Welcome to the first issue of ClarityBV’s new quarterly newsletter, “A Clear Focus on Business Valuation.” This issue focuses on expert credibility in a court setting. Whether or not a business valuation is intended for litigation, remember that what works in court may help to avoid it in the first place.

Volume 1, No. 1, Winter 2010

• Experts in Court: Round-Up
• Credibility in Court—the View from the Bench
• New Thinking on DLOM

This issue is available for download as a PDF (612KB). Our complete newsletter archive is available online.

Experts in Court: Round-Up

In many cases, the need for a valuation expert is obvious and inescapable, which raises a second question: how to choose and use an expert to the best advantage for your legal argument. Recent case law offers some tips in answer to these questions.

It doesn’t pay to skimp. In Villaje del Rio, Ltd. V. Colina, L.P., 2009 WL 1606431 (W.D. Tex.) (June 8, 2009), the developer/plaintiff tried to cut costs by designating himself an expert to testify in regards to the value of his own real estate project, and supplemented his own with two experts’ testimony, based on appraisals they prepared in connection with the project’s financing, two years prior to the insolvency at issue. The court struck the appraisal experts for their failure to consider the relevant facts and data of the actual insolvency, and the plaintiff as well, saying, “lay testimony results from a process of reasoning familiar in everyday life, while expert testimony results from a process of reasoning which can be mastered only by specialists in the field.”

A cost efficient compromise. Although a plaintiff often has no choice but to present an expert, the defendant may have other options. In Sossikian v. Ennis, 2009 WL 2106106 (Cal. App. 1 Dist.) (July 16, 2009) (unpublished), the defendant found an ideal solution, by using an expert for rebuttal purposes only to discredit the damages evidence offered by the plaintiff’s expert. This choice left the jury with no basis for a damages award and they awarded $42,182 on the plaintiff’s $800,000 claim.

Who is qualified? When you make the decision to incur the cost of an expert, you want to make sure it’s the right one. In MDG Internat’l v. Australian Gold, Inc., 2009 WL 1916728 (S.D. Ind.) (June 29, 2009), an otherwise “supremely qualified” expert failed to satisfy the requirements of the Federal Rules of Evidence and Daubert. The expert, a professor of accounting and chair of an accredited MBA program deeply experienced in valuing public companies, was engaged to value a private company. The court concluded that he lacked the requisite “knowledge, skill, experience, training, or education” to testify regarding the value of the closely held business at issue, and went on to find that the expert’s opinions and methodologies were riddled with deficiencies. “Expert” is not broadly defined. It is critical to engage someone experienced in the particular issue of the case.

Of course, there are always outlier situations. Chick-Fil-A v. CFT Development, LLC, 2009 WL 1754058 (M.D. Fla.) (June 18, 2009) is one such case. At issue was whether Panda Express (the defendant), which was proposed to be built next to a Chick-Fil-A, would derive 25% or more of its gross sales from the sale of chicken (and thus be enjoined from opening under a restrictive covenant on the property). The plaintiff’s and defendant’s experts proposed alternative methods of calculating the 25%, and both parties filed Daubert motions, claiming the other’s expert was unreliable or irrelevant. In the absence of any precedents (legal or accounting) on how to calculate the percentage of sales from chicken (for example, does it include non-chicken ingredients in a chicken dish?), the court permitted both experts to testify, saying that “the certainty and correctness will be tested through cross-examination and presentation of contrary evidence.”

Not all experts face the Daubert test. Certain states continue to use a hybrid of that new federal rule and their own standard, based on the so-called Frye rule (from Frye v. United States, 54 App. D.C. 46 (1923)), even though Daubert overruled that case. The Frye test requires that an expert’s opinion derive from a principle that is “sufficiently established to have gained general acceptance in the particular field in which it belongs.” This was the test used by the court in 8000 Maryland LLC v. Huntleigh Financial Services, Inc., 2009 WL 2144895 (Mo. App. E.D.) (July 21, 2009). There the court of appeals affirmed that the plaintiff’s expert, a CPA/ABV, ASA, CVA with a master’s degree in finance and twenty-five years experience valuing public and private companies, had based her conclusions on facts and data reasonably relied on by similar experts.

Watch your expert’s language. You’ve hired an expert. They’ve passed the hurdle of court acceptance. They give their opinion. It goes without saying (or does it?) that that opinion needs to be powerful, well presented, and not based on speculation. In Lucent Technologies, Inc. v. Gateway, Inc., 2009 WL 2902044 (C.A. Fed.) (Sept. 11, 2009), the plaintiff’s expert’s patent damages calculation, which resulted in a jury award of $358 million, was thrown out (and the jury award reversed), based largely on the expert’s testimony that to calculate a lump-sum amount (of damages), the parties might start by looking at the running royalty “and then speculating as to the extent of the future use” (emphasis by court). Perhaps it was semantics, (the expert might just as easily have said “estimate”), but the court held that what it dubbed the “lump sum speculation theory” improperly suggested guesswork, not rigorous analysis. The court went on to bolster its decision, finding that the expert’s comparables had no probative value, as the technology at issue was unique and difficult to compare meaningfully.

The bottom line: it pays to hire an expert, but be sure it’s the right expert doing the best job possible.

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Credibility in Court—the View from the Bench

At the recent Summit on Business Valuation in Divorce, the very first question posed to the panel of four judges was, “What makes a BV expert credible in court?”

