bvr update 200903

8/13/2019 BVR Update 200903

1/24BVResources.com sm

From the developers of Pratts Stats

Timely news, analysis, and resources for defensible valuations Vol. 15, No. 3, March 2009

B USINESS VA LUATION U PDATE BVRWhat Its Wort

Continu ed to page 6...

Wrestling with GuidelinePublic Market Evidence:What You Need to Know

Turbulence in public markets is wreakinghavoc on unprepared appraisers. Thankfully, theGuideline Public Company Method (GPCM) isone of the tools to capture the effect of todaysvolatile economy on the value of an appraisal

target. Given the importance of this topicangrowing interest by BV expertswe recentlysat down with Robert Schlegel ASA, MCBA withHoulihan Valuation Advisors Indianapolis of ce,for insights on the GPCM and a preview of ourupcoming workshop in Miami Beach, Florida.The interview:

Q: Lets begin with a fundamental question:why should we do Guideline Public Company re-search?

A: Public company trades are the best funda-mental barometers of market conditions that wehave. Valuation implies an appraisal opinion ata date in time , which re ects, as IRS RevenueRuling 59-60 points out, the economic outlook ingeneral and the condition and outlook of the spe-cic industry in particular. Common standardsof Fair Market Value and Fair Value (for nancialreporting) imply our examination of market trans-actions and intentions of market participants.Therefore, an appraisal that ignores market evi-dence really is not an appraisal.

Q: Is Guideline Public Company research ap-propriate only for the large and fast-growing com-panies that may be capable of going public?

A: The answer is both yes and no. If a subjectcompany is a likely candidate for an IPO, condi-tions in public markets are extremely relevant.However, there is merit in avoiding direct com-parison of the corner hardware store on Main

INSIDE THIS ISSUE

Special Report ..............2

Appraisals for Tax PurposesCollateralDamage of the Pomeroy BillWith the introduction of H.R. 111-436 (thePomeroy Bill), on January 14, 2009, thevaluation of fractional interests in familyowned investment entities is threatened withextinction.

Legal & Court Case Updates....................11Grelier v. Grelier Kaminsky v. Herrick Feinstein, LLP.

Fluor Enterprises, Inc. v. Conex Interna-tional Corp.

Funai Electric Co. v. Daewoo ElectronicsCorp.

Russo v. Ballard Medical Products

Medical Staf ng Network, Inc. v. Ridge-way

Kingsway Financial Services, Inc. v. Price-

waterhouseCoopers LLPData & Publication Update........................20

Valuation analysts are often called on to pro-vide litigation support and expert testimonyservices.

BVRConferences.......................................23

Calendar......................................................23

Cost of Capital ..........................................24

Discount Metrics ......................................24

There is a New Beta inTown and its Not CalledTotal Beta for Nothing!By Keith Pinkerton, ASA, CFA, and Peter J.Butler, ASA, CFA

When presenting the Butler Pinkerton Model(BPM) at various conferences across the coun-

Continued to page 4...

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2/24 B usiness V aluation U pdate march 20092

NEIL J. BEATON, CPA/ABV, CFA, ASAGrant Thornton, LLPSeattle, Wash.

JOHN A. BOGDANSKI, JDLewis & Clark Law SchoolPortland, Ore.

NANCY J. FANNON,ASA, CPA/ABV, MCBA

Fannon Valuation GroupPortland, Me.

JAY E. FISHMAN, FASA, CBAFinancial Research AssociatesBala Cynwyd, Pa.

LYNNE Z. GOLD-BIKIN, Esq.Wolf, Block, Schorr & Solis-Cohen, LLPNorristown, Pa.

LANCE S. HALL, ASAFMV Opinions, Inc.Irvine, Calif.

JAMES R. HITCHNER, CPA/ABV, ASAThe Financial Valuation GroupAtlanta, Ga.

JARED KAPLAN, Esq.McDermott, Will & EmeryChicago, Ill.

GILBERT E. MATTHEWS, CFASutter Securities IncorporatedSan Francisco, Calif.

Editorial Advisory Board

Business Valuation Update (ISSN 1088-4882) is published monthly by Business Valua-tion Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. Peri-odicals Postage Paid at Portland, OR, and at additional mailing of ces. Postmaster: Sendaddress changes to Business Valuation Update , Business Valuation Resources, LLC,1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035.The annual subscription price for the Business Valuation Update is $339. Low cost sitelicenses are available for those wishing to distribute the BVU to their colleagues at thesame address. Contact our sales department for details. Please feel free to contact us viaemail at [email protected], via phone at 503-291-7963, via fax at 503-291-7955 or visit our website at BVResources.com. Editorial and subscription requestsmay be made via email, mail, fax or phone.

Please note that by submitting material to BVU, you are granting permission for the news-letter to republish your material in electronic form.

Although the information in this newsletter has been obtained from sources that BVRbelieves to be reliable, we do not guarantee its accuracy, and such information may becondensed or incomplete. This newsletter is intended for information purposes only, and itis not intended as nancial, investment, legal, or consulting advice.

Copyright 2009, Business Valuation Resources, LLC, (BVR). All rights reserved. No part ofthis newsletter may be reproduced without express written consent from BVR.

B USINESS VALUATION U PDATE

Z. CHRISTOPHER MERCER, ASA, CFAMercer CapitalMemphis, Tenn.

JOHN W. PORTERBaker & Botts, LLPHouston, Texas

JAMES S. RIGBY, ASA, CPA/ABVIN MEMORIAM (1946 2009)

RONALD L. SEIGNEUR,MBA CPA/ABV CVASeigneur Gustafson LLPLakewood, Colo.

BRUCE SILVERSTEIN, Esq.Young, Conaway, Stargatt & Taylor, LLPWilmington, Del.

JEFFREY S. TARBELL,ASA, CFA

HOULIHAN LOKEYSan Francisco, Calif.

GARY R. TRUGMAN,ASA, CPA/ABV, MCBA, MVS

Trugman Valuation Associates, Inc. Plantation, FL

KEVIN R. YEANOPLOS,CPA/ABV/CFF, ASA

Brueggeman & Johnson Yeanoplos, P.C. Tucson, AZ

Executive Editor: Lisa Isom

Legal Editor: Sherrye Henry Jr.

Contribut ing Editors: Paul Heidt & Adam Manson

Publisher: Doug Twitchell

Production Manager: Laurie Morrisey

President: Lucretia Lyons

Customer Service: Stephanie Crader

Sales: Linda Mendenhall

Chair and CEO: David Foster

Continued to next page...

SPECIAL R EPORT Appraisals for Tax Purposes:

Collateral Damage of the Pomeroy Billations requirements for family owned operating

businesses would also be reduced. If the Pome-roy Bill becomes law, many people who dependupon such appraisals for their livelihoods will beout of work. All professionals who perform thesetypes of assignments as part of their overall prac-tice will see their revenues decline. This is notlimited to appraisers. Attorneys, accountants, -nancial planners and other nancial service pro-viders will be affected as well.

At the heart of the valuation provisions of thePomeroy Bill is the reestablishment of the family

attribution doctrine, which had been largely dis-credited since a1981 U.S. appeals court decision(Estate of Mary Frances Smith Bright v. U.S .) re-pudiated this doctrine. Family attribution meansthat all fractional interests in family-controlledentities are deemed to be controlling interests.The IRS formally abandoned this notion with thepublication of revenue ruling 93-12 in 1993. ThePomeroy bill is an end run around the judicial andregulatory prohibitions against family attribution.

The seeds of this legislation are found in the

January 27, 2005 report of the Joint Committeeon Taxation:

Under present law, valuation discounts can sig-nicantly reduce the estate and gift tax values oftransferred property. Minority and marketabilitydiscounts in particular often create substantialreductions in value. In some cases, these reduc-tions in value for estate and gift tax purposesdo not accurately re ect value. For example, ataxpayer may make gifts to a child of minorityinterests in property and claim lack-of-controldiscounts under the gift tax even though the tax-

payer or the taxpayers child controls the propertybeing transferred. A taxpayer also may contributemarketable property such as publicly-tradedstock to a partnership (such as a family limitedpartnership) or other entity that he or she controlsand, when interests in that entity are transferredthrough the estate, claim marketability discountseven though the heirs may be able to liquidatethe entity and recover the full value by accessingthe underlying assets directly (p. 399).

By Wil liam Frazier, ASA

With the introduction of H.R. 111-436 (thePomeroy Bill), on January 14, 2009, the valua-tion of fractional interests in family owned invest-ment entities is threatened with extinction. Valu-

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It is clear from the foregoing statement thatthe proponents of the bill are ignoring the re-quirement that fair market value be determinedbased on a hypothetical buyer and seller. Thisis a fundamental part of the meaning of fair mar-ket value and an issue with an extensive judicialand regulatory history.

It is interesting that the bill does not reallyseek to ensure that FLPs are properly valuedonly that more taxes are raised, fairly or not. Ifthe elimination of valuation discounts is basedon the theory that such discounts do not accu-rately portray what happens in an actual markettransaction of a fractional interest, then this ruleshould apply broadly to all tax-related valuations.However, this is not the case. If an FLP interestis gifted to a charity, full valuation discounts willbe required. Therefore, we know that the argu-ment is not based on the economic veracity ofvaluation discounts.

