How Does the Fair Value Hierarchy Influence Legal Strategy in a Valuation Case?

Concept

In any valuation dispute, the legal contest is rarely about the final number in isolation. Instead, the conflict centers on the system of assumptions and data that produced the number. The Fair Value Hierarchy, as defined by accounting standards like ASC 820 and IFRS 13, provides the very architecture for this system. It is the blueprint that dictates the points of strength and vulnerability in a valuation argument.

Understanding its structure is the first step in designing a legal strategy that can systematically dismantle an opposing valuation or defend one’s own. The hierarchy is not merely an accounting convention; it is a framework for evidentiary reliability that has profound consequences in a legal setting.

The system is organized into three distinct levels, each representing a different degree of objectivity and, therefore, a different quality of evidence in a legal context. These levels categorize the inputs used in valuation techniques, not the techniques themselves. The categorization of the entire valuation is determined by the lowest-level input that is significant to the measurement.

This principle is fundamental; a valuation is only as robust as its most subjective critical component. This creates a clear pathway for legal scrutiny, allowing counsel to focus on the weakest link in the valuation chain.

The Fair Value Hierarchy functions as a legal roadmap, guiding litigation strategy toward the most subjective and defensible elements of a valuation.

The Three Tiers of Evidentiary Strength

The three levels of the hierarchy establish a clear gradient of contestability. Legal strategy must adapt to the specific level at which a valuation is categorized, as each presents unique challenges and opportunities.

Level 1 Inputs

Level 1 inputs are quoted prices for identical assets or liabilities in active markets. This represents the highest and most reliable form of evidence. The data is unadjusted, directly observable, and reflects the consensus of numerous market participants. Examples include the closing price of a publicly traded stock on a major exchange.

From a legal standpoint, a Level 1 valuation is exceptionally difficult to challenge on the basis of the price itself. The market has spoken, and its verdict is considered definitive. The legal strategy, therefore, does not attack the price but rather its applicability to the specific situation at hand.

Level 2 Inputs

Level 2 inputs are data points that are observable for the asset or liability, either directly or indirectly, but are not quoted prices in active markets for identical items. This category includes quoted prices for similar assets in active markets, quoted prices for identical or similar assets in markets that are not active, and other inputs that are observable or can be corroborated by observable market data, such as interest rate yield curves, credit spreads, and volatility surfaces. Here, the valuation requires some degree of modeling or adjustment to arrive at a final number. For instance, valuing a corporate bond might involve using a benchmark government bond yield and adding a credit spread derived from observable market data for bonds with similar credit ratings and maturities.

Level 3 Inputs

Level 3 inputs are unobservable inputs for the asset or liability. These are the most subjective and, consequently, the most fertile ground for legal disputes. Level 3 inputs are used when there is little, if any, market activity for the asset or liability at the measurement date. The valuation relies on the reporting entity’s own data and assumptions about what market participants would use in pricing the asset or liability.

Examples include financial forecasts for a private company, estimating the probability of default for a distressed debt instrument, or projecting cash flows from a unique intangible asset like a patent. A valuation categorized as Level 3 is a direct reflection of management’s judgment, making that judgment the central focus of any legal challenge.

Strategy

A legal strategy in a valuation case is not a monolithic concept; it is a dynamic response to the specific evidentiary foundation of the asset in question. The Fair Value Hierarchy provides the critical organizing principle for this response. The strategic objective is to identify and exploit the inherent weaknesses associated with the valuation’s position within the hierarchy. This involves a targeted approach to discovery, expert witness selection, and argumentation, all calibrated to the specific level of the inputs driving the valuation.

Strategic Approaches by Hierarchy Level

The legal game plan changes dramatically depending on whether the valuation is classified as Level 1, 2, or 3. An attempt to argue against a Level 1 price with a Level 3-style critique of assumptions is destined to fail. The strategy must align with the nature of the evidence.

