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LITIGATION

VALUATION

F LV I N S I D E R / December ‘14

CARTER VS. CLEMENTS WALKER:

THE DANGERS OF SPECULATIONTo prevail in commercial litigation, a plaintiff must establish damages

with a reasonable degree of certainty. Speculative calculations are

insufficient to support an award — even if presented by an expert.

In Carter v. Clements Walker, the plaintiff learned this lesson the hard

way when the North Carolina Superior Court threw out his $33 million

claim on a motion for summary judgment.

The case arose from a legal malpractice claim against a law firm that

the plaintiff had retained to obtain patent protection — both domestic

and foreign — for his invention. According to the complaint, the firm

filed a domestic patent application and allowed it to be published

before filing an application for international patent rights. As a result,

the plaintiff allegedly was unable to obtain patents in countries that

require “absolute public novelty.”

A VAGUE IDEA

In support of damages, the plaintiff offered little more than his expert’s conclusion that failure to secure foreign patent rights had cost him about $33 million in lost profits. But deposition testimony revealed that he:

• Hadn’t earned any profits on the invention,

• Hadn’t researched the invention’s sales potential,

• Hadn’t sought to manufacture the invention (he only hoped to license it),

• Claimed no knowledge of the invention’s foreign marketing or licensing potential,

• Didn’t know of anyone (including infringers) who placed any monetary value on the invention,

• Believed the patent would develop commercial value, but had no documentation or research supporting that opinion, and

• Hadn’t been approached about buying his company or the patent rights.

The plaintiff acknowledged in written discovery that no one had ever bought or licensed the invention.

LACK OF DOCUMENTATIONThe court also emphasized that the plaintiff refused to produce

documents that might have supported his damages calculations,

including “agreements, communications, meeting records, letters of

intent, or term sheets between [the plaintiff] . . . and any other person

or entity regarding development, licensing, or commercialization of the

invention.”

The plaintiff did offer unauthenticated “Internet printouts” allegedly

showing products similar to his invention being sold in foreign markets.

But absent supporting testimony, these documents weren’t sufficient

to withstand summary judgment.

Given the “overwhelming evidence” that the plaintiff had never realized

or reasonably projected any commercial value from the invention,

and the absence of credible documentation to support the plaintiff’s

damages claim, the court found that the expert’s “speculative, bare-

bones conclusion is insufficient to create a genuine issue of material

fact on whether [the plaintiff] suffered damages.”

SOLID EVIDENCE

To avoid this type of result, it’s important to work with your experts to ensure their damages conclusions are based on solid evidence — not just speculation.

Contact one of our Valuation Specialists to see if your damages conclusions are based on solid evidence today!

Matt Stelzman, CVA, MAFF, ASA 423.702.8147 mstelzman@hhmcpas.com

Travis Flenniken, CFA, CVA 423.702.7252 tflenniken@hhmcpas.com

WHAT SECRETS MIGHT THIS 1040 TELL?EXPERTS LOOK TO TAX RETURNS HIDDEN-ASSETS INVESTIGATIONS

Business owners involved in divorce or engaged in fraudulent activity

have plenty of motivation to manipulate their companies’ financial

statements for their own ends. Fortunately, for financial experts such

as forensic accountants and valuators investigating hidden assets,

business tax returns aren’t so easy to misrepresent. In fact, these

returns have some built-in protections that help ensure their accuracy.

GETTING THE REAL STORY

Taxpayers who falsify information on their returns risk being charged with tax evasion. In addition, many income and deduction items are reported directly to the IRS by third parties — such as employers, banks, lenders and brokerage firms — making it difficult to omit or alter them.

Tax returns are particularly useful if an expert can obtain them from several years early on in the investigation. Examining changes from one year to the next can provide valuable leads in the search for hidden assets or income sources.

FINDING BURIED TREASUREMany treasures to be discovered in tax returns are buried in attached

schedules, including:

FORM 1040, LINE 7 — INCOME FROM WAGES, ETC. This is

where the taxpayer reports sources of income. If he or she

receives wages from several businesses, it may be possible

to discover previously undisclosed business interests. The

attached W-2s also contain information about retirement

plans and fringe benefits.