The JCT report echoes the complaints of theIRS that FLP valuation discounts are determinedon a hypothetical willing buyer-willing seller con-cept but, in reality, the taxpayers are abusing theconstruct, making the FLP nothing more than adevice to escape estate taxes. This is the recy-cling of dollars argument.

Proponents of the recycling of dollars theoryassume that the family recipients of the discount-ed, gifted partnership interests will liquidate theentity as soon after the death of the donor aspossible, thereby receiving their pro-rata shareof the partnerships assets (undiscounted). Inthis way, the monetary cycle has been com-pleted and the assets have been successfullyplaced in the second generations hands with atax expense far below the statutory rates. Sincewe know, the FLP is designed to be a very long-term investment vehicle, those knowingly partici-pating in such a plan to liquidate a partnershipprematurely are gaming the system and aresubverting the use of the FLP into a tax avoid-ance device.

We know that such abuses exist but, we be-lieve these abuses exist far more often in smallertransactions in which the taxpayer was not rep-resented by truly quali ed professionals. For ex-ample, a Quali ed Appraiser 1 would be in viola-tion of generally accepted appraisal guidelines if

she were to determine a signi cant valuation dis-count for an FLP, which is soon to be liquidated.

As we will later suggest, there are less draconianways to solve the problem than the bills heavy-handed measures.

The valuation discount provisions of thePomeroy Bill are an over action to the problemand its proposals to far more harm than good.In addition, the tax dollars it seeks to recover forthe Treasury are now illusory.

The Joint Committee on Taxation, in its Janu-ary 27, 2005 report (the JCT Report), Optionsto Improve Tax Compliance and Reform Tax Ex-penditures, claimed that the elimination of valu-ation discounts for transactions involving fami-ly-controlled entities would raise $500 - $600

million per year in additional estate taxes for theyears 2011 and beyond. The JCT based its es-timates on the Congressional Budget Of ces2004 baseline projections for the years 2005-2014. The projections with respect to estate andgift taxes assumed that the tax laws existing in2004 would remain operative. At the time JCTmade the projections, this was an understand-able assumption. Now, however, we know thatassumption is wrong and, therefore, the projec-tions of the JCT Report are no longer valid.

It is known now that the Federal estate andgift tax laws will change. The Pomeroy Bill itselfseeks to increase the lifetime exemption amountto $3.5 million per person. 2 This equates to $7million for a married couple--$5 million higherthan was available when the JCT revenue analy-sis was made. These facts will cause the estateand gift tax increases touted by the JCT Reportto be far overstated and unreliable.

The Pomeroy Bill will deprive taxpayers of theright to have the assets transferred (i.e., limited

partnership interests) properly valued in accor-dance with the Tax Code (i.e., fair market value).The bill proscribes the use of valuation discountsbut is silent on how this can be accomplishedwithin the context of the meaning of fair marketvalue as de ned in the Tax Code. If implementedthe valuation rules of the bill would violate nu-merous sections of the Internal Revenue Codeand many Revenue Rulings. The bills valuation


The Pomeroy Bi ll...continued

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Guideline Public Company Method...continued from fr ont page

rules are in con ict with Treasury Reg. Section20.2031-1(b)) which govern estate taxes andTreasury Reg. Section 22.2512-1, which governsgift taxes. In addition, the bill is counter to Rev-enue Rulings 59-60, 77-287 and 93-12, amongothers. Will Congress repeal all of these rulingsfor the sake of one bill?

The practical effect of this tax inequity is that itwill cause taxpayers to avoid making gifts. Mon-ey not gifted will stay in estates but with a $7 mil-lion exemption, much of this will escape taxation.This would certainly thwart the tax-raising goal ofthe bill.

The argument boils down to one of publicpolicy. Because of perceived abuses, the propo-nents of the bill see FLPs as tax avoidance loop-

holes for the wealthy. Their question is: Whyshould the wealthy be able to reduce their estatetax burden by clever and sophisticated planningwhose only purpose is to avoid taxes?

Suggested solutions to FLP abuses. With-out getting into a public policy debate, there arepractical, appraisal-based solutions to the abus-es that obviate the need for the valuation provi-sions of the Pomeroy Bill. First, require that alltax-related valuations be done by Quali ed Ap-praisers preparing a Quali ed Appraisals. 3 This

will go a long ways towards eliminating inexpert-ly done appraisals or outright cheating.

Next, In order to validate that an FLP is in-deed a long-term investment vehicle designedto promote capital appreciation, professional as-set management, and intergenerational familywealth retention, we recommend that a valua-tion assurance clause be added to the partner-ship agreement. 4 The clause will ensure that,if the FLP is liquidated before the tenth year ofthe date of a gift transfer, the transferee limited

partners will not receive their full pro-rata shareof the partnerships net asset value (NAV). Dur-ing the 10-year period, any amount distributed inliquidation that exceeds the discounted value re-ceived at transfer would be subject to a tax sur-charge unless donated to a qualifying charity.

The two measures described above would elim-inate most of the currently perceived abuses. Fur-thermore, and more importantly, these suggestedchanges would avoid the introduction of new valu-

ation rules, which would massively con ict with theexisting Tax Code and Treasury regulations.

About the author: William Frazier, ASA of Howard FrazierBarker Elliott, Inc. is vice-chairman of the American Society

of Appraisers Government Relations Committee

As that term is de ned under the proposed nal regula-1.tions governing Substantiation and Reporting Require-ments for Cash and Noncash Charitable ContributionDeductions (REG-140029-07).

This is the exemption amount currently in place but, in2.2011, the combined exemption amount is set to revertto $2 million. At this level, the elimination of valuationdiscounts would give rise to the projections suggestedin the JCT report. However, it is a virtual certainty thisassumption is wrong. A $7 million joint spousal exemp-tion would make a large number of previously taxableestates non-taxable.

Again, see proposed nal regulations governing Sub-3.stantiation and Reporting Requirements for Cash andNoncash Charitable Contribution Deductions (REG-140029-07).

William Frazier, Valuation Assurance Clauses,4. Trusts& Estates . December, 2007.

Street with valuation multiples The Home Depot.Obviously, there are substantial differences in

size, markets served, risk, access to capital, anddepth of management, just to name a few dis-tinctive issues.

Rob Slee has done some excellent work in dis-tinguishing the factors between public and privatecapital markets, and we are going to spend sometime on that in the March 26-27 Miami seminar(call 888-BUS-VALU for registration informa-tion.) In contrast, Peter Butler and Keith Pinker-ton suggest that public market evidence providessupport for quantifying company-speci c risk in

the closely held company. I would say that pub-lic market research is vital to understanding theeconomics surrounding small companies. Accessto debt capital is more dif cult now, which wouldpotentially limit the type and capacity of buyers.Generic market evidence of industry trends andeconomic patterns are valid considerations forvaluation choices of growth, forecast, selection ofmultiples, and capital structure.


The Pomeroy Bill...continued f rom pr evious page

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Non-controlling, minority interest values arerelevant to public markets, if we can establishsimilarity of risk and reward. There are few piec-es of evidence appraisers can point to regardingnon-controlling, fractional interest trades on anarms length basis. The issue becomes one ofchoice of the multiple and application of a dis-count for lack of marketability (or liquidity). Ashok

Abbott has done some interesting research here,particularly that market volatility amid decreas-ing cash ows reduces price, but also widens thebid/ask spread.

Q: We hear the term active market as a re-quirement for reliance on trades between buyersand sellers. How does an appraiser decide if themarket is active and the data is any good?

A: We have common benchmarks, such asvolume of shares traded on a single day, oatmeasures, and skepticism of pink sheet trades,but there are risks of non-activity in our presentenvironment. This is another factor of appraisal

judgment.

The latter half of 2008 has seen unprecedent-ed turmoil throughout the U.S. and Internationalmarkets, which most appraisers have not had tostruggle with . . . ever. Toxic assets are usuallyseen as debt securities backed by subprime mort-

gages or complex derivatives. Most have not trad-ed since last Fall; hardly a sign of an active mar-ket. Yet the M&A market is not dormant, and thedeclining stock indexes show there are more sell-ers than buyers these days. The public marketsgive us an insight into risk tolerance and liquidityfor buyers making a pure investment decision.

Another central appraisal decision concerns thetime frame for calculation of the market multiple.Most us tend to default into the Latest TwelveMonths (LTM) mentality. We get the latest four

quarters of reported data from the public company,divide it by the Market Value of Equity (or the MarketValue of Invested Capital), and apply the multipleto the LTM results of our subject company. Couldwe use a four or ve year average? YES. . . Howabout a six or ninth month period? SURE. . . Howmany buyers of closely held companies would onlyrequest nancial data for one year? A true guide-line company is one where we can see depth inperformance to assess growth and aberrations,particularly in use of the operating assets and li-

abilities. Although some transaction databasesare attempting to gather longevity data, GuidelinePublic Company analysis is about the only form ofmarket evidence to offer such depth.

