New case digests and court opinions added to BVLaw
Here’s a sampling of cases we’ve added to BVLaw in the last month:
U.S. Bank, N.A. v. Cold Spring Granite Co., 788 N.W.2d 160; 2010 Minn. App. LEXIS 142 (Sept. 14, 2010)
Appellate court affirms that, absent showing of fraud, a board’s determination of fair value in the context of a reverse stock split is conclusive.
Experts: Schmidt Financial and Neil Lapidus (plaintiffs); Arthur Cobb and Jason Vavra (defendants)
Judge: Worke
State/Jurisdiction: Minnesota
Court: Court of Appeals
Type of case: breach of fiduciary duty
SIC code: 1423 Crushed and Broken Granite
U.S. Bank, N.A. v. Cold Spring Granite Co., 802 N.W.2d 363; 2011 Minn. LEXIS 548 (Minn. 2011) (Sept. 7, 2011)
Minnesota Supreme Court affirms that, absent showing of fraud, a board’s determination of fair value in the context of a reverse stock split is conclusive.
Experts: Schmidt Financial and Neil Lapidus (plaintiffs); Arthur Cobb and Jason Vavra (defendants)
Judge: Anderson
State/Jurisdiction: Minnesota
Court: Supreme Court
Type of case: breach of fiduciary duty
SIC code: 1423 Crushed and Broken Granite
Versata Software, Inc. v. SAP America, Inc., 2011 WL 4017941 (E.D. Tex.)(Sept. 9, 2011)
Court upholds $345 million lost profits/reasonable royalty award for patented software infringement based on careful market reconstruction and calculations by plaintiff’s team of four experts.
Experts: Neeraj Gupta, Chris Blackwell, Roy Weinstein (plaintiff) and Michael Wagner (defendant)
Judge: Everingham
State/Jurisdiction: federal/ Texas
Court: E.D. Texas
Type of case: IP
SIC code: 7372 Prepackaged Software (software publishing)
Latest ‘Bad Facts’ FLP Case Emphasizes Poor Planning
Estate of Liljestrand v. Commissioner, T.C. Memo 2011-259; 2011 Tax Ct. Memo LEXIS 251 (Nov. 2, 2011)
Here’s yet another case that proves the simple point that hiring an accredited appraiser can make a huge difference in estate planning.
After retiring in 1978, a doctor exchanged his interest in a Hawaiian hospital for several real property holdings, including condominiums and a shopping center in California, a warehouse in Oregon, a Florida strip mall, and a medical building in Arizona. Just about six years later, the doctor formed a revocable trust to hold the real property, naming his eldest son as trustee and also paying him to manage the property.
FLP to ensure son’s employment. By 1996, the doctor wanted to plan his estate on behalf of all his four children, but also wanted to make sure that his eldest son kept his position managing the real estate businesses, in which none of his siblings showed an interest. In addition, he was concerned that if he gifted the property while it remained in trust, then local (Hawaiian) law would allow his other children as beneficiaries to seek judicial partition of the property and oust him as manager.
To alleviate these concerns, an estate planning attorney suggested that the father form a family limited partnership (FLP), funded with the trust-owned properties. Accordingly, the attorney formed the FLP in 1997, naming the father as the 99.8% general partner and giving the son a small Class A limited partnership (LP) interest. Within six months, the father transferred all his real property investments, appraised at roughly $6 million, to the FLP.
Over the next two years, he gifted Class B LP units to four trusts established for each of his grown children. Based on the underlying real property values, an appraisal firm valued the Class A LP units at $2.14 million and the Class B units at $5.91 million, as of the date of FLP formation (1997). However, according to court records, the parties “ignored” the formal appraisal. Instead, they valued the FLP’s general partnership units at $59,000, and its LP units at $310,000 (Class A) and $2.0 million (Class B). “It is unclear how the interests were valued,” the court observed.
The parties also ignored the formalities of the FLP and its operations. For instance, they continued to treat the father’s former revocable trust as owner of the real estate, depositing the operational income into the trust’s bank account until 1999, when they finally created a bank account for the FLP. The family’s accountant also reported the real estate income on the father’s personal tax returns in 1997 and 1998. After discovering her mistake, the accountant began keeping appropriate books and records for the FLP, and filed its return in 1999; but rather than go back and amend the prior returns, she decided (along with the father and his attorney) to treat the FLP as commencing operation in 1999. Similarly, the FLP did not execute a formal management agreement with the eldest son until 2001.
