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Valuation and the Freeze-Out of a Minority Member in a Limited Liability CompanyBy: Alan L. Frank, Esq., CPA and Samantha Millrood, Esq.

This article discusses the valuation of a minor-ity interest in a limited liability company in the context of a member “freeze-out.” Pennsylva-

nia case law and statutory structure is referenced be-cause it illustrates the national trend, and particularly because recent Pennsylvania jurisprudence has bor-rowed heavily from case law in other jurisdictions.

While there is significant reported authority in Pennsylvania addressing the valuation of a minority interest in the context of a minority freeze-out of a partner in a partnership, or a minority shareholder in a closely held corporation, the same cannot be said for limited liability companies. Recently, however, various courts in Pennsylvania and throughout the country have addressed the issue.

What is a Limited Liability Company

A limited liability company (“LLC”) is a hybrid between a partnership and a corporation. It may be thought of as a limited partnership without a general partner

or, if the LLC will be manager-managed, it may be thought of as a limited partnership with one or more persons (managers) who have authority similar to general partners but limited liability that is similar to the officers and directors of a corporation. LLCs provide the liability protection of a corporation with some tax and other advantages of a partnership.

The Law Applicable to Limited Liability Companies in Pennsylvania

In Pennsylvania, the formation, management and operations of limited liability companies are governed by Pennsylvania statute 15 Pa.C.S. §§ 8901 et seq, titled “The Limited Liability Company Law of 1994” (“Pennsylvania’s LLC Act”). The requirements for registration, purposes, names, liabilities, powers, and duties are all covered by various sections of Pennsylvania’s LLC Act. However, there are almost no restrictions in the Act on how the members of a limited

I Solemnly Swear

Early in my career during a deposition I was asked by opposing counsel: “Are your damages cal-culated to a reasonable degree of accounting

certainty?” Although I do not remember now how I answered, I do know, as an accountant and degreed professional in finance that my first instinct was to consider whether the question could be answered in a numerical sense and following that, “yes, or no.”

I have been consistently asked this question in all subsequent depositions in alternative forms such as “are your damages within a reasonable degree of economic certainty?” or “are your damage calculations

The Reasonable Certainty Rule of Damage Recovery – Who Needs to Be Certain?By Shari Lutz, CPA/ABV/CFF, ASA with assistance from Jay Jester, Esq.

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liability company may conduct their affairs. Instead, the statute provides that the operation of a limited liability company is controlled by its certificate of organization1 and the operating agreement among the members.2

1. Under Pennsylvania’s LLC Act, an operating agreement is defined as “[a]ny rules or procedures adopted for the regulation and governance of the affairs of a limited liability company and the conduct of its business.”3 The statute specifically provides that an LLC operating agreement may be written or oral,4 and may contain any provision for the regulation of the limited liability company’s internal affairs agreed to by the members, whether or not authorized by or in contravention of Pennsylvania’s LLC Act, except where the LLC Act: (1) refers only to a rule as set forth in the certificate of organization, or (2) expressly provides that the operating agreement shall not relax or contravene any provision on a specified subject.5

The owners of a limited liability company are known as “members,”6 and are defined under Pennsylvania’s LLC Act as “[a] person who has been admitted to membership in a limited liability company and who has not dissociated from the company.”7 Members of an LLC may manage the company or delegate their authority to “managers”. A membership interest in a limited liability company is personal property,8 and a member has no interest in specific property of the company.9

Duties Owed By LLC Members

Members of a limited liability company are not generally liable, solely by reason of being a member or manager, for the debts, obligations, or liabilities of the company. Nor are they personally liable for the acts of any other member, manager, agent, or employee of the company10. However, members have been held to owe each other certain fiduciary duties.

Pennsylvania cases, as well as cases in other jurisdictions, have specifically held that members of limited liability companies owe each other fiduciary duties and that members of LLCs can maintain fiduciary duty claims against one another. One Pennsylvania case example is Harbor Hospital Services, Inc., v. Gem Laundry Services, L.L.C., 2001 Phila. Ct. Com. Pl. LEXIS 38 (Phila.) Ct. Com. PL. July 18, 2001)(J. Sheppard). In an even more recent case, Ballarini v. Ergency Associates, LLC, Court of Common Pleas, York County, 2010-SU-2446-Y07, Judge Linebaugh of the York County Court of Common Pleas ruled that the

1 See, 15 Pa. C.S.§ 8913. 2 See, 15 Pa.C.S.A. § 8903 (definition of operating agreement). 3 15 Pa. C.S.§ 8903.4 15 Pa. C.S. § 8903. 5 15 Pa. C.S. § 8520(b).6 See,15 Pa. C.S.§ 8903.7 15 Pa. C.S. § 8903.8 15 Pa. C.S. § 8924(a)9 15 Pa. C.S. § 8923(a)10 15 Pa.C.S. § 8922(a)

members of an LLC (which operated an emergency medicine urgent care center) owed a fiduciary duty to one another. In so holding and ruling that one member could pursue his claim of breach of fiduciary duty against the other members of the LLC, Judge Linebaugh stated:

We need only look to Section 8904 of the Limited Liability Corporation Law. While there is case law that we believe is on point, we don’t need to proceed any farther than the language of the Act itself.

Under that Section, (a)(1), if the certificate of the organization does not contain a statement to the effect that the limited liability company shall be managed by managers, the members will be deemed to be general partners for the purpose of this section.

In this case the LLC operating agreement for the ... LLC provides that the members shall have the right to manage the business organization. The by-laws provide the same.

It is true that the operating agreement does permit the appointment of a person to act on behalf of the organization, but the operating agreement does not state that there be a managing partner, but rather that the owners are managers and shall manage the company.

Therefore, since there is no provision for a manager, this issue is decided by general partnership law and by Section 8943 of the Limited Liability Corporation Law that provides that when a limited liability company is not to be managed by a manager, then every member will account to the company for any benefit derived from the company, and has an obligation to the other partners and the other owners of the company.

The partners or manager in this case owe a fiduciary duty to one another, and they are expected to pursue a common goal, not work at cross purposes...

The operating agreement states that members shall have the right to manage the organization, that the members may delegate that management authority to another person, but that is not a specific provision that mandates a person in the management role of the company.

Therefore, the allegations in the Complaint by the Plaintiff are sufficient to establish that there is a fiduciary duty that is owed by each of the managers or owners to the other.11

In addition to the cases cited above, Section 8904(a)(1) of Pennsylvania’s LLC Act states that if the certificate of organization does not contain a statement to the effect that the limited liability company will be managed by managers, the members will be

11 Ballarini v. Ergency Associates, LLC, Court of Common Pleas, York County, 2010-SU-2446-Y07., see, September 28, 2010 Order therein.

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deemed to be general partners. Where there is no provision for a manager in the Operating Agreement, the fiduciary duties of the members shall be decided by general partnership law and by section 8943 of Pennsylvania’s LLC Act which provides that when a limited liability company is not to be managed by a manager, then every member will account to the company for any benefit derived from the company, and has an obligation to the other partners and the other owners of the company.12

Several Pennsylvania cases describe the fiduciary duties of majority shareholders to minority shareholders in a closely held corporation, which can be offered as persuasive authority in the context of a minority member freeze-out in an LLC. Pennsylvania law clearly holds that an attempt by a group of majority shareholders to “freeze out” minority shareholders for the purpose of continuing the enterprise for the benefit of the majority shareholders constitutes a breach of the majority shareholders’ fiduciary duty to the minority shareholders.13 An attempt by a majority shareholder to “freeze-out” or “squeeze-out” a minority shareholder constitutes a breach of this fiduciary duty. A “freeze-out” occurs in a closely-held corporation when a minority shareholder is removed from office or his power or compensation is substantially diminished, in an attempt to exclude the shareholder from any meaningful role in the corporation or deny him benefits from the corporation.14

Tactics employed against a minority shareholder to effect such a “freeze-out” include, but are not limited to: “generally oppressive

12 15 Pa.C.S. § 894313 See, e.g., Viener v. Jacobs, 2003 Pa. Super. 324, 834 A.2d 546, 556 (Pa. Super. Ct. 2003);

Weisbecker v. Hosiery Patents, Inc., 356 Pa. 244, 258, 51 A.2d 811, 817 (1947)14 Viener, 834 A.2d at 556 (citing 15 Pa. Cons. Stat. § 1767 comment)

conduct, the withholding of dividends, restricting or precluding employment in the corporation, paying excessive salaries to majority stockholders, withholding information relating to the operation of the corporation, appropriation of corporate assets, denying dissenting shareholders appraisal rights, failure to hold meetings and excluding the minority from a meaningful role in the corporate decision-making.”15 These same tactics would trigger a freeze-out of a member of an LLC.

Valuing a Membership Interest Where an LLC Member Has Been Frozen-Out

Under Pennsylvania’s LLC Act, a “member” of a limited liability company is defined as “[a] person who has been admitted to membership in a limited liability company and who has not dissociated from the company.”16 “Event of dissociation” is also a specifically defined term under the Act17; “Event of Dissociation” is defined as “[a]n event that causes a person to cease to be a member of a limited liability company.”18 Pennsylvania’s LLC Act further allows

15 Orchard v. Covelli, 590 F. Supp. 1548, 1557 (W.D. Pa. 1984), aff’d, 802 F.2d 448 (3d Cir. 1986 ). 16 15 Pa. C.S. § 8903.17 15 Pa. C.S. § 8903.18 Following the specific definition above, the statute states “See section 8971(a)(4) (relating

to dissolution).” Section 8971 specifically and only addresses dissolution, which, in the context of a member freeze-out of an ongoing LLC, is arguably inapplicable. Section (a)(4) of 8971 provides: a limited liability company is dissolved and its affairs shall be wound up upon the happening of the first to occur of the following events: [e]xcept as otherwise provided in writing in the operating agreement, upon a member becoming a bankrupt or executing an assignment for the benefit of creditors or the death, retirement, insanity, resignation, expulsion or dissolution of a member or the occurrence of any other event that terminates the continued membership of a member in the company unless the business of the company is continued by the vote or consent of a majority in interest, or such greater number as shall be provided in writing in the operating agreement, of the remaining members given within 180 days following such event.

