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New Study of M&A Deals Spotlights Fairness Opinions

A study of about 2,000 M&A deals from 2006 to 2016 suggests that acquirers should pay closer attention to the fairness opinions third-party analysts provide. The study’s author, Matthew Shaffer, a doctoral candidate at the Harvard Business School, finds that differences between actual deal prices and the valuations estimated by third-party analysts consistently predict whether acquirers will eventually be forced to write down their goodwill over the following five years. The study examines the usefulness and the bias of fairness opinion valuations and finds “tight evidence for both.” The study is discussed in the paper, “Truth and Bias in M&A Target Fairness Valuations: Appraising the Appraisals.”

Courts Are Alert to Valuations Unmoored From the Facts

Cristofano v. Chahal, CL17-1291 Circuit Court of Fairfax County (Honorable Jan L. Brodie), Judge’s Ruling (March 26, 2018)

Perhaps experts feel pressure from the hiring attorney or the client, perhaps they are unable to access key documents or information, or perhaps they simply lack valuation and litigation experience. Whatever the reason, case law provides too many examples in which valuation and damages experts have proffered opinions that were plainly counterfactual and in which the court called them out on it. The lesson for experts is simple. Don’t be an ostrich. Deal with the facts of the case (especially so-called “bad facts”) and keep your calculations real.

Two recent decisions illustrate the point. Cristofano v. Chahal is a buyout dispute in which the plaintiff’s expert augmented income by developing projections based on the plaintiff’s forecast, resulting in an estimate double that of the actual profit for that particular year. The expert’s projections also assumed ongoing income from a lucrative contract, even though it was known that the contract likely would end in 2018. The court found there were other ways in which the expert inflated income and by extension the value of the company. In contrast, the defense expert analysis relied on historical data and properly accounted for the facts of the case, the court said, adopting his value conclusion.

Zaffarkhan v. Domesek concerned a shareholder dispute involving a short-lived software startup whose one product, a medical software application, never got beyond the beta stage of development. The plaintiff, a founding member, rejected a buyout and sued the other founders, alleging various breaches. The plaintiff’s expert claimed the company’s “most likely” value was $6 million. A defendant shareholder described the company as “a very Mickey Mouse operation,” with “poor documentation, poor record keeping, poor legal counsel, and naïve team members.” The trial court awarded zero damages, noting the plaintiff’s expert had no experience valuing software companies, misapprehended basic facts, and developed multimillion-dollar valuations for a company with no product, no revenue, and no investors. The appeals court affirmed.

Court Rejects Appreciation in Value Calculation, Citing SSVS Violations

Hebert v. Cote, Case No. 312017DR000305, Circuit Court of the Nineteenth Judicial Circuit in and for Indian River County Florida (Order 5/29/2018 and Order 8/29/2018)

This appreciation in value case collapsed when the court decided in two orders to exclude valuation testimony the nonowner spouse offered to make a claim to a portion of the increase in value of the owner spouse’s separate business. The expert’s calculation did not meet the statutory requirements for valuing the asset and failed the expert admissibility requirements, the court found. Moreover, testimony from an SSVS expert showed the appreciation analysis breached the professional standards in several regards. The nonowner spouse’s subsequent attempt to introduce a revised calculation failed for essentially the same reasons, leaving her unable to meet her legal burden.

Background. In April 2003, the husband set up a Canadian company (Canix Colo Inc.) that provided “business technical collocation services.” This meant offering server space in a multivendor-enabled environment, direct connection to optic networks, domain name hosting, etc. The company was very successful, and, in February 2011, the husband sold it for about $37 million. Net sales proceeds were about $22 million.

The husband and wife married in October 2009, years after the creation of the company. The company, by all accounts, was the husband’s separate property.

The issue during the divorce proceedings was whether the marital unit had a right to a portion of the appreciation in value the company experienced during the marriage. The analysis has two parts. For one, the court has to make a determination that there was an appreciation (or “enhancement”) in value. Assuming the court finds there was an increase in value, it must determine the reasons for the appreciation in order to determine whether all or a portion of the enhanced value is marital property. Under the applicable law, if a nonmarital asset increases in value during the marriage, only the part of the appreciation that is the result of either party’s efforts qualifies as marital property. Basically, once the owner spouse shows the asset was separate property, the nonowner spouse must show there was an enhancement in value and it is marital property. If he or she succeeds, the other party has to show that some or all of the enhanced value is not part of the marital property.

