March 01, 2011

For any expert witness, acquiring accurate, timely, and complete information is an important component in assembling a supportable opinion. However, for a valuation or forensic expert in a divorce case, having timely access to the true “universe” of relevant information is paramount. Given the personal and often contentious nature of divorce, navigating the sometimes murky waters of discovery can be challenging, even for the most seasoned veteran of the courtroom. Involving a financial expert early and throughout a case is a proactive measure an attorney can take to ensure the proper questions are asked, the correct documents are requested, and, sometimes most crucial in family law cases, that any information that has been withheld does not go unnoticed.

This article addresses some of the challenges encountered during the discovery phase of divorce cases and presents a case study showing how involving a financial expert can assist an attorney in protecting the best interests of his client by identifying important opportunities and ensuring key information does not slip through the cracks.

Challenges During the Discovery Process

While many attorneys recognize the need to engage financial experts “at some point” during an asset-intensive divorce, determining when that point is can be a pivotal factor in both the quality and quantity of information requested and received. Some common points at which experts are engaged include:

1| When counsel has become inundated with a flood of data
2| When an attorney is unfamiliar with the type of financial information that would be required by an expert, or when he realizes that the response to an initial document request is incomplete
3| Finally, and potentially most damaging for a client’s case, when the discovery cutoff date has passed and not all relevant information has been requested or provided

As a result, an attorney may find himself in one of the following situations:

Too Much – If overly broad or nonspecific discovery requests are initially issued, the result may be a broad and burdensome amount of data provided. When a deluge of information arrives, it becomes important to sift through everything provided to separate what is relevant from what is extraneous. At this point, either the attorney can attempt this undertaking himself, or it can be delegated to an expert and his or her engagement team. In either case, receiving too much of the wrong information can bog down the litigation progress, decreasing efficiency of all parties, and increasing the professional fees as this information is cataloged, analyzed, and ultimately disregarded.

Too Little – It is also common for an expert to be engaged after counsel realizes he is not familiar with the information that will be required to complete a financial analysis or when he recognizes that not all pertinent information has been provided. At this point, an attorney has the option of hiring an expert to determine what additional information is required, or devoting his own valuable time to learn more about financial analysis and valuation to determine what documents would be required to perform them.

Too Late – The analysis a financial expert performs depends largely on the fact pattern of each case and the documentation to which she has access. In nearly all cases, as more information is acquired and analyzed, more facts come to light. When this happens, it becomes clear that additional information is required to properly reach a supportable conclusion. If an expert is not hired sufficiently in advance of a discovery cutoff date, the opportunity to request information that is potentially vital to a sound analysis may be lost. A valuation adage states “garbage in, garbage out,” meaning that if the information and assumptions that go into an analysis are faulty or incomplete, so too will be the conclusion. In court, the judge may understand the difficult situation one litigant’s expert has faced by arriving late in a case; however sympathy will only go so far if the opposing expert was privy to key documents the other side never even requested.

Utilizing an Expert Throughout the Discovery Process

To paraphrase a retired NFL coach, if they want you to cook the dinner, they ought to let you shop for the groceries. While an expert can usually “make do” with certain limited information, it is undeniable that the expert, as the proverbial cook of the analysis, has a unique perspective regarding the grocery list of information that will be required to reach accurate and supportable conclusions.

The following case study walks through several ways in which a financial expert can be an invaluable resource to an attorney and his client.

Case Study – The Smith Divorce

Background

Mr. Smith is a 33% owner in Polytech, Inc., a manufacturing entity that grosses $10 million in annual revenue. Along with another 33% owner (collectively the “Conspirators”), Mr. Smith has been fraudulently removing $800,000 to $1 million annually in Polytech profits through fake vendors they created. These funds are transferred to offshore accounts held by the Conspirators’ fake vendors. Effectively, Mr. Smith and his partner are defrauding both the U.S. government (by underreporting income) and the silent third shareholder by leading him to believe there is minimal net income available to be distributed to the shareholders. The Conspirators also own a holding company that owns the land and building in which the company operates. Polytech pays rent of $300,000 annually to this holding company.