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for distribution upon an “Event of Dissociation.”19 Specifically, Section 8933 of the Act provides:

Upon the occurrence of an event of dissociation which does not result in the dissolution of the limited liability company, a dissociating member is entitled to

receive any distribution to which the member is entitled under the operating agreement on the terms provided in the operating agreement and, within a reasonable time after dissociation, the fair value of the interest of the member in the company as of the date of dissociation based upon the right of the member to share in distributions from the company.20 (Emphasis added)

Many Pennsylvania Courts have addressed the issue of what “fair value” means in the context of appraising a minority interest in a closely held corporation, or a partnership, and those cases provide guidance for those practitioners valuing a member’s interest in an LLC. In the case of In re Glosser Bros., Inc., 382 Pa. Super. 177 ( Pa. Super. 1989), the Pennsylvania Superior Court explained that the leading Pennsylvania case defining the methodology for valuing stock is the second O’Connor Appeal21, decided by the Supreme Court in 1973. There, the Pennsylvania Supreme Court instructed that fair value is to be construed as going concern value, as contrasted with liquidation value.22 The court noted that there is a potentially endless list of factors, including: asset value, market value, market prices of comparable companies, market price and earnings ratio, management and its policies, earnings, dividends, valuation of assets, reserves for various contingencies, tax liabilities, future earnings, and predictions of future business events, that are considered relevant to this value.23

The Pennsylvania Superior Court in In re Glosser Bros., Inc. explained that the “going concern” concept of fair value and the many individual factors comprising it were aptly described by the Delaware Supreme Court in Tri-Continental Corp. v. Battye, Del., 74 A.2d 71, 76 (1950). The Battye Court stated:

The basic concept of value under the appraisal is that the stock-holder is entitled to be paid for that which has been taken from him, viz., his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate en-terprise is meant the true or intrinsic value of his stock which has been taken by the merger. In determining what figure represents this true or intrinsic value, the appraiser and the courts must take into consideration all factors and elements which might reason-ably enter into the fixing of value. Thus, market value, asset value, dividends, earning prospects, the nature of the enterprise and any other facts which were known or which could be ascertained as of the date of the merger and which throw any light on future prospects of the merged corporation are not only pertinent to any inquiry as to the value of the dissenting stockholders’ interest, but must be considered by the agency fixing the value.24

The Pennsylvania Supreme Court in O’Connor noted that courts had properly distilled all of these factors into three principal valuation methods, i.e. (1) net asset value; (2) market value; and (3) investment value. The court defined these valuation methods as follows:

Net Asset Value is the share which the stock represents in the value of the net assets of the corporation. Such assets

19 15 Pa. C.S. § 8933.20 15 Pa. C.S. § 8933 (emphasis added) .21 O’Connor Appeal, 452 Pa. 287, 304 A.2d 694 (1973).22 Id.23 Id.24 Tri-Continental Corp. v. Battye, Del., 74 A.2d at 72.

include every kind of property and value, whether realty or personalty, tangible and intangible, including good will and the corporation’s value as a going concern.

Market Value refers to the price at which the stock was selling on the market prior to the action which is objected to, disregarding any change in price due to the action.25

Investment Value is an estimate of present worth in light of past, present and prospective financial records of the company and is obtained by capitalizing earnings. There are two basic steps in the capitalization process: calculation of a representative annual earnings figure, and choice of a capitalization ratio which reflects the stability and predictability of earnings of the particular corporation.

However, the Pennsylvania Superior Court in In re Glosser Bros., Inc. specifically stated “we do not read the O’Connor opinion as limiting a trial court to a consideration of only these three valuation methods26 The Superior Court in In re Glosser Bros., Inc. further stated:

Financial analysis has become increasingly complex with the passage of time. New methods of valuing investments have been developed and are generally accepted in the financial community as being reliable. In recognition of this fact, other jurisdictions that previously restricted a trial court to the foregoing three valuation methods have now expanded the types of valuation information that may be considered in a stock valuation proceeding. For example, in Weinberger v. UOP, Inc., 457 A.2d 701 (Del.1983), the Supreme Court of Delaware, known for its expertise in these matters, directed that Delaware courts would no longer be bound to use only the traditional “Delaware block” or weighted average approach to valuation. By this method, which is still generally in use in Pennsylvania and which was applied by the trial court in the instant case, the court considers only the three traditional methods of valuation, assigns each a percentage weight and adds the resulting amounts to come to a total value.

The Weinberger court found this approach too restrictive and directed that courts henceforth use a “more liberal approach [which] must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court . . .” Id. at 712-13.Although we do not question the reliability of the three traditional methods of valuation, we do recognize that they are not the exclusive methods to be used in determining going concern value. We approve of the Weinberger approach to valuation. Such a broader attitude not only comports with the O’Connor court’s recognition that all factors relevant to value should be considered, but will also serve to assist trial courts greatly in their difficult valuation task by allowing them to consider a broader and perhaps more sophisticated range of information.27

In In re Jones & Laughlin Steel Corp.,328 Pa.Super. 442, 477 A.2d 527 (1984), the Pennsylvania Superior Court also noted that O’Connor does not require a trial court to assign weight to each of the three valuation methods, but rather to consider whether each is relevant in the context of the particular case. In Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983), cited by Pennsylvania’s Superior Court in In re Glosser Bros., Inc., the Delaware Supreme Court stated “[t]hus, market value, asset value, dividends, earning prospects, the nature of the

25 O’Connor, 452 Pa. at 292-93 n. 7, 304 A.2d at 698 n. 7.26 In re Glosser Bros., Inc., 382 Pa. Super. 177, 133 (citing O’Connor, 452 Pa. at 291-92, 304 A.2d at

697-98).27 In re Glosser Bros., Inc., 382 Pa. Super at 133-134.


enterprise and any other facts which were known or which could be ascertained as of the date of merger and which throw any light on future prospects of the merged corporation are not only pertinent to an inquiry as to the value of the dissenting stockholders’ interest, but must be considered by the agency fixing the value.”28

In fact, courts throughout the United States have held that elements of future value may be a factor in assessing fair value to the extent they are known or susceptible of proof and not the product of speculation.29 Courts often rely on pro forma projections and possible expansion plans in determining fair value where an entity, either a corporation, LLC or partnership, has not been in business for a significant amount of time. For example, in the case of Del. Open MRI Radiology Assocs., P.A. v. Kessler, 898 A.2d 290 (Del. Ch. 2006), the Delaware Chancery Court held that it gives great weight to pro forma projections “because they usually reflect the best judgment of management, unbiased by litigation incentives.” Courts have held that this is especially so when management provides estimates or projections to a financing source, and is expected by that source to provide a reasonable best estimate of future results.30 The Court further held that the value of expansion plans, whether they have yet materialized or not, must be taken into account in valuing an entity as a going concern, under the teaching of the Delaware Supreme Court in Cede & Co. v. Technicolor, Inc., 684 A.2d 289, 300 (Del. 1996).

In Cede & Co., Inc. v. Medpoint Healthcare, Inc. 2004 Del. Ch. LEXIS 124 (Del. Ch. August 16, 2004), the Delaware Chancery Court held that it had a preference for the use of management forecasts because management is typically deemed most knowledgeable about the Company’s prospects, and thus, adopted the management forecasted values and used an 8-year pro forma period to calculate the fair value of approximately 2.3 million shares of stock of Carter-Wallace, Inc. In Lawson Mardon Wheaton, Inc. v. Smith, 160 N.J. 383, 734 A.2d 738 (N.J. 1999) the Supreme Court of New Jersey held that post-merger information is relevant to a fair value and the trial court should have considered information available in 1996 to gauge, assess, and determine the fair value of the dissenters’ stock on December 5, 1991, the valuation date. In Onti, Inc. v. Integra Bank, 751 A.2d 904, 911 (Del. Ch. 1999), the Delaware Chancery Court stated, “I would suggest to you that a valuation of that company as of the date of the merger that doesn’t take into consideration the nonspeculative possibilities of developing this cornfield into something other than a cornfield is not a realistic valuation of the company. The minority shareholders, under those circumstances, are entitled to a valuation that reflects the value of a company that owns a cornfield that can be developed into a major office center.”; and in Allenson v. Midway Airlines Corp., 789 A.2d 572, 585 (Del. Ch. 2001) the same court stated that even value added by an acquiror’s business plan can become cognizable in an appraisal proceeding if it is actually being implemented.

What each of the foregoing cases teach is that in determining fair value of a dissociating member’s interest in an LLC, consideration must be given to all factors and elements which reasonably might enter into fixing of value, including those which may occur in the future. In any event, the trier of fact, whether it be the jury or a judge, has considerable freedom to select the method or methods of valuation appropriate in the particular case.31

28 Weinberger v. UOP, Inc., 457 A.2d at 713 (Del. 1983).29 See, e.g., Id.30 Del. Open MRI Radiology Assocs., P.A. v. Kessler, 898 A.2d 290 (Del. Ch. 2006) (citing 18 U.S.C.A.