Here, the applicable valuation dates were the value of the company on the date of marriage (October 2009) and on the date of the sale of the company (February 2011).

To quantify the increase in value, the wife retained a valuation expert who calculated what he called a “minimum marital component” from the proceeds of the sale of the company. The marital portion was $8.9 million from the gross sale and nearly $6.5 million from the net sale, the expert determined.

Broadly speaking, the approach he used considered revenue and earnings between July 2009 and July 2010 (not valuation dates!) to determine a percentage change. He applied this percentage change to the valuation dates (October 2009 and February 2011) to calculate a value for retained earnings as of the date of marriage. He calculated a goodwill value by subtracting the retained earnings as of the sales date from the gross sales price. He then applied the percentage change to the goodwill value to determine the goodwill value as of the date of marriage. Finally, he added the extrapolated value of the increase in goodwill between the valuation dates to the extrapolated value of the increase in retained earnings between those dates to arrive at the $8.9 million figure related to the gross sale.

Inadmissible testimony. The husband argued the expert testimony was inadmissible under Florida’s version of Daubert. (Readers of BVWire may remember that the statute that governs the admission of expert testimony was revised in 2013 to reflect Florida’s adoption of the Daubert standard.)

In its May 2018 ruling, the trial court agreed with the husband and excluded the wife’s expert. The court’s order noted the expert admitted he had not calculated the fair market value of the husband’s company and had not determined an increase in value based on the relevant dates. Under the applicable law, he was required to do so, the court noted.

Further, he did not use any of the valuation methodologies (asset, market, income approaches) that were required under the professional standards that apply to business valuators. “Professional standards” refers to the Statement of Standards for Valuation Services (SSVS) of the American Institute of Certified Public Accountants.

The court noted that, instead, the wife’s expert developed “a completely different technique” to calculate the amount allegedly owed to the marital unit. In a footnote, the court made a fact-finding that the expert’s “minimum marital component” calculation “does not meet the only recognized standard for ‘fair market value.’” Further, the court’s order noted the expert had not requested or received documents from the opposing party that might have been helpful in developing his valuation. The expert maintained his valuation met the SSVS because he was retained under a calculation engagement, as opposed to a valuation engagement.

The court also rejected this argument, finding a calculation engagement “has no precedent in any statutory or case law in the state of Florida to render an opinion of fair market value.” The court further pointed out the expert used “subsequent acts,” specifically the sale of the company, “as one of the anchor points in reaching his conclusion of valuation.” Under the law, “only known facts may be used in making the evaluation,” the court said. For all of these reasons, the expert opinion was inadmissible, the court concluded.

Exclusion affirmed. The wife filed a motion for rehearing, reargument, and clarification in which she asked the court to reconsider its earlier order not to allow the expert to testify. However, the husband offered testimony from an expert on the SSVS that confirmed the valuation the wife’s expert had proposed failed to comply with the professional standards.

The SSVS expert had done over a thousand business valuations and was one of the three “primary writers” of the SSVS, which became effective on Jan. 1, 2008. In deposition testimony, this expert explained that all 50 states have adopted the SSVS and any CPA providing valuation services had to follow the standards. He further explained that he was only retained to provide an opinion on whether the work of the wife’s expert was in compliance with the SSVS. He did not give an opinion on the methodology the wife’s expert used or on the figures the wife’s expert proposed.

The SSVS expert determined the new valuation by the wife’s expert reflected four SSVS violations. One, the wife’s expert did not seem to have a work paper file. Two, the wife’s expert had not done enough work to offer a valuation opinion. Three, the opinion the wife’s expert offered relied, at least to some extent, on subsequent events, i.e., documents related to the sale of the company as opposed to the date of marriage. And four, the wife’s expert did not provide an engagement letter or any memorandum identifying the client and the type of valuation the expert was asked to perform. The court rejected the wife’s request to allow her expert to offer a “new” opinion. Instead, it found the work of the wife’s expert “does not conform to the SSVS standards in many respects.” It cited the expert’s failure to keep a work file, the failure to use one or any of the accepted valuation methods for his value determination, as well as the failure to provide a valuation based on the date of the marriage. The court also said there was no evidence the expert was “now prepared to testify to the fair market value” of the company, as the wife claimed in her motion. The court’s refusal to allow the wife to recall the valuation expert meant the wife had no evidence to support her claim that there was an appreciation in value during the marriage and that the enhanced value was marital property.