Q: What are the market inputs in using an In-

come Approach?A: The Market Approach and the Income Ap-

proach are linked, so to speak. Essentially, invaluing equity we are considering a CAP rate (ora discount rate less long-term growth) againstsome level of earnings. Value is deduced fromeither a single period capitalization model or amulti-period discounting model of future cashows. CAP rates are either derived from directmarket evidence, as in a Market Approach, orconstructed from a build up of individual vari-

ables, which we call an Income Approach. Rely-ing on the Capital Asset Pricing Model (CAPM)is like a build-up method, because we still haveto assess risk-free rates, Equity Risk Premiums,Betas, and other factors.

All of the key Income Approach elements arebased on public market evidence. That is whywe commonly apply a discount for lack of mar-ketability to the value conclusion. Too many ap-praisers fall into the trap of mistrusting the marketevidence in a Market Approach while blindly, and

somewhat mechanically, adopting an Income Approach without understanding the market dy-namics and underscore the valuation assump-tions. Many discounted cash ow models areeducated guesses with considerable margin forerror. The devil is in the assumptions.

There has been some recent interesting re-search on the Equity Risk Premium componentand faulty Betas by Roger Grabowski and oth-ers, which we are going to explore. Volatility inthe markets may give rise to Equity Risk Premi-

ums higher than the 4% or 5% many of us haveused in the past, and actually closer to the Ib-botson derived calculations over the long term.However, our Miami seminar is less on theoryand more on practice.

A second key market variable in an Income Approach is the weight given to the debt andequity components in constructing a Weighted

Average Cost of Capital (WACC). Ideally, weContinued to next page...

Guideline Public Company Method...continued

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are looking at the percentage market value ofinterest bearing debtwhich may not be bookvalueand market value of equity within capitalstructure. Where do we get this? Most common-ly, from publicly traded market participants in theindustry of the subject company! The turbulenteconomic conditions of 2008 and 2009 haveshaken the stability of accepted notions of pre-ferred capital structure, particularly with the urryof drawdowns in lines of credit during economiccontractions. Current leverage ratios may not besustainable in the long-term amid higher risk, li-quidity needs, and industry contractions.

Q: What should participants bring to the semi-nar?

A: Bring a healthy dose of valuation experi-

ence and suspicion about examining our wildand crazy public markets. Bring your laptopcomputer, because we are going to install theFetchXL program on everyones laptop to exam-ine, real time, public market evidence. A wirelessfeature is key: attendees will play with the varietyof other data sources available. Dont expect to

just sit and take notes here. Ill going to be moreof a shepherd among colleagues, and less a pro-fessor. I would say that our 12 or so hours wouldnot be for the casual appraiser or part-time faint-of-heart analyst. Come to get your hands dirty.

For more information: Rob Schlegel, ASA, MCBA ahighly-rated instructor for the ASA, IBA, and accounting or-ganizationswill offer a one-time intensive seminar in currentapplication of the GPCM on March 26-29 in Miami Beach,Florida. Rob promises a dynamic, hands-on workshop thatwill bring newer business appraisers fully up to speed, allowestablished professionals to hone their skills, and earn 12CPE credits in Miami Beach! For registration details, visitwww.bvresources.com or call 888-BUS-VALU.

Guideline Public Company Method...continued fro m previous p age

Total Beta...continued from front page

culation that so many of us thought, or think,beta performed.

What is Total Beta? The basic concept underly-ing any beta (Market Beta, Sum Beta, Total Beta,etc.) is that it measures the sensitivity of a change

in the return of a security to the change in returnof the market portfolio. Total Beta has been in ex-istence since at least 1981 2. We have relied uponTotal Beta as part of a process to quantify empiri-cally both total cost of equity (TCOE) and compa-ny-speci c risk premiums (CSRPs) for guidelinepublicly traded companies since 2005.

By using Total Beta, we can speci cally, andmore objectively, compare private companieswith our guidelines to better defend and supportthe selection of a discount rate. Indeed, we be-

lieve Total Beta is the most important tool thatanalysts can use to develop an appropriate costof capital for privately held companies (see theaccompanying sidebar, Why Total Beta Trumpsall Other Betas.)

Professor Damodaran of New York Universi-tys Stern School of Business was, presumably,the rst to apply Total Beta in an equation thatshould look vaguely familiar. Rather than apply-ing a Market Beta in the standard capital assetpricing model (CAPM), Professor Damodaran

applies Total Beta in its spot:TCOE = risk-free rate + (Total Beta x Equity

risk premium)

Because Market Beta does such an awful jobof describing total risk, two important questionsmust be considered.

Question: Other than this relatively new con-cept known as Total Beta, what, if any, otherbetas are needed to value privately heldcompanies?

Answer: None, if you so choose 3.

Question: Intuitively, doesnt it make sense touse Total Beta to perform the function that somany of us assumed beta performed?

Answer: Yes, it does make a lot of sense.We explore these two potentially controversial

questions and answers by comparing Total BetaContinued to next page...

try, we often ask audience members to de nebeta. Typically, a brave attendee responds thatbeta, Measures the volatility of the stock relativeto the volatility of the market. This is the com-mon perception of beta 1. Yet in reality, it does notadequately capture the relationship.

To do this, you need the new beta in townTotal Betawhich fortuitously performs the cal-

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with some of the more popular beta measure-ments used in the business valuation industry.First, however, we de ne Total Beta as:

Market Beta divided by R; or

Total Beta = /R and equivalently as the:

Standard deviation of a stock divided by thestandard deviation of the market; or

Total Beta = s / mImportantly, please note the identity: Total

Beta = /R = s / mTotal Beta is concerned with volatility of re-

turns, so it captures total risk 4all systematicrisk, size risk, and company-speci c risk not

just market risk which OLS Market Beta purports

to capture5. For appraisal purposes, this makesTotal Beta very appealing; this is the reference

point we use to value privately held companiesmost of the time.

One calculates Market Beta by ordinary leastsquares regression (OLS), and R is the result-ing correlation coef cient between the stock andthe market de ned as:

R = s,m / s * mWhere s,m represents the covariance of the

stock with the market. Covariance is a statisticalmeasure of the degree to which variables movetogether. OLS Market Beta is de ned as:

Covariance of the stock and the market dividedby the variance of the market; or symbolically as:

= s,m /2

m

Thus, OLS Market Beta is dependent uponcovariance. OLS Market Beta is also the slopeof the best- t linear regression line between thereturns of the stock and the returns of the mar-

ket. As we will nd out, the slope of this line andthe relative volatility of the stock and the marketmay have very little in common. Importantly, OLSMarket Beta can also be de ned as:

= R* s / mThis equation is critical to understanding the

difference between Market Beta and Total Beta. As one can see, OLS Market Beta combines thecorrelation coef cient, R, with relative volatility. Continued to next page...

Thus, Market Beta is not a pure measure of rela-tive volatility. Total Beta, on-the-other-hand, isthe pure measure of relative volatility we as agroup thought we had in beta. Please see therelationship again in the following identity:

Total Beta = /R = s / mConsequently, it should now come as no sur-

prise that a low correlation coef cient could resultin a low beta and simultaneously conceal a highlyvolatile stock. We believe some investors havebeen kidding themselves by falsely believing thatthey have selected a defensive stock becauseits Market Beta has been well less than 1.0 whenin fact the stocks volatility could be ve times ashigh as the markets volatility 6, for example.

Total Beta will always be greater than the OLSMarket Beta since R will never equal 1.0 (indi-cating a perfect, positive linear relationship be-tween a stock and the market). From the otherside of the identity: the standard deviation of anyone particular stock 7 will almost always be great-er than the standard deviation of the market, of-ten times de ned as the S&P 500, for example.

Dividing the Market Beta by R effectively re-moves the guideline stock from a well-diversi edportfolio perspective. This action takes the corre-lation coef cient out of the OLS Market Beta; thestock stands alone, which fortuitously happens tobe the perspective from which we value privatelyheld companies most of the time. Why else havewe traditionally added a CSRP to the discountrate to value privately held rms? No other typeof beta has this perspective. Total Beta trumpsall other betas on this point.

Total Beta also captures 100% of a companystotal risk when all risks are properly disclosedand the market for the particular stock is ef-cient. 8 No other measurement of beta comesremotely close to this ability, including modi ca-tions to OLS Market Beta measurements suchas Sum Beta. Total Beta, therefore, trumps allother betas on this point too. Now lets compareTotal Beta to the other contenders.

Comparing OLS Market Beta to Total Beta: Tocalculate Total Beta, we de ned and used theOLS Market Beta. We disappointingly observed

Total Beta...continued

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Total Beta...continued f rom pr evious page

that OLS Market Betas, depending upon thestock, have extremely poor abilities to capturestocks total risk. In fact, most OLS Market Betasexplain substantially less than 30% of stocks to-tal risk 9, leaving more than 70% to other forces,such as size, unsystematic risk, and possiblyother reasons 10. Despite its faults, we use OLSMarket Betas inside the CAPM to measure sys-tematic risk in the Butler Pinkerton Model in aprocess to provide empirical data on CSRPs asshown below:

CSRP = (Total Beta OLS Market Beta) xEquity risk premium Size premium

CSRP is dependent upon both Total Beta andOLS Market Beta. If you want to separate theCSRP from systematic risk you need both beta

measuresa step the authors like to perform eventhough it is admittedly a moderately subjective ex-ercise. If you want to directly key in on the guide-lines TCOEan approach some appraisers preferbecause they then only have to explain one num-ber to a client, judge, or jurythen you only needto look at Total Beta as shown in this formula:

TCOE = risk-free rate + (Total Beta x Equityrisk premium)

As implied above, appraisers who choose todirectly observe the TCOE do not need to esti-mate a beta, a size premium or, for that matter,a CSRP for a privately held company. Theoreti-cally, if you have only one number to defend, itcould make a deposition and/or cross examina-tion a bit easier. Therefore, Total Beta trumps allother betas on this point too.

