Foody v Horewood (No 2)
[2004] VSC 222
•1 July 2004
| IN THE SUPREME COURT OF VICTORIA | Not Restricted | |
AT MELBOURNE
COMMERCIAL AND EQUITY DIVISION
No. 7242 of 1999
| ANDREW EMMETT FOODY & ANOR | Plaintiffs |
| v | |
| TIMOTHY HOREWOOD & ORS | Defendants |
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JUDGE: | Hansen J | |
WHERE HELD: | Melbourne | |
DATE OF HEARING: | 16, 19-23 April 2004 | |
DATE OF JUDGMENT: | 1 July 2004 | |
CASE MAY BE CITED AS: | Foody v Horewood (No. 2) | |
MEDIUM NEUTRAL CITATION: | [2004] VSC 222 | |
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Corporations – Minority shareholder – Oppression - Ascertainment of fair value of shares.
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APPEARANCES: | Counsel | Solicitors |
| For the Plaintiffs | Mr M A Dreyfus QC and Ms G A Costello | Fetter Gdanski |
| For the Defendants | Mr P W Almond QC and Mr S R Horgan | Rigby Cooke |
HIS HONOUR:
This judgment deals with the fair value of Foody’s 10% shareholding in Musashi Pty Ltd.
In my judgment on 22 September 2003 I upheld the derivative claim brought by Foody on behalf of Musashi in certain respects and Foody’s oppression claim.[1] I concluded as follows on the matter of relief.[2] Foody’s shares were to be purchased at their fair value. For this purpose the items on which the plaintiff succeeded on the derivative claim were to be written back into Musashi’s accounts with interest as appropriate. I would hear counsel as to these matters, on the matter of interest on the loan to Harrisons Clocks, and would determine the amount and timing of the write back. The accounts to be used were those audited by Brierley which were not to be reopened save only to the extent I may permit by order. The identity of the transferee and the manner of acquisition of Foody’s shares was a matter for the defendants in the first instance. In addition to payment of the fair value of Foody’s shares there would be an order for payment of the garnisheed sum of $29,752.37 with interest thereon at a rate to be determined, and there would be injunctions restraining Musashi from enforcing certain court orders.[3] The further hearing was stood over to allow the parties time to consider the reasons for judgment, and submit minutes of orders.
[1]Foody v Horewood [2003] VSC 347.
[2]At [303].
[3]See [69] – [78], [120] and [294] – [295].
At a hearing on 13 October 2003 I was told that Musashi had repaid the garnisheed sum to Foody and that the interest payable on that amount remained to be agreed. Otherwise the parties were still addressing matters and I adjourned the further hearing to a date to be fixed.
I next heard the parties on 7 November 2003. They had agreed the adjustments required by the judgment save for amounts of legal costs paid by Musashi in respect of Horewood and Hore’s defence of the oppression claim, which I had held should not be borne by Musashi. While the dollar amount of the costs had not been agreed the basis of the apportionment had been agreed in principle. I was provided with a written statement of agreed adjustments signed by counsel and dated 7 November 2003 which I received as Exhibit CC. The audited accounts of Musashi for the years ended 30 June 1998 to 30 June 2002 inclusive were to be adjusted in accordance with the agreed adjustments.
The principal issue then remaining for determination was the fair value of Foody’s shares. For the purpose of the hearing and determination of that issue I made the following orders by consent. First, I fixed 1 March 2004 as the date for the hearing. Secondly, I ordered that:
“Subject to any further order as to the dates in paragraph (a), the Plaintiff file and serve any affidavit of the expert(s) upon which he intends to rely as to the fair valuation of his 10% shareholding in [Musashi]
(a) as at:
(i)5 March 2002 and
(ii)30 June 2002
(b)based on the company’s audited financial statements for the financial years ended 30 June 1998, 30 June 1999, 30 June 2000, 30 June 2001 and 30 June 2002 (both inclusive) adjusted to make allowance for the agreed adjustments and apportioned legal costs of the oppression proceeding
by 4.00 pm on 5 December 2003.”
The orders also made provision for expert affidavits in answer and reply. I added the words “Subject to any further order as to the dates in paragraph (a)” to the draft order provided to me as I did not wish to commit myself to the dates in para (a) of the draft order as being the only possible dates at which it was appropriate to value Musashi. Indeed in discussion I said to counsel that the appropriate date may be the date of making of the order, that the question was to be determined in light of the relevant circumstances of the case, and that I reserved my position on the issue. Subject to that, the dates in para (a) represent the following: 5 March 2002 was the second day of the trial on which the defendants made an open offer to Foody, and 30 June 2002 was the end of the five year period of audited accounts.
The trial date was adjourned to 16 April as a result of delay in the provision of expert reports.
The audited accounts of Musashi were amended in accordance with my judgment and the agreed adjustments. As so amended they were put into evidence at the trial.[4]
[4]Exhibit DD.
The following reports of experts were filed and relied on at the trial.
(a)For Foody – joint reports of Thomas Peter Borsky and Gary Charles Greco of Alexander and Spencer, chartered accountants, as follows:
· a report dated 18 February 2004 which valued Musashi at 5 March 2002 and 30 June 2002 ("the first Borsky report").[5]
[5]Exhibit EE.
· a report dated 14 April 2004 which valued Musashi at 22 September 2003 (being the date of the judgment) ("the second Borsky report").[6]
[6]Exhibit FF.
(b) For the defendants –
· a report by Michael Wesley McCann of Hayes Knight, chartered accountants and business advisors, dated 29 March 2004.[7] In addition, when he gave evidence McCann provided some written notes on Borsky’s reports and a comparison table of the experts’ conclusions.[8]
· a report by Christopher Charles Hugh Phillips of Deloitte Touche Tohmatsu, chartered accountants, dated 7 April 2004 ("the first Phillips report").[9] In addition, when he gave evidence Phillips provided a number of schedules of calculations which he had made on further consideration of the issues ("the second Phillips report").[10]
(c)The first Borsky report, the report of McCann and the first Phillips report, considered the valuation at 5 March 2002 and 30 June 2002. It is apparent from what I was told that on counsel being engaged for Foody, they determined that Foody’s shares should also be valued at a later date, and they selected the date of the judgment. That explains the late provision of the second Borsky report, which was a valuation at that later date.
(d)In addition to that second report, Borsky provided two further reports, namely:
· a report dated 14 April 2004 which commented on McCann’s report.[11]
· a report dated 15 April 2004 which commented on the first Phillips report.[12]
[7]Exhibit OO.
[8]Exhibit PP.
[9]Exhibit TT.
[10]Exhibit UU.
[11]Exhibit GG.
[12]Exhibit HH.
The experts, other than Greco, gave evidence and were cross-examined.
The only other person to give evidence was Horewood. His evidence in chief included a witness statement.[13] He gave evidence as to the nature of Musashi’s products, of matters relevant to the market in which Musashi operates, of his importance to the business, and some other matters. The purpose was to provide an evidentiary foundation for the experts’ evidence and Musashi’s case generally. He was cross-examined.
[13]Exhibit KK.
Shortly prior to the trial the experts conferred, pursuant to an order I made on 29 March 2004, for the purpose of identifying and providing a report on matters in issue. A joint report was filed on 15 April 2004.[14] It reflected differences and a measure of agreement but, because of a lack of time, was not as explanatory of matters as it should have been to provide appropriate assistance.
[14]Exhibit QQ.
The experts agreed that the future maintainable earnings method was the appropriate basis on which to value Musashi. By the end of the trial the differences between the experts were in the following areas:
(a)As to adjustments to be made to the amended audited results to arrive at the earnings properly to be taken into account;
(b) Whether the maintainable earnings should be ascertained:
(i)on the basis of the results for the year ended 30 June 2002 or the year ended 30 June 2003, with reference to historic results, as Borsky contended, or
(ii)by reference to a weighted average of the results over a five year period to 30 June 2002 or 30 June 2003 or such other period as considered appropriate.
(c)As to the appropriate multiplier;
(d) As to the items to be accounted in determining net surplus assets.
Before dealing with the differences I make some observations about the witnesses, commencing with Horewood. In my earlier judgment I made findings concerning Horewood’s role in Musashi. At [177] I concluded that:
“Horewood's role in Musashi was pivotal, not just in the last year or so, but at all times prior to and following Foody's involvement in the company. Horewood described himself as the technical manager, marketing manager, and managing director. I accept that evidence, but he was more than that. Stewart described him as "the driving force behind the company as well as the creativity behind new product development". I accept that evidence. Horewood was an originating, and the driving, force in the company. It was a small, ambitious company, and it depended on him for its drive and on his courage in keeping the company together in the financially difficult years.”
Having again had the benefit of observing Horewood give evidence, and considering the evidence given at this further trial, I adhere to those findings. Further, I accept Horewood’s evidence in para 17 of his witness statement on the present trial that:
“Since the late 1980’s I have been involved in building up the business of Musashi Pty Ltd. I have been the sole driving force and creative force behind the business. I am involved in the management of each individual department of the business including finance, product development, marketing, technical, sales, production and despatch. I am involved in each facet of the business.”
Horewood was subjected to a searching cross-examination. I take account of the objections to his witness statement and the responses thereto, and do not rely on unfounded assertions and otherwise inadmissible material.[15] However, as to a number of these matters, he was thoroughly cross-examined so that the extent and limits of his knowledge as to impugned matters was apparent. I take account also of the criticism that he over-played the difficulties facing the business, both presently and likely in the future. He had an interest to cast gloom on Musashi’s present and future business prospects for the purpose of minimising predictions of future profitability, and thus to keep the value of Foody’s shares to a figure lower than might otherwise have been the case. This interest did in fact manifest itself in his evidence as to the present and likely future changes in marketing the business and its products, and in relation to business prospects. His evidence had a degree of excessive pessimism, but also reflected an appropriate and sensible conservatism, an attitude that success is a constant challenge and cannot be taken for granted.
[15]The objections and the response have been placed on the court file.
In assessing the reliability of his evidence concerning the industry or market in which Musashi operates it is to be borne in mind that he has been the central inspiration and driving force in Musashi since the late 1980’s. It is evident, and I find, that he possesses an expert knowledge of that industry and market and that his evidence was informed by that knowledge. I do not consider that Horewood’s credibility was significantly affected by the statements in parts of Musashi’s website[16] by reason of inconsistencies with his evidence as to the loss or limitation of sponsorship arrangements with sporting clubs or associations. I accept Horewood’s account as substantially stating the current position, and thus that in some respects the website has not been kept up to date. At the same time his evidence in this respect was in my view influenced by his apprehension of a lack of sponsorships in the future, or of decreasing opportunities for sponsorships in the future, and his interest to dampen forecasts of Musashi’s future success. On another matter, I note that Horewood’s insistence that the item of GST had arisen in the ordinary course of Musashi’s business was, following completion of his evidence, conceded to have been correct after he made available the relevant business activity statement. Taking these and all of the matters relied on by counsel for the plaintiff into account, including Horewood’s interest, I find that Horewood was an essentially honest and reliable witness.