FORM 1040, LINE 8B — TAX-EXEMPT INTEREST INCOME.

This income may reveal other investment assets.

FORM 1040, LINES 15 AND 16 — RETIREMENT PLAN

DISTRIBUTIONS. These funds can be traced to determine

whether they were rolled over into other tax-deferred plans

or used for some other purpose.

FORM 1040, LINE 45 — ALTERNATIVE MINIMUM TAX

(AMT). An entry on this line indicates the existence of

tax preference items — deductions, credits and other tax

benefits that are disallowed for AMT purposes. Obtaining

more information about these items, which are listed on

Form 6251, may lead to the discovery of hidden assets.

A potentially significant item is the exercise of incentive

stock options, which may signal a sudden increase in the

taxpayer’s net worth. Each of these items may provide

clues about the taxpayer’s investments.

FORM 1040, LINE 73 — REFUND. This line on previous years’

returns may reveal important information. Dishonest owners

and unscrupulous spouses have been known to overpay taxes

in previous years and then seek a refund after the dust has

settled.

SCHEDULE A — ITEMIZED DEDUCTIONS. A comparison of

real estate taxes (Line 6) with taxes on disclosed property

may show additional income resulting from hidden real estate

assets. Similarly, entries for state and local taxes (Line 5),

personal property taxes (Line 7) and investment interest paid

(Line 14) may reveal the existence of undisclosed assets.

SCHEDULE B — INTEREST AND ORDINARY DIVIDENDS. It’s

important to pay close attention to any foreign accounts or

trusts reported in Part III. If the taxpayer has set up an asset

protection trust in a foreign country with strict secrecy laws,

this may be the only clue that such a trust exists.

SCHEDULE C — PROFIT OR LOSS FROM A SOLE

PROPRIETORSHIP. Depreciation expenses listed in Part II

may show that the owner has valuable business equipment.

Entries for mortgage interest as well as pension and profit-

sharing plans may reveal other undisclosed assets.

If insurance expenses are reported on Line 15, the types of

insurance the business bought may be significant. Taxpayers

sometimes use whole life insurance policies to hide assets.

SCHEDULE D — CAPITAL GAINS AND LOSSES. It’s important

to review any capital transactions reported here and make

sure the business has accounted for all sales proceeds. A

large decrease in a taxpayer’s net worth from one year to

another may indicate an asset sale

SCHEDULE E — SUPPLEMENTAL INCOME AND LOSS.

Schedule E reports income from rental properties, royalties,

partnerships, S corporations, estates and trusts. Entries

here may reveal important information about the taxpayer’s

assets and business interests. Income and expenses that

seem suspicious or unreasonable may indicate that these

entities are being used to conceal assets.

LEADING TO VICTORYTax returns — again, especially several years’ worth obtained early in

the process — can form part of a solid foundation to a successful legal

action. Specifically, tax-related information can aid in the drafting of

discovery requests that lead to victory.

F LV I N S I D E R / December ‘14

CALCULATING DAMAGES IN IP LITIGATION:

AN INFRINGER’S PROFITS MAY BE RECOVERABLE

CONTRIBUTING FACTORSDistinguishing between profits attributable to the infringement and

profits derived from lawful activities can be a challenge. So it’s a good

idea, particularly for defendants, to involve a financial expert early in

the litigation.

Generally, in non-patent cases, the plaintiff has the burden of proving

the defendant’s revenues from infringing products. Then the burden

shifts to the defendant to prove, if possible, the portion of its revenues

attributable to factors other than the infringement.

The defendant may be able to show, for example, that it has certain

advantages that enable it to generate greater revenues from the

infringing product. Perhaps the defendant has a larger and stronger

sales force, better distribution channels or a bigger advertising budget.

Maybe the defendant can manufacture the product more cheaply than

the plaintiff and, therefore, charge a lower price.

