Charles v. Charles, 2013 Cal. App. Unpub. LEXIS 2386 (April 2, 2013)

“The subtext of this date-of-valuation-of-a-community-business case,” the California Court of Appeal said, “is how a strategy can backfire.” The operating spouse of the business counted on its value declining between the date of separation and the date of trial. Instead the company flourished in the five years leading up to trial. After the trial court denied his last-minute request to change the valuation date, the husband appealed the judgment.

Upward revision

The husband was an equal partner in a two-man interior design firm. His interest, including all of goodwill, was community property. In May 2006, the husband and wife separated, and one year later, in May 2007, the trial court declared the marriage dissolved. One month later, both parties retained the same CPA firm to value the marital interest in the business. It calculated a value of $226,000 for the end of 2006.

In 2009, the husband, in a one-sided conversation with the accountants, claimed the company was in grave financial trouble and expected a $100,000 loss for the first quarter of 2009. In response, the appraiser lowered the value to $198,000.

In reality, however, 2009 proved to be a successful year, with gross revenue of about $2.4 million and a profit of $1.3 million before officers’ compensation. This yielded a $716,000 value, a revised October 2010 report from the accountants showed.

In September 2010, the wife asked the court to set a trial date, stating that “all discovery has been completed.” The court ordered a trial setting conference for November 2010. In December 2010, the husband retained a new lawyer, who, within days, filed a motion to value the community’s interest in the firm at the date of separation. The court only heard the motion a week before trial was to begin, in February 2011. The wife successfully objected to
a change in valuation date, claiming the motion was untimely. She also persuaded the court to preclude the husband from offering testimony about the valuation closest to the date of separation, showing the $226,000 value. Ultimately, the trial got underway only in late August 2011.

By then both parties presented competing experts, but the court also heard from the once jointly retained expert. It noted that, at some point, the husband had stopped paying the accounting firm, which “substantially interfered with their on-going work.”

A matter of ‘reasonable compensation.

‘ The wife’s expert was a recognized economist, who valued reasonable compensation for the husband at $649,000 per year, using data from the Risk Management Association. By contrast, the husband’s expert, a CPA, set the figure at $1.34 million based on information from the Economic Research Institute. The formerly joint expert gave an in-between figure: $875,000 per year.

Moreover, the husband’s expert stated that a $51,530-per-month income for the husband represented the business’s cash flow situation as of July 2011, the date nearest to the trial. However, based on data he received from the company’s controller, he also projected a lower figure, $41,612, for the whole of 2011.

The business showed a low in gross revenue of $2.3 million in 2006 and an increase to $2.6 million in 2008. Gross revenue in 2009 was about $2.4 million. But in 2010 it was $3.7 million. The wife’s expert and the former joint expert, both, averaged income for the years 2006 through and including 2010.

The trial court noted that the critical difference in the valuations was the calculation of goodwill, which, in turn, hinged on how much “reasonable compensation” the experts attributed to the husband. “The more income of the business is attributable to the operating spouse, the less an investor wants to pay to buy the business and replace the operating spouse,” it summed up the issue.

It credited the opinion of the wife’s expert for two reasons: One, his credentials were “over-the-top impressive”; two, he based his analysis on studies from the Risk Management Association that provided a better comparison sample of firms in terms of asset size and sales. On the other hand, the Economic Research Institute data did not provide the husband’s expert with any information as to how closely the sample data lined up with his own criteria, the court found.

To the reasonable compensation figure of $649,000, the court then applied a multiplier of 2 to capture risk, finding that gross revenues for the relevant period never dipped below $2.3 million. (The higher the multiplier, the lower the perceived risk.) It valued goodwill for the entire firm at $1.45 million. Combining this amount with fixed assets of approximately $190,000 and an additional $190,000 in owners’ equity, it found the business’s total value amounted to $1.8 million, which yielded a community interest of $918,000.

For purposes of spousal support, the court used the $51,530-per-month figure the husband’s expert had proposed to reflect cash flow for July 2011, finding there was no corroboration for the data undergirding his lower projection for all of 2011.

Beware ‘the chimera of projection.’

The husband appealed. arguing first and foremost that the trial court erred by not establishing the value of the business on the date of separation. Secondarily, he objected to the trial court’s rejection of his expert’s projections for 2011 and the use of “outdated data” in the valuation of the wife’s expert.

