Jump to Navigation | Jump to Content
American Bar Association

 

Presenting Evidence when Businesses Have Limited Financial Information

By Neil Steinkamp, Gavin J. Fleming Esq., and Jacob Reed

 

The facts and data relied on by an expert witness can often be the difference between a strong opinion and one the courts reject. In commercial litigation, a reasonable level of certainty relating to the cause of damages and the damages amount is required for damages to be awarded. Therefore, a financial expert preparing a calculation of damages should gather facts and data sufficient to establish a basis for the opinions offered. The evidentiary guidelines for testifying experts are outlined by the Federal Rules of Evidence (FRE). Rule 702 of the FRE identifies several key criteria for determining whether the testimony offered by a qualified expert witness is acceptable, including (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.[1]


The "sufficient facts or data" requirement described by Rule 702 is often a point of contention in cases where such data may not be readily available, such as in cases involving new or underestablished businesses. Such businesses may not have historical operating results, detailed financial and other records typically available in cases involving mature, established businesses. To meet the requirements of Rule 702 of the FRE in such cases, the expert often must consider the facts of the case in addition to industry and economic factors to ensure the damages conclusion is supported by factual evidence and data. In other words, it may be up to the expert to develop "sufficient facts or data."


Measuring Damages in Cases Involving Significant Uncertainty
An experienced economic expert will typically request a host of factual documents and data relevant to the issues of the case in an effort to prepare detailed and factually supported damages calculations. Despite the expert's preference to receive such data, detailed factual information may not always be available. For example, in a case involving a lost-profits claim relating to a property-zoning request that was allegedly wrongfully denied, the business may never have opened or received a single dollar of revenue. In such cases, establishing a strong evidentiary basis from historical operating results may not be possible. Adding to the challenges, new business owners are often entrepreneurs who did not prepare detailed business plans, forecasts, or budgets. This doesn't necessarily indicate there are no damages, but quantifying damages with reasonable certainty can become challenging.


Numerous professional organizations provide guidance pertaining to the standards for "sufficient data" to be gathered by experts, including the National Association of Certified Valuation Analysts (NACVA), the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). AICPA Practice Aid 06-4 titled "Calculating Lost Profits" states "[t]he practitioner needs to be able to support conclusions and opinions with sufficient relevant data. The practitioner is responsible for gathering enough sufficient relevant data to provide a reasonable basis for the opinions offered."[2] While published guidelines from these organizations may be referenced to help determine the extent of relevant facts and data required, they are generally nonspecific to any particular type of case.


Courts have significant experience in cases involving lost profits for new and under-established businesses. A legal framework for establishing lost profits in such cases is often referred to as the "new business rule." The application of the "new business rule" has evolved over time and varies across jurisdictions. A common interpretation of the new business rule is that it is not a rule that prevents the award of damages to new businesses, but rather is an evidentiary rule that creates a higher "level of proof needed to achieve reasonable certainty as to the amount of damages."[3]


Several widely referenced decisions have addressed the new business rule. In Capital Corp. v. United States, the Federal Circuit Court of Appeals indicated that while the nature of a new business can make it more difficult to prove lost profits, the court can draw reasonable inferences from the evidence to make a fair approximation of damages.[4] Further, in Cardinal Consulting Co. v. Circo Resorts, Inc., the Minnesota Supreme Court held that the jury could reasonably base its decision relating to lost profits of a new business on the plaintiff's skill and expertise, the existence of the market, or evidence of profitability of similar business.[5]


Often, the burden of establishing this level of proof required for a new business is the responsibility of the plaintiff and its experts. An expert may consider numerous sources of information in establishing a reasonable basis for damages. The American Law Institute states:


if the business is a new one or if it is a speculative one that is subject to great fluctuations in volume, costs or prices, proof will be more difficult. Nevertheless, damages may be established with reasonable certainty with the aid of expert testimony, economic and financial data, market surveys, business records of similar business enterprises, and the like.[6]

Legal Considerations
When proffering an opinion involving a new or undeveloped business enterprise, an expert will be faced with numerous legal challenges under FRE 702 and applicable state law.[7] Indeed, as one court recognized, in this context, an expert is simply "estimating" what the business or venture would have done in the future.[8] Therefore, the expert must strike an appropriate balance between a reasonable estimation of damages and speculating about what could have been.


