Law of Unintended Consequences

The Ninth Circuit Court of Appeals recently upheld the District Court in Howard v. United States.  In 1980, Howard incorporated his solo dental practice.  At the time, Howard also executed a covenant not to compete ('CNTC")with his own corporation.  I don't know what risk Dr. Howard was attempting to mitigate; and in retrospect it may have been in his best interest, considering his circumstances.  However, as it turns out, this did not play out very well as an income tax avoidance strategy.

Thirty years later, Dr. Howard sold his practice and allocated nearly $550,000 to his personal goodwill and treated it as capital gains on his federal tax return.  Arguing that the CNTC transferred Howard's personal goodwill to the corporation, the IRS re-characterized the $550,000 as a dividend, subject to tax as ordinary income.  From an income tax standpoint, the implication is clear.

However, the precedent is a good deal murkier with respect to marital dissolution.  The majority of states currently hold that personal (a/k/a professional) goodwill is not subject to inclusion in marital property.  The McReath divorce case in Wisconsin introduced transferable goodwill as the amount included in marital property.  CNTC's may become instrumental in characterizing personal goodwill as transferable; and, thus includable in the marital estate.  Of course, if this becomes the norm, the pendulum will swing to assessing reasonable compensation and avoidance of double-dipping on alimony.

It's About the Goodwill Stupid

As I have addressed several times, inclusion of goodwill in marital assets vary from state to state.  The majority of states include entity or practice goodwill  and exclude personal or professional goodwill from divisible marital assets.  A minority of states include or exclude all goodwill, while a smaller number currently has no precedent.

As I discussed recently, within the last year the Wisconsin Appellate and Supreme Courts returned a ground-breaking decision in McReath v. McReath.  This case involves the valuation of a dental practice.  The Court coined a new definition - saleable goodwill.  Saleable goodwill is the amount of professional and / or practice goodwill that can be transferred to a buyer.  Generally, saleable professional goodwill is substantiated by the presence of a reasonable and enforceable covenant not to compete.  This seems reasonable enough because no intelligent person is going to pay for anything beyond tangible net assets absent a covenant not to compete.

However, the Court did not stop there.  The Court went on to rule that it was not "double-dipping" to award periodic payments supported by excess income generated by goodwill and to include that goodwill in marital assets.  The court reasoned that an income-producing asset has intrinsic value beyond the cash flow it generates to its owner.  What?!  You cannot be serious!! This is wholly illogical Mr. Spock!

An asset is defined as something that has the capability of providing income, cash flow, or benefit in the future.  Regardless of what we are valuing, an asset is only worth the present value of its future cash flows. Period.  End of discussion.  As my grandmother used to tell me, "You cannot have your cake and eat it, too."  If you strip away all the future cash flow, what ever income-producing asset you hold is, well, worthless.  The Court whiffed badly here.  Actually, probably worse than that.  I think this went OB and they are hitting 3 on the tee.

Brave New World of FRCP Rule 26

It has been about six months since Federal Rules of Civil Procedure No. 26 was revised to protect communications between an attorney and any witness required to file a report.  The exceptions to this protection are :

1. Compensation of the expert.
2. Facts and assumptions that the engaging attorney provided to expert which were considered in rendering his/her opinions.

Many states have adopted provisions similar to revised Rule 26.  However, as an expert, you should discuss with the engaging attorney beforehand whether these provisions will apply to the case at hand. 

Before rushing into the brave new world of Rule 26, consider the following:

1. There will probably be increased scrutiny at deposition or expanded disclosure requests by the opposition to ensure that the authorship of the report is solely the experts.
2. Take care to segregate protected communications from discoverable documents.  This should be vetted by the engaging attorney to ensure that there are no omissions.
3. The engaging attorney should review the expert's produced work file to make sure nothing in it could damage the expert's credibility or endanger the basis of his/her opinions.

In other words, be careful out there.

At What Point In Time Should Future Lost Profits Be Estimated

Coincident with the current recession, court cases have been coming out that challenge the timing of the estimation of future lost profits.  Primarily, the cases deal with commercial real estate; but they may get extended to other industries as the recession continues.

Obviously, plaintiffs want to forecast future lost profits based on the economic conditions at the date of the breach of contract or other "but for" event.  On the other hand, defendants want to use the economic conditions prevailing at the date of trial. 

In November 2010, the Court found in favor of the defendant in Capitol Justice LLC v. Wachovia Bank N.A.  This decision reduced the plaintiffs claimed losses from $33 million to $6.7 million.  In March 2010, the Court ruled that the forecasted losses should be estimated based on the anticipated conditions at the date of breach (Epicenter Partners LLC v. Northeast Phoenix Partners). 