Since the father had contributed all but his personal residence to the FLP, the FLP made disproportionate distributions, larger than those provided by the partnership agreement, to pay his living expenses and debts as well gifts to his grandchildren. The FLP also “loaned” money to the eldest son, but he never wrote a promissory note or repaid the loans. When the father passed away in 2004, the FLP refinanced certain properties and used the proceeds to pay the father’s estate taxes of $2.3 million.
In 2008, the IRS assessed a $2.6 million deficiency, based on including the entire fair market value of the father’s real estate holdings in his estate pursuant to IRC Section 2036(a), and the taxpayer petitioned the court for a determination of liability.
FLP asserts three business purposes. To qualify the FLP transfers for the 2036(a)(1) exception as bona fide sales for full and adequate consideration, the estate claimed that the FLP had at least three legitimate, non-tax business purposes, and the Tax Court examined each in turn:
1. Ensured son’s continued employment. By preventing the conflict of interest that formerly existed when the son was acting both as trustee of the revocable trust that held the real properties and their manager, the FLP form made sure he could continue his management role, the estate argued.
But the formation of the FLP simply changed the nature of the trust’s holdings, from directly owning the real property to owning FLP interests, the court observed. The son was still trustee of the trusts that held the partnership interests; and he was the FLP’s general partner. As a result, the FLP “did not resolve [the son’s] conflict of interest…nor did it change [his] his roles with respect to the trust,” the court found
2. Protect the FLP assets from partition. Most of the properties were located outside of the state, beyond the reach of Hawaiian trust laws. Further, the father’s estate planning attorney never researched the application of trust laws in those other states. “The lack of such basic legal research is telling as to the significance of [the threat of] partition in the decision to form” the FLP, the court observed. In any event, the Hawaiian partition laws would not have applied to the trust-owned properties, and the father had left his personal residence to the children as joint tenants, without any apparent “fear of partition” or any evidence that they wanted to partition the FLP properties. Thus the “threat of litigation” did not serve a legitimate business purpose, the court held, declining to apply Estate of Shurtz v. Commissioner, T.C. Memo 2010-21 (litigious atmosphere in Mississippi sufficient non-tax purpose to form FLP)(available at BVLaw).
3. Protection from creditors. Likewise, the court was “skeptical” that the father formed the FLP to protect the assets from creditors, since the estate “failed to name a single” potential claim or “even establish a pattern of activity by the partners” that could expose them to liability.
So, despite some minimal changes to the FLP assets and operation between the time of formation and the father’s death (opening a checking account in 1999, for instance, and minimizing the payouts to the father and the son), the “partnership served primarily as a testamentary device through which [the father] would provide for his children at his death,” the court held. In light of all the other factors in the case, the court included the full, fair market value of the FLP assets in the father’s gross estate, pursuant to Section 2036, and denied the estate’s petition.
Despite ‘egregious’ theft of trade secrets, damages hard to prove
Pure Power Boot Camp v. Warrior Fitness Boot Camp, 2011 WL 4035751 (S.D. N.Y.) (Sept. 12, 2011)
While working as a Wall Street trader, the plaintiff got inspired to start her own physical fitness studio, based on a military boot camp. She visited Fort Knox to research the design, and after investing substantial time and all her savings, she opened the first “Pure Power Boot Camp” in New York City in 2003.
Unique concept. The studio used military camouflage colors and obstacles fitted to the smaller, indoor facility, with flooring made of crushed rubber tires, separated by sand bags, and a running track overhead. Unlike other personal gymnasiums, the “Boot Camp” did not charge a membership fee but enlisted clients as “recruits” who signed up for returning “tours of duty,” outfitting each in camouflage pants and a “Pure Power” t-shirt. The owner hired former marines as “drill instructors,” including two who became her most trusted and sough-after employees.
The studio was an immediate success, and the owner planned to franchise the operations. She had each instructor sign an Employment Agreement, which required them to “devote their skills and best efforts” to the company and contained non-disclosure, non-compete, and non-solicitation provisions. She also registered the “Pure Power” trade dress, receiving a service mark consisting of drawings for an “exercise facility styled to look like a military boot camp training course.”
