July 1999 Issue


Update On The Preclusion Of Financial Experts Under Daubert

By Vincent J. Love, CPA, Kramer & Love, and Dan L. Goldwasser, Esq., Vedder, Price, Kaufman, Kammholz
& Day

Since our article on the Federal rules of evidence was published (The CPA Journal, January 1999), the Supreme Court in Kumho Tire Co. Ltd. v. Carmichael has clarified the trial court's responsibility to act as a gatekeeper to preclude the admission of unreliable expert testimony. In addition, there have been a number of decisions in U.S. district courts that provide further guidance to the financial expert on what the courts will, and will no longer, accept as support for the expert's opinion.

Kumho Tire Co. Ltd. v. Carmichael

On March 23, 1999, the Supreme Court ruled that its decision in Daubert v. Merrell Dow Pharmaceuticals applies to nonscientific testimony and reemphasized that the U.S. district courts must act as the gatekeeper to exclude unreliable expert testimony. The ruling is not only significant because many Federal courts had been reluctant to apply Daubert to nonscientific testimony but also because the excluded testimony was far from "junk science," indicating that the bar for admitting expert testimony has been raised to a much higher level.

In Kumho, the plaintiffs sued a tire manufacturer for injuries sustained when a tire blew out and caused their car to spin out of control. Plaintiffs called an engineer with many years of experience in the manufacture and testing of tires to testify that the tire was defective. Although the engineer was unquestionably qualified and his testimony appeared logical, the district court nevertheless excluded it, citing certain weaknesses in his methodology and conclusions. The Eleventh Circuit reversed the district court decision, holding that Daubert only applied to scientific testimony and that experience-based testimony was not governed by Daubert.

The expert in Kumho had examined the tire following the accident and noted that the tread (albeit badly worn) had come apart from the "carcass" of the tire, a circumstance that can be caused either by defective manufacture or "overdeflection" (a condition caused by driving the car with a deflated tire). The expert concluded that overdeflection had not been the cause because his visual inspection of the tire did not reveal two of the four common signs of overdeflection--greater wear on the shoulders of the tire than on the center of the tire's tread and excessive wear on the rim flange of the tire. The expert, however, had not performed any tests on the tire and relied solely on his visual inspection. The defendants argued that this visual inspection was unreliable, notwithstanding the expert's many years of experience analyzing tire failures.

The expert's testimony was undermined by two factors. First, the literature on tire failure did not support the proposition that overdeflection could be detected solely by visual inspection. Perhaps more importantly, the tire had traveled approximately 50,000 miles and was badly worn, suggesting that it was at least approaching the end of its useful life. Moreover, it had been punctured on at least two occasions and the repairs admittedly had been done badly, raising the possibility that the tire may have been used in a partially deflated condition on one or more occasions.

The problem was not so much that the expert's testimony was clearly implausible, but rather that it was not fully supported by objective evidence. In short, the expert may have been the victim of his own expertise, having perhaps concluded that more extensive testing would not have altered his conclusion. This poses a serious problem for expert witnesses that may be tempted to not thoroughly document those conclusions as to which they have a high level of confidence.

In reversing the circuit court and restoring the district court's ruling to exclude the expert's testimony, the Supreme Court unanimously held that its decision in Daubert was not to be limited to cases involving scientific issues. The Court also held that the tests for assessing the reliability of expert testimony set forth in Daubert are to be applied with "flexibility," meaning that the courts should use those and other tests to assess the reliability of the expert's opinion. Lastly, the Court emphasized that decisions as to admissibility are to be made by the district courts and that the circuit courts should only overturn such determinations where there has been clear abuse of discretion. Having made such a ruling in a very close case, the Court demonstrated that the district courts would be given a free hand in excluding unreliable expert testimony. It thereby signaled that it does not want such decisions to be the basis of a successful appeal.

