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Summing It Up

Keeping you ahead of the curve with timely news & updates.


Joe Aquino

Recent Posts

When Are Daubert Challenges Justified?

A district court strikes testimony in a patent case


green_arrow_being_held.jpgRecently, a district court judge noted that the overall percentage of successful Daubert challenges to damages in patent cases is “exceedingly small.” Yet, he went on to say that, “every once in a great while, a Daubert challenge to a patent damages expert is justified.” This judge found that to be the case in Dynetix Design Solutions, Inc. v. Synopsys, Inc., where the patent expert’s reasonable royalty testimony was neither tied to the facts nor reliable.

The ins and outs of the expert’s testimony

As you know, calculating a reasonable royalty is a two-step process. In the first step, an expert determines the revenue pool that’s implicated by the infringement (that is, the royalty base). Next, the expert determines the percentage of that pool adequate to compensate the plaintiff for that infringement (that is, the royalty rate).

In the Dynetix case, the plaintiff’s expert started by determining the royalty base. The patented feature was just one of numerous features in the defendant’s product. Nonetheless, the expert determined that the royalty base would be the entire sales of the product simply because the defendant hadn’t separately sold any smaller unit with the patented component. And he also didn’t further apportion the royalty base to account for nonpatented features.

As to the royalty rate, the expert divided the gross margin of the infringing product equally between the two parties. And then he applied the Georgia-Pacific factors for determining reasonable royalties in order to alter the rate. When focusing on the third and fourth factors (the nature and scope of the hypothetical license in terms of exclusivity and the licensor’s policy for maintaining its patent monopoly by limiting licensing), he then reduced the royalty rate to 19%.

After he made a couple more adjustments, the expert arrived at a royalty rate of 14.25%. He then applied that rate to the royalty base for the relevant time period, thus concluding that the reasonable royalty would be around $156 million. Because only one of the two components originally accused of infringement remained in the case, he then apportioned 75% of the royalty to the remaining component, which resulted in a royalty of some $117 million.

The court weighs in

The district court ultimately rejected the royalty base, finding that the expert had failed to apportion profits between the numerous noninfringing features in the defendant’s product and the patented feature. So, even though he was correct that the smallest salable infringing unit was the defendant’s entire product, he should not have ended his analysis there. Moreover, he needed to determine the infringing component’s value relative to the entire product’s other components. This failure to apportion justified the exclusion of his opinion.

But the court also rejected the royalty rate. It found that the expert’s analysis only compounded the problems with his opinion. Although half of the gross margin for the infringing profits may indeed have been “one reasonable starting point,” the law required the expert to customize the royalty rate to the specific facts of the case — including the particular industry, technology or party. And, as the court explained, “an arbitrary starting point is impermissible under Uniloc.”

The Federal Circuit in Uniloc rejected a “25% rule of thumb” profit margin for starting the royalty rate calculation. And the 50% starting place, the district court said, was even more arbitrary because the expert based it solely on his own judgment and experience, without even considering analogous licenses offered in the industry or the nature of the patented component as an optional and small feature in the product.

The court’s striking of the expert testimony wasn’t the end of the matter. The court then granted the plaintiff five days to submit a new expert report on the damages.

The bottom line

Many have questioned the “gatekeeper” role of courts in evaluating and admitting the reliability of expert testimony. But many courts still exclude testimony based on Daubert objections. It’s critical that attorneys keep on top of developments in this area and work with qualified experts who’re unlikely to face Daubert challenges.

Sidebar: Limits to the gatekeeper role

The Supreme Court’s decision in Daubert assigned district courts a type of “gatekeeper” role in admitting expert testimony and evaluating its reliability. A recent case, Manpower, Inc. v. Insurance Co. of the State of Pennsylvania, demonstrates that this role has limits.

The “Manpower” case involved a dispute over reimbursement for business interruption losses under an insurance policy. The insured’s forensic accounting expert expressed an opinion on the total loss, and the insurance company moved to exclude the testimony, saying it wasn’t the product of reliable methodology.

The district court found that the expert had, indeed, followed the insurance policy’s prescribed methodology for calculating losses. But the reliability of the expert’s calculations turned on whether he’d used reliable methods when he selected numbers for the projected total expenses and revenues. The court held that the method for projecting revenues was unreliable due to his estimated growth rate, so it excluded his testimony. The insured party then appealed.

