October 17, 2012 | Issue #121-3  

New ESOP case a tragedy of errors
by trustees, appraisers

Owners of closely held companies with employee stock ownership plans (ESOPs) may be desperately seeking exit strategies these days, but if you want a “textbook” case on how not to conduct a management buyout by leveraging plan assets, consider these facts:

  • First, a company that specialized in “flipping” ESOP companies purchased a firm in the steel storage business for $24 million in 2002. It merged the firm’s ESOP plan into its own and gave stock interests to management insiders on both sides of the deal.
  • Five years later—as real estate markets crumbled, taking the storage industry with it—the “flipping” firm structured an ESOP-leveraged buyout for $44 million, without telling the management-buyers about a third-party deal that had just fallen through at $38 million.
  • A week before closing, the “flipping” firm dissolved the board of directors of the “flipped” firm, reconstituting it with two insiders who held substantial interests in the deal. The board then created an ESOP for the to-be-formed company, appointing the same management insiders as trustees.
  • At the 11th hour, the trustees realized they faced a conflict of interest and retained an “independent” appraisal firm as fiduciary, but forbade the firm from conducting its own valuation, forcing it to rely on an abbreviated valuation conducted by another firm—the same one, in fact, that had annually appraised the ESOP on behalf of the “flipping” firm.
  • A fairness opinion provider also did not conduct its own appraisal and applied a $1.9 million “tax shield” to the final value, when—as expert testimony later revealed—there was “no consensus among the valuation community” to do so.
  • In conducting its “final” appraisal, the firm that had appraised the ESOP holdings in prior years changed its treatment of cash-on-hand and applied marketability discounts unevenly.
  • None of the appraisers were ever told about the failed third-party bid.

Within 18 months, the storage company folded under its debt load and its ESOP participants sued for multiple breaches of the trustees’ ERISA duties. Based on the facts, the federal district court upheld most of the claims and set the trial for damages. Importantly: The trustees’ appointment in this case did not qualify the independent appraisal firm as an ERISA fiduciary. We’ll have the complete digest of Chesemore v. Alliance Holdings, Inc., 2012 U.S. Dist. LEXIS 103731 (July 24, 2012) in the December Business Valuation Update; the court’s opinion will be posted soon at BVLaw.

Our latest online survey: How to treat cash-on-hand and other ‘settled but unsettled’ aspects
of DCF

How do you treat cash on hand (in excess of working capital) in your discounted cash flow analysis of a privately held company under the income approach? That was the lively topic of discussion in a recent LinkedIn thread (registration required). It was also a key focus of the Chesemore ESOP case, above, particularly the way the annual appraisal firm changed its treatment from prior valuations to the final.

In particular, in its first two annual appraisals of the ESOP holdings, the firm concluded that the storage company needed $2.5 million and $4 million in working capital, respectively, and only then included any excess cash in equity. In the year prior to the leveraged buyout, it included only “non-operating capital” in equity without identifying its specific working-capital assumption. Finally, in the abbreviated appraisal conducted specifically for the ESOP trustees, the same firm included all cash in equity, excluding only current customer deposits. Similarly, the fairness opinion provider assumed all cash above customer deposits was nonoperating and counted it as part of the company’s value.

Notably, the court found that neither valuation estimated the company’s “necessary operating capital in light of its historic needs,” but “incorrectly” assumed the company needed no operating cash beyond the amounts necessary to cover its unfunded customer deposits.

Surveying the ‘accepted’ aspects of a DCF. Whether to include cash in net working capital requirements might be a “no-brainer” for most business appraisers—and yet, in the month since the LinkedIn thread began, over 100 comments have challenged this “accepted” DCF practice. Admittedly, some are from the more active participants—but the continued debate prompted us to put together a new online survey (with the help of Rod Burkert, Burkert Valuation) of the “settled-but-unsettled” mechanics of the DCF. Do you ever apply a DLOM to a 100% controlling interest? Should depreciation always equal capital expenditures in the terminal year? There are seven questions in all. The survey won’t take long, and we’ll publish the results in next week’s issue. To participate, click here now.