Traditionally, experts have relied on the economic conditions and outlook that existed at the date of loss, while disregarding subsequent events and conditions.  Although we attempt to focus on what was known or knowable at the date of loss, we must consider whether a particular subsequent event could have been reasonably expected to occur in the future.  Case in point - Consider Hurricane Katrina and its devestating effect on New Orleans.  While it may be reasonable to consider that hurricanes will periodically occur along the Gulf Coast, is it reasonable to include a storm of that magnitude in your assumptions when forecasting future losses?

Off topic bonus heads up - The IRS is not subject to the recent changes to Rule 26(2) of the Federal Rules of Civil Procedure.  Furthermore, U.S. Tax Court has not adopted FRCP 26.  So be careful with report drafts related to income tax issues.

The Ongoing Rage Over Tax Affecting Pass Through Entities

As many of you know, for years there has been an ongoing dialogue over whether pass-through entities should be tax-affected for valuation purposes.  At a recent ASA (American Society of Appraisers)-IRS Symposium, Miles Friedman , Associate Area Counsel in the IRS Office of Chief Counsel, stated definitively that courts and the IRS say no to tax-affecting.  This statement was certain to launch at least a thousand rebuttals.

Intelligent and well-qualified valuation experts hold positions on both sides of this argument.  Personally, I generally tax-affect pass-throughs for valuation purposes.  Many proponents of not tax-affecting point to Gross v. Commissioner as justification.  Like any precedent, care should be taken in applying it.  In Gross, the Court did not reject tax-affecting, it merely said that given a choice between 40% and 0%, 0% was a better choice under the circumstances at hand.  It remains incumbent on the valuation analyst to support his/her position and persuade the Court to accept that tax affecting is justified.

Good data, appropriate analysis, well-reasoned application, and effective communication will generally carry the day.

A Decade After SOX and SAS No. 99, Are We Any Better?

Modern awareness of occupational fraud has its inception with the formation of the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in 1985.  Occupational fraud can be defined as the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organizations resources or assets.  This definition includes asset misappropriation schemes, corruption, and financial statement frauds.  In response to a spate of high-profile financial statement frauds including Enron, WorldCom, and Tyco, the Sarbanes-Oxley Act of 2002 (“SOX”), alternatively known as the Public Company Accounting Reform and Investor Protection Act, was signed into law.  Although not in response to these frauds, the Auditing Standards Board issued Statement on Auditing Standards No. 99 (“SAS 99”), Consideration of Fraud in a Financial Statement Audit, in 2002.  While one would like to believe that the heightened awareness of occupational fraud, the enactment of SOX, and the implementation of SAS 99 would deter financial statement frauds, the evidence indicates that it just is not so.

In 1992, COSO released its initial report, Internal Control –An Integrated Framework. This project assimilated various concepts regarding internal control into one document.  It remains a starting point for designing and assessing effective systems of internal control.  SOX and SAS 99 build on the concepts contained in the COSO report to focus attention on the prevention and detection of fraud.  SOX puts the burden of accountability for financial statement fraud on the boards of directors and management of publicly-traded companies.  SAS 99 expanded the scope of procedures and emphasized the assessment of fraud risk as part of a financial statement audit.  Specifically, SAS 99 highlighted the risk of management overriding internal controls while perpetrating frauds.

Several studies have been performed over the last fifteen years relating to occupational fraud in general and financial statement fraud in specific.  These studies shed light on whether progress is being made to curtail financial statement fraud.  COSO issued two studies, Fraudulent Financial Reporting 1987-1997 and Fraudulent Financial Reporting 1998-2007. These studies examine publicly-held companies.  Since 1996, The Association of Certified Fraud Examiners (“ACFE”) has presented a biennial Report to the Nations on Occupational Fraud and Abuse.  These reports include frauds at publicly-held companies, privately-held companies, non-profit organizations, and governmental entities.  Finally, COSO issued two reports in 2010 on enterprise risk management (“ERM”), Board Risk Oversight – A Progress Report and COSO’s 2010 Report on ERM.  ERM includes all business risks, not just occupational fraud.  These ERM studies include publicly-held companies

Salient observations from COSO’s Fraudulent Financial Reporting 1998-2007, include the following:

·         There were 347 alleged cases of fraudulent financial reporting, versus 294 from COSO’s previous study.

·         The median loss increased from $4.1 million in the first study to $12.1 million more recently.

·         The Securities Exchange Commission named the chief executive officer and/or the chief financial officer for involvement in 89% of the frauds (as compared to 83% in the earlier study).

