to New York law provides a helpful review of the test a plaintiff must meet to qualify for lost profits. Here, the plaintiff’s case was poorly litigated and ultimately made it impossible for the plaintiff to advocate for lost profits. On the record, the plaintiff initially conceded that it was a new business with no track record and that lost profits or lost opportunities damages would be speculative. Later efforts to walk back these statements were unsuccessful. The court also found flawed the plaintiff expert’s methodology for calculating lost profits. The expert seemed unaware of key facts and relied blindly on statements from the plaintiff as to possible sales and profit margins, the court noted. This case illustrates how a damages case falls apart when it lacks a consistent damages theory, the participants are not on the same page, and the expert is not fully informed of the facts and the record.

Litigation history. The plaintiff, MY Imagination, was a new stationary company that wanted to enter the school supply market. For this purpose, it bought the assets of the defendant, M.Z. Berger, a well-established consumer-goods wholesaler. The defendant had a number of valuable license agreements including ones with LEGO, Universal Studios (Universal), and One Direction, a very successful English-Irish pop boy band.

The plaintiff claimed that, under the parties’ asset purchase agreement, which was governed by New York law, the defendant had agreed to make “commercially reasonable” efforts to help the plaintiff in transferring those licenses. Also, the plaintiff said, the defendant had promised to leave the stationary industry.

After the sale, the parties’ relationship broke down. The plaintiff obtained the LEGO license, the most lucrative license, but not the others. The record showed that there was a dispute between the plaintiff’s principals as to whether to pursue other licenses. For example, the plaintiff twice turned down a licensing agreement with Nickelodeon. A Universal representative later testified that Universal decided on its own not to transfer the stationary license from the defendant to the plaintiff.

In suing the defendant, the plaintiff brought contract and tort claims, alleging the defendant breached the asset purchase agreement. The federal district court adjudicating the case granted the defendant’s summary judgment motion as to all claims. Regarding the contract claims, the court found the plaintiff failed to prove actual damages.

The plaintiff appealed the findings with the 6th Circuit Court of Appeals, which affirmed the dismissal of the tort claims but reinstated the contract claims. The appeals court found there were genuine issues of fact as to: (1) whether the defendant made “commercially reasonable” efforts on behalf of the plaintiff; and (2) whether the defendant, after selling its goodwill, solicited former retail customers on behalf of Universal’s new product line.

In addition, the 6th Circuit noted “the [district] court’s emphasis on actual damages was misplaced. In New York, nominal damages are ‘always available for breach of contract.’” It sent the case back to the district court.

Inconsistent damages theory. In deposition testimony, the plaintiff’s two principals admitted that it was difficult to predict how much profit the plaintiff would reap from a particular license. Importantly, in a court brief, the plaintiff conceded:

Here, Plaintiff was a new business with no established history and approval of specific license transfers would be difficult to establish. Under these circumstances, due to the admittedly speculative nature of Plaintiff’s damages relative to lost profits or lost business opportunities, rescissory damages are an available, appropriate and proper measure of damages for Breach of Contract.

On remand to the district court, the plaintiff suddenly asked for lost profits and presented expert testimony to support its position. In response, the defendant filed another summary judgment motion, arguing the plaintiff was unable to meet the legal requirements for lost profits and asking the court to limit the remedy to nominal damages.

The court found the expert testimony unreliable and ruled for the defendant.

Applicable law. The court explained that, under the applicable New York case law, the party seeking lost profits has to satisfy a three-part test. See Kenford Co. v. County of Erie, 67 N.Y.2d 257 (1986) (available at BVLaw).

Causation. In the controlling Kenford case, the New York high court said the plaintiff first has to show causation. Put differently, the plaintiff has to establish a causal connection between the alleged wrongdoing and the alleged harm to the plaintiff.

Here, the court explained the plaintiff had to show on a license-by-license basis that, “but for” the defendant’s alleged failure to make “commercially reasonable efforts” to transfer the individual licenses, the plaintiff would have obtained them. The court noted the defendant never guaranteed the licenses would be transferred.

In addition, the plaintiff had to show that the defendant’s alleged solicitation of former retail customers directly caused the plaintiff to lose business.

The court observed that the plaintiff failed to take discovery from any licensor other than Universal. The plaintiff could not point to any statement that, “if [the defendant] had done X, then Licensor A would have transferred the license to [the plaintiff],” the court said. As regards Universal, at deposition, the plaintiff never asked the witness what impact the defendant’s “commercially reasonable efforts” at the relevant time might have had on Universal’s decision, the court added.

Based on the record of the case, the court said to conclude that a license would have transferred, but for the defendant’s conduct, and that the plaintiff would have accepted a particular license, was nothing more than speculation. The plaintiff failed to meet the causation requirement.

Reasonable certainty. Secondly, the plaintiff had to show lost profits with “reasonable certainty.” This requirement has particular importance when the plaintiff is a new business, the court pointed out. The bar in effect is higher because there is no “reasonable basis of experience upon which to estimate lost profits with the requisite degree of reasonable certainty,” the court explained (citing Cramer v Grand Rapids Show Case Co., 223 N.Y. 63 (1918)).

The court further noted that expert testimony was necessary to establish that lost profits damages were “capable of measurement based upon known reliable factors without undue speculation” (citing Schonfeld v. Hilliard, 218 F.3d 164 (2d Cir. 2000) (available at BVLaw).

The court found the plaintiff’s expert was unable to do so. He did not offer an “advanced and sophisticated method for predicting the probable results of contemplated projects,” the court said (citing Kenford). Instead, the expert relied on the plaintiff’s projections and interviews with the principals, ignoring the fact that those principals on the record had admitted that lost profits would be speculative.

Further, the expert used the defendant’s 2013 sales data but applied a profit margin from the plaintiff’s 2014 projection of sales. He also failed to consider that not every license would be transferred. In doing so, he contradicted the record, which showed that Universal, on its own, had declined to transfer its license to the plaintiff and that the plaintiff, on its own, twice had declined a license with Nickelodeon, the court said.

New York courts have found that relying on what the plaintiff thinks “might” have happened fails to meet the applicable test, the court noted. Here, the expert assumed a profit margin based on the plaintiff’s representations that it would have sales of $25 million in 2014 and its profit margin would increase over that of the defendant. The expert also seemed unaware of actual sales data as to the important LEGO license, the court noted. Ultimately, his calculation assumed a series of transactions—all hypothetical—would occur. This approach “constitutes precisely the sort of conjecture that the reasonable certainty standard prohibits,” the court said.

The court also rejected the expert’s alternate, more conservative, calculation that was based solely on the Universal license. The court said the plaintiff never asked for actual sales figures from any licensee, including Universal, or any customer (such as Target or Walmart).

In a footnote, the court dismissed the plaintiff’s late claim that it was not a new business because its principals were “experienced business men with extensive familiarity with product licensing.” The court pointed out that the plaintiff’s expert in his report said the plaintiff was a “new business.” Further, the 6th Circuit earlier also found the plaintiff was a “new stationary company.”