Auditors still expect appraisers to apply the 25% rule of thumb?

The Federal Circuit’s decision in Uniloc v. Microsoft to abolish the 25% rule of thumb in reasonable royalty analyses couldn’t have been more clear. The case blew the 25% rule “out of the water,” said Steve Economou (Curtis Financial Group) at one of the closing sessions at the ASA’s Advanced BV Conference in Phoenix last week. Prior to the decision, he’d seen the rule used constantly and “too broadly.” An IP appraiser would collect the royalty data, pick the median rate, apply the 25% rule of thumb, and “see if it all worked, without considering the qualitative factors.”

But even post-Uniloc, “we still have to come up with a reasonable [royalty rate] conclusion that the client can support as well,” Economou told ASA attendees. Clients are still the “first line of defense” against taxing authorities, who historically accepted the 25% rule to resolve transfer pricing issues, and also auditors, many of whom will ask—if they don’t see the rule in the analysis—why the IP appraiser didn’t apply it. For these reasons, Economou said, he still includes the rule as a reasonableness check. And when he asked how many at the ASA session still consider it in their analyses, there was a substantial show of hands. As one audience member volunteered, “We used [the 25% rule] in one case because we knew the auditor still used it.”

USPAP review process appears to be working

The Appraisal Standards Board (ASB) received 25 written comments to its Second Exposure Draft of the 2014-2015 version of USPAP, according to J. Carl Schultz Jr., chair of the ASB, who opened last Friday’s public hearing on the proposed changes—or what one attendee called “a meeting of USPAP geeks.” (Another one suggested bringing the USPAP draft home with a bottle of wine as a way to “have a romantic evening with your partner.”)

As we reported last week, the ASA’s BV Committee was among those who submitted formal comments—in particular, its concern regarding when “other aspects” of an assignment could be construed as part of the final conclusion of value. Although the proposed new language ostensibly provides that a report is only final when it’s signed, a spokesperson for the Appraisal Institute asked the board to continue to review its proposed definition. For example, should “any interim communications prior to the signature be marked as such: ‘interim,’ or ‘not yet finished,’ or ‘draft,’ or whatever?” the AI rep asked. “These communications are snippets; they aren’t the real report and should not be treated as such.” At the same time, she congratulated the ASB, saying that “the draft review process is working, and we’re getting closer to something that will help the profession.” For a full “live” report from the ASB meeting, check out the BVWire News.

Walsh case leaves critical question for experts: how to distinguish future income from goodwill?

The latest case to consider the goodwill value of a professional practice highlights some of the complex issues involved without really resolving them, comments Jim Alerding (Alerding Consulting), about last week’s write-up of Walsh v. Walsh. For instance, the Arizona Court of Appeals “does not discuss the standard of value at all,” he says, not even to frame its dismissal of the trial court’s “realizable benefits” approach. Yet by affirming the established Arizona rule—that all personal goodwill, salable or no, is marital property—the court effectively moved “the standard of value from fair market value to investment or intrinsic value."

The Court of Appeals also “punted” on a critical question, Alerding says. That is, after likening personal goodwill to a pension, because the values of both assets are generated and established during the marriage, the court failed to give any guidance on how to allocate future earnings between income that arises as a result of an established asset value (such as a pension) and income that results directly from the practitioner’s continued efforts (which are not divisible). In fact, “this issue of future income” has persuaded several states to exclude personal goodwill from the value of a private practice in divorce, Alerding points out. “In other words, if the income generated from the personal goodwill is not salable,” then it is not akin to pension earnings and would not be part of the marital estate.