Can ESOP Appraisal Satisfy Charitable Contribution Reporting Requirement?

Chrem v. Commissioner, 2018 Tax Ct. Memo LEXIS 164 (Sept. 26, 2018)

This charitable contribution case, which was in front of the Tax Court on motions for partial summary judgment, includes a noteworthy discussion about what it means to provide a “qualified appraisal” in the tax context. Here, the petitioners-sellers donated stock to a nonprofit as part of a two-step stock acquisition by a related entity. The petitioners later argued a related ESOP appraisal sufficiently satisfied the income tax verification requirements. Although the court explained in great detail why, on the face of it, the ESOP report did not seem to be the kind of appraisal the regulations contemplated, the court ultimately found a reason to send this issue to trial, barring settlement by the parties.

Two-step acquisition. A number of petitioners owned all of the stock of a closely held Hong Kong company, Comtrad Trading Ltd. As of October 2012, Comtrad had 7,000 shares of outstanding common stock, of which the petitioners owned 5,425 shares. A few other individuals or couples related to the petitioners held the remainder shares.

Comtrad’s primary customer was a U.S. corporation (SDI Technologies) that manufactured and sold a broad spectrum of consumer electronic goods. SDI was organized as an S corporation and was owned by an employee stock ownership plan (ESOP). The petitioners and other shareholders of Comtrad appeared to be beneficiaries of the ESOP. Comtrad and SDI were related in other ways as well. The companies had shared management, and there was an overlap of the board of directors.

In late 2012, SDI developed a plan to buy all of Comtrad’s stock in a two-step process. SDI said the acquisition, among other things, was intended to “take advantage of the favorable tax treatment that would be afforded Comtrad’s net earnings due to SDI’s status as an S corporation.” The first step was for SDI to buy 6,100 of the 7,000 shares for a price of $4,500 per share, with $450,000 paid in cash and $27 million paid in promissory notes. The second step required the petitioners to donate the remaining 900 shares to a Jewish nonprofit and “use all reasonable efforts” to cause the nonprofit to tender the shares to SDI. SDI would pay $4,500 per share in cash for the 900 shares and secure 100% ownership of Comtrad. If that effort failed, SDI would use a squeeze-out merger or other technique to secure the remaining shares; however, if those efforts failed within 60 days of acquiring the majority of shares, SDI would return the acquired shares to Comtrad’s shareholders.

‘Sole use’ appraisal. The ESOP trustee hired a valuation firm to determine the fair market value of “100% of the ordinary shares of Comtrad” to ensure that the ESOP paid no more than adequate consideration for the stock, as required under the Employment Retirement Income Security Act (ERISA). The ESOP valuator noted that the acquisition would occur “in two stages” and that, in each stage, the contemplated price per share was $4,500. The appraiser valued Comtrad as a going concern, using the market approach and income approach (discounted cash flow analysis) and applying a 5% marketability discount. The relatively low DLOM was appropriate because the discount rate was significantly less for a control block than a minority interest block, the appraiser explained.

Based on its analysis, the ESOP appraiser concluded that the FMV of Comtrad’s shares was between approximately $4,200 per share and $4,600 per share. The valuator submitted to the ESOP trustee a “restricted use appraisal report” and two days later a fairness opinion that concluded the contemplated transaction was fair to the plan. The valuator also said that its combined report was for “the sole use” of the ESOP trustee and that the appraisal “does not take into consideration any tax consequences related to Comtrad’s selling shareholders” (i.e., the petitioners and remaining shareholders).