The owner also opened a second studio just outside Manhattan. She offered one of her top two instructors the option to become a partner in this second studio—but he declined, saying he didn’t have the money. In reality, he was planning his own military-themed gym with the other instructor. Backed by investments from their girlfriends, the two instructors leased a space just fifteen blocks away from the Pure Power studio. They also stole documents from the owner’s office and personal computer, including Pure Power’s business plan, its start-up and operations manuals, and its client list. They also destroyed a folder full of employment agreements—including their own.
The instructors used the stolen materials to launch their “Warrior Fitness Boot Camp.” The sent emails to Pure Power clients, providing detailed description of Warrior Fitness and its classes that closely mirrored Pure Power’s promotional materials. They also disparaged the owner of Pure Power to potential clients. In the spring of 2008, one of the instructors engaged in a “heated exchange” with the owner, prompting her to fire him; within two weeks, the second instructor quit, leaving the studio understaffed.
Three weeks later, the owner discovered the theft of her confidential materials and the plans to open Warrior Fitness by reading her former employees’ personal emails, stored on the company’s computer. In May 2008, she sued both instructors in state court, seeking a temporary restraining order against opening their competing business. The court denied the request, finding that the non-competition agreement was unenforceable, but nevertheless ordered the defendants to return the stolen materials and alter the Warrior Fitness décor to remedy some of the trade dress issues.
Plaintiffs also lose their expert. The defendants then removed the action to federal court and sought to preclude the plaintiff from using their personal emails. The court agreed that the plaintiff’s access of the employees’ personal email accounts, without their permission, violated the federal Stored Communications Act (18 U.S.C. § 2701 et. seq.), and ordered $4,000 in damages. In a pre-trial Daubert proceeding, the court also precluded the plaintiff’s damages expert from testifying as to lost profits, finding that he used a “fundamentally flawed methodology” by calculating lost profits over a ten-year period without adequate support. (Note: research indicates the court made this ruling from the bench rather than in a published opinion.)
The parties subsequently agreed to a bench trial, at which the court considered the plaintiff’s claims that the defendants breached their employment contracts and their common law duties of loyalty, infringed the plaintiff’s trade dress and committed torts of interfering with her prospective economic advantages and contracts.
After a review of the facts and evidence, the court found that the defendants clearly breached the non-disclosure provisions in their employment agreements. As compensatory damages, the plaintiff submitted two alternative measures of lost profits for the claimed damages period (May 2008 to December 2010). First, she attributed all of Warrior Fitness’s revenues to Pure Power and then applied the latter’s 58% profit margin to yielded nearly $1.4 million in lost profits. Second, she took the 147 clients that the defendants had allegedly stolen and, asserting average annual revenues for each of $2,655.00, arrived at nearly $355,000 in damages.
To recover lost profits for breach of contract under New York law, however, the plaintiff needed to show not only that the employment agreement contemplated such a remedy, but that the defendant’s breach caused the loss, which was “capable of proof with reasonable certainty,” the court explained. Based on the evidence presented, the plaintiff failed all three requirements. First, the employment agreements made no reference to lost profits and there was no proof that the parties contemplated such when they entered the contracts.
Second, “regardless of the alternative measures of lost profits offered by the plaintiff,” she failed to establish that her losses were caused by the breach of the non-disclosure agreement, the court held. In other words, there was no proof that “but for” the employees’ stealing her records and client lists, they would not have opened Warrior Fitness. Nor did the plaintiff show that use of the client list was the specific reason why 147 former clients signed up for Warrior Fitness.
Finally, the plaintiff’s proof of lost profits failed for lack of reasonable certainty. Attributing all of the defendants’ profits to Pure Power was “overreaching, inherently speculative, and cannot be tied to the breach,” the court ruled. More importantly, although the relevant information was available to the plaintiff, she chose to ignore the actual financial data in the case, preferring to rely instead on the “mass asset” theory that her expert had promulgated.
“Here, the plaintiff’s lost profits calculation with respect to the 147 allegedly solicited Pure Power clients is based, not on Pure Power’s financial statements or on the actual revenue generated by those clients, but instead on [her expert’s] excluded…report,” the court stated. Although she claimed that her expert’s limited trial testimony established the existence of those 147 clients, the court disagreed, and, “in any event,” found that it had excluded the expert’s report as “inappropriate” to the case. The plaintiff tried to argue that financial evidence in the case established her 58% profit margins, but the court found this number came directly from the “arbitrary” assumptions in her expert’s excluded report, and denied lost profits for breach of contract.