§1344 (2006) which states that it is a felony to knowingly obtain funds from a financial institution by false or fraudulent pretenses or representation).

31 See, e.g., In re Jones & Laughlin Steel Corp., 328 Pa. Super. 442, 457-58, 477 A.2d 527, 534-35 (1984); In re Spang Indus., 369 Pa. Super. 133, 535 A.2d 86, 89 (1987).

Minority Interest and Lack of Marketability Discounts

The prevailing law in Pennsylvania and the majority of jurisdictions is to forego the application of either a minority interest discount and/or a lack of marketability discount when valuing a minority interest in a closely held corporation and/or LLC in the context of shareholder/member oppression litigation. All courts that have addressed similar issues have dismissed these discounts as inapplicable for two reasons: (1) courts have rejected the discounts because they presuppose a market for the interest at issue, but there is no market on which the interests are being traded and, in an LLC, the minority member’s interest is not being offered on the market in any event. Rather, the shares at issue are being valued and transferred in the context of a private dispute; and (2) application of any discounts would simply, and most inappropriately, result in an unfair windfall to the majority group despite their oppressive and illegal conduct.32

In Pueblo Bancorporation, v. Lindoe, Inc, 63 P.3d 353 (Colo. 2003) the Colorado Supreme Court outlined and considered the law across the country relating to the applicability of minority and marketability discounts in interpreting “fair value” under dissenters’ rights statutes, which contain similar language to Pennsylvania’s LLC Act’s dissociation provision. There, the Colorado Supreme Court stated that since the decision was rendered in Cavalier Oil Corporation v. Harnett, 564 A.2d 1137, 1989 Del. LEXIS 325 (S.Ct. Del. 1989), courts across the country have considered the issue of marketability/minority discounts and have generally followed Delaware’s lead in holding that discounts should not be used in determining the “fair value” of dissenters’ shares. It further specifically recognized this is the clear majority view, and that it has been adopted by most courts that have considered the issue, the authors of the Model Business Corporation Act, and the American Law Institute.33

The Committee’s Comments at Section 8933 of the Pennsylvania LLC Act, state that “the ‘fair value’ of the interest of the member is to be fixed generally with reference to the right of the member to share in distributions from the company. As such, it should not include discounts for lack of marketability or minority interests and thus is different from ‘fair market value’, which term has been specifically avoided.” (Emphasis added) The Committee Comments to Section 8933 of Pennsylvania’s LLC Act, which clearly provide that no marketability or minority discount applies, is further supported by persuasive Pennsylvania case law.

32 See, e.g., Committee Comments to 15 PA. C.S. 8933; In re Reading Broadcasting, Inc., 2008 Bankr LEXIS 2438 (July 8, 2008); Denike v. Cupo, 394 N.J. Super. 357, 926 A.2d 869 (N.J. Super. 2007); See also, Propriety of Applying Minority Discount to Value of Shares Purchased by Corporation or its Shareholders from Minority Shareholders, Christopher Vaeth, J.D., 13 A.L.R.5th 804; The Sharehold-ers’ Appraisal Remedy and How Courts Determine Fair Value, Barry M. Wertheimer, 47 Duke L.J. 613 (1998); See also, Cavalier Oil Corporation v. Harnett, 564 A.2d 1137, 1989 Del. LEXIS 325 (S.Ct. Del. 1989); In re Valuation of Common Stock of McLoon Oil Co, et al., 565 A.2d 997, 1989 Me. LEXIS 305.

33 (Citing Offenbecher v. Baron Serv., Inc., 2002 Ala. Civ. App. LEXIS 365, No. CV-98-1538, 2002 WL 959833 (Ala. Civ. App. May 10, 2002); Devivo v. Devivo, 2001 Conn. Super. LEXIS 1285, No. CV980581020, 2001 WL 577072 (Conn. Super. Ct. May 8, 2001) (interpreting “fair value” stan-dard of statute authorizing a buy-out of minority shareholder who has petitioned the court for dissolution of the corporation); Blitch v. Peoples Bank, 246 Ga. App. 453, 540 S.E.2d 667 (Ga. Ct. App. 2000); In re Valuation of Common Stock of McLoon Oil Co., 565 A.2d 997 (Me. 1989); Ad-vanced Communication Design, Inc. v. Follett, 615 N.W.2d 285 (Minn. 2000) (interpreting the “fair value” standard of statute authorizing a buy-out of a minority shareholder who has petitioned for corporate dissolution); Swope v. Siegel-Robert, Inc., 243 F.3d 486 (8th Cir. 2001) (interpreting Missouri law); Rigel Corp. v. Cutchall, 245 Neb. 118, 511 N.W.2d 519 (Neb. 1994); Lawson Mardon Wheaton, Inc. v. Smith, 160 N.J. 383, 734 A.2d 738 (N.J. 1999); Woolf v. Universal Fid. Life Ins. Co., 1992 OK CIV APP 129, 849 P.2d 1093 (Okla. Ct. App. 1992) (expressing approval of the Delaware position of prohibiting all discounts at the shareholder level); Charland v. Country View Golf Club, Inc., 588 A.2d 609 (R.I. 1991) (interpreting the “fair value” standard of statute authorizing a buy-out of a minority shareholder who has petitioned for corporate dissolution); Morrow v. Martschink, 922 F. Supp. 1093 (D.S.C. 1995) (same); First Western Bank Wall v. Olsen, 2001 SD 16, 621 N.W.2d 611 (S.D. 2001); Hogle v. Zinetics Medical, Inc., 2002 UT 121, 63 P.3d 80; No. 20000470, 2002 WL 31780185 (Utah Dec. 13, 2002); U.S. Inspect Inc. v. McGreevy, 57 Va. Cir. 511, No 160966, 2000 WL 33232337 (Va. Cir. Ct. Nov. 27, 2000); Matthew G. Norton Co. v. Smyth, 112 Wn. App. 865, 51 P.3d 159 (Wash. Ct. App. 2002).


In re Reading Broadcasting, Inc., 2008 Bankr LEXIS 2438 (July 8, 2008) the United States Bankruptcy Court for the Eastern District of Pennsylvania, applying Pennsylvania law, determined that a minority discount was not applicable when valuing stock options of a creditor’s claim against the Debtor. In that case, there was no evidence that the company’s shares were publicly traded. Likewise, there was no public market for the stock options. Accordingly, the Court rejected the trustee’s expert’s position that the shares of a closely held corporation should be discounted by thirty percent (30%) as the result of the limited rights resulting from minority ownership. The court explained that Pennsylvania cases do not apply minority and marketability discounts in the context where no actual shares are being transferred and the sale of the entire business is unlikely.34The Court ultimately employed the services of its own expert who explained that “the purpose of the valuation was to determine the worth of the business to [the surviving member], not to an open market.”35 Therefore, the Court’s appointed expert did not apply any minority or marketability discount to the value of the interest at issue. The valuation was upheld on appeal.

In Denike v. Cupo, 394 N.J. Super. 357, 926 A.2d 869 (N.J. Super. 2007), the New Jersey Superior Court unequivocally rejected application of a m i n o r i t y / m a r k e t a b i l i t y discount when assessing the fair value of a dissociated member’s interest in an LLC. In Denike, the defendant was a disassociated limited liability company member who had maintained a fifty percent (50%) interest in Classic Mortgage, LLC. The plaintiff therein sought to buy out the defendant’s interest. The plaintiff’s expert witness applied a marketability and minority discount to value the defendant’s membership interest while the defendant’s expert did not apply any discounts. The Court rejected the valuation methods employed by both the plaintiff’s and the defendant’s experts, and specifically the application by plaintiff’s expert of a minority and marketability discount, stating “whatever value the business may have to a willing outside purchaser is probably less than the value of the business to the surviving member who obtains complete control of the entity through the purchase.”36

34 In re Reading Broadcasting, Inc., 2008 Bankr LEXIS 2438 (July 8, 2008) at fn 12 ( citing Colmen Capital Advisors, Inc. v. Polar Plastics, Inc., 2005 U.S. DIST. LEXIS 15178 AT *5 (E.D. Pa. 2005)).

35 Id.36 Denike v. Cupo, 394 N.J. Super. 357, 926 A.2d at 876.

Based on the Committee’s Comments to 15 PA.C.S. §8933, and the foregoing cases, it is the clear majority view and the law in Pennsylvania that no minority or marketability discount should apply in assessing the fair value of a dissociating member’s interest in a Pennsylvania LLC.

The Date of Actual Dissociation is Critical

In calculating fair value, the objective is to provide the oppressed or frozen-out member with his or her proportionate share of the LLC. According to Pennsylvania’s LLC Act, the frozen-out member is entitled to receive and be paid the “fair value” of his or her interest in the LLC as of the date of dissociation. The fair value of a member’s

interest can vary greatly depending on the date of dissociation.