Credibility, by any standard definition, connotes the quality, capability, or power to elicit belief. The following are the qualities that convey credibility to a court:

Flexibility. “I can tell you what makes an expert incredible: it’s taking the defensive… saying ‘nothing will change, my valuation stands as it is,’ then you become incredible,” said Judge Jacqueline Silbermann (New York). Your experts should be adaptable and prepared to recalculate their values depending on what a judge or opposing attorney asks.

“Show reasonableness,” added Judge Moshe Jacobius (Illinois). Be careful your expert doesn’t compare the small subject company to a Fortune 500 or omit an exceedingly obvious (even to a lawyer or judge) item from a valuation. Judge Howard Lipsey (Rhode Island) says he doesn’t like the “wise-ass, defensive expert, who gets on the stand and says, ‘I know everything.’”

Transparency. Judge Edward Jordan (Illinois) expects valuation experts to demonstrate “transparent objectivity.” Should the witness come across as a “hired gun,” then “that gets my attention quickly,” he said. “And if that person’s credibility goes, it’s gone completely, no matter how hard counsel may work to rehabilitate.”

Real credentials, not just alphabet soup. “It really doesn’t make any difference how many designations an expert has,” Judge Jacobius said, perhaps summing up the panel’s view. Of greater significance is how much work the expert has done in an area, and how knowledgeable and reasonable they are. “My experience has been that some experts are more interested in marketing their qualifications than offering sound, substantial opinions,” said Jacobius. But you don’t always have to hire the most experienced expert. Judges are also willing to give newly credentialed experts a break. “I like getting rookies in my courtroom,” Judge Jordan said. “Everyone has to start somewhere,” and as long as they offer transparent, objective, and inherent rationale opinions, they’ll lay a foundation to lasting credibility.

Industry vs. appraisal experience. “Remember the five P’s,” Judge Jordan said: “prior planning prevents poor performance.” The more credible expert is the one who puts the most work into the valuation. In other words, “If you have more experience in industry, take the time to learn business valuation,” Fishman said, “and vice versa.”

Written vs. oral. “An oral report is only as good as the paper it’s written on,” joked Judge Lipsey. Even written, technically, all valuation reports are hearsay. To expedite matters, consider asking whether the attorneys on the case will stipulate to the admissibility of the report. If they will, then the content is still open to cross-examination but the hearsay problem becomes moot. As for rebuttal reports, it’s a better idea to use a chart to show the contrasting points between your expert’s opinion and that of the opposing expert. This helps the court focus on the critical differences and the reasons behind them. Also, in the case of court-appointed experts, each side may retain its own expert to critique the neutral.

Prior disqualifications or discredited opinions. What if opposing counsel argues that the expert was disqualified in a prior decision? That evidence is simply not admissible; it’s highly prejudicial and irrelevant. “Your credibility is based on our report, the work you’ve done, your transparency, and your objectivity in this case,” Jordan said. However, there are some exceptions. If an expert valued a company five years prior to trial, then that report is likely to be relevant. To be on the safe side, experts should always disclose to the lawyer anything in their past that might discredit their opinion—a rejected report, findings of incredibility by a certain judge, etc.—so they can prepare the issue for depositions and trial.

Do judges give more credibility to court-appointed experts?“I vouch for the credentials of court-appointed experts, not their credibility,” Judge Lipsey said. “We have to be open-mined; fair-minded,” Judge Jacobius concurred. “We have to base our ultimate opinions on the requirements and results of testimony.”

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New Thinking on DLOM

A new survey by the BVWire™ on the current methods for calculating the discount for lack of marketability (DLOM) shows an increasing sophistication among business appraisers in their understanding and appreciation of the factual, legal, and empirical underpinnings of any DLOM conclusion. Following are some of the most interesting revelations from this survey and key points to consider in the assessment of your expert:

Experts agree on differentiation of marketability from minority risks. In other words, DLOM is not DLOC (discount for lack of control). “No one who is competent aggregates them into one discount anymore,” said one survey participant. Another participant noted that the two discounts “are not additive and represent different considerations: level of cash flow and control vs. liquidity.”

How is Mandelbaum being handled? In the seminal tax court case, Mandelbaum v. Comm’r, T.C. Memo 1995-255 (1995), Judge Laro, “[h]aving found limited refuge in the opinions of either expert,” proceeded to determine the value of the marketability discount based on the following 10 criteria:

1. Private vs. public sales of the stock
2. Financial statement analysis
3. Dividend policy
4. Nature of the company: its history, industry position, and economic outlook
5. Company management
6. Amount of control in the transferred shares
7. Restrictions on transferability
8. Holding period for the stock
9. Company’s redemption policy
10. Costs associated with a public offering

These criteria have since become known as the Mandelbaum factors, and for many appraisers, they serve as the starting point for any DLOM analysis. Still, they are seen as a guide only to maintain the line between valuation process and legal practice. Other methods are generally used to support DLOM conclusions besides Mandelbaum.

Finding method in the madness. The survey identified the following four commonly accepted and applied methodologies for calculating marketability discounts (and one that is not):

1. Restricted stock studies (used by 90% of respondents).
2. IPO studies (56%).
3. Discounted cash flows (19%).
4. Options valuation models (16.7%).
5. Bajaj-type analyses—which follow Dr. Mukesh Bajaj’s study of restricted stock transactions—do not seem to have gained much traction among the judiciary or legal and appraisal communities.

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