Valuation date. As the state Court of Appeal put it, the husband’s objection to the valuation came in two “permutations.” One, he claimed the trial court had no choice but to value the design firm at the date of separation; two, if the court was going to use the date of trial, it had to reduce the value so that it took into consideration the husband’s post-separation efforts.

This argument, the court stated, had no traction with it for a simple legal reason: It ignored the standard of review that applied to the lower court’s decision. Under state law, the trial court “shall” value assets and liabilities as near as possible to trial; it “may,” upon a timely motion and for good cause, switch to valuation as of the date of separation to achieve an equal division. Given the trial court’s discretion, the issue on appeal was not whether the trial court erred but whether it acted reasonably when it denied the husband’s late motion, the appellate court stated with emphasis.

To assess the trial court’s decision in this light was an “an easy call,” the higher court said. By the time the husband finally brought his motion, discovery was complete. Opening up the issue would have put the wife at a disadvantage. She would have had to redepose the husband as well as obtain depositions from his business partner and other employees. The latter, the appellate court noted, “might be somewhat less inclined to ascribe the entirety
of the business’s recent success just to [the husband’s] efforts.” A new valuation date also would have required substantial extra work from the experts, who would have to reconstruct the business environment that existed in 2006 to fix the company’s value.

Moreover, policy reasons, such as “the need to deter operating spouses from gamesmanship in the control of community businesses,” supported the decision, the appellate court stated. The trial court reasonably questioned the husband’s motive for requesting a change in valuation date so close to trial. Had he been serious about his contention that the firm “was fundamentally a two-man show (or maybe even a one-man show),” the appellate court said, he would have filed his motion in 2007, 2008, or even 2009. What’s more, as the court pointed out, the company had a website that emphasized “the institutional stability of [the firm] (as distinct from the company simply being a manifestation of [the husband’s] own artistic vision).” When questioned by the trial court, the husband said that some of the information on it was not accurate.

The true reason for bringing the motion so late, the appellate court concluded, was that the husband mistakenly thought the firm’s value would decline from its date of separation value.

Projections. The husband also claimed that the trial court “improperly discounted” the projections his expert created for 2011. Under the evidence code, there was no need for extra corroboration from the firm’s controller or the husband’s business partner; the testimony was admissible. Also, the trial court had to consider his expert’s projection of reduced income for the balance of 2011 determinative.

The appellate court disagreed. The trial court was not making an evidentiary decision, but one related to the credibility of the experts and their methodologies. On the whole, it simply found the figures the wife’s expert proffered “more compelling.” The trial court acted reasonably when it preferred “hard historical data to the chimera of projection.”

The trial court’s decision to base its support calculation on the $51,530 monthly income figure the husband’s expert specified when determining cash flow for July 2011 at most was harmless error. That figure worked out to less than half of what the same expert said was reasonable compensation for purposes of determining the company’s goodwill ($1.34 million). Had the trial court used the value the husband’s own expert claimed as reasonable compensation, his income for support purposes would be more than twice the amount the trial court determined. He “got off easy,” the appellate court said, because that figure was lower than the lowest reasonable compensation figure by any of the experts.

Outdated data. Finally, the husband claimed the trial court “had to” reject the valuation from the wife’s expert because it relied on data for 2010, when the business had an exceptionally good year. The year 2011, he contended, generated much less income. Because the expert did not exclude the 2010 data but did exclude the 2011 data, his valuation lacked substantial evidence.

Not so, the appellate court found. As to the year 2010, the wife’s expert averaged income for 2006 up to and including 2010 and thus obtained a properly representative longitudinal sample. Moreover, the trial court was right to credit an expert who excluded data for the year 2011. Considering trial took place in August 2011, the middle of the third quarter, any decline for that year would at best be a projection based on data from the first two quarters. “The year was still subject to manipulation and uncertainty.”

Also, the reviewing court said, given the husband’s “track record,” that is, his earlier misstatements about the company’s health in 2009, the trial court had reason to be skeptical about any negative projections. In its decision, the trial court expressly noted that the projection from the first two quarters of 2011 indicated a gross of $2.57 million, higher than 2006, 2007, and 2009, but a bit lower than 2008.

For all these reasons, the court of appeal affirmed the trial court’s determination.