Legal Update: Rosenthal v. Erber

Rosenthal v. Erber illustrates the pressure and perils of dueling experts. The expert is charged with assisting the court ascertain the facts, rather than furthering the client’s ambition. The case is a reminder to business valuation professionals that ethical considerations are paramount and that doing the contrary leads to courts’ suspecting the role of experts in the process.

In the main, valuation experts pride themselves on reasoned analysis and well supported use of professional judgement. As a profession, valuators are confident that most reports uphold the demanding standards of the profession. Judges, on the other hand, do not always view the reports before them with the same degree of confidence. In Rosenthal v. Erber, 2023 N.Y. Misc. LEXIS 4035, 2023 NY Slip Op 32750(U) (N.Y. Sup. Ct., August 8, 2023), Judge Schecter viewed the parties’ valuation reports before her with a healthy degree of skepticism, if not downright hostility, in ordering the defendant to buy the plaintiff’s ownership interest in the subject business.

Background

Ted Rosenthal (“Petitioner”) and Jeffrey Erber (“Respondent”) each own 50% of 87^th Street Optical Corp. (the “Company”), which operates a boutique eyewear store on the Upper West Side of Manhattan, doing business as “Jeffrey’s Manhattan Eyeland.” Respondent runs the store while Petitioner is a passive shareholder.

On February 3, 2021, Petitioner filed his petition to dissolve the Company. (The court did not discuss the nature of the dispute between the parties.) On March 9, 2021, Respondent exercised his rights under the applicable state law to purchase Petitioner’s interest at its “fair value” as of the day before the petition was filed, or February 2, 2021 (the “Valuation Date”).

Petitioner submitted a report, dated October 29, 2021, that valued the business at $631,000. From that enterprise value, Petitioner’s expert added cash as of the Valuation Date ($82,786) and deducted back rent due to the landlord ($95,576) and an SBA loan ($150,000) for an equity value of $468,210, and a $234,105 value for the subject interest. In contrast, Respondent offered an expert report claiming that the Company’s equity had no value. Respondent’s expert’s conclusion was based, in part, on a disagreement about the debt owed to the landlord. Respondent claimed that the Company owed its landlord $384,497.59, based on a January 2022 letter purportedly from the landlord.

Court Findings

Initially the court addressed the dispute over the amount owed to the landlord. Then it addressed the actual valuation analyses.

            The Back Rent Dispute

Petitioner’s expert utilized an invoice from the landlord dated October 18, 2021, approximately 8½ months after the Valuation Date. The landlord had produced the invoice in response to a subpoena.

The letter that Respondent argued provided the correct liability was dated January 18, 2022, nearly a year after the Valuation Date. Presumably to clear up confusion over the discrepancy with the October invoice showing a much smaller debt, the January 2022 letter says that the balance is “as of February 3, 2021.” However, as the court notes, the “as of” language is “in a smaller font than the rest of the letter, suggesting that it was copied and pasted there.”[1] Respondent also proffered an agent of the landlord to support the amount of the debt, but the court found both the letter and the witness’ testimony “wholly unbelievable.”[2]

The court also found that Respondent’s expert’s reliance solely on internally prepared financial statements misplaced since they were based on unreliable accounting records (which were in the sole possession and control of Respondent) and inconsistent with the Company’s tax returns. Between the misrepresented rent liability and the unreliable financial data, the court completely disregarded Respondent’s claim that the Company’s equity had no value.

            Petitioner’s Valuation

The elimination of Respondent’s claimed value did not, in the end, assure Petitioner of receiving $234,105. Petitioner’s expert made several normalizing adjustments, which the court found acceptable. He then applied four valuation methods—discounted cash flow (DCF), capitalization of earnings, guideline public company, and comparable transactions—and averaged the results of those methods to reach an indication of value for the entity. Again, the court found the methodology acceptable. It was the application of judgment in growth rates, the choice of public companies, and the selection of a multiple for the comparable transaction approach where the court determined that Petitioner’s expert went off the rails.

The Valuation Date, falling in the tail end of the COVID-19 pandemic shutdowns, presented particular issues with financial performance. Petitioner’s expert determined that the Company would experience substantial revenue growth as business, generally, recovered from the pandemic period. For his DCF analysis, he assumed a revenue growth rate of approximately 30% for year one, approximately 10% in year two, approximately 9% in year three, and approximately 3% thereafter.[3] According to Petitioner’s expert, the larger growth during the projection years would bring revenues back to the level of pre-pandemic revenues. Respondent’s expert contended that growth at those levels were “highly exaggerated.” In light of revenue declines in four of five years preceding the Valuation Date, Respondent’s expert characterized that level of growth as “impossible.” The court agreed with Respondent.

