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.