Keep in mind, if you directly focus on TCOE,you must compare and contrast your guidelinecompanies with your subject company on ev-ery single risk factorsystematic as well as un-systematic. Conversely, if you separate the twomeasures (systematic and unsystematic) andtake a measure of central tendency for beta,or some other potentially logical representa-tion of systematic risk, you only need to key inon CSR factors when comparing and contrast-ing your guidelines with your subject company.(We will leave it up to other analysts on how theyapproach the discount rate and whether to keyin on TCOE directly, or attempt to allocate therisk via the BPM and build-up the risk and then

compare the private company TCOE against thepublic companies TCOE benchmarks.)

One point is certain: we believe all appraisersshould not only put Total Beta in their toolboxnow, but also reach for it every time they perform

an income approach to valuation. The bene ts ofTotal Beta continue to show themselves. It alsohas been empirically shown that Total Betas arehistorically much more stable than OLS marketbetas or sum betas for that matter. We see thiseven during the same look-back period where weuse different days of the trading week to calcu-late Total Betas, OLS Market Betas, and CSRPsvia the BPM. In other words, there is generallymuch less volatility in Total Betas than OLS Mar-ket Betas. Thus, this is another very importantreason that Total Beta trumps all other betas.

A comparison of OLS Market Beta and SumBeta. Many small public companies (based onmarket capitalization) have small OLS marketbetas. Excluding the troubling rami cations ofmarket inef ciency 11, Sum Betas allegedly cap-ture the lagged response of a companys reac-tions to movements in the overall stock market.This modi cation effectively increases the betameasurement and the calculation of the stockssystematic risk.

Instead of using OLS regression, Sum Betauses multiple linear regression to calculate abeta. Instead of only using current market move-ments to calculate beta, Sum Beta calculationsalso use the returns of the market in a prior pe-riod. Sum Beta is merely the addition of the twobeta coef cients arrived at using current, as wellas prior period, market movements in a multiplelinear regression. We have no criticism of whatSum Beta attempts to doother than the im-plied inef ciency in the market for many stocks,which may or may not be the case (see footnote11.). We do, however, question if it has becomeobsolete, given the introduction of Total Beta? 12 Consider the following quote from MorningstarsBeta Book , 2006 ed.:

Because of non-synchronous price reac-tions, the traditional betas estimated by ordinaryleast squares are biased down for all but thelargest companies. (Emphasis added)


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The non-synchronous price reactions referredto above are company-speci c; Total Beta cap-tures all of these price reactions. Since Total Betacaptures these along with every other disclosedrisk, business appraisers need not be concernedthat some small guideline companies have po-tentially low measurements of systematic risk.

Total Betas inclusion of CSR (as well as allsystematic risks) picks up the OLS Market Betasslack in the measurement of total riskour ref-erence point when we value privately held com-panies. As a result, there is no need to correctmarket risk if our reference point is total risk andthe benchmark is an ef ciently traded stock. Itsprecisely why the aforementioned quote does notsay: Because of market inef ciency , the tradition-al betas estimated by ordinary least squares arebiased down for all but the largest companies.

The market for many smaller stocks is ef cientin the semistrong form. 13 Their total risk just hap-pens to be dominated by CSR, rather than sys-tematic risk. If the market for a particular stock isef cient, regardless of its low measure of sys-tematic risk, its corresponding Total Beta neverneeds corrective action. This is yet another ben-e t to the Total Beta measurement.

Why bother with a Sum Beta adjustment if

the stock trades in an ef

cient market? Whilethe OLS Market Beta may be low, the use ofSum Betas apportions more of the total risk tosystematic risk. The natural result is a smallerand arti cially low CSRP because the total riskof the company should not change for an ef -cient stock 14. Consequently, we believe that thecalculation of Sum Beta is an unnecessary andsubjective step for ef cient stocks after the intro-duction of Total Beta.

Having made the argument above that Total

Beta never needs correction; let us now intro-duce the proverbial wrench. If a guideline isthinly tradedas in an inef cient marketthenappraisers need to explore the possibility thatthere may be an implicit illiquidity discount inthe calculation. By noting when there is a gapin trading volume and/or when the statistical sig-nicance of the linear regression is below 80%,the BPM helps alert appraisers to this possibil-ity. We subjectively chose 80% as a demarcation

line between the ability/inability to allocate totalrisk among its various components. We do notbelieve that there is much con dence in the cal-culation of beta (systematic risk), and hence anyother component of total risk as these percent-ages fall below 80%.

If there is an implicit illiquidity factor in theTCOE of a guideline company, then appraisersmust consider it when assigning a lack of mar-ketability discount to their subject company, or ifthey want to use the guideline at all.

Whether one labels the allocation of risk (sys-tematic or company speci c) is not really that im-portant for business appraisers 15 as long as all ofthe risks are accounted for with Total Beta, and youare consistent among your guidelines and your

subject company. While the BPM attempts to al-locate the risk when subjectively deemed possible,as previously mentioned, focusing on TCOE is an-other viable approach 16. If you decide to allocatethe risk, you can use the TCOEs as reasonable-ness checksanother bene t to Total Beta.

What about forward-looking betas? Forward-looking betas, such as Smoothed Betas, supply in-teresting information. Yet, as we have alluded pre-viously, why not use a forward-looking Total Beta ifyou are interested in using a forward-looking per-

spective, when available? Remember: Total Betais the only beta that views risk from a stand-aloneperspective and captures 100% of the disclosedsystematic and unsystematic risks. Remember aswell that you calculate Total Beta by one side of theidentity with the following formula:

Total Beta = s/ mIf a guideline has publicly traded options, you

can calculate implied forward-looking volatilities(standard deviations) for the guideline and themarketthe only two inputs into Total Betatoget to a forward-looking TCOE. Adjustments toforward-looking OLS Market Betas are inherent-ly guesses. Then again, forward-looking total be-tas are based on empirical data (option prices).

About the authors: Keith Pinkerton and Peter J. Butler areDirectors of Valuation at Hooper Cornell, PLLC in Boise,Idaho.

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Some textbooks describe beta as a relative volatility1.measure.

Please see The Beta Quotient: A New Measure of Port-2.folio Risk by Robert C. Camp and Arthur A. Eubank, Jr.published in the Summer 1981 edition of the Journal ofPortfolio Management, pages 53 - 57. (Note: This articlerefers to Total Beta as the Beta Quotient.)

The authors still rely upon market betas to capture CS-3.RPs in the BPM. However, you do not have to isolateCSRPs if you do not want to. Moreover, Total Beta isso powerful, that you never again have to look at asize premium unless you want to. In the interest of fulldisclosure, the authors still look at size premiums tocalculate benchmark CSRPs.

It has long been accepted that volatility, or standard4.deviation, is an appropriate measure of risk for stand-alone assets.

Models other than the CAPMsuch as the Fama French5.Three Factor Modelmay capture other systematic risksrather than just market or single factor beta risk. Despiteits faults, we have modeled the BPM off CAPM theorysince the CAPM remains today the most widely usedcost of capital model.

In this example, the stocks Total Beta would equal 5.0.6.

Not including closed-end mutual funds that often times7.have more than 500 stocks in their portfolios.

Total Beta will not capture surprises or risks not previ-8.ously disclosed.

Ibbotson SBBI,9. 2008 Valuation Yearbook , p. 112.

As stated above, the BPM depends on standard10.CAPM theory. Analysts who use a different underlyingmodelsuch as the Fama French Three Factor Modelor otherswill arrive at different conclusions regardingCSR, for example.

It seems that if OLS Market Betas historically and con-11.sistently fail to measure systematic risks for smallerpublicly traded stocks, and everyone knew it, then thisphenomenon would eventually be arbitraged away.

Sum Beta does not appear to be widely used on Wall12.Street anyway. For example, we could not nd anymention of it in the most recent (2009) CFA requiredreading materials. On the other hand, OLS Market Betais quite prevalent.

A market is semistrong form ef cient if prices incorporate13.all publicly available information.

Using the same assumptions for the risk-free rate, the14.equity risk premium, the look-back period, the valuationdate, and the market proxy.

Note that we did not say for portfolio managers.15.In our presentations, given the inherent subjectivity16.of CSRP calculations (because they are potentiallydependent upon unstable beta calculations), we havereferred to the BPM as a value-add and commentedthat the signi cant contribution behind the Total Cost ofEquity and Public Company Speci c Risk Calculatoravailable at www.bvmarketdata.com to be the TotalBeta (developed in 1981) and TCOE calculations, whichwere developed by Professor Damodaran. In fact, wehave developed templates (written reports), available tosubscribers, describing each approach (TCOE-focusedversus CSRP-focused.)

