The Hempstead Letter
Business Valuation & Corporate Finance News
Vol. XXI, No. 1
In This Issue:
Federal Court Raises
Bar for Expert Valuation Testimony
A District Court Judge in the Southern District of New York tossed
out the testimony of two purported business valuation experts
on the grounds that their work didn't pass muster under the Daubert
standard.
The case was Lippe v. Bairnco Corp., 2003 U.S. Dist.
LEXIS 1133 (S.D. N.Y. Jan. 28, 2003). This was a bankruptcy proceeding
in which the Plaintiffs sought to prove that Bairnco and other
defendants had engaged in a series of fraudulent conveyances to
protect assets from the reach of asbestos claimants. Plaintiffs
offered the testimony of two experts, Thomas E. Dewey, Jr. and
Jocelyn D. Evans, to prove that newly-created subsidiaries did
not pay fair consideration for the assets they purchased from
Bairnco.
Defendants filed a motion to exclude the testimony of the valuation
experts. After reviewing the reports and depositions of the experts,
the Court ruled that their testimony was inadmissible under the
Daubert standard.
The Court found that the testimony of Dewey, an investment banker,
was unreliable for a number of reasons. First, he didn't use the
discounted cash flow method of valuation, even though the court
said that it is recognized as "the most reliable method for determining
the value of a business."
Second, Dewey did not offer his opinion as a range of values,
but rather as a single number. The Court cited a case and several
treatises in support of its conclusion that a range of values
is more appropriate because "fairness is a range, not a point."
Third, Dewey did not rely on accepted business valuation principles
and methods. The Court quoted several excerpts from his deposition
testimony indicating that he did not keep up with business valuation
literature or otherwise educate himself regarding what others
in the field were doing. Accordingly, his methods could not be
tested or compared with any accepted standard.
The Court also had a number of other criticisms of Dewey's work,
relating to a lack of a concrete basis for certain ratios and
premiums.
Jocelyn Evans, a finance professor, was the Plaintiffs' other
valuation expert. The Court discussed her report and deposition
testimony and found that it was also unreliable.
First, the Court did not care for her selective use of control
premiums, which appeared "designed to support the desired results."
Second, Evans relied on a list of comparable companies provided
by Plaintiffs' attorneys, rather than developing one on her own.
Finally, she testified that she had no business valuation experience,
and that this was her first valuation engagement.
The Court concluded that the reports of Dewey and Evans were
not reliable and would not assist a trier of fact. Said the Court,
"the opinions of Dewey and Evans are (not only) shaky, but (they)
are so unreliable-'so unrealistic and contradictory'- as to suggest
bad faith or, at a minimum, as to constitute an 'apples and oranges'
comparison.-I conclude that Dewey and Evans are unlikely to 'assist
the trier of fact' because their opinions are speculative and
conjectural,-they do not apply reliable principles and methods
in a fair and reliable way, and they make no effort to account
for major variables that one would expect to have an impact on
their conclusions. Taken together, these flaws and failings go
far beyond weight." Accordingly, the testimony of both experts
was excluded.
In a subsequent opinion, Lippe v. Bairnco Corp., U.S.
Dist. LEXIS 3861 (S.D. N.Y. Mar. 14, 2003), the Court ruled on
Plaintiffs' motion to substitute a new valuation expert or submit
a supplemental expert report. The Court denied this motion, and
went on to rule favorably on the Defendants' motion for summary
judgment because Plaintiffs had failed to provide any "concrete
evidence" in support of their fraudulent conveyance claim.
This case is an object lesson, if ever there was one, on the
importance of using a properly qualified and experienced valuation
expert in any matter where there is a likelihood that the valuation
work will end up being tested in court.
Tax Court "Digs Deeper"
in Determining Valuation Discounts in a Family Limited Partnership
A recent Tax Court decision, Charles T. McCord, Jr. and Mary
S. McCord v. Commissioner of Internal Revenue, 120 T.C. No.
13 (May 14, 2003), has shed light on how the IRS and the Tax Court
approach the determination of appropriate discounts for lack of
control and lack of marketability in the valuation of family limited
partnerships (FLPs).
While the McCord decision dealt with a number of non-valuation
issues, including the extent of the rights transferred (limited
partnership interests vs. assignee interests) and several charitable
gift issues, the Tax Court's discussion of the various studies
and/or empirical data typically used by valuation professionals
to support appropriate valuation discounts provides a useful road
map in preparing supportable FLP valuations.
The taxpayers formed McCord Interests, Ltd., L.L.P. (Partnership)
in 1995. At the valuation date, the Partnership's assets consisted
of marketable securities (65%), real estate limited partnership
interests (30%) and directly owned real estate (5%). In early
1996, the taxpayers effectively transferred assignee interests
in the Partnership to their children.
