650-730-9848 brian@sullivanco.net

Alkayali v. Boukhari, 2019 Cal. App. Unpub. LEXIS 2390 (April 5, 2019) 

In a convoluted shareholder dispute that resulted in a jury award for the plaintiff, a California appeals court upheld the economic damages. It found the trial court did not err in admitting the plaintiff expert’s valuation testimony on which the jury’s award was based. Neither the expert’s methodology nor the key assumption underlying the expert’s damages calculation was unreliable. The appeals court noted that a business valuation expert may use the sales of other businesses as comparable sales, provided he or she endeavors to tie the selected companies to the subject business. The expert here did this, the appeals court found. Therefore, the jury award was based on sufficient evidence.

Backstory. The plaintiff developed a collagen-based dietary supplement. Years later, he teamed up with the defendant and formed NeoCell, a company that marketed the dietary supplement. NeoCell eventually succeeded in selling its products to Costco stores in the United States and internationally. NeoCell initially had outsourced the manufacture of the products and later developed its own production capability.

The plaintiff, the defendant, and three others (who also were defendants at one point in the litigation) set up a new company, Healthwise, which served as NeoCell’s production unit. NeoCell remained Healthwise’s only significant customer. The companies operated from the same location.

When Healthwise was set up, the five founding members made a shareholder agreement based on which the plaintiff would own 36% of the company, the defendant would own 14%, and the remaining three members would own the remaining 50% in equal shares. Eventually, strife ensued, and three of the founding members executed release agreements and sold their ownership interests back to Healthwise. The plaintiff and the defendant remained owners.

The plaintiff later claimed that the release agreements increased his ownership interest in Healthwise to 72% and the defendant’s interest to 28%. The company’s relevant tax returns supported the plaintiff’s representations, as did other pieces of evidence. In contrast, the defendant (and his wife) claimed the agreements rendered the plaintiff’s 36% ownership interest ineffective. According to the defendant, ownership of Healthwise reverted to NeoCell, which, at that time, the defendant and his wife owned.

By 2008, the plaintiff and the defendant had a serious falling out that ended in litigation and a court order prohibiting the plaintiff permanently from entering the NeoCell and Healthwise offices.

The instant litigation focused on the defendant’s decision (framed as NeoCell’s decision) to dissolve Healthwise in September 2010. Because of the permanent injunction, the plaintiff was unable to attend a special shareholder meeting on the dissolution. The plaintiff received nothing when the defendant shut down Healthwise. The defendant claimed that, at that time, the plaintiff no longer had an ownership interest in Healthwise and that Healthwise had never been profitable and had no tangible assets.

Pretrial challenges. The plaintiff sued and the case went to trial on theories of conversion and breach of fiduciary duty by the defendant.

In pretrial motions, the defendant argued the tax returns showing the plaintiff had a 72% ownership interest in Healthwise were inadmissible. The court rejected the claim.

Further, the defendant claimed the proposed testimony by the plaintiff’s business valuation expert was inadmissible: The expert used an unreliable methodology, and his value determination was based on an unsupported assumption. The trial court admitted the testimony. The expert testified in front of the jury, which: (1) found the plaintiff owned 72% of Healthwise; and (2) awarded the plaintiff nearly $4.3 million in economic damages—an amount that slightly exceeded the damages the expert had proposed.

The defendant challenged the jury’s findings in post-trial motions, asking for judgment notwithstanding the verdict or a new trial.

The trial court found the conversion claim had no merit, but the breach of fiduciary duty claim held up. The court’s final judgment awarded the plaintiff $4.3 million.

In response, the defendant filed an appeal with the California Court of Appeal, challenging the breach of fiduciary duty finding and the damages award. The appeals court affirmed as to both issues.

Market approach is only option. To value Healthwise, the plaintiff retained as expert an experienced CPA who also had credentials and extensive experience in financial accounting and economic investigations. The defendant did not dispute the expert’s qualifications. Instead, the defendant’s challenge focused on reliability.

On appeal, the defendant contended the testimony was unreliable and should never have been admitted. By extension, if the expert testimony were stricken, the jury’s award would be based on insufficient evidence and should be stricken down.

In his report and testimony, the plaintiff’s expert explained the three valuation approaches (income, market, and asset-based approaches) and explained why he decided that only the market approach was meaningful here. Even though he normally would have used the income approach, it seemed inappropriate here because of “irregularities” related to Healthwise’s financial statements.