Parties’ contemplation. Thirdly, the applicable test required the plaintiff to show that the parties contemplated lost profits as a remedy for breach of contract. Here, the parties disagreed over whether the asset purchase agreement provided lost profits.

For its current ruling, the court said it did not have to resolve this issue because the plaintiff failed to meet the other two requirements for lost profits.

Nominal damages. The court noted that, under New York law, the plaintiff was limited to nominal damages assuming it could show liability, i.e., the defendant breached its obligations under the controlling agreement.

Futile course change. The court noted, and dismissed, the plaintiff’s efforts to “down play the statements in the record in which it conceded that lost profits are not a viable damage theory and statements indicating that [the plaintiff] was a new business entity.”

The court pointed out that in those very statements the plaintiff admitted that it was: (1) a new business; (2) had no history of sales; (3) could not establish which, if any, of the licenses would transfer; and, most importantly, (4) conceded that any lost profits were speculative.

The court also rejected the plaintiff’s claim that the defendant failed to address the plaintiff expert’s theory for loss of business value. In actuality, the court said, the expert did not present a loss of business value calculation. Instead, the expert said that, under the circumstances, “a short horizon lost profits calculation is more appropriate than a calculation of business value based on long-term projections.”

For all of these reasons, the court granted the defendant’s summary judgment motion, finding that lost profits were not a remedy available to the plaintiff.

 

Daubert Ruling on How to Satisfy Apportionment When Using Benchmark Licenses

Bio Rad Labs. v. 10X Genomics, Inc., 2018 U.S. Dist. LEXIS 187897 (Nov. 2, 2018); Bio Rad Labs. v. 10X Genomics, Inc., 2018 U.S. Dist. LEXIS 167104 (Sept. 28, 2018)

A short but insightful Daubert opinion sheds light on how a damages expert may meet the apportionment requirement where the expert uses benchmark license agreements to develop a reasonable royalty. For purposes of admissibility, the issue in this case was whether the plaintiffs’ expert could assume the prior licenses apportioned for patented and unpatented features, as the plaintiff initially claimed or, as the defendant would have it, whether the expert had to quantify the value of the patented features to the licensed product in the benchmark licenses and show the apportionment was comparable to the value assigned to the patented features in the accused product. The court here found a middle ground.

Background. The plaintiffs alleged that the defendant’s “10X Genomics platform” had violated a number of their patents having to do with “methods for conducting an auto catalytic reaction in a microfluidic system.”

Both parties raised Rule 702 and Daubert challenges to the opposing expert’s damages testimony. The accused products had patented and unpatented features.

The court, in its earlier opinion, admitted the defense expert’s reasonable royalty analysis, but it rejected the plaintiff expert’s lost profits calculation, assuming a two-supplier market. The court found the expert had failed to support his analysis with economic or financial data but had relied on qualitative evidence only.

The plaintiffs’ expert also calculated a reasonable royalty. He relied on three benchmark licenses to determine a royalty rate the parties would agree on in a hypothetical negotiation. The court found the expert made a “showing of baseline comparability between the licenses.”

At the same time, the court found the analysis failed the apportionment requirement. Specifically, the court objected to the expert’s superficial analysis, which asserted, without more, that the benchmark licenses had apportionment “built in,” such that the parties making the agreements would have apportioned for the contribution of the patented feature to the protected products. Therefore, the expert suggested, no further apportionment analysis was necessary.

In its earlier ruling, the court noted that, even assuming the parties to the benchmark agreements dealt with the apportionment requirement in calculating a reasonable royalty, did not show the same royalty rates applied in the instant case. By way of example, one comparable agreement might use a 15% reasonable royalty in a situation in which the patented technology accounted for 50% of the product. Another comparable agreement might use a 3% royalty where the patented technology accounted for 10% of a different product. While there was no doubt that the agreements incorporated apportionment, further analysis was necessary to show that either rate was apportioned in a comparable way to the value of the patented technology to the accused product(s), the court said. See Bio Rad Labs. v. 10X Genomics, Inc., 2018 U.S. Dist. LEXIS 167104 (Sept. 28, 2018).

Although the court rejected the expert’s reasonable royalty calculation, it allowed the plaintiffs to supplement the expert report.

Subsequently, the issue was whether the expert’s supplemental report adequately addressed the apportionment issue for admissibility purposes. The court found it did.

Applicable legal principles. The court explained that Rule 702 imposed a trilogy of requirements: qualification, reliability, and relevance (fit). Under the qualification prong, the witness must qualify as an expert by way of “a broad range of knowledge, skills, and training.” Reliability requires the expert testimony to be based on the “methods and procedures of science” rather than “subjective belief or unsupported speculation.” Relevance or fit means the testimony has to be helpful to the trier of fact when deciding the issues in the case.

Apportionment is a cornerstone of patent infringement cases. It seeks to ensure the patent holder is compensated for the infringement that can be attributed to the patented feature, and not more.

‘Approximation and uncertainty.’ In the supplemental report, the plaintiffs’ expert compared the unpatented features of the accused products with what he considered to be the unlicensed features of the products at issue in the benchmark licenses. He determined that there were unlicensed features analogous to the unpatented features. He also found the relative value of the licensed technology to the licensed products was comparable to the relative value of the patented technology to the accused product. He concluded that the royalty rates in the comparable licenses were apportioned in a comparable fashion to the royalty rate in the hypothetical license.

The defendant argued the opposing expert relied on qualitative rather than quantitative analyses and therefore did not satisfy the apportionment requirement.

The court disagreed, noting the defendant’s argument conflicted with a general principle that “any reasonable royalty analysis necessarily involves an element of approximation and uncertainty.” Also, the court said, “it may be impossible to quantitatively determine the exact percentage of a royalty rate that corresponds to each component of a licensed product.”

The court said it found the following commentary accurate:

The challenge is that apportionment is inherently imprecise. There’s never going to be a perfect basis to apportion … Licensors and licensees are not doing [rigorous scientific analyses] to decide the royalty rate. They negotiate based on their perception of the value being contributed—based on a lot of qualitative information typically … To require that sort of level of scientific discipline, (a) increases the cost of every case, and (b) divorces us from real life.

The court concluded that the plaintiff expert’s supplemental report filled the analytic gap in his initial report, “at least to the extent necessary to make his reasonable royalty opinion admissible.” The court allowed the reasonable royalty testimony into evidence.

 

Court Rejects Expert’s Reliance on Other Celebrity Royalty Agreements to Develop Damages Analysis

Olive v. General Nutrition Centers, 2018 Cal. App. LEXIS 998 (Nov. 2, 2018)

In a California intellectual property case, a model/actor/professional athlete sued General Nutrition Centers (GNC) over the unauthorized use of his likeness. The plaintiff retained three damages experts, including an expert in branding, licensing, and valuing intellectual property and an expert for quantifying damages. The trial court found both of these experts’ opinions inadmissible, saying the analysis was “nearly data free and methodologically primitive.” The appeals court agreed. Among other flaws, the court found the expert opinions were based on “speculative assumptions,” including an unsubstantiated assumption that a causal connection existed between the company’s revenue increase and the unauthorized use of the model’s image.