Misapplication of the law for breach of loyalty. The facts of the case clearly established the defendants breached their common law duty of loyalty to the plaintiff, for which she claimed a disgorgement of their profits during the damages period, or close to $2.4 million. Although New York law permitted the plaintiff to recover “an accounting of the disloyal employee’s gain” through a profit disgorgement, the court said, it also required that she show the breach took place during the time of employment and was a “substantial factor” that contributed to the defendants’ gain.
In this case, the defendants opened up their competing gym after the plaintiff terminated them, the court emphasized. Further, the plaintiff “mistakenly conflates [the] defendants’ breaches of loyalty with the profit they earned by opening a competing business.” As with the breach of contract, the documents stolen by the defendants were not a “substantial factor” enabling them to open Warrior Fitness, the court said. Instead, “it was the knowledge [they] gained as trainers at Pure Power that was key.” Accordingly, it denied the plaintiff’s requests for damages for breaches of loyalty.
At the same time, the court found the defendants liable under the New York “faithless servant” doctrine. This entitled the plaintiff to recover the compensation that she paid the defendants while they still worked for her and acted adversely to her business interests, which began in August 2007 with their theft of documents, the court found, and continued until approximately April 2008, when they were terminated. Accordingly, it ordered the defendants to forfeit a total of roughly $96,000.00 in salary between them. In addition, it ordered the defendants to pay an additional $150,000 in punitive damages for their “egregious” betrayals of the plaintiff’s trust. (Final note: research also reveals that the case is currently under appeal.)
Tax Court is equally as likely to throw out IRS or taxpayer experts, professors argue
New academic research suggests that there may be more behind a Tax Court estate tax valuation than simply “splitting the baby,” and it’s not just the increasing sophistication of the court, counsel, and BV experts. Using models from prior literature as well as an updated data set, the authors of the just-posted article “Asset and Business Valuation in Estate Tax Cases: the Role of the Courts” investigated “whether there are certain factors related to the case, the judge, and the economic environment that might influence the judge’s decision.”
What they found: “Evidence . . . suggests that the number of appraisers used by the taxpayer, the gender of the judge, the type of asset being valued, and the size of the U.S. deficit are related to the decision of the court,” conclude Professors Mark Jackson, Sonja Pippin, and Jeffrey Wong, all from the University of Nevada (Reno), who examined 152 decisions from 1986 through 2009. “The court cases indicate that judges sometimes reject the credentials of the taxpayer’s appraiser and other times that of the IRS’s expert,” the authors noted; “we therefore believe that on average each side’s experts are given equal value.”
Court approves expert’s use of “rules of thumb”
Most courts have expected expert witnesses to provide documents “comparables” when calculating the value of a business in dispute. So it’s noteworthy that a source which averages “rules of thumb” multiples by industry has just been accepted in a recent California divorce.
In the case, a joint expert valued the husband’s physical therapy practice between $450,000 and $550,000, using a multiplier of roughly .42 derived from the Business Reference Guide: The Essential Guide to Pricing a Business (BRG)(Business Brokerage Press), an excerpt of which he attached to his report. The trial court approved the source but adjusted the expert’s multiplier upward to 1.0 based on the firm’s historic growth rates, good location, and well-established clientele.
On appeal, the husband challenged the trial court’s reliance on the BRG for: 1) lack of foundation for the author’s expertise; 2) lack of evidence that the joint expert included the BRG’s method in his appraisal or that the court understood it; and 3) lack of support that the BRG method was “reasonable.” The husband also claimed that the negative factors underlying the joint expert’s selection of a lower multiplier were more credible. The appellate court rejected all these reasons, finding that the BRG was a reliable method used by an “undisputed” expert. Read the complete digest of In re Marriage of Bauer, 2011 WL 4337093 (Cal. App.)(Sept. 16, 2011) in the Dec. 2011 Business Valuation Update; the court’s unpublished opinion is currently posted at BVLaw.