[16]Exhibit MM.
It may not be unduly cynical to observe that the evidence of the experts followed the pattern, so often experienced, of favouring the party on behalf of whom the expert was engaged. The differences between them were not based upon a difference as to a relevant principle of valuation. The differences were due to their individual opinions as to the appropriate approach or calculation in the circumstances of the present case.
To an extent the experts’ reports referred to matters that were not established by evidence, and did not state their instructions or the information obtained by them which they considered, and contained commentary. Counsel recognised this but, knowing that I was aware of the shortcomings, were content to conduct the case without requiring rulings on admissibility. In this case that was a sensible course. The same approach was taken to Horewood’s witness statement. Nevertheless, in final address counsel for the plaintiff submitted that the defendants had not established an evidentiary foundation for certain matters.
Borsky’s evidence suffered from a tendency to be argumentative, not content to simply and responsively answer the question and say no more, but to argue the matter, and at times to provide commentary. I do not consider that he, or McCann and Phillips for that matter, were not honest witnesses, but Borsky clearly saw his role as being to argue a case for Foody. In my view he took every point he considered possible in order to achieve the best result for Foody. I recognise and allow for the fact that had Musashi provided him with information he required, he would have been better able to form his conclusions, but nevertheless conclude as I have. I understand that the basis upon which Musashi did not provide him with requested information was the reference in the order made on 7 November that the valuation be based on the adjusted audited accounts.
McCann approached the task on the basis of his instruction to comment on Borsky’s report. He provided an answering report. As Borsky had gone to the outer possible limits for Foody, I considered that McCann went the other way. Each position was arguable but, as a matter of substance and reasonable sense, on a point or more each went too far in my view to support the interest of the calling party.
Phillips’ ultimate position was between Borsky and McCann. He was thoroughly cross-examined. He impressed me as an independent and reliable witness, neutral to the interest of the parties, who sought to aid the Court with his best professional view.
I now refer to the experts’ reports. I do so in a summary way to indicate their conclusions and differences in their approach to the valuation task. I defer more particular identification and clarification of the issues until later in the judgment when I deal with the issues left for determination.
(a) The first Borsky report
Borsky commenced by noting the terms of the 7 November 2003 order, the statement of agreed adjustments and the adjusted audited financial statements of Musashi for the years ended 30 June 1998 to 30 June 2002 inclusive. He noted that he had been denied the opportunity to communicate directly with the company’s officers or external accountants, and that he was instructed to restrict his report to an analysis of the value of Musashi as disclosed by the audited accounts with adjustments limited to those specified in my judgment.[17] Borsky observed that it was normal for a valuer to adjust the reported results to enable a view to be formed as to the fair value of the company.
[17]I interpolate that the purpose of my judgment in that respect was to avoid a re-opening of issues argued and determined at the trial. It was evident to me from the conduct of the case that Foody would have sought to do that if I had not so ordered.
Borsky adopted the capitalisation of maintainable earnings methodology to determine the value of Musashi’s business. I interpolate that, as mentioned earlier, it is common ground that this is the appropriate basis of valuation.
On that approach Borsky determined the future maintainable earnings likely to be generated by the business, and the appropriate multiplier to those earnings to arrive at the value of the business. He then added the value of its net surplus assets to arrive at the total value of Musashi and, thus, Foody’s 10% interest. He determined the relevant valuation elements, and valued Musashi, as follows:
30 June 2002 5 March 2002 a) Future Maintainable Earnings (after tax) $874,000 $874,000 b) PER Multiplier 9.5 9.5 c) Value of the Musashi Business (a x b) $8,303,000 $8,303,000 d) Value of Net Surplus Assets $3,623,000 $3,346,000 e) Value of Musashi Pty Ltd (c and d) $11,926,000 $11,649,000 f) Value of Foody’s 10% interest in Musashi $1,192,600 $1,164,900
The report set out Borsky’s reasons for his conclusion. In section 4 he set out background information concerning Musashi including its products, revenue, export sales and marketing approach. In section 5 he set out an analysis of the adjusted financial statements. This set out the calculation of net profit in the 1998/2002 years and “key elements” of the net profit, as follows:
| 1998 $’000 | 1999 $’000 | 2000 $’000 | 2001 $’000 | 2002 $’000 | |
| Sales Revenue | 9,467 | 11,602 | 12,090 | 11,847 | 14,629 |
| Gross Profit | 3,873 | 4,787 | 5,299 | 6,138 | 6,175 |
| Operating Expenses | 3,389 | 4,256 | 4,801 | 5,444 | 5,905 |
| Operating Profit | 484 | 531 | 498 | 694 | 270 |
| Other Income | 176 | 552 | 115 | 207 | 315 |
| Net Profit Before Tax | 660 | 1,083 | 613 | 901 | 585 |
KEY ELEMENTS OF NET PROFIT
| 1998 | 1999 | 2000 | 2001 | 2002 | |
| Annual Increase in Sales Revenue | 30% | 22.5% | 4.2% | (2%) | 23.5% |
| Annual Increase in Gross Profit | 25% | 23.5% | 10.7% | 15.8% | 0.6% |
| Gross Profit % | 41% | 41% | 44% | 52% | 42% |
| Wages as a % of Revenue | 11% | 11% | 11% | 13% | 12% |
| $’000 | $’000 | $’000 | $’000 | $’000 | |
| Accountancy and Audit Fees | 26 | 10 | 27 | 302 | 156 |
| Bad & Doubtful Debts | 232 | 590 | 261 | 241 | 298 |
| Consultants Fees | 403 | 548 | 1,011 | 436 | 760 |
| Legal Costs | 49 | 79 | 85 | 123 | 374 |
| Wages | 1,073 | 1,306 | 1,376 | 1,557 | 1,718 |
In section 6 Borsky explained the various valuation methodology. In section 7 he discussed, and determined upon, the future maintainable earnings of Musashi and the appropriate multiplier rate. In undertaking this task he noted that he had been provided with draft unaudited 2003 financial statements which provided a guide for future earnings. Nonetheless, he based his valuation on the June 2002 accounts, as directed by the Court. In doing so he had regard to historic earnings as a guide to expected future performance, and he stated that the past results were to be examined and adjusted to take account of likely future events as well as compensate for items of an abnormal or non-recurring nature. He noted that the period of review should be long enough to cover cyclical fluctuations and establish meaningful trends. He calculated future maintainable earnings as follows:
| Notes | 1998 $’000 | 1999 $’000 | 2000 $’000 | 2001 $’000 | 2002 $’000 | |
| Adjusted Profit | 660 | 1083 | 613 | 901 | 585 | |
| Add Back (Deduct): | ||||||
| Accountancy and Audit Fees | (i) | - | - | - | 232 | 86 |
| Excess Consultants’ Fees | (ii) | 95 | 152 | 557 | 67 | 439 |
| Legal Costs | (iii) | 8 | 37 | 45 | 17 | 319 |
| Profit on Sale of Land & Investments | (84) | |||||
| Interest Received from Associates and from Investment of Surplus Assets | (24) | (34) | (70) | (108) | (96) | |
| Maintainable Profit | 739 | 1238 | 1145 | 1109 | 1249 | |
| Less Income Tax Expense at prevailing rates | (266) | (446) | (412) | (377) | (375) | |
| Maintainable Profit After Interest and Tax | 473 | 792 | 733 | 732 | 874 |
After discussing reasons for adding back items he calculated an adjusted profit after tax for the 2003 year, based on the draft financial statements, of $1.265M, and proceeded to deal with the capitalisation rate. He discussed the general investment climate, similar company earnings as to which he concluded that Blackmores, a listed Australian company, was a comparator, and expressed the opinion that an appropriate price earnings multiple for Musashi, at 30 June 2002, was 9.5 times adjusted 2002 profits after tax.
Borsky then proceeded, in section 8, to consider the issue of net surplus assets. By deducting his assessment of the net operating assets from the total net assets of Musashi he arrived at a figure of $3.623M as the value of net surplus assets at 30 June 2002. Based on the preceding calculations, the total value of equity in Musashi at 30 June 2002 was calculated at $11,926,000. In section 10 Borsky calculated the value as at 5 March 2002. In the absence of monthly financial statements in the 2001/2002 year he assumed that net assets increased evenly throughout the year and apportioned the increase to produce $3.346M. Accordingly, the total value of equity in Musashi at 5 March 2002 was calculated at $11,649,000.
(b) The McCann report
I refer to this now as it was the next report in point of time.
In his report McCann noted his instructions to prepare a report answering Borsky’s report. He did so on the basis of the adjusted audited accounts without making further adjustments for abnormal or non-recurring items as Borsky had done. His opinion was that the fair value of Foody’s interest in Musashi was $439,226 at 30 June 2002, and that the difference at 5 March 2002 (attributable to surplus assets) was immaterial. His calculation was:
Maintainable Earnings after tax 520,000 Maintainable Earnings before tax and interest 743,000 Price Earnings Multiple (After tax) 4.5 Price Earnings Multiple (Before tax) 3.15 CME Value of Business 2,340,000 Value of Surplus Net Assets 1,641,000 Total Value $4,392,264 It will be noticed that the amounts for the capitalised maintainable earnings value of the business and the value of surplus net assets total $3.982M. This was less than the net assets in the adjusted audited balance sheet at 30 June 2002. That, McCann said, was not surprising given the relatively low value of contributed equity and the relatively high undistributed profits. In other words, the profits had been reinvested in the company, so a multiple of earnings was in effect already reflected in the balance sheet. In that situation it was appropriate to assess the value of equity in Musashi as being the adjusted net asset basis at 30 June 2002 of $4,392,264.
McCann identified the major reasons for the difference of opinion between himself and Borsky as being: on maintainable earnings, he had weighted the results over the five year period whereas Borsky had not weighted the results but determined earnings on the basis of the 2002 results; he had not treated consultancy fees paid to Horewood as excessive, and had arrived at a lower maintainable earnings figure; he had arrived at a lower price earnings multiple after tax of 4.5% mainly because Borsky had failed to consider the risks facing the sports supplement industry, the role of Horewood within Musashi, and wrongly compared Blackmores to Musashi; and there were differences on surplus assets, the major variances relating to the cash reserves and loan to Horewood as to which McCann had followed the judgment and treated the loan as an essential part of Horewood’s remuneration.
In section 5 McCann set out the current outlook for the sports supplement industry and noted that several inherent risks existed for companies in this area, namely the failure of Pan Pharmaceuticals along with the adverse effects for nutritional supplement stores which stock Musashi’s products; trends in the United States to ban the use of those supplements in college sport and at the National Football League level; the publication of the Cologne Report which found that 15% of “non hormonal nutritional supplements” contained banned substances; warnings issued by the Australian Sports and Drug Agency; and an increasing number of competitors.