ASA rolls out new marketing toolkit for members

In its continuing efforts to strengthen its professional brand, the American Society of Appraisers unveiled a new marketing toolkit for members. Among the various tools: a postcard bearing the picture of alphabet soup—from which a large spoon is pulling out the letters ASA.

“We’re doing what you’ve been telling us to do for years,” said Linda Trugman, chair of the BV Committee, in her address to ASA conferees in Phoenix last week, “to set up the ASA as being a really good quality credential.” The member toolkit is “just the beginning of our marketing endeavors,” she added. It should be available soon at the ASA’s BV website, with more member-directed marketing efforts rolling out in the months to come. “We’re here for you.”

How to keep your cool when testimony gets heated

Financial experts might expect an opposing attorney to be aggressive on cross-examination—but what happens when the lawyer starts to “lose it,” becoming hostile or even insulting? That’s when the expert can start to lose control, too—and even feel like walking out (when in a deposition) or letting tempers, rather than reasoned testimony, rule in trial. The next time you find yourself in such a challenging situation, “remain calm,” said Jim Hitchner (Financial Valuation Advisors) at his ASA session on expert witness preparation. If you’re in a deposition, ask your attorney to take a sidebar; if you’re in court, ask the judge whether you can take a break to consult your work papers.

In either case, your request should be honored. Use the time to talk with counsel about what you need to continue testifying; for example, the opposing attorney may need a specific instruction to ask questions in a calm, professional manner—or risk the expert exercising his or her right not to answer. Hitchner provided these additional tips for keeping cool under intense cross-examination:

  • Remember, you are the valuation expert. Only answer questions that are specific to valuation.
  • Never try to guess the answer; take a moment to consult your valuation report and if necessary, quote it word-for-word. 
  • Always respond with a “yes” or “no.” If you don't know the answer, say you don't know.
  • If opposing counsel is reading from a resource or document, ask for a copy. 
  • Never digress to the personal; it almost never benefits you.

A summary of FASB’s September consensus

After its meeting on September 11, the FASB’s Emerging Issues Task Force (EITF) reached a final consensus on three out of five issues, reports KPMG in its current newsletter, Defining Issues. The three final consensuses—which the FASB must affirm before releasing—include:

  • Not-for-profit entities: classification of the sale of donated securities in the statement of cash flows;
  • Subsequent accounting for an indemnification asset recognized at the acquisition date as a result of a government-related acquisition of a financial institution; and
  • Accounting for fair value information that arises after the measurement date and its inclusion in the impairment analysis of unamortized film costs.

The EITF also reached consensus on three exposure drafts, and last week the board released Proposed Accounting Standards Update (ASU) No. EITF-12G, Consolidation (Topic 810): Accounting for the Difference between the Fair Value of the Assets and the Fair Value of the Liabilities of a Consolidated Collateralized Financing Entity. Comments are due by December 10.

CPE that takes you ‘into the trenches’

On October 18, join Nancy Fannon (Meyers, Harrison & Pia) and Keith Sellers (University of Denver) for The Latest on S-Corps: Practical Lessons from Research and the Trenches. This webinar will review current methods and approaches, including the IRS and Delaware Chancery models, to find a credible, practical solution to valuing pass-through entities.

On October 30, Timothy Smith (Touchstone Valuation) will present Valuing Physician Employment Arrangements, Part 10 of BVR’s Online Symposium on Healthcare Valuation. As the trend toward hospital-physician integration continues, new studies have started to question many of the traditional methods and assumptions when valuing current physician compensation/employment arrangements under an FMV analysis. Smith will review this new data in depth to provide current best practices.

Baker moves to MHP

Meyers, Harrison & Pia—currently based in New Haven, Conn., Portland, Maine, and New York City—has just announced that Christine Baker is now a managing director of its business valuation and litigation assistance group in its Manhattan office. “We continue to remain committed to attracting and retaining the best professionals in the country,” says managing partner Mark Harrison. The coming months should also see more expansion of the firm’s New York City team.


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