Total Beta...continued f rom pr evious page

Why Total Beta Trumps all Other BetasTotal Beta is the best and most complete measure-

ment of risk for business appraisers to focus on to valueprivately held companies. Why? In our estimation, TotalBeta:

Has the same perspective that we use to value1.private companiesnamely as a stand-alone as-set. All other measures of beta represent system-atic risk as part of a well-diversi ed portfolio that ismost appropriate if you are a money manager orstock analystnot a business appraiser.

Captures 100% of historical (disclosed) risks. Such2.

is the case, whether they are systematic or unsys-tematic risks, if the stock trades in an ef cient mar-ket. No other measurement of beta, including SumBeta, comes remotely close to this percentage.

Is generally much more stable than any other3.beta measurement, providing more con dence inthe measure of risk to compare and contrast riskfactors between guidelines and your closely heldcompany.

Allows for direct comparison to public compa-4.nies rather than relying upon averages of publicly

traded data. For example: industry risk premiumsused in the build-up approach capture all of thecompanies in an industry. Some of these compa-nies may have little comparability to your privatecompany. Gary Trugmans book, UnderstandingBusiness Valuation: A Practical Guide to ValuingSmall and Medium Sized Businesses, which pro-vides analyses of the BPM: Now, instead of usingthe entire industry, we can choose better guidelinedata as a starting point.

Captures all of the disclosed risks; one does not5.

need to subjectively correct for any perceivedlow measurement of systematic risk unless pos-sibly the stock traded in an inef cient market.

Provides a means to defend and support one met-6.ricTotal Betarather than Market Beta, the sizepremium and the CSRP to a judge, jury, or client.Moreover, all three of these inputs are generallymore subjective ( read: more volatile) than TotalBeta. Source: Keith Pinkerton, ASA, CFA, and Pe-ter J. Butler, CFA, ASA.

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LEGAL & C OURT C ASE U PDATEWife Loses Discounts inDivorce Battle, Tries toWin the War on AppealGrelier v. Grelier , 2008 WL 5265056 (Ala. Civ.App.)(Dec. 19, 2008)

The Greliers spent the last two years of theirtwelve-year marriage in divorce proceedings.Their primary dispute: how to allocate the hus-bands 25% interest in a consolidation of closelyheld real estate development companies, whichhe owned with his father, his brother, and a fam-ily friend. In response to the wifes requestandan order drafted by her attorneythe trial court

appointed a special master to audit and examinethe books and records of the business, plus itsphysical assets, for the purposes of identi ca-tion and determination of the fair market value ofall business entities in which the [husband] pos-sesses any interest.

One expert turns to three. At trial, the hus-band testi ed that all of his various interests hadsuffered more than ve years of nancial dif -culties, including poor sales, overdue construc-tion loans, and forced debt. Because of these

liabilitiesand despite nding that the businessowned real estate worth $59 millionthe spe-cial master ultimately valued the husbands 25%interest at just over $1 million, without applyingany minority or marketability discounts.

Each of the parties contested the valuation.The wife presented a nancial expert, who testi-ed that the special master had seriously un-dervalued the interests by relying on outdatedreal estate appraisals, but he agreed that dis-counts were not applicable. By contrast, the hus-bands nancial expert argued that by neglectingto apply discounts, the special master failed tocomply with his court-ordered directive to deter-mine fair market value. The husband had neverowned a majority interest in any of the under-lying businesses that formed the consolidatedbusiness; and he did not have the right to actindependently from the majority-interest holders.Moreover, the husband could not convert hisinterest easily into cash, as all of the operating

agreements required prior approval by the otherowners before the husband could sell. Thus, hisexpert applied a 25% discount for lack of market-ability and 25% minority interest discount, which,when combined, would have reduced the valueof the husbands interest to just over $350,000.

After hearing the testimony from all three ex-perts and soliciting legal briefs on the subject,the trial judge accepted the special masters $1million valuation for the husbands 25% interest,but applied a combined discount of 40%.

Wife argues fair value. The wife appealed,arguing as a general matter that discounts wereinappropriate when valuing business interestsin the context of a divorce. The Alabama CivilCourt of Appeals acknowledged that the ques-tion regarding which standardfair market valueor statutory fair valueapplied in divorce caseswould be a matter of rst impression in the state.However, it did not need to reach the issue in thiscase, for several reasons:

Through her attorney, the wife drafted the1.order appointing the special master, spe-cically instructing him to determine fairmarket value of the husbands minorityinterests.

During the trial, both parties presented2.expert opinions and legal briefs regardingthe application of discounts.

In her legal memorandum, the wife chal-3.lenged only the application of discountsto a proper determination of fair marketvalue; she did not challenge the use ofthe fair market value standard, but waiteduntil the appeal to raise the issue for therst time.

Having instructed the special master to de-termine the fair market value of the husbandsbusiness interest, the wife cannot now assert onappeal that the trial court should have applieda different standard, the appellate court held.[A] party may not induce an error by the trialcourt and then attempt a reversal based on thaterror, it said, and upheld the trial courts valua-tion in all respects, including the 40% combineddiscounts.

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The plaintiff tried to introduce a rebuttal wit-ness, to testify regarding the various options thathe could have used to overcome the restrictions.The arbitrators refused to hear this witness be-cause the plaintiff should have presented theevidence in his direct case and/or by cross ex-amining the brokers expert. The panel awardedplaintiff $294,000 in compensatory damagesplus $50,000 in punitive damages. The plaintiffchallenged the arbitrators ndings, but the NewYork Supreme Court (Appellate Division), upheldthe award, noting that that plaintiff gambled onthe panel adopting [his] post-breach analysis,and lost.

Plaintiff turns against attorneys. Havingexhausted his claims against the brokers, theplaintiff sued his attorneys for malpractice, claim-ing that the presented an insuf cient case to thearbitration panel, resulting in unreasonably lowdamages. In particular, the attorneys failed to:

Introduce evidence to support an award1.based on the post-IPO value (or marketvalue) of his stock;

Adduce testimony from plaintiffs primary2.damages expert to show he could havecircumvented the stock restrictions by us-ing options or a private placement; and

Provide a pre-IPO expert valuation of his3.Next Level share, in case the panel ad-opted a date of breach theory and as-sessed damages before the shares begantrading.

The law rm moved to dismiss the claims, say-ing that they had presented ample evidence tosupport plaintiffs damages, including the avail-ability of option strategies as well as expert tes-timony regarding the pre- and post-IPO values

of the plaintiffs shares. The trial court grantedthe motion, nding no causal link between thealleged malpractice and the harm. The plaintiffonce again took his case to the New York appel-late division.

The court began by noting that calculation ofdamages was central to his original case and hisappeal. Nonetheless, the plaintiff didnt present


LEGAL & C OURT C ASE U PDATE

Denied Pre-IPO Shares,Investor Sue Attorneys ForLack of Expert ValuationKaminsky v. Herrick Feinstein, LLP. , 2008 WL5245901 (N.Y. A.D. 1 Dept.)(Dec. 18, 2008)

In hindsight, the bursting of the dot-com bub-ble seems like a minor blip compared to todayseconomic turmoil. Investors, however, are stilllitigating their losses more than a decade later,now turning to secondary sources of recovery,including attorneys and their nancial and valu-ation analysts.

An IPO denied. In 1998, the plaintiff en-

tered into a verbal agreement with a broker withSpenser Trask Securities to invest $100,000 inreturn for an interest in Next Level Communica-tions, a leading broadband equipment companyback. On the eve of Next Levels IPO, however,the brokerage rm rejected the plaintiffs checkfor $100,000 and instead offered him an un-speci ed cash settlement together with the rightto purchase additional Next Level shares at theIPO price. The plaintiff rejected the offer andsued for breach of contract and speci c perfor-mance, seeking $5 million in damages.

Next Levels IPO took place shortly thereaf-ter, in November 1999, and plaintiff claimed thathis $100,000 investment would have been worthtens of millions of dollars. The brokerage rmoffered to settle the case for approximately $3.25million, but the plaintiff rejected this overture aswell. The brokerage agreement compelled ar-bitration, at which the parties focused primarilyon determining damages. The brokerage rmargued that the proper measure of any dam-

ages was at the time of the breachmeaningshortly before the Next Level IPO. The plaintiff,of course, wanted to use a post-IPO value. Hisnancial expert calculated damages as of twodates, February 9, and May 10, 2000, or threeand six months after the company went public.However, the brokers expert testi ed that statu-tory and contractual restrictions would have pre-vented the plaintiff from selling his shares within6 months of the IPO.

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Inc. , 2d Cir. 2007, for the rule that the proper mea-sure for breach of an option to purchase sharesin a corporation on the eve of a public offering isat the time of the breach. (For an abstract of theSoundview case, see the March 2007 BVU.)

Thus, the appropriate time to assess thevalue of [the brokers] performance to plaintiffwas at the time of breach, and the arbitra-tors properly rejected evidence of the value ofNext Level shares after trading began, the courtheld. A post-IPO valuation was not warrantedbecause, had plaintiff wished to own shares andpro t from their appreciation in subsequent trad-ing, he could have purchased them on the openmarket. Given his attorneys objection to thearbitration award and his offer of an alternativevaluation method, with supporting case law, thecourt found no evidence of any malpractice bywhich the plaintiff received an inadequate dam-age award, and it dismissed his claims.


