NY Bankruptcy Judge Stan Bernstein Tosses Expert's Business Valuation Opinion in a "Must Read" Decision

Self-proclaimed "true" (i.e., non-bankruptcy) litigators who find themselves having to litigate in bankruptcy's free-wheeling arena often lament that "nothing's inadmissible in bankruptcy; everything just goes to the weight of the evidence." Obviously, this is a tremendous over-simplification, and Judge Barry Russell's 1,800 page manifesto, the Bankruptcy Evidence Manual (2005 ed., Thomson/West), is a testament to the fact that everything is clearly not admissible in bankruptcy.

Still, one has to sit up and take note when Judge Stan Bernstein from the Eastern District of New York, in Chartwell Litigation Trust v. Addus Healthcare, Inc. (In re Med Diversified, Inc.), 2005 WL 3077228 (Bankr. E.D.N.Y., 11/14/05), not only bars an expert from testifying in a high-stakes fraudulent transfer case, but adds:

Since this particular issue has not been discussed by any other bankruptcy court, this Court has taken the pains to present a comprehensive analysis of the gatekeeper function in the hope that it may be useful to other bankruptcy judges, the business bankruptcy bar, and, tangentially, the bankruptcy law professoriat.

The Court described the "narrow issue" under submission as whether, in litigation to recover an alleged $7.5 million constructive fraudulent transfer, "the Defendants' proposed expert witness, Scott P. Peltz (Peltz) is qualified and whether his purported expertise satisfies the standards of relevance and reliability under Daubert."

The subject matter of his testimony was "the value of 100% of the shares of the defendant, Addus Healthcare, Inc. (Addus)," a privately held healthcare concern, and "the reasonably equivalent value of an alleged option payment of $7.5 million paid by the Plaintiffs' predecessor in interest, Med Diversified, Inc. (Med D), for a 6 1/2 month extension to close its purchase of these shares."

Mr. Peltz was the Defendants' sole expert on all issues of business valuation. After three full days of intense voir dire on his qualifications, the Court barred his testimony and report and issued a lengthy opinion explaining its reasoning, significant portions of which are set forth below. Obviously, not a good day for the defense.

For anyone interested in bankruptcy litigation, and particularly in issues of business valuation (which invariably require expert testimony), this case is mandatory reading. The Court wrote:

1. Peltz's Qualifications as an Expert Witness on Valuation

Mr. Peltz testified on voir dire that he has no peer-granted certifications as an expert on business valuations, and that his Expert Report is not to be read as a certified business valuation report in contrast to the certified business valuation report of Plaintiffs' expert witness. Moreover, Mr. Peltz's testimony and his report reveal that he has no formal education or training in business valuation. By his own admissions, Mr. Peltz is not qualified as a business valuator.


Mr. Peltz also admitted repeatedly that he personally does not issue business valuation reports, although he relies upon members of his support staff who are certified business valuators for their input. As Plaintiffs' counsel properly pointed out, the Defendants did not call the persons who provided those inputs to testify and be subject to cross-examination, and the alleged inputs of those persons cannot be relied upon as a basis for finding Mr. Peltz an expert witness on business valuation. This Court is not prepared to admit an Expert Report submitted by a corporate entity; 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 this adversary proceeding. The Plaintiffs reserved their right to object to the admission of the Peltz Report and to cross-examine him concerning his purported expertise and other matters arising in his direct testimony. Moreover, Mr. Peltz admitted that his Report cannot be considered a certified business appraisal of value because it does not meet uniform standards for professional appraisal practices that are generally accepted by professional business appraisers.

In effect, the Defendants urge this Court to accept a lower standard of expertise to support Peltz' Report and testimony, averring that he did not have to be certified by peer-groups as a business valuation appraiser. Relying on McCullock v. H.B. Fuller Co., , 61 F.3d 1038 (2d Cir. 1995) and Nimely v. City of New York, 414 F.3d 381 (2d Cir. 2005), the Defendants argue that Mr. Peltz does not need to be certified as a business valuator in order to be qualified as an expert witness on valuation. However, in McCullock, the Court held that the expert was qualified because he had sufficient experience in the field at issue to overcome his lack of formal training and certification. In this case, Mr. Peltz's experience is inadequate to overcome his lack of formal training and certification. Moreover, in Nimely, the Court did not determine whether the expert was qualified, but instead held the District Court should have excluded the expert's testimony because his methods were unreliable.

