The Application Of Daubert Challenges To Economic Damages Expert Testimony In Commercial Litigation Matters
By Willamette Management Associates Business Valuations, Economic Analysis, Financial Advisory & Expert Witness Services
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Trial judges perform a “gatekeeping” function, deciding whether to admit or to exclude expert witness testimony as trial evidence. Trial judges often apply the four factors articulated in the Supreme Court Daubert decision in their judicial decisions regarding the admission of expert testimony. This discussion summarizes the evidentiary considerations regarding (1) the level of certainty in the causation of economic damages and (2) the level of certainty in the measurement of economic damages.
Based on the four factors delineated in the 2003 Supreme Court decision Daubert v. Merrill Dow Pharmaceuticals, Inc., 293 U.S. 579 (1993), trial judges perform a “gatekeeping function.” This judicial gatekeeping function relates to whether or not they will admit as trial evidence the testimony of expert witnesses. Using the four Daubert factors in a motion to exclude the expert’s testimony, opposing legal counsel often challenges the admissibility of an expert’s testimony. The objective of the motion to exclude the expert’s testimony is to convince the trial judge not to admit the expert testimony as evidence in the trial.
A Daubert challenge usually results in an examination as to whether:
1. the expert witness used generally accepted practices and standards and
2. the expert witness was property credentialed.
These questions usually represent the first level of a Daubert challenge to the admission as evidence of an expert’s trial testimony. In addition, the reliability of the underlying data or documents relied on by the expert may also be the foundation for a successful Daubert motion.
Accordingly, a successful Daubert motion to exclude the testimony of an expert witness may be based on legal counsel’s challenge to that expert’s due diligence procedures. In deciding whether to grant the Daubert motion, the trial judge has to consider whether the testifying expert’s analysis and/or report are based on sufficient facts or data to allow for the admission of the expert testimony as part of the trial evidence.
REVIEW OF THE DAUBERT STANDARD REGARDING THE ADMISSION OF EXPERT TESTIMONY
When opposing counsel makes a motion to the trial judge to exclude the testimony of an expert witness, the legal counsel usually requests a Daubert hearing.
The admissibility of expert testimony is a question of law for the trial court to determine.3 The proponent of the testimony bears the burden of demonstrating its admissibility by a preponderance of the evidence.4
It is the responsibility of the trial judge to perform a “gatekeeping” function regarding the admission of evidence at the trial. It is the responsibility of the trial judge to ensure that the expert testimony “both rests on a reliable foundation and is relevant to the task at hand.”5
If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify in the form of an opinion. The expert witness testimony is admitted as evidence in the trial if:
1. the testimony is based upon sufficient facts or data,
2. the testimony is the product of reliable principles and methods, and
3. the witness has applied the principles and methods reliably to the facts of the case.5
Based on the Supreme Court Daubert decision, the four factors that trial courts should consider in determining expert testimony reliability and relevance are:
1. whether the theory at issue can and has been tested,
2. whether the theory has been subjected to peer review and publication,
3. whether there is a known or potential error rate, and
4. whether the theory has been generally accepted within the scientific community.5
The judicial decision to exclude expert witness testimony from evidence is “the exception rather than the rule.”6 This is because “our adversary system provides the necessary tools for challenging reliable, albeit debatable, expert testimony.”7 “Vigorous cross-examination, presentation of contrary evidence, and careful instruction on the burden of proof are the traditional and appropriate means of attacking shaky but admissible evidence.”8
On the other hand, “when an expert opinion is based on data, methodology, or studies that are simply inadequate to support the conclusions reached, Daubert and Rule 702 mandate the exclusion of that unreliable opinion testimony.”9 Therefore, “any step that renders the analysis unreliable under the Daubert factors renders the expert’s testimony inadmissible.”10
Of course, “the district court must focus on the principles and methodology employed by the expert, without regard to the conclusions the expert has reached or the district court’s belief as to the correctness of those conclusions.”11
However, “conclusions and methodology are not entirely distinct from one another…[N]othing in either Daubert or the Federal Rules of Evidence requires a district court to admit opinion evidence that is connected to existing data only by the ipse dixit of the expert. A court may conclude that there is simply too great an analytical gap between the data and the opinion proffered.”12
CERTAINTY OF THE CAUSATION OF DAMAGES VERSUS CERTAINTY OF THE AMOUNT OF DAMAGES
In commercial litigation matters, an expert witness often offers an opinion regarding the magnitude of lost profits and/or economic damages suffered by a plaintiff as the result of some allegedly wrongful action by a defendant. Valuation analysts, economists, financial advisers, and forensic accountants often provide such expert testimony regarding the lost profits and/or economic damages.
These lost profits and/or economic damages opinions are often provided by expert witnesses in litigation claims related to:
1. contract disputes,
2. commercial torts,
3. business interruption claims,
4. antitrust claims,
5. securities litigation,
6. allegations of infringement, and
7. personal injury.