In section 6 McCann considered the sale of GNC as a comparable market transaction and relevant to a valuation of Musashi, notwithstanding the fact that it was considerably larger and the world leader. McCann described it as the world’s largest company in the production, marketing and sale of nutritional supplements with sales of approximately $1 billion in the first half of 2003.
In section 7 McCann set out his calculation of the maintainable earnings. In contrast to Borsky he stated that maintainable earnings should represent the current earnings capacity rather than future earnings capacity as the allowance for future trends is considered when determining the multiplier. McCann also disagreed with some of Borsky’s adjustments in relation to accountancy fees and excess consulting fees. In relation to accountancy and audit fees McCann stated some adjustment should be made for 2001, namely $50,000, and a nominal adjustment of $20,000 for 2002. Borsky had made an adjustment of $232,000 in 2001 and $86,000 for 2002. McCann stated that these were excessive and that fees of $156,000 in 2002 were not unusual for a business of Musashi’s size. In relation to the consultancy fees, McCann disagreed with Borsky’s adjustment, believing that the consulting fees in Musashi’s accounts were a normal and recurring expense for this particular business.
Thus, McCann calculated the maintainable earnings as follows:
| 1998 $000 | 1999 $000 | 2000 $000 | 2001 $000 | 2002 $000 | |
| Maintainable Profit per the report | 739 | 1,238 | 1,145 | 1,109 | 1,249 |
| Add (deduct) | |||||
| Consultancy Fees | (95) | (152) | (557) | (67) | (439) |
| Accountancy Fees | - | - | - | (182) | (66) |
| Maintainable Profit | 644 | 1,086 | 588 | 860 | 744 |
| Less Income Tax @ Prevailing Rates | (232) | (391) | (212) | (292) | (223) |
| 412 | 695 | 373 | 568 | 521 | |
As can be seen, this resulted in a pre- and post-tax maintainable earnings of $744,000 and $521,000 respectively in the 2002 year. However, given that results for the previous five years were available and had been considered, McCann calculated the average of the last five years but on a weighted basis as follows:
| Adjusted Profit | |||
| 2002 | 521 | X5 | 2,605 |
| 2001 | 568 | X4 | 2,272 |
| 2000 | 373 | X3 | 1,119 |
| 1999 | 695 | X2 | 1,390 |
| 1998 | 412 | X1 | 412 |
| 7,798/15 | |||
| Maintainable Earnings | 520 | ||
As shown, this resulted in a figure for maintainable earnings of $520,000.
In section 8 McCann discussed the capitalisation rate or price earnings multiple. McCann disagreed with Borsky’s comparison of Musashi with Blackmores to obtain a price earnings multiple stating that Borsky had failed to consider the importance of Horewood to Musashi, the differences in the product range of the two companies, and the “drugs in sport” problem. McCann preferred as a comparator GNC and adopted a price earnings multiple of 4.5. Consequently the value of Musashi’s business net assets, including goodwill, was $2,340,000.
In section 9 McCann dealt with the valuation of surplus assets and disagreed with certain “surplus assets” as identified by Borsky. These were the surplus cash assets, GST receivables, future income tax benefits and the loan to Horewood. McCann valued the net surplus assets at $1,642,000.
In section 10 McCann valued the equity in Musashi as at 30 June 2002 as $3,982,000 ($2,340,000 + $1,642,000). He also concluded that this amount represented the value at 5 March 2002 as any adjustments to allow for the lesser period would be immaterial.
(c) The first Phillips report
In his report Phillips set out his opinion as to the fair market value of shares in Musashi, noting that it was required in accordance with my 22 September 2003 judgment and the 7 November 2003 order. He had a copy of the first Borsky report. He adopted the capitalised maintainable earnings approach as being appropriate. At the outset Phillips noted that the amount of $8.303M calculated by Borsky as the value of the business implied a value of goodwill of around $7.1M, where goodwill was the difference between the business value and the “fair value” of Musashi’s net assets. That was a high premium to expect that a willing purchaser would pay. Having noted that, Phillips proceeded to consider the issue of maintainable earnings, the multiplier rate and net surplus assets. On the earnings issue, he noted that Borsky had made further adjustments to the adjusted audited financial statements, which he (Phillips) had not done. Borsky had adjusted for suggested excess consulting fees, accountancy and audit fees, legal costs, profit on sale of land and investments, and interest received from associates and from investment of surplus assets. While it was generally accepted practice to make adjustments when determining maintainable earnings, in this case he (Phillips) was informed as follows: the reasonableness of the consultancy fees had been considered in my judgment and no further adjustment was required; that legal costs had already been the subject of agreed adjustments and should not be adjusted further; and, as to the other items, that no further adjustment was required given the basis for the valuation stated in the 7 November 2003 order. On this basis no further abnormal or non-recurring type adjustments were required to be made to the past operating results. I interpolate that Phillips had been informed of these matters by the defendants’ solicitors.
Phillips then noted that Borsky had determined future maintainable earnings after tax, (whereas he had valued the future maintainable earnings before tax), that the profit after tax and interest for the year ended 30 June 2002 was the highest over the five year period, that Borsky had regarded that profit without smoothing or weighting the results to take into account one-off peaks and troughs, and the general underlying trend of performance. Phillips view, which he applied in his calculation, was that earnings should be considered pre tax, and that earnings should be calculated on the basis of weighted results over the five year period. In this way the most recent years are granted the greatest weighting, with the earlier years granted a lesser weighting.
In relation to the multiplier, Phillips contended that Borsky had not considered fully the weaknesses of the Musashi business. These included the volatility of earnings into the future; the limited barriers to entry for competitors; the public relations issues and product perception; industry considerations including regulatory compliance and constraints; the quality of management and reliance of key individuals within the company and their likely continuity into the future. Phillips concluded that Borsky’s use of Blackmore’s price earnings ratio, discounted only for liquidity, was inappropriate. Due to these risks, Phillips adopted a lower multiple of 4.5. Phillips also did not believe that any listed company, including Blackmores, was comparable to Musashi for the purpose of determining a multiplier.
In relation to Musashi’s assets which Borsky had deemed to be surplus, Phillips disagreed with Borsky’s view as to a number of them.
After commenting on Borsky’s report concerning the multiplier and net surplus assets, Phillips moved to the calculation of his valuation. It is sufficient at this stage to note that he concluded the value as at 30 June 2002 as follows:
Maintainable Earnings after tax 484,400 Maintainable Earnings before tax and interest 692,000 Price Earnings Multiple (After tax) 6.42 Price Earnings Multiple (Before tax) 4.50 CME Value of Business 3,114,000 Value of Surplus Net Assets 2,593,000 Total Value
$5,707,000
As at 5 March 2002, Phillips valued Musashi at $5,571,000 by adjusting the net surplus assets to factor in pro rata increases between 30 June 2001 and 30 June 2002.
(d) The second Borsky report
In this report Borsky valued the equity in Musashi at 22 September 2003. At the outset he noted that he had sought explanations and particulars in relation to the 2003 financial statements and that no information had been provided. He approached the valuation on the same capitalised earnings basis applied in his first report. Again, in determining earnings, he made adjustments for abnormal or non-recurring items and he applied an after tax multiplier, this time reduced to 6.25. Among other matters, he considered the 2003 adjusted results alone provided the best guide to the maintainable earnings of Musashi, rather than the results of the past five years. (This was the same approach he took in his first report but in relation to the adjusted 2002 results). He considered that the adjusted 2003 results reflected a steady improvement in and consolidation of export market development; revenue growth; gross profit margin; and overhead costs/salary containment. He considered that an informed review of the trading results of Musashi over the previous five years would lead a purchaser to conclude that the adjusted profits for 2003 were a more reliable guide to the future maintainable profits the business might expect to earn in the future, than the average of several previous years results. He calculated and set out the adjusted financial performance over the five year period to 30 June 2003 as follows:
1999
$’0002000
$’0002001
$’0002002
$’0002003
$’000Revenue
- Domestic
- ExportN/A
N/AN/A
N/AN/A
N/A10,711
3,91910,611
5,282- Total 11,602 12,090 11,847 14,629 15,893 Gross Profit % 41% 44% 52% 42% 49% Gross Profit 4,787 5,299 6,138 6,175 7,782 Operating Expenses 4,067 4,199 5,128 5,061 5,579 Operating Profit 720 1,100 1,010 1,114 2,203 Other Income 552 115 207 231 116 Less Interest Received from Associates etc (34)
(70)
(108)
(96)
(22)
Adjusted Profit Before Tax 1,238 1,145 1,109 1,249 2,297 Less Tax at Corporate Rate (446)
(412)
(377)
(375)
(689)
Adjusted Profit After Tax 792
733
732
874
1,608
In the balance of his report Borsky arrived at conclusions, reflected in the following calculation, which calculation represents his opinion of the value of the equity at 30 June 2003.
Maintainable Earnings after tax 1,600,000 Maintainable Earnings before tax and interest 2,300,000 Price Earnings Multiple (After tax) 6.25 Price Earnings Multiple (Before tax) 4.375 CME Value of Business 10,000,000 Value of Surplus Net Assets 4,396,000
Total Value$14,400,000
(e) Borsky’s reports on the McCann and Phillips reports
These reports are a critique on the McCann and Phillips reports. It is unnecessary to set out the matters of comment and criticism as those of them that remain relevant in light of counsel’s submissions are best left to later when dealing with the issues which require determination.
(f) McCann’s valuation at 30 June 2003
When McCann gave evidence he produced a calculation of the value of the equity in Musashi at 30 June 2003. This valuation was made on the basis of capitalised maintainable earnings over a five year period plus the value of net surplus assets. Unlike his previous valuation for the 2002 year, it was not based on the value of net assets. The calculation is set out in Exhibit PP as follows:
Maintainable Earnings after tax 747,000 Maintainable Earnings before tax and interest 1,067,000 Price Earnings Multiple (After tax) 4.5 Price Earnings Multiple (Before tax) 3.15 CME Value of Business 3,361,500 Value of Surplus Net Assets 2,643,000
Total Value$6,004,500
(g) The second Phillips report
This report was constituted by a series of schedules to which Phillips spoke in his evidence. The schedules reflected the following further consideration by Phillips in light of the second Borsky report and his reconsideration of the matter. He had reconsidered the valuation at 5 March and 30 June 2002 on the basis of making adjustments to the adjusted audited financial statements to remove abnormal or non-recurring items as he considered appropriate, and he had similarly adjusted the results for the four prior years. He also made a valuation of the equity, adhering to the capitalised earnings plus net surplus assets basis, for the year ended 30 June 2003 on the original unadjusted basis and the adjusted basis. The schedules included tables of calculations which set out his conclusions, and other sheets which set out his calculation of certain items.