For example, the expert noted inexplicable cost increases in the relevant valuation year (2009). Costs for the products Healthwise was selling were between 10% and 12% of sales in 2006 and 2007 but jumped to 33% in 2008 and 73% in 2009. Had they remained at the levels of the earlier years, the company would have shown an additional $1.9 million in revenues, the expert noted. He also pointed to “credit memos” by which NeoCell transferred costs from its books to Healthwise’s books. These transfers made NeoCell seem profitable and Healthwise seem unprofitable, the expert noted.

The expert rejected the asset approach because it typically is used to value a company in liquidation, which was not the situation here.

The expert explained that, broadly speaking, under the market approach, he considered recent sales of comparable companies. This meant using the sales prices as a starting point for the valuation of the subject company and analyzing the financials of the comparable companies to determine the relationship between a company’s financial performance and the price for which it sold. By way of example, if a comparable company sold for $5 million and had $1 million in sales, other things being equal, a valuator would project a comparable company with $2 million in sales would sell for about $10 million.

He explained that the applicable standard of value was fair market value—the price a willing buyer and a willing seller would negotiate for the company.

The plaintiff’s expert reviewed the subject company’s income statements and from this data created schedules to analyze changes in revenue and expenses over time. He found that income resulting from sales increased noticeably from 2006 to 2007, but it decreased in 2008. Income increased noticeably again in 2009.

The data on Healthwise showed an upward trend for income, costs, gross profits, and expenses, except for the year 2008, the expert said. At the same time, the company consistently showed negative net income, excepting 2008, when it had a positive net income. He noted the information available to him was from late 2009 and early 2010, thus a few months before Healthwise stopped operating as a separate company. He suggested that the valuation of the company would have been higher had he been able to obtain data from later in 2010 because, by then, Healthwise and NeoCell had made sales to Walmart and Sam’s Club stores.

To identify potential comparable companies, the plaintiff’s expert used the Pratt’s Stats (now known as DealStats) database.

Expert’s sales transactions analysis. The plaintiff’s expert ultimately considered transactions involving three types of companies: (1) private companies that prepare and manufacture pharmaceuticals; (2) public companies that prepare and manufacture pharmaceuticals; and (3) private companies that manufacture miscellaneous items.

For private pharmaceutical manufacturers, he initially identified 28 sales transactions but found 20 were not meaningful. A number of the companies had no sales in the year before the company was sold, which made it impossible to determine the relationship between prior net sales and the price the company sold for. For several companies, Pratt’s Stats/DealStats did not indicate that the companies were manufacturers. The expert believed companies that developed pharmaceuticals but did not manufacture them were not truly comparable to Healthwise.

From the sales of the remaining eight comparable companies, the expert determined an average multiple and a median multiple and applied the median multiple to Healthwise’s sales for the most recent complete year, 2009, to determine a market value estimate.

For Category 2, the public pharmaceutical manufacturers, he identified 28 comparable corporate sales (starting out with 189 sales transactions). He again took the median multiple and applied it to Healthwise’s sales. For this calculation, he applied a discount for marketability (DLOM) and a control premium. The jury was able to see the calculation in the proffered schedules, but the expert did not explain the reason for the DLOM and control premium, the appeals court noted.

The last grouping, private miscellaneous manufacturers, provided only five comparable corporate sales. The expert again applied the median multiple to Healthwise’s sales to achieve a market value estimate.

For the final calculation, the expert weighted the values derived from the two pharmaceutical company sales equally, yielding an adjusted market value of about $16.9 million. He gave the estimate related to the third group ($1.9 million) three times the weight of the other estimate. He said doing so was being “conservative” in terms of valuing Healthwise. He arrived at a market value of about $5.6 million. Assuming the plaintiff owned 72% of the company, his interest was worth nearly $4.1 million, the plaintiff’s expert concluded.

Critical assumption. One point of contention as to the admissibility of expert testimony issue was the expert’s assumption that there would be no change in the business relationship between Healthwise and NeoCell.

At trial, the plaintiff’s expert confirmed that his valuation was based on this assumption. He also explained that, in preparing his value analysis, he expressly raised the issue with the plaintiff’s attorney as to whether there was any chance that the relationship might change and NeoCell might decide to do its own manufacturing in the future. The attorney advised that the assumption was reasonable; the individual defendant and NeoCell could not terminate the relationship with Healthwise because the defendant was an employee and director of Healthwise and as such had a fiduciary duty to other shareholders not to shut down Healthwise and fold its operations into NeoCell, which the defendant and his wife owned.

Defense expert testimony. The defense expert, also an experienced CPA and valuation specialist, used a market approach (comparable company analysis, also using Pratt’s Stats/DealStats) and the income approach. He relied on the company’s financial statements. He weighted the market-based result at 30% and the result of the income approach at 70% and achieved a valuation of Healthwise of $212,000. By this calculation, the plaintiff’s interest was worth $154,000.

