Is valuation still valid after routine destruction of workpapers?

Case law analysis: Lawton v. Bank of America Corp., 2010 WL 1508922 (D.R.I.)(April 14, 2010)

For nearly 15 years the value of stock in a manufacturing company has been the focus of fractious litigation between the beneficiaries of an estate and the co-executor (Bank of America Corp.). The stock was admittedly the estate’s most valuable asset; in 1995, the bank permitted the company to buy-back the holdings at $145.36 per share. Two years later, the company was acquired at a much higher price and the beneficiaries sued the bank for breach of fiduciary duty, claiming it should have obtained an independent valuation before permitting the buy-back at a “bargain” value.

Relying on a 2002 valuation. The plaintiffs had retained a CPA to appraise the same stock back in 2002 in connection with an earlier stage of the litigation. The expert concluded that the stock was worth more than $145.36 per share as of the buy-back date. The court opinion does not say how much more. In fact, after the filing of this action in 2008, the plaintiffs retained the same expert, intending to rely on her prior valuation to show that the bank had simply sold the stock too cheaply (which was all they believed was necessary to prove liability). “There was no need, they felt, to have her start from scratch,” the court explained.

Accordingly, the plaintiffs disclosed the expert and her 2002 report to the bank pursuant to Rule 26 of the Federal Rules of Civil Procedure. Although the report stated that the expert’s accounting firm would maintain “complete and orderly workpapers documenting and providing support for [her] findings,” the firm had since destroyed the papers pursuant to its standard policies. The plaintiffs had been unaware of the document loss when they retained the expert but still believed she could explain and support her 2002 valuation.

A 2009 deposition, however, revealed some weaknesses in the expert’s memory, including calculations she could not fully explain.  The bank filed a motion to exclude the expert’s original report because it: 1) failed to comply with discovery deadlines; and 2) used flawed methodologies and an incorrect date, valuing the stock at the time of the redemption rather than at the offer to redeem three months before.

In response, the plaintiffs provided the expert with additional financial records, which she did not have in 2002. Using those materials, the expert abandoned several computations based on industry data in 2002 (lost with her workpapers) and “tweaked” her substantive analysis. For example, in her original valuation, the expert had found that the company’s net fixed asset ratio exceeded the industry average by 2%, prompting an “excess asset” adjustment of $600,000. She had also added a $1.5 million adjustment to reflect the useful life of company assets as compared to industry averages. Based on the “new” internal data, the expert reduced the $1.5 million asset adjustment and omitted the “excess asset” adjustment entirely, incorporating the changes into a second, supplemental report.

The expert also prepared a third valuation based on the date of the redemption offer rather than the sale date. The plaintiffs provided these two additional reports to the bank more than a month after the close of disclosure deadlines and in conjunction with its opposition to the discovery and Daubert motions.

Valuation shortcuts could be ‘ill-advised.’ The court first considered whether the expert’s original 2002 report was useless without her underlying workpapers. At her deposition, even the plaintiffs admitted the expert was “ fully explain certain calculations and adjustments.” Arguably, the plaintiffs failed to comply with Rule 26 “merely by turning over the 2002 report,” the court observed.

At the same time, the plaintiffs offered the expert’s revised report to alleviate any deficiency in the original. Indeed, Rule 26 requires a party to supplement or correct a disclosure as soon as a material omission or mistake becomes apparent, the court said. Here, the plaintiffs delay (by one month) was not “egregious.” More importantly, the plaintiffs did not destroy the expert’s workpapers or try to “hide” the basis of her opinion. The court said:

Rather, at worst, [the] plaintiffs took an ill-advised shortcut without assuring the preservation of the workpapers. Instead of commissioning [the expert] to mint a new valuation from raw data, they opted to recycle her 2002 opinion to save costs. While perhaps imprudent, particularly in hindsight, this choice was not made in bad faith, and the Court will…allow the plaintiffs some leeway to supplement the 2002 report.

Even so, the bank argued that Rule 26 only permits updated opinions; it does not provide parties with an opportunity to “smuggle in” new arguments or theories. The court agreed with the general proposition, but found that the expert’s second, supplemental report did not cross the line between making “repairs” and advancing a wholly new opinion. Although she relied on company financial information not available in 2002, the internal data permitted her to forego the comparative industry data that she could no longer recall (or reconstruct from her workpapers). “These measures qualify as the type of repairs to incomplete or incorrect disclosures envisioned by Rule 26,” the court held.

Only the expert’s third report, based on the alternative valuation date, “strayed closer into forbidden territory,” the court said. Yet, in this case, the plaintiff did not act in bad faith or create any bias. Indeed, the use of the redemption date permitted an “apples to apples” comparison with the bank’s valuation evidence. Ultimately, the court discerned no clear abuse of Rule 26, and although the plaintiffs overshot the discovery deadline, “this infraction did not call for the maximum penalty of exclusion of the expert.” Instead, the plaintiffs would have to pay for any additional depositions and the bank could supplement its own expert report, if required—but the court permitted the plaintiff’s expert to testify regarding all three valuation opinions.