Lesson to be learned: Experience alone is not always sufficient to support an opinion. Support your opinion with references to professional literature. For accounting issues, refer to SAS No. 69, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles in the Independent Auditor's Report, for guidance on the hierarchy of GAAP that can be used to support an opinion. For auditing issues, reference the guidance in the Statements on Auditing Standards. And for damages, reference texts such as Robert L. Dunn's Recovery of Damages for Lost Profits, Dan Dobbs' Remedies, and other texts on damage determination issues.

David Otis v.
Doctor's Associates, Inc., et al.

In David Otis v. Doctor's Associates, Inc., et al. (September 14, 1998, U.S. District Court, N.D. Illinois, No. 94 C 4227), the court precluded the testimony of the plaintiff's CPA damage expert and barred other evidence regarding the plaintiff's alleged lost profit damages. This lawsuit involved an allegation of fraud by a fast food franchise restaurant known as Cajun Joe's Chicken. Lost profit damages were claimed by the plaintiff under the benefit-of-the-bargain theory. The claim was for compensatory damages in the amount the defendant would have earned during the 20-year life of an agreement.

The court found that the calculations were based exclusively on projections contained in the agreement and that the expert did not perform any comparative analysis to measure the projections against actual results achieved by other fast food chicken franchise restaurants. The expert made two separate calculations based on the estimated profit per franchise in the agreement's projections; one based on the established goal for the number of Cajun Joe's franchise restaurant openings and the other based on the minimum opening required under the agreement.

The court found that the defendant failed to show that the "formula and project values" upon which the expert relied were accurate or had been tested for accuracy. The expert himself admitted that he did not perform any independent market analysis to verify the reasonableness or factual accuracy of the figures used in the average weekly sales estimates contained in the franchise agreement.

The final issue mentioned by the court was the defendant's failure to show that the expert's theory of calculating lost profits for a fast food franchise had been generally accepted by other experts that frequently predict future sales for similar franchise operations. This last criticism of the expert's report is rather harsh since lost profit modeling does not necessarily change significantly from industry to industry. Revenue and expense streams may change from industry to industry, and other economic factors relating to operations at different levels of activity may affect variable expense analyses, but the basic model and approach to calculating lost profits in most instances would remain the same.

Lesson to be learned: Do not blindly accept data even if it is considered an "admission against interests." Support a damage model's foundational data with reasonable testing of its accuracy and consider whether the amount of lost profits can reasonably be achieved. Also, support the damage model with reference to the appropriate accounting, marketing, economic, or legal literature.

Robert Billet Promotions, Inc. v.
IMI Cornelius, Inc., et al.

In Robert Billet Promotions, Inc. v. IMI Cornelius, Inc., et al. (April 1, 1998, U.S. District Court, Eastern District of Pennsylvania), the court applied the Daubert criteria to restrict the testimony of a damages expert in a claim related to the breach of an oral contract. The court found the expert qualified and his methodology appropriate. However, there were some aspects of the application of the methodology that gave the court pause.

The court, while expressing some concern about certain assumptions made by the expert in calculating damages, focused on an assumption relating to the number of units of product sold under the contract. The court found the method of "arriving at units sold to be unacceptably speculative for the purpose of direct damages." The expert intended to testify that the parties expected to sell 8,000 units in the course of the contract period. He derived this amount from the plaintiff's internal projections used to determine whether the transaction was economically feasible.

The financial projections were not alleged to be a part of the contract. Under an oral agreement, the plaintiff undertook an obligation for a maximum production of 3,750 units. The court was of the opinion that the contracted unit production represented the limit of the plaintiff's potential contractual obligation. The court consequently decided that the expert's reliance on the extracontractual business justification documents to arrive at the amount of units sold in the damage model was "methodologically unsound."

The last aspect of the damage calculation addressed by the court was the computation of consequential damages. The expert consulted a number of industry sources to determine the potential market for the plaintiff's services. However, he ultimately relied on discussions he had with Robert Billet, the plaintiff. Here the court found that the assumptions were "sufficiently straightforward that the proper remedy is in cross-examination rather than exclusion."

