Wednesday, January 30, 2019

Court Case Insights

Investment Banking
Here are some recent court cases involving business valuations and business damages that we found interesting…

Duty calls: A recent Delaware case involving a financial advisor’s fairness opinion resulted in an adverse outcome for the advisor.

Mesirov v. Enbridge Energy Co., 2018 Del. Ch. LE XIS 294 (Aug. 29, 2018)
In a somewhat rare decision in the Delaware Court of Chancery, a claim against the financial advisor to a controversial transaction was allowed to proceed. In a transaction between related parties, the defendant, a master limited partnership, Enbridge Energy Partners LP (EEP), in 2015 bought back a significant asset from its general partner, Enbridge Energy Co. Inc. (EEP GP) for roughly $1 billion after having sold the same asset for $800 million to EEP GP in 2009. The asset in dispute was the U.S. portion of the Alberta Clipper pipeline (the AC interest), representing about two-thirds of the pipeline. The substance of the plaintiffs’ claim was that EEP overpaid in the 2015 transaction.

Several valuation metrics indicated to the special committee and its financial advisor that EEP was overpaying. EEP GP bought the AC interest in 2009 for a multiple of 7 times projected EBITDA. The 2015 transaction price of $1 billion represented a multiple of 10.7 times projected EBITDA. Between 2009 and 2015, projected EBITDA declined by almost 20% due to a sharp decline in the price of Canadian crude oil. Also, the 2015 transaction did not include expansion rights, which were part of the 2009 sale. The newer transaction also embedded additional risk – a possibility that tariffs on the pipeline would be rebased, which could impair revenue. The implied market and fair value of the AC interest was only between $674 million and $707 million, the plaintiffs claimed. Also, in a September 2014 memo, management for EEP GP reported to the board that the discounted cash flow value of the AC interest was only $478 million. This meant that EEP paid roughly 45% over the DCF value that EEP GP had determined, the plaintiffs contended.

Further, the plaintiffs claimed that, as part of the deal, EEP GP obtained shares in a new class of units (Class E units) that had unique tax benefits resulting from the transaction. Holders of Class A common shares did not get this benefit. Also, the Class E units benefitted from a “Liquidation Preference” that public unit holders of EEP did not enjoy. Neither the special committee nor the financial advisor determined the value of the Class E preferred units, the plaintiffs contended. Instead, the financial advisor “inexplicably” assigned the Class E preferred units the same value as the Class A common units.

The governing limited partnership agreement stated that “whenever a particular transaction … is required under this Agreement to be ‘fair and reasonable’ to any Person, the fair and reasonable nature of such transaction … shall be considered in the context of all similar and related transactions.” The plaintiffs argued that the financial advisor ignored this provision, which required consideration of the 2009 transaction, “by far the most relevant comparable transaction.” The plaintiffs noted that the financial advisor here knew well that the defendant entities would use the fairness opinion to escape liability for breach of fiduciary duty but was willing to provide a “perfunctory valuation” to maintain its relationship with Enbridge.

In its decision, the Court of Chancery found the controlling LPA included “contractual fiduciary duties.” The key question was whether the financial advisor had aided and abetted the alleged breaches. Under applicable law, a plaintiff alleging aiding and abetting a breach of fiduciary duty must show that: (1) there was a fiduciary relationship; (2) there was a breach of that relationship; (3) the defendant non-fiduciary (here, the financial advisor) “knowingly participated” in the breach; and (4) the breach proximately caused damages. The survival of the plaintiffs’ claim depended on whether they could satisfy the “knowingly participated” requirement, the Court of Chancery explained.

The Court ultimately determined that in the instant case the plaintiff had presented sufficient facts to sustain a claim against the financial advisor of aiding and abetting a breach of fiduciary duty. As to that claim, the court denied the defendants’ motion to dismiss. The defendants were not entitled to a presumption of good faith by arguing they relied on the financial advisor’s fairness opinion, the Court of Chancery said, allowing the case to advance to discovery on the surviving claims.

What happens in Vegas: The U.S. Postal Service was recently challenged in a copy-right infringement proceeding, as summarized below.

Davidson v. United States, 2018 U.S. Claims LEXIS 801 (June 29, 2018)
In this copyright infringement matter, the United States Postal Services (USPS) paid Getty Images $1,500 for a three-year, nonexclusive license to use an image of “Lady Liberty.” After printing nearly 3 billion copies of the stamps bearing the image, at an investment of $8 million, the Postal Service learned that the Lady Liberty image was not a photo of the Statue of Liberty but of a Las Vegas sculpture replica. In Las Vegas, the sculptor’s wife excitedly told her husband “our statue is on the stamp.” The plaintiff sculptor subsequently sued the USPS for copyright infringement and economic damages.

In defending against the suit, USPS initially argued that the work was not legally protected, as it was not original; alternatively, this was an architectural work whose pictorial representations are exempted from copyright protection. Moreover, USPS’s use of the image was “fair use” and thus excluded from the definition of infringement. The court rejected all of the defendant’s arguments, finding the face of the sculpture was original and protected and that USPS was liable for infringement.

The applicable statute states that a court should award “reasonable and entire compensation as damages for such infringement,” with the applicable measure of damages being the fair market value of a license to use the plaintiff’s work, assuming a hypothetical willing buyer and a hypothetical willing seller negotiating at arm’s length. The guiding framework for determining a reasonable compensation includes the use of the Georgia-Pacific factors, and also consideration of signs of the value of similar work in the market.

At trial, both parties offered testimony from experienced business valuation experts who specialized in valuing intellectual property. USPS also presented fact witnesses who provided context on what USPS typically pays for the use of art and what it has obtained from third parties to license its own art. Witnesses testified that USPS never paid more than $5,000 for images the service used on stamps, and accordingly USPS asked the court to limit damages to that amount.

Witnesses testified that USPS’s own licensing agreement are based either on a flat fee or a running royalty. During the relevant period, USPS licensed its intellectual property out at a rate of 8% of the other party’s total gross sales, and the current rate was 10%, a witness said. If a third party wanted to use a single image, the license likely would be based on a flat fee agreement.

Offering dramatically different perspectives, the plaintiff’s expert considered the market for artwork broadly speaking, while the defendant’s expert emphasized USPS’s particular licensing approach. The plaintiff’s expert considered the factors the two sides hypothetically would consider when negotiating: timing, duration, exclusivity, and territory. The expert concluded that a running royalty would be between 2.5% and 10%, or 6.5% on average. Based on USPS’s sales, the license would be worth in excess of $53 million.

In its opinion, the court emphasized that the measure of damages – fair market value – required it to assume a willing buyer as well as a willing seller. “This means that the government cannot avoid accountability by arbitrarily imposing limits on what it would have been willing to pay,” the court said. In choosing the Las Vegas Lady Liberty image, the Postal Service specifically opted for an image that was likely to attract buyer interest and maximize USPS’s profit. It was reasonable to assume the plaintiff would ask for some percentage of the profit USPS would make of these stamps and related philatelic products and that USPS would have been willing to pay such a percentage as it reflected no additional risk.

The court decided it was appropriate to apply a 5% running royalty. Applying the 5% royalty rate to the $71 million estimate, the court arrived at a damages figure of slightly over $3.5 million. In its opinion, the court rejected various arguments by the plaintiff that the government would have paid at least $10 million for this license given various exigencies. “The economic incentives and realities cited above would have driven both parties toward a running royalty in the range that we have found,” the court concluded.

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