From the September 2008 issue of the TMA’s Journal of Corporate Renewal.
Written by Ken Naglewski, CTP, Managing Director, Focus Management Group
If ever there was a classic insolvency case, it was Zulu, an old-economy manufacturing company with a proud history that nevertheless was by all objective measures in the end-game cycle of its existence. Despite Herculean restructuring efforts by a turnaround firm, Zulu had filed Chapter 11. The filing was more of a timeout than a strategy since there was no clear exit plan.
A restructuring advisor had performed an analysis for one member of a large consortium of senior secured lenders who had loaned Zulu tens of millions of dollars. The lender had significant debt exposure and wanted the advisor’s expert opinion on the viability of Zulus business and its business model. In the advisor’s professional opinion, Zulu’s situation was beyond repair. He concluded that the company had no realistic chance of a successful reorganization, nor was a white knight likely to save the company through a 363 sale. In the advisor’s opinion, Zulu’s value was not a dollar more than the liquidation proceeds of its assets.
The report to the senior secured lender that retained the advisor was persuasive. Unfortunately, other lenders in the consortium with large amounts at stake were willing to put more money on the table in the forlorn hope that somehow Zulu would work out its problems and their loans ultimately would be repaid.
As the advisor mused over the issues of the engagement, the lender’s legal team made its entrance. After the usual pleasantries and a brief review of the situation, the firm’s senior litigator challenged the advisor: “Why should anybody believe what you have to say?”
Good question. Despite a long career in the restructuring profession and more than a few hard-earned letters after his name, was the restructuring advisor qualified to render expert opinions on such grave matters? Why should his or her opinions be heeded?
Who Is an Expert?
An experienced, savvy restructuring advisor was not accepted by legal counsel as a qualified, credible expert witness because, as he later lamented, “I don’t have a bunch of letters after my name.” While having professional designations such as CPA, CTP and CIRA helps, it does not necessarily qualify a person as an expert.
According to Rule 702 of the Federal Rules of Evidence:
If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if (1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods and (3) the witness has applied the principles and methods reliably to the facts of the case.
At a recent panel discussion, a U.S. Bankruptcy judge described a case in which the plaintiff’s expert provided a lengthy report on an issue regarding valuation of extensive farmland holdings in an estate valuation matter. The report was expertly worded and documented. The expert who prepared the report had a commanding presence and was well-versed on testifying.
The defendant’s expert, on the other hand, was a local real estate broker who had somewhat rumpled appearance and had not provided the court with a written valuation report. During cross-examination, the plaintiff’s counsel asked the broker how he had arrived at his valuation.
“Well, I’ve brokered 95 percent of farmland sales in the surrounding three-county area for the last 35 years,” the broker responded.
The judge said that he found the defendant’s expert opinion persuasive and credible, and he made his decision in favor of the defendant.
Yet, a well-prepared report can be devastating to the other side. In one recent case the plaintiff’s counsel asked for a settlement conference, settling for a fraction of what they were litigating for after receiving a well- prepared and convincing report from the expert employed by the defendant.
The advisor’s report in the Zulu case documented his concerns with the company. The company’s list of problems seemed endless: price-minded customers, offshore imports, irrational price competition, supply- chain innovations, and a B, adversarial union. It was owned by a private equity group that touted its ability to invest in and fix troubled businesses. The senior secured lending group was led by a well-known hedge fund that had invested tens of millions into the Zulu story.
The turnaround firm that had been called in employed the usual turnaround actions. It downsized, segmented, rationalized, and re-engineered processes. Nevertheless, Zulu continued to bleed cash as each initiative was offset by a continuing trend of unfavorable market dynamics.
The emotions of Zulu stakeholders were intense, reflecting differing agendas. Management wanted to keep their jobs and equity interest. Employees wanted to keep their jobs, and their union leaders wanted to show how tough they could be. The private equity group wanted to recoup its sizable investment. The lenders wanted to be repaid, and the trade creditors, also with significant amounts at risk, wanted repayment and Zulu’s ongoing patronage as a customer. Even price-minded customers wanted Zulu to survive to keep prices low.
