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There is an old story in which a lawyer asks a potential expert, “How much is two plus two?” Eager to get the engagement, the expert replies, “How much do you want it to be?” In the maze of valuation evidence, it is often difficult to determine which evidence is reliable and which is not. Numbers, accounting and valuation principles are often mystifying to the bench and bar. To a jury, they can be downright incomprehensible without the guidance of expert interpretation. In Daubert v. Merrell Dow Pharms., Inc. the U.S. Supreme Court wisely noted that “expert evidence can be both powerful and quite misleading because of the difficulty in evaluating it.” In this age of ever-changing technology and ever-increasing sources of information, society is becoming saturated with so-called “experts.” In the area of asset and business valuation, there is an increasing number of experts who purport to be able to value assets and interests in private companies and calculate damages from the lack of disclosure. Valuation testimony is often offered in cases dealing with stockholder freeze-outs, stockholder appraisal proceedings, proxy and takeover contests, dissolutions, federal estate tax proceedings in the tax court and various kinds of bankruptcy proceedings. This article will discuss the standard laid out by Daubert, as applied to valuation testimony. UNDERSTANDING VALUATION CONCEPTS Many concepts in accounting and valuation analysis are counterintuitive. For example, a balance sheet for a company will necessarily reflect the so-called “book value” or “shareholders’ equity” of the company. Book value is simply the company’s assets minus its debts. While balance sheets are prepared by accountants, most accountants will concede that the book value or shareholders’ equity has little to do with the true value of either a private or public company, let alone the ownership interests in the company. In the case of public companies, stock prices are determined by the organized stock markets, although such does not necessarily reflect the value of the company as a whole or the company’s various assets. Private companies, on the other hand, rarely have an organized market for their ownership interests, whether they be stock, partnership interests or limited liability membership units. As a result, their valuation is a challenging exercise. The balance sheet itself is often a confusing document. Balance sheets typically reflect assets at cost minus depreciation. Barclay’s Comprehensive Financial Glossary defines depreciation as “the charge against revenues which represents the prorated capitalization of the cost of an asset.” Barclay’s offers the following example: “If a computer is expected to have a useful life of 5 years and cost $6,000 with no salvage value, then the annual, straight-line depreciation would be $1,200 per year[;] if the same computer had an estimated salvage or residual value of $500, then the annual depreciation would be $1,100 ($6,000–500=$5,500 divided by 5 years).” While the balance sheet value of an asset is nothing more than a mathematical calculation of how the asset should be carried on the books of the company, such a calculation does not necessarily reflect the fair market value of the asset. “Valuing a Business,” which is regarded as one of the most authoritative treatises concerning valuation principles discussed here, defines “fair market value” as the “price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” This is not to say that cost less depreciation will not reflect the fair market value of the asset, but only that the analysis used in arriving at the value of the asset for balance sheet purposes is different from arriving at the fair market value of the asset. Real estate assets are particularly problematic in this regard. Financial statements often reflect the value of real property and improvements, such as large office and apartment buildings, after a significant amount of depreciation. The accounting for depreciation is usually motivated by the fact that depreciation is an expense which may be used to decrease the taxable income to the entity owning the real estate and real estate improvements. Thus, even though depreciation is a non-cash item, depreciation may be used to decrease the amount of taxable income, which is a cash item. The result of this application of depreciation is the reduction of taxable income through to the owners of the entity, as most real estate ventures are pass-through entities. For this reason, the book value of a company whose assets are mainly real estate is often negative. While accounting for the value of real estate and real estate improvements is mathematical in nature, valuing companies whose main asset is real estate is hardly so. The problem multiplies when the company being valued does not own real estate outright, but owns partnership or other kinds of fractional interests in other companies that own real estate. Looking first toward the income side of the exercise, an appraiser is faced with several possible approaches, the most common of which are the capitalized income approach or discounted cash flow approach. A capitalized income approach utilizes the gross income, based on a rental survey, deducts expenses, and then applies a capitalization rate. Judgments are necessarily made concerning which rents are appropriate when adopting a survey, what expenses are reasonable, and finally what capitalization rate is proper, as the capitalization rate can vary significantly from appraiser to appraiser. A discounted cash flow analysis similarly starts with gross income, then projects out what the income and expenses will be in the future and discounts the cash flow back to present value. Obviously, the further into the future the projection, the more speculative the valuation becomes. Similar to the capitalized income approach, the appraiser must exercise a certain amount of judgment in predicting the income and expenses in the assumptions