O’Rourke v. Burke and Hotchkiss, PLLC, 2013 N.H. Super. LEXIS 4 (March 6, 2013)

Citing an authority on the going concern methodology but failing to apply the prescribed principles was only one of several critical errors an expert made when he assessed damages for a struggling bagel company related to its legal malpractice claim. In its Daubert ruling, the court found the testimony unreliable.

The plaintiff, a bagel business, filed suit in state court against the defendant, a law firm, alleging it had failed to perfect the lending shareholders’ security interests in the company. As a consequence, when the business filed for bankruptcy, the trustee was able to take possession of all of its assets. Had the firm performed to standard, the company shareholders would have kept the secured assets, disposed of the unsecured debt, and continued in business upon reorganization.

The company retained an expert, a CPA, who analyzed the going concern value of the business’s assets, their depreciated value, and the value of other assets. The defendant objected under Daubert, as adopted by state law. The plaintiff claimed the opinion was admissible because any legitimate concerns went to weight and credibility.

No sustained earnings.

The expert stated he chose to value the company as an “active business with future earning power as opposed to liquidation value.” He said he used the “going concern methodology” James S. Queenan set forth in “Standards for Valuations of Security Interest in Chapter 11,” a 1987 law review article. It suggests that an expert consider earnings of the five previous years and refrain from making “long-range projections of substantial earnings for a business currently suffering losses or making only a small profit.” The article calls them “largely speculative.”

However, the expert here only considered earnings for one year in business—2009 to 2010—during which the company actually showed a loss of $238,187. Also, in a deposition, its owner stated that in years prior to bankruptcy its weekly cash flow was “basically a little over break-even.”

Moreover, the expert based his analysis on the assumption that if the business had been able to continue it would have made a number of changes to increase profits. For example, he assumed it would have moved to a cheaper location, disposed of the retail portion of the business, and downsized in terms of space and menu. In line with this vision, he calculated labor costs, utility costs, and other expenses and projected income and annual net income. Ultimately, he concluded that the business’s “going concern” value was $448,000.

The court found the testimony problematic. First, it noted that the expert had failed to follow the very method he referenced as authoritative. Contrary to the “Queenan methodology,” he did not base his valuation on anywhere near a five-year period. Also, it was obvious, even at the time he performed his analysis, that the company was no longer “an active business,” the court stated. In fact, “the business never generated sustained earnings.”

Second, he based his analysis “entirely on speculation.” Calculating damages based on a going concern valuation ultimately was based on lost profits, the court said. Even if the law does not require absolute certainty, it considers evidence of expected profits incompetent where operations have never begun. This was the case here because the expert’s analysis was based on the business starting over, under a “substantially different business model from the old business.”

Although the going concern methodology itself was reliable, it “cannot reliably be applied to the facts in issue,” and it was not applied to the facts, the court concluded.

Regarding the expert’s analysis of the depreciated value of the business’s assets, the defendant noted that, even though the depreciated book value of an asset was meaningful for tax purposes, it “says little about the asset’s current fair market value.” The court agreed, finding this testimony could, in effect, mislead a lay jury. In sum, it excluded the expert’s entire opinion.