To tip the balance in favor of admissibility, an expert should avoid these common mistakes:


  • making unwarranted assumptions regarding the profitability and performance of the business[9]
  • drawing unreasonable inferences regarding market penetration and success of the new enterprise[10]
  • using outdated projections of industry performance[11]
  • in a case involving sales of a product, assuming that the product at issue represents 100 percent of the business's sales[12]
  • placing undue reliance on unverified conclusions set forth in business plans, planning reports, or projections[13]
  • proffering optimistic calculations divorced from a business's prior poor performance[14]
  • failing to conduct an independent analysis of facts and figures[15]
  • ignoring inconvenient facts or evidence[16]
  • failing to link alleged wrongful conduct to claimed damages to the exclusion of other factors[17]
  • using gross sales or profit figures that fail to account for the expenses normally incurred in generating such sales[18]

Further, as the Seventh Circuit Court of Appeals has recognized, if an expert uses an approved method of damages calculation, taking into account the limited facts the expert has to work with, the expert's opinion is much more likely to stand up to scrutiny.[19] The Reference Manual on Scientific Evidence sets forth several methods of damages calculation, including regression analysis, matching analysis, stratification, probit analysis, logit analysis, and factor analysis.[20] Although some other courts may not be as rigid as the Seventh Circuit, the Reference Manual should be considered a resource when there are limited facts available to an expert.[21]


Finally, to bridge a factual gap, an expert may also consider using an industry expert, or even the business-owner plaintiff or defendant, in an attempt to glean sufficient facts to bolster an opinion. Importantly, standing alone, business owners may provide testimony regarding the facts underlying a lost-profits calculation under FRE 701 without having to be qualified as an expert.[22] Unfortunately, there is no magic formula for admissibility, but, if the expert avoids common errors, uses appropriate methods taking into account an insufficient factual record, and mines available resources, the expert's opinion is much more likely to withstand scrutiny.


Testing, Research, and Risk Considerations In certain situations, fact documents produced in discovery may not provide the expert with sufficient relevant data from which to draw a reliable conclusion. When an expert encounters such a situation, an expert may choose to identify additional information or use alternative methods to review and analyze information. This can result in reasonable conclusions being drawn, even when fact documentation may be limited. An expert may supplement documents produced in discovery with an assortment of research that may assist in drawing reasonable conclusions about financial damages. With respect to lost profits, diminution in value, and other measures of damages, an expert may look to the following for additional information:


  • industry and market research relating to the business or product in question
  • comparable company research
  • trade-periodical reviews
  • analyst reports of public companies or industries
  • academic publications or journals

Additionally, an expert may choose to use data from different perspectives in an attempt to measure the same or similar effects. That is, an expert may be able to draw reasonable conclusions if the results of alternative methods of calculations are similar. For example, an expert may use a reasonable royalty method as well as a lost-profits calculation as alternative measures of similar impacts. Or, when valuing damages relating to a business or a certain asset, the expert may consider the costs required to develop the business as well as lost profits.


In drawing reasonable conclusions from sufficient relevant data, the expert need not determine what the lost profits or damages would be with absolute certainty. That is, the expert should provide an estimate that is reasonably certain. As events in the but-for world cannot be predicted with absolute certainty, it is necessary for the expert not only to use the data available to draw reasonable conclusions, but also to use measurements of risk to reduce the value of the damages for the uncertainty inherent in the outcome of but-for or future events. In doing so, the expert is more reasonably estimating damages and therefore drawing a more reliable conclusion. Thus, with limited data from which to draw conclusions, the application of an appropriate discount rate that captures the possible variation in cash flow or operating results can assist in drawing a more reliable conclusion.


Discount rates are commonly used to account for the risk inherent in the cash flow of businesses. Situations of higher risk and uncertainty generally require the use of a higher discount rate. In some cases, discount rates may be 50 percent or higher. This is consistent with the rate commonly sought by stage-one venture-capital investors for high-risk investments. However, a careful analysis of the risk of the projected or expected cash flow should be undertaken to match the risk with the appropriate financial measure.


While an expert often may aid in performing economic and market research to establish the basis for the damages calculation, in certain matters, clients may have limited access to funds whereby retaining an expert to perform exhaustive market research may be cost-prohibitive. As an expert cannot be retained on a contingent basis (i.e., their compensation cannot be tied to the magnitude of their opinion), it can be challenging to meet the standard of care within restrictive budgetary limitations. In such cases, experts can assist clients in identifying certain types of documentation that may be useful and clients can physically do the research and gather relevant documents, saving costs. However, the expert should take the time to carefully review the material and its completeness and accuracy. Doing so will ensure the facts and data form a reliable basis for any conclusions and will help establish the expert's conclusions as independent opinions.