Limited use of image. The plaintiff was Jason Olive. His modeling career peaked in the mid-1990s, when he earned up to $25,000 per day working on campaigns for Ralph Lauren, Versace, Armani, and other brands and magazines. Olive later turned to acting. He also was a professional volleyball player.

The defendant was GNC, a retailer and manufacturer of vitamins and nutritional products with roughly 8,000 retail stores. In 2010, GNC undertook a “Live Well” advertising campaign for which it wanted models who were, among other things, “everyday relatable people.” The plaintiff and about 15 other people were hired for a one-day photo shoot. The plaintiff executed a “Photograph and Likeness Release” that gave GNC the right to use and reuse his “image and likeness and photograph to be taken at the photoshoot scheduled for September 24, 2010.” The plaintiff was paid $4,000 for the three-hour shoot and also received an $800 agent fee. The release was for one year from GNC’s first use in print media. GNC had the unilateral right to agree to a one-year renewal for the same amount of compensation. GNC’s right to use the plaintiff’s likeness expired sometime in late 2011 or early 2012.

Later, in November 2010, the plaintiff executed a second release that allowed the defendant to use his image and likeness on print media displayed on any company trucks and other vehicles in North America. The plaintiff received $8,000 in compensation. The contract was valid through Dec. 31, 2021.

GNC used the plaintiff’s image sometime in January 2011 in various settings: outdoor billboards, bus shelters, kiosks, social media websites, direct mail advertising, in-store posters, and signage. The plaintiff said he believed he had agreed to a “very small job” given the small fee he obtained and that he was “shocked” and “angered” over the far-reaching use of his image.

Later, GNC failed to keep track of the expiration of the model release agreements. While it eventually negotiated extensions with every model that participated in the September 2010 campaign (paying between $7,500 and $32,000 for five-year extensions), it failed to obtain a release extension from the plaintiff. Sometime in late 2012, GNC offered the plaintiff $150,000 for such an extension, which he rejected. Instead, he sued. GNC removed his image from any marketing materials at the end of 2012, incurring about $350,000 in take-down expenses.

In his lawsuit, the plaintiff alleged common law and statutory misappropriation of likeness (Cal. Civ. Code § 3344.1). He also claimed unjust enrichment and sought disgorgement of any profits GNC had made from the unauthorized use of his image. He asked for over $23.5 million in damages. Before trial started, GNC admitted liability; it recommended damages of $4,800.

Expert testimony wants data and science. In a pretrial motion, GNC asked the trial court to exclude the testimony of two of the three experts the plaintiff designated to testify to GNC’s profits attributable to the misappropriation.

Expert 1 was to testify to actual damages and to apportionment—how much of the defendant’s profits was attributable to GNC’s misappropriation of the plaintiff’s likeness. Expert 2 was to calculate the defendant’s revenue, expenses, and profits. He also was to perform an apportionment analysis and give an opinion on whether the defendant had committed fraud or intentional misconduct. (The plaintiff initially proposed testimony by a third expert, but it’s not clear from the court’s opinion what the purpose of this testimony was. Ultimately, the plaintiff did not call this witness.)

In challenging Expert 1’s testimony, GNC argued the opinion was speculative and lacked a foundation and an objective methodology. Expert 2’s testimony was inadmissible because it relied on Expert 1’s defective analysis, GNC contended.

Expert 1. In the relevant year, 2012, GNC’s revenue was approximately $2.4 billion. Expert 1 claimed that 1% to 3% of the revenue was attributable to the infringement. He said his conclusion was based on a review of royalty agreements for various other celebrities, including, for example, George Foreman, Kathy Ireland, Barry Bonds, Michael Jordan, Alex Rodriguez, and Tyra Banks. He also claimed GNC’s president and CEO had admitted in his deposition that at least 1% of the company’s revenue resulted from in-store advertising. Further, Expert 1 said GNC’s revenue increased during the subject period. He noted that the median compensation for a celebrity endorsement was 5% but believed a more conservative figure was appropriate in this case.

Expert 1 also determined that actual damages for the plaintiff were between $500,000 and $1 million for 2012 and $1 million for 2013. He based these figures on a statement from the plaintiff that he would not work for any less compensation as well as on testimony from the plaintiff’s agent that the minimum fee acceptable for the plaintiff would have been in the “high six figures.” Further, Expert 1 considered a list of earnings of top male models that appeared in Forbes magazine.

Expert 2. Expert 2’s quantification of damages relied on Expert 1’s opinion that 1% to 3% of the defendant’s profits were attributable to the misappropriation. Expert 2 acknowledged that he did not perform an independent calculation, noting that Expert 1 had “a long track record” as well as a reputation as an expert in branding, licensing, and intellectual property valuation. Expert 2 said he had met Expert 1 and reviewed the work Expert 1 had done, “so I would feel comfortable with it.”

The trial court rejected both expert opinions, saying they were based on “mere wishful thinking” rather than science and data. Expert 2’s opinion was “directly tethered” to Expert 1’s inadmissible determination opinion; therefore, Expert 2’s opinion was inadmissible. Further the issue of fraud and intentional misuse of the plaintiff’s image was not the proper subject of expert testimony. Therefore, Expert 2 was not able to testify on this point.

A jury ultimately awarded the plaintiff about $1.1 million in damages, including $213,000 in actual damages and $910,000 for emotional distress. The jury found the plaintiff had not proven that any of GNC’s profits were attributable to the unauthorized use of his image. Also, the jury found GNC had not acted with malice or committed fraud.

The trial court itself ruled for GNC on the unjust enrichment claim. But the court denied GNC’s post-trial motions for a new trial and judgment notwithstanding the verdict on the emotional distress award.

Analytical gap ‘too great.’ The plaintiff appealed the verdict on various grounds. It argued the trial court improperly applied the germane statute. Moreover, the trial court’s exclusion of the damages experts was an abuse of discretion.

Regarding the first argument, the plaintiff said the trial court erred by failing to instruct the jury correctly on the burden each party had in determining damages related to the defendant’s profits resulting from the misappropriation of the plaintiff’s likeness. According to the plaintiff, the defendant had the burden of proving the amount of its gross revenue that was not attributable to the use of the plaintiff’s likeness. The trial court failed to provide the jury with an instruction to this effect.

The California Court of Appeal disagreed, noting the statutory language was “clear and unambiguous,” requiring the plaintiff (“injured party”) to prove the gross revenue attributable to the defendant’s unauthorized use of the plaintiff’s likeness and requiring the defendant to prove his or her expenses. The appeals court said the approach the plaintiff proposed would turn “that statutory language on its head,” in that it would require the defendant first to prove total gross revenue to determine what portion was not attributable to the infringement. What’s more, this approach “would create the absurd result of effectively placing on each party the burden to prove the same disputed fact [revenue attributable to infringement].”