Two days after submission of the ESOP fairness opinion, SDI purchased the 6,100 shares. At the time of the Tax Court proceedings, the parties were in dispute over when the petitioners donated the remaining 900 shares to the nonprofit. The timing mattered for purposes of deciding whether the petitioners were liable for taxes related to the donation. The parties agreed, however, that the nonprofit tendered the gifted shares on the same day the Comtrad shareholders tendered their shares. All shareholders received $4,500 per share, but the nonprofit was paid in cash.

On their income tax forms for the applicable tax year 2012, the petitioners claimed a noncash charitable contribution deduction. The petitioners submitted an appraisal summary on Form 8283, Noncash Charitable Contributions. The individual petitioners indicated the number of shares each of them donated. A representative of the ESOP appraiser signed a “Declaration of Appraiser” on each Form 8283. The forms listed Dec. 5, 2012, as the date on which the nonprofit received the donated stock.

Under the verification requirements applicable in charitable contribution situations, where a taxpayer makes a charitable contribution of property worth more than $5,000, the taxpayer must secure a “qualified appraisal.” See 26 U.S. Code § 170(f)(11)(C). If the taxpayer claims the contribution is worth more than $500,000, he or she must provide a copy of the appraisal with the tax return. 26 U.S. Code § 170(f)(11)(D).

Here, none of the petitioners secured an individualized appraisal or attached an appraisal to their individual returns. But the Internal Revenue Service (IRS) examined the petitioners’ tax returns and asked that, for qualified appraisals, each petitioner provide a copy of the ESOP appraiser’s report. The IRS then issued notices of deficiency, stating that the petitioners were liable for taxes in connection with the transfer of shares to the nonprofit under the assignment of income doctrine. Further, the petitioners were liable for failing to satisfy the charitable contribution substantiation requirements. The IRS also claimed that accuracy-related penalties applied. In response, the petitioners, in 11 separate actions, asked the U.S. Tax Court for a review. The court consolidated the cases. Both sides filed motions for partial summary judgment, on which the court ruled in this decision.

Assignment of income issue. The court first dealt with the IRS’s claim that the petitioners faced a tax liability related to the donated stock under the assignment of income doctrine, which says that income is taxable to the person who earns it and that a person who anticipates receipt of income “cannot avoid taxation by entering into a contractual arrangement whereby that income is diverted to some other person.”

Numerous cases have dealt with the assignment of income doctrine involving the use of charitable contributions, the court observed. Typically, the taxpayer donates to a charity stock that is about to be acquired by the donor through stock redemption or by another corporation in a merger or acquisition. Before the doctrine applies, courts must decide whether there is a mere expectation of acquisition or whether the future acquisition, and realization of gain, is virtually guaranteed. Another important consideration regarding this issue is the donee’s control. The question is whether the parties involved in the transaction can compel the donee (charity) to surrender the donated shares. The court noted that the existence of an “understanding” among the participants to the transactions might be a relevant piece of information, as might the timing of the transactions.

The court decided it was not able to resolve this issue summarily because a genuine dispute over material facts existed and required development at trial. For example, the buyer and seller in this transaction were related and both aimed to complete the stock acquisition, the court observed. Further, email and a document exchange involving the chosen charity suggested that the charity in advance agreed to tender the donated shares and that the steps to the transaction were prearranged.

The parties disagreed over the dates on which the transactions occurred. The petitioners claimed the donation took place about a week before SDI acquired the remaining shares from the nonprofit. Some documents appeared to support this claim, the court found. However, the IRS contended the nonprofit became owner of the remaining shares only two days before it tendered them to SDI and only until it had unconditionally agreed to sell them to SDI. There was support for this contention as well, the court found, including a note from the ESOP appraiser that said the remaining 900 shares would be transferred “[s]imultaneously with SDI’s acquisition of the 6,100 shares.”

Another important factor might be whether the nonprofit, as the custodian of charitable assets, sold the shares because it had certain fiduciary duties to the organization, the court noted. It pointed out that, if the nonprofit tendered the shares, it would immediately receive $4,500 per share in cash. If it failed to do so, it might be left with a 13% minority interest in a closely held Hong Kong company whose market value “might be questionable.”

“A trial will be necessary to determine whose version of the facts is correct,” the court concluded as to this issue.