For Level 1 assets, the legal challenge is rarely about the quoted price. Instead, the strategy focuses on meta-level arguments concerning the context and applicability of that price. For example, a legal team might argue that the market is not truly “active” as defined by ASC 820, or that the size of the holding is so large that a “blockage discount” should be applied, a factor not reflected in the quoted price for a single share. The fight is on the perimeter of the valuation, not its core number.

With Level 2 valuations, the strategic focus shifts to the process of adjustment and comparison. The inputs are observable, but their application is not. The legal team will scrutinize the choice of comparable assets, the mathematical adjustments made to account for differences, and the models used to derive the valuation from those inputs.

The core question becomes ▴ Were the observable inputs applied in a manner consistent with how market participants would price the asset? This is where the battle of experts often begins.

Level 3 is where legal strategy becomes a full-scale assault on the valuation’s internal logic. Since the inputs are unobservable and based on the entity’s own assumptions, the entire process is open to scrutiny. The legal strategy attacks the credibility of the assumptions, the integrity of the underlying data, and the appropriateness of the valuation model itself. Every management forecast, every growth rate assumption, and every discount rate calculation becomes a target for cross-examination.

The hierarchy dictates whether the legal argument targets the market’s conclusion, the analyst’s calculation, or the manager’s judgment.

The following table outlines the distinct strategic frameworks required for each level of the Fair Value Hierarchy.

How Does Input Classification Shape Discovery?

The discovery process, which involves the compulsory disclosure of evidence, is fundamentally shaped by the valuation’s level in the hierarchy. A well-designed discovery plan seeks to acquire the specific ammunition needed to challenge a valuation at its weakest point.

• Level 1 Discovery ▴ Discovery is limited and highly targeted. Requests would focus on documents that could prove the market is not active, such as internal analyses of trading volume or reports from market makers. For a blockage discount argument, discovery might seek documents related to previous large block trades by the company or its bankers.
• Level 2 Discovery ▴ The scope expands. Document requests will target the valuation model itself, including all spreadsheets and supporting data. Counsel will seek all information on the comparable assets chosen and, just as important, those that were considered but rejected. The goal is to find inconsistencies in the selection and adjustment process.
• Level 3 Discovery ▴ This is the most invasive and extensive form of discovery. The legal team is entitled to a vast range of internal documents that shed light on the entity’s own assumptions. This includes:
  • All drafts of financial projections and business plans.
  • Board presentations and minutes where those projections were discussed and approved.
  • Internal correspondence (including emails) between executives debating the company’s future prospects.
  • Reports from any third-party consultants who assisted in preparing the forecasts.

  The objective is to find any discrepancy between the optimistic assumptions used in the valuation and the more candid, and often more skeptical, internal discussions about the business.

Execution

In a valuation dispute centered on Level 3 assets, success is a function of methodical and rigorous execution. The legal team, in concert with its valuation expert, must operate as a forensic unit, systematically deconstructing the opposing party’s valuation and constructing a more credible alternative. This is a multi-stage process that moves from high-level model critique to granular cross-examination, all guided by the principle that every unobservable assumption is a potential point of failure for the valuation.

The Operational Playbook for a Level 3 Dispute

A successful engagement follows a clear operational sequence. This playbook provides a structured approach for a legal team to manage the complexities of a Level 3 valuation challenge.

