Attorneys may miss the power of the discount rate
“In my experience, most lawyers don’t understand the power of numbers, and they may ignore the discount rate in preparing for trial,” attorney and author Robert Dunn told attendees at last week’s 24th Annual Seminar by the Valuation Roundtable of San Francisco in Oakland, CA. “To a lawyer, 8% versus 12% may not sound like a lot, but of course as you all know it can make a substantial impact on the calculation of damages. ”After your retention in a litigation matter, make sure to graphically explain to your attorney the difference the discount rate can make,” Dunn suggested.
More good advice: In a notable number of lost profits and economic damages cases, Dunn sees only the plaintiffs presenting expert evidence on the discount rate. So if you’re in a case defending against a claim of damages, it’s even more important to alert your attorney to the need (and your ability) to develop and present discount rate testimony, Dunn explained. If not—and if the trial court accepts the plaintiff’s discount rate—then an appellate court is not likely to reject or adjust it without competing/opposing evidence from the other side.
And did you know there are only twelve significant economic damages cases that discuss the discount rate in any meaningful detail? The leading case is Energy Capital Corp. v. United States, 302 F.2d 1314 (Fed. Cir. 2002), in which the trial court used a 5.9% risk-free rate, the then-current return on 10-year Treasury notes. On appeal, the Federal Circuit Court of Appeals held that a risk-free rate was inappropriate, because it failed to factor in the risk that the plaintiff would not realize the cash flows (projected in its damages claim).
The court reviewed evidence from the plaintiff’s expert (risk-adjusted rate of 10.5%) and the defendant’s (25%), and chose the plaintiff’s as the more realistic. “There’s a lot of meat in the case,” Dunn said, including discussion of using ex post (date of judgment) vs. ex ante (date of breach) for determining overall damages. To add this important case to your legal library, we’ve just posted it as a new free download. The court opinion and case abstract is also available at BVLaw™—along with the rest of the “dirty dozen” discount rate cases.
Laro to appraisers: Be aware of precedent in your jurisdiction
Only 4% of taxpayers are successful in winning their cases in front of the U.S. Tax Court. More importantly, the taxpayer’s residence determines in what jurisdiction the Tax Court “sits” and what federal circuit law applies.
These are just two of the numerous interesting and illuminating facts presented by Judge David Laro and appraiser Mel Abraham during their session to the San Francisco Valuation Roundtable last week. Most attendees were amazed to learn, for example, that the issue of subsequent events could have one of five possible federal rules apply, depending on the location/jurisdiction of the Tax Court in the case. Valuation of embedded capital gains is another “split” issue: Courts in the fifth and eleventh circuits now follow the “bright line” rule of Estate of Dunn and Estate of Jelke, while others have yet to consider and decide the issue. “Which law, which court, which judge, what facts, which expert—these are all questions to ask before a case to make decisions regarding where to file the case and how to prepare the expert evidence,” Judge Laro told attendees. Read and know the precedent that applies to your case.
What if the federal circuit in which the Tax Court sits has yet to rule on an issue? Discuss the matter with the attorney and decide on the better valuation approach. “This is your field; the trier of fact needs your best analysis, one that’s reliable and credible,” Laro said. “Our job is to tell a ‘valuation story’ in an objective, educational way,” Abraham added. “Can we take the triers of fact down the ‘valuation path’ and explain every decision point along the way—the equity risk premium cap rate, size premium, discount rate, etc.—so that by the end of the story they are looking at the result and finding it credible.”
When all else fails, use a forward-looking approach
Keith Prescott addressed this question in last week’s BVR webinar Valuing Construction Companies. While his thoughts are particularly relevant to the hard hit AEC market, they should be recalled in any valuation where volatility is pronounced. “The forward-looking approach will probably be the most valid given the current economic environment and in the near future,” said Prescott. “This approach makes the management interview extremely important.” Prescott advises appraisers to look at the subject company’s backlog, the marketing plan that's in place, and industry and economic forecasts. “We're probably not going to have as high a degree of confidence as we've had in the past, and that's why this whole process becomes much more valuable and much more touchy,” he added.
For more information on the webinar click here.
CPE Opportunity: tiered partnership structures
Join William Frazier and John Porter in a webinar on valuation challenges borne of the increased use of FLPs and other ownership structures. “Valuing Tiered Partnership Structures” is tomorrow, Thursday, May 27th at 10:00 am PT/1:00 pm ET. For more information, or to register click here. Two CPE credits are available.
Ludwick expert reveals unique aspects of
A Tax Court case usually has a large dollar amount at stake or a divisive issue, and Ludwick v. Commissioner (reported in last week’s special edition BVWire™) tackled the long-contested application of valuation discounts to undivided half-interests in real property. “What made this case unique—and what certainly contributed to it reaching Judge Halpern—was a Tenancy in Common (TIC) agreement,” reveals Carsten Hoffman (FMV Opinions, Inc.), expert for the taxpayers. In particular, this TIC prohibited the co-tenants from partitioning the property but gave them the right to sell their undivided interest to each other; or, alternatively, to sell the entire property. In his analysis, Hoffman gave the waiver-of-petition right precedence while the IRS expert favored the forced-sale aspect, but without discussing the TIC. “Judge Halpern appears to have equated the forced-sale provision to a partition right, thereby giving each co-tenant the unrestricted right to force a judicial partition of the property,” Hoffman says.
Moreover, an investor’s ability to sell their interest to the other investors or to sell the entire property prompted the Judge to assume “a virtually risk-free liquidity option for the investor,” Hoffman adds. Yet, under either scenario, investors would have to forego the enjoyment of a luxury home without being able replicate the existing benefits at one-half the cost—factors that “could significantly increase the likelihood of a vigorously contested process,” Hoffman says.