For the guideline public company approach, the Petitioner’s expert used public companies that were wholly inconsistent with the Company, a single store operation in Manhattan. These included, among others, National Vision Holdings, Inc. (which operated through 1,205 retail outlets throughout the country), EssilorLuxottica Société anonyme (a global manufacturer and distributor of eyewear products), and Formosa Optical Technology Co., Ltd. (a Taiwanese manufacturer and distributor). The court found “that many of the comparable companies used for the guideline public company method are not that comparable.”[4]

Rather than engage in recalculating Petitioner’s expert’s numbers, the court simply reduced the DCF, capitalization of earnings, and guideline public company amounts by 20% to “account for these aggressive assumptions.”[5]

The court provided a more detailed review of Petitioner’s expert’s guideline transaction approach. The expert had used a 2.7 multiple of discretionary earnings based on 76 transactions in SIC Codes 5995 (optical goods stores) and 5999 (retail stores not elsewhere classified). The population of transactions for his analysis included many non-optical stores, including pet supply stores, picture framers, beauty supply shops, and “dollar stores.” The analysis showed a multiple range, across all categories, of 0.1 to 6.0 with a median of 1.8 and a mean of 1.9. Respondent’s expert contended that looking only at the nine retail optical stores, the average was 2.4.

Again, the court agreed with Respondent that Petitioner’s expert was being overly optimistic. “As with the guideline public company valuation, the companies from which this multiple was derived are not sufficiently similar, so the court finds this multiple to be too aggressive.”[6] However instead of applying the 2.4 multiple that Respondent claimed was the average for the optical stores in the list, the court used a 2.0 multiple, reducing the guideline transaction indication from $536,000 to $333,816. The court provided no explanation for using a multiple below the average for comparable transactions.

In the end, after making its adjustments, the court awarded Petitioner a fair value of $141,908, which is approximately $92,000, or 39%, less than what Petitioner had sought, and approximately $142,000 more than what Respondent claimed the equity was worth.

Conclusion

There is an aphorism in investment circles that bulls make money and bears make money, but pigs get slaughtered. As this case demonstrates, a similar assessment can be applied to parties in valuation disputes. Valuation professionals can face a lot of pressure to push the boundaries of propriety in their use of judgment in reaching either a higher value or a lower value, depending on the client’s needs. Doing so can be problematic.

[1] 2023 N.Y Misc. LEXIS 4035 at *3. Also, while not discussed in the opinion, the January 2022 letter raises an interesting evidentiary question. Both the landlord’s invoice and the letter are hearsay. As with most jurisdictions, the New York Rules of Evidence provide an exception that makes hearsay admissible if it is a “business record,” that is a document “made in the regular course of any business, and … was the regular course of such business to make it, at the time of the act, transaction, occurrence or event, or within a reasonable time thereafter.” 8.08 Business Records (CPLR 4518) Accordingly, an invoice prepared in the ordinary course of business would reasonably qualify for exemption from the hearsay prohibition, while a letter prepared at the behest of a party might not.

[2] The witness’ credibility was not helped by their inability to explain (a) why a January 2022 letter would be discussing a back rent balance as of February 3, 2021, or (b) why the amount owed according to the letter was inconsistent with the amount shown on the invoice produced in discovery.

[3] The court’s opinion does not discuss the details of the analysis, but in a rare circumstance, the actual reports are part of the public record and available for review.

[4] 2023 N.Y Misc. LEXIS 4035 at *4.

[5] Ibid. at *5.

[6] Ibid.

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Michael J. Molder, JD, CPA, CFE, CVA, MAFF, applies 30 years of experience as a Certified Public Accountant and litigator to help investigate and analyze cases with complex financial and economic implications. He has acted as both counsel and accounting expert in pending and threatened litigation as well as participating in internal investigations of financial misconduct. As a litigator, Mr. Molder helped co-counsel understand complex financial and accounting issues in dozens of cases. In 2006, Mr. Molder returned to public accounting applying his unique skills to forensic engagements. He has also performed valuations of business interests in a wide variety of industries.

Mr. Molder has served as valuation expert for both plaintiffs and defendants in commercial litigation matters and owner and non-owner spouses in matrimonial dissolutions. He has participated in the valuations of businesses in a wide variety of industries, including: food service, wholesale and retail distribution, literary development and production, healthcare, manufacturing, and real estate development.

Mr. Molder has also investigated and valued damages in a wide variety of litigation contexts ranging from breach of contract claims to personal injury cases, and from employment disputes to civil fraud. He has consulted on many matters which have not involved the issuance of a report for litigation or resulted in deposition or trial testimony. Accordingly, the identity of these matters is protected by attorney client privilege.

Mr. Molder has also lectured widely on a variety of accounting and litigation related topics including business valuation, financial investigations in divorce proceedings, accountant ethics, financial statement manipulation and “earnings management.”

Mr. Molder can be contacted at (610) 208-3169 or by e-mail to Molder@lawandaccounting.com.