Regarding the admissibility of expert testimony, the Court of Appeal explained that, under the applicable California law, the trial court, as the gatekeeper, may exclude expert testimony if the court determines that the expert opinion is based on the type of matter on which an expert may not reasonably rely; the expert opinion is based on reasons that are not supported by the material on which the expert relies; or the expert opinion is based on speculation or conjecture. See Sargon Enterprises, Inc. v. University of Southern California, 55 Cal. 4th 747 (2012). Further, the trial court may conclude that the analytical gap between the expert’s data and his or her opinion “is simply too great” and may exclude the opinion as speculative or irrelevant. Ibid. In general, the trial court “must simply determine whether the matter relied on can provide a reasonable basis for the opinion or whether that opinion is based on a leap of logic or conjecture.” Ibid.

The Court of Appeal found none of the reasons Expert 1 gave for attributing 1% to 3% of the defendant’s revenue to the infringement were persuasive. The celebrity royalty agreements Expert 1 relied on to support his opinion were not comparable, the court said, noting the plaintiff did not share “anywhere near the same degree of celebrity as those included in [the expert’s] sample.”

Also, the plaintiff’s agreement with the defendant was nothing like the referenced celebrity agreements, the court found. The expert compared the limited use of the plaintiff’s image from one photo shoot to much more extensive licensing agreements that included the celebrity’s name, signature, voice, initials, endorsement, and copyright. The appeals court dismissed the expert’s claim that the plaintiff became the spokesperson for the company—the “face of the brand” that “finally resonated with everyone.” The court emphasized that the plaintiff “was not the company spokesperson, and the use of images taken from a photo shoot with 15 other models is in no way analogous to a comprehensive celebrity endorsement arrangement.” It is not proper for an expert to base his or her opinion “upon a comparison of matters that are not reasonably comparable,” the Court of Appeal said.

The appeals court also found that, in order to support his claim that 1% of revenue stemmed from the misappropriation, Expert 1 “mischaracterized a statement from GNC’s President and CEO.” The executive, when asked what drove sales, said that in-store marketing had “the least amount of value of anything I’ve told you in regards to whether a consumer buys a product.” When pressed for a percentage, he said it was very little—”I’ll go zero to one.” Also, the executive never apportioned revenue between the Live Well campaign for which the plaintiff’s image was used or other in-store marketing efforts, and he did not apportion between the plaintiff and other models used in the Live Well campaign, the Court of Appeal pointed out.

In addition, the court noted the expert asserted a causal connection between the company’s annual sales increase and the infringement but did not identify “any reliable evidence linking the two, such as data from a focus group.” The court said he did not consider “the macroeconomic conditions” that prevailed during the relevant period, such as the company’s pricing promotions, general sales in the vitamin and supplement industry, other marketing efforts, and “the impact of professional athletic ‘ambassadors’ used by GNC.” The court found the analysis was “conclusory” and as such speculative. The testimony was inadmissible as it would not have reasonably assisted the jury. The trial court did not err in finding the analytical gap between the data the expert used and the opinion he submitted was “simply too great,” the Court of Appeal concluded.

‘No independent evidentiary value.’ In appealing the exclusion of Expert 2’s testimony, the plaintiff seemed to argue the trial court failed to perform an independent review of the expert’s testimony and as such erred.

The Court of Appeal disagreed. It noted that expert testimony may rely on information from others as “long as the information is of a type reasonably relied upon by professionals in the relevant field.” But this expert testimony is only of value if the source is reliable, the court explained.

Here, Expert 2’s opinion hinged on Expert 1’s speculative assumptions. Expert 2 did not perform any investigation to ensure Expert 1’s information was reliable. For example, Expert 2 did not know how Expert 1 chose his sample of royalty agreements. Expert 2 did not independently determine whether the sample was appropriate. He did not ask Expert 1 how the latter ruled out other persons in the sample, and he did not ask Expert 1 “about the parameters for his sample database.” At the same time, Expert 2 said he was “very comfortable” with the way in which Expert 1 performed his analysis, the appeals court observed. Expert 2 also did not offer “compelling evidence” that the misappropriation of the plaintiff’s likeness directly caused an increase in company sales, the appeals court said. In sum, Expert 2’s opinions had “no independent evidentiary value” and therefore were properly excluded.

The Court of Appeals did, however, find the trial court erred when it decided neither party prevailed (noting that both sides were visibly unhappy with the jury verdict) and denied the plaintiff’s motion for attorney fees. The court noted that, even though the plaintiff recovered less than 10% of the maximum damages he sought, the award to the plaintiff was much higher than the defendant’s proposed $4,800. The plaintiff prevailed on a “practical level,” the court said. Therefore, he was entitled to attorney fees under the applicable statute, the Court of Appeal ruled.

About Ron
Ron Lenz is the partner-in-charge of KSM’s Litigation Services Group.  He advises clients and attorneys in matters of financial litigation and often challenges assumptions to help clients obtain the best possible litigation outcome. Connect with him on LinkedIn.
 

About Jay
Jay Cunningham is a director in KSM’s Litigation Services Group. Jay counsels clients faced with litigation or other disputes through forensics and commercial damage analyses, often serving as an expert witness. Connect with him on LinkedIn.

link

Valuation Services Bulletin: Q2 2019

Posted 1:39 PM by

In This Issue:

Simplified MUM Approach Weathers Attacks in Illinois Divorce Case

In re Marriage of Preston, 2018 Ill. App. Unpub. LEXIS 1281 (Aug. 1, 2018)

One of the key questions in an Illinois divorce case was how to allocate goodwill between enterprise and personal goodwill. One expert used the “with-and-without” method; the other used the MUM approach in a simplified version. The latter prevailed. Although the appellate court’s opinion is unpublished, valuators should take note because the court’s discussion of the dispute over the validity of MUM reflects an ongoing debate in the valuation community.

At issue was the value of a company offering design assistance and engineering services as well as machining and molding assembly. The husband was the sole shareholder and, by the wife’s admission, the “key guy” at the company. Both sides retained seasoned, credentialed business appraisers who used a similar methodology to value the company, weighting the results of the income and market approach. But the analyses diverged in a number of respects, including the approach for determining the value of goodwill attributable to the husband—a value that was not marital property and therefore excludable from the company’s overall value.

The wife’s expert used the “with-and-without method,” comparing the company’s projected cash flow over five years under two scenarios: if the husband left the company having signed a noncompete and if he left without signing a noncompete agreement. The expert valued personal goodwill at nearly $1.1 million.

The husband’s expert used the multiattribute utility model (MUM) for which he selected 10 attributes that he scored in a binary manner, i.e., the attribute either existed or did not exist. (The traditional MUM method uses an elaborate scoring system, but the expert used a simplified version.) He determined that two-thirds of the total goodwill value, $2.1 million, represented personal goodwill and one-third was enterprise goodwill.

