A simple theory of complex valuation.

• Author: Casey, Anthony J.

Complex valuations of assets, companies, government programs, damages, and the like cannot be done without expertise, yet judges routinely pick an arbitrary value that falls somewhere between the extreme numbers suggested by competing experts. This creates costly uncertainty and undermines the legitimacy of the court. Proposals to remedy this well-recognized difficulty have become increasingly convoluted. As a result, no solution has been effectively adopted and the problem persists. This Article suggests that the valuation dilemma stems from a misconception of the inquiry involved. Courts have treated valuation as its own special type of inquiry distinct from traditional fact-finding. We show that reintroducing fundamental principles of fact-finding can provide a simpler and more accurate method of complex valuation.

Our conclusion rests on the premise that valuations are nothing more than exercises in routine fact-finding. Valuation is not an ethereal question with no right answer. Rather, valuation is a process of inferring the value that a relevant community places on an asset. This basic point has been ignored in practice and received almost no attention in the academy. Recognizing this foundational point can both restore the legitimacy of the process and reduce the costs of uncertainty and biased testimony. We demonstrate that a return to traditional evidentiary rules, including attention to burdens of proof, will discourage courts from resorting to ad hoc calculations and will encourage courts to arrive at valuations through vetted methodologies that are shown to be reasonably accurate and, most importantly, supported by the record. We further show that this will lead to an improvement in the quality of information provided by expert witnesses.

TABLE OF CONTENTS INTRODUCTION I. JUDICIAL VALUATION TODAY A. A Theoretical Void B. The Current Practice C. The Costs 1. Legitimacy 2. Uncertainty and the Cost of Contracting II. A NEW (OLD) THEORY OF VALUATION A. Foundation B. Implementation III. IMPLEMENTATION IN VARIOUS AREAS IV. LIMITATIONS ON APPLYING THE SIMPLE THEORY CONCLUSION INTRODUCTION

California's prison population reached nearly 200 percent of capacity over an eleven-year period leading up to 2009. (1) Among the physical indignities and deficiencies in medical care associated with such overcrowding, "as many as 54 prisoners" shared a single toilet. (2) In proceedings designed to identify a remedy for this conceded Eighth Amendment violation, the state of California argued that a reduction to 145 percent of capacity over two years would be constitutionally adequate. (3) The plaintiffs, meanwhile, identified a reduction to 130 percent of capacity as the minimum needed to "allow the state sufficient room to run their medical system." (4) A three-judge panel concluded that California had to reduce its prison population to 137. (5) percent of the prison's design capacity within two years. (5) The court explained that it arrived at this number because it was "halfway between the cap requested by plaintiffs and the wardens' estimate of the California prison system's maximum operable capacity." (6) The U.S. Supreme Court upheld this decision. (7)

In 2011, Daniel Bruckner, the owner of thirty-six parcels of rental property, ran into difficulties meeting his tax burden and filed for personal bankruptcy. (8) Bruckner owed money to Fannie Mae in connection with three of his multimillion-dollar properties. (9) In bankruptcy proceedings, both Bruckner and Fannie Mae introduced expert testimony on the value of the properties at issue. (10) The bankruptcy court determined that each property's value was exactly halfway between the values proposed by the competing experts. (11) The court's stated rationale for these valuations was that "where there [are] two appraisers, both of whom are competent ... I've ... on some occasions gone somewhere in the middle." (12) The bankruptcy court's ruling was upheld on appeal. (13)

These seemingly disparate examples illustrate a common phenomenon that arises when courts face the task of valuing complex assets, entitlements, and claims. In such cases, it has become routine for courts to eschew expertise and valuations grounded in research and mathematical models in favor of the middle ground. To the extent that judges attempt to be scientific in finding an alternative to numbers proposed by experts, they generally employ a mathematical technique most judges have mastered by the sixth grade--averaging. Judges seek compromise because they are often confronted with skewed valuations from biased experts. While middle ground outcomes are palatable solutions, they have no inherent claim to legitimacy or accuracy in any given complex valuation case. In addition, despite courts' assertions to the contrary, it is generally possible to find an objective value for an asset using best practices in an area or industry. Typically, that value will be neither a random number in between the two expert opinions nor the exact average of dueling expert figures. This is especially true given that experts currently have every incentive to inflate or deflate their valuations knowing that courts will generally come out somewhere near the middle.

