Spring 2007 Articles:
- Top Ten Ways to Succeed in A Judicial Appraisal Action
- Allocation of Stock Purchase Price to Non-Compete Must Be Clear, Unambiguous
- Another Court Considers The Distinction Between Personal vs. Enterprise Goodwill
- How to Avoid Post-Divorce Dissatisfaction: Hire Good Help
1. Top Ten Ways to Succeed in A Judicial Appraisal Action
Judicial appraisal actions often involve sophisticated financial applications, analysis, and assumptions. To present appraisal evidence with the greatest likelihood of success, attorneys and their business appraisal experts will want to heed these “top ten” suggestions:
- # 10. Be familiar with precedent and the judge’s prior
decisions. Which valuation methods have met
with the particular court’s prior approval? A new
or less-favored method requires a well-prepared
explanation by the experts and persuasive
reasoning by the attorneys.
- # 9.Present an effective witness. You’ll want the
business appraiser to tell a clear story about how
the company makes money and how that ties
into its valuation. The analyst needs to describe
the approaches and methods, explain the inputs
and assumptions, and determine an appropriate
weight for each method. If a particular method is
not appropriate, the expert should be prepared to
explain, as mistakes and last-minute changes will
surely undermine credibility.
- # 8.Present an effective report. The valuation report
should be in plain, understandable terms, with
ample use, where appropriate, of charts, graphs,
and CDs with spreadsheets. Take advantage of
available resources and technology—but don’t bury
the court with paper.
- # 7.Decide whether to prepare a rebuttal report. This
is a tactical decision, for which sensitivity analysis is
critical. If the court is not completely persuaded by
your expert’s report, then submission of a rebuttal
or alternate valuation report gives the court a
basis on which to rule (other than adoption of your
opponent’s expert report.)
- # 6.Use reliable management projections. By and
large, courts prefer contemporaneous management
projections, prepared in the ordinary course.
Projections prepared when a fairness opinion,
acquisition, or other major deal is in the offing are
generally considered less reliable.
- # 5.Be prepared to justify a DCF. All inputs and
aspects of a discounted cash flow analysis (DCF)
will come under the court’s scrutiny, including
the discount rate and its inputs and the terminal
value. Attorneys and their experts should make
sure the analysis will “hold together” under cross examination.
- # 4.Check your ‘reality-checks.’ In many appraisal
actions, courts have found reality or “sanity” checks
helpful, such as market prices, control premiums,
evidence of a “thorough and fair auction,” etc.
- # 3.Don’t forget interest. If the parties bear the
burden of proof in determining interest in a statutory
appraisal action, make sure your experts assist with
this calculation. Absent reliable evidence, courts
will fall back on the statutory rate.
- # 2.Expert should be skeptical. The appraiser should
also be sure to test any management assumptions
and projections against a reasonableness or
“reality” check.
- # 1.Expert must be independent. Business appraisers
are important members of the “litigation team,” but
they must retain their independence. Experts who
appear “too cozy” with their own side risk losing
their credibility in the court.
Finally, a 1997 valuation of the company (two years after the patent lapse) had estimated its worth between $8.5 million and $11.5 million, with a “strategic value” of up to $22 million. These values fit within the expert’s “undamaged” valuation as of 2002, and AccuWeb did not adequately reconcile the asserted damaged values to the 1997 appraisal. Though the dissent argued that the expert report raised a material dispute, the majority summarily dismissed all claims.
2. Allocation of Stock Purchase Price to Non-Compete Must Be Clear, Unambiguous
Becker v. Comm’r of Internal Revenue, 2006 Tax
Ct. Memo LEXIS 268 (December 13, 2006)
The Tax Court reviewed the two primary rules
governing the allocation of a portion of a stock
purchase price to a covenant not to compete and
found that the overriding standard—as in most
contract construction cases—is the clarity of the
provisions and, failing that, evidence of the parties’
intent.
Family company buys out shareholder/son
Internecine disputes led the Becker Holding
Corporation, a family owned, Florida citrus operation,
to purchase all shares held by one Becker son for $23.9 million, payable with $5 million in cash and
the remainder by an installment note. None of the
purchase documents provided for an allocation of the
price to a covenant not to compete, which the Becker
son executed at the sale.