To receive a judicial award of economic damages, the plaintiff must prove the occurrence of damages with certainty. What the plaintiff must prove with certainty is that the damages were the result of the defendant’s wrongful actions.
There is an important distinction in the evidentiary burden related to:
1. the measure of proof necessary to establish the fact that a petitioner has sustained some economic damage and
2. the measure of proof necessary to establish the amount of the economic damages.
Sometimes when expert testimony regarding economic damages is excluded, it is because the trial judge has determined that the testimony relates to damages that are not attributable to the alleged wrongdoing. Expert testimony that describes economic damages that are definitely attributable to the wrongful action, but only uncertain in respect of the amount of such damages, should not be excluded.13
THE RECOVERY OF ECONOMIC DAMAGES DUE TO WRONGFUL ACTIONS
Damages that are remote, contingent, or merely possible are not recoverable. “The real use of the term reasonable certainty seems to be to screen out an issue from the jury when the court has concluded that the evidence, taken as a whole, is clearly insufficient to establish the fact sought to be proved…If reasonable men could be persuaded of the validity of the claim on the evidence presented, the jury must be allowed to make the decision.”14
Although the amount of this kind of economic loss is often difficult to prove, courts have noted that it is the wrongful action of the defendant that made the proof necessary. Accordingly, courts have concluded that it would not be just to require the wronged plaintiff to provide precise and exact proof.15
A defendant, whose wrongful conduct rendered the ascertainment of the plaintiff’s precise damages difficult to measure, is not entitled to complain that they cannot be measured with the same exactness and precision as would otherwise be possible.16 Therefore, courts have concluded that the burden of proof regarding uncertainty as to the amount of the damage is judicially placed on the wrongdoer.17
Courts have noted that damages experts should exclude the effects of random subsequent events on the measurement of economic damages. This is especially true if the effects of the random events are material in relation to the original loss.
Courts have noted that it is the plaintiff who decides when (and if) a litigation claim is filed. Therefore, when random subsequent events exaggerate damages, the plaintiff’s decision to file a case is affected—because the plaintiff’s analysis of economic damages is affected.
If the measurement of economic damages allowed the inclusion of random subsequent events, courts are concerned that plaintiffs:
1. would bring cases that happen to have amplified damages and
2. would be less likely to pursue those cases where damages, including the random later event, are negative.
Similarly, if plaintiffs could decide whether or not to include the effects of random subsequent events, then plaintiffs would decide (1) to include those effects when they are positive and (2) to exclude those effects when they are negative.
Courts have recognized that the effect of including random subsequent events in the measure of economic damages would generally be to overcompensate plaintiffs.
THE DAUBERT MOTION TO EXCLUDE EXPERT TESTIMONY
A Daubert motion often involves a challenge to more than the professional practices, standards, theory, and methodology of the expert. In preparing the expert report, the testifying expert typically provides full disclosure as to the subject theories and methodology. This is because the testifying expert may not have an opportunity to supplement an expert report that provides too little disclosure.
To assess the thoroughness of the expert report disclosure, the testifying expert may want to consider whether, based on the report, another expert in the same field could duplicate the expert’s work. Some obvious objections can be avoided when the expert witness specifies in the expert report the reasons for his/her rejection of alternative techniques. In addition, the expert report may also explain why the testifying expert did not rely on some of the data that was disclosed to the expert.
THE APPLICATION OF DAUBERT CHALLENGES TO EXPERT TESTIMONY
In the due diligence stage of the economic damages assignment, the testifying expert identifies the analysis scope, data requirements, and alternative methodologies. In this stage of the damages analysis, there is not always a bright line between the role of the fact witnesses and the role of the expert witness.
For example, one analytical approach that is often relied on by an economic damages expert is the income approach. In the income approach, the future financial performance of the damaged company “as if undamaged” is projected. To develop that income projection, the damages expert will often:
1. interview parties who were involved in managing the damaged company at the time of the damages event and
2. gather documents that describe the projected financial performance of the company at that time.
To the extent that the evidence gathered by the analyst is needed to support the quantification of economic damages, that evidence should be presented to the trial court consistent with the prevailing rules of evidence. The economic damages analysis may depend on information (1) learned by the damages expert during a management interview or (2) based on documents provided by the management interviewee. In that case, the management interviewee may need to provide fact witness trial testimony regarding the integrity of that evidence.
There is a process to establishing the facts on which the damages expert witness depends. During the management interview process, the damages expert will usually track down the source of documents/data until the expert decides that the documents/data are reliable for purposes of the damages analysis. The standard for the expert’s reliance on evidence is what is “customary and reasonable” in the expert’s profession.