Pennsylvania’s LLC Act defines “Event of dissociation” as “[a]n event that causes a person to cease to be a member of a limited liability company.”37Pennsylvania’s LLC Act further provides for distribution upon an “Event of Dissociation” as follows:

Upon the occurrence of an event of dissociation which does not result in the dis-solution of the limited liabil-ity company, a dissociating member is entitled to receive any distribution to which the member is entitled under the operating agreement on the terms provided in the oper-ating agreement and, within a reasonable time after dis-sociation, the fair value of the interest of the member in the company as of the date of dissociation based upon the right of the member to share in distributions from the com-pany.38

In the context of a member-freeze out, the member is in most instances either terminated as an employee, removed from office, or his

power or compensation is substantially diminished, in an attempt to exclude the member from any meaningful role in the LLC. Those wishing to diminish the fair value of a minority member’s interest

37 15 Pa. C.S. §8903. Following the specific definition quoted above, the statute states “See section 8971(a)(4) (relating to dissolution).” Section 8971 specifically and only addresses dissolution, which in the context of a member freezeout of an ongoing LLC, is arguably inapplicable. Section (a)(4) of 8971 provides: a limited liability company is dissolved and its affairs shall be wound up upon the happening of the first to occur of the following events: [e]xcept as otherwise provided in writing in the operating agreement, upon a member becoming a bankrupt or executing an assignment for the benefit of creditors or the death, retirement, insanity, resignation, expulsion or dissolution of a member or the occurrence of any other event that terminates the continued membership of a member in the company unless the business of the company is continued by the vote or consent of a majority in interest, or such greater number as shall be provided in writing in the operating agreement, of the remaining members given within 180 days following such event.

38 15 Pa. C.S. §8933


in an LLC, have argued de facto dissociation where a member’s employment with the LLC has been terminated, where he or she has ceased participating in the LLC’s operations, or alternatively, when the frozen-out minority member institutes suit to obtain the fair value of his interest. However, Pennsylvania courts, as well as Courts in other jurisdiction, have clearly and unequivocally held that termination of a member’s employment and/or institution of suit does not constitute dissociation as a member of an LLC.

Specifically, in the case of Ballarini v. Ergency Associates, LLC, Court of Common Pleas, York County, 2010-SU-2446-Y07, Judge Thompson, rendering a decision and verdict for the Court stated “in short, a termination of an at-will employee does not terminate ownership interest in [an] LLC.” And further stated “one final comment regarding the date of valuation. As stated previously, termination of employment is not termination of membership in [an] LLC.”39

There are also Pennsylvania federal courts, as well as courts in other jurisdictions, which have rendered holdings supportive of the Ballarini decision. See, by way of example, the case of Bair v. Purcell, 2008 U.S. Dist. LEXIS 6518 (M.D. Pa. January 29, 2008)40 in which the United States District Court for the Middle District of Pennsylvania, in the context of a motion to exclude at trial expert testimony of the value of a shareholder interest, addressed the specific issue of the date on which a shareholder’s interest should be valued in a minority shareholder’s squeeze out action.

Also in the recent case of Simko v. Simko, 2010 Conn. Super. LEXIS 640 (Conn. Super. March 11, 2010), the Connecticut Superior Court addressed a similar issue. There, the plaintiff was seeking to dissolve a law firm under Connecticut’s LLC Act, General Statutes § 34-207. The defendants in Simko moved to dismiss on the ground that the plaintiff failed to meet the statutory requirements for standing because he allegedly “effectively” dissociated himself from the LLC on December 31, 2007 by the voluntary act of forming a new limited liability corporation with another attorney. By voluntarily dissociating himself from the LLC, the defendants argued that the plaintiff was “no longer a member” when he filed his complaint on January 31, 2008, and therefore lacked standing to seek judicial dissolution of the LLC under § 34-207 and the winding up of the firm under § 34-208(a). Id. In response, the plaintiff argued that he had standing because he had not dissociated himself from the LLC when he filed suit, because the defendants admitted on the record that the plaintiff continued to be a “member” of the LLC. While the Superior Court of Connecticut acknowledged that the defendants offered evidence purportedly demonstrating the plaintiff’s dissociative acts, it held that because the LLC had no formal operating agreement, the text of § 34-180 provided the controlling language for dissociation and required 30 days written notice. Because no written notice of dissociation from the plaintiff appeared on the court record, the Court held that the defendants did not establish that the plaintiff had dissociated himself from LLC, or that he lacked standing.41

Even before the Simko case, the Connecticut Superior Court had addressed this issue in Radding v. Freedom Choice Mortgage, LLC,

39 Ballarini v. Ergency Associates, LLC, Court of Common Pleas, York County, 2010-SU-2446-Y07, Judge Thompson (Decision and Verdict of December 16, 2011).

40 Following entry of the foregoing January 29, 2008 opinion, the case, was ultimately decided by Bair v. Purcell, 2009 U.S. Dist. LEXIS 6518 (M.D. Pa. March 17, 2009), wherein the Honorable Yvette Kane, Chief Judge, rendered a verdict in favor of the plaintiff on his breach of fiduciary duty/shareholder oppression claim and breach of a stock buy-out agreement. The Court awarded the plaintiffs significant actual, compensatory, and punitive damages, as well as prejudgment interest. The court also directed the defendants to respond to plaintiff’s motion for an award of fees in connection with his breach of fiduciary duty claim under the Court’s equitable powers and the bad faith exception to the American Rule.

41 Simko v. Simko, 2010 Conn. Super. LEXIS 640 (Conn. Super. March 11, 2010)

Superior Court, judicial district of Hartford, Docket No. CV 970571812, 2001 Conn. Super. LEXIS 1512 (May 29, 2001, Hennessey, J.), aff’d, 76 Conn.App. 366, 820 A.2d 317 (2003). There, the Connecticut Superior Court found, and was upheld on appeal, that an LLC member, who was also an employee, retained his LLC membership after his employment was terminated because he was not given written notice pursuant to the § 34-180 dissociation requirements.

The United States District Court for the Eastern District of Michigan addressed a similar issue in Rehab Mgmt. Solutions v. Diversa Care Therapeutics, 2011 U.S. Dist. LEXIS 104156 (E.D. Mich. September 14, 2011). Rehab Management Solutions, also involved a dispute between the co-owners of a Michigan limited liability company. Within a motion to dismiss based on res judicata and collateral estoppel, the defendant argued that “the plaintiff ceased to have any right as a member of the LLC at the time of the filing of the arbitration,” arguing that the filing of a lawsuit in October of 2007 divested the plaintiff of his membership interests. The court held that the exhibits attached to defendant’s motion to dismiss did not show the plaintiff’s interests in the LLC were terminated in October 2007. The court held that, although the operating agreement had provisions regarding the voluntary and involuntary transfer of a member’s interest in the company, nothing suggested that those provisions were triggered. It further held that nothing in the LLC’s operating agreement, which addressed dissociation, stated that a membership interest is terminated by commencing litigation.42

Thus, despite arguments of “effective” or “de-facto” dissociation, the prevailing case law in Pennsylvania and persuasive case law from other jurisdictions finds that even though a minority member has been terminated as an employee of an LLC, and/or has filed suit to obtain the fair value of his membership interest in an LLC, he or she is still a member of the LLC, and there has been no “event of dissociation.” As such, pursuant to Sections 8903 and 8933 of Pennsylvania’s LLC Act, a member’s interest in an LLC must be valued as of the date he actually ceases being a member of the LLC, and actually dissociates therefrom, not when he is frozen-out or terminated.

Each of the foregoing issues are critical to properly valuing a member’s interest in, the duties to, and the general assessment of a freeze-out of a minority member in a Pennsylvania limited liability company. Each should be considered by the attorney and expert hired in such a case.

Alan L. Frank, Esquire, CPA is admitted to practice law in PA, NJ and NY, and is a CPA in PA. Mr. Frank is AV rated by Martindale Hubbel. He has appeared in multiple Federal, State and arbitration venues throughout the country. Mr. Frank concentrates his practice in commercial litigation matters including disputes by and among owners of commercial enterprises. He is the managing attorney for a ten lawyer practice.

Samantha Millrood is admitted to practice law in PA and NJ. Ms. Millrood has appeared in multiple Federal, State and arbitration venues throughout the country. Ms. Millrood concentrates her practice in commercial litigation matters including disputes by and among owners of commercial enterprises.

42 Rehab Mgmt. Solutions v. Diversa Care Therapeutics, 2011 U.S. Dist. LEXIS 104156 (E.D. Mich. September 14, 2011).



Preparing Counsel for Deposition TestimonyBy James A. DiGabriele, PHD/DPS, CPA, ABV, CFF, CFE, CFSA, Cr. FA, CVA and Fabiana M. Mello, CPAIntroduction

The successful outcome of most litigated financial controver-sies is often dependent on the attorneys’ understanding of the information presented. Therefore, it is no surprise that we

have observed an increased demand for forensic accounting expert consulting services preparing counsel for depositions in financial litigation. Competent and diligent attorneys understand the direct correlation in comprehending the matter at hand from all different aspects, including the expert’s area of expertise, and their ultimate success in the case outcome. The purpose of this article is to illus-trate the importance and significance of counsel comprehending the salient issues in financial litigation. We illustrate perils and pitfalls with a brief case study using actual deposition transcripts.

The Preparation Phase

The first step in preparing counsel for a deposition is to determine what type of deposition will be taking place. There are two types of depositions: a discovery deposition called by opposing counsel or a deposition called by retaining counsel to preserve the testimony of the expert. During a discovery deposition the opposing counsel will evaluate how well the expert testifies and nail down the expert’s testimony in order to minimize surprises at trial. A discovery deposition will also be called for key persons involved in the financial litigation. A deposition called by the retaining counsel to preserve the expert’s testimony closely resembles actual testimony at trial. The retaining counsel usually calls a deposition to maintain the expert’s testimony as an attempt to curb litigation costs or when the expert is unavailable for trial.