To protect victims of intellectual property (IP)

infringement, federal law provides several

alternative measures of damages. Generally,

plaintiffs are entitled to recover their lost

profits attributable to the infringement or,

at minimum, a reasonable royalty. Often, a

plaintiff’s lost profits are difficult to measure or

prove. In those cases, the plaintiff may be able

to recover the infringer’s profits as a substitute.

This remedy — which is available for infringement of

non-patent IP (copyrights and trademarks, for example)

and design patents — ensures that the plaintiff is fairly

compensated, prevents the infringer from profiting from

its wrongful conduct and serves as a deterrent.

THE CHALLENGE OF APPORTIONMENT

Suppose, for instance, a defendant smart phone manufacturer ships

its product, which contains unlicensed software the plaintiff created.

A financial expert might use consumer surveys or other techniques

to determine the extent to which sales are driven by the design or

functionality of the hardware, as opposed to the extent to which they’re

driven by the design and functionality of the software. The answer

would depend, in part, on how important the infringed software is to

the phone’s operation. Does it perform a discrete function or does it

constitute the entire operating system?

Apportionment can be a challenge because the factors that drive sales

are often qualitative. Suppose a music company creates a recording

that contains songs by a variety of musicians. One song, by a world-

famous group, is used without permission, while the rest of the songs

are by lesser-known artists. Arguably, if the unlicensed song is the

driving force behind the compilation’s sales, the copyright owner should

be entitled to all or most of the music company’s profits on those sales.

To quantify the portion of the company’s revenues attributable to the

infringed work, a financial expert might examine surveys of consumers

who bought the recording or compare sales of the infringing product

with sales of compilations that contain no songs by prominent artists.

To get an accurate picture of damages, it’s critical to apportion revenues between infringing and non-infringing products. Often, a company sells an infringing product together with, or as a component of, related non-infringing products.

COST CONSIDERATIONS

In some courts, indirect costs are allocated among all of a defendant’s

products — whether they are infringing or non-infringing — based on

a factor such as direct labor hours. Other courts use an incremental

approach, limiting the defendant’s cost deductions to its increased

costs attributable to the infringing product. The incremental approach

Revenue is just one side of the profits equation. It’s also important to determine which costs are appropriately deducted from infringing sales in calculating the defendant’s profits. Permissible cost allocation methods vary from court to court. Generally, the direct costs of producing the infringing product are allocable to that product. But different jurisdictions treat indirect costs, such as overhead and administrative expenses, differently.

results in larger damages awards, so it’s important to determine which

methods are used in the relevant jurisdiction. Some courts apply

different cost allocation methods depending on whether or not the

infringement was willful.

INVOLVE EXPERTS EARLYGiven the challenges involved in recovering damages based on the

infringer’s profits — or defending against such a claim — it’s important

to get financial experts involved early in the litigation. An expert can

assist in drafting a complaint or other pleadings, and can guide you in

formulating discovery requests designed to elicit documents and other

evidence needed to perform the profitability analysis.

SIDEBAR:

NON-DESIGN PATENT CASES:ARE THE INFRINGER’S PROFITS RELEVANT?

As noted in the main article, a plaintiff may recover the

infringer’s profits in non-patent intellectual property cases

and in cases involving design patents. But what happens in

other types of patent cases? Although the infringer’s profits

aren’t a proper measure of damages, they may be relevant to

determining a reasonable royalty.

Courts typically examine the 15 “Georgia-Pacific factors” in

calculating a reasonable royalty. These include:

• Actual royalties received by the patent holder.

• Royalty rates for comparable patents.

• The patent holder’s established licensing policies.

• The patented product’s established profitability.

• The amount a willing licensor and licensee would have

negotiated at the beginning of the infringement period.

Generally, a reasonable royalty is based on anticipated profits

at the time the infringement began. But several courts have

held that evidence of the infringer’s subsequent actual profits

is relevant in determining a reasonable royalty rate.

Contact our FLV Partner today for any Litigation needs you may have.

