Katz, Sapper & Miller Certified Public Accountants IN THIS ISSUE litigation services bulletin Court Case Summaries 2 Reasonable Certainty: The Lens Through Which Lost Profits Damages Are Viewed 3 Court Seeks ‘Fit’ Between Lost Business Value Calculation, Facts 4 Attempt to Base Lost Profits on Infringer’s Sales Alone Fails 5 Does Use of Full Product Line Data Invalidate Damages Formulation? 6 Book Value Accurately Reflects Fair Market Value of Departing Partner’s Interest Fall 2013
Transcript
Katz, Sapper & MillerCertified Public Accountants
IN THIS ISSUE
litigation services bulletin
Court Case Summaries
2 Reasonable Certainty: The Lens Through Which Lost Profits Damages Are Viewed
3 Court Seeks ‘Fit’ Between Lost Business Value Calculation, Facts
4 Attempt to Base Lost Profits on Infringer’s Sales Alone Fails
5 Does Use of Full Product Line Data Invalidate Damages Formulation?
6 Book Value Accurately Reflects Fair Market Value of Departing Partner’s Interest
Fall 2013
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Jay R. Cunningham CPA/CFF, CVADirectorLitigation Services [email protected]
Reasonable Certainty: The Lens Through Which Lost Profits Damages Are ViewedIn order to recover economic damages, the plaintiff must prove the damages actually occurred. However, in cases involving lost profits, the plaintiff is often faced with a different challenge — proving something that never actually happened would have otherwise occurred. How do you prove that a car accident was the fault of the defendant? Perhaps you can gather eyewitness testimony saying the defendant ran a red light. But in lost profits, how do you prove that the defendant would have run the red light?
Enter financial damage experts. Certified public accountants who testify as experts often perform a variety of economic damage calculations, including assessing lost profits. In determining the admissibility of the calculation of loss, the court will consider if the expert’s calculation meets the standard
of reasonable certainty. Of course, this begs the next question: How certain is reasonably certain? In Morris Concrete, Inc. v. Warrick, the court described it in this manner:
In order that it may be a recoverable element of damage, the loss of profits must be the natural and proximate, or direct, result of the breach complained of and they must also be capable of ascertainment with reasonable, or sufficient, certainty … absolute certainty is not called for or required.
Though experts use financial models and projections to help quantify a damage claim, one of a financial expert’s true values is establishing how the facts of the case help support the lost profits claim. The court stated in Holt Atherton Industries, Inc. v. Heine that “at a minimum, opinions or estimates of lost profits must be based on objective facts, figures, or data from which the amount of lost profits can be ascertained.”
Still, reasonable certainty remains ambiguous. There is no such thing as a universal checklist that can be applied to determine if the reasonable certainty threshold has been met. However, the American Institute of Certified Public Accountants (AICPA) Damages Task Force (DTF), in support of the AICPA Forensic and Litigation Services Committee, is examining the issue, and
Continued on page 7.See “Reasonable Certainty.”
COURT CASE SUMMARIES
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Christou v. Beatport, LLC, 2013 U.S. Dist. LEXIS 9034 (Jan. 23, 2013)
Court Seeks ‘Fit’ Between Lost Business Value Calculation, Facts
In a suit (D.C. Colo.) involving dueling dance club owners and their businesses, the defendants filed a Daubert motion to exclude expert testimony regarding lost profits and lost enterprise value.
The plaintiff owned two Colorado nightclubs that gained national attention for electronic dance music (EDM), featuring live DJs. The defendant worked for the plaintiff as a “talent buyer,” booking “A-List” and other DJs. While employed, he also developed an “enormously successful” EDM e-commerce site. The parties had a falling out, and in 2008, the defendant set up a competing club. In 2010, the plaintiffs sued, alleging various antitrust violations, trade secret theft, and interference with prospective business expectancies. The plaintiffs claimed that, by threatening A-List DJs that he would not feature their work on his site, the defendant coerced them into performing primarily in his club and took over the relevant market.