This Court does not accept Defendants' representations and argument that his substantive experience over the past twenty-plus years as an accountant and as a liquidating agent or bankruptcy trustee in bringing avoidance actions in the bankruptcy court add up to a satisfactory substitute for formal education and training in business valuations and in peer-recognition in this sub-branch of substantive expertise in business valuations, especially in such a unique and highly regulated business of in-home health care services. As stated above, Mr. Peltz admitted during his voir dire that he has no experience in preparing valuation reports and very little hands-on experience in serving as a paid consultant in the health care industry. Mr. Peltz's principal claim for expertise is a few speeches and short articles on health care insolvencies. This Court declines to find that Mr. Peltz' thin record is an adequate and reliable substitute for extensive and direct experience in valuing businesses in this sub-industry as a consultant or as an expert witness in fraudulent transfer actions of this character before the federal district or bankruptcy courts.

As set forth below, not only does Mr. Peltz fail to qualify as a business valuation expert, but, in performing its gatekeeper role, this Court must also exclude Mr. Peltz's testimony 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.

Furthermore, Mr. Peltz found himself in what this Court perceives is a very serious ethical conflict as a result of his prior engagements in which he served as a fraud auditor in the National Century Financial Enterprises (NCFE) cases, which were filed as related Chapter 11 cases in 2002 with the Bankruptcy court for the Southern District of Ohio, sitting in Columbus. First, in preparing his Report for this case, Mr. Peltz deliberately chose not to use information he personally acquired about the massive fraud committed by the principals of NCFE in the securitized financing of, among many others, the two debtors here, Tender Loving Care (TLC) and Med D. This would have been probative on the issue, raised by Mr. Wright in his direct testimony, whether Med D could close the transaction with Addus, given that Med D was increasingly reliant upon NCFE as a principal source of funding for the transaction when its "deal" with the Swiss investment bankers was taken off the table. Second, Mr. Peltz knew that at least two of the principal directors of NCFE also served on the Board of Directors of Med D, and one of the subordinate issues in this adversary proceeding is whether the Board granted its corporate authorization to enter into the First Amendment. So either Mr. Peltz's testimony is biased because he had formed a preconception of NCFE's role in the relevant Med D acquisitions of the stock of the TLC entities and the proposed acquisition of 100% of the shares of Addus; or, alternatively, Mr. Peltz deliberately chose not to apply his existing knowledge when it was directly relevant to issues he knew had been raised in this case from reviewing the transcripts of the depositions by the time he completed his Report. On either of these grounds alone, his direct testimony is not admissible.

2. Reliability of Peltz's Expert Opinion

Even if Mr. Peltz were found to be otherwise qualified as an expert on business valuation, his testimony is still inadmissible because he showed a discernible measure of negligence in purportedly applying the alleged professional standards and techniques found in the published practical treatises, including the standards and techniques published in the writings of Dr. Shannon Pratt and his co-authors, which were repeatedly propounded by both the Defendants and the Plaintiffs during the respective voir dire and testimony of both Mr. Peltz and Mr. Cimasi. This was thoroughly explored in the lengthy and detailed cross-examination of Mr. Peltz by counsel for the Plaintiffs. The Court cannot accept the testimony of an alleged expert in business valuations when he failed to employ the necessary peer-reviewed methods of business valuation, when he based his analysis on inadequate data, and when he thoroughly conflated the discreetly different concepts of gross cash flow and net cash flow from operations.

The methodology used by Mr. Peltz in determining the value of Addus consisted of two separate valuation techniques: (1) a Guideline Company Multiple Approach ("Company Approach") and (2) a Guideline Transaction Multiple Approach ("Transaction Approach"). Yet the leading authorities on business valuation, including the authority most cited by the parties, Dr. Shannon Pratt, "recognize that the most reliable method for determining the value of a business is the Discounted Cash Flow ("DCF") Method." Yet the leading authorities on business valuation, including the authority most cited by the parties, Dr. Shannon Pratt, "recognize that the most reliable method for determining the value of a business is the Discounted Cash Flow ("DCF") Method." Lippe v. Bairnco Corp., 288 B.R. 678 (S.D.N.Y. 2003) (citing Shannon P. Pratt et. al., Valuing A Business: The Analysis and Appraisal of Closely Held Companies 154 (4th ed. 2000)("Regardless of what valuation approach is used, in order for it to make rational economic sense from a financial point of view, the results should be compatible with what would result if a well-supported discounted economic income analysis were carried out.")), aff'd, 99 Fed.Appx. 274 (2d Cir.2004).

