The
WINTER 2015
Expert
Federal Circuit clarifies
entire market value
rule for patent damages
Divorce and CRTs:
What are the tax effects?
Fraud interviews deserve
professional attention
How experts gather facts and get to the truth
Reorganization value
Industry matters
in bankruptcy court
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Dannible & McKee, LLP is the exclusive local member of the National Litigation Support Services Association (NLSSA), a
national association of CPA firms dedicated to the delivery of superior quality services to trial lawyers. We enthusiastically subscribe
to that philosophy and the NLSSA mission statement:
NLSSA serves as a network for the exchange of information about case preparation and emerging issues in forensic accounting. We help
our members stay informed on current developments in litigation support. In addition to support in multi-state cases, NLSSA, through its
members, provides trail lawyers with a broader, deeper knowledge of a wide range of industry and functional disciplines.
Federal Circuit clarifies entire
market value rule for patent damages
A
pple’s many litigation fronts continue
to provide useful insights on a variety of
issues related to patent law. This includes
the proper calculation of infringement damages. In
one case where Apple was a defendant, VirnetX,
Inc. v. Cisco Systems, Inc., the U.S. Court of
Appeals for the Federal Circuit clarified the application of the entire market value rule when the
smallest salable unit is the entire accused product.
Apple sued
VirnetX owns four patents related to technology
for providing secure data transmission over networks such as the Internet. It claimed that Apple’s
FaceTime feature infringed two of the patents and
that Apple’s VPM On Demand Service infringed
the other two patents.
The jury awarded VirnetX $368 million in reasonable royalty damages, and Apple appealed.
Among other things, Apple challenged the
district court’s jury instruction on damages. It
asserted that the instruction inappropriately
created an exception to the entire market value
rule that would allow a patentee to rely on the
entire market value of a multicomponent product
as long as that product is the smallest salable unit
containing the patented feature.
Identifying damages associated with
the smallest salable patent-practicing
unit is just one step toward meeting
the apportionment requirement.
Rule clarified
The Federal Circuit clarified that, when the
patented claims at issue cover an individual
component of a multicomponent product, damages may be based on the value of the overall
multicomponent product. But this is true only
where a patented feature creates the basis for
customer demand or substantially creates the
value of the component parts. Otherwise, principles of apportionment apply.
The Federal Circuit rejected the district court’s
jury instruction that suggested that, when the
smallest salable unit is used as the royalty base,
there’s no further constraint on the selection of
the base. Concerns about suggesting an inappropriate range of damages don’t disappear simply
because the smallest salable unit is used.
Moreover, the Federal Circuit said, the smallest
salable unit approach was intended to produce
a royalty base more closely tied to the claimed
invention than to the entire market value of the
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close relation to the patent’s
claimed functionality. Patentees
must apportion the royalty down
to a reasonable estimate of the
value of its claimed technology or
establish that its patented technology drove demand for the entire
product. VirnetX did neither.
Lesson learned
accused products. Thus, identifying damages associated with the smallest salable patent-practicing
unit is just one step toward meeting the apportionment requirement. When, as here, the overall
product includes several noninfringing features
unrelated to the patented feature, the patentee
must do more to estimate which portion of the
value of that product is attributable to the patented technology.
The court recognized that patentees may face
difficulty in assigning value to a feature that
might not have ever been sold individually. It
noted, though, that absolute precision isn’t
required, because the task might involve some
degree of approximation and uncertainty.
Expert’s testimony tossed
For similar reasons, the Federal Circuit found that
the expert’s testimony on a proper royalty base —
which relied on the entire market value of Apple’s
products — should have been excluded. The
expert used the base price at which each product
was sold, excluding only charges for additional
memory sold separately, and called this the smallest salable unit. He didn’t attempt to subtract
any other unpatented elements from the base.
Therefore, the base included various unpatented
features such as the touchscreen, camera, processor, speaker and microphone.