1. Model Acquisition and Forensic Analysis ▴ The first step is to obtain the complete, native-format valuation model (e.g. the Excel spreadsheet) from the opposing party through discovery. A PDF is insufficient. The legal team and its expert must be able to see the formulas, linked cells, and any hidden tabs or data. The expert then conducts a forensic audit to trace the flow of data and identify every single input, classifying each as Level 1, 2, or 3.
2. Assumption Sourcing and Verification ▴ For every identified Level 3 input, the team must trace it back to its source document, also obtained in discovery. A projected growth rate, for instance, might come from a specific board presentation. The team then cross-references this assumption with other internal documents. Is the growth rate presented to the board consistent with the more cautious operational budgets or internal risk assessments? Any inconsistency undermines the credibility of the input.
3. Sensitivity and Scenario Analysis ▴ The expert uses the opponent’s model to run sensitivity analyses on the key Level 3 inputs. This process quantifies how much the final valuation changes in response to small changes in inputs like the discount rate or terminal growth rate. This analysis reveals which assumptions are most critical to the valuation, allowing the legal team to focus its attack on the inputs that have the greatest impact. The expert should also build alternative scenarios using more conservative or better-supported assumptions.
4. Expert Report and Rebuttal ▴ The team’s expert prepares a detailed report that does two things. First, it provides a comprehensive critique of the opposing valuation, identifying every flawed assumption and methodological error. Second, it presents an independent, alternative valuation based on more defensible inputs. This report becomes the central piece of evidence for the team’s case.
5. Deposition and Cross-Examination Preparation ▴ The final stage is preparing for testimony. The legal team must prepare its own expert to defend their report vigorously. Simultaneously, they must prepare to cross-examine the opposing expert, using the forensic analysis and sensitivity testing to craft highly specific and challenging questions that expose the weaknesses in their valuation.

Executing a Level 3 challenge requires transforming subjective assumptions into objective points of quantifiable weakness.

Quantitative Modeling in a Legal Context

Visualizing the dispute through data is a powerful courtroom tactic. The following table presents a simplified but illustrative example of how two parties might arrive at vastly different valuations for a private software company, highlighting how Level 3 inputs drive the disagreement.

What Is the Best Way to Question an Opposing Expert?

The cross-examination of the opposing valuation expert is a critical event. The questioning must be precise, surgical, and grounded in the evidence gathered during discovery. The goal is to force the expert to admit the subjectivity of their inputs and the existence of reasonable alternatives.

A well-structured cross-examination might include the following lines of inquiry:

• On Forecasts ▴ “The 15% revenue growth you project for Year 5, that is a Level 3 input, correct? It is an assumption, not a fact? Can you point me to any internal company document from that period that shows management had a high degree of confidence in achieving that specific number?”
• On Discount Rates ▴ “You applied a 2% company-specific risk premium in your WACC calculation. This is a subjective, Level 3 input, is it not? Were you aware that the company’s own risk committee had identified customer concentration as a major threat? Would you agree that such a threat might warrant a higher risk premium?”
• On Alternative Scenarios ▴ “Your report presents a single valuation number. Did you model any alternative scenarios? For example, a scenario where the company’s new product launch is delayed by six months? Would you agree that market participants would consider such potential downsides when pricing an asset?”
• On Contradictory Evidence ▴ “I’m showing you an email from the CEO to the CFO, dated one week before your valuation date. In it, he says, ‘We are facing significant headwinds next year.’ Your valuation model projects 20% growth for that year. How do you reconcile your optimistic projection with the CEO’s private concerns?”

This disciplined, evidence-based approach to execution transforms the abstract principles of the Fair Value Hierarchy into a concrete and powerful legal weapon. It moves the argument away from a simple disagreement over price and toward a demonstrable critique of process, methodology, and judgment.

Reflection

The Fair Value Hierarchy provides a clear structure for dissecting a valuation. Yet, its application in a legal context requires a shift in perspective. The objective is not simply to understand the rules of the hierarchy but to view them as the operating system for financial argumentation. How does your current litigation framework process and analyze valuation disputes?

Does it systematically classify evidence according to these levels of reliability? Does it possess the forensic capability to deconstruct a Level 3 model and stress-test its core assumptions?

Viewing the hierarchy as a system reveals that a valuation is a composite of interlocking parts, each with a defined level of certainty. The ultimate strength of the entire structure is dictated by its most subjective component. A robust legal strategy, therefore, is one that has a protocol for identifying that weakest point and concentrating the full force of its evidentiary and argumentative power upon it. The knowledge of this system is a necessary component of a superior operational framework for managing financial litigation risk.