Chapter 5 Other Litigation

• Jurisdiction: United States

Chapter 5 Other Litigation

This chapter surveys other areas of litigation, offering them as examples where prospective financial information may be subject to debate. Each area has its own legislative requirements and case precedent that utilizes language emphasizing projections, forecasts or other items. The examples in this chapter highlight common issues that may affect the interpretation and use of prospective financial information. Although the discussion focuses on financial projections, many of the issues raised may also apply to financial forecasts and other prospective financial information.

Note that, for purposes of our more general discussion, the terms "valuation analyst" and "damages analyst" (or "valuation expert" and "damages expert") are used synonymously in this publication, notwithstanding the different terminology that may appear in litigation matters. These terms all serve as examples of professionals who may rely upon prospective financial information in their valuation and/or damages measurements for various litigation applications.

Mergers and Acquisitions

Financial projections and other prospective financial information prepared by management are important to merger-and-acquisition deals. For example, "sell-side" financial projections are frequently used in merger proxies and other reporting for proposed transactions, and may provide the primary source of information used and relied upon when making decisions about a transaction. In particular, management projections, or adjusted management projections, typically underlie discounted cash flow business valuations used to set deal prices. When a deal goes wrong, subsequent disputes may refer to those management projections, which are often used to support litigation positions concerning the thoroughness of disclosure, the accuracy of information provided to stakeholders, the reasonableness of management's assumptions, or other factors.

Courts generally acknowledge that management has "the best first-hand knowledge of a company's operations."¹⁰⁶ Management, of course, is not without its biases, particularly if it is preparing financial projections in aid of a specific transaction where it may be incentivized to show increased value.¹⁰⁷ Consequently, courts who are addressing valuation disputes arising from mergers or other corporate transactions generally prefer to see a discounted cash flow analysis that is "derived from contemporaneous management projections prepared in the ordinary course of business."¹⁰⁸

Courts have generally found management projections made in the ordinary course (as opposed to those made in connection with a potential transaction) to be reliable. In contrast, projections prepared outside the ordinary course of business are particularly subject to criticism, and may be entirely disregarded by courts.¹⁰⁹

Nevertheless, evaluation of management's projections should be case-specific, and reliance upon those projections depends on the facts and circumstances of each situation. As noted, management projections and other prospective financial information may reflect management's own biases, overly optimistic assumptions, or a dependency on circumstances that are outside of its control. Management projections may also reflect a track record of unproven optimism that correlates with a history of unachieved plans. Comparisons of budget versus actual performance, or comparisons of projections versus forecast versus actual performance can ferret out these historical patterns, helping to establish or refute management's credibility in achieving intended outcomes.

These issues reveal themselves in a growing trend toward increasing amounts of appraisal litigation, where the value of the company being acquired or sold and the proposed consideration to be given (based on the underlying projections) are disputed, rather than litigating whether stockholders were fully informed as to the facts of the transaction (e.g., Revlon Inc. v. MacAndrews & Forbes Holdings Inc. and KKR Fin. Holdings LLC S'holder Litig.) or whether initial and supplemental disclosures made by the company to shareholders were adequate (e.g., Trulia Inc. S'holder Litig.).¹¹⁰

Appraised values in merger and acquisition litigation depend, in part, on the valuation approach used. In addition, an expert's ability to apply a discounted cash flow methodology will, in turn, depend on the quality of the forecasts or projections. If reliable financial forecasts or financial projections are available, an income approach valuation methodology (i.e., a discounted cash flow analysis) may be appropriate.¹¹¹ Unreliable projections, however, may not support the selection of an income approach valuation methodology.¹¹² Each set of projections (or other prospective financial information) should be analyzed on its own terms and tested for bias. For example, some studies have found that management projections in merger and acquisition settings are biased toward optimism — e.g., actual operating earnings or revenues do not achieve the projected amounts.¹¹³ However, this is certainly not the rule, and each document should be evaluated on its own merits.

Valuation experts may be criticized for imputing an upward or downward bias into their financial calculations and valuation analyses in order to drive a result desired by their side of the litigation. Context matters, and "the materiality of any fact, projection, or figure cannot be divorced from the particular circumstances facing the defendant company and the challenged transactions."¹¹⁴ Also, projections prepared to drive a particular result may be suspect "where the projections were created for the purpose of obtaining benefits outside the company's ordinary course of business."¹¹⁵

Consequently, the initial management projections and other prospective financial information should be scrutinized for unwarranted bias and, if necessary, revised to eliminate that bias. Counsel and experts should focus on the purpose of the projections, motivations behind the use of the projections, incentives for bias, and other inquiries to substantiate, or if necessary to adjust, the projections in order to achieve the greatest degree of objectivity. A court may similarly consider such factors when assessing the reliability of management projections.

Intellectual Property

Intellectual property (e.g., patents, trademarks, copyrights, trade secrets) valuations may be performed for financial accounting, income tax accounting, property tax accounting, fairness opinions and in bankruptcy matters.¹¹⁶

Intellectual property is typically valued using an income approach, because the value of intellectual property may be derived from future economic returns such as the royalty income obtained from licensing. Other approaches may be used, such as the cost approach, which analyzes the reproduction cost new or replacement cost new, or the market approach, which relies on comparable transactions to determine pricing metrics. Both the income approach methods and the market approach methods rely on forecasts or projections of future income, whether discounting that future income stream or determining a pricing multiple of that anticipated future income.

Calculating the present value when applying the income approach requires:¹¹⁷

• estimating the duration of the intellectual property income projection period, typically measured as the remaining useful life;
• projecting the income from the intellectual property; and
• determining a discount rate or capitalization rate, typically measured as the required rate of return on an investment in the intellectual property.

Projected income is often the central feature of intellectual property valuation. Counsel and valuation experts should analyze the credibility of management's financial projections and other prospective financial information prior to use in any valuation or damage computation. In that regard, the party analyzing intellectual property valuation and the underlying income projections should ask a number of questions, such as:¹¹⁸

• What was the purpose of the management projections?
• Were the projections prepared in the ordinary course of business or for some other intended use?
• Are the projections contemporaneous with the valuation date?
• Were the projections based on assumptions that were known or knowable as of the valuation date?
• Are there other versions of the projections, and do they reconcile with the final version used in any transaction?
• Are there any forecasts and budgets to compare with the projections to analyze the various future outcomes to assess and evaluate the reasons for their differences?
• What was management's prior experience in preparing forecasting and projections (i.e., accuracy, thoroughness, reliability)?
• Are the assumptions realistic and objective?
• Did any independent parties rely on the financial projections?
• Are there any limitations on access to documents?
• Is there access to management and/or other relevant parties to discuss methods, contexts, purposes, perceptions and other factors affecting the interpretation of important facts and documents?
• Do alternative scenarios exist or should they be prepared, and do they reconcile with a base case or other documents?

ESOPs

The quality and reasonableness of management projections have likewise become an issue in Employee Stock Ownership Plan (ESOP) litigation. Specifically, the Department of Labor (DOL) regulations requirement that ESOPs pay no more than "adequate consideration" when investing in employer securities results in the preparation of valuations. Generally, the analysis of adequate consideration follows the guidelines of Revenue Ruling 59-60.¹¹⁹

ESOP valuations are sometimes based on discounted cash flow analyses that rely on management's financial projections, which may be compared to valuations based on the market approach, guideline public company method. Challenges to income approach valuations may...