Whether you will be assisting counsel preparing for an opposing expert’s deposition or the deposition of a fact witness for example, it is extremely important to understand the differences between the two types of deposition. The most common type of deposition an expert will be involved in is a discovery deposition. Keep in mind that in this type of deposition, counsel will attempt to discover any relevant and pertinent information to the matter and/or the expert’s creditability. Counsel will usually go over the expert’s report and ask questions regarding his or her credentials, assumptions, opinions and methodology utilized (or lack thereof ). Therefore, counsel’s understanding of the report’s strength and weakness is vital to the successful resolution of the legal dispute. During a discovery deposition of a witness, the opposing counsel should ask questions that are relevant to the case and that will assist him or her in the preparation and trial of the case. Often times we read deposition transcripts where counsel failed to effectively take the witness’s testimony by superficially touching on core issues, ignoring them all together and/or failing to successfully counter the expert’s answers.

A Brief Case Study

ABC Company, Inc. (hereinafter ABC) is a contractor owned 100% by Bill Smith. In 20X1 ABC was hired as the contractor to develop a commercial building for Joe Moe. The development of the commercial building was delayed as a result of several issues including redesign and environmental concerns. In 20X1 ABC was notified by Joe Moe

to cease any further work on the development of the commercial building and to prepare a statement of costs and expenses incurred.

ABC submitted a report prepared by a forensic accounting expert for its alleged damages. Joe Moe was unsuccessful in all his attempts to settle this matter. In 20X3 ABC filed a complaint against Joe Moe seeking compensation for its alleged damages comprised of lost profit, overhead, damage for work performed, cost of delay and interest. Throughout the course of this litigation several individuals were deposed. We will review some of these deposition transcripts and comment accordingly.

Example 1: Automobile expense

Bill Smith claimed automobile expense for all three years. During his deposition the following questions were asked by counsel:

Q. Did you have a Honda Automobile?A. I did have a Honda automobile.

Q. And what year was that Honda?A. 19X9

Q. Did you have one in 20X2?A. I don’t believe so.

Q. Here is a 20X2 check made payable to Honda in the amount of $485.

A. I do not recall what that payment is for. I had a Toyota.

Counsel proceeded to a different topic without understanding what the Honda payment was for. More importantly, counsel should have obtained information on the vehicles included in ABC’s alleged damages. Some important questions include: What vehicles were included in ABC’s alleged damages? Were the vehicles usually leased or owned? Who owned the vehicles (ABC or Bill Smith)? Were the vehicles utilized both for business and personal purposes? If so, what was the average utilization for business purpose?

Often times we’ve noticed that counsel will lose their focus and move on to a different topic because the witness’ responded differently from what was “expected” or because counsel was unfamiliar with the subject and did not want to ask a “bad” question. This is a critical mistake and a significant reason why attorneys end up with unconvincing records in this important phase of litigation.

Example 2: Rent Expense

Bill Smith claimed rent expense for two different locations, 123 Market Street and 456 Main Street, for all three years. Bill Smith formed separate companies to handle each of his real estate properties. The following questions were asked about one of the locations:


Q. Are there any other companies that you had a personal interest in between the year 20X1 and the present time?

A. I think so. I think there were a couple of companies.

Q. What other companies? Can you provide me their names?A. I don’t remember, but I know there were more.

Q. What about 123 Market Street?A. That’s not a company.

Q. There was not a company formed to purchase the property at 123 Market Street?

A. No.

Q. Okay.

Counsel moved forward without understanding important facts about the rent expense claimed as alleged damages by Bill Smith. Some important facts to understand in order to analyze the reasonableness of the alleged rent expense allocated to this project include: Who owned 123 Market Street? What was the property utilized for? Were there any other tenants in the property? Is there a lease agreement for this property? What were the terms of the lease? If it was owned by a related party, how was the monthly rent per the lease agreement stipulated? Was the space rented by ABC utilized by any other company? If so, expand on what it was utilized for and what percentage of the property was actually utilized by ABC. The pervading question is how is this related to the damages?

Example 3: The Opposing Expert

During deposition preparation, both the retaining counsel and con-sulting forensic accountant should consider having a mock deposition to explore the opposing expert’s potential responses. This exercise will improve counsel’s ability to effectively depose the opposing expert witness on an unfamiliar subject (accounting, finance, economics, etc.) without losing focus.

During discovery ABC had three different reports prepared by three different experts. We were advised by retaining counsel that unreimbursed expenses ABC had incurred in connection with this litigation, (such as legal, accounting, consulting, or litigation expert fees} are not recoverable, including pre-litigation consulting. The opposing forensic accounting expert included in his report the consulting fees from one of the other experts as part of the damages for work completed. The following questions were asked during the opposing expert’s deposition:

Q. Did you include the fees charged by the litigation expert firm for preparing their report related to this litigation matter in the damages that you calculated?

A. The amount included was for consulting.

Q. And did you review the invoices of that litigation expert to determine what that was?

A. Yes. That invoice stipulated it was for consulting and accounting.

Q. But did it include the fees for their report in this litigation matter?

A. No. They had separate invoices for the report.

Q. And did you include those – you’re saying that’s not included in the damages that you calculated?

A. This fee is completely different. Their invoice does not describe that they did any work with regards to the report.

Q. But he could have—you’re saying that the invoice is not descriptive enough?

A. It is descriptive enough. I recall it says consulting and accounting and there were separate invoices that specified work for the report.

Counsel moved to a different topic after the opposing expert witness consistently insisted that the consulting fee included in his calculation was unrelated to this litigation. However, upon determining that the consulting fees were not related to this litigation matter, counsel should have focused on whether this was an expense incurred and/or paid in relation to this project. Expenses incurred and/or paid by ABC not related to this project should not be included as damages associated with this ligation either.

Conclusion

A discovery deposition is always difficult. Counsel’s main goals are to evaluate how well the expert or fact witness testifies, discover any information that is relevant to the matter, and assess the expert’s or fact witness’s credibility to minimize surprises at trial. Competent counsel will usually not ask a question at trial unless he already knows what the experts or witnesses answer will be. Consequently, during deposition counsel will ask all the questions he does not know the answers to with the purpose of preparing for settlement or trial. However, deposing counsel will attempt to inquire of all relevant facts without providing the expert or fact witness with a preview of what to expect at trial. Thus the discovery deposition is a challenging area where forensic consulting experts can assist counsel in achieving their goals.

In preparing counsel for a fact witness or opposing expert’s deposition, it is the consulting expert’s role to know the matter well and to educate counsel on the opposing expert’s opinion and to point out the factual basis, if any, used to form these opinions. During preparation the consulting expert should determine the goal of retaining counsel in taking the deposition. This will assist the consulting expert in developing a list of the opposing expert’s assumptions for counsel along with related questions. The more comprehensive and detailed the list of assumptions, the easier it will be for counsel to impeach the expert’s opinions.

References

Babitsky, Steven, and James Mangraviti. How to Become a Dangerous Expert Witness: Advanced Techniques and Strategies. Falmouth, MA: SEAK, 2005. Print.

Pagano, Walter J., and Thomas A. Buckhoff. Expert Witnessing in Forensic Accounting. Philadelphia, PA: R.T. Edwards, 2005. Print.

James A. DiGabriele, Ph.D/DPS, CPA, ABV, CFF, CFE, CFSA, Cr. FA, CVA, is a professor of accounting at Montclair State University and has been published in various journals, including Journal of Forensic Accounting, Journal of Business Valuation and Economic Loss Analysis, and The Value Examiner. Dr. DiGabriele is also Managing Director of DiGabriele, McNulty, Campanella & Co., LLC, an accounting firm specializing in forensic/investigative accounting and litigation support. He may be contacted at [email protected] or [email protected].

Fabiana M. Mello, CPA is a Senior Forensic Accountant at DiGabriele, McNulty, Campanella & Co., LLC, an accounting firm specialized in forensic/investigative accounting and litigation support. Fabiana is responsible for managing the day-to-day activities of the litigation department. She has been actively engaged in the practice of financial and economic analysis. She may be contacted at [email protected].


more probable than not?” Again, these questions assume that I, as the expert, somehow know the answer and that I am able to respond in the affirmative or, if I can’t, that somehow the damage calculations are flawed.

What these questions have in common is: 1) their reference to the reasonable certainty factor for calculating damages, and 2) the fact that the question, regardless of the expert’s credentials or education, cannot be answered by the expert with a simple “yes,” or “no.” In fact, it really isn’t the expert’s question to answer at all.

Lawyers and experts involved with preparing damage calculations know that the courts require that three factors typically must be established to prove damages:1

1. Proximate cause: i.e., damages must be caused by the wrongful act of the defendant;

2. Reasonable certainty: i.e., damages must be proved with reasonable certainty; and

3. Foreseeability: damages must be foreseeable as a result of the breach.

The extent to which the expert is involved in proving these three factors varies from case to case. For example, causation might be assumed by the expert. In such cases the expert has no part in providing any analysis or testimony regarding this issue and the damages are calculated assuming liability and causation. In my experience, the third factor, foreseeability, is generally not the province of financial/accounting experts.

In contrast, frequently the evidence and support for the reasonable certainty factor is based largely on the expert’s analysis in conjunction with the other witnesses and evidence in the matter at hand.