Mr. and Ms. Smith live in an affluent suburb and both drive luxury vehicles. Prior to the divorce, the Smiths vacationed three to four times per year at an approximate cost of $15,000 per trip. When they traveled Mr. Smith always paid with cash, but in and around their hometown, both Mr. and Ms. Smith regularly paid with credit cards. In his initial answers to interrogatories (“Answers”), Mr. Smith claimed his annual income to be $150,000, consistent with his W-2 wages, and indicated the only liquid accounts he has are $10,000 in a Chase Bank savings account and $150,000 in his 401(k).

Ms. Smith tells her attorney, Mr. Thompson, that she remembers overhearing her husband on a telephone conversation a few years ago in which he told someone to “move it to the Caymans.” The night before he filed for divorce, Ms. Smith saw Mr. Smith burning several CD’s from the family computer, but when she looked at Mr. Smith’s “Documents” folder after she was served with the divorce complaint, the folder was empty. Suspicious of Mr. Smith’s interrogatory answers, lavish lifestyle, and odd behavior, Mr. Thompson engages, Ana Lysis, a well-respected local financial expert, and describes the situation.

The Approach of a Multi-disciplined Expert

In a case with possible hidden assets and a spouse committed to obstruction and obfuscation, many requests and subpoenas will likely be required as new facts come to light. As these facts are analyzed, new questions are raised and additional documentation must be requested to provide answers. Because of this “request, analyze, repeat” procedure, it is often said that discovery can be a highly iterative process.

The following paragraphs illustrate how an expert like Ms. Lysis may approach the problem of discovering the true net worth of Mr. and Ms. Smith.

Initial Review – Ms. Lysis’ first steps would be to review any financial documents provided thus far. Mr. Thompson had already received the couple’s tax returns (1040s) and Polytech’s financial statements (income statements, balance sheets, cash flow statements), all of which seem to support Mr. Smith’s story of a struggling company and personal income of $150,000. However a careful review of the Smiths’ 1040 from the previous year might show interest and/or dividend income from financial institutions other than the one Chase account Mr. Smith identified in his Answers. If this is the case, Ms. Lysis would add statements for these accounts to her first list of information to be requested.

Financial Data Request – After reviewing the few documents initially supplied, Ms. Lysis’ next step would be to prepare a comprehensive list of documents she would require to better investigate the unreported bank and investment accounts, the spending patterns of the Smiths, and finally the detail (invoices, general ledgers, purchase orders, etc.) behind the previously-provided financial statements of the business. Ms. Lysis can assist the attorney in preparing a document request tailored to the Smiths’ unique situation.

Review of New Documents and Follow-up Data Request – It is rare that all documents an expert requests are provided immediately, or upon first request. Furthermore, sometimes the absence of documents from production can be just as telling as the information actually provided. For instance, Mr. Smith’s inability or unwillingness to produce invoices for certain questionable vendors may be yet another clue in helping to prove the bogus nature of hundreds of thousands of dollars in expense deductions.

After the expert receives the document production, a new list will likely be created to highlight those documents not yet provided and request any additional follow-up information to address new issues identified.

Mr. Smith’s Deposition – If Mr. Smith is to be deposed, it can be very helpful both to the attorney and Ms. Lysis to have her prepare a list of questions and a document production request ahead of time and attend the deposition to supply follow-up questions based on Mr. Smith’s answers. If the moneyed spouse’s deposition can be taken in two or more parts over a period of weeks or months, this would afford the expert the opportunity to request documents based on the deponent’s answers and then follow up with additional questions once the information has been supplied.

Discussion of Other Services – At this point, a cross-disciplined expert may be able to recommend other important complementary services during the discovery process. In the case of the Smith Divorce, the fact pattern suggests that a “lifestyle” analysis, a computer forensic “acquisition,” a real estate appraisal, and a marital net worth statement may all yield valuable results for the client.