The wife’s expert acknowledged that MUM was an accepted goodwill allocation method but criticized it for being “subjective” in terms of selecting the attributes and the binary scoring. The “with-and-without” methodology was able to eliminate subjectivity, the wife’s expert said.

The trial court adopted the value determination the husband’s expert proposed, awarding the wife half of it. In appealing the trial court’s valuation decision, the wife attacked the opposing expert’s personal goodwill determination as “far too subjective, and far too suspect, to be accepted by the court.” MUM, the wife argued, allowed for “cherry-picking” and for skewing the results. The appellate court was not persuaded. It found the trial court faced conflicting valuation testimony, considered the weakness in each expert’s opinion, and noted that both goodwill methods were accepted in the profession. Under the applicable standard of review, the appellate court said it was required to give deference to the trial court as fact finder.

Extra: Goodwill is just one of the many topics on the agenda of the upcoming AAML/BVR National Divorce Conference, which will take place in Las Vegas, May 8-10. In addition, the conference offers attendees a great opportunity to explore a host of other legal and valuation-related topics and interact with peers.

 

‘Mixed-Purpose’ Valuation Is Discoverable, New York Court Rules

Noven Pharmaceuticals v Novartis Pharmaceuticals, 2018 N.Y. Mis. LEXIS 5133 (Nov. 9, 2018)

When it comes to document discovery, the “why and “when” matter greatly, as a recent New York ruling centering on a valuation report makes clear. The issue was whether a valuation the defendant had commissioned months before the plaintiff filed suit was privileged or protected by the work-product doctrine.

No protection: In 2012, two pharmaceutical companies made an agreement to end a joint venture. Years later, they were still at odds as to whether the agreement required a valuation of noncash assets to effect the distribution of capital contributions. The plaintiff believed a fair market valuation of products was necessary, whereas the defendant initially disagreed. In spring 2015, the defendant changed course and began to pursue its own valuation, which, it then said, the parties “could use as a starting point.” Contemporaneous communication between the parties showed that, at the time, the parties were in negotiations.

In fall 2015, the defendant’s in-house counsel decided the plaintiff’s position as to the valuation was “antithetical” to the agreement. The disagreement, he believed, “could lead to litigation.” At the same time, in the ongoing discussions with the plaintiff, the defendant did not mention anything about a valuation. The defendant eventually hired a law firm that formally retained an appraiser, saying an estimate of the value of the products would help the firm “assess the case.” The appraiser’s final report from February 2016 said it was “privileged and confidential.” The valuation was assisting with “the provision of services for corporate planning purposes.” The appraiser’s services were solely for internal use “to assist with … litigation due diligence.”

In March 2016, the parties again met to settle their dispute. The defendant used the valuation to prepare for the meeting. The parties did not achieve a resolution, and, six months later, the plaintiff sued.

The plaintiff asked for the defendant’s valuation. The court found it was discoverable. When the defendant continued to refuse producing the report, the plaintiff filed a motion to compel, which the court granted.

The court’s concise opinion pays close attention to the purpose of the valuation and the timing. The court found the attorney-client privilege did not apply because the valuation was not prepared by an attorney “acting as such,” and it did not reflect an attorney’s thinking and professional skills. The work-product doctrine did not apply because the valuation was not “created solely and exclusively in anticipation of litigation.” The court noted that, before the defendant contemplated litigation, its business people chose an appraiser to prepare the valuation for business purposes. Even if the defendant shortly afterwards contemplated the possibility of litigation, the defendant could not show that “the actual scope or nature of the retention changed in any material way.” After the valuation was completed, the parties were still in business discussions to resolve their disagreement. “Under the circumstances, a mixed purpose cannot be ruled out,” the court said.

 

Mix of Real Estate and Business Assets Poses Valuation Challenges for Courts

Persaud v. Goad, 2018 Md. App. LEXIS 1076 (Nov. 19, 2018) (unreported opinion)

This Maryland divorce case, which features a combination of real estate and business assets, raised several noteworthy valuation questions. One concerned the trial court’s decision to assign a negative value to one company where case law says marital property cannot have a negative value. The appeals court sought to affirm this principle while also upholding the trial court’s overall analysis. A second issue was the valuation of the spouses’ catering company that operated out of a space the spouses’ real estate company owned. The parties’ experts relied on different sets of financials—one was based on cash-basis accounting, and the other on accrual-basis accounting. Moreover, one expert argued that the catering business formed a single unit with the real estate holding company, which meant both companies had to be valued as one business. The opposing expert rejected this proposition, as did the trial court. Ultimately, the trial court declined to adopt either expert’s opinion and came up with its own valuation. The appeals court, noting the trial court’s discretion, affirmed.

A mix of marital assets. The spouses acquired real estate (residential and nonresidential) and a catering business in a “unique and historic building” in Baltimore that used to be a luxury hotel but was converted into a condominium with commercial and residential units. At the time of divorce, the spouses owned about 45% of the building’s square footage and a majority of seats on the board of the condominium association. The board had the authority to impose use restrictions and “special assessments.” However, in their proposed valuations, the parties’ experts did not quantify the value of control over the board, the appeals court later observed.

Because the husband had a judgment against him, the wife came to hold title to the companies. At the time of divorce, she managed the real estate holdings and operated the catering business.

Valuation issues dominated the divorce proceedings, prompting the trial court to comment that, even though “this is a divorce case … effectively, this is a business dissolution matter.” The parties’ expert appraisals were $5 million apart. In a nutshell, the husband’s expert claimed the holding company for the nonresidential properties was worth slightly over $1.9 million and the operating company for the catering business was worth slightly less than $1.2 million. In contrast, the wife’s expert contended both of those entities should be considered a single entity worth -$1.76 million.

The trial court found the total value of the marital property that was in the wife’s name (the real estate and business holdings) was about $2.8 million. The property to which the husband held title was worth about $750,000 (his retirement assets). The court awarded the businesses to the wife, and it awarded the husband half of the total value of the wife’s property, offset by half of the total value of the husband’s property in the form of a monetary award.

Initially, the trial court decided that it was important to account for the cost of selling the assets. If the wife were to sell her real estate, she “most likely would incur sales costs,” including a 7% realtor fee and a 1% fee to cover closing costs, the court found. Therefore, in calculating the monetary award to the husband, the court included 46% of the value of the wife’s real property and business holdings and 50% of the value of the wife’s other holdings. The husband objected to this and other findings and asked the court for an amended order. In response, the trial court took away the deduction for costs of sale, which increased the monetary award to the husband from $650,000 to approximately $760,000.

Negative value controversy. The husband unsuccessfully raised other challenges in a post-judgment motion and later made the same arguments on appeal with the state Court of Appeals.