But in filing its tax return, the company allocated
the $5 million to the non-compete, declaring an
amortization deduction. The IRS asserted a
deficiency, consolidating the action with one against
the son, who’d claimed capital gains tax on the
total consideration paid to him (and not ordinary
income, as would have resulted from the company’s
characterization).
The relevant rules
In deciding the case, the Tax Court applied the standards of the 5th and 11th Circuits:
- ‘Strong proof rule’ and ‘mutual intent test’. When considering tax allocation cases involving a covenant not to compete, the 5th Circuit adopted the “strong proof rule,” which held that when the parties have set out the covenants with an assigned value, then only “strong proof” can overcome the declarations.
Over time, the 5th Circuit departed from the rule, adopting the more specific “mutual intent test,” where the question becomes: “Did the parties... when they signed the agreement, intend to allocate a portion of the purchase price to the covenant not to compete?”
- Danielson rule. In cases where the parties do allocate a stated portion of the purchase price to the non-compete, then the rule of the Danielson case (3rd Circuit, 1967), adopted by the 5th and 11th Circuits, applies:
-
- A taxpayer who enters into a transaction...to sell his shares and executes a covenant not to compete for a consideration specifically allocated to the covenant may not, absent a showing of fraud, undue influence and the like...challenge the allocation for tax purposes.
The Danielson rule holds true even if, as in that case, “the explicit allocation had no independent basis in fact or arguable relationship with business reality.”
Both rules consistent with this case
Both the Becker son and the IRS contended that the
Danielson rule applied, as the purchase documents
clearly allocated the entire consideration to the stock.
Therefore, the transaction should result in capital
gains to the taxpayer, with nothing allocable to the
non-compete, as the company argued.
The company claimed the “mutual intent” test
controlled, because the parties intended to allocate
some value to the non-compete, and thus the Court
should independently determine its value. (Note:
Neither party obtained an appraisal at the time of the
stock purchase agreement.)
The Tax Court held that the outcome was the same
under both standards. The purchase documents
clearly allocated the entire price to the shareholder’s
stock (Danielson rule). Although the parties obviously
considered the non-compete an important element of
the deal, nothing in their transaction—including their
discussions and negotiations—evidenced a mutual
intent to allocate a portion of the price to that provision
(mutual intent test).
Notably, the company had argued the parties’ failure
to obtain a formal valuation of the shareholder’s stock
had evinced ambiguity about allocating a value to
the non-compete. But the Court firmly disagreed,
stating that the “absence of a third-party appraiser
does not render the purchase documents ambiguous,”
especially when the parties themselves clearly valued
the stock at $23.9 million.
3. Another Court Considers The Distinction Between Personal vs. Enterprise Goodwill
Gaskill v. Robbins, 2006 Ky. App. LEXIS 364
(December 8, 2006)
In this Kentucky divorce case, the wife was a
successful oral surgeon, having opened two practices
during the marriage, to which the husband had
contributed his tax and accounting skills.
At trial, in valuing one of her practices, the wife’s
expert attributed a zero value to goodwill. In his
opinion, the goodwill was all “personal”—that is,
derived entirely from the wife’s individual skills,
reputation, and knowledge. He concluded that the
fair market value of her practice was $114,000.
The husband’s expert took the opposite view.
Without distinguishing any separate components,
he included goodwill in his overall calculations,
concluding that the wife’s practice had a fair market
value of nearly $670,000.
Trial court felt compelled to value goodwill
The trial court rejected the wife’s valuation, saying,
“[T]here is no reported legal authority for the distinction
in goodwill” made by her expert. In fact, in adopting
the valuation by the husband’s expert, the lower court
held, “[I]t is generally accepted in Kentucky that the
goodwill of a closely held medical corporation should
be assigned value in a dissolution proceeding.”
On appeal, the wife contended that the family
court “operated under the misconception that it was
compelled to assign a goodwill value” to her practice,
and the Court of Appeals agreed. While Kentucky
law requires considering goodwill in the valuation of
a medical practice, it does not compel its inclusion.
Thus, the case merited remand.
A chance to join the majority
At the wife’s urging, the appeals court also considered
whether Kentucky law should join the majority of U.S.
jurisdictions in distinguishing enterprise and personal
goodwill in divorce actions.