Randall Hebert, MBA, CPA, CVA 423.702.8145 rhebert@hhmcpas.com

LACK OF MARKETABILITY DISCOUNTS- FROM THE IRA’S PERSPECTIVE

It’s widely accepted that interests in closely held companies are entitled

to a discount for lack of marketability (DLOM). Clearly, an interest that

can’t readily be sold on a national stock exchange is worth less than a

comparable interest in a publicly traded company. But the amount of

the discount is another story.

A few years ago, an IRS employee publicly released a report entitled

Discount for Lack of Marketability: Job Aid for IRS Valuation

Professionals (“Job Aid”). The report offers little in the way of

affirmative guidance on how valuators should determine a DLOM. But

its critique of common methodologies used to calculate the discount

provides valuable insights into IRS views on the subject.

If you’re involved in litigation with the IRS, it’s a good idea to familiarize

yourself with the Job Aid and be prepared to meet any challenges to

your experts’ conclusions. The report is also a good overview of the

DLOM concept itself. Here are some of the highlighted areas:

RESTRICTED STOCK STUDIES. Many valuators use one or more

published restricted stock studies to support a DLOM. These studies

measure the spread between prices paid for freely traded shares of

public company stock and shares of otherwise identical restricted

stock. Holders of restricted stock are prohibited from selling it for a

specified period (usually one year). Typically, these studies indicate

marketability discounts ranging from 30% to 45%.

The Job Aid warns against using restricted stock studies based on

historical data that’s several years, or even decades, old. It also

criticizes reliance on averages of these studies without examining

the underlying transactions and comparing their specific facts and

circumstances to those of the subject company.

PRE-IPO STUDIES. These studies compare stock prices at the time

of an initial public offering (IPO) with prices of the same stock in

private, arm’s-length transactions before the company went public.

One advantage of this method is that, unlike restricted stock (which

represents an interest in a public company), pre-IPO stock is true,

privately held stock.

According to the IRS, these studies overstate the DLOM and, therefore,

are unreliable, because (among other things) they:

• Examine only successful IPOs.

• Reflect not just lack of marketability, but also the risk that an IPO

won’t occur.

• Usually reflect compensation to employees or other related parties

who receive a bargain price.

• Aren’t contemporaneous — that is, there’s a significant time gap

between pre-IPO transactions and the public offering.

OPTION PRICING MODELS. Some valuators quantify a DLOM using

theoretical or analytical models, often based on option-pricing theory.

One example is the quantitative marketability discount model, which

calculates a DLOM based on the subject company’s expected future

dividends, holding period and return requirements.

According to the Job Aid, these models may be “conceptually sound

in the abstract,” but “there is no attempt to validate the model using

actual current market data.” The IRS advises, therefore, that they not

be used unless the results can be “verified with market evidence.”

COURT CASES. Valuators shouldn’t rely on discounts applied in

previous court decisions, the IRS warns. Judges aren’t valuators

and their determination may be based on factors other than the

DLOM in question. Also, a judge may select a discount based on the

persuasiveness or skill of one party’s counsel or experts, rather than

on valuation theory.

OUR CONSULTING SERVICES

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RANDALL HEBERT, MBA, CPA, CVA, CGMA

423.702.8145 RHEBERT@HHMCPAS.COM

JACK LONDON, CPA, CVA, CFE, CGFM, ABV, CFF

423.702.7277 JLONDON@HHMCPAS.COM

MATT STELZMAN, ASA, CVA, MAFF

423.702.8147 MSTELZMAN@HHMCPAS.COM

CALL THE VALUATION & LITIGATION SPECIALISTS AT HENDERSON HUTCHERSON & MCCULLOUGH, PLLC

FREIGHT DEPOT | 1200 MARKET STREET | CHATTANOOGA, TN 37402 | 423.756.7771 | HHMCPAS.COM

TRAVIS FLENNIKEN, CFA, CVA 423.702.7252

TFLENNIKEN@HHMCPAS.COM

Contact our FLV Partner today for any valuation needs you may have.

Jack London, CPA, CVA, CFE, CGFM ABV, CFF 423.702.7277 jlondon@hhmcpas.com