The court of appeals acknowledged that district court judges have a lot of leeway when determining whether particular expert testimony is reliable. It pointed out, however, that a district court “usurps the role of the jury … if it unduly scrutinizes the quality of the expert’s data and conclusions rather than the reliability of the methodology.”

The appellate court determined that the district court’s concerns weren’t due to the reliability of the expert’s methodology, but the resulting conclusions. The district court then took issue with his selection of particular data. But the selection of data inputs to apply in a model is a question that’s separate from the reliability of the methodology reflected in the model itself.

The appellate court warned that it wasn’t saying that an expert can rely on data with no quantitative or qualitative connection to the methodology. Experts should use the type of data on which specialists in the field would reasonably rely.

© 2014

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IRS Victory Highlights the Importance of Careful Estate Planning

IRS Undermines a Family Limited Partnership 

Author: Joe Aquino

Recently, the IRS celebrated another victory in its long-running campaign to challenge family limited partnerships (FLPs). In Estate of Lockett v. Commissioner, the agency attacked an FLP for being an invalid partnership under state law. Ultimately, however, it was the decedent’s estate planning that undermined the FLP, thus handing the IRS another win.

Widow takes ownership

Lois Lockett was predeceased by her husband, whose will established a trust for her benefit (Trust A). In 2000, as part of her estate planning, Lockett formed Mariposa Monarch, LLP under Arizona law. The partnership’s formal agreement, signed in 2002, named her sons Joseph and Robert as general partners. Lockett, the sons and Trust A were named as limited partners. At that point the parties hadn’t yet agreed on initial capital contributions or their percentage interests in Mariposa.

Shortly after the agreement was signed, Lockett and Trust A began funding Mariposa. Joseph and Robert never made any contributions. In 2003, Trust A was terminated, and Lockett became the owner of her limited partnership interest in the partnership. An amended agreement was executed to reflect this. The agreement continued to list the sons as Mariposa’s general partners, but an exhibit listed their mother as holding 100% of the partnership and each of the sons holding 0%.

When Lois Lockett died in 2004, Mariposa held assets worth more than $1 million. On its tax return, the estate valued Lockett’s 100% ownership interest in Mariposa at $667,000 after applying control and marketability discounts.

IRS raises state law

Initially, the IRS argued that Mariposa wasn’t a valid partnership under Arizona law. In that state, partnerships are defined as an association of two or more persons and are formed to operate a business for profit. The IRS contended that only Lockett contributed assets to Mariposa and that Mariposa wasn’t operated for profit.

Nevertheless, the court found that Mariposa was a valid partnership. Although the sons didn’t hold interests in it, Trust A contributed assets and was therefore a limited partner, satisfying the requirement of an association of two or more persons.

The court also found no requirement that an Arizona business engage in a certain level of economic activity. Moreover, it determined that Mariposa was operated to derive a profit. The partnership hired a financial advisor to manage its stock portfolio, purchased real estate that it leased and made loans requiring annual interest payments. It thus operated as a business for profit.

Trust termination found faulty

Unfortunately for the estate, the IRS had an alternative argument. Even though a valid partnership was formed, it had terminated at the time of Lockett’s death because she had acquired 100% of the interest in it. This occurred when Trust A was terminated in May 2003 (effective Dec. 31, 2002). At that point, Lockett had become the owner of Trust A’s limited partnership interest in Mariposa as well as being its sole partner.

Arizona law provides that a partnership is dissolved when a dissolution event previously agreed upon in the partnership agreement occurs. The Mariposa agreement established that the FLP would be dissolved when one partner acquired all of the other partners’ interests. So on Dec. 31, 2002, Mariposa dissolved and Lockett became the legal owner of its assets.

Many potential errors

Because the FLP had dissolved by the time of Lockett’s death, its assets were included in her gross taxable estate. If her sons had made contributions to fund their general partnership interests or she had gifted them with small interests in Mariposa, the FLP may well have withstood scrutiny and removed the assets from the estate.

Lockett’s mistakes were only a few of the many errors that can sabotage an FLP. To protect your clients from IRS attack, work with financial experts when drafting partnership agreements and making estate plans.