A major point of contention was the valuation of one business entity, Truffles LLC. Truffles owned two units (R1 and R2) in the building, both of which were underground. The R1 unit used to be a “bottle club” where people held parties fueled by alcohol that frequently resulted in fights and police presence, as well as unfavorable coverage in the local paper. The husband said he had bought this space to shut down the operation because it had negative effects on the catering business in the building. R2 was a space that was unusable because of water damage. The husband said owning both of these spaces did increase voting power on the condominium board,

The husband’s real estate expert said the value of the two units was zero. “Any value attributed to these spaces would be offset by the liability of the cost to correct the space, the condominium fees and taxes,” the expert explained. The wife’s real estate expert also arrived at a zero value. He said R1 and R2 were “in poor condition and could not be rented.” At the same time, the units “still incur the fixed condominium fees” of almost $78,300 as well as “combined real estate taxes” of over $19,600. Therefore, the annual expenses related to the two spaces were almost $97,900.

The wife’s business valuation expert said Truffles, as the holding company for R1 and R2, had a value of -$118,200. He pointed out the units were vacant and did not generate any income, while leaving the owner with sizable yearly expenses in condo fees and taxes.

The trial court noted there was “uncontroverted testimony” that the units had “little or no commercial use or value to the food service businesses, but were purchased so [t]he [p]arties could strengthen their position on … [the] condominium board.” The court also found that, given “the unusually high carrying costs … and the fact that they do not generate income,” valuing them at zero () “undercuts the negative impact they have on the total value of the other units.” The court said it was difficult to see how one could sell the “valuable” commercial properties in the building “while keeping units with $97,000 in annual … carrying costs with no income.” Accordingly, the trial court decided Truffles, as the owner of the units, had a value of -$118,200, crediting the wife’s expert. As a consequence, the trial court reduced the husband’s monetary award by half of that amount.

In his post-judgment motion, the husband argued that, under the applicable law, it was error to assign a negative value to Truffles. The wife conceded that “in most cases the court cannot attribute a negative value to marital property in granting a marital award.” At the same time, the wife maintained it was appropriate for the court to consider the “financial drain” resulting from the units. She requested that the trial court “adjust the overall marital award” to account for this negative effect on the marital property held in the building.

The trial court let stand its finding, emphasizing it had decided the units “negatively impact[ed] the value of all of the marital property associated with [the building].” According to the trial court, it was of “no moment” that the court had “expressed this impact as a negative value” in its original opinion.

Focus on fairness. In reviewing the trial court’s ruling, the appeals court explained that, pursuant to Maryland law, the trial court must follow a three-step process in making an equitable distribution of property. Step 1 is to determine which property is marital property. Step 2 requires determining the value of all marital property. Step 3 asks the court to “evaluate whether ‘the division of marital property according to title will be unfair; if so, the court may make an award to rectify the inequality.’” If the trial court decides in favor of a monetary award, it must consider the factors set forth in the applicable statute (FL § 8-205(b)) to calculate the amount of the award.

The appeals court agreed with the husband that the trial court, in its original order, erred. But the reviewing court found a reason to uphold the trial court’s findings. The Court of Appeals acknowledged that the controlling case law requires the court to value each item of marital property separately. “There is no authority for the deduction of the loss incurred by a spouse in a bad investment from the value of the other marital property titled in his name.” The value of the bad investment would be zero. See Green v. Green, 64 Md. App. 122 (1985).

However, the Court of Appeals explained that, under case law, a trial court need not “ignore economic reality where the liabilities associated with a marital asset greatly exceed whatever money an owner could hope to extract from the asset.” See Randolph v. Randolph, 67 Md. App. 577 (1986). For example, in Randolph, the court allowed that debt associated with the husband’s partnership interests was “a factor to be considered in granting a monetary award but not in determining the value of any marital property other than” that asset.

The Court of Appeals found that the trial court, in its amended opinion, had “re-characterized” its arguably improper original decision to make it clear the reduction of the monetary award to the husband was based on the negative impact that asset had on all of the marital property. The trial court “unmistakably signaled” it was concerned about “fairness and not simply about finances” when it emphasized that it would be “inequitable for [the husband] to receive the benefit of the ‘good’ property, but not receive a portion of the burden of the ‘bad’ property,” the appeals court said.

And, considering the trial court’s later reasoning, requiring that court to revisit this issue would be unreasonable. Further, the trial court’s valuation of Truffles was not prejudicial because the error ultimately did not affect the outcome. The trial court would have made this deduction anyway, whether it did so when valuing the various marital assets or when considering the parties’ economic circumstances, the Court of Appeals found.

Disputed catering business valuation. The husband also attacked the trial court’s zero valuation of the catering business, which the husband’s expert had valued at $1.2 million. The record “constrained the court to assign a positive value” to the catering business, the husband contended.

In 2009, when the husband bought the catering business as part of a larger transaction, he paid almost $4.3 million for the real estate in the building but a mere $10,000 for the food-service businesses. The husband later admitted that he and the seller had not obtained an appraisal but had “picked a number of $10,000.” The catering businesses at that time had liabilities of several hundred thousand dollars.

Trial testimony showed the business model for the catering business was unusual in that the business operated inside the building and did not offer off-site catering. Sales were tied to events taking place inside the building’s other spaces. Because the spouses owned the real estate, they did not charge the catering company market rent but only charged enough to cover costs.

The catering business required customers to pay upfront (usually one year in advance) 25% of the price for catering an event. The customer would pay the remainder in 25% increments before the event. When the husband managed the companies, he would redirect funds from the catering business’s account to other investments in the building.

Under the husband’s management, beginning in 2013, the company’s accountant was ordered to switch from accrual-basis accounting to cash-basis accounting. The husband later claimed this method gave a more accurate picture of the company’s profits. The wife, in contrast, argued this approach allowed the husband to show higher profits than there actually were, in an effort to impress lenders.

When the wife took over management and operations, she hired another accountant who returned to accrual-basis accounting for 2015 and the first three quarters of 2016. Testifying at trial, this accountant said cash-basis accounting was “very misleading” where the company collected deposits long in advance of events. Cash-basis financials “would overstate the net worth” of the company as this information “underestimated liabilities.” By way of example, at the end of 2015, the company had $850,000 in “deferred revenue” but only $173,000 in cash. By mid-2016, it had $1.6 million in “deferred revenue” against $427,000 in the bank. The deficiency at the end of 2016 was even greater, the accountant testified. He characterized the catering company as “definitely insolvent.”

The husband’s business valuation expert, valuing the company at $1.2 million as of December 2015 (the agreed-upon valuation date was June 2016), relied on the former accountant’s financial records prepared under the cash-basis accounting method. The expert did not consider the data the testifying account had prepared.

The wife’s expert argued the holding companies for the nonresidential real estate and the catering company should be valued as a single entity. They were “wholly dependent” on each other. He noted that customers signed up for the catering and the use of the event space simultaneously. In a hypothetical transaction, a willing buyer and a willing seller would only agree to a transaction involving both companies at the same time, the expert said. Relying on data from the testifying accountant that was based on accrual-basis accounting, this expert concluded the fair market value of the catering business and the real estate holding company together, as of June 2016, was -$1.76 million.

The husband’s expert objected to the single valuation, noting a “real estate appraisal is different from the appraisal of an operating entity.” Moreover, it was conceivable that the catering company would allow other caterers to service events and charge those companies a facility fee, the expert claimed.

