Beware the Gatekeeper

In Daubert, the Supreme Court stated that the trial judge must perform a 'gatekeeping' function to ensure that the expert testimony rests on a reliable foundation and is relevant to the matter at issue. This gatekeeping role applies not only to testimony based on scientific knowledge, but also the testimony based on technical and other specialized knowledge. See Daubert, 509 U.S. 579, 597, 113 S. Ct. 2786 (1993); see also Celebrity Cruises.

While the Court has a duty to admit expert testimony that is reliable and will assist the trier of fact, Daubert also charged the Court with a duty to ensure that the courtroom door remains closed to junk science ' Accordingly, the trial court acts as a gatekeeper by ensuring that every step of the expert's analysis is reliable ' Acting in its gatekeeper role, the trial court has a duty to undertake a rigorous examination of the facts on which the expert relies, the method by which the expert draws an opinion from those facts, and how the expert applies the facts and methods to the case at hand. In re Med Diversified, 2006 Bankr. LEXIS 1677, 12-13 (Bankr. E.D.N.Y. 2006) (quotations and citations omitted).

In Daubert, the Supreme Court provided a non-exclusive list of factors the trial court should apply in assessing whether expert evidence should be admitted. The Daubert factors are: 1) has the method been tested; 2) has it been subjected to peer review; 3) what is the rate of error; 4) are there controlling standards (as by a professional organization); and 5) has the method achieved acceptance? Daubert at 593-94.

The Med Diversified case resulted in two published opinions disqualifying valuation experts in connection with an adversary proceeding filed in a bankruptcy case to recover an alleged constructive fraudulent transfer of $7,500,000. First, the plaintiffs in the litigation filed a motion in limine to exclude the defendants' valuation expert's expert testimony, contending that he was not qualified as an expert and that his purported expertise did not satisfy the standards of relevance and reliability under Daubert and ensuing precedents. More specifically, the motion in limine was based on the contention that the proposed expert did not qualify as an expert with regard to the valuation of all the shares of a privately held healthcare services company. '[T]his motion gave rise to the Court's exercise of its gatekeeper functions in excluding expert testimony that is neither relevant nor reliable.' Med Diversified at 94. The court decided to conduct a voir dire of the proposed expert witness and then determine whether the motion in limine should be granted at the conclusion of the voir dire. The voir dire lasted for the majority of three business days and the court actively participated in the process. Id.

In determining that he would disqualify the defendants' proposed expert witness, the court in Med Diversified applied the Daubert factors and made the following findings and conclusions:

• The proposed expert had no peer-granted certification as an expert on business valuations and his expert report is not to be read as a certified business valuation report (in contrast to the certified business valuation report of the plaintiffs' expert witness ” interestingly, as discussed below, the court later disqualified the plaintiffs' valuation expert);
• The defendants' proposed expert had no formal education or training in business valuations;
• The defendants' proposed expert admitted repeatedly that he personally does not issue business valuation reports although he relies upon members of his support staff who were certified business valuators for their input;
• The defendants did not call the persons who provided those inputs to testify and be subject to cross examination and, accordingly, the inputs of support staff cannot be relief upon as a basis for finding the proposed expert witness to be qualified as an expert on business valuation;
• The court was not prepared to admit an expert report submitted by a corporate entity, holding that the person who signs the report has to testify until the admission of his report for all evidentiary purposes has been stipulated to, which did not occur in the subject adversary proceeding;
• The proposed expert's experience was inadequate to overcome his lack of formal training and certification; and
• The court refused to accept the argument that the proposed ex-pert's substantive experience of over 20 plus years as an accountant and as a liquidating agent or bankruptcy trustee in bringing avoidance actions in bankruptcy could add up to a satisfactory substitute for formal education and training in business valuations and in peer-recognition, especially in such a unique and highly regulated business of in-home health care services.

The court concluded that the proposed expert not only failed to qualify as a business valuation expert, but that, even if he had qualified, his testimony must be excluded as unreliable because he did not employ the same level of intellectual rigor that characterizes the practice of an expert in the field of business valuation for, among other things, the following reasons:

• Failing to use a discounted cash flow analysis in his business valuation, even though that method was recognized by leading authorities as the most reliable method for determining the value of a business;
• Basing his analysis on inadequate data; and
• Misapplying certain financial concepts in connection with his valuation analysis. Med Diversified, Inc., at 95-104.