Qualified appraisal issue. The court explained that income tax regulations applicable to charitable contributions other than money require that a “qualified appraisal” include (among other things): (1) a sufficiently detailed description of the donated property; (2) a “statement that the appraisal was prepared for income tax purposes”; (3) the date of (or expected date of) contribution to the donee; (4) the appraisal date; (5) the appraised fair market value of the donated property. See Sec. 1.170A-13(c)(3)(ii).

Case law shows that in certain circumstances the taxpayer claiming a deduction may satisfy the appraisal verification requirement by proving substantial, as opposed to literal, compliance. Also, as a defense, the taxpayer may show the failure to comply with the reporting requirements “is due to reasonable cause and not to willful neglect.” The taxpayer may show “reasonable cause” by proving that he or she relied on the advice of a tax professional.

The IRS did not challenge the ESOP appraiser’s status as a “qualified appraiser.” Instead, the government claimed the appraiser’s report did not represent a “qualified appraisal and that, even if the report were a qualified appraisal, the petitioners who donated stock worth more than $500,000 did not qualify for a deduction because they failed to attach copies of the appraisal to their tax return, as required by the regulations.

The petitioners countered that they substantially complied with the legal requirements. In the alternative, they maintained the failure to comply was excusable under the “reasonable cause” defense.

The court agreed with the IRS that the ESOP appraisal “fits awkwardly with the appraisal reporting requirements.” The court noted the offered appraisal did not examine any charitable contributions of property, it did not state the date or expected date of the contribution, and it did not include a statement that it was prepared for income tax purposes. Just the opposite, the court noted. The ESOP appraisal expressly said it was for ERISA compliance purposes and it did not consider any tax consequences for the selling shareholders. Also, the appraiser did not value the specific property each petitioner actually donated. The donations ranged from 35 to 125 shares of Comtrad’s stock.

The petitioners together donated fewer than 13% of the company’s outstanding shares, but the ESOP appraisal, valuing the company as a going concern, determined the value of 100% of the company’s shares, the court noted. The ESOP appraiser was focused on ensuring the offering price met ERISA’s “adequate consideration” requirement, the court noted. Further, since the ESOP appraisers valued the entire company, it was appropriate to apply no minority discount and a small DLOM. If the appraiser had been asked to value the minority interest block that each petitioner donated to the nonprofit, it “would obviously have written a very different sort of report,” the court said.

The court noted that the petitioners took the position of “no harm, no foul.” They argued that the nonprofit in effect might have received a better deal because SDI paid cash for the shares the nonprofit sold, whereas the other Comtrad shareholders mostly were paid in promissory notes. Rather than a discount, an appraiser might have applied a premium, the petitioners contended. Although the petitioners admitted that the relied-upon appraisal did not meet the requirements the regulations specified, the petitioners considered these lapses nothing more than technical shortcomings.

An appraisal that values property different from the property donated can be fatal to the taxpayer’s claim for a charitable contribution deduction, the court said. Moreover, it pointed out that the petitioners who claimed donations of $500,000 faced another hurdle in their substantial compliance argument in that they failed to attach the qualified appraisal. It is not obvious that providing a fully completed Form 8283 satisfies this extra requirement, the court noted.

At the same time, the court allowed that the petitioners’ failures as concerns the appraisal might be excused under the “reasonable cause” provision. The petitioners claimed an experienced CPA had prepared the relevant tax returns based on the ESOP appraisal report and based on all relevant information about the stock acquisition. According to the petitioners, the tax preparer did not instruct them to include a copy of the appraisal with their returns. The court found, at this time, the record was silent on what, if anything, the CPA advised regarding the appraisal report and whether the petitioners relied in good faith on any advice the CPA gave.

The court said the “reasonable cause” issue was another issue that would need to go to trial, barring settlement. The court further noted that, if the petitioners were able to prevail on the “reasonable cause” defense, it would be unnecessary for the court to determine whether they substantially complied with the appraisal reporting requirements. Moreover, the court said, there could be an overlap between the assignment of income issue and the appraisal requirements issue. The court envisioned a scenario in which the petitioners might argue they did not need to obtain an appraisal at all because the value of Comtrad stock was set at $4,500 per share based on an offer from SDI that was certain to close.

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