The following table sets out the adjusted and unadjusted valuations for 5 March and 30 June 2002.
| With adjustments | Without adjustments | |||
| 5-Mar-02 | 30-Jun-02 | 5-Mar-02 | 30-Jun-02 | |
| $000’ | $000’ | $000’ | $000’ | |
| Future Maintainable Earnings – EBIT | 884 | 884 | 692 | 692 |
| Multiple | 4.50 | 4.50 | 4.50 | 4.50 |
| Enterprise Value | 3,980 | 3,980 | 3,114 | 3,114 |
| Add/Subtract | ||||
| Surplus cash | 813 | 813 | 813 | 813 |
| Surplus assets | 1,644 | 1,780 | 1,644 | 1,780 |
| Equity Value | 6,437 | 6,573 | 5,571 | 5,707 |
The unadjusted and adjusted figures for the year ended 30 June 2003 are as follows:
| Unadjusted | Adjusted | |
| $000’ | $000’ | |
| Maintainable Earnings after Tax | 686 | 769 |
| Maintainable Earnings Before Interest and Tax | 980 | 1.099 |
| Price Earnings Multiple | 6.42 | 6.42 |
| EBIT Multiplier | 4.50 | 4.50 |
| CME Value of Musashi Business | 4,411 | 4,947 |
| Value of Net Surplus Assets | 3,890 | 3,890 |
| Total Value of Equity Value in Musashi | 8,301 | 8,837 |
General Principles
I deal below with the several points upon which the experts disagree and upon which adjudication is required. It is important to note that they do not disagree on principle. Rather, their points of disagreement reflect differences of judgment in the circumstances. Even without disagreement as to a relevant principle of valuation, it is not surprising that the experts differ because, as Young J observed in Gaffikin v Princes St Marina,[18] the valuation of shares is usually a difficult matter. His Honour also noted the role of accounting witnesses in such cases, stating that: “As I have said on many occasions previously, in a valuation of shares exercise, the accounting witnesses are really not experts in the true sense, but provide the court with information from which the court can make its determination of value”.[19] Later in his judgment, after having valued the shares at an amount greater than either valuer, Young J stated that: “My job is to find as a question of fact what the value of the shares is and I treat the accountants’ evidence as merely being material to assist the court”.[20] While I am not bound to accept the evidence of any of the accounting witnesses, I will consider their opinions and related evidence to assist me in arriving at a price for the shares which represents “a fair value in all the circumstances of the case”, to quote from the judgment of the Full Court of the Federal Court in Dynasty Pty Ltd v Coombs.[21]
[18](1995) 17 ACSR 495 at 503.
[19]At 503.
[20]At 507.
[21](1995) 59 FCR 122 at 143.
It is axiomatic that any opinion of the experts in relation to their valuation should have an evidentiary basis to support that opinion. The requirement has recently been conveniently stated by Heydon JA (as his Honour then was) in Makita (Australia) Pty Ltd v Sprowles:[22]
“The basal principle is that what an expert gives is an opinion based on facts. Because of that, the expert must either prove by admissible means the facts on which the opinion is based, or state explicitly the assumptions as to fact on which the opinion is based. If other admissible evidence establishes that the matters assumed are ‘sufficiently like’ the matters established ‘to render the opinion of the expert of any value’, even though they may not correspond ‘with complete precision’, the opinion will be admissible and material … One of the reasons why the facts proved must correlate to some degree with those assumed is that the expert’s conclusion must have some rational relationship with the facts proved.”
[22](2001) 52 NSWLR 705 at 731-732.
Of the many citations of Makita, it is sufficient for present purposes to note that the above passage was referred to with approval by the Court of Appeal in R v Ryan.[23] Counsel for the plaintiff submitted that a number of matters, on which the opinions of Phillips and McCann are based, had not been established by admissible evidence. These matters included Horewood’s role in the company; assumptions by Phillips about the remuneration a hypothetical purchaser would have to pay to a managing director of the company; assumptions by Phillips and McCann about problems facing Musashi’s top-down marketing strategy; assumptions by Phillips and McCann about the supposed risks facing the company in the sports supplement industry; and assumptions by Phillips about the need for, or quantum of, additional salary expenses required after the salary freeze. Both McCann and Phillips also referred to discussions they had had with Brierley, Musashi’s accountant, however Brierley did not give evidence. Consequently, counsel for the plaintiff submitted, insofar as Phillips or McCann may have made assumptions about certain aspects of the accounts or Musashi’s operations, those assumptions were not based on facts proved.
[23][2002] VSCA 176 at [9] – [10].
It was further submitted for the plaintiff that in these circumstances a Jones v Dunkel inference arose and the decisions of Vincent JA in R v GEC[24] and Handley JA in Commercial Union Assurance Company of Australia v Ferrcom Pty Ltd[25] were referred to. These decisions confirm that a Jones v Dunkel inference may arise not only when a party fails to call a witness in their camp without explanation, but also when a witness is called and fails to give evidence in chief concerning a matter which would be reasonable to anticipate was within the witness’ personal knowledge. After approving the decision of Handley JA, Vincent JA stated that:[26]
“If nothing is asked about a particular topic concerning which the witness might be expected to have knowledge, then the inference may be open that either the witness was unable to provide evidence on that topic or that any evidence that the witness might have been able to give would not have advanced the case of the party concerned. There is no reason why the principle should be confined to situations in which a witness is simply not called at all, nor is it an adequate response to state that a cross-examining party is able to address the situation.”
[24](2001) 3 VR 334.
[25](1991) 22 NSWLR 389.
[26](2001) 3 VR 334 at [41].
Counsel for the plaintiff submitted that the Jones v Dunkel principle was properly to be applied as a result of the failure by the defendants to call Brierley and other employees of Musashi to adduce evidence about relevant and contentious matters, and also, having called Horewood, to the failure to adduce evidence from Horewood in relation to his remuneration and the consultancies.
On the other hand, counsel for the defendants submitted that there was no question of a Jones v Dunkel inference.
In a sense the plaintiff’s submissions served, and doubtless were so intended, as a counter-attack to the defendants’ submissions that Borsky had formed views and expressed opinions without a sufficient evidentiary basis. Also to be understood in this context were the plaintiff’s submissions which sought to ascribe Borsky’s position, and any want of an evidentiary foundation, to the defendants’ failure to provide him with requested information.
In fact, on the present trial Horewood gave evidence concerning or relating to matters referred to at [55], with the exception of the need for, or quantum of, additional salary expenses required after the salary freeze. The salary freeze matter, and the matter of the 2% adjustment referred to below, arose in Phillips’ evidence; these were matters which Horewood could be expected to have given evidence about. In addition to the present trial Horewood also gave evidence at the earlier trial concerning his role in the company, and I have referred to this matter at [13] above. Brierley also gave evidence at the earlier trial, but not on this trial which was a central point of the plaintiff’s attack.
It is correct that McCann and Phillips gave evidence of having had discussions with Brierley, and they stated the information he provided. But Brierley did not give evidence as to the information conveyed, and it was not identified in the way of instructions by McCann and Phillips. One does not overlook principle in this respect, indeed I drew it to the attention of counsel during the trial, but in the end the basis upon which all the experts proceeded was clear enough, and readily resolvable bearing in mind the evidentiary principles referred to. Taking the matters of the salary freeze and the 2% adjustment, these arose in Phillips’ mind on his examination of the company’s financial records. He made inquiry and said what he was told; and the judgment he formed was readily understandable, whether one agrees with it or not. The same is true of Borsky’s opinions, in my view. In some respects his judgments or opinions lacked a sufficient evidentiary basis, but nothing turns on that in the sense that in the circumstances his judgments and opinions are readily able to be evaluated, as with McCann and Phillips.
One of the matters upon which the parties differed was consultancies and the remuneration of Horewood and Hore. In the first instance the defendants’ position was that the valuation issue on these matters was determined by my earlier judgment in which I found that the remuneration was reasonable. The plaintiff countered that the issue on a valuation was different, it was concerned with what a purchaser would allow as remuneration for a person in that position. The defendants’ point was that I had found the amounts were reasonable and proper. This was an example of the defendants wanting to limit the valuation exercise to the adjusted audited accounts and findings in my earlier judgment, and the plaintiff, by Borsky, directing the case along the path directed by valuation principles. The plaintiff was correct in this distinction. In the end the point came down to this, that counsel for the plaintiff submitted that in assessing the consultancy fees Borsky proceeded on a sound evidentiary basis whereas Phillips did not. I disagree. The basis upon which Phillips acted, and what he considered, were disclosed in evidence. Horewood also gave evidence on the matter of remuneration and the amount of the remuneration including consultancies was known. In my view too Phillips, in forming his judgment, was entitled to take account of his experience, as all of the experts did in forming their opinions.
In the end counsel have left a series of issues for determination. In dealing with these issues I bear in mind the evidentiary situation and the submissions discussed in this section.
I now deal with the issues requiring resolution to arrive at an appropriate valuation.
Date of valuation
At the outset of the trial counsel for the plaintiff submitted that the appropriate date of valuation is the date of judgment, 22 September 2003. The submission equated the date of judgment with the date of acquisition. This accorded with the authorities, and was logical and fair. As to authority, counsel relied upon the oft quoted statement of Nourse J that, “Prima facie an interest in a going concern ought to be valued at the date on which it is ordered to be purchased”.[27] However, as Nourse J immediately stated, whatever the general rule might be, the overriding requirement is that the valuation be fair on the facts of the particular case. In subsequent authorities the judgment of Nourse J has been accepted as providing the starting point for the inquiry, while at the same time recognising that the date at which to value shares in oppression cases varies having regard to all the relevant circumstances. See Dynasty v Coombs;[28] Roberts v Walter Developments Pty Ltd;[29] Profinance Trust SA v Gladstone;[30] Lucy v Lomas;[31] In the matter of Rankine Bros Pty Ltd.[32] In Profinance Trust the Court of Appeal referred to some of the authorities which illustrated that fairness might require another date. They were:[33] where a company has been deprived of its business; where a company has been reconstructed or its business has changed significantly; where a minority shareholder has a petition on foot and there is a general fall in the market; an early valuation will not be directed simply to give the claimant the most advantageous exit from the company, especially where severe prejudice has not been made out; and the parties’ conduct in making, accepting or rejecting offers.
[27]In re London School of Electronics Ltd [1986] Ch 211 at 224.
[28](1995) 59 FCR 122 at 144 per the Full Court of the Federal Court.
[29](1997) 15 ACLC 882 at 907 per Wheeler J.
[30][2002] 1 WLR 1024 at 1041.
[31][2002] NSWSC 448.
[32]Supreme Court of Queensland, unreported, 3 April 1998 per de Jersey CJ.
[33][2002] 1 WLR 1024 at 1042.
Counsel submitted that valuation as at the date of acquisition of the shares was logical and fair in the circumstances of this case. See Re D R Chemicals Ltd.[34] Counsel also relied on Roberts v Walter Developments Pty Ltd where Wheeler J adopted the date of the order as the date for valuation, as it was a course which was “convenient and works no unfairness”.[35] His Honour noted that there were a number of circumstances which may require the adoption of a different date, for example where the value of the shares had been reduced by oppression or where the plaintiff had unreasonably rejected previous fair offers to purchase. However, none of those circumstances applied in that case. Counsel also referred to authorities which recognised the compensatory nature of the remedy in oppression proceedings.[36]
[34](1989) 5 BCC 39 at 54 per Peter Gibson J.
