Big Surprise: Mortgage Business Bankrupt!

In Wilson v. Wilson, 2008 WL 2312726 (Ky.App.2008), a man started a mortgage brokerage business with his high school sweetheart in 2004. Soon the business blossomed, and so did the romantic relationship between the man and his classmate, who unfortunately was not his wife. The business expanded from Kentucky to Florida and paid all of the classmate’s living expenses. Soon the business floundered, the man bought out his partner, and he filed for divorce and bankruptcy. A discharge order was entered shortly thereafter, the bankruptcy court finding that the business was insolvent and no assets existed.

In the divorce action, a court-appointed valuation professional determined the value of the business as an ongoing concern as of September 2005, one year before the bankruptcy. The trial court accepted the valuation but assigned no value to the business as marital property, since it was bankrupt and worthless a year later. The business owner’s wife appealed, arguing that it should be assigned the value given by the expert.

On appeal, the Kentucky Court of Appeals affirmed, holding the trial court did not commit an error by assigning no value to the bankrupt business. The expert and the court did not seem to violate the principle that facts not known or knowable on the date of valuation may not be considered. Rather, the date of the expert’s valuation did not appear to coincide with the date used by the court. The lesson, perhaps? Make sure the date of expert’s valuation is the same date that the court will consider at trial.

Under Pennsylvania law, the same result probably would have occurred. Under Sutliff v. Sutliff, 518 Pa. 378, 543 A.2d 534 (1988), the proper date for valuing marital assets is presumed to be the date of distribution. There are cases, however, in which the courts of Pennsylvania have adopted an earlier date, such as where there has been intentional dissipation of marital assets. See, Nagle v. Nagle, 799 A.2d 812 (Pa. Super.2002); Smith v. Smith, 653 A.2d 1259 (Pa.Super. 1995). For some reason, the Kentucky courts rejected that logic.

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Credibility is King in War of the Experts

The typical “war of experts” was presented in Bussa v. Bussa, 2008 WL 2117138 (Mich.App.), a 2008 unpublished decision of the Michigan Court of Appeals. In this case, the business owner’s expert gave an opinion of value based upon the asset approach. The subject company (actually, companies) was a petroleum sub-jobber comprised of a gas station operator, a real estate holding company owning the gas stations, and a trucking company delivering fuel to the gas stations. The business owner’s expert relied on an net asset value approach and excluded the income approach because the company was involved in a highly volatile industry.

The wife’s expert considered all three approaches, including discounted cash flow, market comparables, and net asset value. In valuing the operating company, she relied primarily upon the market approach. For the trucking company, she considered all three approaches; and for the real estate holding company, the net asset approach was deemed most reliable.

The trial court rejected the opinion of the husband’s expert and slightly modified the value suggested by the wife’s expert, applying a 5% discount for lack of control (the business owner’s brother owned half of the stock) and a 10% key man discount. The opinion of the husband’s expert was rejected because of significant computational errors, an inability to cite data to support his views, and an impression of advocacy for his client.

On appeal, the Michigan court affirmed, finding that it was mostly an issue of credibility, which is best left to the trial courts to decide. It is perhaps notable that the business owner on appeal seemed to contradict his own expert, arguing that his businesses should be valued at their liquidation value (contrary to his expert’s testimony) and criticizing the discounts that were applied to the value rendered by wife’s expert (which were the discounts to which husband’s own expert testified).

Executive Compensation

An intriguing article, published recently by BVR on its BVWire blast email, reminds us that executive compensation is one of the most important components of a business valuation. The article summarizes a lecture given by Brian Brinig at the California CPA 2008 BV Conference, in which he challenged the term “reasonable compensation adjustment” as well as the methods that are commonly used to arrive at this normalization adjustment to the income statement.

Mr. Brinig would prefer the term “fair-value-of-the-owners’-services adjustment,” which is a mouthful but comes closer to describing the real objective: determining what it would cost to replace the owner with an equally qualified and competent manager. Brinig also indicates that by phrasing the question in this way, valuation professionals can avoid the mistake of valuing non-transferrable goodwill. The question is not whether a neurosurgeon is unreasonably compensated but whether another professional could be hired to replace the neurosurgeon, and at what price.

