Fair value accounting and litigation:
The next wave of valuation risk

A wave of litigation against firms in the financial services sector dominated federal securities class action activity last year, reveals Securities Class Action Filings—2008: A Year in Review, an annual report prepared by the Stanford Law School Securities Class Action Clearinghouse in cooperation with Cornerstone Research. A total of 210 federal securities class actions were filed in 2008, a 19% increase over the 176 such class actions in 2007, and a 9% increase over the average of 192 such class actions between 1997 and 2007.

Fair value accounting appears to be having a significant impact in a number of areas—among them accounting-related litigation and securities class actions. As Antonio Yanez, Jr., a litigation partner with Willkie Farr & Gallagher and a member of the national law firm’s Securities Litigation & Enforcement practice group, explains in his recent Business Valuation Update article, although the impact probably cannot be fully appreciated at this point, there are three key implications for litigation that stand out:

  1. Fair value accounting appears to be contributing to an increase in accounting-related litigation and securities class actions in particular.
  2. Fair value accounting is highly judgment-driven.
  3. Fair value accounting brings to a head the conflict between the evolution of financial reporting, on the one hand, and our system of litigation on the other.

For your own copy of Yanez’ article, visit our free resources page.

Coming soon to BVMarketData.com: Key reports from BizMiner

In the weeks ahead, subscribers will enjoy new improvements at BVMarketData. Case in point: BVResources has entered into an exclusive agreement with BizMiner to provide three-year and five-year historical information on public and private companies. Camp Hill, Pennsylvania-based BizMiner tracks and analyzes the experience of over 18 million U.S. business facilities, condensing millions of data points into the unique measures found in the Profile series. The firm provides many different methods to search for industry reports, including by industry, market area, SIC, or by a keyword search. BVMarketData will be offering a series of reports that focus on financial analysis, as well as industry and market area trends. Stay tuned…

Does personal goodwill attach to a commercial business?

The husband in this divorce case owned and operated a small, closely held commercial business. A court-appointed appraiser valued the business at $421,000, based on the excess earnings method. Similarly, the wife’s expert valued the business at $431,000, in large part due to the husband’s integral role in its operations, but attributed its excess value to “corporate goodwill, not personal to the husband.” By contrast, the husband’s expert said the business was worth barely more than $60,000, based on net asset values, and any additional value was due to the husband’s presence and was personal goodwill (non-divisible).

The court faced an interesting question. At trial, the court noted that both the neutral and the wife’s expert valued the company as a going concern, including a portion of “business” goodwill. Only the husband’s expert valued its net assets, and his treatment of goodwill was contrary to state (Arkansas) law, which distinguished personal goodwill only when valuing professional practices. Averaging the values by the neutral and wife’s expert, the court found the business was worth $425,000, and the husband appealed, arguing that it should have deducted personal goodwill when valuing his commercial enterprise. 

In Cummings v. Cummings (Feb. 11, 2009), the Arkansas Court of Appeals rejected this approach. Both the neutral and wife’s expert included goodwill in their appraisals of the business without assigning it any particular value—and the husband failed to ask the trial court for specific findings regarding this fact. Moreover, by deducting personal goodwill, the husband’s expert did not comply with controlling law, which permits such deductions only in cases involving professional practices, “not ordinary commercial enterprises,” the court said.

For a full write-up of the Cummings divorce, see the upcoming May 2009 issue of Business Valuation Update; the complete text of the court’s opinion will be available at BVLaw.

For the most current, comprehensive overview: Check out the new 2009 edition of BVR’s Guide to Personal vs. Enterprise Goodwill. In addition to 130 on-point case abstracts and 200 court opinions contained on a searchable CD, the Guide contains new articles by professional thought leaders Shannon Pratt, Jay Fishman, Kevin Yeanoplos, Mark Dietrich, Jim Alerding, and a host of others. To view more, click here to see the table of contents.

Significant valuation issues relating to fossil fuel plants

The latest issue of the Energy Market Insights newsletter from NERA Economic Consulting includes an insightful article, Valuing Fossil Fuel Generation Assets in a Green Economy, by NERA vice president James Heidell and senior vice president, Mike King. The piece notes that “challenges for valuing fossil fuel plants will increase going forward as the result of the potential impact of greenhouse gas regulation and policies designed to encourage the development of renewable generating technology,” and outlines a  “stochastic model to help investors gain insights into the critical valuation issues surrounding fossil fuel generation plants.”

Techniques to develop discount and cap rates coming under increased scrutiny

Many traditional models such as CAPM, Modified CAPM, and the Build-Up Model (BUM) are still fully appropriate to utilize, but their inputs now require extra justification. As the economy continues to falter, new questions are being asked about the use of the 20-year Treasury Note as a risk-free proxy and what can be learned from recent work on liquidity and its impact on the cost of capital. Join us on Thursday, April 30 at 10:00am Pacific/1:00pm Eastern for Developing Discount and Cap Rates in a Troubled Economy: New and Emerging Views on Old Issues, a 100-minute teleconference hosted by Ron Seigneur, Don DeGrazia, and Stacy Preston Collins. Two CPE credits are available to all attendees.  To learn more, hear Ron Seigneur describe the program, or to register, click here.  

Venture capital valuations weakening, data show

A recent survey conducted by Fenwick & West—a global law firm that provides services to high technology and life science clients— analyzed the valuations and terms of venture financings for 128 technology and life science companies headquartered in the greater Silicon Valley/San Francisco Bay Area that reported raising capital in the fourth quarter of 2008. According to Fenwick & West’s (F&W) Fourth Quarter 2008 Silicon Valley Venture Capital Survey, up rounds exceeded down rounds 54% to 33%, with 13% remaining flat during the fourth quarter of 2008—the lowest amount by which up rounds exceeded down rounds since the third quarter of 2004. (Note: An up round is one in which the price per share at which a company sells its stock has increased since its prior financing round. Conversely, a down round is one in which the price per share has declined since a company’s prior financing round.)

“Perhaps more ominously, down rounds increased each month through the quarter, and for December 2008, 45% of all financings were down rounds, compared to 48% up and 7% flat,” explains Barry Kramer, partner in the firm and co-author of the survey. Kramer notes that a breakdown of fourth quarter financings by industry disclosed that Web 2.0/digital media was the strongest industry. When Web 2.0/digital media companies are excluded from the results, up rounds decreased to 46%, down rounds increased to 39%, and 15% of the rounds were flat.

Another F&W survey: The 2008 Life Sciences Venture Capital Valuation Survey, also showed a weakening in valuations in the life sciences venture environment. The survey—based on the venture financings of 81 life sciences companies headquartered in the Silicon Valley/San Francisco Bay Area that reported raising money during calendar year 2008—shows that up rounds outpaced down rounds 59% to 22% for life sciences company financings in 2008, with 19% of the financings flat. "This was a significant decline from both 2007 and 2006 as 79% of the financings were up rounds in both of those years," according to Kramer. "Perhaps more importantly, the percentage of up rounds declined as 2008 progressed, with down rounds exceeding up rounds 39% to 30% with 31% flat in the fourth quarter.

ICAEW to SEC: Time mandate IFRS and allow for early adoption

Europe’s largest professional accountancy body, the Institute of Chartered Accountants in England and Wales (ICAEW), says that the global financial crisis has clearly illustrated the need for a global accounting language. It urges the U.S. Securities and Exchange Commission (SEC) to decide quickly on International Financial Reporting Standards (IFRS) transition deadlines to limit uncertainty for U.S. companies. To read public comments received by the U.S. Securities and Exchange Commission (SEC) on its Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers, click here.

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