Unfortunately, there is no clear cut definition of this important concept. “Relatively few cases analyze what is meant by reasonable certainty.”2 However, case law has established some of the qualitative factors that describe components of reasonable certainty and what is necessary to establish whether reasonable certainty exists in a particular case.

First, reasonable certainty is not the same as precision. Courts recognize that damages are not and do not need to be calculated with precision. Rather, if the fact of damages is firmly established, then the calculation of damages can be a reasonable estimate. “The second requirement, that damages be reasonably certain, does not require absolute certainty. Damages resulting from the loss of future profits are often an approximation. The law does not require that they be determined with mathematical precision.” 3

On the other hand, the accuracy of the calculation is important. By accuracy I mean the extent to which the damages calculation is based on reasonable assumptions and verifiable data. For example, when experts, or for that matter, anyone ventures into the province of future lost profits, the calculations are inherently uncertain and not capable of being defined with precision. This is simply because the future is unknown. So the challenge is how to prepare an assessment of future losses that is credible and not entirely speculative.

1 Recovery of Damages For Lost Profits, 6th Edition, Robert L. Dunn2 Ibid3 Ashland Management Inc. v. Janien 82 N.Y.2d 395, 624 N.E.2d 1007, 604 N.Y.S.2d 912 (1993).

Consider the following questions about the damage estimate:

1. What data exists to support the estimate of future losses?

2. What is the track record of the damaged entity, if any?

3. Are projected revenues based on historical entity growth trends? Industry estimates? Other?

4. Have other factors that may account for diminution in profits been considered?

5. Is the methodology used to estimate the damages sound; recognizable, and/or methods commonly used?

6. Has the expert assessed the damage estimate and its risks from all possible angles? What risks exist? Have these been accounted for in a discount rate or range of projections?

The importance of the last factor, providing a range of damage estimates to the trier of fact, cannot be overstated. While it may seem that providing such a range weakens the estimate, in fact it is an explicit acknowledgement that damage calculations are not precise. If the expert has a circumstance in which upper and lower bounds of damages can be reasonably estimated, then the trier of fact has been provided with a range of answers to consider in light of all the other information presented.

It is not the expert who testifies as to whether reasonable certainty has been met, but the expert can certainly assist in proving this to be so. In this sense, more is more. All projections are based on a bundle of assumptions. The question becomes – how reasonable are the assump-tions? What information was available to the expert? What are the as-sumptions based on? History? Market Data? Comparable companies?

Experts know that the legal strength of cases varies greatly. Similarly, the information that exists to support future lost profits also varies greatly. Businesses may be so unique that very little relevant market data exists. Further, businesses may be start-ups or so new there is no track record. Such circumstances are more common than not. Some cases refer to the “best evidence obtainable under the circumstances,”4 which seems to consider these circumstances and the limited availability of information in some cases.

An expert’s calculation and presentation of damages is based on the facts and circumstances of each matter. While damage methodologies are fairly standard, no two cases are exactly alike. The entity incurring damages in one case may have a long history of results, which will assist the expert in predicting future losses. Another entity, however, may have a short history or even no history at all, as is the case with a start-up entity. Comparable market information may be available in one instance but not another. Therefore, the expert must work with the lawyer to understand both the legal and practical issues that are unique to each case as well as what types of data exist to help support damage estimates.

Ultimately, whether the reasonable certainty test has been met is decided by the trier of fact and such decision will be unique to each case. The trier of fact must first be persuaded that the plaintiff has, in fact, been damaged and that such damage was caused by the defendant; and second, that the damages have been quantified with a reasonable degree of certainty in the context of the case. The standard of reasonable certainty is vague at best, varies from case to case and is beyond specific definition. It is not up to the expert to opine that this standard has been met; it is met by the evidence and information provided and presented.

4 Tull v. Gundersons, Inc. 709 P.2d 940 (Colo. 1985)

I Solemnly Swear Continued from page 1...


Practice Tips

Applying the Net Worth Method—For Proving Unreported IncomeBy Mark S. Warshavsky and Andrew P. Ross

On October 24, 1931, The Rhinelander Daily News headline read “Capone Given 11 Years, $50,000 Fine.” Al Capone had just been found guilty of three felonies. Did this conviction

come as the result of his participation in the St. Valentine’s Day massacre? Was it the result of his penchant for bribery, prohibition infractions or illegal gambling? No to all! Al Capone was convicted of income tax fraud, the result of a three-year investigation headed by Frank J. Wilson of The Treasury Department of The Internal Revenue, a precursor to today’s Internal Revenue Service.

How were Mr. Wilson and his staff able to build a tax fraud case against Public Enemy Number One, Al Capone? The answer lies primarily with a financial forensic technique known as the “Net Worth Method.”

The Net Worth Method looks at the difference between a person’s net worth (total assets1 less total liabilities) on any two given dates. If the evidence collected can establish that a person’s net worth increased more than the receipts recorded by a person in the form of money or property, less expenses, then this excess would be additional taxable income to that person. If so, then these expenditures can be assumed to have come from funds received during the year, and would be taxable income to the person. Also considered is the spending for living expenses, taxes, etc., which did not add to the person’s net worth at the end of the year.

1 Assets are measured by their cost and not any unrealized increases in market value.

The Net Worth Method has been around for almost a century, and is often employed by government prosecutors in criminal tax cases. Initially, the technique was used when the target’s books and records were either incomplete or did not exist at all. However, this technique has been sustained even when there are complete books and records available.

The Net Worth Method has been endorsed by the U.S. Supreme Court2 and every circuit court. Its use is not limited to matters of tax fraud. Forensic accountants can also apply this technique to a wide array of cases, such as divorce litigations, shareholder/partnership disputes and fraud investigations. The Net Worth Method is considered an indirect method of proof that, if applied properly, presents compelling circumstantial evidence of a target’s concealment of unreported income. Simply put, the Net Worth Method compares the target’s beginning and ending net worth for a given time period, taking into account adjustments for known income and expenditures.

The Supreme Court has established three requirements that the government must meet before using the Net Worth Method.3 The forensic accountant should satisfy these requirements before putting forth the Net Worth Method in a litigation context. These requirements are:

1. Establishing a definite opening net worth.

2. Consider plausible explanations by the defendant inconsistent with guilt.

3. Establish that net worth increases are attributable to unreported taxable income.

2 See Holland v. United States, 348 U.S. 121 (1954); Friedberg v. United States, 348 U.S. 142 (1954); United States v. Calderon, 348 U.S. 160 (1954); Massei v. United States, 355 U.S. 595 (1958); Smith v. United States, 348 U.S. 147 (1954).

3 See Holland v. United States, 348 U.S. 121 (1954).


Each of the three requirements listed above are arrived at using evidence obtained by the forensic accountant, including financial records, depositions, etc. Then the forensic accountant must compute the target’s actual ending net worth, again, using all of the resources available at that time. Any excess of the target’s actual net worth over the calculated ending net worth would represent funds from unknown sources.

The Net Worth Method can be demonstrated in the following example, using amounts obtained through discovery and the forensic accountant’s diligent investigation:

Beginning Net Worth

Cash in Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000Marketable Securities, at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000Residence, at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000Mortgage on Residence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .(190,000)Beginning Net Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Ending Net Worth

Cash in Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000Marketable Securities, at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000Residence, at cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000Mortgage on Residence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .(180,000)Ending Net Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000

Income from Known Sources

Salary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000Gift from Mother . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000Total Income from Known Sources . . . . . . . . . . . . . . . . . . . . 130,000

Living Expenses and Other Expenditures . . . . . . . . . . . . . . $82,000

Applying the above amounts onto a commonly used Net Worth Method formula yields the following:

Ending net worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000Less: Beginning net worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .(300,000)Increase in net worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000Add: Living expenses and other expenditures . . . . . . . . . . . . . . . 82,000Total expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182,000Less: Income from known sources . . . . . . . . . . . . . . . . . . . . . . . .(130,000)Expenditures in excess of known sources of funds . . . . . . . . . . $52,000

Analyzing the information above, the target’s increase in net worth of $100,000 (from $300,000 to $400,000) is $52,000 in excess of his income from known sources.

Some important considerations when preparing a Net Worth Method analysis:

• The time period selected does not have to be a calendar year. Longer or shorter time periods can be employed as the assignment dictates.

• When computing the beginning and ending net worth, always remember to value assets at cost, not fair market or depreciated value.

• Give as much attention to the beginning net worth as you give ending net worth. Getting the target to stipulate as to these assets can avoid a “hoarding” defense at trial. “Once the government has established the defendant’s opening net worth with reasonable

certainty, the defendant remains silent at his peril.”4 The hoarding defense is when the target claims that he had significant amounts of cash at the beginning of the period of investigation that was not included in the computation. The target then asserts that all, or a portion, of these funds were used to pay for certain living expenses throughout the period.

• Estimating income and expenses is acceptable. However, the forensic accountant should give the target the benefit of doubt as to income and expense items.

• After completing the Net Worth Method calculation, an attempt should be made to interview the target to negate any defenses that may be used at a later date. Again, getting the target to stipulate to certain facts, such as gifts or loans given/received during the year, can limit the opportunity for these issues to surface at trial.

The most common defenses to the Net Worth Method are:

• The calculation included assets recorded at fair market value, and not the cost. This could account for a larger increase in the ending net worth, that is certainly not attributable to unreported income.

• The target claims that the calculation did not take into account large sums of monies held outside traditional financial institutions (hoarding defense). The best way to counter this defense is for the forensic accountant to get the target to admit, early in the investigation, that there were no such funds maintained outside of financial institutions.

