Litigation Outlook: Court Cases Highlight Valuation Issues
The valuation community is always following court cases that shed light on interesting valuation issues. Here are two recent cases of note.
Goodwill in Divorce
Slutsky v. Slutsky
One of the valuation issues in this New Jersey divorce case hinges on the question of goodwill. The husband, an attorney, was an equity partner in his law firm. As a specialist in complex tax matters, he didn’t bring in his own clients, but he was nonetheless quite successful due to his work ethic and billable hours.
As a partner in the firm, he was bound by a shareholder agreement that included a buyout formula if a partner left the firm.
At the initial trial, both the husband and wife presented valuation testimony. The wife’s side presented a calculation of value that included a goodwill interest of nearly $1.2 million. After some challenges by the husband’s team, the wife’s expert recalculated his opinion of value to a slightly lower amount, admitting that his original numbers were flawed.
In the husband’s expert’s presentation, the expert contended that the husband had no separate goodwill interest. Further, he contended that the husband’s income was reasonable and not excessive. Therefore, his expert said, no excess compensation existed, and the wife was due no more than half of his interest in the firm as calculated in the buyout formula.
Interestingly, the trial court judge adopted the wife’s expert’s original—higher—calculation of value and goodwill, saying said the husband’s contention that the firm had no goodwill was “incredible.” With no further fact-finding, support, or commentary, the court awarded the wife half of the total value of the husband’s interest and the goodwill interest she claimed existed.
The husband appealed, claiming that the trial court’s conclusion demonstrated a “misunderstanding of the facts, misapplication of the law, and abdication of responsibility to reach a result that was the product of a careful and reasoned application of the law to actual facts.” He also pointed out that even if a law firm has goodwill, the firm’s individual lawyers may not have separate goodwill.
The appellate court agreed with the husband’s position, saying, “We believe the trial judge misunderstood [the husband’s expert’s] conclusion” about the firm’s goodwill. The appellate court noted that the husband “was actually paid what a similarly skilled attorney would be paid” and that his “compensation matched his earning capacity, nothing more.” Thus, said the court, “there was no additional component of goodwill.”
For these and other reasons, the appellate court remanded the matter for additional review and, citing “certain credibility determinations,” suggested a “newly assigned” judge hear the case.
Lessons learned: Goodwill can be difficult to calculate, but in this case, the appellate court agreed with the husband that there was no separate goodwill to discuss.
But even beyond that conclusion about the facts of the case, the appellate court showed very little regard for the ruling made by the original judge, suggesting that the judge was somewhat clueless about valuation. Indeed, the appellate court felt so strongly about the judge’s lack of understanding of the issues, it recommended that the original trial judge on the case be replaced with a new judge. Ouch!
ESOP Valuation Gone Wrong
Brundle v. Wilmington Trust
This case involves the employee stock ownership plan (ESOP) of a privately held security firm. The firm had two main clients, government entities that represented 70 percent of the firm’s revenues.
In mid-2013, the owners of the firm formed an ESOP, selling 90 percent of their shares to the ESOP and holding 10 percent in warrants. Known for its ESOP expertise, the firm hired Wilmington Trust as the ESOP trustee, and Wilmington Trust hired Stout Risius Ross (SRR) as the ESOP’s financial advisor.
The litigation referred to two valuations. McLean Group did the first in January 2013, before the ESOP was formed. The McLean appraiser used management forecasts for the remaining months of the year. He performed a discounted cash flow (DCF) analysis and used the guideline company method (GCM) but ultimately ignored the GCM result because the guideline companies were so different from the target company.
In his DCF analysis, the McLean analyst included a “specific company and industry risk factor” due to the company’s small client base. He also applied a discount for lack of marketability and, for the nonvoting stock, a discount for lack of control.
Later that year, SRR did another valuation to determine price per share, relying on both DCF and GCM methods. SRR added a 10 percent control premium for the GCM analysis and adopted five-year management projections.
With the end of the year approaching, the parties hurriedly agreed to a $4,235 per share price. Notably, the trustee committee asked very few questions about the SRR valuation and none about the McLean valuation.
In early 2014, due to financial concerns, management negotiated a quick sale of the company, and the ESOP ended after just seven months.
The ESOP’s unusually short life and the hurried nature of the sale prompted a U.S. Department of Labor investigation of the trustee’s conduct. Did the trustee ensure that the price the ESOP paid for the stock was no more than fair market value (FMV)?
After hearing testimony from two financial experts, as well as the McLean analyst, whom it considered to be “highly credible,” the court found that the ESOP indeed paid more than FMV for the stock because the trustee didn’t adequately review the SRR valuation.
Specifically, the court pointed out that, among other deficiencies, the trustee never examined the McLean valuation report. Also, the trustee knew of the company’s very concentrated client base but didn’t seem to accommodate for that risk.
The court concluded that the ESOP overpaid by $28 million due to the trustee’s failure and requested that Wilmington Trust pay up.
Lessons learned: An ESOP trustee is responsible to the ESOP and is obligated to perform due diligence, including careful examination and understanding of a valuation. It seems obvious that the trustee didn’t do its job here, having overlooked several key factors in the valuation that should have raised red flags about the stock price. In this case, regardless of intent, it appeared that the trustee bought into a scenario painted by SRR that significantly benefitted the sellers.