Valuation Services Bulletin: Q1 2020
In This Issue:
- Calculation Engagements Receive Mixed Reactions From Courts
- BV Expert Shows How to Produce a Viable Valuation With Little Financial Data Available
- Court Says Corrected DCF Still Supports Original Fair Value Determination
- Novel Issue of Law Raised in ESOP Case That Pits Trustee Against Appraiser
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.
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.
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).
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.
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