January 1999 Issue

By Vincent J. Love and Dan L. Goldwasser

In Brief

Careful What You Say
Recent Federal court decisions and proposed changes to the Federal Rules of Evidence will have a profound effect on how experts form and support their opinions. These decisional and statutory refinements to existing evidentiary rules have their genesis in the "junk science" and improperly supported opinions commonplace in the late 1980s and early 1990s. This led to a Supreme Court decision in Daubert that was intended to put an end to junk science in the courtroom.

Following up on this decision and in a continuing effort to improve the litigation process and reduce the amount of incompetent evidence introduced at trial, the Judicial Conference Advisory Committee has proposed amendments to the Federal Rules of Evidence. If accepted, these amendments will clarify and reinforce the courts' role as gatekeepers, preclude the introduction of unreliable expert testimony, treat all witnesses who offer expert testimony equally, and narrow the loophole used to introduce otherwise inadmissible evidence through an expert witness.

The proposed changes to Rule 702 would subject all expert witness testimony to the standards originally enumerated in Daubert. The proposed change to Rule 701 will require a lay witness' opinion testimony to be subject to the same scrutiny as an expert's opinion testimony if it is based on scientific, technical, or other specialized knowledge. Lastly, the proposed change to Rule 703 narrows a loophole that allows a party to introduce otherwise inadmissible evidence through an expert witness.

CPAs and consultants are increasingly requested to act as expert witnesses at trials and in other dispute resolution forums. They give testimony on financial and business transactions and on damages suffered as a consequence of the alleged actions of the defendant. Recent Federal court decisions and proposed changes to the Federal Rules of Evidence will have a profound effect on how experts form and support their opinions. Other proposed rule changes will affect CPAs and consultants who are fact witnesses for clients but will also express opinions on the validity or reasonableness of the client's actions.

These decisional and statutory refinements to existing evidentiary rules have their genesis in the "junk science" and improperly supported opinions that were commonplace in the late 1980s and early 1990s. The use of novel and unrecognized methodologies, or unrealistic and speculative assumptions, has been cited as the basis for the courts' refusal to admit an expert's opinion. The decisions excluding opinion testimony based on its competency include cases involving the proposed opinion testimony of CPAs and consultants, as well as medical testimony in personal injury cases. Indeed, a real danger exists that the courts, in precluding an accounting expert's testimony, could limit the types of issues considered within the expertise of a CPA or financial consultant. Unless the profession adopts its own standards for preventing unreliable expert testimony, the law could be changed to adversely affect the entire profession based upon the inferior work of one or a few individuals.

Expert Opinion Before and After Daubert

The application of the Federal Rules of Evidence on expert testimony has received widespread attention over the past few years because of the Supreme Court's decision in Daubert v. Merrell Pharmaceuticals Inc. In it, the Supreme Court charged U.S. district court judges (trial judges) with the responsibility to act as gatekeepers to exclude unreliable expert testimony.

Prior to the Supreme Court's decision in Daubert, the only questions regarding the admissibility of expert testimony were whether such testimony would likely be of assistance to the trier of fact and whether the individual offering that testimony was an expert. With respect to the latter issue, if the offering party could provide evidence that the proffered expert had special knowledge in the field through education, training, or experience, the expert was deemed to be qualified, and his or her opinion became admissible irrespective of its scientific basis.

This became a serious problem in medical malpractice and product liability cases in which expert testimony without any scientific support was routinely admitted into evidence, often with disastrous results. The breast implant cases were a clear example of this phenomenon, as subsequent scientific studies have proven that there is no causal relationship between breast implants and many, if not most, of the medical complaints attributed to them. The Supreme Court's decision in Daubert was intended to put an end to junk science in the courtroom.