The trial court found that all of the real estate was worth about $4.6 million, but it had encumbrances of $3.7 million. Therefore, the net value of the properties was about $930,000. Concerning the catering company valuation, the trial court found the “accrual-basis accounting system more accurately reflects the finances of the business.” But the court rejected the proposition by the wife’s expert to treat the companies as a single entity. Doing so “masks the true value of each LLC,” the trial court said. It assigned this asset a value of zero “[g]iven its dependence on [the real estate holding company] for rent ‘at cost.’”

The court noted that, if a third party demanded market rent from the catering business, the latter would cease to exist, “given the competitive market for catering services.” The court noted the $10,000 sales price, which “considered the lack of working capital in [the company’s] possession.” In fact, at the time of sale, the business had collected nearly $330,000 in customer deposits that required performance at future events, but the company did not have the cash to put on the events. The seller agreed to credit the husband dollar for dollar when purchasing the real estate if the husband agreed to take the catering business off the seller’s hands.

The trial court affirmed its finding in its amended order, saying the catering business “has no value absent ownership of the real estate.” The value of the catering business was “inextricably tied to the value of the real estate used by it,” the court said, adding the original sale made this obvious.

The Court of Appeals noted the husband failed to cite to case law that required the trial court to adopt the valuation the husband’s expert proposed. The trial court had given specific reasons why it discounted that expert’s opinion, including the expert’s use of the wrong valuation date and his reliance on cash-basis accounting data. Although the expert explained his use of that data, there was countervailing expert testimony, the appeals court found.

Further, the husband’s attack on the opposing expert was “immaterial” because the trial court had not adopted the opposing expert’s opinion. There also was no merit to the argument that assigning the catering business zero value “simply defies logic.” There was testimony, including from an accountant for the company, that said redirecting customer deposits into illiquid real estate investments for other entities had a “negative impact on [the catering company’s] ability to meet its obligations as they become due,” the appeals court said. It noted the husband’s expert agreed that a third-party buyer would lower the sales price to account for the company’s working capital deficiency,” even though the expert did not think the reduction would be dollar for dollar.

The husband’s various arguments against the trial court’s valuation “cannot overcome the deferential standard of review,” the Court of Appeals said. While a different fact-finder might have come to a different conclusion than the trial court, the latter’s valuation was not clearly erroneous, the appeals court concluded.

“The [trial] court here was even-handed in its decisions and transparent in its reasoning,” the Court of Appeals said. It upheld the trial court’s value determinations and the amount of the monetary award to the husband.

 

Appellate Court Upholds Use of Risk Discount in Fair Value Determination

Saltzer v. Rolka, 2018 Pa. Super. Unpub. LEXIS 4044 (Oct. 30, 2018)

Although unpublished, this Pennsylvania appellate ruling in a buyout dispute merits attention as it shows how the trial court tried to reconcile the contrasting expert valuations in determining fair value. Here, as is often the case, the members of a company executed an operating agreement but did not include a buyout provision for valuing a departing member’s shares. This omission later became a liability when two members tried to force the third member out by devising their own buyback formula. Litigation ensued, leading to a trial and ultimately to an appeal because neither side was satisfied with the trial court’s value determination. The court’s valuation was substantially higher than the proposed buyout price, but the court, agreeing with the defendants’ expert, found it was appropriate to apply a company-specific risk discount. The treatment of goodwill became another sticking point.

Forced sale. Three members created a closely held limited liability company that offered consulting services to state public utility commissions and the federal government. The company’s main source of income was one contract that was structured as five contracts generating about $300,000 in profits per year. All three members worked for the company, receiving regular salaries. One served as the company’s president and manager, and the other worked on the consulting side of the business. The third member, the plaintiff, was the specialist in information technology and served as VP of operations. As owners of the company, the members also periodically received profit disbursements in proportion to the size of their interests.

In April 2007, the members made an operating agreement under which the defendants (remaining members) each owned 400 units of the company and the plaintiff (departing member) owned 200 units. The operating agreement did not address a member’s departure (by death or otherwise). In the next few years, the members talked about amending the agreement to include a buyout provision, but they took no action.

In May 2013, the defendant members fired the plaintiff. But the latter remained an owner and as such continued to share in the company’s profits.

In June 2014, the defendant members decided to force the plaintiff out. As they together owned a majority interest in the company, they decided they could amend the operating agreement by devising a formula for determining the buyout price. The record later showed that the defendants arrived at the purchase price ($63,400) by “arbitrarily plugging numbers into their self-created formula.” The appellate court later noted that the defendants “had no factual basis for the valuation.”

To add insult to injury, the defendants gave the plaintiff a check for only 20% of the purchase price and two promissory notes for the remaining obligation. As the appellate court noted, in essence, the defendants made the forced-out member finance the buyback of his ownership interest. The plaintiff sued.

At trial, the parties presented valuation expert testimony. (However, the appellate court does not discuss the testimony in great detail.) The defendants’ expert said that it was appropriate to discount the value of the company by 24% to account for the uncertainty around the valuation date as to whether the key contract would be renewed. The final (fifth year) portion of the contract was to expire in June 2016. However, by the time this case went to trial, the contract had been extended to December 2016. The defense expert also argued in favor of excluding the value of personal goodwill attributable to the two remaining members from the valuation.

In contrast, the plaintiff’s expert rejected a personal goodwill deduction as well as a risk-based discount related to the company’s largest customer because the contract in fact continued into the following years.

Date of valuation matters. The trial court found the remaining members had breached their fiduciary duty to the plaintiff and had acted in an oppressive manner when they forced a sale on their terms. The court said the plaintiff’s expert was more credible and adopted her valuation. Therefore, the court did not deduct the value of personal goodwill from the company valuation.

However, the court agreed with the defense expert that a risk discount was appropriate under the facts of the case. Fair value was “the value on the date of dissociation,” i.e., the value in 2014 when a renewal of the contract was not a certainty. The trial court valued the plaintiff’s share in the company at $294,000. It declined to award the plaintiff punitive damages even though it recognized that the defendants’ conduct vis-à-vis the plaintiff was close to outrageous conduct, as defined by law.

Both parties appealed the trial court’s findings with the Superior Court of Pennsylvania (appellate court). The plaintiff challenged the application of risk discount, and the defendants attacked the trial court’s decision not to allow a personal goodwill deduction. In addition, the plaintiff claimed it was entitled to punitive damages, considering the defendants’ “recklessly indifferent” conduct.

The Superior Court affirmed. It agreed with the trial court that the existing operating agreement did not allow for an amendment by a majority of votes. Under the applicable state Limited Liability Company Act (LLCA), which governed here, the modification of the operating agreement required the unanimous vote of all members, not simply a majority of votes, the reviewing court found.

