Challenges to Expert Appraisers in Valuation Proceedings
November 28, 2022
Ask a trial lawyer what he or she would give to have an expert witness as effective as Mona Lisa Vito, the third-generation mechanic/out-of-work hairdresser whose testimony on positraction saved the day in Judge Chamberlain Haller’s courtroom. Their answer will tell you everything you need to know about the importance of expert witnesses.
In business divorce litigation, the expert appraisers often are the key witnesses. There are many different ways that owners of a closely-held business can find themselves litigating a special proceeding in which the sole question before the court is the appraised value of the business: the death or retirement of a partner under Partnership Law 73, a buyout election under BCL 1118, a member’s withdrawal under LLC Law 509, and—of course—the cash-out merger. And all these valuation proceedings turn largely on the testimony of the expert appraiser hired to value the business.
For these reasons, New York business divorce attorneys practicing amid a surge in cash-out mergers and valuation proceedings might take particular insight from PwC’s 2022 Daubert Study, which analyzes the court decisions concerning challenges to a party’s financial expert over the past two-decades. The full study (available here) is loaded with interesting statistics and observations.
Takeaways from the PwC Study
According to the PwC Study, challenges to expert appraisers had a 38% success rate in 2021, higher than challenges to economists (27%) or accountants (32%). While the study does not specify whether any of the successful challenges to expert appraisers occurred in valuation proceedings, it should give counsel and potential expert appraisers in business divorce litigation plenty to think about. Notable takeaways include:
2021 Featured More Challenges.The PwC Study identified 272 reported challenges to financial expert witnesses in 2021, an increase of almost 20% over the prior year. Expert challenges are becoming more common, possibly since even an unsuccessful motion to exclude expert testimony might nonetheless expose flaws in the expert’s testimony that are difficult to overcome at trial.
Successful Challenges Focus on Reliability. Of the 3,342 financial expert challenges that the PwC Study analyzed, most exclusions were based on the court’s finding that the expert’s testimony was not reliable. Relevance of the opinion and qualifications of the expert were a distant second and third.
Appellate Courts Tend to Be More Inclusive. The PwC Study analyzed 103 appeals of lower-court rulings concerning financial expert challenges. The reversal rate for courts that excluded a financial expert was 31%, but the reversal rate for courts that refused to exclude a financial expert was only 12%.
The PwC Study and the rise of statutory valuation proceedings in business divorce inspire us to take a deeper dive into some keystone cases where courts excluded the expert testimony of an appraiser. The decisions highlight several principles that an expert appraiser and counsel would be wise to consider in valuation proceedings.
Indecisiveness Results in Exclusion
Appraisers utilizing an income approach to value an asset must decide whether to use a direct capitalization method or the discounted cash flow (DCF) method. Chris Mercer explains the difference between the two methodologies better than I could. Selecting the wrong methodology (and not adequately defending the selection) might land your expert on the wrong side of a preclusion motion.
In DAGS II, LLC v Huntington Natl. Bank, the Sixth Circuit affirmed the district court’s exclusion of an appraisal expert that valued the property at issue using a direct capitalization method, but then conceded that the income and expenses of the property were likely to change in an irregular pattern over time—a fact that, all else equal, would counsel for use of the DCF methodology (865 F3d 384, 390 [6th Cir 2017]).
The Sixth Circuit also commented on how the expert’s direct capitalization methodology differed from his own prior appraisals of the property, in which he used a DCF method:
It gets worse. Schaal’s appraisal conflicts with his own pre-litigation appraisal of the same property, in which he used “discounted cash flow” analysis—an “appropriate tool for valuing any pattern of regular or irregular income” . . . and the method used by Huntington’s expert appraiser—to arrive at an estimate between $1.8 and $2.2 million. Schaal did not explain the change in methodology to the district court’s satisfaction, and has not done so to ours.
Appraisers should pick a valuation approach and methodology, stick to it, and (as this post demonstrates) apply it consistently. And an expert that has appraised the same asset more than once had better be prepared to explain any differences in methodology or outcome.
Uniform Standards Were Meant to be Broken?
The Uniform Standards of Professional Appraisal Practice (“USPAP”) are the generally recognized ethical and performance standards for the appraisal profession. They include requirements ranging on everything from independence and objectivity, to the required contents of an appraisal report, to certification requirements. Accredited appraisers generally must profess compliance with USPAP.
Is an appraiser’s material violation of USPAP a ground for exclusion? According to at least one federal court, yes. In Cooper v Meritor, Inc., the court excluded the testimony of an appraisal expert who sought to opine on the diminution in value of a property as a result of alleged contamination (16-CV-52, 2019 WL 545169, at *4 [ND Miss Feb 11, 2019]). The appraiser included in her calculation certain general remediation costs, but USPAP Advisory Opinion 9 only allows for consideration of remediation costs where they are necessary to bring the property into regulatory compliance.
The Court observed:
The USPAP represent the ‘minimum standards for appraisal practice’ . . . Thus, under Mississippi law, material breaches of the USPAP render an appraisal invalid. . . . A breach is material when it ‘would have materially affected [the] opinion of value on the subject property.’
Because the appraiser violated USPAP Advisory Opinion 9 by considering remediation costs above those that were necessary to bring the property into regulatory compliance, her testimony was excluded. Expert appraisers can expect to be challenged on any perceived non-compliance with USPAP.
Unchecked Projections In, Exclusion Out
Appraisers sometimes assume the truth of and rely on data or projections prepared by another—usually a party to the litigation or another expert. When they do so, USPAP requires not only that the appraiser identify those assumptions in their report, but also that the appraiser make some independent inquiry as to the reasonableness of the data or projections relied upon. Blind reliance won’t suffice.
In Contr. Packaging, Inc. v Cent. Garden & Pet Co., an expert appraiser’s offered testimony was rejected because the expert failed to test the reasonableness of the projections he relied upon. This, said the court, was a fatal flaw in the appraiser’s methodology, requiring exclusion of the opinion:
The starting point of Zyla’s analysis was the assumption that the projections created by Gulfstream were accurate and attainable, and although an expert may rely on assumptions, he must premise his opinion on reliable assumptions. Instead, Zyla has merely accepted the Gulfstream projections as true based on the opinions of others and on Gulfstream’s alleged marketing expertise without any independent examination.
(2011 WL 13162306, at *6 [ND Ga Mar. 31, 2011]). While an appraiser need not perform a full audit of the company prior to rendering a valuation opinion, an appraiser who fails to perform some reasonableness testing on projections provided by management is risking exclusion. As Contr. Packaging demonstrates, that failure goes not only to the weight of the expert’s opinion, but also to the reliability of the methodology, and it therefore is an appropriate basis for exclusion.
Valuation proceedings often rise and fall with how the court receives the testimony of an expert appraiser, and the exclusion of an expert appraiser in a valuation proceeding would be disastrous. It is incumbent on counsel to rigorously oversee the selection of and engagement with an expert appraiser, avoiding these and other pitfalls along the way.