The Med Diversified court in the same fraudulent transfer adversary proceeding subsequently addressed the defendants' motion to exclude the testimony of the plaintiffs' expert on business valuation on the ground that his expert report and testimony were unreliable because the methodology he used was flawed (In re Med Diversified, Inc., 2006 Bankr. LEXIS 1677, 9-10). The court set forth a detailed review of and found significant flaws with the analysis of the plaintiffs' proposed expert. Further, the court found that these flaws weren't simply the result of incompetence or negligence, but rather the result of even more serious offenses, stating that the proposed expert was guilty deliberate, manifest, pervasive and systematic bias. As a result, the court struck the experts report and testimony from the record. In re Med Diversified, Inc., 2006 Bankr. LEXIS 1677, 56.

Valuation Conclusions and the Market

When there is a marketplace for the property being valued, many courts give significant deference to marketplace values. For example, in the context of determining reasonably equivalent value in a fraudulent transfer adversary proceeding in connection with the bankruptcy case, a court stated:

When sophisticated parties make reasoned judgments about the value of assets that are supported by then prevailing marketplace values and by the reasonable perceptions about growth, risks, and the market at the time, it is not the place of fraudulent transfer law to reevaluate or question those transactions with the benefit of hindsight. Peltz v. Hatten, 279 B.R. at 738.

In In re Oneida Ltd., the court found that even a contingent, non-consummated offer from a potential purchaser of the debtors was material and valuable to the court in reaching its valuation conclusion (In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 34-38). Further, in Oneida, the court found that the debtors' exit credit facilities appeared to have been priced by the market and that the interest rate that would be charged on the debtors' actual exit facilities would be a better indicator of the cost of debt of the reorganized debtor than that provided by the equity committee's expert which relied on problematic comparables (In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 24-27). Not surprisingly, courts will generally be more comfortable with real world market driven/proven value conclusions than theoretical conclusions lacking connection to any marketplace.

Conclusion

Courts recognize that the determination of enterprise value in connection with a contested Chapter 11 plan confirmation hearing is not an exact science. Expert evidence is required in order to reach a value conclusion. Further, competent, qua-lified valuation experts generally use the same methodologies, but their valuation conclusions frequently diverge dramatically.

The court serves as a gatekeeper charged with precluding unqualified, irrelevant and/or unreliable expert evidence from being considered in the court's determination of enterprise or going concern value. Moreover, this determination is frequently at the heart of a contested Chapter 11 plan of reorganization process and may dictate whether junior creditors and/or shareholders are in the money or, instead, senior creditors will receive all or a higher percentage of the reorganized enterprise in satisfaction of their claims. As a result, in the context of competing experts and plans presenting and based upon conflicting enterprise valuation conclusions, it is imperative that an expert maintains credibility with the court and avoids arrangements, approaches, and actions that undermine her or his independence.

David S. Kupetz is a partner with SulmeyerKupetz in Los Angeles. He is an expert in business reorganization, debt restructuring, bankruptcy, and other insolvency alternatives. He can be reached at [email protected].

Last month, we explained that valuation issues come into play throughout Chapter 11 business reorganization cases. We discussed how to recognize the uncertainties underlying expert valuation conclusions; enterprise/going concern value; and the fact that the goal of any valuation is to make an estimate based on an informed judgment that embraces all facts relevant to future earning capacity and hence to present worth, including, of course, the nature and conditions of the properties, the past earnings record, and all circumstances that indicate whether or not the record is reliable criterion of future performance. We conclude this month with a discussion of expert evidence.