Could Zulu return to sustainable profitability? Perhaps it could, but in the advisor’s mind, putting more money into Zulu was akin to drawing to an inside straight in a poker game — success is possible, but unlikely, and it isn’t a rational play.
The Art of Testifying
The two most important traits of an expert witness are credibility and persuasiveness. Other issues an expert witness should keep in mind are:
Litigation Bias. Unlike typical witnesses, experts are sought by litigators and paid for their testimony Experts are supposed to provide courts with impartial information and opinions based on their expertise and investigation of relevant facts, not to advocate for a particular side.
The surest way to lose creditability and persuasiveness with the court is to provide any indication of bias. An expert who doubts the veracity of the testimony an attorney expects of him or her should decline the engagement. Good questions for experts to ask themselves are: Why is the other side wrong? Why is my client right? Does the truth lie somewhere in between?
Quintessential Differences. If a report is available, an expert should look for the quintessential essence of what his or her counterpart is saying. To a large extent, all arguments center on one central, overriding theme: why one side is right and the other is wrong. The expert should find that theme and ask, “Is she/he more right than I?”
An expert who finds that the testimony of the other expert witness convinces him that he is wrong has a problem. Such an expert should ask the attorney to request a recess so that he or she can explain the situation; however, the expert should conduct sufficient upfront analysis to avoid this situation.
Clarity. A savvy expert witness can explain complex issues in a simple manner, A restructuring advisor, for example, should avoid using complex terms or jargon, such as trailing 12 EBIDTA, comparable sales, or non- controlling discount. While these terms might be clear to those in the industry others in the courtroom might not understand. Michael Douglas in the film “The Game” offered a useful, although perhaps oversimplified, example of the technique when his character, an investment banker, was asked what an investment banker does. “I move money around,” he replied.
Alertness. In one recent case on inventory evaluation, the defendant’s expert, a CPA, authoritatively read aloud to the court a pronouncement from the Financial Accounting Standards Board, which appeared to justify an attempt to write up the value of inventory to market values, the plaintiff’s expert provided an even more authoritative basic accounting standard stating that inventories are to be valued at the lowest of cost or market. On redirect examination, the other expert was asked to read from an established pronouncement that inventories are valued at the lower of cost or market. The judge ruled in favor of the plaintiff.
In another case involving a motion to replace management with a trustee, the defense counsel asked in reference to a brief projection analysis, “Have you seen the other set of books Mr. Smith kept?”
Although fully understanding what the attorney was referring to, the expert looked at the judge and exclaimed, “Your honor, I didn’t know they were keeping two sets of books.” Almost as if rehearsed, the attorney who hired the expert jumped up and exclaimed, “Your honor, I want to see the other set of books these people are keeping.”
There was no other set of books, but the poorly phrased question from the defendant’s attorney hinted otherwise, and the expert had the presence of mind to take advantage of gaffe.
Poise. An expert witness should expect the opposing attorney to challenge his or her credentials. Everything an individual has ever published will be studied to find inconsistencies between the expert’s current opinions and what the individual said in the past.
Experts should make sure that the attorneys who retained them are aware of all articles these witnesses have published, books they have written, and previous testimony they have given. They shouldn’t be caught on the witness stand looking foolish after the opposing attorney asks about an article that contradicts the expert’s testimony.
Failed Gamble
Despite the advisor’s recommendations in the Zulu case, the court approved the DIP financing, denied adequate protection, and allowed the company to proceed down a dual path of an attempted reorganization and a 363 sale. Neither effort was successful. The case was converted to a Chapter 7, and Zulu’s assets were liquidated. The amount of the DIP loan consumed during the failed efforts resulted in a substantial reduction in the amount paid to the secured lenders.
Ken Naglewski, CTP is a managing director of Focus Management Group and heads the firm’s Nashville office. A restructuring advisor and interim executive, he is a CPA and a CIRA. He has testified as an expert witness in several jurisdictions on a variety of matters and also has testified before the U.S. Department of Justice and the Federal Energy Regulatory Commission. Naglewski recently completed the CTP Interactive Forensics Workshop at the University of Wisconsin—Madison, which focused on expert witness testimony. He can be contacted at (615) 491-7331 or k.naglewski@focusmg.com.