The testifying damages expert should be sensitive that:
1. the analysis measure only the damages that are attributable to the alleged wrongdoing and
2. the documents/data relied on come from a source that is consistent and gathered within the legal rules of evidence.
Increasingly, Daubert challenges are focused on the link between:
1. the rationale used by the analyst to measure the economic damages attributable to the alleged wrongful action, and
2. the documents/data provided by others to support the damages expert’s analysis.
SUMMARY AND CONCLUSION
Attorneys often rely on valuation analysts to provide expert analysis and expert testimony in shareholder oppression claims, in dissenting minority shareholder appraisal rights matters, in marital dissolution cases, in income tax and property tax cases, and in securities fraud cases. In addition, attorneys often rely on valuation analysts (1) to perform lost profits/economic damages analyses and (2) to provide expert testimony in breach of contract and other commercial litigation matters.
Many valuation analysts have the technical skills to be successful expert witnesses in lost profits and economic damages cases. However, such lost profits and economic damages analyses often call for a customized application of the technical skills of the typical valuation analyst.
The quantification of economic damages and of business enterprise value are similar technical disciplines. However, there are some analytical differences when these two disciplines are put into practice.
A successful Daubert challenge may relate as much to the reliability of documents/data the testifying expert relied on as it does to (1) the credentials of the expert and (2) the methodology used by the expert.
The quality of the analyst’s due diligence procedures is increasingly important when the analyst provides expert witness testimony. In a typical business valuation assignment, the analyst may only investigate such issues as the subject company’s history and financial performance, the economic environment, and the way its financial projections were developed. The analyst will investigate these issues sufficiently to convince himself/herself as to the reliability of any management-provided financial projections.
During the trial, it may be the role of company management witnesses to demonstrate to the jury that management is reliable when it comes to:
1. the history of the company,
2. the economic environment in which the company operates,
3. and the historical and prospective financial performance of the company.
In a Daubert hearing, however, the damages analyst may be expected to be familiar with all aspects of the subject company budgeting and financial planning processes. This is because the damages analyst relies on the output of these planning processes in developing an income projection. That is a different (and more rigorous) due diligence standard than the standard typically relied on by a valuation analyst to test the reliability of management financial projections.
1. Daubert, 509 U.S. at 592.
2. Bourjaily v. United States, 483 U.S. 171, 175-76 (1987); Berk v. St. Vincent’s Hospital and Medical Center, 380 F. Supp. 2d 334, 349 (S.D.N.Y. 2005) (citations omitted); and Astra Aktiebolag v. Andrx Pharmaceuticals, Inc., 222 F. Supp. 2d 423, 487 (S.D.N.Y. 2002).
3. Daubert, 509 U.S. at 597.
4. Fed. R. Evid. 702.
5. Daubert at 593-94.
6. Advisory Committee notes to the 2000 amendments to Rule 702. See also E.E.O.C. v. Morgan Stanley & Co., 324 F. Supp. 2d 451, 456 (S.D.N.Y. 2004); U.S. Information Systems, Inc. v. International Brotherhood of Electrical Workers Local Union No. 3, AFL-CIO, 313 F. Supp. 2d 213, 226 (S.D.N.Y. 2004).
7. Amorgianos v. National R.R. Passenger Corp., 303 F.3d 256, 267 (2d Cir. 2002).
8. Daubert, 509 U.S. at 596 (citation omitted).
9. Amorgianos, 303 F.3d at 266; see Ruggiero v. Warner-Lambert Co., 424 F.3d 249, 253 (2d Cir. 2005).
10. Amorgianos, 303 F.3d at 267 (emphasis omitted) (quoting In re Paoli Railroad Yard PCB Litigation, 35 F.3d 717, 745 (3d Cir. 1994)).
11. Id. (citing Daubert, 509 U.S. at 595).
12. General Electric Co. v. Joiner, 522 U.S. 136, 146 (1997); see Ruggiero, 424 F.3d at 253-54; Amorgianos, 303 F.3d at 266.
13. From an antitrust case: Story Parchment Co. v. Patterson Parchment Paper Co., 282 U.S. 555, 562, 75 L. Ed. 544,51 S. Ct. 248 (1931).
14. Welch v. U.S. Bancorp, 286 Or. 673, 704, 596 P.2d 947 (1979).
15. In re James E. O’Connell Co., 799 F.2nd 1258 (9th Cir. 1986).
16. Autowest, Inc. v. Peugeot, Inc. 434 F.2nd 556, 565 (2d Cir. 1970) quoting a 1929 case.
17. Contemporary Mission, Inc. v. Famous Music Corp., 557 F.2d 918, 926 (2d Cir. 1977).
ABOUT THE AUTHOR: Robert Schweihs
Robert Schweihs is a managing director of the firm and is located in our Chicago office. Bob specializes in complex business asset valuations.
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While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
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