Daubert introduced a nonexclusive list of criteria for Federal judges to use when assessing the reliability of scientific expert testimony. The criteria included in Daubert are as follows:

* Whether the expert's technique or theory can be or has been tested, i.e., can the expert's theory be challenged in some objective manner, or is it simply a subjective, conclusory approach that cannot reasonably be assessed for reliability;

* Whether the technique or theory has been subjected to peer review and publication;

* The known or potential rate of error of the technique or theory when applied;

* The existence and maintenance of standards and control; and

* The degree to which the technique or theory has been generally accepted in the scientific community.


The Daubert decision, which is currently the accepted case law, emphasizes that the factors are not all-inclusive, nor are they dispositive (i.e., they are not a checklist to be used without application of judicial judgment). This is due to the wide variety of expert opinions routinely offered in court proceedings, including expert opinions on customary practices within a given field. The lower courts have recognized that not all of the factors specified in Daubert apply to every type of expert testimony.

Daubert involved scientific experts, and the Supreme Court left open whether the Daubert standards likewise apply to expert testimony that is not scientifically based. The fact that some of the criteria do not apply to disciplines outside of the pure sciences--such as its susceptibility to peer review and failure rate (rate of error)--has led some courts to conclude that Daubert is not applicable to testimony by non-scientist experts. However, other courts have held that Daubert applies to all expert testimony, but recognize that not all of the specific factors can be applied to the testimony of experts who are not scientists. In re Executive Telecard Securities litigation, a U.S. district court declined to apply the specific Daubert tests to the testimony of a damage expert in a securities litigation, while citing some of the underlying principles of Daubert in its decision.

The use of a CPA, or other financial expert, to explain financial transactions or calculate damages is so widespread and accepted that the courts do not often use Daubert to evaluate the admissibility of this type of expert testimony. However, not all courts agree with this position in all instances. One court found that Daubert was inapplicable to testimony based on a payroll review prepared by an accountant in an action against an employer for delinquent contributions to an ERISA fund. The plaintiff's accountant prepared a report on the number of employees and hours worked. The appeals court refused to subject the accountant to Daubert, "as that case specifically dealt with the admissibility of scientific evidence." Other courts, however, have invoked Daubert to preclude a CPA's expert testimony when an unusual methodology was used. In Frymire-Brinati v. KPMG Peat Marwick, the appeals court reversed a lower court's decision regarding its admission of a CPA's testimony. The CPA calculated and testified to the value of a number of partnerships by taking only their past (but not their future) cash flows into account. The appellate decision cited Daubert and held that this methodology was not typically used by experts in the field and therefore was unreliable.

Often, testifying experts have based their opinions solely on their experience and what they themselves would have done in a given situation. This basis for an opinion is considered by some courts as not within the scope of Daubert's underlying principles. In Terrell v. Childers, it was held that a CPA, testifying as to an investment advisor's performance, must compare the advisor's performance to the industry standard and not to a "this is what I would have done" standard.

Daubert has also been applied when an expert testified about matters outside his or her expertise. In Robert Shanchez v. KPMG Peat Marwick, the judge held that, under Daubert, he had the responsibility to assess the principles and methodology underlying an expert's opinion. The judge concluded that an opinion not based on sound methodology or resulting from mere surmise or conjecture should be excluded. The judge also stated that the party proffering the expert bears the burden of demonstrating that the expert has the required specialized skill. The court, in this case, found that certain liability issues being addressed by the CPA expert related to the legality of a transaction and were matters of law, not accounting. Consequently, a request to preclude the CPA expert's testimony, known as a motion in limine, was granted.

Of particular interest to CPAs providing litigation services is the decision of the U.S. District Court in JMJ Enterprises, Inc. v. Via Veneto Italian Ice, Inc., in which the court excluded the testimony of the plaintiff's expert in a breach of contract case. The expert had been asked to assess the damages that the plaintiff, a distributor, suffered when the defendant manufacturer unilaterally terminated the plaintiff's distributorship. The expert calculated the damages at in excess of $5 million based upon the plaintiff's 1995 sales of 6,000 containers and sales of another 6,000 containers in the first half of 1996. Underlying his damage assessment was an assumption that plaintiff's 1996 sales would total 20,000 containers and grow to 57,600 containers in 1997 and 115,200 containers for each year from 1998 to 2006.