[35](1997) 15 ACLC 882 at 907.
[36]Rankine v Rankine (1995) 124 FLR 340 at 346; Dynasty v Coombs (1995) 59 FCR 122 at 143-144.
Relevant matters in the present case were: Foody’s funds were made available to Musashi at an early stage when Musashi was fragile, and needed cash; Foody had been engaged in protracted litigation in relation to the oppression he suffered for several years; the defendants had never made an offer to Foody that reflected the fair value of his shares; the delay in resolving the matter had been beyond the power or control of Foody; Foody had not delayed the claim in order to benefit from the increasing fortunes of Musashi; the oppression of Foody continued right up until the current proceedings; the defendants had not paid any dividend to Foody or advanced him any money; further, as the shares have not yet been purchased back, or until the shares are ordered to be purchased back, the valuation of his shares cannot occur. Finally, the fact that the audited accounts for the year ended 30 June 2003 have been made available to the valuers makes 22 September 2003 a convenient date for valuation.
When the point as to the appropriate date of valuation was raised at the outset of the trial, counsel for the defendants objected that the plaintiff had not given adequate notice of his change of position in relation to the date of valuation. The parties had signed consent orders by which they agreed to valuations as at 5 March 2002 and 30 June 2002 and the matter had accordingly been prepared by counsel and the experts on that basis. The defendants did not have time to consider the new proposed footing. The defendants submitted that the plaintiff should not be allowed to resile from the previously agreed position. In any event, it was submitted, the new position was not supportable on the facts. I declined to then rule on the issue, allowed the defendants some time in which to obtain instructions, and proceeded with the trial. As a result evidence was given concerning the results in the 2002/2003 financial year.
As the hearing unfolded counsel for the defendants was able to deal with the plaintiff’s case of valuation at 22 September 2003. It was clear that counsel and the defendants’ witnesses worked hard to do so, but they did and without being prejudiced in my opinion.
I now summarise the defendants’ submissions.
First, they submitted that there is no firm rule as to the date at which valuation should occur. The overriding requirement is that the valuation should be fair in the circumstances of the particular case. In this case the appropriate date for valuation is the date of trial in March 2002. That was for the following reasons, briefly stated. The points of defence admitted the factual basis upon which an order for the defendants to purchase the plaintiff’s shares might have been made, and that the plaintiff was entitled to an order that the defendants purchase the plaintiff’s shares at their fair market value.[37] Thus, as at March 2002, the plaintiff could have proceeded to valuation of his minority interest virtually immediately, rather than proceeding to trial and raising a number of issues and claims, many of which failed. Any issue, such as the garnishee matter, that required determination would not have taken a long time. In my trial judgment I referred to Foody having prolonged the dispute and to not having genuinely tried to reach a compromise; see the judgment at [92], [116] and [141]. At [116] I referred to Foody having used the case as a means to acquire either control of Musashi or a larger portion of equity in Musashi, and I rejected many claims, including serious allegations. To allow a later date for valuation would reward Foody for making numerous improper and unjustified allegations against the defendants, thereby causing a long trial and the need for extensive reasons for judgment when he would otherwise have obtained a prompt and fair resolution.
[37]Foody v Horewood & Ors [2003] VSC 347 at [99], [268] and see [269] – [271].
The defendants further submitted that the adjusted audited accounts for 1998 to 2002 formed the agreed basis for the present valuation and provide a sound basis for determining the true value of Musashi at March 2002, or alternatively, the date of 30 June 2002 could be adopted to provide year end accuracy to any such valuation. This would avoid re-opening assertions and claims in respect of consultants’ fees and third party payments made at trial.
Finally, the Court should not allow additional compensation by way of interest in the period from 30 June 2002, or alternatively, such interest should be at a modest commercial rate in the order of 5 – 6%.
In pressing for the earlier dates of 5 March 2002 or 30 June 2002, counsel for the defendants referred, as I have mentioned, to facts and matters unfavourable to Foody, in essence that he prolonged the dispute. However, it is not to be overlooked that he had a difficult opponent who, as the findings on the garnishee matter evidence, had tried to bankrupt Foody on a false basis as a way, it is reasonable to infer, of removing him from the plot. One thing can lead to another and unfortunately by the time of the trial the mutual bitterness, discord and distrust ran very deep. And at times Foody had run the case himself, without legal assistance. He had legal representation at the trial but as a consequence, it would seem, of financial constraints, he did not have the benefit of representation of independent counsel, senior or junior. At the end a lot of factors combined to produce in Foody an unreasonable persistence in a variety of points upon which he ultimately failed. As critical as one might be of Foody in these matters, and as I was in the judgment, there is substance in the submissions made on his behalf as to factors to be considered in favour of the date of valuation being 22 September 2003. I should qualify that by noting that in the evidence at trial there was reference to offers or discussions in which figures or possible offers were suggested but they were not all investigated to the extent that I could make a finding as to them, let alone relate them to the value of the shares at the time, and neither counsel attempted such an exercise in the present hearing. Further, the respective causes of delays in the proceeding were not the subject of analysis.
The question for me to determine is what is the fair date in the circumstances. Regarding the matter overall, in light of the matters discussed in this and the earlier judgment, I conclude that it is fair and just that the valuation be as at 30 June 2002.
Even allowing for the need to resolve some issues, such as the garnishee matter and in the derivative proceeding, that is a fair date as between the parties. It is true that the oppression continued, and that in that respect since the earlier trial there was the spending of over $800,000 on a property in Queensland not related to Musashi’s business, while at the same time paying Foody no amount at all in respect of his shareholding. Yet, even allowing Foody the benefit of the time until May 1997 when he filed his application in the Federal Court, and to delay occasioned by Re Wakim,[38] a long time had passed until March 2002. Then, in the face of conceded oppression Foody ran both the oppression and derivative claim with the result determined in my judgment. With a due sense of proportion and reality, which Foody had lost by the time of the trial, the relatively few properly arguable issues could have had an expeditious and economic trial, with judgment, and a reference for valuation with an answer in 2002. It is sufficient to say, without repeating the matters in [116] of my earlier judgment or other matters concerning the case and its conduct, that by the time of the trial Foody’s disposition precluded that occurring.
[38](1999) 198 CLR 511.
In the circumstances, and regarding the matter overall, I consider that the fair and just date of valuation is 30 June 2002. That, rather than 5 March 2002, is a sensible and convenient date. It allows a little time in favour of Foody as time in which he could have considered his position, and is a time at which there are adjusted audited accounts.
When the order is made, which will be soon, consideration can be given to the allowance of interest on the fixed value of the shares as compensation for the period since 30 June 2002. If necessary I will hear counsel on the rate; at present I incline to the position contended for by the defendants.
Notwithstanding this conclusion as to the date of valuation, in view of the issues raised, and lest the case goes further, in dealing with the issues I will make findings in relation to the 2003 year.
Method of valuation
As mentioned at [12] the experts agreed that the future maintainable earnings method was the appropriate basis on which to value Musashi. I agree and proceed accordingly.
This method requires consideration of three factors: first, an estimation of future maintainable earnings; secondly, the determination of an appropriate capitalisation rate or earnings multiple; and thirdly, a separate assessment of surplus or unrelated assets and liabilities.
Determination of maintainable earnings
The experts generally accepted the approach to the calculation of future maintainable earnings (“FMP”) stated in Lonergan’s text The Valuation of Business, Shares and Other Equity[39] where it is stated that:[40]
“The selection of an appropriate maintainable profits figure is a matter of judgment depending on the circumstances. For example, a company may be in a position of short-term decline as a result of industry pressures or internal management problems. In such a situation, it is important to adopt a longer term view so as to discount any short term irregularities in the company’s profitability.
Too many FMP-based valuations are flawed in that they automatically employ historical profits as a proxy for FMP without undertaking sufficient critical examination of past performance and likely future events. An understanding of the future of a business is essential for an accurate valuation, yet is omitted when historical profits are used in isolation.
The assessment of a company’s FMP is an exercise of judgment that should take into consideration various factors including those discussed below.
Historical profits must be taken into account. These must be adjusted for non-recurring items, and include only the operating results of current activities. In most circumstances more weighting will be given to the most recent results than to historical results.”
[39](4th ed) Allen & Unwin, pp 34 - 35.
[40]At pp 34 - 35.
As to their evidence in relation to that passage, Borsky said that a weighted average of historical results was not the appropriate approach in all circumstances. McCann stated that historical profits must be examined as well as considering any known things which will happen in the future. As to the last quoted sentence, with which McCann agreed, McCann agreed that the amount of weighting to be given to past years results was a matter of judgment for the valuer. Phillips agreed in general with the principles including the last quoted sentence concerning weighting.
In determining the maintainable earnings of the Musashi business, the experts differed in the following matters: adjustments; weighting; before or after tax timing; assumed 2% adjustment; and the capitalisation rate.
I now deal with each of these issues in turn.
Adjustments
There are principally three areas in which the experts have disagreed over the appropriate adjustments to make to the maintainable earnings: accountancy and audit fees, consulting fees and legal fees.
(a) Accountancy and audit fees
In relation to accountancy and audit fees, Borsky assessed a reasonable level of accountancy and audit fees for a company the size of Musashi to be in the range of $50,000 to $80,000 per annum, treated amounts exceeding that range as abnormal and made adjustments accordingly. Borsky allowed a notional $70,000 for the 2001 to 2003 years, thus adding back $232,000 in 2001, $86,000 in 2002 and $64,000 in 2003.
In cross-examination Borsky conceded that a company similar to Musashi, which does not have an internal accountant and relies on external accountants, would pay a higher amount for accountant’s fees than otherwise. However, he qualified this by referring to the accountancy and audit fees paid by Musashi in 1998, 1999 and 2000 which were $26,000, $10,000 and $27,000. Borsky believed that this provided a good indication of the range of ordinary accounting fees Musashi would incur. Thus, an allowance of $70,000 for accounting and audit fees, even with Musashi having a high reliance on external accountants, was reasonable.
McCann believed that fees of $156,000 for the year 2002 were not unusual for a business of Musashi’s size and provided for an adjustment of $50,000 for 2001 and $20,000 for 2002. This resulted in him adding back $182,000 into the expenses for 2001 and $66,000 for 2002. In cross-examination McCann was unable to state what proportion of the 2002 accounting fees related to these proceedings.
