The danger of relying on your valuation expert in the Family Court

Going to court to argue the value of the family company can be a risky affair, as a recent Family Court case illustrates. In the case, called Riley and Riley, all property settlement issues between the husband and wife were settled save one: how much was the husband’s interest in the family company worth?

There was $1.7 million difference between the parties as to the value of the shares. Not surprisingly, the expert engaged by the husband, Mr A, said that the shares were worth a lot less; but the expert engaged for the wife said that the shares were worth a lot more.

And for this argument about the value, the parties engaged in a trial in the Family Court that lasted eight days.

Why ever did the parties not engage a joint expert, consistent with usual practice, and save themselves an enormous amount in legal and accounting fees?

The husband’s expert Mr A, who was ultimately favoured by the court,  was of the view that there was no goodwill attached to the business, and that the appropriate valuation was net value of the physical assets. The wife’s expert, Mr K, formed the view that the usual approach of capitalisation of future maintainable earnings was the right approach to valuation. Mr A was ultimately favoured because the husband was seen as acting prudently and efficiently, and the husband had provided more detailed information to Mr A than he had to Mr K. Mr A was therefore better informed, and therefore in a better position to offer an opinion than Mr K.

The wife’s submissions

The case sets out a good summary of the law concerning valuations, as provided for in the submissions of the wife’s counsel (but also their limits, as set out by Justice Thornton);

• There is no fixed rule in the Family Court for the methodology for determining the value of shares or other property or commodities.
• The standard for the determination of a fair price for a business is generally that which a hypothetical prudent purchaser would pay a not over anxious vendor who desired to purchase it for the most advantageous purpose for which it was adapted. In this regard counsel referred to Nettler & Nettler [2009] FamCAFC 185at [28], which identified this as the guiding standard in relation to the valuation of land, as articulated in Spencer v Commonwealth (1907) 5 CLR 418.
• The fact that a business does not sell need not be taken as indicative of the value of shares of a business; the test laid down in Spencer v Commonwealth can only be applied where there is a ready market, and is “of no application” in a case where a market is lacking.The fact that a business may be unsellable – that the value of its shares may be unrealisable through sale – does not necessarily render it valueless.
• The value to a hypothetical prospective purchaser is not necessarily the relevant figure when evaluating the value of shares in private companies in a family law context, and in fact this is an entirely inappropriate approach in a family law context. The value to the owner, and the reality of that value, is the relevant figure,and commercial valuation methods are not necessarily appropriate in a family law context, as the commercial valuation of shares in a proprietary company will not necessarily be reflective of the value to the spouse (or other family member). In a family law property valuation context, shares in a company are valued differently depending on the value of the shares to each shareholder; the value is determined by considering, among other things, the shareholder’s relationship with the company and thus the different forms of benefit the shareholder can derive from the shares. The value must be a realistic value, the reality of the worth to the shareholder party.
• Where a business is a long running business and there is no reasonable or realistic evidence to show it is to cease operations, it makes sense to look to the future maintainable earnings to determine the value of the business unless it is found that the net tangible assets are greater. Counsel relied on the decision of Scott & Scott [2006] FamCA 1379 at [55]. Counsel also relied on Georgeson & Georgeson where capitalisation of future maintainable earnings was considered the most appropriate methodology for valuing certain shares in a business, because the business was an active trading entity.
• It is necessary to look to the best value to which the business would be put. If a better value for a business is to be found by taking certain actions or viewing the business a certain way, then that is the valuation to be preferred. Counsel referred to the case of Nettler & Nettler, suggesting that the judge at first instance in that case, in preferring the valuation derived by selling a business’ loan book rather than a valuation based on future maintainable earnings, was preferring the valuation methodology arrived at by considering the best value that could be derived from the business in the circumstances of that case. At first instance, the judge referred to the principle that it is most appropriate to refer to the “highest and best use” of an asset when its value is being determined, and the endorsement of this principle in numerous cases.
• The role of a judge is more nuanced than accepting one expert’s wholesale view or another’s. A judge can accept part of an expert’s view without accepting the entirety of the expert’s view,and, in considering the evidence and coming to their own conclusions, is not necessarily under any obligation to accept the evidence of one expert witness about a matter relevant to a valuation merely because they have rejected the evidence of the other.A judge can (and must) come to their own conclusions about valuation evidence,including about whether a method of valuation is an appropriate one in the circumstances of a case, and is to do so “by the application of established principles of valuation”.
• Referring to obiter comments by Mason J in Mallet v Mallet, counsel for the wife stated that there can be a risk, in examining methods of valuation, of losing sight of the true object of the exercise of valuation, which is to ascertain the real value of the shares, and focusing instead on the means of achieving that object.
• Counsel for the wife referred to the Court’s comments in Lenehan & Lenehan that “in ordinary circumstances the vendor’s borrowings are irrelevant” and are not a matter that a hypothetical purchaser would take into account, and “the question of the value of that business … is to be calculated independently of those factors, otherwise it would mean the value of the business would vary depending upon the particular circumstances of the individual vendor”.

The approach by Justice Thornton

Her Honour found:

179. There are competing valuations of the business of the Company made by the experts whose expertise was not seriously challenged. On the state of the evidence as it stands, it is not open to me to adopt a different valuation or approach from that of either of the experts. I do not accept Mr K’s midpoint valuation of $2,686,467 because of the deficiencies outlined above and prefer Mr A’s valuation.
180. I reject the submissions of counsel for the wife, so far as they were asserted, regarding the application of principles of “value to the owner” as being relevant for present purposes where I cannot accept Mr K’s valuation.
181. I also reject the submissions of counsel for the wife that the “highest and best use” of an asset principle should be adapted and applied in favour of Mr K’s valuation of the Company. The “highest and best use” analogy is not appropriate here and in circumstances where there are flaws identified in the valuation of Mr K because of the lack of information about the financing arrangements of the Company.
182. The conclusion reached by the Full Court on the facts of the case of Lenehan & Lenehan (“Lenehan’s case”)that “the vendor’s borrowings are irrelevant to the question of the value of that business which is to be calculated independently of those factors” and that it is not a matter which the hypothetical purchaser would take into account is distinguishable on the facts in this case.Lenehan’s case involved the valuation of a pharmacy business where there were competing expert valuations based on capitalisation of future maintainable earnings. An importation business operating in international markets is very different from a pharmacy business because it is a business where borrowing and foreign exchange fluctuations are integral to the operation of the business. A hypothetical prudent purchaser of such a business would not enter into a purchase without factoring the costs of any trade finance arrangement into the equation. Any prudent purchaser must factor in the costs of borrowings in order to determine the value of the business.
183. The foreign exchange fluctuations into the future remain within the realm of speculation but I am satisfied that the three year period of earnings considered by Mr A is reasonable having regard to the fluctuations in the value of the Australian dollar and the economic factors he outlined.