According to the court, VirnetX should have identified a patent-practicing feature with a sufficiently
The Federal Circuit ultimately
vacated the jury’s award and
remanded the case for further
proceedings. Its conclusions
reinforce the necessity for experts opining on patent damages in cases involving multicomponent
products to go beyond merely determining the
smallest salable unit. If that unit doesn’t drive
demand for the overall product, the royalty must
be further apportioned. F
Nash bargaining
solution is rejected
The U.S. Court of Appeals for the Federal Circuit
in VirnetX, Inc. v. Cisco Systems, Inc. (see main
article) also rejected the plaintiff’s expert’s use of
the Nash bargaining solution (Nash) to estimate
reasonable royalty damages. Several district courts
have addressed the use of the Nash theorem in
recent years.
VirnetX’s expert began by determining incremental or additional profits associated with the use of
the patented technology. He then invoked Nash to
determine how the parties would split these profits.
Nash posits that each party would take 50%.
The court agreed with the district courts that have
rejected invocations of the theorem without sufficiently establishing that the theorem’s premises
actually apply to the facts of the case at hand. It
found that the use of the theorem here was “just
such an inappropriate ‘rule of thumb.’” Anyone
seeking to invoke Nash, the court said, must establish that the theorem fits the particular situation,
and VirnetX’s expert failed to do so.
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Divorce and CRTs:
What are the tax effects?
W
hen marriages end and marital assets
must be split, some assets are easier to
split than others. For example, it may
seem obvious to simply divide a charitable remainder trust (CRT) right down the middle into two
new trusts — one for each spouse. But a 50/50
split isn’t as easy as it may seem to your clients.
Common scenario
In Revenue Ruling 2008-41, the IRS has provided
tax guidance on dividing CRTs. The agency considered a scenario in which divorcing spouses are both
income beneficiaries of a CRT that will terminate on
the death of the second spouse. When one spouse
dies, the other will be entitled to the entire income
payment. And when the surviving spouse eventually
dies, the CRT will distribute its remaining assets to
its charitable remainder beneficiary.
The IRS approved a pro rata distribution of
the CRT assets into two separate CRTs. Each
new CRT will pay the same amount the income
beneficiary was entitled to receive under the original, and the trusts will generally have the same
provisions as the original.
The division of assets in the original
CRT doesn’t constitute a sale or
exchange producing gain or loss.
Tax implications
In its ruling, the IRS addressed several tax issues
related to a 50/50 division of a CRT:
Qualification as CRTs. The IRS reasoned that
because the new trusts generally operate in the
same manner as the original — with only minor
modifications to attain the same result — they
continue to qualify as CRTs.
Basis and holding periods for assets. The IRS
found that the division of assets in the original
CRT doesn’t constitute a sale or exchange producing gain or loss. Therefore, the basis of each
separate trust’s 50% share of the assets immediately after the division of the original CRT is 50%
of the basis of those assets in the hands of the
original CRT immediately before the division. And
each separate trust’s holding period for each asset
transferred to it includes the period the asset had
been held by the original CRT immediately before
the division.
Excise tax on private foundation terminations.
CRTs are split-interest trusts that generally are
subject to Section 507 of the Internal Revenue
Code (IRC), as if they were private foundations.
Section 507 imposes an excise tax on termination of private foundation status. But the IRS
indicated that, in the CRT division, the original
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CRT hasn’t terminated its private foundation status, because no notice was, or was required to be,
filed. Moreover, the new CRTs aren’t treated as
newly created trusts, because the asset transfers
were pursuant to an “adjustment, organization or
reorganization.”
Taxable expenditures excise tax. CRTs are subject to excise taxes on taxable expenditures, too.
However, the IRS said that transfers of assets to
the new CRTs aren’t taxable expenditures.
Self-dealing excise tax. CRTs are also subject to
IRC Section 4941(a)(1), which imposes an excise
tax on acts of self-dealing between a private foundation and a “disqualified person.” The
IRS held that, in the CRT division,
the spouses are insulated from
self-dealing because they
don’t receive any additional
interest in the assets of the
original CRT.
Although the Revenue Ruling makes 50/50 divisions of CRTs between spouses possible, actual
division may not prove as straightforward in the real world as on
paper — particularly with CRTs
holding assets that aren’t easily divided, such as real estate.