Phillips sought to apply over a five year period a level of accountancy and audit fees which he believed reasonable for a business the size of Musashi, and to remove any one-off costs or items of an unusual nature. Phillips adjusted the accountancy costs upwards for the 1998, 1999 and 2000 years to redress the large amount of accountancy fees incurred in 2001 due to the need to bring the books of account into order for the purpose of an audit. No audit fees were allowed in those years and this resulted in a net adjustment whereby $23,000, $40,000 and $48,000 were deducted in those respective years. He adjusted the accountancy fees downwards for the 2001, 2002 and 2003 years to $110,000 in each year and allowed audit fees of $40,000, $25,000 and $25,000 respectively. This resulted in a net adjustment whereby $152,000 and $21,000 was added back in 2001 and 2002. The accountancy and audit fees for 2003 involved a net adjustment whereby the small amount of $1000 was deducted; the smallness of this amount doubtless explains why in his evidence in chief Phillips said that he made no adjustment in 2003. In reaching these figures, Phillips conferred with Brierley, who provides accounting services to Musashi, to ascertain his charges, which Phillips reduced for earlier years (when the business was smaller) to an amount he thought not unreasonable, and increased the charges over the years as the business grew and GST was introduced. Phillips believed that a valuer cannot only adjust for excess expenses but should also adjust for expenses which may be too low.
The defendants submitted that Phillips’ approach provided the truest indication of the accounting and auditing component of Musashi for a purchaser as Borsky relied on the early years without taking into account that Musashi had not maintained its books correctly and consequently had to be brought into order in 2001. By removing large amounts in 2001 and 2002, Borsky had created a false impression to a purchaser of the accountancy fees.
The plaintiff submitted that Borsky’s approach should be preferred and disagreed with Phillips’ upward adjustment of accountancy fees resulting in Musashi incurring costs which it had never in fact incurred.
In my view the approach of Phillips in relation to the treatment of accountancy fees is reasonable and appropriate in the particular circumstances where it was necessary to undertake a lot of work to bring the books of account into proper order. Just as the accounting and audit fees incurred by Musashi for the years 2001 and 2002 may be considered abnormal or excessive, so too may the accountancy and audit fees for the years 1998, 1999 and 2000 be considered too low. I concur with Phillips’ approach that it may be, and in this case is, necessary to both adjust upwards and downwards in order to reflect the true cost to Musashi of its accountancy and audit fees for a purchaser. In my view a purchaser would make such an adjustment.
Further, as Musashi has grown and expanded over the past few years and with the introduction of GST, accountancy and audit fees will have increased. On the one hand I regard Borsky’s assessment of $70,000 for the years 2001 – 2003 to be optimistic, however, on the other hand, I find McCann’s assessment of $156,000 for accountancy and audit fees to be overly conservative. I find that Phillips’ approach strikes a fair and reasonable middle ground and adopt his approach.
(b) Consultancy fees
In relation to consultancy fees, Borsky relied on advice from Foody as to whether the beneficiaries of the consultant fee payments were associates of the directors or independent parties. Borsky noted that directors receive remuneration in a number of ways, namely by salaries, director’s fees, or consultant fees to themselves or to other associated companies. In any event, the task is to assess the total remuneration paid to the director and then to assess the remuneration which would be required for a replacement director. In this way Borsky determined the quantum of excessive remuneration paid to Horewood and Hore by way of consultants fees and treated that excess as an abnormal item to be adjusted in determining the maintainable earnings.
In arriving at his conclusion as to a reasonable salary for Horewood and Hore, or for persons in their positions, Borsky referred to the annual survey of the Australian Institute of Managers (“AIM”) for 2002. Phillips agreed that this provided a guide to what a managing director would get paid. The survey describes the role and activities of various positions in terms of companies with different levels of turnover, namely (a) less than $3 million, (b) $3 to $6 million, (c) $6 to $10 million, and (d) $10 million and above. By virtue of Musashi’s turnover, Musashi falls within category (d), but at the bottom end of this range. The survey discloses three categories of salary for the different positions, namely a lower, median and upper quartile. The survey disclosed a salary of $198,000 for a managing director of a manufacturing company turning over in excess of $10m, and $86,500 for a plant and factory manager. Considering the size of Musashi Borsky expected that a purchaser would pay less than the average of the upper quartile, but added a premium of 10% to the salary of the managing director, taking into account the important role of Horewood in the successful management of Musashi, to arrive at a figure of $218,000 for 2002. With respect to Hore, Borsky deducted 5% from the upper quartile salary of the plant and factory manager to arrive at a figure of $82,000.
In Appendix 4 to Borsky’s report dated 18 February 2004, Borsky set out a reconciliation of consultants’ fees. The parties listed in this reconciliation were either parties that were clear to Borsky as being associates by virtue of their record from the trial transcript, namely Harrisons Clocks Pty Ltd, 4T’s Pty Ltd and Scoop Nominees Pty Ltd, or were parties advised by Foody who were associates or did not provide commercial services. Foody advised him that names such as Al Miller, C Hutchins Consultants, Bacarli, Gillespie, Davie Simpson, M.E. MR, and Gray were all either associates or in many cases were the recipients of payments in relation to the buying and selling of motor vehicles of some unusual nature which had no relationship to Musashi’s activities. However, very few of these made a material contribution in 2002, the year which Borsky examined. Borsky made four adjustments in 2002 in relation to Scoop Nominees, K Horewood, 4T’s and Harrisons Clocks. The amounts totalled $584,000 out of a total of $739,000 paid to consultants in 2002. Thus, Borsky determined that a total of $155,000 was paid to arm’s length consultants. To determine the excess consultant fees for 2003, Borsky deducted the salaries of Horewood and Hore of $309,000 (indexed by 3% from the previous year) and an estimate of the arm’s length fees as per 2002 of $155,000, to produce a calculation of $546,000 for excess consultants fees. This was set out in Borsky’s first report. This calculation was based on the assumption that no other remuneration was paid to Hore and Horewood and that the fees paid to arm’s length consultants remained at the same level as in 2002 as Borsky was not provided with a list of consultants for 2003. Borsky stated that:
“Accordingly, I’ve had to make some assumptions in arriving at the adjustment I made in respect of the 2003 year, but I do believe that those adjustments were, if I may use the expression, on the conservative side, that is, I think they would have resulted, if anything, in a lesser adjustment than might be made based on the actual figures but until I see those figures I can’t be certain of that”.
Borsky was not challenged by the defendants in relation to these assumptions.
Borsky also noted that in relation to the remuneration of Hore and Horewood, both “have interests in a number of other active businesses which must take some good amount of their time. Again I’m not privy to the activities of these companies but I understand that they are 4T’s, Ozimer Trading, International Cadence, Harrisons Clocks, I don’t know what they do, they may just be shelf companies…”. Similar statements were made in his first report. In cross-examination, Borsky conceded that he did not know anything about Horewood’s duties in respect of these entities.
McCann stated that the consultancy fees were a normal and recurring expense for this particular business and declined to make any adjustment. He said in evidence that this was based on two reasons. First, he was cognisant of remarks I made in my judgment handed down on 22 September 2003 that the remuneration was reasonable and appropriate in the circumstances. However, as counsel for the plaintiff noted, these comments were in relation to the remuneration and consultancies for the years up to and including the year ended 2001. Secondly, McCann considered the ease or difficulty with which Horewood could be replaced and the possible need to appoint multiple persons or an independent board of directors. As a result of this he felt it appropriate not to make any adjustment for consultancy fees. McCann conceded in cross-examination that he did not assess the consultancy fees individually, at least not beyond the consideration in Borsky’s report, nor had he assessed, save as to note the difficulty of doing so, a monetary amount as the amount needed to replace Horewood and Hore or to employ persons of similar abilities.
Phillips explained in evidence how he calculated his valuation of reasonable consultancy fees and consequently the excess consultancy fees. Starting with the figure of $1,291,000 representing the total consultants fees paid in 2003, provided by Brierley, Phillips excluded the amounts paid to 4T’s, Harrisons Clocks and Scoop Nominees as these entities were directly related to Hore and Horewood and any amounts may be a form of remuneration. This was on the basis of information provided by Horewood. This resulted in an amount of $277,000 which Phillips assumed was paid to external consultants.
Phillips then adjusted the consulting fees to add back amounts in excess of an assumed salary of $500,000 for Horewood and $95,000 for Hore in 2003, $450,000 for Horewood and $90,000 for Hore in 2002 with continuing decreased increments of $50,000 and $5,000 for Horewood and Hore respectively until 1998. This resulted in an assumed excess consultancy fee in 2003 of $173,000.
In assessing a reasonable remuneration for Horewood, Phillips took into account his remuneration of approximately $600,000 in 2003, his prior experience with companies dominated by a few entrepreneurial individuals, and discussions with Horewood in which Horewood revealed he required a remuneration of $500,000 to be retained by Musashi. In relation to Hore, Phillips assessed his salary of $70,000 in 1998 to be not unreasonable and increased that by $5,000 per annum to reflect the improved performance of Musashi over that period.
The plaintiff submitted that Phillips made no real assessment of his own in relation to commercial salaries and largely relied on discussions with Horewood. Horewood did not provide any evidence as to his current level of remuneration, save to indicate that unless he was receiving his current remuneration from Musashi he would not be working in the business and that if the business were purchased by another entity, he would require at least the remuneration he is currently earning to make him stay in his present position.
When questioned by counsel for the plaintiff as to whether Musashi should be valued by examining what it would cost to employ a managing director and plant manager rather than examining what it would cost to keep Horewood and Hore, Phillips stated that he believed that without Horewood, Musashi would face considerable difficulties. He disagreed with Borsky’s assessment of Horewood’s salary valuation, ranging from $193,000 in 1998 to $218,000 in 2002 stating that it was unreasonable. Further, Phillips stated that he would seriously consider adjusting his multiple if Horewood were to sell the business and move on as his services were entirely connected to the growth and the revenues, and had indeed considered as a factor in determining his multiple, the possibility that Horewood would leave. The plaintiff submitted, and Phillips denied, that this was double-dipping.
In response to the defendants’ submission that the trial proceedings had indicated that the consultants provided commercial services at reasonable rates, the plaintiff submitted that findings in the judgment about the propriety of certain payments were of no assistance for the purpose of examining adjustments in a valuation exercise in a later year, as Borsky is not arguing that these excess consultancy payments are improper. The issue dealt with in the judgment is different to the issue now facing the valuers. Further, the plaintiff noted that Horewood gave no evidence about Scoop Nominees, 4T’s, Harrisons Clocks and K Horewood, nor made any attempt to put before the Court on the present trial a factual account of the consultancy fees. The plaintiff submitted that Phillips also engaged in exactly the same kind of adjustment as Borsky when assessing the adjustment to make for Horewood and Hore’s remuneration by excluding the three consultancies (Scoop Nominees, 4T’s and Harrisons Clocks) as being to a related party.
As noted at [57] the plaintiff submitted that due to the defendants’ failure to adduce any evidence from Horewood or any other Musashi employee as to whether the consulting fees were anything other than payments to Hore and Horewood, the defendants cannot now assert otherwise.
The defendants submitted that either the Phillips approach or the McCann approach to the adjustment for consultancy fees should be adopted.
