Analysis of Daubert Motions
Jack Tyler Engineering Co. v. Colfax Corp., 2013 U.S. Dist. LEXIS 51603 (April 10, 2013)
In a contract dispute, the plaintiff’s expert used the discounted cash flow method (DCF) to calculate lost profits. In its Daubert motion, the defendant took no issue with the method as such, but contended that the expert’s reliance on numerous unfounded assumptions rendered the analysis unreliable.
In 2001, the plaintiff received exclusive distributorship rights to sell the defendant’s industrial and construction products in designated parts of the country. Although the defendant promised a contract by the end of 2004, the parties never formalized their arrangement. Instead, in October 2007, the defendant unilaterally terminated the agreement. In 2010, the plaintiff sued in federal court (W.D. Tenn.), alleging a violation of the state’s Repurchase of Terminated Franchise Inventory Act, breach of contract, and unjust enrichment.
The plaintiff retained an economist to determine lost profits, and the defendant presented a credentialed business valuator to rebut the testimony. Both parties filed pretrial Daubert challenges.
No variable costs, no mitigation. The plaintiff’s expert used the DCF method to compute damages. He calculated the plaintiff’s annual sales of the defendant’s products based on the plaintiff’s average sales of those products from 2004 through 2006. At his deposition, he explained that he developed his discount rate of 6.0% by applying a 2.5% real rate of return, 2.35% equity risk premium, 3.1% size premium, and a negative 2% adjustment for “one product line instead of a business valuation to account for possible real growth.” He identified the sources (not specified in the opinion) that were the basis for his analysis and explained certain judgments he made based on his experience to arrive at the final numbers.
Because the plaintiff’s owner and CEO told him that there were no variable costs in connection with the sale of the defendant’s products, he did not include them in his analysis. But in his deposition, he acknowledged that these costs could exist. In the same vein, based on his conversations with the owner, he assumed the plaintiff did not mitigate. “I have no way of knowing what [the plaintiff’s] mitigation opportunities are,” he said, adding that the owner was the expert in this regard.
He calculated lost profits into perpetuity. Specifically, his analysis began with a year-by-year calculation of past losses for five years, followed by a year-by-year calculation of projected future losses for 15 years, and an assignment of a capitalized terminal value. By calculating damages into perpetuity, he maintained, his analysis assumed the defendant’s product line was part of a business that could go on forever. Even if the plaintiff’s owner could not stay in the company indefinitely, he could sell the company; in case of sale, the plaintiff’s value would be contingent on the product lines it had at that time. Moreover, the expert used ex-post discounting, that is, he discounted damages to the date of judgment.
The defendant’s rebuttal expert disagreed with several aspects of this analysis. For one, he preferred ex-ante discounting, discounting damages to the date of the breach; this approach was appropriate for businesses with an uneven earnings history or historical losses. His review of the plaintiff’s profit history since 2000 indicated significant losses and financial problems, he said.
He also criticized the competing expert’s failure to include variable costs and mitigation in his analysis. His experience showed that it was “unreasonable” to assume that all of the plaintiff’s costs were fixed costs. As he saw it, “there are marginal costs associated with marginal activity.” As for mitigation, the plaintiff showed an increase in gross sales in 2007, which suggested that it was successful in mitigating any damages resulting from the defendant’s conduct.
Further, the plaintiff’s expert failed to prepare the requisite analysis of “local, regional or national economic outlooks as of the date of termination or subsequent to termination.” These aspects, the rebuttal expert stated, were important considerations when computing lost profits. The defendant’s expert’s opinion included a discussion of industry trends as well as the defendant’s performance. As he put it, the plaintiff’s expert made no “attempt to ascertain why [the plaintiff] was experiencing sharply declining sales of the defendant’s products and sharply lower gross margins throughout the business.”
Speculative base for annual sales figure. The defendant agreed that the DCF approach to calculating lost profits was valid but claimed the plaintiff’s expert used numerous baseless assumptions that made his analysis unreliable. The court considered the objections in turn.
The expert’s base annual sales figure was speculation because he did not analyze the plaintiff’s historic overall profitability or consider sales of the defendant’s products outside the three-year period, the defendant argued. The court noted the plaintiff’s expert did not arrive at the base annual sales “by merely guessing” but used “reasonable facts.” Specifically, he derived the figure from the plaintiff’s actual sales of the defendant’s products. As for his not analyzing the plaintiff’s overall sales or considering additional sales, the defendant did not show that the DCF method required this type of analysis. Concerns that the calculation failed to include all the relevant facts were best addressed at trial.