Consult a financial expert
to ensure you’ve developed a
workable division of assets. F
Real world caveat
Fraud interviews deserve
professional attention
How experts gather facts and get to the truth
A
ll too often, companies defrauded by
employees attempt to solve the problem
internally. Whether motivated by cost
concerns or the desire to keep occupational fraud
incidents quiet, owners and managers may even
conduct employee interviews themselves. This
usually is a mistake.
Not only are forensic accounting experts experienced at eliciting confessions from guilty parties,
but they’re also better able to extract vital information from witnesses, who may be reluctant to
“squeal” on a co-worker in the presence of their
boss. So when a client suspects fraud, your first
step should be to engage an expert interviewer.
Preparation is key
When interviewing fraud suspects, forensic experts
aim to find any stolen funds and determine
whether they can be returned to the company.
These experts also can uncover key evidence to
help in a criminal prosecution or civil suit leading
to a judgment against the suspect’s assets. Finally,
they’ll try to obtain a signed confession.
To gain the best chance of securing a confession,
the expert needs documentary evidence the suspect committed the fraud. So he or she starts by
examining company books and records, as well
as insurance claim reports, management reports
and, if available, police reports. The expert also
gets acquainted with the suspect’s responsibilities,
authority in the company and work history.
Before questioning the primary suspect, the
expert interviews other employees who may have
knowledge of the scheme. Even those least likely
to be involved can sometimes provide useful
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Confession time
Management’s role
in preventing fraud
Fraud interviews are best left to the experts. But
business owners and managers are strongly advised
to take an active role in preventing fraud. Some of
the best practices for keeping the workplace fraudfree include enforcing control procedures such as
segregation of duties and addressing employee
grievances as soon as they arise.
Managers who cut corners when pursuing business targets or pay for personal expenses with
company funds make it easier for their workers to
justify unethical behavior. But if management is
conscientious, treats employees respectfully and
shows good leadership, fraudulent activities probably won’t even enter employees’ minds.
information. Next come people who may be helping the perpetrator, and, finally, the suspect.
Psychological nuances
Suspects don’t have to agree to be interviewed. But
refusal raises a big red flag, so most will consent.
Fraud experts know how to create a “comfort zone”
for the suspect so he or she feels at ease going into
the interview and is less likely to clam up while it’s
in progress. Often experts write down key points to
guide the talks, rather than writing actual questions
that can inhibit spontaneity. And they generally start interviews in a casual, conversational mode, avoiding questions that may
seem intimidating or pointed. Because
body language is as important as spoken
answers, fraud experts carefully watch their
subject’s facial expressions and postures.
These professionals don’t talk too much
but truthfully answer the suspect’s questions about why he or she is being interviewed — for example, “We’re auditing
the company’s financial statements and
would like your help.” And they avoid
acting defensive even when subjects
become aggressive or threatening.
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When a fraud suspect understands the documentary evidence against him or her and seems ready
to confess but is still stalling, some forensic experts
will suggest a motive other than greed. “Family
financial problems” often works well. Indeed, a
“nobler” motive lets the perpetrator confess and
still save face.
If a subject confesses, the forensic expert tries to
pin down how much he or she stole, in case some
evidence has yet to surface. Numbers the suspect
initially provides can be significantly understated,
so persistence is essential. This is also the time to
ascertain exactly where the stolen money is and
whether the company can get it back.
Finally, experts try not to leave the interview without a written statement. This may be the only time
the perpetrator is willing to put it all in writing and
affix a signature.
Knowledge is power
Conducting effective fraud interviews requires
knowledge about everything from behavioral psychology to criminal law to accounting and auditing rules — a breadth of knowledge few business
managers possess. To help ensure your client nabs
the perpetrator and recovers financial losses, talk
with an experienced forensic accounting expert
whenever occupational fraud is suspected. F
Reorganization value
Industry matters in bankruptcy court
B
ankruptcy attorneys generally are familiar
with the three most common methods
of determining reorganization value: discounted cash flow (DCF), market multiple (or
comparable companies) and comparable transaction. However, depending on the sector involved,
courts can consider other methods. That’s what
happened in a recent shipping industry bankruptcy
case, In re Genco Shipping & Trading Ltd.