The defendants submitted that in referring to the AIM salary scale, Borsky ignored the fact that such scales excluded performance pay and submitted that his valuation was on the basis that executives could run Musashi on the scale plus 10% remuneration. The defendants submitted that any valuation exercise must relate to the business and the company, and relied on the following statements of Byrne J in Re D G Brims & Sons Pty Ltd:[41]
“It is unrealistic to expect the long-standing opposition to major borrowing … to change in the foreseeable future… In all likelihood, the company will continue to fund expenditure from savings. An adjustment to FME that proceeds upon a contrary assumption is inappropriate. Some allowance might be made for the chance that a purchaser of the company’s shares or assets might pay a little more because the company has not borrowed and retains a potential to do so. That remote prospect aside, the shares should be valued having regard to the company as it is and will remain, not by reference to an assumed state of affairs which is most unlikely to eventuate under the present owners.”
[41](1995) 16 ACSR 559 at 591.
In my view those statements are truly apposite to this case. The defendants submitted that the valuation is not to be performed in vacuo, and that it is Borsky’s failure to value this particular company which has led to differences in relation to adjustments for consultancy fees, capital reserves, and the consideration of industry risks and Horewood’s importance when determining the capitalisation rate.
The defendants submitted that Borsky wrongly excluded the consulting fees by relying on Foody’s advice, whereas in fact the consultants provided commercial services at reasonable rates. In cross-examination Borsky conceded that he could not comment on the work performed by the consultants in 2000 and 2002, years in which he made substantial deductions of $557,000 and $439,000 for excess consultants fees, nor comment on the work performed, nor on their level of remuneration. Borsky also conceded in cross-examination that he had assumed that services performed by a non-arm’s length party was not for proper services and proper remuneration and thus was paid for the benefit of the directors and should be calculated in their total remuneration. He further explained his reasoning by saying that after determining a reasonable remuneration, he deducted this amount from the total remuneration and the difference was an amount of excess which should not be taken into account in determining maintainable profits. When questioned by counsel for the defendants, Borsky agreed that the amounts for consultants fees which he had adjusted in 2002 would not be adjusted if those services were properly performed for reasonable fees with the result that a purchaser of the business would have to incur those fees. The defendants submitted that the consultants did provide commercial services at reasonable rates as had been confirmed at trial.
The defendants noted that Horewood gave evidence that Musashi had experienced a decrease in profits and submitted that based on the figures for four months provided to Phillips, Phillips’ comparison supported Horewood’s statement of a decrease in profit.
In my opinion the 2% margin should not be allowed. There is either sufficient allowance as a result of the weighting exercise or in the multiplier selected. Nor should there be an allowance for the wage freeze. That is because the last year for the valuation is the 2001/2002 year, the year in which the wage freeze was introduced. Were the valuation to be at or include 2003 there would be an allowance for the underpayment of the three senior employees, but I would allow this over two years. That is, $75,000 in 2003 and 2004.
Capitalisation rate – the multiplier
The capitalisation of maintainable earnings methodology requires the selection of an appropriate capitalisation rate to reflect both risks and opportunities for the future of the business. In determining his multiplier, Borsky contended that it was appropriate for a valuation at 30 June 2002 to have regard to the actual profits for the year ended 30 June 2003, and similarly for a valuation at 30 June 2003 to have regard to the profit figures for the 2003/2004 financial year.
There is no real issue between the parties as to whether to use pre- or post-tax multipliers as it is possible to restate pre-tax profits as after tax profits. However the multiplier should be adjusted accordingly as the equivalent multiplier after tax is higher due to the profits after tax being lower. Phillips used a pre-tax multiplier. Borsky and McCann used a post-tax multiplier. The difference between the multipliers selected by the experts differ principally for two reasons, namely industry risks and the relevance of Blackmores Ltd (“Blackmores”) as a comparator.
In cross-examination Horewood gave evidence as to the risks and problems faced by Musashi. He stated that the top down marketing style adopted by Musashi was no longer effective in the current marketplace due to the sports supplement industry being tainted from the deaths of athletes in the United States and the findings of the Cologne report which found that 15% of supplements were tainted. However, he conceded that Musashi had recently entered into a new arrangement with Hockey Australia in February 2004. Further, Horewood stated that apart from increased sales in Japan, there has been a decrease in their traditional domestic marketplace which is health food stores and gyms. Although he conceded that, according to the trading revenue for the years 1998 to 2002 as set out in Phillips’ report, Musashi’s trading revenue has continued to rise throughout the period since 1998 when the above risks occurred.
Horewood was also cross-examined in relation to documents he produced in response to the plaintiff’s request for production. These documents included handwritten notes of Horewood and the Musashi area budget,[47] and provided sales revenue figures for seven months in the 2003/2004 year. Horewood accepted that an annualised total from these seven months would produce an annual sales revenue for 2003/2004 of $18,338,000 and an annualised gross profit of $9,961,000, but believed that such figures would not be reached and predicted a drop in profit of somewhere between 30% to 50% due to an increase in fixed and variable expenses.
[47]Exhibit RR.
Borsky contended that Phillips and McCann, in selecting their more conservative multiplier, made an excessive allowance for perceived risks. The plaintiff submitted that Phillips and McCann relied excessively on representations from Horewood about the risks to Musashi from the adverse publicity associated with the “drugs in sport” issue or the “banned substances in supplements issue”. Borsky stated in evidence that “Broadly speaking I considered the regulatory environment, yes. For companies that comply with the regulations I can’t see a significant risk factor”. In relation to the drugs in sport issue and the Pan Pharmaceuticals crisis, Borsky stated that those issues “lead to a flight to quality and the companies with solid reputations, the companies that can assert that they are qualified and safe are the companies that have thrived…”. Borsky also stated that he considered the trend for restrictive sponsorship deals, which now exclude entities like Musashi from adopting a “top down” marketing style, but noted that sales had nevertheless continued to increase.
In forming a view as to the value of Musashi at 30 June 2002, Borsky selected a relatively high after tax multiplier of 9.5 based on the June 2002 accounts. Later, when asked to value Musashi at September 2003, he based his valuation on the June 2003 financial statements. This resulted in a different set of circumstances with the June 2003 profits being higher than forecast in June 2002. Since the relative risk of maintaining the increased profits is higher, Borsky adopted a more conservative after tax multiplier of 6.25. Borsky explained this change by stating that “I changed it because one would not apply the same multiplier to record profits as one would to profits which are poised to double, and that was my first multiplier and my second multiplier was to profits which had achieved those high levels”. As the anticipated record performance of Musashi, which was considered in establishing the 9.5 multiple, had been achieved, Borsky determined that a more conservative approach was appropriate for capitalising the later profits.
Borsky was recalled during the hearing to give evidence of his analysis of the handwritten documents produced by Horewood. His analysis is set out at Exhibit SS and indicates an annualised total revenue for 2003/2004 of $18,338,000. This was calculated by taking the profit figures for the seven months provided, dividing the resulting aggregate of $10,697,000 by seven and multiplying by 12. Then Borsky made an analysis of the gross profit by deducting the cost of sales which resulted in an amount of gross profit at 54%. This resulted in an annualised gross profit amount of $9,719,000. After deducting the annualised amount of operating expenses of $6,661,000, which for the purposes of his calculation he assessed at $6M, he calculated the net profit before tax to end up with an amount of $3.7M. Taking into account this new information, Borsky stated that if he had had this information he would have been inclined to use a higher multiplier as at June 2002.
McCann adopted an after tax multiplier of 4.5 for both his valuation at 30 June 2002 and his valuation at 30 June 2003, and a pre-tax multiplier of 3.15. This was after having considered the following factors: the nature of the sport supplement industry going forward; a comparison with other investments available to investors in the marketplace; the return expected by a purchaser for a business such as Musashi; the fact that Musashi is not a listed company; and the dominant role of Horewood running the business. Referred to the risks facing Musashi and the sports supplement industry outlined in his report at para 5.3, McCann agreed that Musashi had faced these risks over the last five years and had nonetheless prospered.
McCann agreed in cross-examination that Musashi has a number of opportunities as well as risks, namely being a market leader in the sports supplement field in Australia; having no bank borrowings and consequently substantial unutilised financial capacity; and enjoyed stability over a five year period with significant increases in sales.
In cross-examination, McCann revealed that in employing a multiple of 4.5 to the earnings which he had calculated, he produced a value lower than the net assets, implying a negative goodwill value of more than $550,000, which value he ultimately brought up to an equivalent net asset value. McCann disagreed with counsel for the plaintiff that such a calculation was unrealistic and that net asset value is more ordinarily applied to a struggling company, or a company in liquidation. By cross-checking against the net assets, McCann revised his valuation upwards to the value of the net assets. Counsel for the plaintiff noted that for the year 2003 McCann had calculated Musashi’s goodwill at $850,000 and submitted that a comparison of the goodwill figures for 2002 and 2003 should suggest that a negative goodwill of $550,000 was inappropriate. McCann disagreed with this submission.
Phillips adopted a pre-tax or EBIT multiplier of 4.5 at both 30 June 2002 and 2003. His after tax multiplier for both dates was 6.42. EBIT multipliers in the range of two to three generally indicate high risk companies; EBIT multipliers in the range of seven to eight generally indicate low risk companies. In adopting 4.5 as the multiplier, Phillips believed Musashi was an inherently strong, small privately owned business. This equated approximately to a mid-range of risk. Phillips then considered three factors which increased his risk valuation resulting in a reduced multiplier: the market within which Musashi operates, namely the sports supplement industry; the reliance on Horewood driving the business; and the regulatory requirements imposed by the Therapeutic Goods Administration.
As noted, Phillips maintained the same multiplier for all his valuations, merely changing the calculation of maintainable earnings through making some adjustments. In cross-examination Phillips conceded that Musashi had managed well throughout the difficult environment of the drugs in sport issue but that there was a risk that regulatory bodies which examine sports supplement products may increase hurdles for Musashi.
In relation to the indispensability of Horewood to Musashi, the plaintiff referred to two decisions, Commissioner of Succession Duties (SA) v Executor Trustee and Agency Co of South Australia Ltd[48] and Abrahams v The Federal Commissioner of Taxation.[49] In the former case, in their joint judgment Latham CJ, Rich and Williams JJ stated that:[50]
“It was contended that the deceased had an uncanny instinct for sensing the public taste in motion pictures so that his death was a serious blow to the future prospects of both companies. No doubt outstanding business capacity may be shown in the motion picture business as in most other businesses, but we find it difficult to believe that it is a business in which any particular individual is irreplaceable.”
[48][1947] 74 CLR 358.
[49][1944] 70 CLR 23.
[50][1947] 74 CLR 358 at 369.
Starke J stated that the deceased’s death may have some influence on the value of the shares of the company but that how far the shares would be affected was “conjectural and incapable of estimation”.[51]
[51]At 373.
Williams J in Abrahams also noted that such an argument can also work both ways. His Honour stated that:[52]
“The argument that the shares should be discounted on this ground is really a two-edged sword, as it can just as reasonably be suggested that he is such an able business man that people would be induced to put their money into these companies just because he was in control of their affairs.”