BVWire also considered whether valuation professionals, who are not generally trained or experienced in executive compensation matters, can qualify to give expert opinions in litigation on this subject. The verdict? If judges are unwilling to disqualify business appraisers from giving testimony on the subject, it must be okay to do so.

Valuation Held Preferable to Judicial Sale

In Parker v. Parker, 980 So.2d 323 (Miss.App. 2008), the Mississippi Court of Appeals held that the trial court should not have ordered a judicial sale of businesses that were marital property in a divorce action. The trial court sold the businesses because the parties failed to comply with an order directing them to obtain accurate and up-to-date business valuations. On appeal, the Mississippi court held that the trial court could have appointed a business valuation professional or divided the property in kind.

Astleford has valuation professionals FLiP’n

Last month the U.S. Tax Court released its memorandum opinion in Astleford v. Com. (TC Memo 2008-128), a case dealing with the minority and marketability discounts applicable to family limited partnerships. In Astleford, the widow of a Minnesota real estate tycoon contributed her interests in real estate (which included real estate partnerships and trusts) to a family limited partnership (FLP) for the benefit of the parties’ children.

In valuing the interests gifted to the children for the donor’s IRS Form 709s, the taxpayer’s valuation expert took a 41.3% absorption discount against the value of the real estate. The taxpayer’s expert opined that the parcel of farmland was so much larger than the average comparable sales that it would flood the market, warranting a discount. The IRS, predictably, rejected the absorption discount.

On appeal, the Tax Court reduced the absorption discount considerably, to approximately 20%. In doing so, the Tax Court examined the specific data on which the taxpayer’s expert relied and reached its own conclusion from that data by excluding certain datapoints and determining its own weighting.

The taxpayer’s expert also discounted the value of the partnership donated to the FLP and the FLP interests conveyed to her children for lack of control and lack of marketability, relying on market data from sales of registered real estate limited partnerships (RELPs). Deriving a range of 22% to 46%, the donor’s expert settled on a 40% combined discount against the value of the partnership. The IRS did not discount at the partnership level, arguing the discounts should be applied only at the FLP level.

The taxpayer’s expert applied “tiered discounts” by discounting the partnership interests that were donated to the FLP and the FLP interests that were transferred to children. In other words, the value was discounted once at the partnership level and again at the FLP level. The Tax Court noted that tiered discounts were disallowed where minority interests comprised most of the assets of the FLP entity being valued, but since the partnerships were just 16% of the FLP’s value, the tiered discounts would be allowed. The TAx Court arrived at a 30% combined discount at the partnership level.

The IRS in calculating discounts at the FLP level applied data from REIT sales, which the Tax Court deemed more reliable than RELP data. Because of the data source, the IRS expert had to adjust his minority interest discount to account for the unusual liquidity of REITs. By eliminating the liquidity premium from the observed discount, the IRS arrived at a minority interest discount of 7-8%, which the Tax Court deemed too low. The Tax Court instead calculated a minority interest discount of 16-17%.

The Tax Court accepted the IRS’s marketability discount of 22% (which was slightly higher than the marketability component of the taxpayer’s combined discount).

Battle of the “Rules of Thumb” in North Dakota

In Evenson, a recent decision of the North Dakota Supreme Court, the business which was implicated in a divorce action was an insurance agency. The business owner sold multi-peril crop insurance through local banks for which the owner had previously worked. Both valuation experts agreed that insurance agencies are generally valued by applying a multiplier to the agency’s gross commissions over a period of time.

The wife of the insurance agent testified that a 1.75 multiplier should be applied to an average of gross commissions over the best three consecutive years in the agency’s five year history. (Yes, I said that the wife herself testified.) Her expert testified that 1.5 would be an appropriate multiplier, and 1.75 was “in the upper range.”

The husband testified that a multiplier of 1.0 should be applied to the agency’s gross commissions over the first four years (including the agency’s worst year). The trial court instead applied a multiplier of 1.0 to the agency’s gross commissions in the most recent year (which was neither the best nor the worst, but closer to the worst than to the average). The trial court chose the 1.0 multiplier based on evidence of growing loss ratios, a steady decrease in commission rates, and the testimony of an insurance manager that 1.0 would be an appropriate multiplier under current market conditions.

Finding sufficient evidence to support the verdict, the appellate court sustained the trial court’s decision.