The wife cited a survey from a 2003 West Virginia
case, May v. May, in which the state Supreme Court
found that twenty-five U.S. jurisdictions made the
distinction, with only enterprise goodwill constituting
divisible marital property. Kentucky fell into the
minority of twelve that do not exclude the personal
component from the overall goodwill of a business
and/or professional practice. (The remaining states
have not directly addressed the issue.)
After a brief discussion of the majority/minority views
as well as related Kentucky law, the Court of Appeals
in this case decided it was “not inclined to deviate
from long-standing precedent by creating a wholesale
change of law holding that ‘personal’ and ‘enterprise’
goodwill should be distinguished for purposes of
property valuation in a divorce proceeding”—not even
in the case of a sole proprietorship.
Precedent aside, principles of equity persuaded the
Court to continue to hold that the “form of the business
enterprise [cannot] defeat the [marital] community’s
interest in the professional goodwill.” Any other
ruling, it said, would ignore the contribution made by
the non-professional spouse to the success of the
professional—as in this case, where the husband had
contributed his financial time and skills, among other
things, to the wife’s practice.
Leaves question for the state Supreme Court
As in the May case, which went through an appeals
process to the highest state level, the Kentucky Court
of Appeals may simply have deferred the ultimate
question to the state Supreme Court.
In a dissent, a senior appellate judge opined
that “’personal’ goodwill should not be considered
marital property to be divided between the
parties.” However, he added, “[T]his is a matter
to be addressed to our Supreme Court,” as both
the trial and appellate courts had not erred in their
rulings under current Kentucky law.
4. How to Avoid Post-Divorce Dissatisfaction: Hire Good Help
Kojovic v. Goldman, 2006 N.Y. App. Div. LEXIS
12518 (October 19, 2006)
This is yet another case where the parties thought
they could do it more cheaply and quickly themselves:
The husband was CEO and minority shareholder
(7-8%) of a closely held information technology
company; the wife was a former financial analyst
with an MBA. When the couple decided to divorce,
they moved rapidly, exchanging simplified financial
information and waiving further discovery. After
retaining some legal and accounting assistance,
they reached a comprehensive settlement within four
months of filing.
Per the agreement, the wife received $1.15 million
cash, plus annual maintenance of $87,500 for four
years. She also signed off on conducting any further
inquiry into the husband’s assets, in particular his
shares of the IT company.
Just over a month after the agreement was executed,
however, the company sold for approximately $225
million, of which the husband received $18 million.
The wife sued for fraud and rescission of the
settlement, claiming the husband had affirmatively
misrepresented the liquidity of his shares. She also
asserted that it was the husband’s obligation to
disclose the value and potential value of his shares
and that he concealed knowledge of the “imminent”
sale of the company.
The husband moved to dismiss the wife’s claims,
relying on the settlement agreement waivers and
New York precedent. But the lower court denied his
motion, finding that the wife’s assertion of affirmative misrepresentations distinguished the case from those upholding similar settlement agreements; and the
wife appealed.
Disdain for such claims
“This Court does not stand alone in its disdain for
post-divorce claims of concealment,” the appeals
court began. The Court found nothing irregular or
unconscionable about the settlement agreement. The
case did not involve the concealment of an asset,
but rather its valuation and potential sale. Given the
wife’s professional background and her retention of an
attorney and an accountant, “she should have been
aware of the distinct possibility that [the company]
would be sold.”
That the wife opted for an immediate and certain
payout over the risk of an eventual sale did not warrant
setting aside the settlement, the court held. That the
husband harbored a more optimistic assessment of
the potential value of his minority interest than he
disclosed—or even had additional information that
he kept to himself—was “irrelevant.” That the parties
could have “freely availed themselves of any number
of valuation and discovery procedures…but declined
to do so,” is the lesson from hindsight, which this case
helps bring home to divorcing parties.
This Valuation Connection issue in .PDF format
©2007. No part of this newsletter may be reproduced or redistributed without the express written permission of the copyright holder. Although the information in this newsletter is believed to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal or consulting advice.
Please contact Les Smeach at Schlabig & Associates to discuss any of the items outlined above.