Admissibility of Expert Evidence and Disqualification Of Experts

The admissibility of expert testimony is a preliminary question of law for the court to determine. [Fed. R. Evid. 104(a); see also Celebrity Cruises, Inc., v. Essef Corp., 434 F. Supp. 2d 169, 175 (S.D.N.Y. 2006), citing Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 592, 113 S. Ct. 2786, 125 L. Ed. 2d 469 (1993)]. The proponent of the testimony bears the burden of demonstrating its admissibility by a preponderance of the evidence. Id. In order to be admissible, expert testimony must be relevant and based on a reliable foundation (Chartwell Liti-gation Trust v. Addus Healthcare, Inc. (In re Med Diversified, Inc.), 2006 Bankr. LEXIS 1677, 10 (Bankr. E.D.N.Y. 2006). Further, an expert must also be qualified as an expert in order for his or her testimony to be admissible as expert testimony. Id.). Expert evidence is relevant if it 'has any tendency to make the existence of any fact that is of consequence to the determination of the action more probable or less probable then it would be without the evidence.' (Fed. R. Evid. 401). Under Rule 702 of the Federal Rules of Evidence, expert testimony is reliable if: '(1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case.' Fed. R. Evid. 702; see also (In re Med Diversified, Inc) 2006 Bankr. LEXIS 1677, 10 (Bankr. E.D.N.Y. 2006).

In Daubert, the Supreme Court stated that the trial judge must perform a 'gatekeeping' function to ensure that the expert testimony rests on a reliable foundation and is relevant to the matter at issue. This gatekeeping role applies not only to testimony based on scientific knowledge, but also the testimony based on technical and other specialized knowledge. See Daubert, 509 U.S. 579, 597, 113 S. Ct. 2786 (1993); see also Celebrity Cruises.

While the Court has a duty to admit expert testimony that is reliable and will assist the trier of fact, Daubert also charged the Court with a duty to ensure that the courtroom door remains closed to junk science ' Accordingly, the trial court acts as a gatekeeper by ensuring that every step of the expert's analysis is reliable ' Acting in its gatekeeper role, the trial court has a duty to undertake a rigorous examination of the facts on which the expert relies, the method by which the expert draws an opinion from those facts, and how the expert applies the facts and methods to the case at hand. In re Med Diversified, 2006 Bankr. LEXIS 1677, 12-13 (Bankr. E.D.N.Y. 2006) (quotations and citations omitted).

In Daubert, the Supreme Court provided a non-exclusive list of factors the trial court should apply in assessing whether expert evidence should be admitted. The Daubert factors are: 1) has the method been tested; 2) has it been subjected to peer review; 3) what is the rate of error; 4) are there controlling standards (as by a professional organization); and 5) has the method achieved acceptance? Daubert at 593-94.

The Med Diversified case resulted in two published opinions disqualifying valuation experts in connection with an adversary proceeding filed in a bankruptcy case to recover an alleged constructive fraudulent transfer of $7,500,000. First, the plaintiffs in the litigation filed a motion in limine to exclude the defendants' valuation expert's expert testimony, contending that he was not qualified as an expert and that his purported expertise did not satisfy the standards of relevance and reliability under Daubert and ensuing precedents. More specifically, the motion in limine was based on the contention that the proposed expert did not qualify as an expert with regard to the valuation of all the shares of a privately held healthcare services company. '[T]his motion gave rise to the Court's exercise of its gatekeeper functions in excluding expert testimony that is neither relevant nor reliable.' Med Diversified at 94. The court decided to conduct a voir dire of the proposed expert witness and then determine whether the motion in limine should be granted at the conclusion of the voir dire. The voir dire lasted for the majority of three business days and the court actively participated in the process. Id.

In determining that he would disqualify the defendants' proposed expert witness, the court in Med Diversified applied the Daubert factors and made the following findings and conclusions:

• The proposed expert had no peer-granted certification as an expert on business valuations and his expert report is not to be read as a certified business valuation report (in contrast to the certified business valuation report of the plaintiffs' expert witness ” interestingly, as discussed below, the court later disqualified the plaintiffs' valuation expert);
• The defendants' proposed expert had no formal education or training in business valuations;
• The defendants' proposed expert admitted repeatedly that he personally does not issue business valuation reports although he relies upon members of his support staff who were certified business valuators for their input;
• The defendants did not call the persons who provided those inputs to testify and be subject to cross examination and, accordingly, the inputs of support staff cannot be relief upon as a basis for finding the proposed expert witness to be qualified as an expert on business valuation;
• The court was not prepared to admit an expert report submitted by a corporate entity, holding that the person who signs the report has to testify until the admission of his report for all evidentiary purposes has been stipulated to, which did not occur in the subject adversary proceeding;
• The proposed expert's experience was inadequate to overcome his lack of formal training and certification; and
• The court refused to accept the argument that the proposed ex-pert's substantive experience of over 20 plus years as an accountant and as a liquidating agent or bankruptcy trustee in bringing avoidance actions in bankruptcy could add up to a satisfactory substitute for formal education and training in business valuations and in peer-recognition, especially in such a unique and highly regulated business of in-home health care services.