Mixed MethodologiesRender Experts OpinionOn Lost Pro ts UnreliableFluor Enterprises, Inc. v. Conex InternationalCorp. , 2008 WL 5860048(Tex. App.)(Dec. 18,2008)

A petrochemical company hired a mechanicalcontractor to perform certain heat and weldingwork on a large Turnaround Project (the Project)at one of its Texas re neries in 2001. The com-pany also hired a consultant, Fluor Enterprises,to provide engineering guidelines and advice onthe Project, including the welding work done by

its mechanical contractor. After completion, thecompany failed to pay the contractor for nearly$2 million of extra work on the Project. The par-ties settled that dispute for less than $400,000,apparently because that was all the companycould afford to pay.

The contractor also sued the consultant,claiming business disparagement and interfer-

any legal basis for the panel to award damag-es on a post-IPO basis (the price at which NextLevel shares traded during the lockup period orthereafter) or on a pre-IPO basis (expected re-turn from his investment.) The bottom line: heneeded to show how his attorneys failure to pro-vide additional expert testimony would have sup-ported a higher arbitration award.

By contrast, the court noted substantial evi-dence supporting the panels award, includingthe plaintiffs own testimony on his expectedposition in Next Level shares at the time of theIPO ($500,000); and his experts testimony thatconcluded roughly the same return based on theshare price set forth in the IPO prospectus. Anagent from the brokerage rm testi ed that at thetime of the breach, there was a 70% likelihoodthat the IPO would go through; applying this 30%discount to the plaintiffs expected return result-ed in a $420,000 value for the shares.

Finally, the attorney for the brokerage rmsuggested yet another 30% discount would beappropriate, due to the restrictions on the stock.This yielded a net return of $294,000, or precise-ly the amount awarded by the arbitration panel.

Although this portion of the award (the second30% discount) appeared to have been at least

partially based on facts not in evidence, thecourt said, the question of arbitral misconductwas not at issueimplying, perhaps, that theplaintiff missed a possible ground for overturningor increasing the award during his prior appeal.

The court also noted that during the arbitration,plaintiffs attorney objected to the damages esti-mation, claiming that the discounts were basedon made up assumptions. Moreover, plaintiffsattorney alerted the arbitrators to an alternativevaluation method, based on a Massachusetts

case, which used the closing price on the rstday of trading to measure damages in a breachof contract to deliver IPO shares.

The arbitrators apparently rejected this mea-sure for damages without citing the legal founda-tion for their conclusion. While the court acknowl-edged that there was no New York decision onpoint, it cited Boyce v. Soundview Tech. Group,


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ence with its contractual relations, costing it notonly payment for the extra work but also futurework (lost pro ts) from the company on the Proj-ect and others. A jury awarded the contractorover $98 million in damages. The consultant ap-pealed.

The court devoted the rst portion of its opin-ion to considering whether there was suf cientevidence to support the contractors claims forbusiness disparagement. Although it found someevidence from which the jury could have con-cluded that the consultant made malicious state-ments about the contractors work, ultimatelythe court ruled that the record was too weakto support the verdict, which was clearly wrongand unjust. Similarly, the court found that theconsultant failed to produce suf cient evidenceto support the jurys ndings for tortious interfer-ence with contract, and ordered a new trial on allliability issues, including the contractors claimsfor unpaid work on the Project.

The also court addressed whether the con-tractor failed to provide legally suf cient proof tosupport the jurys damages award, including $8.5million for past lost pro ts, $8.5 million for futurelost pro ts (other than those connected with theone project) and $50 million for lost pro ts con-

nected with the Project. Because it ordered anew trial on all liability issues, the court neededonly to determine whether the consultant hadprovided enough proof to support the fact of lostpro ts damages, not the [speci c] amount. (Em-phasis added)

The consultant had to show more than it suf-fered some losses, the court said. At a mini-mum, opinions or estimates of lost pro ts mustbe based on objective facts, gures, or data fromwhich the amount of lost pro ts [may] be ascer-

tained. The bare assertion of lost contracts doesnot demonstrate a reasonably certain objectivedetermination of lost pro ts, it added.

Expert valuation is mixed. The contrac-tor presented an economics professor as itsdamages expert, who limited his opinion to lostpro tsnot causation. (The court does not com-ment on this limitation in its review of the expertsevidence.) He analyzed the contractors average

yearly billings with the petrochemical companyduring an eight-year prior to and a ve-year pe-riod following the Project, and then assumed a21% pro t margin on the difference between thetwo averaged gures.

Apparently, the expert did not consider thecontracts that the company actually awarded thecontractor during the ve-year post-Project pe-riod, nor does it appear that he considered thecontracts actually awarded to [other] contrac-torsfor the period that preceded the [Project],the court said. He also did not consider whetherthere was a downturn in business at the re n-ery during the relevant periods, or whether thecontractor made competitive bids following itswork on the Project. In other words, [the expert]provides no evidence of speci c lost sales re-quired to recover for business disparagement.The court observed additional problems with theexperts lost pro ts analysis:

The expert was not familiar with what the1.normal pro t margin for a mechanicalcontractor would be.

He did not analyze or evaluate the job cost2.analysis provided by the contractor.

He did not include any overhead compo-3.

nent in his calculations.He included the contractors pro ts earned4.through an exclusive maintenance con-tract that was in effect during the 1990sbut terminated three years prior to theProject.

The expert failed to apply his methodol-5.ogy consistently and with objectivitythemost notable shortcoming.

Although the expert included both the turn-around work that the contractor did on the Proj-ect and large capital expenditures, he based hisopinion on lost future pro ts on past performanceonly when it bene tted [the contractor], and heeschewed historically-based averaging when itcame to the [Project]. He used the pro t marginsfrom his previous calculations but not the aver-aged income and costs, the court said. Thus,


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he did not supply one complete calculation, butprovided piecemeal computations based on dif-ferent methods of calculation. Employing mixedmethodologies renders his opinion on lost pro tsunreliable, the court held.

Still, because the company offered some tes-timony (from management) that it suffered someamount of lost pro ts, the court ruled that theconsultant was not entitled to a take nothing

judgment, and remanded the lost pro ts dam-ages claims for a new trial.

One judge on the panel published a strongdissent. Judge Gaultney asserted that there wassuf cient evidence for the jury to return a verdictfor special damages related to the contractorsunpaid work on the project. However, the dissentwould have reversed the remainder of the verdictand render a take nothing judgment against asto all other damages. Generally, lost pro ts nottied to a speci c contract are not recoverable ina business disparagement claim, because theyare not the type of special damage for which thistort action provides a recovery.


Keeping Market ShareReconstruction FromLapsing into SpeculationFunai Electric Co. v. Daewoo ElectronicsCorp. , 2008 WL 5057408 (S. D. N.Y.)(Nov. 26,2008)

After a fteen-day trial, a jury found that vari-ous entities of the Daewoo Electronics Corpo-ration (the defendants) infringed on three valid

patents held by the plaintiff in connection withvideocassette recorder technology. The juryawarded over $9.5 million in lost pro ts damag-es, and the defendants moved for a judgment asa matter of law and a new trial.

In reviewing the record, the court found sub-stantial evidence to support the jurys verdictand rejected the defendants request for a nd-ing that they had not infringed the plaintiffs three

patents as a matter of law. As to the defendantschallenge of the damages award, the court de-scribed the two alternative models that the plain-tiffs expert presented at trial:

A mixed framework that included1.

a lost pro t and a reasonable royaltycomponent. The expert based his lostpro t calculations on evidence that thedefendants sold 1.14 million of the pat-ented units to a major retailer (Target) and.24 million units to other customers, salesthat the plaintiff said it would have madebut for the defendants infringement. Toderive his other sales gures, the expertused a market share analysis, estimatingthat the plaintiff accounted for 30% of allU.S. sales of VCRs. Under this hybrid ap-

proach, damages totaled $11.3 million.A reasonable royalty calculation that2.resulted in $2.5 million total damages. In reconstructing what reasonably royaltythe parties would have agreed to, in a hy-pothetical negotiation, the expert used afour-year period beginning in the fall of2002 and continuing through the end of2006; he also assumed a rate of 10 centsper unit.

Defendants contended that both damagesmodels failed to provide adequate and reliableevidence, suf cient to sustain the jurys award of$9.5 million. The court considered these claimsin turn.

Market reconstruction requires sound eco-nomic proof. To recover lost pro ts, a patentholder must demonstrate that there was a rea-sonable probability that, but for the infringement,it would have made the infringers sales, thecourt observed. This causation inquiry requiresa reconstruction of the market as it would havedeveloped, absent the infringing product. Spe-cically:

Reconstructing the market, by de nition a hy-pothetical enterprise, requires the patentee toproject economic results that did not occur. Toprevent the hypothetical from lapsing into purespeculation, this court requires sound economicproof of the nature of the market and likely

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outcomes with infringement factored out of theeconomic picture.... Within this framework, trialcourtsconsistently permit patentees to presentmarket reconstruction theories showing all of theways in which they would have been better offin the but for world, and accordingly to recover

lost pro

ts in a wide variety of forms.The court found that the plaintiff provided

substantial evidence that there was market de-mand for the patented features of their products,and that non-infringing alternatives were notavailable. Moreover, it presented substantial evi-dence of the products that it would have sold toTarget, but for the defendants infringement; andthe defendants failed to rebut the expert testimo-ny regarding the plaintiffs 30% market share. Asa general model of market share, the plaintiffs

evidence had suf cient basis in fact to prove reli-able, the court said.