New updates to BRG: In addition, BVR has just received the new Business Reference Guide online, in which 65% of the content was just updated—including its sections on Industry Trends, Rules of Thumb, Pricing Tops, General Information, and Expert Comments. Benefits of subscribing to the BRG Online include: 1) the ability to search for businesses using keywords and SIC codes; 2) access to continual updates throughout the year; 3) ease of adding BRG data to reports; 4) access to current industry reports, and more.
Using financial experts in Delaware Chancery Court
To keep up with this important precedent from the “Supreme Court” of corporation law, don’t miss Delaware Chancery Roundtable: Views from the Bench, Council & Witness Stand. In this special two-hour webinar, Neil Beaton (Grant Thornton) and Stephen C. Norman (Potter Anderson & Corroon) will ask Vice Chancellor Donald F. Parsons Jr. what the Delaware Court of Chancery expects from financial experts, their valuation methods, conclusions, and credibility. The session starts December 8th at 1 PM ET.
New digests and court documents recently added to BVLaw
Here’s a sampling of new cases where issues of business valuation, damages calculations, or other analyses by financial experts and business appraisers was crucial to the outcome. The digests and court opinions of all such cases are all available at BVLaw.
In re Southern Peru Copper Corp., 2011 WL 4907799 (Del. Ch.)(Oct. 15, 2011)
Delaware Chancery finds merger process and price tainted by “relative” DCF valuations that obscured “real world” market values, and orders $1.3 billion in damages, based on its own calculation of DCF of acquired company.
Experts: Daniel Beaulne (plaintiffs); Eduardo Schwartz (defendants)
Judge: Strine
State/Jurisdiction: Delaware
Court: Chancery Court
Type of case: breach of fiduciary duty
SIC code: 1099 Miscellaneous Metal Ores, NEC
Dixon v. Crawford, McGilliard, Peterson & Yelish, 2011 WL 4348058 (Wash. App. Div. 1)(Sept. 19, 2011)
Appellate court affirms goodwill value of a dissociated law partner’s interest in a well-established public defense firm under the capitalization of excess earnings method.
Experts: Joe Lawrence (plaintiff); James Weber, Steve Kessler, and Ronald Nelson
Judge: Ellington
State/Jurisdiction: Washington
Court: Court of Appeals
Type of case: judicial dissolution
SIC code: 8111 Legal Services
In re Marriage of Bauer, 2011 WL 4337093 (Cal. App. 4 Dist.)(Sept. 16, 2011)(unpub.)
Appellate court upholds Business Reference Guide rules of thumb for valuing a physical therapy practice at 1.0 times gross income.
Experts: S.M. Zamucen (joint expert); David Hanzich (wife)
Judge: O’Leary
State/Jurisdiction: California
Court: Court of Appeals
Type of case: marital dissolution
SIC code: 8049 Offices and Clinics of Health Practitioners, NEC (physical, occupational, recreational and speech therapists, and audiologists
Felman Production, Inc. v. Industrial Risk Insurers, 2011 WL 4543960 (S.D. W. Va.)(Sept. 29, 2011)
Court dismisses claim for business interruption losses because neither the plaintiff nor its experts could prove an actual lost sale or lost sale opportunity caused by the damaged equipment.
Experts: Brad Murlick
Judge: Chambers
State/Jurisdiction: federal/West Virginia
Court: U.S. District Court
Type of case: breach of contract
SIC code: 3312 Steel Works, Blast Furnaces (Including Coke Ovens), and Rolling Mills (coke ovens)
Estate of Gallagher v. Commissioner, 2011 WL 4809106 (U.S. Tax Court)(Oct. 11, 2011)
Tax Court corrects a previous error in the present value factor used to value an 80% interest in a privately held limited partnership, resulting in a $3.2 million increase in overall value.
Experts: Richard May (taxpayer) and John Thomson (IRS)
Judge: Halpern
State/Jurisdiction: federal
Court: Tax Court
Type of case: federal tax
SIC code: 2711 Newspapers: Publishing, or Publishing and Printing (except Internet newspaper publishing)
California’s “double dipping” legislation changes groundrules for divorce attorneys
BVR has released a new training pak on Asset or Income? Double Dipping in Divorce, which discusses how to recognize the possible double-counting of income and assets, and how different jurisdictions have tried to resolve the continuing quandary.