A lifestyle analysis tracks and categorizes the funds spent by Mr. and Ms. Smith over a period of months or years. Typically all bank, investment, and credit account statements are analyzed for cash outflows and each transaction is entered into a spreadsheet or personal accounting software. If, for example, a lifestyle analysis indicates Mr. and Ms. Smith spend $350,000 per year, yet the husband claims to be earning only $150,000, this is strong evidence that there are other unreported sources of income, possibly totaling $200,000 or more. Additionally, during the process of analyzing each account, large or irregular transfers or payments may help identify other accounts that would require further discovery.

A computer forensic “acquisition” and analysis involves a computer forensic analyst who, with specialized equipment and training, creates an identical copy of a computer hard drive, cell phone, Blackberry, or other device.1 This analysis can unearth documents, email, and text messages believed to be deleted, and in the Smith case, may recover whatever information Mr. Smith intended to remove permanently from the family computer. Again, sometimes the information that is withheld can be the most telling.

An additional service that may be appropriate for the Smiths is a real estate appraisal for the land and building in which Polytech operates. Such an appraisal is important to the marital net worth statement in two ways: first, Mr. Smith’s ownership in the real property holding company would be directly stated on the net worth statement; and second, and more subtle, a comprehensive appraisal commissioned to be utilized in conjunction with a business valuation will include a “market rental rate” that may give rise to an adjustment in the valuation of the company. For example, if Polytech is paying $300,000 in rent when only $100,000 would be reflective of a market rate, a valuation adjustment to decrease the expenses of Polytech by $200,000 may be appropriate.

If a real estate appraisal will be required, it is important to identify the need before the discovery cutoff deadline has passed so the appraiser can request any information required for his opinion. Furthermore, there are several advantages of selecting a real property appraiser with whom the business valuation expert has familiarity. For instance, not only will the valuation expert request a market rent analysis be prepared, but she can share with the appraiser the rent methodology (e.g., triple net, gross rent, etc.) that should be utilized to ensure the figure is consistent with the valuation. Other benefits of involving the valuation expert in the selection of a real estate appraiser are the sharing of relevant documents, a reduction in the number of discovery requests issued, and the coordination of deadlines so the appraisal is completed with enough time for the valuation expert to utilize the results in her analysis.

Marital Net Worth Statement – The three financial tasks in a typical divorce are to: 1) identify the couple’s assets and liabilities; 2) place a value on those assets and liabilities; and 3) equitably divide the net worth resulting from subtracting the liabilities from the assets. While discussions of the second and third goals are beyond the scope of this article, the first goal is a natural extension of the expert’s work and involvement in the discovery process. As part of her valuation assignment, an expert may already be reviewing individual income tax returns, bank, investment, retirement, and credit account statements, as well as other real and personal property lists and appraisals. This leads to intimate knowledge of the financial documents and facts of a case, and places the expert in a unique position to assemble a “master list” representing the marital net worth statement without a significant additional commitment of time and other resources.

It should also be noted that in addition to identifying the couple’s current assets, in cases where one or both of the parties held material assets or liabilities before the marriage, an expert can assist in compiling, and even valuing, a list of possible separate or pre-marital property.

Conclusion

There are a myriad of ways in which a financial expert can be a valuable addition to a client’s professional team above and beyond simply providing a business valuation. Engaging an expert to be involved “early and often” during the discovery process helps to proactively address the challenges of having too much or too little information, and ensures that discovery deadlines do not expire without the “cook” of the analysis ever having had a chance to create her shopping list. Furthermore, a multi-disciplined expert who can focus on financial discovery will allow the attorney to dedicate more time to the legal issues involved in the case, and will be engaged early enough to suggest other services that may provide significant benefits to the client.

1 Please research local statutes and case law before initiating a computer forensic acquisition.