The taxpayers' valuation expert essentially valued the transferred
assignee interests at $7.4 million utilizing an effective minority
interest discount of 22% and a discount for lack of marketability
of 35%, resulting in a total discount of 43.8% from the Partnership's
net asset value. In contrast, the IRS' valuation expert essentially
valued the transferred assignee interests at $12.4 million utilizing
an effective minority interest discount of 8.34% and a discount
for lack of marketability of 7%, resulting in a total discount
of 14.8% from the Partnership's net asset value. After considering
the testimony of the two experts, the Tax Court ultimately concluded
that an effective minority interest discount of 15% and a lack
of marketability discount of 20% were appropriate (i.e. a total
discount from net asset value of 32%).
In arriving at effective minority interest discounts to apply
to the Partnership's net asset value, both experts examined data
on publicly traded closed-end investment companies that typically
trade at discounts from net asset value due to investor's lack
of control over the assets owned by these funds. The IRS' expert
also examined data from a sample of over sixty publicly traded
real estate investment trusts (REITs) while the taxpayers' expert
relied on data from a sample of just five publicly traded real
estate holding companies.
With respect to the data on closed end investment companies,
the taxpayers' expert selected discounts at the high-end of the
range while the IRS' expert selected discounts at the low end
of the range. Ultimately the Tax Court rejected both experts'
arguments and elected to utilize the average discount indicated
by the applicable data. The Tax Court also rejected the taxpayers'
expert's analysis of publicly traded real estate holding companies
based on the limited sample size and accepted the IRS' expert's
REIT analysis, although with significant adjustments.
In selecting an appropriate discount for lack of marketability,
the taxpayers' expert relied on two categories of published studies
commonly used by business appraisers. The first type of study
(referred to as a Pre-IPO study) compares the private market price
of shares sold before a company goes public with the public market
price obtained in the initial public offering (IPO) of the shares.
The second type of study (referred to as a private placement study)
compares the private market price of restricted shares of public
companies with their public market price.
The IRS' expert offered testimony that the Pre-IPO studies are
flawed based on the fact that the Pre-IPO discount may reflect
more than just the availability of a ready market. Since the taxpayer's
expert was unable to offer any rebuttal to the IRS' expert's criticism
of the Pre-IPO studies, the Tax Court rejected the Pre-IPO studies
and turned its attention to the private placement studies utilized
by both experts.
The taxpayer's expert cited four published private placement
studies in concluding an applicable discount for lack of marketability
of 35%. The IRS' expert countered with the argument that the discounts
observed in traditional restricted stock studies are attributable
in part to factors other than impaired marketability. To support
his arguments, the IRS' expert analyzed data from other studies
(including his own unpublished study) involving both unregistered
private placements (similar to those used by the taxpayers' expert)
and registered private placements in concluding an applicable
discount for lack of marketability of 7%, which was towards the
lower end of the range of discounts indicated by his studies.
In reaching its decision, the Tax Court agreed with the IRS'
expert that private placement studies used to quantify discounts
for lack of marketability should include both unregistered and
registered private placements. However, the Tax Court saw no reason
to select a lack of marketability discount at the lower end of
the range and instead concluded that the appropriate discount
for lack of marketability should be 20%, based on the average
of the discounts in the IRS' expert's studies.
At first glance, this case may look like an attempt by the Tax
Court to split the difference between the taxpayers' position
and that of the IRS. However, a close reading of the Tax Court's
decision shows an increased willingness to delve into the underlying
empirical data and methodologies used to derive appropriate valuation
discounts. We believe that this case will ultimately raise the
bar on what constitutes an acceptable valuation report and shows
the dangers in relying on "cookie-cutter" appraisals prepared
by experts who do not have a full understanding of the underlying
data and methodologies used in their reports.
A
Contemporaneous Appraisal Can Help Defuse "Cheap Stock" Issues
on IPOs
The American Institute of Certified Public Accountants (AICPA)
is about to issue a practice aid dealing with the valuation of
shares issued by privately-held companies. The principal purpose
of the practice aid is to provide guidance in meeting the demands
of the SEC in reviewing the issuances of private company stock
made during the eighteen-month period prior to an IPO. Unless
the registrant can support the prices as having been made at fair
value, it is required to take an expense hit for issuing "cheap
stock" equal to the difference between the price of the private
offering and the IPO price.
One of the principal points made by the practice aid is that
it is important to perform a valuation at the time of the issuance
of the private stock. Such a valuation, a "contemporaneous" valuation,
will be accorded considerably more weight than will one which
is done "retrospectively," that is to say many months after the
issuance. The bottom line advice is that any company planning
an IPO within the next few years would be well advised to have
an appraisal performed at the time of any issuances of stock.
The AICPA practice aid is tentatively entitled Valuation of
Privately-Held Company Equity Securities Issued in Other Than
a Business Combination.
Some
Tips on Making FAS 142 Work
The Appraisal Issues Task Force (AITF),
at its most recent national meeting, held in Atlanta in April,
spent some time discussing what its members have learned to date
about making the FASB's goodwill impairment standards work for
clients. These standards, set forth primarily in FAS 142, instruct
preparers of financial statements on how to test acquisition goodwill
on the balance sheet for impairment, and when impairment is found,
how to measure it. Here is a summary of some things that the group
has found to date:
The AITF is a group of business valuation professionals
organized to advise the SEC and the FASB on valuation issues related
to financial reporting. Hempstead & Co. is an active participant
in the group.
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