The court reached a conclusion that the expert "may not offer direct damage computations based on a number of units in excess of 3,750, the greatest number that may be derived from the [draft agreement]. In all other respects, [the expert] may testify as proffered."

Lesson to be learned: Not only is the financial expert's damage model required to be appropriate and acceptable, the expert's testimony must also
conform to the facts in the case. An acceptable methodology must be properly applied to the facts in the case.

Securities and Exchange Commission v. David E. Lipson

In Securities and Exchange Commission v. David E. Lipson (January 5, 1999, U.S. District Court, N.D. Illinois, No. 97 C 2661), the plaintiff sought to bar the defendant's expert from testifying at trial and to strike his report. This case involved the allegation that Lipson, who was the CEO of Supercuts, Inc., traded in shares of Supercuts stock on the basis of internal company reports revealing poor sales performance.

The expert for the defendant opined that Lipson and others at Supercuts in March and April 1995 considered the internal financial reports unreliable and that the relevant financial reports were in fact unreliable.

The CPA expert neither audited the internal financial reports nor performed an analysis to determine whether the internal financial reports reliably reported corporate revenues or how they compared to budgeted amounts. He also did not compare the internal reports to publicly filed reports.

The expert reiterated his opinion in his report that Lipson "didn't think the reports were very reliable" and "didn't pay much attention to them, didn't read them since the middle of 1994." The expert also gave deposition testimony that not only Lipson, but also certain others in Supercuts management considered the information in the internal financial statements useless.

The court evaluated the expert's opinions in light of the Daubert principles and noted that besides being reliable, acceptable, and valid, the methodology underlying the expert's testimony must be helpful to a trier of fact. The court stated the following:

Daubert also makes it clear that even if proffered expert opinion meets the reliability standard, the expert testimony will not be admitted unless it will assist the trier of fact in understanding the evidence or determining a fact
in issue.

The conclusions relating to the CPA expert's opinion concerning what Lipson or other Supercuts management believed about the reliability of the internal financial statements is telling. The court found that the expert's training and experience as an accountant did not equip him "to divine" what Lipson believed about the reliability of the reports.

The expert's opinion concerning whether the internal reports in March and April 1995 were in fact unreliable is within the scope of an accountant. However, under the evidence presented at the hearing in this case the court found that the expert's opinion on this subject failed to meet the criteria for admissibility.

The court concluded as follows:

[The expert's] opinion suffers from an additional, and serious, defect that independently undermines its reliability. [The expert's] report reveals that his opinion about the reliability of the internal financial reports is intertwined with, and in part based upon, statements by the defendant and others that the reports were unreliable and that they considered them to be so. Allowing an opinion about the objective reliability of certain records to be influenced by the subjective statements of an interested party about what he believed does not, in this court's view, comport with the principles and methodology of the accountancy profession. [Emphasis added.]

Based on the foregoing reasoning, the court found that "defendant is not entitled to bolster his defense by having [the expert] provide under the banner of expert opinion what is, in fact, an extra summation of the evidence that fails to meet Rule 702's standards of reliability and helpfulness."

Lesson to be learned: Stay within your area of expertise when giving expert testimony. Also, when you rely on a party-in-interest, support the representations of the parties with evidence, if available. This is similar to the acceptance of management's representation in an audit. Obtain corroborating evidence and, if none is available because of the nature of the representation, consider the other work you have done to support your opinion and the reasonableness of the representations. Only then decide if you can render an opinion on the issue in question.

Gone are the days when experts could testify to almost anything within reason with only the weight of "because I say it is" to support their opinions. Courts are parsing the reports and testimony of experts to determine whether the expert is qualified to give the opinions being expressed, whether the testimony will assist the trier of fact, and whether the opinions are based on a valid, appropriate, and acceptable methodology properly applied to the facts in the case. *

Dan L. Goldwasser, Esq.
Vedder, Price, Kaufman,
Kammholz & Day

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