[52][1944] 70 CLR 23 at 44.
The plaintiff submitted that Horewood’s alleged indispensability is overstated due to his ignorance of a number of key aspects of the Musashi business. These matters related to the company’s marketing, website, sponsorship and computer software arrangements. They indicated that he is not involved in all major aspects of Musashi. The plaintiff further submitted that, based on representations made on Musashi’s website, any problems which faced Musashi have been overcome as Musashi is complying with the regulatory requirements and it is continuing to use top down marketing.
Given the nature of Musashi’s business and its profitability, and McCann’s calculation of zero value for the goodwill of Musashi, the plaintiff submitted that McCann’s evidence should be entirely disregarded.
In contrast, the defendants submitted that Borsky failed to appreciate the risks faced by Musashi in the future. Borsky also failed to consider the effect of the wage freeze and available markets, the decline in domestic sales and the sustainability of earnings. The defendants note that Phillips and McCann maintained their respective multiplier (pre and after tax) for 2002 and 2003, indicating that both were appreciative that the nature of the risks underlying Musashi had not changed. Conversely, Borsky’s 2002 multiple provided an inflated value which he had to reduce in 2003 to avoid an absurd result for 2003 as no changes to the business had occurred in terms of fundamental risks. Lastly, Borsky is said to have also failed to consider Musashi’s reliance on Horewood and the associated inherent risks.
Secondly, Borsky contended that Blackmores provided an appropriate comparison with Musashi as a “cross check” against which he could benchmark his multiplier. In his report Borsky detailed a number of similarities between Blackmores and Musashi and determined that the application of 50% of Blackmores’ price earnings multiple to Musashi was very reasonable. When asked by counsel for the defendants as to whether he had made allowance for the fact that Musashi was dependent on its key personnel, Borsky believed that this was not the case, at least to a degree of significant risk and refused to make any material allowance for this in selecting his multiplier.
However, further in cross-examination Borsky conceded that Blackmores’ products and Musashi’s products were different, but maintained that both companies fall within the health sector and that it was reasonable to conclude that the market would perceive similarities between the companies. Borsky rejected McCann’s comparison of Musashi with GNC on the basis that GNC is a multi national company with massive cost structures, and possibly a host of other activities and stated that there was insufficient information in order to make a comparison with GNC.
McCann believed that GNC and Twinlab Corporation, both based in the United States, provided a more appropriate comparison. McCann rejected the comparison with Blackmores on the basis that the sports supplement industry was very different to the natural medicine industry in which Blackmores operates. As a result, Blackmores has very few products which actually compete head to head with Musashi which means that a different customer will buy a Blackmores product to a Musashi product.
Phillips could not find an appropriate comparison and contended that Borsky failed to consider Musashi’s weaknesses when making his comparison relative to Blackmores. Phillips did not believe that Blackmores faced the same risks in the vitamins and minerals industry as Musashi. Further, Blackmores retails predominantly to the supermarket industry, whereas Musashi does not. Blackmores has a number of factories and production facilities and has benefited significantly from the Pan Pharmaceuticals collapse, which Musashi has not. Blackmores has a different management structure whereas Musashi is dominated by a personality such as Horewood. Phillips also rejected GNC as an appropriate comparator. Phillips applied more weight to the reliance on Horewood and the issues concerning the sport supplement industry.
The plaintiff submitted that the use of a comparator company is merely a cross-check on a valuation and even if one were to accept that Blackmores is not an appropriate comparator that does not necessarily mean that the Court should not accept Borsky’s valuation. Rather, it simply meant that that cross-check is not available. The plaintiff submitted that McCann’s comparison of Musashi with GNC and Twinlab Corporation was inappropriate.
The defendants submitted that Blackmores cannot provide an appropriate comparison as it has different products, and operates in a different market with different risks. Rather an appropriate comparator is a company such as GNC with similar products facing the same risks.
I find that neither Blackmores, nor GNC and Twinlab Corporation, provide appropriate comparators for Musashi. I accept Phillips’ evidence, and reject the evidence of Borsky and McCann in this respect. Blackmores and Musashi operate in similar but distinct markets, produce different products to a different audience, have different management structures and face different risks. While GNC and Musashi produce similar products for a similar audience, the size of GNC and the fact that it is based in the United States makes it an inappropriate comparison.
The adoption of the multiplier is a matter of judgment, as counsel recognised in leaving the matter for me to determine. Phillips was by far the sounder and more reliable on this aspect. I find that his selection of 6.42 after tax and 4.50 pre tax reflected an appropriate assessment of the risks and relevant factors affecting Musashi’s business. It is significant that in the end, for the 2003 year, Borsky came almost to the multiplier which Phillips had selected for 2002, and which he (Phillips) adhered to for 2003. For my part, having considered the evidence and submissions, I am well satisfied, on the balance of probabilities that the appropriate judgment in all of the circumstances is that of Phillips with a multiplier of 4.50 pre tax or 6.42 after tax.
Net surplus assets
The final area of dispute between the experts was in relation to the assessment of the net surplus assets. The dispute centred around three items: the appropriate “cash allowance”, an amount for future income tax benefits, and a sundry debtor for legal oppression costs. I will deal with these in turn.
(i) Cash allowance
In evidence Horewood stated that Musashi made an investment of $889,399 in 2002 in the Gallia Australia unit trust, which used those funds to purchase a freehold property south of Cairns at Kurramine Beach. Musashi continued to maintain that investment in 2003. All experts agreed that this was a surplus asset as the funds were in no way employed in the Musashi business.
As at 30 June 2002 the total cash funds of Musashi were $1.013 million and as at 30 June 2003 were $1.6 million.
For the 2002 and 2003 years Borsky was of the view that Musashi required only $200,000 in the bank. Phillips agreed with Borsky’s assessment for 2002 but increased the amount to $300,000 for 2003 on the basis of a need to increase working capital given the movement to export sales, the decline in domestic sales, and re-emergence in the United States market. This knowledge of re-emergence in the United States market was based on discussions he had with Horewood. Phillips conceded that the business could afford to withdraw $889,339 in cash from its operations to make a property investment without any apparent impairment to the earning capacity of the business as a result.
McCann’s valuation of the net surplus assets was considerably lower than Borsky’s due to his treatment of the cash allowance. McCann believed that the sum of money taken out in relation to the investment in the unit trust would impact on the business going forward and consequently made no adjustment with respect to cash funds. In respect of the 2003 year, McCann allowed $600,000 of the $1.6 million to be treated as a surplus asset. McCann stated that:
“I don’t believe there’s any correct, definable amount that is correct for a business to hold. Suffice to say that the manner in which that business has been operated is to accumulate cash. At the end of the day it does equate to approximately one month’s expenses for the business and there are, I suspect, a lot of businessmen around town who are very, very happy to have a substantial amount of cash like that in their business just as a means of giving them comfort for operating the business but, I stress it’s an opinion and I don’t think there’s any correct formula for calculating it.”
The plaintiff submitted that Borsky’s view is to be preferred due to Musashi’s low level of debt and the ease with which Musashi was able to make available $889,399 in cash to purchase the resort property.
The defendants submitted that as Musashi is being valued, McCann’s valuation should be preferred to that of Borsky. Alternatively, the cash reserve at the midpoint at $500,000 for 2002 or $800,000 for 2003 is an appropriate compromise.
It is a feature of Musashi that it has been run by accumulating cash rather than through bank financing. As often is the case with private companies, the owner has left money in the business. I consider that both Borsky ($200,000) and Phillips ($300,000) gave insignificant and insufficient weight to how Musashi has been run. Cash reserves of $200,000 or $300,000 are not a significant amount and, if Musashi were restricted to such limited reserves, it may have to seek bank financing, a course which it has reasonably and prudently resisted. The change in business practice contended for by Borsky and Phillips is unreasonable and there is no reason to suppose it would be adopted, or why Musashi should be regarded on a basis that would run it so close to the line of having to seek bank finance to conduct its business. McCann’s treatment of the cash allowance by only treating $600,000 of the $1.6m as surplus more appropriately reflects the Musashi business. However, McCann did not account for the $889,399 spent on the purchase of the Queensland property in 2002 in his valuation of the cash allowance. This amount should be taken into account in assessing the cash allowance for Musashi as it was surplus to Musashi’s business. If such an amount is regarded as being retained within the business, then Musashi’s cash funds in 2002 amounted to approximately $1.9M. In my view the better judgment is that $600,000 should be allowed as surplus cash in 2002 and 2003.
(ii) Future income tax benefits
Borsky stated that the future income tax benefit has a real value, for which a purchaser would pay additional consideration as “A deferred tax asset suggests that the company has paid an amount of income tax ahead of when it should have been incurred and it is expected to recover the value of that tax benefit at a future date. So if you bought the Musashi business, the company would be left with that deferred tax asset as its own and it would recover that tax value. If you sold the shares in Musashi … then a purchaser would consequently pay a premium for a tax saving that he’s going to make in the future”.
Phillips stated that this item related to timing differences in the accounting and tax profits of the business and saw no value of this asset as a surplus asset. It was not something which was able to be exchanged into cash or a cash equivalent; it merely sits within the business and represents a normal operating asset. Further, by using an EBIT multiplier, Phillips excluded the tax related issues and any specific tax issues of the business. Phillips stated that he had taken into account that a purchaser would pay additional consideration for the future tax benefits within his EBIT multiplier. Phillips maintained that there should be little difference between his EBIT multiplier and Borsky’s PER multiplier.
McCann also did not regard future income tax benefits as surplus assets.
I accept as correct the opinion of Phillips on this matter, supported by McCann. The opinion of Borsky was speculative and unpersuasive on the balance of probabilities. I do not allow the future income tax benefit as a surplus asset.
(iii) Sundry debtor (legal oppression)
This item appears as an asset in the balance sheet in the adjusted audited accounts for 2002 as $155,654.69.
The item arises in this way. In my judgment I held that Musashi funds should not have been used to pay the directors’ costs of the oppression proceeding and that, lest they had been, Foody’s shares should be valued on the basis that any such amount paid by Musashi be written back into Musashi’s accounts with interest. Subsequent to judgment the parties agreed that the amount of $155,654.69 be written back in accordance with that holding. In other words, that is an agreed sum, including interest to recoup Musashi its expenditure on costs of the oppression proceeding.
There is a simple difference between the parties on this item. Whereas Borsky contends that the item is an asset because the amount is a debt payable by the directors to the company, the defendants contend that it was a mere revenue adjustment taken up in one year and not meant to be a capital item. It may suit the directors to deal with this item in that way, but as between themselves and the company the item represents an amount which they wrongly had the benefit of, as against the company, and which for valuation purposes at least stands as a debt payable by them to the company. Whether the directors ever actually repay the money is a matter for them and the company, but that is not the present issue. For the purpose of valuation the item is properly treated as a surplus asset.
Conclusion
I have now dealt with all the matters in issue. I will stand the case over and at an appropriate time hear counsel on the orders to be made to finally determine the proceeding.
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