Case Study: The Importance of Using Standard Methodology in Calculating Economic Damages

BY MONICA H. KADEN, ASA, ABV, CHFP, MBA, SOBELCO

When preparing an economic damages report, it is important to 1) include certain components discussed in this article, 2) ensure that the expert report is specific to the damages being calculated, and 3) identify the actual harm done to the plaintiff.

I was hired as an expert in a recent matter to rebut a plaintiff’s expert’s report. The plaintiff’s expert was a well-known, credible professional from a large, respected firm. However, there were certain flaws in the report that I believe changed the outcome of the subject case.

KEY COMPONENTS OF THE CASE

* This was a case in U.S. Federal court because the plaintiff and defendant companies were located in different states.

* The plaintiff sued the defendant for breaching restrictive covenants.

* The plaintiff’s expert was hired to prepare an economic damage calculation report.

* The defendant had purchased several clients from the plaintiff.

* The plaintiff’s expert calculated a hypothetical transaction price to show the value of all potential clients that plaintiff’s expert believed the defendant had the ability to potentially attract, and not limited to just those the defendant had purchased already.

A SIGNIFICANT CONCERN

The plaintiff’s expert did not show an actual forecast of lost customers or lost revenues and profits, but rather developed a value for the potential customer relationships the defendant might attract. He did this using the model used to value intangible assets (the multi-period excess earnings model).

Basically, the plaintiff’s expert developed a hypothetical purchase price that the expert believed the defendant should pay the plaintiff for the possibility of attracting these customers. The calculated damage was the difference between what the defendant had already paid to the plaintiff to purchase certain customers and the total hypothetical purchase price that was calculated by the expert.

To simplify the concept without using the real numbers of the case, if $300,000 was paid for certain customers by the defendant to the plaintiff in a transaction, and the hypothetical value of all customers that the plaintiff deemed to be at risk was calculated to be $800,000, the economic damage calculated by the plaintiff’s expert was $500,000 (the difference).

FAULTY METHODOLOGY

The plaintiff’s expert was faced with a Daubert challenge from the defendant’s legal counsel for performing an economic damage calculation that the defendant’s attorneys did not believe followed standard methodology and practice for the calculation of damages. Additionally, the damage calculation did not show the specific harm, such as lost revenues, lost clients or lost profits, that was allegedly experienced by the plaintiff.

The Daubert challenge was heard in the Federal judge’s chambers in Philadelphia in U.S. District Court. After the hearing, the judge recommended that the two sides settle that day, because his ruling on the plaintiff’s expert’s report and the Daubert challenge was going to change the nature of the case and upcoming trial. Based on the judge’s statements, the two sides did settle that day.

While we cannot know for sure what the judge was thinking, I suspect that he was likely going to dismiss the plaintiff’s expert’s report because it did not show the actual harm and economic damages suffered by the plaintiff. In Pennsylvania, harm to the plaintiff must be shown as part of damages, and this aspect of the report was omitted.

PRESENT RELEVANT FACTS

Certain facts in the case had been ruled on by the judge before this hearing, specifically regarding certain restrictive covenant provisions. The judge had ruled that the defendant had been compliant and had not breached certain covenants. The plaintiff’s expert’s report was not updated to account for the latest rulings that were favorable to the defendant. By not adjusting the plaintiff’s report for the changes in the case, the expert report became less relevant to the case.

COMPONENTS OF A STRONG ECONOMIC DAMAGE REPORT

There are certain key elements in an economic damage report as well as standard economic damage methods that should be used, or at least addressed, in order to avoid an issue with the report. The standard recognized and tested methods for calculating economic damages are the “Before and After” method, the “Yardstick” method, the “Sales Projection” method and the “Market Model” method.

An excellent explanation of these methods can be found in The Comprehensive Guide to Economic Damages, Volume One, edited by Nancy J. Fannon and Jonathan M. Dunitz. This book is an excellent resource for preparing damage reports. Additionally, certain key concepts are discussed in the guide which should also be discussed in an economic damage expert report: causation, foreseeability, reasonable certainty and mitigation efforts.

Financial experts (e.g., valuation analysts, CPAs) used in litigation are considered experts because their work is expected to be based on standards, methods and other trusted protocols that have been tested and tried. The analysis and calculations shouldn’t be “outside of the box” unless they have to be, and, in that case, the expert must explain why he or she is deviating from normal practice. Use of a traditional, recognized method generally will be much better received by the court and much easier to defend.

When calculating economic damages, the expert should show the damages and harm experienced by the plaintiff. The expert report must show the actual damages incurred (with reasonable certainty) and should show any harm done. In the case described above, the judge was looking for the specific harm done, and the expert’s report only showed a hypothetical purchase price and a calculation of what the expert thought the defendant should pay based on the hypothetical purchase price. This didn’t address any harm experienced by the plaintiff.

Different states have different laws that are pertinent to damage calculations. Thus, what has to be shown in a damages report (such as the concept of harm in Pennsylvania) is based on each state’s unique laws regarding damage calculations. It is important to have a conversation with the attorney to find out if there are specific conditions in the relevant state’s law that should be taken into consideration in preparing an economic damages claim or report.

Monica H. Kaden, ASA, ABV, CHFP, MBA, is the managing director of business valuations at SobelCo and can be reached at monica.kaden@ sobelcollc.com.