In rejecting the proposed testimony of the expert, the court emphasized that all expert opinions must be based upon facts and a sound methodology. With respect to the former, the court quoted the U.S. Supreme Court decision in General Electric Co. v. Joiner as follows:

Trained experts commonly extrapolate from existing data. But nothing in either Daubert or the Federal Rules of Evidence requires a district court to admit opinion evidence which is connected to existing data only by the ipse dixit of the expert [that is based solely on his own statement]. A court may conclude that there is simply too great an analytical gap between the data and the opinion proffered.

This is the same position taken by the court in the previously discussed case, Terrell v. Childers. The district court also relied on Joy v. Bell Helicopter Textron, Inc., in which an appellate court reversed a decision to admit expert testimony characterized as "based solely on guesswork, speculation and conjecture." In finding that there was an insufficient factual basis for the expert's opinion, the court pointed out the following:

* The expert knew very little about the plaintiff's industry;

* The expert did not perform or review any market surveys or studies;

* The expert knew nothing about the capabilities of the subdistributors that the plaintiff was relying upon; and

* The expert ignored the plaintiff's 1994 operating results.

The court also found the expert's methodology to be badly flawed in that there were elements of double counting, an assumption that costs would not increase as revenues increased, and a complete omission of certain costs. The court stated as follows:

A reasonable accountant does not report certain expenses, and choose to omit other, like expenses. Such accounting practices do not produce consistent results. Further, an expert must be able to point to methods that he applied. An expert cannot simply base his conclusions on his "thirty-one years of experience."

To harmonize the sometimes divergent court decisions, the legal body responsible for proposing changes to the Federal Rules of Evidence has begun the process to formalize the underlying principles inherent in Daubert and to clarify their applicability to all expert testimony.


Proposed Changes to the Federal Rules

The Judicial Conference Advisory Committee is recommending changes to the Federal Rules of Evidence that will affect testimony given by expert witnesses. These proposed changes, if adopted, will have a significant effect on CPAs and other financial professionals who give expert testimony in litigation. They will require them to explain how their testimony is in accordance with the mainstream of expert opinion in the area. Although the proposed changes must be approved by the Judicial Conference, the Supreme Court, and Congress, their adoption, more or less as proposed, is a strong likelihood.

 PROPOSED RULE 702  If scientific, technical, or

Proposed Changes to Rule 702

The most significant proposed changes are to Rule 702 of the Federal Rules of Evidence, the basic rule on expert testimony. The proposed changes to Rule 702 will reinforce the Daubert principles and also clarify some of the ambiguities of Daubert that have lead to conflicting decisions in the lower courts.

The proposed changes clearly and unambiguously place the responsibility for determining the reliability of the expert's testimony with the trial court. They also establish some general guidance for trial courts to use in their evaluation that is consistent with the objective of Daubert to exclude unreasonable and unfounded expert testimony. The language in the proposed rule is broad and is designed to give the courts flexibility in consideration of any, or all, of the specific Daubert factors where appropriate.

Most importantly for CPAs and other financial professionals who offer expert testimony, the changes to Rule 702 will clearly indicate that the Daubert principles will apply to all expert testimony and will not be limited to scientific experts. Thus, the committee rejected the notion that an expert's testimony should be treated more permissively simply because it is outside the realm of pure science. Under the proposed changes, the trial judge must find that the expert's testimony is properly grounded in accepted practice and theory, reasoned, and not speculative before it can be admitted.

If there is an accepted body of knowledge in the expert's field, then the expert's testimony must be grounded in that body of knowledge to be considered reliable. If the witness is relying solely, or primarily, on his or her individual experience, then under the proposed amendments the witness must explain how that experience supports the conclusion reached. In this regard, the trial court's gatekeeping function requires more than simply taking the expert's word at face value.