Additionally, the court considered the plaintiffsreasonable royalty analysis, which envisionedthe terms of a hypothetical licensing agree-ment between the parties. The defendants tookover sales of the infringing products in the fallof 2002the point at which plaintiffs analysisbegan. Further, through his own investigations,plaintiffs expert concluded that 10 cents per unitwas a reasonable royalty rate, taking into account

the various factors that in uence cost (supplier,quantities ordered, delivery schedule, etc.). Thecourt found that substantial evidence supportedthe plaintiffs reasonable royalty analysis, andupheld the jurys damages award in its entirety.


Conservative GrowthEstimates Help toSustain Damages AwardRusso v. Ballard Medical Products , 2008 WL5247934 (C.A. 10 (Utah))(Dec. 18, 2008)

A medical device inventor created a trachealcatheter that more than tripled the useful life of aprior design. In 1998, he marketed his inventionto Ballard Medical Productsthe worlds largestmanufacturer of closed tracheal systemsun-

der a two-year con dentiality agreement. Ballardagreed to pay a 3% royalty rate for licensing thenew design, but it rejected the inventors requestfor a guaranteed minimum annual payment of$50,000, and the parties broke off their negotia-tions.

The inventor asked Ballard to return his proto-type and related design materials. The companywas unable to locate them and used the inven-tors work to secure two patents and develop acatheter that contained his essential design inno-vations. Ballard began selling the new, improvedcatheter in 2001. The inventor sued for breach ofthe con dentiality agreement and unjust enrich-ment.

At trial, the inventor claimed that the only ma-terial differences between the companys oldcatheter and the new stemmed entirely from hisinnovations and exploitation of his trade secrets.Thus, he was entitled to the entire present valueof the companys expected net pro ts from thenew devices over the 17-year life of the patents,which his expert estimated at $32.3 million.

In addition, applying a 3% royalty rate and$50,000 minimum annual payment, the expertalso testi ed that the inventor would have re-ceived royalties worth $2.75 million (presentvalue) over the life of the patents. This estimatewas conservative, according to the expert, be-cause he used a 5% annual growth rate whenthe company achieved 42% growth from 2001 to2005, and 17% growth in 2004-2005. Moreover,the expert calculated royalties only through thelife of the patentseven though he testi ed thatsimilar medical products have a very long life.Lastly, the expert told the jury that any changesto his assumptions could yield damages in ex-cess of $3 million.

The jury found the company liable on bothcounts, and awarded the inventor $17 million forhis unjust enrichment claim and $3 million forbreach of contract, for a total of $20 million indamages. The company appealed.

The truth lay between the extremes . Thecompany asserted that the inventors contribu-


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tion added nothing or very little of value to itsindependent making and marketing of the newdevice. At trial, the inventor argued that the newdevice was entirely dependent on misappropriat-ing his trade secrets. As if often the case, the

jury found the truth to lie somewhere betweenthe extremes, the court said. The damagesaward represented only 53% of the inventorsoriginal request; in addition, the experts use ofconservative growth rates was another indicationthat the jurys assessment fell within the range ofevidence.

The company urged the court to limit the dam-ages to the two-year span of the parties con -dentiality agreement. After all, the inventor couldhave patented and licensed his device to a dif-ferent company.

This argument was a strain, the court said.The parties agreement did not any limit dam-ages for its breach. Further, the inventor testi-ed that he did not market his device elsewherebecause the con dentiality agreement protectedhis ideas, and he was certain that the partieswould eventually reach an arrangement. Plain-ly, the jury was free to conclude on the basis ofthese facts that [the inventor] had a valid reasonfor waiting to patent his idea, the court ruled.

The award of only 53% of the inventors origi-nal claims was also consistent with some of thecompanys argumentse.g., that at most, thetrade secrets merely lent it a head start on whatit would have achieved on its own.

The company argued that unjust enrichmentdamages are appropriate only when the defen-dant usurps a trade secret to compete with aplaintiff, and the court should limit the inventorsdamages to reasonable royalties. However, oneof the functions of trade secret law is deterrence,

the court said, and to ensure that industrial es-pionage is [not] condonedor made pro table.

Unlike a standard breach of contract claim,misappropriation involves an element of theft,which requires the thief not only to return thestolen goods but also any resulting pro ts. Thecompany must assume the risk for its wrongfulacts, the court held, including paying the inventormuch larger sums than it would have if the par-

ties had entered a lawful licensing arrangement.It con rmed the $20 million damages award.


Courts Void Non-Competeand Remands $1.1 Millionin DamagesMedical Staf ng Network, Inc. v. Ridgeway,2009 WL 21056 (N. C. App.)(Jan. 6, 2009)

Two competitors in the healthcare staf ngindustry vied for the Raleigh, North Carolina,market. One company succeeded in luring theothers top-producing manager, despite knowingthat he was bound by a non-compete agreement.Shortly before he left, the employee accessed anumber of con dential les from his former com-panys computer network, including its marketaction plan and personnel lists. He also tried torecruit several of his former staff to follow him.In the year after his departure, his old staf ngcompany saw revenues decline while his newemployer enjoyed signi cant revenue boosts,due in part to capturing one of its competitorsmajor customers.

The former sued the latter and its former em-ployee for breach of the non-compete agree-ment, misappropriation of trade secrets, and tor-tuous interference with contractual relationship.

A jury returned a $1.1 million verdict for the plain-tiff, and the defendants appealedclaiming thatthe non-compete was invalid and overbroad andthe damages were speculative.

The enforceability of non-compete turnson balancing act. In examining a covenant

not-to-compete, courts generally consider thereasonableness of its time and geographic re-strictions by balancing the employers right toprotect its legitimate business interests versusthe employees right to work. In this case, theplaintiffs non-compete prohibited its employeefrom working in any business within a 60-mileradius that not only competed with the plaintiff,but also any of its divisions, subsidiaries, af li


Conservative Growth Estimates...continued

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ates, predecessors, or assignees, even if [his]employment dutieshad nothing to do with thatbusiness. Likewise, its non-solicitation clauseprevented the employee not only from engagingin business with the plaintiffs current and formerclients, but also precluded him from soliciting thebusiness of any of its clients, which includedclients of its af liates and divisions outside of themedical staf ng business.

We conclude that on its face, this bar extendsbeyond any legitimate interest [plaintiff] mighthave in this case, the court held. The restrictivecovenants were overbroad and unenforceable,and the court reversed the jurys decision withrespect to the breach of contract and interfer-ence with contract claims.

The defendants similarly challenged the mis-appropriation of trade secrets claim. Althoughevidence showed that the employee accessedmarketing information, business strategies, andother con dential client les during his nal dayswith his former employer, there was no evidencethe defendants actually used this informationonce the employer came on board, they said.But the court disagreed, nding that the plaintiffsoffered proof not only that the employee had ac-cess to its trade secrets, but that he used them

as wellin particular in making calls to nursesto recruit them to join the defendants. There wasalso evidence that he accessed the con dentialcomputer les shortly before having a dinnerwith defendants to con rm his new employ. Fi-nally, there was evidence of a substantial turn-around in the defendants business at the sametime plaintiffs business declined, the court said.Viewing all of these circumstances together,there was suf cient evidence to sustain a ndingthat defendants knew of [plaintiffs] con dentialinformation, had an opportunity to acquire it, and

did so, causing [plaintiff] harm.

Economic damages require most reliablemeasure. According to applicable state statute,the proper measure of damages for the misap-propriation claim is the economic loss or the un-

just enrichment that the misappropriation of trade

secrets causedwhichever is greater. However,the trial courts award did not specify which por-tion of the $1.1 million damages was attributableto the misappropriations claim. Thus, the courtof appeals remanded the case for a new calcula-tion of damages that would award plaintiffs thegreater of: 1) its economic losses or 2) the extentto which the defendants unjustly bene ted fromthe use of plaintiffs marketing strategies andnurse contact information.

The court noted that the plaintiff would stillbear the burden to show that its damages couldbe calculated with reasonable certainty. The cal-culations that it presented at trial were basedon the defendants revenues, and the court saidthese were too speculative because: 1) theyused an arbitrary midpoint; and 2) they as-sumed that the plaintiff would have gained allof the defendants revenues but for the wrong-ful conduct. We conclude that [the defendants]revenue could have increased for a number ofreasons unrelated to defendants conduct, thecourt held. For example, if any of the defendantsformer clients simply expanded their operationsand began placing larger nurse orders, thentheir revenues would have increased, a boostthat would have no relation to their bad conduct.