If you have any questions about FLPs or any other issue, give us a call at 716.847.2651, or you may contact us here.

Family Limited Partnerships

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Litigation Support: The “Gold Standard” of Valuation

Standard Used to Determine Damages in Cases

Author: Joe Aquino

Many legal issues revolve around business valuation, including damages calculations in commercial litigation. In a recent case, Malik v. Falcon Holdings, LLC, Seventh Circuit Court of Appeals Chief Judge Frank Easterbrook turned to what he called the “gold standard of valuation” to help determine damages for plaintiffs who were deprived of their stakes in a business.

Managers sue owner

Aslam Khan held 40% of the common units in Falcon Holdings, a limited liability company that owned and operated 100 fast-food restaurants. Khan allegedly told Falcon’s managers that he would acquire full ownership one day and would then reward the top managers with 50% of Falcon’s equity. In 2005, Khan bought out Falcon’s other owners and became the sole equity owner. When he failed to distribute common units to any of the managers, five of them took him to court.

litigation supportUsing the price Khan paid in the buyout, the plaintiffs calculated that the company was worth about $48 million. Twenty managers qualified for units under the terms of Khan’s offers, meaning each plaintiff lost about $1.2 million ($48 million × 50% ÷ 20).      

The district court, in summary judgment, found that Khan had promised the plaintiffs an equity stake in Falcon. But it held that the managers hadn’t adequately estimated their damages:

  1. The other owners didn’t own 100% of Falcon, making it impossible to derive the value of the whole firm from the amount Khan paid for their interests.
  2. The amount the other owners were paid depended on how much Khan and Falcon could borrow — not on Falcon’s true value.

Therefore, the district court found that the plaintiffs’ approach was flawed.

Judge rejects two prongs

On appeal, Judge Easterbrook rejected the district court’s two-prong analysis. The two propositions ignore the fact that the “gold standard of valuation” is what a willing buyer will pay a willing seller in an arm’s-length transaction. The judge concluded that the buyout of the other owners involved a willing buyer and a willing seller dealing at arm’s length, so the price they agreed on was the value of the asset.

But Easterbrook also found problems with the plaintiffs’ damages estimate. First, the interest that plaintiffs valued and the interest Khan owned were different. The plaintiffs valued the entire company — or the sum of Falcon’s debt plus its equity — not just the equity portion that Khan owned. Khan owned 100% of the equity, but the bank held the debt interest. The judge found it unsound to assume that Khan’s equity interest in Falcon was worth 100% of the firm’s total value.

Easterbrook also questioned the plaintiffs’ assumption that Khan would give each of the 20 managers 2.5% of Falcon’s equity units without any terms or conditions. To do so “would be a disaster not only for the ownership structure of a closely held firm but also from a tax perspective.”

Back to square one

Easterbrook vacated the district court judgment and remanded the case for proceedings consistent with his opinion. Assuming they find a qualified expert to calculate damages according to the “gold standard,” the plaintiffs should still receive something. But the amount will likely be less than the $1.2 million each manager had anticipated.

If you have any questions about the “gold standard” of valuation or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.

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FLP Fails the “Full and Adequate Consideration” Test

Family Limited Partnership Misses the Mark in Tax Court Ruling

Author: Joe Aquino

Although a family limited partnership (FLP) can be a viable method of handling assets in a tax-advantaged way, it must be established and administered correctly. The estate in Estate of Liljestrand v. Commissioner failed to properly set up and manage its FLP, and when the IRS challenged it, the result was a tax deficiency of about $2.6 million.
DIY valuation

Paul Liljestrand owned interests in several pieces of real estate through a revocable trust and his son Robert managed the real estate. Liljestrand formed an FLP and transferred the real estate to it in exchange for a 99.98% interest. Robert received the remaining interest. Liljestrand subsequently gifted FLP interests to trusts established for each of his four children. His estate planning attorney obtained an independent valuation of the interests, but Liljestrand came up with his own value estimates.

After Liljestrand died, the estate paid his taxes. However, the IRS issued a notice of tax deficiency in which it included the value of the real estate transferred to Liljestrand’s FLP in the gross estate. The estate turned to the Tax Court for relief.