This could pose a serious impediment for experts who offer damage analyses in securities class actions, in which they must estimate the percentage of shares traded that were held to the end of the class period. Unless they can support their conclusions regarding the size of discounts to the trading volume by analyses of similar trading data, their opinions are likely to be inadmissible. Similarly, expert opinions regarding the impact, or lack of an impact, of company-specific factors on the price of the issuer's securities could also be deemed inadmissible if not substantiated by objective testing.

When a CPA testifies on issues involving the financial recording of economic events, or the applicable procedures to use in conducting an audit, review, or compilation engagement, there are long and well established standards with which the expert's opinions need to conform. When forming an opinion on the financial recording of economic events, the CPA expert's opinion should conform to GAAP. The auditing literature in SAS No. 69, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles in the Independent Auditor's Report, clearly establishes a hierarchy for GAAP and a sequence to follow to determine the proper accounting for a transaction. Under Rule 203 of the Code of Professional Conduct, reasoned judgment and demonstration that applying an authoritative pronouncement would be misleading must support any deviation from these established standards.

As with GAAP, there are well-established standards for auditing, reviewing, and compiling financial statements. Compliance with SAS for performing audits of financial statements and SSARS for performing reviews or compilations of financial statements is required under the respective codes of professional conduct of the AICPA and state CPA societies and under state regulations governing CPAs. The CPA expert is expected to deliver an opinion grounded in these standards when evaluating the work of another CPA in professional malpractice litigation. Applying a different set of standards could lead to the expert's report and testimony being excluded by the court.

Opinion testimony on compliance with SAS and SSARS presents additional problems for expert witnesses because these standards are designed to permit the exercise of reasoned professional judgment based on the specific facts surrounding their application. Consequently, an expert testifying on the application of these standards may be required to establish that his or her judgment on their application is reasonable and within the mainstream of professional practice. The expert's opinion may require the support of references to authoritative literature, treatises, or articles in professional journals.

Another important aspect of the proposed change is the specific requirement that the gatekeeper function applies equally to the application of an accepted methodology to the facts of the case as it does to the methodology itself. According to Professor Daniel Capra of the Fordham University School of Law, Reporter to the Judicial Conference Advisory Committee on the Federal Rules of Evidence, the committee in considering these changes was persuaded by the reasoning of Judge Edward R. Becker in re Paoli R.R. Yard v. PCB litigation when he wrote "any step that renders the analysis unreliable renders the expert's testimony inadmissible. This is true whether the step completely changes a reliable methodology or merely misapplies that methodology." Thus, misusing an accepted theory or methodology would also render the expert's report and testimony inadmissible under the amended rule.

An example of an unacceptable application of an otherwise acceptable methodology is the inappropriate use of price erosion as an element of retrospective lost profit damages. Price erosion, as used in damage models, is the lost additional revenue that the plaintiff would have received from increasing the sales price of the product but for the actionable conduct of the defendant. A damage expert's merely stating that the plaintiff could have increased the price of its product to maintain a specific profit margin (or increase it by a specific percentage each year) would not be sufficient to support this element of retrospective lost profit. To prove damages from price erosion, the expert would need to show that the price could have been increased in the face of competition, product demand, and the state of the economy. An economic and factual analysis should be conducted to demonstrate that the plaintiff tried, or contemplated, increasing the product's sales price and that the price could have been increased without adversely affecting the demand for the product and the plaintiff's profits, but for the actionable conduct of the defendant.

Experts can have differences of opinion on the proper methodology to use where there is more than one acceptable methodology. They can also differ on the interpretation of the results of the application of an acceptable methodology where the underlying data are in contention, or when there are different, but equally reasonable, assumptions that may be applied in the given situation. However, the use of an inappropriate or unaccepted methodology or the unacceptable application of an otherwise acceptable methodology would be grounds for precluding an expert's testimony.