This Article contends that the most accurate valuations in complex valuation cases will, of necessity, come from the use of state-of-the-art valuation techniques introduced by highly trained experts. In most cases, therefore, a judge should--consistent with the traditional notion of evidentiary burdens--choose one of the valuation methodologies offered by the parties' experts, or find that the party with the burden of proof has failed to meet that burden. If a judge reaches a valuation without support in the record, the valuation has no legal or factual basis and should not be upheld on appeal. This Article proposes that the solution to the valuation quagmire is not first principles of division, but rather first principles of fact-finding.

It is no secret that courts are ill equipped to perform complex valuations--at least on their own. (14) As a result, valuation has become its own industry within the world of complex litigation, in both civil and criminal contexts. (15) This industry reaches a wide range of legal disputes. Courts routinely rely on experts to assist them in valuing corporations, (16) financial assets, (17) tax liability, (18) tort and civil rights damages, (19) and even the costs or benefits of entitlements such as public education. (20) Because the valuation process is embedded in our traditional adversarial system, it often requires courts to assess the merits of competing experts who may function more as advocates than informative experts. (21)

In general, the use of experts in litigation creates a set of legal and philosophical dilemmas that have--as Judge Learned Hand pointed out--troubled courts, lawyers, and scholars for centuries. (22) Complex valuation cases introduce an added dimension: they require mathematical models. Experts identify the best methodology for assessing value, as well as the variables that must be determined for the methodology to be successful. The experts then perform the ultimate mathematical analysis. (23) But despite the variability of expert quality and statistics themselves, courts regularly respond to complex valuation cases by assigning a value that often falls at an arbitrary point somewhere in between the experts' high and low values. (24) The experts' models set the outer limits and may provide an ex post justification of the final judicial valuation. (25) But they often play little role as actual analytical tools to guide the court in reaching that value. (26)

This state of affairs is concerning to courts, scholars, and practitioners alike. Some have argued that it lacks legitimacy and fails the requirements of the rule of law. (27) That can have major consequences for our justice system as a whole. (28) Others have highlighted its negative practical consequences. They suggest it creates incentives for experts to exaggerate their value estimates. This leads to an arms race among litigants. (29) One might expect this to result in litigants abandoning experts as a useless expense altogether. But our system's sticky procedural rules require a party to put at least something into evidence to make each part of its case. While litigants can introduce market information, tax returns, and other data pertaining to the value of assets, without more, there is nothing to translate those raw numbers into a valuation. Admissible expert testimony fills that evidentiary void. (30) Moreover, the party with the weak case has every incentive to introduce the skewed evidence. And the party on the other side, knowing that courts tend to average the evidence, will respond in kind. There is a de facto penalty for presenting reasonable evidence. In the extreme scenario, expert testimony becomes an uninformative process that imposes a cost on litigants and courts and creates no social value. (31)

Thus, parties will continue to employ skewed experts. And they will continue to have incentives to choose the most extreme experts that a court will accept as qualified under Daubert. (32) These bad incentives deepen the legitimacy problem as experts--and the lawyers and courts that rely on them--lose public trust. (33)

In addition to skewed incentives and legitimacy problems, the current use of experts creates a transaction cost of uncertainty (or risk). (34) If experts provide no useful valuation information to courts, and judges have no expertise themselves, judicial valuations will have no relation to actual value. This disconnect can make transactions more costly in three ways. First, in some cases uncertainty can be costly itself ex ante. (35) Second, once the parties have entered into a transaction, their subsequent behavior will be distorted by the uncertainty. Litigation that produces arbitrary results gives the...