The issue has received more attention since California Senator Roderick Wright (D-Inglewood) sponsored a bill, SB 481, regarding the determination of spousal support in marital dissolution actions. “Existing law requires the court to consider various factors for determining spousal support, including, among other things, the ability of the supporting party to pay spousal support, and the obligations and assets of each party,” states the committee notes. “This bill would require the court to also consider the extent [to] which income for support was already capitalized and paid to the other spouse in the division of community property, in order to avoid double counting the income when the result would be inequitable.”
Although currently tabled in the Senate, the California bill represents “an interesting attempt to legislate this issue,” according to Stacy Collins (Financial Research Associates). The bill wouldn’t necessarily eliminate the double dip so much as extend the discretion that trial courts already enjoy in determining spousal support to include, on a case-by-case basis, the possible impact of the double counting of income, first in capitalizing a business asset for distribution and then again in using the owner’s earnings to award support.
The legislation, if passed, might set a precedent for other state jurisdictions, which currently seem to straddle a range between an outright prohibition—in Mississippi, for instance, courts says the double dip presents a “glaring inequity”—to an ad hoc fairness review, to a passive tolerance.
Finance and accounting for lawyers released
Finance & Accounting for Lawyers by Brian Brinig
Order Now for $79.00 | View Table of Contents
This textbook serves as an introductory guide for attorneys working with accountants and financial experts.
The principles of accounting and finance directly extend to contract issues, torts, business and securities matters, taxation issues, partnership disputes, gift and estate matters, to name only a partial list. These areas of jurisprudence are often based significantly on substantive financial questions, and their measurement can be the heart of the entire matter. The application of broad accounting principles to countless business transactions requires an understanding of the objectives of financial reporting and the needs of the users of financial information.
Contrary to popular belief, accounting is not a mathematical formula or calculation, but rather an organized system that logically summarizes business transactions into useable information that is meaningful to management, creditors, business investors and other stakeholders. This text takes readers through the system of accounting and the development of financial statements. Complexities and limitations of accounting information are explored, culminating in a study of ratio analysis of financial statements to glean relevant insights. The objective of this introductory study of accounting is to provide a broad, workable knowledge base that will facilitate the use of accounting information as it relates to the practice of law.
“The other major book on this subject, published by the American Bar Association, is now three years out of date,” said David Foster, BVR CEO, the publisher of Finance & Accounting for Lawyers. “Brian’s taught this course at USD School of Law, and he knows the subject forward and backwards, so this is a great addition for any attorney who needs to know theories of debits and credits, business valuation, or other complex financial issue.”
When a court counts a professional’s income as an asset …
After more than 20 years of marriage, a lawyer and his wife divorced. The wife hired a CPA expert, who testified that the husband’s practice had no real assets but a bank account with nearly $120,000—and that was the value of the enterprise, he said. The court found that the husband earned approximately $270,000 per year and the value of his law practice was $65,000, and awarded each party half. The husband appealed, saying the court erred by considering the goodwill value of his practice.
The appellate court disagreed, finding that the trial court did not consider goodwill or the husband’s future income in its valuation of the law practice. However, it did not properly characterize the cash account, which did not “change from income to asset” merely because it had not been distributed by the time of trial. The husband’s income, “past and projected into the future, should be (and was) considered in addressing . . . spousal support,” the court held, in finding that the law practice had no appreciable value. Read the complete digest of In re the Marriage of Jackson, 3925703 (Iowa App.)(Sept. 8, 2011) in the December Business Valuation Update; the court’s unpublished opinion will be posted soon at BVLaw.
The quandary of the double-dip: Clearly, the law practice in that case did not generate more than a “living” for the practitioner-spouse. But what happens when a thriving professional practice is valued under an income or earnings approach for purposes of distribution—and the court also considers the professional’s income to determine support? See, e.g., McReath v. McReath (also available at BVLaw), in which the Wisconsin Supreme Court said it wasn’t too worried about double counting, because “when a trial court assigns an income-earning asset to one spouse, it is awarding the full, fair market value of that asset at the time of the property division. Presumably, that spouse could turn around and sell the asset next day, attaining the same value; or he/she could retain the asset for its income-producing properties.”
For currency and clarity on this complicated issue, tune in to: Asset or Income? Double Dipping in Divorce, featuring Don DeGrazia (Gold Gocial Gernstein) and Stacy Preston Collins (Financial Research Associates) on Thursday, Nov. 17.
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