In or out?

Under Internal Revenue Code Section 2036(a), when assets are transferred by decedents during their lifetime, those assets are considered part of their gross estate if they continued to derive a benefit from the assets or controlled the enjoyment of them. However, if the transfer was a bona fide sale for full and adequate consideration, the assets are excluded from the estate.

The court determined that Liljestrand’s transfers weren’t bona fide sales. It cited several reasons:

Formalities weren’t observed. The FLP existed for two years before a separate bank account was opened for it. Prior to that, its banking was done through the trust’s bank account. As a result, partnership and personal funds were commingled. Only one partnership meeting — at which no minutes were kept — was ever held. What’s more, Liljestrand used FLP assets to pay for personal expenses and was financially dependent on his disproportionate partnership distributions.

Transfers weren’t at arm’s length. Liljestrand formed and fully funded the FLP and received almost 100% of the partnership interests. In other words, he stood on all sides of the transaction.

Contributions lacked full and adequate consideration. Because Robert made no contributions, interests credited to the FLP’s partners weren’t proportionate to the fair market value of the assets that each contributed. Also, the assets contributed by Liljestrand weren’t properly credited to his capital account.

The court ultimately decided that Liljestrand did not contribute the real estate for full and adequate consideration. “Especially significant” in the court’s eyes was the fact that the FLP failed to even maintain capital accounts when it was first formed and used neither the values established in the independent valuation nor the fair market value of the real estate to establish the value of each partner’s FLP interest.

FLP failure

business interruptionThe Liljestrand case is only one of many battles in a larger conflict between FLPs and the IRS. Fortunately, the Tax Court has also upheld FLPs, allowing the exclusion of their assets from estates. To help your clients’ FLPs withstand any challenges, ensure that they’re properly set up and administered to take advantage of the Sec. 2036(a) exclusion.

For any questions regarding this case or other litigation support issues, contact us here or give us a call at 716.847.2651.

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Determining Damages in Copyright Infringement Cases

Actual Damages are Commonly Measured by Lost Profits. Here’s How:

Author: Joe Aquino

columns_2.jpgDigitizing technology and other advances have made it all too easy for copyright infringers to duplicate the work of others. And with the Internet, what was once difficult to find is often instantly available. Those who infringe on copyrights, however, may find themselves liable for significant statutory and actual damages.

Statutory vs. actual damages

The Copyright Act and the Digital Millennium Copyright Act (DMCA) provide for statutory damages. Such damages generally are subject to caps of $30,000 per work under the Copyright Act and $2,500 per violation under Section 1201 of the DMCA. In some cases, courts may increase the award to a sum of up to $150,000 if an infringement is found to have been committed willfully. If, on the other hand, an infringer wasn’t aware — and had no reason to believe — that his or her acts constituted an infringement of copyright, some courts may reduce the award to a sum not less than $200.

Actual damages are commonly measured by lost profits. Courts have applied several different approaches to compute such losses. Four of the most common are:

1. Infringer’s sales. The copyright holder may allege that, if not for the infringement, its sales of the protected work would have grown in an amount equal to the infringer’s sales.

2. Diverted sales. A plaintiff could claim that it lost customers to the infringer and, if not for the infringer, those customers might have purchased from the plaintiff again. Courts consider comparability, especially in the customer base, as well as other factors affecting the customers’ decisions.

3. Sales projections. The plaintiff might use records of its projected and actual sales from previous financial periods to establish a historical correlation between the figures that would support the use of sales projections to measure lost sales.

4. Product mix. The sales of different products during periods of both infringement and non-infringement could establish benchmarks for projecting the mix relationships in the absence of the infringement.

Some courts also consider changes in market size and sales of alternative products.

The final amount of actual damages may be affected by other factors, as well. For example, the Copyright Act allows plaintiffs to recover the infringer’s profits that were attributable to the infringement but not already taken into account in the actual damages formula.

Multiple approaches work best

business interruptionBy offering multiple approaches that produce similar results, a plaintiff can increase the likelihood of recovering appropriate damages. A qualified financial expert can help you decide the best route for your client.

For any questions, contact Freed Maxick’s team here, or call us at 716.847.2651.

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