Conclusion
Commercial litigation involving businesses with little operating history or other situations of heightened risk and uncertainty can often make meeting the requirements of the Federal Rules of Evidence more challenging. In many cases, an expert's failure to provide a sufficient factual basis for opinions or to verify all assumptions has led to courts dismissing all or a portion of an expert's opinions. While there may not be perfectly defined evidentiary requirements for experts to follow in cases involving heightened uncertainty, an expert that makes reasonable efforts to supplement the limited factual record will be more likely to withstand scrutiny. An expert can often compensate for risk and uncertainty by preparing independent research and analysis and applying appropriate damages methodologies and discount rates. By doing so, an expert may ensure that the evidentiary basis of the analysis is "sufficient" for the damages conclusion to be accepted by the courts.


Neil Steinkamp, AVA, CCIFP, is a director and Jacob Reed is an analyst in the Detroit, Michigan, office of Stout Risius Ross, Inc. Gavin J. Fleming Esq. is a senior associate with Beals Hubbard, PLC, in Farmington Hills, Michigan.



 

  1. Fed. R. Evid. 702.
  2. AICPA BVFLS Section, Calculating Lost Profits, Practice Aid 06-4, at 7.
  3. Litigation Services Handbook, the Role of the Financial Expert, 11.3.
  4. See Energy Capital Corp. v. United States, 302 F.3d 1314 (Fed. Cir. 2002).
  5. See Cardinal Consulting Co. v. Circo Resorts, Inc., 297 N.W.2d 260 (Minn. 1980).
  6. Restatement (Third) of Contr acts § 352 (1981).
  7. For an outstanding survey of state law and federal law on this issue, see Joseph Wylie & Christopher Fahy, Proving and Defending Lost Profit Claims, ABA Bus. Torts J., Fall 2007, at 7–13.
  8. See Humetrix, Inc. v. Gemplus, 268 F.3d 910, 919 (9th Cir. 2001) ([W]e . . . have recognized that lost profits are necessarily an estimate and their amount cannot be shown with mathematical precision.”) (internal citations and quotation marks omitted).
  9. See Target Market Publ’g, Inc. v. Advo, Inc., 136 F.3d 1139, 1144–45 (7th Cir. 1998); see also Fashion Boutique of Short Hills, Inc. v. Fendi USA, Inc., 314 F.3d 48, 60–61 (2d Cir. 2002).
  10. See Target Market Publ’g, Inc., 136 F.3d at 1144–45.
  11. See Advent Sys. Ltd. v. Unisys Corp, 925 F.2d 670, 681–82 (3d Cir. 1991).
  12. See Irvine, IRG Research Group, Inc. v. Murad Skin Research Lab., Inc., 194 F.3d 313, 320–21 (1st Cir. 1999).
  13. See Meterlogic, Inc. v. KLT, Inc., 368 F.3d 1017, 1019 (8th Cir. 2004).
  14. See Lifewise Master Funding, LLC v. Telebank, 374 F.3d 917, 927–28 (10th Cir. 2004); Olympia Equip. Leasing Co. v. W. Union Tel. Co., 797 F.2d 370, 382–83 (7th Cir. 1986).
  15. See Seatax, Inc. v. Sonbeck Int’l, Inc., 200 F.3d 358, 372 (5th Cir. 2000).
  16. See Concord Boat Corp. v. Brunswick Corp., 207 F. 3d 1039, 1056–57 (8th Cir. 2000), cert. denied , 531 U.S. 979, 148 L. Ed. 2d 436, 121 S. Ct. 428 (2000); see Firestone Tire & Rubber Co. v. Pearson, 769 F.2d 1471, 1479–80 (10th Cir. 1985);
  17. See Stelwagon Manuf. Co. v. Tarmc Roofing Sys., Inc., 63 F.3d 1267, 1275–76 (3d Cir. 1995).
  18. 18. See Club Car, Inc. v. Club Car (Quebec) Import, Inc., 362 F.3d 775, 780–81 (11th Cir. 2004).
  19. See also Wylie supra at note 7, at 10 (citing Zenith Elec. Corp. v. WH-TV Broad. Corp., 395 F.3d 416, 419 (7th Cir. 2005)).
  20. See also Wylie supra at note 7, at 10 (citing Federal Judicial Center, Reference Manual on Scientific Evidence 181, n.3).
  21. It is important to note that while the Reference Manual on Scientific Evidence primarily discusses matters involving non-financial “scientific evidence,” it also mentions that the application of concepts discussed therein is relevant to “soft” sciences, such as economics. See Reference Manual supra at note 20, at 469.
  22. See Wylie supra at Note 7, at 10 (citing Miss. Chem. Corp. v. Dresser-Rand Co., 287 F.3d 359, 373–74 (5th Cir. 2002)).

 
Copyright © 2017, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).


Back to Top