During his testimony, even Mr. Peltz recognized that the DCF method is commonly used to value 100% of the equity of a privately held company. Yet he did not use the DCF method in determining the value of the Addus shares. In Lippe, the court excluded the testimony of a business valuation expert based, in part, on the expert's failure to use the DCF method in determining the value of the business. The court held "[b]y failing to use the DCF method and relying solely on the comparable companies method, [the expert] did not have an ability to do a 'check' on his determinations." Lippe, 288 B.R. at 689. Accordingly, the expert's testimony was excluded as unreliable. Id. at 701.

For essentially the same reason, Mr. Peltz's failure to use the DCF method amounts to a material flaw in his methodology sufficient to bar his testimony as an expert witness because his conclusions lack 'good grounds.' Although Mr. Peltz used two methods in determining the value of Addus, both approaches are considered "market" approaches which apply a multiple computed from data derived from other alleged comparable companies. In contrast, the DCF method is considered an "income" approach to valuation that uses data derived from the target company itself to compute the current value of the projected future economic benefit of owning the company. Mr. Peltz never determined that the DCF method was inappropriate as a valuation method under the circumstances, and he even considered using the DCF method, stating at one point in his testimony: "[t]he methodology is appropriate. No question." For some unknown reason, Mr. Peltz did not use the DCF method and he failed to offer an adequate explanation why he did not do so. Instead, he testified that he simply ascertained the method he used was reliable. As in Lippe, this Court finds that Mr. Peltz's use of only two "comparable companies" methods simply did not provide the necessary "check" on the value he arrived at that would render that value a reliable measure of the company's worth.

This conclusion is further supported by the fact that Mr. Peltz testified that he only performed a second analysis using the Transaction Approach as a "check" on the results from his analysis using the Company Approach. He stated: "if I used the transaction approach and reached a wildly variant conclusion, I'd have to go back and consider my methodology." However, Mr. Peltz also testified that although he believed he had good data for his Company Approach, he did not believe he had a very good set of transactions for use in performing an analysis under the Transaction Approach. Mr. Peltz never provided any explanation why he believed the Transaction Approach could serve as a test for the reliability of the Company Approach when, by his own admission, his analysis using the Transaction Approach was itself unreliable.

Moreover, in deriving a value for Addus using both the Company and Transaction approaches, Mr. Peltz depended on databases of research findings of only ten allegedly comparable privately held companies engaged in home health care and related industries. Mr. Peltz testified that he did not do any independent analysis of these companies, and did not independently analyze the data from the databases from which he derived his figures---"Mergerstat" and "Factset." In choosing the companies and transactions upon which his analysis is based, Mr. Peltz admittedly never considered the nature or products of the businesses, or the market in which these businesses operated. Thus, the data on which Mr. Peltz's conclusions are based is simply inadequate.

Further, in computing a value under the Transaction Approach, Mr. Peltz applied a discount of 25% for the "illiquidity" of the business, even though the Transaction Approach presumably uses data from actual transactions of privately held companies that are similar to the transaction at issue. As a result, "illiquidity" is already built into the results. When asked whether he had any support for applying such a discount, Mr. Peltz replied: "I haven't researched that. It's common--I can tell you that it's been my common practice." However, without this discount, Mr. Peltz would have reached a "wildly variant" conclusion, which, by his own testimony, would have forced him "to go back and consider [his] methodology...."

The Supreme Court has clearly stated: "nothing in either Daubert or the Federal Rules of Evidence requires a ... court to admit opinion evidence which is connected to existing data only by the ipse dixit of the expert. A court may conclude that there is simply too great an analytical gap between the data and the opinion proffered." General Electric v. Joiner, 522 U.S. 136, 146 (1997). As such, "when an expert opinion is based on data, a methodology, or studies that are simply inadequate to support the conclusions reached, Daubert and Rule 702 mandate the exclusion of that unreliable opinion testimony. Mr. Peltz's expert opinion and testimony were loaded with multiple ipse dixits.

Accordingly, the Court must exclude the expert valuation opinion of Scott P. Peltz on this ground as well. His testimony did nothing to assist this Court in performing its role as the finder of fact on the material issues in this adversary proceeding; indeed, his testimony made this Court's role even harder to perform.

© Steve Jakubowski 2005

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