A more reasonably certain measure of theplaintiffs economic lossor the unjust enrich-ment that defendants caused by misappropri-ating the marketing informationwould be thepro t that the defendants gained from the tennurses that they acquired from the plaintiffs list.On remand, the trial court should also considerwhether the parties respective market shareschanged since defendants misappropriation,and if so, it should measure the pro ts attribut-able to such changes. In calculating pro t withreasonable certainty, the trial court must take

into account all relevant factors, the court of ap-peals said, which in this case would include, forinstance, the rate paid by the parties clients aswell as the rates paid to the nurse employeesduring the relevant period.

Courts Void Non-Compete...continued fro m previous p age

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Baf ing Hide the BallTactics in EconomicDamages Discovery

Kingsway Financial Services, Inc. v. Pricewa-terhouseCoopers LLP , 2008 WL 5336700 (S.D. N.Y.)(Dec. 22, 2008)

A law suit is not a game but a search for thetruth. The ends of justice are served, not by giv-ing one side a vested right to exhaust the other,but by affording both an equal opportunity to afull and fair adjudication on the merits. Pola-roid Corp. v. Casselman , 213 F. Supp. 379, 381(S.D.N.Y. 1962)

The Kingsway court highlighted this quotefrom an older case when deciding whether to im-pose discovery sanctions on the plaintiffs in theirsuit against PricewaterhouseCoopers (PwC)for security fraud and conspiracy. The plaintiffsclaimed that from 1999 to 2002, the defendantsfraudulently in ated the stock price of companyto induce their purchase of the same. During thislong litigationspanning at least four yearsthe plaintiffs have refused or resisted providing adetailed description of the precise methodologythey and their disclosed experts used to calcu-late damages, which they allege to be worth over$205 million.

The case highlights costly, contentiousdiscovery disputes. For example, in PwCs rstset of interrogatories, they asked the plaintiffs toidentify: 1) each category of damages sought; 2) a computation of each category of damages; 3) the person(s) most knowledgeable regarding thedamages and their calculations; and 4) the docu-ments that support the calculations.

In a conference with the court, the plaintiffsexplained that they did not want to disclose themethodology by which they calculated damagesbecause they were concerned the calculationsmight change during discover; and they mightgive defendants a road map by which to plantheir trial strategy.

The court nevertheless directed the plaintiffsto respond to the discovery requests pursuantto the Federal Rules of Civil Procedure. Theirresponse provided signi cantly more detail re-garding the computation of damages, includ-ing a breakdown of nine categories of damages(e.g., $50.4 million lost due to materially under-stated reserves; $107.4 million lost due to in-creased cost of capital). They also designatedthree persons with knowledge of the damagescomputations. Nonetheless, when the defen-dants deposed one of the identi ed witnesses,she turned out to know nothing about the dam-ages component; at one point, for example, shestated that she did not realize the plaintiffs suf-fered any adverse consequences to its capital

reserves.The plaintiffs moved for sanctions against the

defendant, including a request for the ultimatepenalty of default judgment. The court expressedsome clear frustration with the unnecessarycosts and con ict that the plaintiffs caused:

The defendantsshould not have been forcedto spend hours at a deposition attempting todiscover which speci c transactions out of thelarger universe of facts underlying the ninedamage categories were within [the witnesss]knowledge. The proper course would have beenfor plaintiffs to identify those categories of dam-ages or those transactions which [the witness]had knowledge and identify any other witnesseswho contributed to the damages calculations, or ifnoemployee had any knowledge ofdamages,that fact should have been disclosedBy nam-ing [the witness] as one of three witnesses withthe most knowledge regarding each componentof these damage calculations, when she lackedany knowledge regarding several of the damagecategories, plaintiffs made it impossible for de-

fendants to tailor their deposition question to [thewitnesss] expertise and therefore unnecessarilyand vexatiously delayed discovery.

As an appropriate sanction, the court orderedthe plaintiffs to pay the defendants fees andcosts in taking the deposition.

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D ATA & P UBLICATION U PDATE

Valuation analysts are often called on to pro-

vide litigation support and expert testimony ser-vices. Below are 20 recommended proceduresfor the valuation analyst who provides expert tes-timony services abridged and adapted from therecently released Guide to Property Tax Valua-tion by Robert F. Reilly and Robert P. Schweihs.

The procedures relate speci cally to ad valor-em tax disputes, including real estate appraisal,tangible personal property appraisal, business(i.e., unit) and intangible asset appraisal, andother appraisal practice areas. However, they

apply equally to all valuation disciplines.The authors note that the recommended

valuation analyst procedures are not presentedin any particular order of relative signi cance.Moreover, these valuation analyst proceduresare merely recommendations. As with all valu-ation analyst procedures, expert testimony pro-cedures are ultimately a matter of the individualanalysts reasoned judgment and professionalexperience. The suggestions:

Understand that the valuation report isyour best friend. This statement is trueon the witness stand it is also true duringdeposition testimony. Accordingly, alwaysbring the valuation report to the courtroomwitness stand or to the deposition. It is ap-propriate to refer to the property valuationreport as often as possible and to readfrom the report from time to time. Experttestimony is not a memory test.

Be fully prepared to present your experttestimony. Review valuation engagement

work papers just before offering expert tes-timony and any analyst eld notes just be-fore offering expert testimony. In addition,review the property valuation report justbefore offering expert testimony. Of course,you should be familiar with the facts of thematter. Moreover, be familiar withand beprepared to explainthe property valua-tion report, the taxpayer property valuationanalysis, and the value conclusions.

Always tell the truth, as you believe it.

Expert witnesses, and valuation witnessesin particular, win if they honestly and fac-tually assert their valuation opinions. Be-lieve in the truth of your valuation analy-sis and value conclusions and demonstrateto the trier of facts that you a fundamental(almost religious) conviction in the truth ofyour value conclusions.

Never trust memory and/or guess theanswer to a question , either in direct ex-amination or in cross-examination. Whennecessary, it is always appropriate to an-swer a factual question, to refer to a spe-cic document to refresh your recollec-tion about a document, a work paper, datasource, or any other matter, or when beingexamined in a deposition, take all of thetime needed to read all documents askedabout. However, when it is the truthful an-swer, the valuation analyst should not hesi-tate to admit: I dont recall or to admit: Idont know.

Do not feel compelled to agree with short

quotes that are taken out of context. Youmay be confronted with short quotes fromthe subject valuation report, the opposingvaluation analyst report, valuation pro-fessional organization course materials,learned valuation textbooks and treatises,and other sources. In addition, you shouldnot feel compelled to readand should notallow the examining attorney to readonlypartial quotes from the property valuationreport, or a valuation treatise, or any otherdocument. The valuation analyst shouldread the entire quote to him or herselfand into the recordbefore answering thequestion being asked. In fact, it may be ap-propriate for the valuation analyst to readseveral paragraphsor even an entirepagebefore answering a question re-garding a quotation.

Never let them see you sweat. It is inap-propriate for a valuation expert to argue


Expert Testimony: Simple Suggestions HelpBV Analysts Bring their A-Game to Court

8/13/2019 BVR Update 200903


during expert testimony, either with the ex-amining attorneys or with the trier of fact.Remember, your role in the courtroom isto educateit is not the role of the valua-tion expert witness to litigate the dispute.That is the job of the trier of fact. It is usu-

ally inappropriate for a valuation expertwitness to advocate for the position of theclient, although it is entirely appropriate forthe valuation expert witness to advocatefor the truth of his or her value conclusionopinion.

Admit mistakes and any omissions. In-tellectually honest valuation experts canchange their value opinions, based on newinformation. It is true that even the bestvaluation experts sometimes make mis-takes. However, it is also true that the verybest valuation experts admit their mis-takes, correct their mistakes, and continuewith their expert testimony.

Acknowledge any material methodolog-ical or conceptual inconsistencies. If it isrelevant to any apparent inconsistencies, itis appropriate for the expert witness to ex-plain how the facts and circumstances aredifferent than in previous litigated cases,previous valuation reports, and so forth. Itis also appropriate to admit if your method-

ology, research, or opinions have changedover time. It is intellectually honest for thevaluation analyst to admit, Ive changedmy opinion on that issue. Remember: thethinking of most professionals (includingvaluation analysts) evolves over time.

Note any inconsistencies in your anal-ysis with (and departures from) theUniform Standards of Professional Ap-praisal Practice (USPAP), other valuationprofession standards, generally acceptedvaluation practices, authoritative valuation

reference treatises, and so on. Of course, itis equally appropriate to explain why theseanalytical inconsistencies and departuresare, in fact, appropriate under the factsand circumstances of the subject taxpayervaluation.

Confront questions intended to implythat you do not have the appropriate ex-perience or expertise thoughtfully. Youmay be asked the following type of voir dire

question: Are you an expert in the taxpayerindustry? One appropriate answer to sucha voir dire question may be: I am an expertin analyzing and valuing taxpayer corpora-tions (or operating assets or properties) inthe subject taxpayer industry. My testimo-

ny is based on my professional valuationexperience and expertise and not on anyoperational experience in the taxpayer in-dustry.

Explain what procedures you performedand why those procedures were rele-vant. You should be con dent when not-ing why the valuation procedures that wereperformed are adequate and appropriateunder the circumstances. If you believethat you have performed a thorough andrigorous valuation analysis, then there isno need to be def

bvr update 200903

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