This expert argued for the use of a discount to account for the risk to Healthwise of relying on a single customer, NeoCell. He objected to the opposing expert’s assumption of a continuing relationship between Healthwise and NeoCell, and he argued the multiples in the opposing expert’s calculation related to the private sales of pharmaceutical companies were too high.

Assumption is not defective. The defendant argued he did not have a fiduciary duty to Healthwise as a matter of law. Therefore, the plaintiff expert’s assumption was “demonstrably false” and the expert opinion was unreliable and did not represent substantial evidence of the value of Healthwise.

The Court of Appeal disagreed. It said corporate records showed that, at the relevant time, the defendant was an officer and board member of Healthwise. This was “solid, credible evidence” that was available to the jury. Further, the jury had evidence that the plaintiff was a shareholder of Healthwise. The jury had a basis on which to conclude that the defendant owed the plaintiff a fiduciary duty to conduct the business of Healthwise in a way that was fair to the plaintiff, the appeals court said. Moreover, the jury had evidence that it would be self-dealing, and therefore a breach of fiduciary duty, if the defendant were to shut down Healthwise and make it part of NeoCell.

The assumption underlying the valuation of the plaintiff’s expert “was neither contrary to the law nor contrary to the evidence submitted to the jury,” the Court of Appeal concluded. The opinion did not rely on a “defective assumption.”

Methodology is not unreliable. The defendant also attacked the expert’s methodology, arguing primarily that the selected companies were not “reasonably comparable.” The trial court erred in not excluding a value opinion that was essentially a “guess, surmise, or conjecture” and that did not assist the trier of fact in determining the issues, the defendant claimed.

The Court of Appeals explained that, under the applicable state law (especially, Evid. Code, § 801), the trial court acts as gatekeeper to ensure expert testimony will assist the trier of fact and is based on matter “that is of a type that reasonably may be relied upon by an expert in forming an opinion upon the subject to which the testimony relates.” An expert opinion based on speculation or conjecture is inadmissible. See Sargon Enterprises, Inc. v. University of Southern California (2012), 55 Cal.4th 747. The trial court may consider whether the material the expert relies on actually supports his or her reasoning, the Court of Appeal noted. A trial court may find that the analytical gap between the data used and the opinion offered is simply too great. See Sargon.

In determining admissibility, the trial court as gatekeeper must focus solely on principles and methodology, not on the conclusions in the expert opinion. The trial court “must simply determine whether the matter relied on can provide a reasonable basis for the opinion or whether that opinion is based on a leap of logic or conjecture.” See Sargon.

Against this background, the Court of Appeal found the trial court’s decision to admit the expert testimony was not error. It said the expert explained why he used the market approach to value the subject company. Evidence of inaccurate financials and questionable credit memos provided the expert with a sound basis for rejecting the income approach.

Using data from the Pratt’s Stats/DealStats database provided a reasonable basis for identifying sales of comparable companies, the appeals court found. The expert used the database to identify potentially comparable companies and used the descriptions of the businesses to eliminate companies that were not comparable. The Court of Appeal said that the defendant cherry-picked from the descriptions of certain companies to argue the companies were not truly comparable. Further, the defendant had the opportunity to cross-examine the opposing expert on this issue at trial. Also, the defendant offered competing testimony from an expert who also relied on Pratt’s Stats/DealStats and who relied at least in part on the market approach for his valuation, the appeals court pointed out. Pratt’s Stats/DealStats and the descriptions of businesses “gave both experts a reasonable and nonspeculative basis for identifying comparable companies,” the appeals court said. The trial court did not abuse its discretion when it admitted the plaintiff’s expert testimony and allowed the jury to make a factual determination.

The Court of Appeal observed that the plaintiff’s expert explained why he included or excluded certain businesses when determining comparable companies. For example, he excluded companies that were too focused on research and development and he discounted the prices of companies that had a significant research and development component. Also, he excluded public companies that manufactured miscellaneous products. He made other adjustments. Doing so constituted an effort by the expert to connect the selected companies to the subject companies, the Court of Appeal said. The expert was cross-examined on the issue of comparability and the jury “evidently credited his testimony,” the appeals court said.

The Court of Appeal concluded it was not error for the trial court to determine that the expert testimony was not too speculative. Moreover, the expert opinion “was not so speculative that it couldn’t, as a matter of law, constitute substantial evidence for the jury’s verdict,” the Court of Appeal concluded and upheld the jury’s verdict “in all respects.”