 PROPOSED RULE 701  If the witness is not testif

Proposed Changes to Rule 701

Rule 701 governs opinions by lay, rather than expert, witnesses. This rule provides that lay opinion testimony is not inadmissible simply because it is an opinion, so long as it is rationally based on the personal perception of the witness and is helpful to the trier of fact. The standard of helpfulness and rational basis in the current Rule 701 could be read as less rigorous than the standard of reliability set forth for expert witnesses by the Supreme Court in Daubert. Under the proposed rule, however, any opinion testimony given by a lay witness that is based on scientific, technical, or other specialized knowledge is also subject to scrutiny under the rules that relate to expert opinions.

Accordingly, an internal accounting professional who testifies as a lay witness on issues based on his or her interpretation of GAAP or GAAS, and states an opinion on the applicability of an accounting or auditing standard, would have his or her opinion scrutinized under the requirements of Rule 702. The same would hold true for a party's independent auditor or outside management consultant when giving fact testimony that also encompasses opinions based on technical or other specialized knowledge. Therefore, a CPA who testifies why he or she believed that certain financial obligations were in default under a loan agreement could be required to explain the basis for that conclusion, and failing to do so, his or her opinion may be deemed inadmissible.

 PROPOSED RULE 703  The facts or data in the par

Proposed Changes to Rule 703

Rule 703 permits an expert, in forming an opinion, to rely on information that is not normally admissible at trial--most commonly hearsay evidence. (The credibility of hearsay evidence rests not only upon the credibility of the testifying witness but also upon the veracity and competency of another person not being exposed to cross-examination.) The only requirement is that the information must be "of a type reasonably relied on by the experts in the particular field in forming opinions or inferences upon the subject." The committee proposed to amend Rule 703 to make it clear that the rule is not to be used as an end-run around other evidentiary rules mandating the exclusion of certain evidence.

The change emphasizes that when an expert reasonably relies on normally inadmissible evidence to form an opinion, it is the opinion, and not the underlying information, that is admitted as evidence. When inadmissible evidence is relied on by an expert, the court must consider the information's probative value in assisting the jury to weigh the expert's opinion on the one hand, and the risk of prejudice resulting from the jury's potential misuse of the information on the other.

Under the proposed rule, the probative value of the information in allowing the jury to weigh the expert's opinion must substantially outweigh its prejudicial effect. The proposed rule governs the disclosure to the jury of otherwise inadmissible information reasonably relied on by an expert. It is not intended to affect the admissibility of the expert's testimony itself, nor to deprive an expert of the use of inadmissible information to form and propound an expert opinion.

This is an important rule in class action cases as the plaintiffs' counsel frequently relies heavily on expert accounting testimony and damage experts to explain the background to the case as well as to present their expert opinions. Thus, the proposed rule change will clarify the extent to which this practice is permissible and the requisites for using it. It also places a burden on the expert to be able to document the fact that the nonadmissible evidence relied upon is of the type that is customarily relied on by experts in his or her field. While this may be critical in many fields, it is not likely to present a substantial additional burden for accounting, financial, and damage experts who customarily rely on most forms of data. However, CPAs serving as expert witnesses must be prepared to demonstrate that the substance of the nonadmissible evidence relied on is customarily considered by other experts and that the source of the information is generally deemed sufficiently reliable for the formation of an opinion. *

Vincent J. Love, CPA, a member of Kramer & Love, is the chair of the New York State Society of CPAs' Committee on Auditing Standards and Procedures and the immediate past chair of the Society's Professional Ethics Committee. Dan L. Goldwasser, Esq., a member of Vedder, Price, Kaufman, Kammholz & Day, is a frequent speaker and writer on topics relating to the law as it relates to CPAs. He is also an editor of The CPA Journal.

The authors take note of an excellent article on these proposed changes to the rules of evidence published in the October 5, 1998, issue of the National Law Journal. The author, Professor Daniel Capra of Fordham University School of Law, is Reporter to the Judicial Conference Advisory Committee on the Federal Rules of Evidence. Capra's article was a primary source of information to the authors on the proposed changes.

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