The court concluded that the proposed expert not only failed to qualify as a business valuation expert, but that, even if he had qualified, his testimony must be excluded as unreliable because he did not employ the same level of intellectual rigor that characterizes the practice of an expert in the field of business valuation for, among other things, the following reasons:

• Failing to use a discounted cash flow analysis in his business valuation, even though that method was recognized by leading authorities as the most reliable method for determining the value of a business;
• Basing his analysis on inadequate data; and
• Misapplying certain financial concepts in connection with his valuation analysis. Med Diversified, Inc., at 95-104.

The Med Diversified court in the same fraudulent transfer adversary proceeding subsequently addressed the defendants' motion to exclude the testimony of the plaintiffs' expert on business valuation on the ground that his expert report and testimony were unreliable because the methodology he used was flawed (In re Med Diversified, Inc., 2006 Bankr. LEXIS 1677, 9-10). The court set forth a detailed review of and found significant flaws with the analysis of the plaintiffs' proposed expert. Further, the court found that these flaws weren't simply the result of incompetence or negligence, but rather the result of even more serious offenses, stating that the proposed expert was guilty deliberate, manifest, pervasive and systematic bias. As a result, the court struck the experts report and testimony from the record. In re Med Diversified, Inc., 2006 Bankr. LEXIS 1677, 56.

Valuation Conclusions and the Market

When there is a marketplace for the property being valued, many courts give significant deference to marketplace values. For example, in the context of determining reasonably equivalent value in a fraudulent transfer adversary proceeding in connection with the bankruptcy case, a court stated:

When sophisticated parties make reasoned judgments about the value of assets that are supported by then prevailing marketplace values and by the reasonable perceptions about growth, risks, and the market at the time, it is not the place of fraudulent transfer law to reevaluate or question those transactions with the benefit of hindsight. Peltz v. Hatten, 279 B.R. at 738.

In In re Oneida Ltd., the court found that even a contingent, non-consummated offer from a potential purchaser of the debtors was material and valuable to the court in reaching its valuation conclusion (In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 34-38). Further, in Oneida, the court found that the debtors' exit credit facilities appeared to have been priced by the market and that the interest rate that would be charged on the debtors' actual exit facilities would be a better indicator of the cost of debt of the reorganized debtor than that provided by the equity committee's expert which relied on problematic comparables (In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 24-27). Not surprisingly, courts will generally be more comfortable with real world market driven/proven value conclusions than theoretical conclusions lacking connection to any marketplace.

Conclusion

Courts recognize that the determination of enterprise value in connection with a contested Chapter 11 plan confirmation hearing is not an exact science. Expert evidence is required in order to reach a value conclusion. Further, competent, qua-lified valuation experts generally use the same methodologies, but their valuation conclusions frequently diverge dramatically.

The court serves as a gatekeeper charged with precluding unqualified, irrelevant and/or unreliable expert evidence from being considered in the court's determination of enterprise or going concern value. Moreover, this determination is frequently at the heart of a contested Chapter 11 plan of reorganization process and may dictate whether junior creditors and/or shareholders are in the money or, instead, senior creditors will receive all or a higher percentage of the reorganized enterprise in satisfaction of their claims. As a result, in the context of competing experts and plans presenting and based upon conflicting enterprise valuation conclusions, it is imperative that an expert maintains credibility with the court and avoids arrangements, approaches, and actions that undermine her or his independence.

David S. Kupetz is a partner with SulmeyerKupetz in Los Angeles. He is an expert in business reorganization, debt restructuring, bankruptcy, and other insolvency alternatives. He can be reached at [email protected].