• Lack of thoroughness by the forensic accountant during the investigation (i.e.: forgetting to include gifts received in the income portion of the computation).

If only Al Capone knew of the power of the Net Worth Method. Perhaps he would not have made the statement “the government can’t collect legal taxes on illegal money.”

The Net Worth Method can be an effective tool in the forensic accountant’s arsenal. However, to withstand the defenses presented by the target, the forensic accountant must be meticulous with the procedures and assumptions employed.

Mark S. Warshavsky is Partner-in-Charge of the Business Valuation and Litigation Support Group at the New York firm of Gettry, Marcus, Stern & Lehrer, CPA, P.C. He has been a consultant to various entities providing services in areas of litigation support, forensic accounting and business valuations and has been retained as an expert witness on federal and state cases. Mr. Warshavsky is a national instructor for the National Association of Certified Valuation Analysts (NACVA) and has lectured to its Consultants’ Training Institute and various state CPA societies. He is on the editorial advisory board of a national financial forensic publication, and is a Past Chairman of the New York State Society of CPAs’ statewide Business Valuation Committee. Mr. Warshavsky can be reached at [email protected] or 516-364-3390 ext. 121.

Andrew P. Ross, CPA, CVA, CFE, PFS, is a Partner at Gettry Marcus Stern & Lehrer, CPA, P.C.. With over 25 years of experience, Mr. Ross provides audit, tax, and litigation services to his clients, many of whom are in the service, manufacturing, and wholesale industries. He is also a member of the firm’s Business Valuation and Litigation Support Group and Quality Control Committee. Mr. Ross can be contacted at [email protected] or (516) 364-3390 x246.

4 See United States v. Stone, 531 F.2nd 939 (8th Cir. 1976).


View From the Bar

Face it, from Mel Brooks’ 1968 classic, The Producers, to episodes of Two and a Half Men in 2012, investment scams make good stories. While “Ponzi schemes” have been around for ages (pre-

dating, in fact, Charles Ponzi’s “original” scam in 1920), the Great Recession of 2008 revealed the existence of dozens of Ponzi schemes that had been operating for years … decades in some cases. Many of these fraudsters have become household names: Bernie Madoff, Scott Rothstein and Allen Stanford. Others, perhaps more obscure, are no less notorious: Donald Anthony Young, Charles Hays, Jr., Joseph Forte and Tom Peters. Once the investigation is complete and the guilty verdict or plea (and many of these scams end with some kind of negotiated plea) entered, it is the court’s job to evaluate the crime and establish the penalty. Whether working with defendants or advising a victim who may be involved in related civil litigation, it is useful to know how the court will sanction defendants in criminal fraud cases.

The Sentencing Reform Act of 1984 provided for the creation of the United States Sentencing Commission. The goal of the Sentencing Commission was to develop guidelines for a rational framework that would further “the basic purposes of criminal punishment: deterrence, incapacitation, just punishment and rehabilitation.”1 Sentencing under the guidelines involves four primary components:

• Identification of the guideline section applicable to the offense;

• Apply adjustments based on the victim, the role of the perpetrator and degree to which the operation of justice was thwarted by the perpetrator’s actions;

• Apply adjustments based on the defendant’s acceptance of responsibility, and

• Identify the appropriate guideline range of punishment based on the adjusted offense level and the defendant’s

1 U.S. Sentencing Commission Guidelines Manual (“U.S.S.G.”), November 1, 2011, p. 1

criminal history.

Typically, investment frauds, including Ponzi schemes, are prosecuted as violations of mail and wire fraud statutes (18 U.S.C. § 1341 and § 1343, respectively). Other crimes which can form the basis of prosecution are securities and commodities fraud (18 U.S.C. § 1348) and bank fraud (18 U.S.C. § 1344). These crimes carry a “base offense level” of 6 or 7, depending upon the specific statutory provision.2 The court then adjusts the base offense level for “Specific Offense Characteristics” – most notably, the amount of the loss, the number of victims and the level of sophistication of the fraud.

While bank robberies and extortion lend themselves to easily computed value determinations, the amount of loss in an investment scheme can be more elusive. In U.S. v Hsu, 2012 U.S. App. LEXIS 3257 (2d Cir., February 17, 2012), the court addressed precisely this question. In Hsu, defendant pled guilty to mail and wire fraud charges related to his operation of a Ponzi scheme over the course of seven years. Hsu solicited investments to provide short term financing for small, high-end retailers. Hsu provided his “investors” with post-dated checks in the amount of their investment plus a substantial, “guaranteed” return. Some investors would cash the checks at “maturity,” but many returned the checks, preferring to reinvest the “earnings.” In reality, there were no retailers being financed, and the investors who happened to cash their checks were paid with funds from newer investors.

In sentencing, the district court added the value of all of the outstanding, post-dated checks to arrive at a theft amount of approximately $100 million. Defendant argued that the loss should be calculated based on the actual, out-of-pocket losses sustained by the victims, or approximately $20 million. Depending on the amount of the loss, the Base Offense Level enhancement can be anything from 2 levels (for losses over $5,000 but less than $10,000) to 30 levels (for losses over $400 million). In Hsu, the calculation of the theft loss

2 U.S.S.G. § 2B1.1(a).

Criminal Penalties for Ponzi SchemesBy Michael J. Molder, J.D., CPA/CFF, CVA, CFE


was a significant issue resulting in a sentencing enhancement of 26 levels instead of 20, as the defendant sought.

Defendant’s position relied upon language from the explanatory notes to the Sentencing Guidelines that losses “shall not include … [i]nterest of any kind, finance charges, late fees, penalties, amounts based on an agreed-upon return or rate of return, or other similar costs.”3 Typically this would preclude a computation of the value of the fraud based on the illusory profits which Ponzi scheme perpetrators promise. The Second Circuit came to a different conclusion:

The situation is different, however, in a case in which an investor is told not simply that his investment will grow, but that it has grown, and that the total of his original investment and the accrued interest or other gain is now available to be withdrawn or reinvested in the scheme, depending on the investor’s preference. When an investor in a Ponzi scheme faces the choice either to withdraw or to reinvest, the choice to reinvest -- an act frequently necessary to maintain the scheme itself -- transforms promised interest into realized gain that can be used in the computation of loss for the purposes of federal sentencing.

Hsu at *23-24 (emphasis in original), citing United States v. Alfonso, 479 F.3d 570 (8th Cir. 2007); United States v. Hartstein, 500 F.3d 790, 800 (8th Cir. 2007).

The Second Circuit’s approach to valuing the fraud for criminal purposes differs significantly from that often used in assessing civil damages. In general, civil damages are predicated on the amount of victim cash actually invested into the scheme with distributions of “earnings” being subject to recapture or, so-called, “clawback.” In the modern world of multi-year investment scams and investor expectations of monthly progress reports, or even instantaneous, Internet-enabled data access, the perpetrators’ communications with victims are more likely to portray the investment as having grown, not merely having the potential to grow.

Another major area of concern in sentencing for investment schemes is the number and nature of victims. The Sentencing Guidelines impose a 2 level enhancement for offenses involving 10 or more victims; a 4 level enhancement for offenses involving 50 or more victims; and a 6 level enhancement for offenses involving 250 or more victims.4 The Sentencing Guidelines provide an additional 2 level enhancement if the defendant “knew or should have known that a victim of the offense was a vulnerable victim.” The enhancement factor is doubled (to 4 levels) if the offense involves a “large number of vulnerable victims.”5 A victim can be considered “vulnerable” based upon age, physical or mental condition or some other characteristic making them “susceptible to criminal conduct.”6

The Application Notes to the Sentencing Guidelines caution that the vulnerable victim enhancement does not apply simply because a victim happens to be especially vulnerable, but rather, it applies when the victims were targeted because they were especially vulnerable.7 Thus, the perpetrator of an investment fraud promoted through a mass mailing to a purchased list of credit card holders or through an advertisement in an investment magazine might not be subject to the vulnerable victim enhancement even if all of the victims were, in fact, especially vulnerable. On the other hand, if the mass mailing was specifically directed to residents of retirement communities, or

3 U.S.S.G. § 2B1.1, Application Note 3(D)(i).4 U.S.S.G. § 2B1.1.(b)(2)5 U.S.S.G. § 3A1.1.(b)(1)6 U.S.S.G. § 3A1.1(b) Application Note. 27 Id.

the advertisement was placed in “seniors” magazine, the vulnerable victim enhancement might be appropriate.

In United States v. Bolze, 2010 U.S. Dist. LEXIS 74775 (E.D.Tenn. July 23, 2010), aff’d 2012 U.S. App. LEXIS 449 (6th Cir. 2012), the court addressed defendant’s objection that age alone was not a sufficient basis for the vulnerable victim enhancement.8 Acknowledging that “age alone is not enough to uphold an enhancement” under § 3A1.1(b), the Bolze court found:

many of the victims in this case invested large sums of money that they intended to depend on throughout their retirement. Further, many of the victims were retired, removed from the work force, and neither wealthy nor asset management savvy. Accordingly, the Court finds that the victims’ ages, combined with defendant’s representations that investing with defendant and [his fraudulent entity] was the right decision because of victims’ professed fears of financial instability in their retirement, indicates unusually [sic] vulnerability in regard to financial matters.