The appellate court rejected the plaintiff’s argument that no evidence at trial “even remotely suggested that the stream of income from the … contract would end,” obviating the need for a risk-based discount. The valuation date was the date of dissociation, the appellate court affirmed. The plaintiff’s expert improperly relied on information after the plaintiff had been made to leave. Also, the appellate court noted, the valuation findings were credibility determinations that were “well” within the trial court’s discretion and with which the appellate court could not interfere. Likewise, the trial court, in balancing the circumstances accompanying the forced buyout, did not abuse its discretion in finding that punitive damages were not appropriate in the instant case.

The appellate court upheld the $294,000 valuation of the plaintiff’s ownership interest.

About Dan
Dan Rosio is the partner-in-charge of Katz, Sapper & Miller's Valuation Services Group. Dan advises clients on valuation, succession planning, and transaction matters, often serving as an expert witness and helping find solutions to unique challenges. Connect with him on LinkedIn

 

About Andy
Andy Manchir is a director in Katz, Sapper & Miller's Valuation and ESOP Services Groups. Andy helps clients understand the value of their business and advises them on succession planning options, including ESOP, third-party sales, or family transitions. Connect with him on LinkedIn.

link

State & Local Tax Update - 8/7/15

Posted 12:45 PM by

KSM Location Advisors 

Whether your company is just starting up, looking for the best location to build a new headquarters, or you have been in the business for many years and are looking to expand, KSM Location Advisors can provide a high-level and/or in-depth location analysis, which includes information important to your company’s location decisions. For more information about how your business may benefit from this service, please contact Katie Culp at kculp@ksmlocationadvisors.com

 
 

Arizona Provides Sales and Use (TPT) Guidance on Changes to Prime Contracting Classification

TPN 15-1 has been issued to provide guidance on questions arising from recent legislative changes to the prime contracting classification, including new exemptions for the gross income derived from the maintenance, repair, replacement or alteration (MRRA) activities affecting real estate when the activities are performed directly for the property owner or authorized party. Note that modifications remain taxable.

Kansas Issues Guidance on Effective Date of Change Taxing Guaranteed Payments

The Kansas Department of Revenue has issued Public Notice 15-11, indicating the exclusion of guaranteed payments as an acceptable deduction to Kansas AGI is effective July 1, 2015, and not retroactively. 

Maryland Issues Guidance on 2015 Amnesty Program

The Maryland comptroller has issued information on the upcoming 2015 Tax Amnesty Program. The program runs from Sept. 1 through Oct. 30, 2015, and waives all civil penalties and one-half of the interest for delinquent taxpayers who apply and are approved. The tax amnesty application, tax amnesty calculator, and Tax Amnesty BillPay will be available by Aug. 28, 2015. Tax amnesty applications will be accepted beginning Sept. 1, 2015. See Maryland 2015 Amnesty for additional information on the program. 

New Jersey Rules on Residency of Telecommuters

In Gundecha v. Board of Review and DB Services New Jersey, the New Jersey Superior Court, Appellate Division, has ruled a telecommuter working in North Carolina for her employer in New Jersey was considered to be working in North Carolina and was not eligible for unemployment compensation benefits in New Jersey. Although the case dealt with unemployment compensation, some parallels from this case may be applied in the income tax context. 

New York Rules Buyer Responsible for Seller Sales Tax Liability

The taxpayer was liable for sales tax related to the bulk purchase of the business assets of a New York-based kitchen and bath company. The transfer at issue was clearly a bulk sale as a transfer to the taxpayer of the entire business assets of the seller outside the ordinary course of business.

At the time of the bulk sale transfer, the seller owed sales tax. The taxpayer, as the purchaser, was obligated to notify the Division of the transaction and withhold from the seller the transfer of any consideration on the purchase until payment of that liability was made.

Failure to comply with the notification requirements resulted in the taxpayer becoming personally liable for the payment of any New York state sales and use taxes determined to be due from the seller. For more details, see In the Matter of the Petition of GB&K/DCS LLC.

Tennessee Issues Notice on Taxability of Remotely Accessed Software

Important Notice 15-14 has been issued to reflect recent legislative changes with regard to the taxability of certain software products. Effective July 1, 2015, the taxable use of computer software in Tennessee includes the access and use of software that remains in possession of the seller and is remotely accessed by a customer for use in Tennessee. The notice outlines the reason for the change and related issues, including multiple points of use.

Tennessee Amends Definition of Nexus for Franchise, Excise and Business Taxes

Effective for tax years beginning on or after Jan. 1, 2016, taxpayers are subject to the franchise and excise tax if they are doing business in Tennessee and have substantial nexus with Tennessee. Substantial nexus is created if:

  1. The taxpayer is organized or commercially domiciled in Tennessee;
  2. The taxpayer owns or uses capital in Tennessee;
  3. The taxpayer has systematic and continuous business activity in Tennessee that has produced gross receipts attributable to customers in Tennessee (often referred to as economic nexus);
  4. The taxpayer licenses intangible property for use by another party in Tennessee and derives income from the use of that intangible property; or
  5. The taxpayer has bright-line presence* in Tennessee.

*The taxpayer has bright-line presence in Tennessee if any of the following applies:

  1. The taxpayer's receipts in Tennessee exceed either $500,000 or 25% of the taxpayer's total receipts everywhere;
  2. The average value of the taxpayer's real and tangible property owned or rented and used in Tennessee during the tax period exceeds $50,000 or 25% of the taxpayer's total real and tangible property; or
  3. The taxpayer paid compensation in Tennessee that exceeded more than $50,000 or 25% of the total compensation paid by that taxpayer. For more information, see HB0644

Tennessee Amends Apportionment Sourcing and Factor Weighting

Effective for tax years beginning on or after July 1, 2016, receipts from sales, other than sales of tangible personal property, are in Tennessee if the taxpayer's market for the sale is in Tennessee. In the case of the sale, rental, lease or license of real or tangible property, the market for the sale is in Tennessee to the extent that the property is located in Tennessee.

In the case of sale of a service, the sale will be sourced to Tennessee to the extent that the service is delivered to a location in Tennessee. In the case of intangible property that is rented, leased or licensed, the sale will be sourced to Tennessee to the extent that the intangible property is used in Tennessee.

Additionally, the weight of the sales factor increases so that it makes up 60% of the apportionment factor rather than 50% of the apportionment factor. For more information, see HB0644.

Washington Rules Captive Paymaster Subject to Business and Occupation (B&O) Tax

By failing to establish it had no liability to pay the employer obligations except as an agent of its affiliates, failing to establish it was a Form 2678 Agent for its clients, and failing to notify employees of the client’s status as employer liable for all employer obligations, a taxpayer was subject to B&O tax on all gross income received from related parties for the provision of payroll and benefits services, accounting services and administrative services. For more information, see  WA Tax Determination 14-0175.

About the Author
Donna Niesen is a partner in Katz, Sapper & Miller’s State and Local Tax Group. Donna helps keep clients up-to-date on the multitude of tax rules and requirements in all 50 states. She guides them in the right direction as they address the complex issues that emerge on both the state and local levels. Connect with her on LinkedIn.

link
First | Prev | Page 1 / 21 | Next | Last