Sinking shipper seeks reorganization
Genco, one of the world’s largest dry bulk shippers, filed for Chapter 11 bankruptcy in April
2014. Its restructuring plan provided that existing equity holders would receive only warrants in
exchange for their interests. The equity committee challenged this plan, generally asserting that it
wasn’t “fair and equitable” as required by law.
The committee used the three main valuation
methods and the net asset value (NAV) method,
weighting DCF most heavily, to reach a reorganization value of $1.54 billion to $1.91 billion.
Court rejects DCF
The bankruptcy court stated that a determination
of the debtor’s value directly affects the issue of
whether a proposed plan is fair and equitable. The
court had to determine whether Genco’s value
exceeded $1.48 billion — the amount that would
entitle equity holders to any recovery. It found
that DCF analysis used by the equity committee
wasn’t appropriate, largely due to the speculative
nature of the discount rate projections for the dry
bulk shipping industry.
Genco urged the court to adopt a pure NAV
analysis that put the value at $1.36 billion to
$1.44 billion. The court concluded that, given the
nature of dry bulk shipping, a competitive, highly
fragmented industry with low barriers to entry,
NAV should be given substantial weight. Dry bulk
shipping has little brand loyalty or other features
to distinguish competitors, making the industry
vulnerable to weak profits.
But the court wasn’t convinced that NAV should
be the sole basis for valuing Genco. The comparable company’s analysis, for example, required only
the identification of companies with similar attributes. The parties agreed on four such companies.
Similarly, they agreed that three change-of-control
transactions were available for a comparable transaction analysis.
Right method obtains approval
The court went on to find that none of the three
non-DCF methods produced a valuation above
$1.48 billion. Therefore, the equity holders weren’t
entitled to a recovery.
The bankruptcy court’s ruling illustrates the critical role the relevant industry can play in obtaining
court approval of a value. And, at least according
to this court, DCF isn’t appropriate for volatile
industries where companies consistently struggle to
produce returns in excess of the cost of capital. F
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advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. ©2014 EXPwi15
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Litigation support that gives you an edge
F
or over 30 years, Dannible & McKee, LLP has been helping law firms and businesses prepare, present
and win cases in and out of court. Our expertise has enabled us to provide substantial assistance in disputes
involving valuation, ownership transition, matrimonial issues, fraud, audits, income tax matters and damage
claims. We offer a comprehensive set of litigation support and expert witness services, including:
F Analysis of financial records
F Asset valuation
F Fraud investigations
F Tax dispute assistance
F Preparation of financial trial exhibits
F Damages calculations
F Expert witness testimony
F Deposition assistance
F Pretrial planning assistance
F Litigation cost analysis
Dannible & Mckee, LLP is the exclusive local member of the National Litigation Support Services Association
(NLSSA), a group of CPA firms dedicated to the delivery of superior service to trial lawyers. The association serves
as a network for the exchange of information about case preparation, emerging issues in forensic accounting and
developments in litigation support. Through its members, NLSSA provides trial lawyers both multi-state support and
access to a broader deeper knowledge of a wide range of industry and functional disciplines.
We would be pleased to answer any questions you have about the topics discussed in this newsletter or others related
to forensic litigation and litigation support. We would also welcome the opportunity to talk with you about ways
we can help you achieve your financial goals and legal objectives.
Anthony F. Dannible, CPA/ABV, CVA, CDA, is in charge of the firm’s litigation support department. With
30 years of experience in the accounting profession, Tony is recognized as the leading tax expert in New York State
and is frequently called upon to provide expert testimony in income tax and corporate valuation matters. A graduate
of Syracuse University, Tony is a member of numerous professional and community service organizations, including
the NLSSA, the Estate Planning Council of Central New York, and the Syracuse University Tax Advisory Board.
For assistance or more information, please contact Anthony F. Dannible CPA/ABV, CVA, CDA
at 315-472-9127 or [email protected] and let us know how we can be of service.
Financial Plaza, 221 South Warren Street
Syracuse, New York 13202