2010 U.S. Dist. LEXIS 74775 at 37-38.

A final sentencing enhancement which is often utilized in investment frauds relates to the manner in which the defendant perpetrates the scheme. The Sentencing Guidelines provide:

If (A) the defendant relocated, or participated in relocating, a fraudulent scheme to another jurisdiction to evade law enforcement or regulatory officials; (B) a substantial part of a fraudulent scheme was committed from outside the United States; or (C) the offense otherwise involved sophisticated means, increase by 2 levels.

U.S.S.G. §2B1.1(10)

Sophisticated means have included creation of faux entities in multiple jurisdictions,9 using attorneys to create legitimate looking investment agreements and other documentation10 and fabrication of fictitious invoices and checks to support insurance claims for non-existent repairs.11

Once the court determines the Offense Level, it must take into account the offender’s criminal history. Chapter 4 of the Sentencing Guidelines provides a point system for assessing the individual’s criminal background. Offenders who have previous convictions may have one to three points added to their criminal history category for each prior offense. Other criminal history enhancements may come from being a “career offender” (three or more felony convictions) or armed criminal conduct (admittedly an uncommon element in investment frauds).

Equipped with the offense level and the criminal history category, the court is in a position to determine the applicable period of imprisonment. Investment fraud perpetrators are typically not repeat offenders with Criminal History Categories in the I, II or III range. Even on the low end of the spectrum for criminal history, the offense level enhancements add up quickly leading to significant sentences for investment frauds. By way of a hypothetical example, A is a first time offender – Criminal History Category I. A operated a Ponzi scheme in which he sold unsecured debentures. These debentures were available in various terms, ranging from 3 months to 5 years. The investor could receive interest payments currently or allow interest

8 Defendant cited U.S. v Anderson, 249 F.3d 568 (8th Cir. 2003) for the proposition that older people tend to be “more experienced investors,” so the vulnerable victim enhancement might not be appropriate in an investment scheme.

9 Bolze, supra, at 10-2010 Bunchan v United States, 2011 U.S. Dist. LEXIS 80358 (D. Mass. July 25, 2011)11 U.S. v. Miell, 744 F.Supp. 2d 904 (N.D. Iowa, 2010)


Technology Tips

BITCOIN: Digital Currency and the Future of Our EconomyBy Mitchell HendersonWHAT IS BITCOIN?

Bitcoin is a decentralized, open source digital currency that has the potential to be a replacement for traditional monetary systems all over the world. Bitcoin’s mainstream adoption is

growing rapidly as an ever-increasing number of merchants accept it as payment for goods and services.

To most people, decentralization is one of Bitcoin’s greatest advantages over traditional currency. The money you have stored away in a bank would be in jeopardy if the banking system were to fail. Bitcoin, however, has no single point of failure. The entire Internet would have to breakdown before Bitcoin users would experience any significant problems.

Bitcoin is one of the first implementations of “crypto-currency.” Building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts, Bitcoin is designed around the idea of using cryptography to control the creation and transfer of money, rather than relying on central authorities.

Keep in mind that the concept of digital currency has existed long before Bitcoin emerged. However, nearly all other digital currencies are centrally controlled. This means that they can be printed on a whim by their controllers, they can be destroyed by attacking the central point of control, and arbitrary rules can be imposed upon their users by the controllers. As a decentralized currency, Bitcoin solves all of these problems.

HOW DOES BITCOIN WORK?

A user would begin by downloading one of the many Windows/Mac/Linux-compatible Bitcoin clients available from the official Bitcoin website (http://www.bitcoin.org/). This client allows a user to send Bitcoins, monitor transactions, and view the balance of your Bitcoin “wallet.” To put it simply, a Bitcoin wallet is an address, or hash, that stores the Bitcoins sent to the user. Just like the physical wallet you wouldn’t leave home without, a Bitcoin wallet is valuable and needs to be safeguarded against loss or theft. Wallets are typically lost when the hard drive they are residing on becomes damaged in some way, leading to the corruption of data. If a wallet resides on a hard drive that suddenly decides to stop working properly, the user’s Bitcoins may be permanently lost. Regular backups can prevent this tragedy. If a wallet is stolen by malware or a passerby with a thumb drive, those Bitcoins will likely be spent fraudulently. It is becoming clear to Bitcoin users that taking the time to encrypt their Bitcoin wallets will prevent others from accessing its contents.

Once a user has installed the Bitcoin software and understands the basics of the wallet, they can begin collecting Bitcoins. Bitcoins are earned through a process called “mining.” A computer’s processing power is used to generate blocks. Currently, each block generated provides 50 Bitcoins to the wallet of the computer’s controller. Because it can take a long time for an individual to generate a block and thereby receive Bitcoins, some have turned to pooled mining for a steadier source of income. Pooled mining is an approach where multiple computers contribute to the generation of a block, and then split the block reward according the contributed processing power. Pooled mining can support a large amount of contributors as Bitcoins are divisible up to eight decimal places. So, for example, a block reward could be as little as 0.00000001 Bitcoin if necessary.

Immediate Bitcoins can be gathered from simply visiting sites like Bitcoin Faucet (freebitcoins.appspot.com). Bitcoin Faucet is determined to make the currency successful by helping site visitors fill wallets with a few Bitcoins.

to accrue over the life of the debenture. At maturity, the investor could redeem interest, principal or both, or allow the proceeds, or any portion of them, to be re-invested in a new debenture. In case you haven’t already noticed, A’s unsecured debentures had all of the hallmarks of bank issued certificates of deposit (CDs). The only real differences between A’s investments and bank CDs were:

• A’s interest rates were approximately twice the going rate which banks offered;

• A’s debentures were not insured; and

• A did not invest in an actual business. Proceeds from the sale of debentures were used to pay interest and redemptions of earlier investors … the classic Ponzi scheme.

When A’s scheme finally collapsed after approximately ten years, A had sold debentures to approximately 1,500 different investors. His investors were mostly retirees living on fixed incomes who leapt at the opportunity to buy a CD at twice the rate banks were paying. Between original investments and rollovers, those 1,500 people held debentures with face values of approximately $23 million. In the sentencing phase following conviction, the court assessed the offense level at 40 based on:

Description Offense LevelBase offense level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6Value of the loss greater than $20 million . . . . . . . . . . . . . . . . . . . . . . . 22Offense involved more than 250 victims . . . . . . . . . . . . . . . . . . . . . . . . . 6Sophisticated scheme . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2Especially vulnerable victims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4Adjusted Offense Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

An offender with a Criminal History Category I and an adjusted offense level of 40 faces a prison term of 292 to 365 months. While complex criminal frauds are difficult to prosecute and complicated for juries, the criminal penalties which attach to them are nothing to ignore.

Michael J. Molder, J.D., CPA/CFF, CVA, CFE is a senior manager in the Philadelphia, PA office of Marcum LLP. A graduate of the Pennsylvania State University and Temple University School of Law, he has investigated and litigated major commercial cases involving alleged financial statement fraud and manipulation. Since 2006, Mr. Molder’s practice has focused on litigation consulting, valuation and damage calculations primarily in commercial disputes and accounting and legal professional negligence actions. He can be reached at 484.270.2500 or via e-mail at [email protected].


Finally, after configuring a wallet and mining, the user’s last step would be to trade goods and services for Bitcoins. Plenty of websites exist for Bitcoin discussions and popular Bitcoin exchangers, such as Mt. Gox (https://mtgox.com), can change Bitcoins into physical currency and vice versa.

BITCOIN IN THE NEWS

On June 14, 2011, a total of 25,000 Bitcoins were stolen from an individual in the Bitcoin community. The unidentified thief may have used a Trojan horse or similar malware program to infiltrate and plunder the Bitcoins from the victim’s computer. At the time of the theft, 25,000 Bitcoins would have traded for approximately $500,000, making this a very lucrative crime.

Bitcoin is heavily relied upon in the underground world of the “Dark Web”, an illegal online drug marketplace. Operating unhindered for months, U.S. senators are asking federal authorities to crack down on narcotics markets that accept digital currency.

Although not yet observed, it is only a matter of time before a botnet is harnessed to perform pooled Bitcoin mining. A legion of compromised computers from around the world could earn their controller a disproportionably large amount of Bitcoins in a short amount of time. The botnet controller could then cash out the Bitcoins for a substantial amount of traditional currency.

Some Bitcoin miners have even been falsely accused as indoor marijuana farmers. A Canadian town has a bylaw that allows government officials to search private homes if they are using more than 93 kilowatt hours of electricity per day. Police have shown up

at two individual’s homes expecting to find illegal drugs when, in fact, a multitude of computers was found to cause the extended use of electricity.

CONCLUSION

Bitcoin has been speculated to replace traditional monetary systems, make banks obsolete, and possibly even topple governments. Realistically, Bitcoin will likely supplement existing currencies in the near future once a majority of the world’s population embraces it. That is, of course, if governments do not decide to ban it first. Although no government has yet banned Bitcoin, it is almost certain to happen somewhere in the world considering how much attention is being drawn to the project.

Bitcoin’s qualities as a digital currency could serve the needs of our modern world far better than traditional monetary systems. For example, Bitcoin transfers are finished in about ten minutes and don’t require waiting for a central authority (banks) to open. There are no limitations on trading between time zones. Bitcoins have the potential to become a global currency for our global economy, but it is up to the public whether the project lives or fades into obscurity.

Mr. Mitchell B. Henderson is a key member of the information technology department at INA, a private investigative and security consulting agency. He is responsible for managing INA’s computer network as well as multiple client networks. Over 4 years of hands-on experience in the IT field has provided him with insight into modern topics such as data security, encryption techniques and network management.

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