Two, the discount rate was speculative, the defendant stated. The expert failed to consider all of the relevant risk factors and external market forces. He did not probe into the plaintiff’s financial health, the potential loss of a product line, an industry premium, industry trends, the defendant’s sales trends, and future economic conditions.
The court saw it differently. The expert developed his 6.0% discount factor from identified source material and judgments based on his expertise. Choosing a discount rate is not a “purely mechanical calculation,” the court pointed out; rather, it “is a decision that requires a number of subjective judgments.” Whether the analysis incorrectly disregarded additional considerations was a matter of weight, not admissibility.
Three, the analysis failed to include variable costs and account for mitigation, the defendant objected. The expert’s admission at his deposition that there could be variable costs was proof that he should have taken those costs into account. Also, the plaintiff “clearly” mitigated its damages considering it earned higher profits in 2007 and 2008, after the defendant’s termination of the contract, rather than earlier when it was still a distributor.
The court noted that, the defendant’s objections notwithstanding, it did not identify variable costs or mitigation opportunities. Its claims were just as speculative, resting on nothing more than the expert’s statement as to variable costs and the plaintiff’s realization of higher profits following the termination of the contract. Even if not based on substantial evidence, the plaintiff’s expert’s assumptions were not “so unrealistic and contradictory as to suggest bad faith.”
Four, there was no justification for calculating lost profits into perpetuity. The defendant claimed the expert improperly assumed that the parties would be doing business into eternity, even though manufacturers frequently terminated sales agreements with representatives. Also, the defendant had a right to end the contract upon giving proper notice, and it would have done so much before the 20-year period following the contract’s end.
The court pointed out that the defendant’s own expert agreed that “when determining the value of a portion of a business, the discounted cash flow method provides a forecast for a finite number of years at which point a terminal value is calculated.” The defendant did not contest the methodology but only the length of time for calculating lost profits, the court concluded.
For its part, the plaintiff agreed it was appropriate to present the rebuttal expert’s report to the jury, barring three topics.
First, the plaintiff objected to the rebuttal expert’s ex-ante discounting. It claimed that the Federal Circuit had “soundly rejected” this methodology, citing Energy Capital Corp. v. United States, 302 F.3d 1314 (Fed. Cir. 2002).
The court disagreed. For one, Energy Capital did not hold that ex-ante discounting always required exclusion under Rule 702. In any event, that case did not explain why ex-ante discounting was an inappropriate methodology for calculating lost profits in all circumstances. Other authority made it clear that the answer as to what type of discounting applied depended on “the facts of the case,” the court noted. Here, the rebuttal expert reasoned that the method was appropriate because of the plaintiff’s history of losses and financial trouble. This method was reliable, the court found.
Second, the plaintiff argued, the rebuttal expert’s criticism of its expert’s failure to consider variable costs and mitigation was unwarranted. That he, himself, could not identify any such costs or prove mitigation made his critique speculative. What’s more, the plaintiff expert’s decision was firmly “rooted in the evidence of the record.”
The court stated the rebuttal expert based his critique on the defendant’s tax returns and his own expertise, both of which provided a reliable basis for his argument.
Finally, the plaintiff objected to the rebuttal expert’s discussion of industry trends and the defendant’s economic performance. These statements, it argued, were not rebutting the testimony of its expert; rather, they were an attempt to bolster the defendant’s anticipated theory that it terminated the contract for cause, based on the plaintiff’s low sales.
The court also dismissed this argument, finding the expert’s discussion of these points was relevant to his critique of the competing opinion. And even if the only purpose were to strengthen the defendant’s defense, this testimony was admissible because it was relevant, the court concluded.
In sum, the court denied both parties’ Daubert motions. The judge viewed both the plaintiff and defendant’s arguments as a matter of weight, not admissibility. It could have ended very differently.
Calculations of lost profits are prophesies of the future – and like all prophesies they are subjective. At Rosenfarb LLC we produce well supported, well-reasoned and well communicated damage calculations that withstand the rigors of litigation. We are a firm of forensic accounting and valuation experts. We understand business, have keen insights and always connect the dots. We understand the litigation process. We frame the issues simply and in alignment with the litigation strategy. We use logic to support our opinions, while creating compelling stories. We are sincere, professional and credible. We are accounting experts with legal acumen.