being made along the way. Since the reliability of the analysis provided by both the capitalized income approach and the discounted cash flow approach relies upon the judgments and assumptions adopted by the appraiser, the reasonableness of such judgments and assumptions is of great import, both for the party proffering the evidence and for the party opposing its admittance. The question of reasonableness therefore becomes simultaneously the foundation for the expert’s admittance under Daubert and the means by which the expert will be attacked during cross-examination, as both Fed. R. Evid. 702 and Daubert require that before expert evidence can be admitted, the proponent must show that “the testimony is the product of reliable principles and methods.” While the stock market dictates the value of the ownership interests in publicly traded entities, there is usually no organized market for private companies. In the case of private business entities, valuation experts will often look to the nature of a company’s assets, cash flow, and the nature of the ownership interests as set forth in any partnership, stockholder and membership agreements. Where there are multi-tiered companies and assets, each must be separately valued. Private companies are unique, or “one-offs.” Accordingly, valuation evidence relating to private company litigation will not address market data, but rather will construct a value of the company that is based on some form of capitalized income or discounted cash flow approach. In litigation addressing the value of private companies and their ownership interests, it is a rare event indeed where a court receives testimony from a witness who has expressed a willingness to buy the company or its interests. Instead, the court typically hears from a series of experts who make educated guesses about the value of the company and its ownership interests. For this reason, there is a significant amount of subjectivity involved. Herein lies the danger, as valuation is more of an art than it is a science. How much of an art it is depends on the credibility and credentials of the valuation expert. As such, the expert’s qualifications, as well as the reasonableness of the expert’s methodology, are crucial in assessing a valuation expert. VALUATION QUALIFICATIONS Accountants, economists and people with experience in the industry all purport to be experts in valuation. While many valuation experts also happen to be accountants, they do not necessarily need to be licensed as such. Real estate appraisers, for example, are not required to be certified public accountants. In fact, real estate appraisers are only required to hold a high school degree and to have taken 60 classroom hours related to real estate appraisal from a recognized appraisal organization, school, college or university. Nevertheless, the discipline of real estate appraisal can provide comfort for the legal practitioner on two levels. First, the practice of real estate appraisal is regulated; Article 6-E of the Executive Law of the State of New York governs the licensing of real estate appraisers, and real estate appraisers must be certified and licensed. Examination is a prerequisite of licensing. Real estate appraisers are required to take continuing education. Generally, real estate appraisers may not take a contingency fee. In addition, real estate appraisers may be disciplined. Second, there are standards for appraisals, as set forth in the Uniform Standards of Professional Appraisal Practice (USPAP). Thus, the licensing and USPAP compliance of a real estate professional may be attacked both in an in limine motion seeking to preclude the testimony and on cross-examination at trial. The practice of business valuation, however, is not regulated. While there are organizations such as the American Society of Appraisers and the Institute of Business that accredit business appraisers, appraisers are not licensed. Neither Daubert nor its progeny requires licensing. Rule 702 of the Federal Rules of Evidence, amended in the wake of the Daubert line of decisions, provides that a witness who is qualified by “knowledge, skill, experience, training or education, may testify thereto in the form of an opinion or otherwise.” Thus, using the example of a real estate appraiser, courts are not required to exclude as a valuation witness someone who has been in the real estate business for many years and who professes to “know the market.” Because such a hypothetical witness is not a licensed real estate appraiser, the witness would not be bound by the methodologies typically used by real estate appraisers, such as USPAP. In a world hooked on reality television, where people often are judged more on personality than qualifications, there can be no assurance that a jury would believe a licensed real estate appraiser over an unlicensed one. Furthermore, should a jury rely upon the testimony of a questionable “expert,” there would be little recourse to overturn the jury verdict. A review of the most recent Daubert decisions reveals that few courts in the 2nd U.S. Circuit Court of Appeals are excluding experts on qualification grounds, especially in cases where the proposed witness is an accountant. Courts have broad discretion in such matters, and courts within this circuit have liberally construed expert qualification requirements. Rightly or wrongly, it would appear that there exists a perception that where an issue involves numbers, accountants are automatically qualified as experts. PURPOSES OF TESTIMONY The testimony of accountants is used for a variety of purposes. For example, in TVT Records et al. v. Island Def Jam Music Group, 250 F.Supp.2d 341 (S.D.N.Y. 2003), the defendants sought to strike on Daubert grounds the expert report of plaintiff’s accounting expert named Kolbrenner, which was being offered to prove damages in the form of lost profits. The defendant argued that Kolbrenner’s accounting qualifications did not qualify him as an expert on the market performance of a music