·         There was little difference in the composition and character of the boards of directors for victim companies versus non-victim companies.

·         Companies with fraudulent financial statements were twice as likely as companies with reliable financial statements to change external auditors before or during the fraud.

Significant findings on financial statement fraud from ACFE’s 2010 Report to the Nations are as follows:

·         Median loss for companies in the United States is $1.7 million.

·         The median duration for the frauds is 27 months.

According to the 2010 Report to the Nations, fewer than 5% of all frauds are initially detected by external audit.  Furthermore, survey respondents estimated that the typical business enterprise loses 5% of its annual revenue to fraud.  Applied to Gross World Product, fraud potentially causes losses in excess of $2.9 trillion.

Key findings from COSO’s Board Risk Oversight – A Progress Report are as follow:

·         47% of the directors noted that improvement is necessary in their ERM.

·         87% of the directors believe that improvement is necessary specifically in the monitoring of the risk management process.

·         86% of directors indicated that their ERM is inadequately resourced.

Observations from COSO’s 2010 Report on ERM include the following:

·         72% of executives responded that improvement in ERM was needed.

·         Over half of the organizations have not established a board subcommittee to oversee ERM.

·         60% of the organizations performed ERM on an informal or ad hoc basis in specific areas with no ERM applied company-wide.

Considered in the aggregate, the results of these surveys should be alarming.   Financial statement fraud is up in the last decade versus the preceding decade.  Top executives are involved in almost 90% of financial statement frauds. The typical financial statement fraud occurs for over two years before detection.  Fewer than 5% of occupational frauds are discovered by external auditors. Less than half of publicly-traded companies have board subcommittees assigned to risk management.  A majority of executives believe that improvement is required in ERM and that inadequate resources have been designated for the process.  SAS 99’s emphasis on management override has not resulted in effective detection of financial statement frauds perpetrated by high-level executives.  SOX’s mandate to make executives and directors responsible for the prevention of financial statement fraud has not succeeded.  Senior executives are the primary perpetrators and directors have not developed reliable risk management systems. 

The results of these surveys point up the expectation gap that auditors face.  Owners and third party users of financial statements generally expect the auditor to detect all fraud.  Auditors need to bring healthy doses of professional skepticism to their work.  In addition, they need to focus on fraud risks and specifically investigate those areas that benefit executives (e.g., incentive compensation plans and debt covenants).  Rigorous analytic review procedures that tie income statement and balance sheet accounts together should be designed.  Finally, if earnings don’t translate into cash flow to equity, further investigation is warranted.  Almost a decade after SOX and SAS 99, we expected to see improvement in fraud detection and prevention.  For now, we appear to be no better than we were before Enron and WorldCom.

Company Specific Risk Double Dipping in Cost of Capital?

Business valuation analysts use the cost of capital as the denominator in an equation (where annual cash flow or income available to equity is the numerator) to estimate entity value.  Cost of capital is sometimes loosely referred to as reasonable or fair return.  In the models that we use to develop cost of capital, we include risk premia for company size (based on equity or revenue) and company-specific factors.  The follow list of considerations for company-specific risk is not exhaustive but covers most of the primary factors:

• Small company
• Insufficient management depth
• Insufficient access to capital
• Customer concentration
• Customer pricing leverage
• Lack of product / service diversification
• Volatility of earnings and / or cash flow
• Technology life cycle
• New competitors
• Life cycle of current products or services
• Availability of labor

It can be argued that many of these company-specific risks are commonly found in smaller enterprises.  That being the case, the size premium most likely includes a component of risk that reflects most or all of these risks.   As such, due consideration must be given to the development of a company specific risk premium (CSRP) which will not double count some of the size premium.

There is not a quantitative formula to establish the CSRP.  As such, estimating a reliable CSRP is a highly subjective process.  Valuators will perform extensive qualitative analysis to develop the CSRP; but converting the qualitative analysis into a quantitative expression requires significant judgment.  Absent factors which are truly unique to the company or its industry (if industry specific risk has not been separately included in the cost of capital), I believe that the CSRP should rarely exceed 1%. 

I frequently perform valuations of medical practices or ancillary services (eg. ambulatory surgery centers, imaging centers, dialysis centers).  This industry is highly regulated and the regulations evolve over time.  The extent of regulation affects the revenue stream and allowable legal structures / ownership.  Furthermore, much of the technology is constantly evolving and obsolescence can be a concern.  In light of these factors, I will often use a high CSRP in valuing such operations.

Although there are valid exceptions, valuators need to use due professional care in developing the CSRP to ensure that the same risk is not accounted for twice.