Case studies: Litigation Consulting

#1: Dissenting Shareholders in a Buyout – Litigation Consulting and Business Valuation Issues
#2: Real Estate Fraud: How a Forensic Accountant Saves Clients Money – With Just a Few Questions
#3: When Attorneys Misuse Independent Experts

#1: Dissenting Shareholders in a Buyout – Litigation Consulting and Business Valuation Issues

Summary of issue: Recently, Arxis Financial was contacted to assist with the initial strategy discussion regarding a developing shareholder dispute. At issue was how to negotiate the departure of three partners without going through the process of expensive litigation.

The situation was that the majority of partners wanted the three partners to go. The three partners under the shareholder agreement had enough votes to block any formal move to force them out. Further, the written agreement clearly stated that the buy-in amount for each partner was $100 and the buy-out for each partner was $100. State law where the firm was located clearly stated that clients and cases were owned by partner- lawyers and not the firm. So, in addition to the $100, the departing partners could also take their clients with them.

Further inquiry revealed that the balance sheet of the firm was substantial, as it included minimal cash and substantial accounts receivable and work-in-process. The shareholder agreement established a formula for compensation of the partners that basically shared revenue equally, regardless of the partner’s contribution. A review of the history of the firm revealed that the shareholder agreement had been followed exactly for decades. Every incoming partner had paid $100 and every departing partner had received $100 and their clients. Compensation for decades had followed the formula.

So what was the issue here? The remaining partners all agreed that the three departing partners needed to go. However, under the shareholder agreement the three departing partners had enough votes to effectively prevent the forced departure. Stalemate!

Arxis work: Arxis Financial was contacted to discuss one question: What is the likely position of both sides if this case goes to court?

Our conclusion was that the remaining partners will hold the line at the shareholders agreement: $100 and their clients. The departing partners would likely pay for a valuation of the entire firm and claim that if the firm was sold, they were due the sale price times their ownership percentage. It seemed to us that the low end was $100 and the high end of the negotiating range was their portion of the value of the firm.

Result: It turned out that was exactly the position of both sides in this dispute. Given the potential for expensive litigation with devastating results to both sides (e.g., forced dissolution under the laws of the state where the firm was located), cooler heads prevailed and a settlement was reached.

#2: Real Estate Fraud: How a Forensic Accountant Saves Clients Money – With Just a Few Questions!

Summary: Arxis Financial was contacted to assist legal counsel in determining the validity of a fraud claim and the best approach to credibly establishing the claim. The victim was a network of inter-related entities that owned commercial property and undeveloped real estate.  Significant cash flow from the entities was managed and controlled by one of the owners. The allegation was that millions of dollars had been fraudulently taken by the manager/owner. The initial contact by the law firm was to retain Arxis to do a preliminary forensic investigation to establish the equivalent of probable cause.

Arxis Work: In this case not a single document was reviewed. No forensic accounting was done. No damage calculations performed. Instead, a series of simple questions established that all the elements of fraud could be easily proven – except one. In this case, the disbursements to the owner were recorded as loans and reported on internal financial statements and tax returns. Therefore, the core of the case would revolve around whether the loans were authorized and whether the disclosures to the other owners over several years constituted ratification or approval of the transactions. Significant work might eventually be done to verify the accuracy and completeness of the accounting and to establish whether additional money was taken through other forms (expenses, distributions, payroll, etc.).

Result: The client was saved a lot of unnecessary accounting fees by redirecting the focus of the efforts away from an accounting and back to a legal question that would eventually be the core of the case.

#3: When Attorneys Misuse Independent Experts

Summary of Issue: Attorneys representing parties involved in a business partner dispute contacted our office to request assistance with developing a theory of damages and preparing damage calculations. This is a typical request that happens in our offices at least 30 times a year – something bad happens and the lawyers need to know the financial impact. Unfortunately, this was a case of hiring the expert too late in the process and with unrealistic expectations.

Why the Request?: A holding company was formed to buy, hold, and operate businesses that were to be acquired in the future. The holding company did indeed buy several franchise businesses before the relationship between the shareholders soured significantly. At the core of the broken relationship was a financial commitment by one owner on behalf of the entire business obligating the expenditure of millions of dollars under a binding contract with a franchisor. The required timing and amount of the expenditures would require large capital contributions to provide the necessary cash or acquiring debt that was likely beyond the ability of the firm to either obtain or repay from operating cash flow.

Arxis Analysis: Financial data was obtained and analysis was done to understand the historical, financial, and economic activity taking place in the business. Historical financial reporting was converted to monthly cash flow analysis that isolated operating results, working capital, fixed asset activity, and debt transactions. Based on the cash flow history, analysis was done to project the impact of the disputed contract historically and into the future. There was no doubt the contract that was the subject of the dispute was ill-advised and highly unfavorable to the business. The damage to the business was significant. The analysis done and methods used to calculate damages were consistent with normal expectations and prior similar cases.

As is customary in similar cases, there was a series of meetings with the clients and attorneys to review preliminary findings and opinions. In the initial meeting, counsel and their clients kept turning the conversation towards a single theory and methodology (which was not used or recommended by Arxis) and it emerged in the conversation that there was either a legal or even emotional attachment to their “preferred” method. Both the client and counsel became increasingly agitated as they heard that their “preferred” methodology might not be appropriate and that using that method would result in a much lower damage conclusion than they had hoped. Although an alternative was presented showing a more appropriate method that resulted in a larger (and more accurate) damage amount, they simply would not adopt it due to their predisposed position.  As the conversations progressed, aggressive statements were made by the attorneys and clients that, “you must testify” using their preconceived methods, assumptions, and conclusions.

Result: Counsel later contacted our office to say that, although the Arxis professional was disclosed as a testifying expert, opposing counsel did not disclose a financial expert. Therefore, the attorneys decided to present their preferred theory of damages through their clients’ testimony and the expectation was there would be no opposing expert to challenge their methodology or conclusions. The services of Arxis were no longer needed. Unfortunately, to the client’s detriment, Arxis’ loss calculations were not to be utilized in the litigation proceedings, even though the amount of damages actually exceeded what they ended up asking for and the methods and assumptions were far more logical, sound, and defensible.

Observations: There is a reason that financial, and other, experts are retained initially as consultants. This gives the retaining counsel the opportunity to decide whether they want the independent expert to actually testify after seeing and hearing how the expert will testify. If for any reason, they are uncomfortable with it they simply move on without that expert. It does not reflect poorly on the expert or the retaining law firm. It is part of the strategy of litigation.

However, there were some elements of this case that made it notable. The following are some observations about this case:

  • By the time Arxis was retained, everyone involved – attorneys and clients – were firmly settled on a methodology that was inaccurately applied and, when properly applied, understated the loss. This methodology was not disclosed until after Arxis presented our conclusions.
  • A financial expert should be involved early enough in a matter to assist the parties with settlement and mediation attempts. All too often the litigator exhausts all attempts to avoid trial and then, when that fails, there is a scramble to find an expert to validate, affirm, and testify. It is a dangerous strategy, as illustrated in this case.
  • Insistence that an expert “must testify” contrary to their training and experience is, at best, unwise. A reputable expert would never compromise their independence and objectivity. For the sake of the client’s case, a litigator should never want to hire an expert that is willing to do so.