Hoffman’s summary of this new and somewhat unclear decision:
Having read the decision many times, it remains unclear whether the court’s focus on the relatively minor costs associated with an uncontested sale of the property is a consequence of the TIC Agreement, or of a new line of thinking put forth by Judge Halpern for any undivided interest valuation in which a co-tenant retains the right to force a partition. It seems unfortunate that, on the heels of several decisions emphasizing the importance of transactional data over sole reliance on the cost-to-partition approach, this decision gives little weight to illiquidity considerations [such as] lack of control and lack of marketability. Instead, it focuses on a best-case scenario between cooperative investors. Although much can be said about the shortcomings of a partition approach, one sure way to avoid the argument is to have an iron-clad waiver of the right to partition.
Read Hoffman’s excellent summary and analysis of Ludwick v. Commissioner. And let us know if this case changes how you’ll be approaching and analyzing fractional interests in real property in the future. Comments to the editor welcome, as always.
Federal courts signaling stricter standard for expert
Patent plaintiffs once considered the U.S. District court in the Eastern District of Texas one of the more favorable forums for winning damages—see, e.g., the recent $200 million jury award in i4i Ltd. Partnership v. Microsoft Corp, 2009 WL 2449024 (2009)(as reported in BVWire #85-1). But perhaps no longer: A new case may signal a much stricter damages standard among federal circuit courts and an increased need for plaintiffs to provide more detailed (and more expensive) expert evidence concerning customer use and demand for patented products.
The case is IP Innovation LLC v. Red Hat, Inc., 2010 WL 986620 (E.D. Tex.)(March 2, 2010), and in another turn of events, Judge Rader from the U.S. Court of Appeals for the Federal Circuit was brought in to preside over the Texas proceedings. The plaintiffs claimed their patented workspace switching feature was sold in the defendant’s operating systems, and after applying the “entire market value rule,” their expert included 100% of the defendant’s sales in calculating reasonable royalty damages. His methodology failed to consider, however, that the patented item was but one of a thousand components in the accused products, and evidence showed users did not consider the patented feature essential. Further, the majority of the defendants’ revenues came from sales of servers—which didn’t even include the patented item. In sum, these “stunning methodological oversight[s]” prevented the court from giving the expert any credibility, and it dismissed his evidence under Rule 702 and Daubert.
Next time, use KtMine. The court also discredited the expert for failing to use existing licensing agreements in his reasonable royalty calculations (relying instead on broad, non-comparable industry studies). Perhaps the expert would have fared better by looking at ktMINE™, the only interactive IP database that provides direct access to royalty rates, source licensing agreements, and detailed agreement summaries. For more information on ktMINE’s direct access to royalty rates, source licensing agreements, and detailed agreement summaries from over 13,000 public royalty rate, licensing, and lump sum agreements—contact Randy Cochran.
Court rejects use of historic three-year average under Daubert
Have you ever used a business’s three-year historical annual average to project sales and revenue growth, EBITDA or capital expenditures? Have you ever used the term “zone of insolvency” to describe a business on the brink of bankruptcy? Does your valuation report sometimes omit the precise formula used in your DCF?
If you answered “yes” to any of these questions, then the Onex bankruptcy opinions—a duo focused on a Daubert challenge to the BV expert—are a must-read. In the first phase, the federal district court considered the trustee’s claims that three LBOs were fraudulent conveyances. The trustee’s expert rejected management projections in favor of using industry data and flat, three-year historical averages in his DCF. However, the expert provided no “reasoned explanation” or reliable authority in support, the court found. “Rather, [the expert] appears to have selected the three-year rate because it produced a revenue growth outcome closest to the…industry numbers.” Similarly, the expert used “zone of insolvency” without citation to any authority, legal or financial, and the court dismissed his entire opinion under Daubert.
The trustee moved for a reconsideration—attaching a “supplemental” expert report that cited four treatises supporting the use of three-year historical averages, but the court rejected the effort as barred by discovery rules and Daubert. Read the complete digest of Kipperman v. Onex Corp., 411 B.R. 805 (Aug. 2009) and Kipperman v. Onex Corp., 2010 WL 761227 (N.D. Ga.)(March 2010) in the June Business Valuation Update™; the full-text of the court’s opinions will also be available at BVLaw™.
Mercer Capital on the accounting considerations in the acquisition of a failed bank
“Assisted transactions whereby the acquirer obtains the failed bank’s assets, including its loans, along with a loss-sharing agreement present a much more complicated series of valuation and accounting issues,” according to a recent Mercer Capital article, “Accounting Considerations in the Acquisition of a Failed Bank.”
When purchasing a failed bank, acquirers must answer several challenging questions, such as:
- How should the acquirer consider credit deterioration in the determination of the fair value of the loan portfolio, particularly when weak underwriting or servicing lead to great uncertainty as to future credit losses?
- What adjustments are necessary when the actual cash flows from the portfolio differ from the projected cash flows? The preceding analysis made the greatly simplifying assumption that cash flows occur as originally anticipated. In reality, as actual cash flows differ from expected cash flows, the acquirer may need to adjust the loan discount accretion, the loss-share asset, and perhaps even establish a loan loss reserve when anticipated cash flows are lower than initially expected.
Mercer Capital’s full analysis is here.
Chairman’s View: A dynamic business opportunity for valuation practitioners
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For more information visit www.chairmansview.com or contact Chuck directly at email@example.com.
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