album. The court denied the defendant’s motion stating that Kolbrenner’s experience in the music and entertainment business, “together with his accounting background adequately qualified him to make such projection of sales performance.” Id. at 351. With respect to the methodology used by Kolbrenner, the court determined that such would be best addressed through cross-examination and the defendant’s own expert. In SEC v. U.S. Environmental, Inc., No. 94 CV 6608, 2002 WL 31323832 (S.D.N.Y. Oct. 16, 2002), the court accepted the testimony of a forensic accountant to opine on conduct constituting a “wash trade” in a market manipulation case. In AIA Holdings, S.A. v. Lehman Brothers, Inc., No. 97 CV 4978, 2002 WL 1334809 (S.D.N.Y. June 17, 2002), the testimony of an accountant was accepted to prove lost profits. Curiously, in Supply & Building Co. v. Estee Lauder International, Inc., No. 95 Civ. 8136, 2001 WL 1602976 (S.D.N.Y. Dec. 14, 2001), the court precluded the plaintiff’s expert, an economist whose testimony was proffered on lost profits, for lack of a sufficient factual basis for certain assumptions, stating, “it seems a witness with expertise in accounting would seem to be more useful” Id. at 4. When an accountant takes the stand he or she projects an imprimatur on numbers. That is to say, for those who do not know the difference between tax accounting and forensic accounting, or between auditing and valuation, the mere fact that the witness is an accountant carries weight. For this reason, an accountant’s testimony, if used improperly and without proper instruction, could be particularly misleading, as the Supreme Court cautioned in Daubert. This especially occurs in disclosure cases where the line can be blurred between numbers relating to disclosure and the damages alleged to have been inflicted. In a disclosure case, the plaintiff may want to bring to the attention of the jury certain numbers which allegedly should have been disclosed. There could be many ways of going about this. If the numbers are already in evidence, the plaintiff may simply seek to argue that the numbers should have been disclosed, through the use of demonstrative exhibits or summaries under Fed. R. Evid. 1006. Alternatively, the plaintiff may seek a disclosure expert to opine on the reasonableness of the disclosure itself, including the numbers. Or the plaintiff may seek to call an accountant to the stand to add up the numbers, and perhaps even provide a total of all of the disclosure numbers. At first blush, this might seem perfectly reasonable because all the accountant is doing is adding numbers. However, such testimony is fraught with difficulties. Calling upon an accountant simply to add numbers at counsel’s instruction serves no useful purpose, as jurors themselves can add. In addition, the accountant’s parroting of counsel’s arguments runs afoul of the notion that experts are supposed to offer an independent evaluation, and it blurs the line between evidence and argument in a process that will almost certainly result in jury confusion. When viewed in this light, such testimony’s potential for prejudice may outweigh its probative value, and as such its exclusion under Fed. R. Evid. 403 would be justified. HEARINGS AND JURY INSTRUCTIONS In limine motions under Daubert which seek to preclude expert testimony are typically made just before trial, and after the cut-off date for expert designation and discovery. For this reason, the granting of a Daubert motion often results in leaving the party whose expert is being challenged without an important expert and without time to find a replacement. It is precisely for this tactical reason that Daubert motions are made, and it is for this same reason that courts tend to temper a potentially draconian result with the notion that proper cross-examination will bring out the flaws and weaknesses in the expert’s analysis. Herein lies the tension, as the court must reconcile its preference against allowing a jury to hear potentially confusing testimony with its reluctance to preclude a party’s central expert witness, since such preclusion could have the same effect as granting summary judgment. Removing some of the gamesmanship from the Daubert in limine motion practice would aid the courts in better determining which experts are qualified and which are not. Evidentiary hearings at which the proposed expert is examined on qualifications and methodology in the presence of the court only, and without the theatrics usually at play in jury trials, can facilitate the decision making, especially if such a hearing is held well in advance of the discovery cut-off. If the expert is precluded, the proffering party would have the opportunity to try to replace the disqualified expert. Such a procedure would enable the court to perform an active gatekeeper function, as mandated by the Supreme Court in Daubert. Charging the party whose expert has been precluded with the costs of any additional depositions would further deter parties from choosing experts whose qualifications are marginal. In corporate and securities disputes involving valuation issues, there is usually overlapping opinion evidence from accountants, economists and other experts. The practitioner needs to be mindful that extensive financial testimony will be mystifying to the jury. Opening and closing statements do not always demystify such testimony, especially where lengthy trials are involved, as financial testimony is rarely self-evident. The court may seek to instruct the jury during the trial as to why certain testimony is being offered, and the reasons why a jury may exclude it. Without careful scrutiny on the admission of financial testimony and without sufficiently explanatory jury instructions, the jury is in danger of being left stranded without a road map. Robert J.A. Zito is a litigation partner at Schiff Hardin. William P. Scott, a litigation associate at the firm, assisted in the preparation of this article.

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