Faulty Assumptions Preclude Experts from Testifying

Myservice Force v. Am. Home Shield, 2014 U.S. Dist. LEXIS 61207 (May 2, 2014)

In this breach of contract action the admissibility of the plaintiff’s two experts’ opinions hinged on one key issue.  One of the expert’s revenue projections utilized a Monte Carlo simulation that the defendant attacked as invalid. The projected revenues formed the basis of the other expert’s determination of the value of the company.

The defendant sold warranties that covered larger systems and appliances in the home. It used three types of contractors to perform the work: (1) preferred contractors who had operations agreements with the defendant and a commitment for a certain number of calls per year; (2) network contractors, who had operations agreements, but no call commitments; and (3) direct contractors who had no formal agreements with the defendant. The plaintiff developed a service work order automation and status reporting system that enabled the contractors to report their customer appointments and the date and time of completion of their work orders. In January 2010, the plaintiff and defendant entered into a two-year agreement that mandated that contractors report appointments within 24 hours and work order completion within 5 business days; and also to support the plaintiff in its efforts to market its products to the defendant’s list of contractors.

The parties’ relationship soured when the defendant decided not to pursue steps that would oblige its contractors to use the plaintiff’s products. The plaintiff sued in federal court (E.D. Pa.) and retained two damages experts. The first expert determined what the plaintiff’s revenues and profits would have been if the defendant had not breached its duty as to the status reporting requirements. The second expert, using the first expert’s forecasts, calculated the value the plaintiff would have had at the end of the agreement’s second year if the defendant had not breached its duty.

To forecast revenues and profits, the first expert used a Monte Carlo simulation. It was based on the assumption that the defendant had a contractual obligation to make all of its preferred and network contractors comply with the reporting requirements or eliminate those contractors who did not comply. This meant the contractors either would use the defendant’s existing services or the plaintiff’s products.

He accounted for “potential delays of product rollouts, software defects, and operational failures” in the Monte Carlo simulation by setting up three “business ramp-up scenarios” with different market penetration assumptions. His high estimate model assumed that contractors would have bought products from the plaintiff by the end of the fourth quarter of Year 1 of the agreement. His median estimate model assumed a two-quarter slip in those purchases, and his low estimate model assumed a four-quarter slip in those purchases. He determined that in 2010 the defendant had 4,748 contractors. In 2011, there were 4,300 contractors.

The simulation rested on what he called the “market penetration assumptions,” which drew on an effort the defendant started in June 2010 to pressure contractors into status reporting compliance. Then, the defendant had selected 191 contractors to serve as a focus group for its effort. When the defendant tried to compel them by way of phone calls or reducing their number of service calls, the plaintiff’s expert found that between 15 and 29 contractors either bought products from the plaintiff or used the defendant’s services. Based on these results, he developed a “range for use in the Monte Carlo simulation that represents the effect that [the defendant’s] enforcement efforts would have had upon a contractor.” Critically, in calculating the range, he excluded the 162 to 176 contractors who did not respond to the defendant’s efforts at all. He concluded that a minimum of 28% and a maximum of 53% of contractors would have bought the plaintiff’s products to ensure compliance. “[T]his data is representative of the total population of Preferred and Network contractors because it is a statistically significant sample size (191 out of approximately 4,500 Preferred and Network contractors),” he asserted.

The Monte Carlo simulation also included assumptions as to which products the contractors would buy and the corresponding pricing. Further, it assumed that between 64% and 97% of the contractors would use the plaintiff’s credit card processing service. And it considered a customer attrition rate of between 3% and 26% based on the expert’s review of attrition rates of 13 publicly traded companies whose businesses were similar to that of the plaintiff. The fixed costs the expert used for the simulation related to general, administrative, engineering, and professional services personnel—the variable costs related to maintaining an established data center. Because the defendant’s contractor base was a captive market, costs did not include marketing and sales costs.

The first expert concluded that, under his low estimate scenario, Years 1 and 2 together would have resulted in a pretax net income for the plaintiff of over $2.1 million; under the mean estimate scenario, the total would have been nearly $4.2 million; and under the high estimate scenario, it would have been nearly $6.7 million.

The second expert valued the plaintiff at the end of Year 2 using a “Market Multiple” of the first expert’s revenue forecast. He said his multiples took into account the acquisition values of actual and comparable companies with revenue models similar to that of the plaintiff during the relevant period and the “unique” relationship between the plaintiff and the defendant. He concluded that the plaintiff would have been valued between $8.6 million and $27.7 million if the defendant had adhered to its duty of good faith and fair dealing.

The defendant filed a pretrial motion arguing the opinions were inadmissible under Fed. Rule of Evid.702 (Daubert). The first expert’s opinion was based on an assumption that “did not fit” the facts of the case, and his methodology was unreliable. If the court struck the first testimony, it also had to exclude the second expert’s opinion because the latter relied on the former’s projections.

The biggest problem with the first expert’s approach was the assumption that the defendant had a contractual obligation to force its contractors to buy from the plaintiff or cut its ties with them. The agreement imposed no such duty, the defendant said. The erroneous assumption led to the expert’s decision to eliminate from his market penetration assumption the 161 to 176 nonresponders, the defendant claimed. In fact, only 4.2% of the target group bought products from the plaintiff during the seven months following June 2010. The expert’s conclusion that 28% to 53% of the defendant’s preferred or network contractors eventually would have bought the products depended on his improperly eliminating the nonresponders from his calculation.

Also, the defendant claimed the opinion was unreliable because the sample was too small. And there was no proof that the sample group was representative of all the preferred and network contractors. Finally, there was no evidence that the few contractors in the target group who bought the plaintiff’s products did so as a result of pressure from the defendant.

At the outset of its analysis, the court explained that “fit” primarily pertained to relevance. Precedent in the circuit required that courts exclude testimony based on assumptions that had no factual foundation in the record. Whether the first expert’s assumption fit the case came down to whether the defendant’s duty of good faith and fair dealing in terms of the status reporting requirements meant it had to compel 100% of its contractors to comply and terminate the noncompliant ones.

The plaintiff responded that the expert’s assumptions aligned with the court’s prior decision on the defendant’s summary judgment motion. Specifically, the opinion included language that there was evidence that the defendant “willfully rendered imperfect performance … by failing to mandate 100% timely compliance with status reporting requirements.”

The court disagreed. The plaintiff and the expert misinterpreted the agreement, it said. And they took the court’s statement out of context. “[O]ur statement does not support [the expert’s] assumption that [the defendant] could only satisfy its duty of good faith and fair dealing by ensuring that all of its Preferred and Network contractors comply with their status reporting obligations 100% of the time” and by terminating those who did not comply, the court emphasized. Therefore, the expert’s market penetration assumptions did not fit the facts of the case and were inadmissible.

Finally, because the plaintiff’s second expert prepared a valuation of the plaintiff as of the end of the second year of the contract that used the first expert’s unreliable data, the valuation was not sufficiently reliable under Rule 702. In sum, the court struck both expert opinions, leaving the plaintiff with no damages evidence.

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