To quantify lost profits and lost enterprise value damages, the plaintiffs presented testimony from a CPA who was also certified in business valuation and financial forensics.
Lost profits. His methodology for calculating lost profits met both AICPA and accounting industry recommendations, the expert stated. First, he projected revenues that the business probably would have realized had it continued as in the past; next,
he accounted for factors unrelated to the case that likely would have affected revenues; finally, he deducted projected expenses.
He first determined the cover charge revenue the plaintiff’s two clubs realized in 2006 and 2007 on their respective EDM nights — Thursdays and Saturdays. Assuming “things would stay about the same,” he then calculated “expected” cover charge revenue for 2008-2010. Acknowledging the economic downturn at that time, he adjusted by using statistics from the North American Industry Classification System specific to Colorado bars, nightclubs, and other drinking establishments during that period. Similarly, he calculated the clubs’ historical revenue (2006-2007) from food, drinks, and various sales and assumed he could use the average percentage of revenue from those years for his forecasts. These data gave him “total” revenue projections.
He next projected the clubs’ variable expenses (cost of goods sold, advertising, bank fees, equipment rental, and payroll taxes) from 2006 to 2007 to 2008 through 2010. After subtracting them, he concluded that lost profits for both clubs were about $1.2 million.
The defendants’ objections focused on how he applied his methodology:
Continued on page 8.See “Lost Business Value.”
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Brighton Collectibles, Inc. v. RK Texas Leather Mfg., 2013 U.S. Dist. LEXIS 24644 (Feb. 12, 2013)
Attempt to Base Lost Profits on Infringer’s Sales Alone Fails
The plaintiff’s expert claimed $115 million in damages from lost sales, but the defendants argued the testimony was inadmissible under Daubert for many reasons, including his reliance on a theory that had no grounding in “the real world facts of this case.”
The plaintiff manufactured and sold higher-end women’s accessories, including expensive handbags, and alleged defendants’ knockoffs infringed its trade dress. Under the Copyright Act, it sought actual damages, including the owner’s lost profits and damage to goodwill as well as additional profits of the infringer.
Instead of using the plaintiff’s sales data — actual sales or forecasts of future sales — the plaintiff’s expert proposed to determine lost profits based solely on the number of the defendants’ sales. Under this theory, he assumed that one of the defendants’ infringing sales correlated with one lost transaction in which the plaintiff’s customer would have bought 2.06 authentic items. As all but one of the defendants were wholesale importers and distributors, he counted each transaction in the chain of distribution as a separate sale, disregarding the number of handbags consumers ultimately bought. Even though the defendants’ sales amounted to only $8 million, he determined a loss to the plaintiff of $115 million.
His report did not include an economic
analysis of the fashion marketplace to support his conclusion of a 1-to-1 ratio or set forth a method with which to arrive at the appropriate scale.
In their pretrial motion, the defendants argued the testimony had no basis in facts and, therefore, was irrelevant. It was implausible that every customer who bought one of the defendants’ imitation handbags, which cost between $20 and $50, would have paid over $200 for one of the plaintiff’s handbags. The expert provided no evidence that there was direct competition between the defendant retailer, which had small Western-style stores, and the plaintiff, which owned upscale boutiques and sold to upmarket department stores.
Moreover, the expert did not use a scientific methodology that others could replicate, simply offering an ipse dixit conclusion. His assumptions were “non-committal and evasive,” making his opinion unhelpful to the jury. The expert’s math would give the plaintiff a windfall.
The plaintiff contended that a lost profits determination was “inherently imprecise:” its expert simply offered a “framework” that the jury could use when deciding on a reasonable amount.
At the outset, the court noted with emphasis that the proven method of
Continued on page 8.See “Lost Profit.”
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Does Use of Full Product Line Data Invalidate Damages Formulation?
In a trade dress infringement suit, the defendants challenged the qualifications of the plaintiff’s damages expert and the completeness and methodology of his lost profits determination. Both parties retained experts to compute the damages the plaintiff allegedly sustained from the defendants’ sale of infringing sheathed, elastic resistance bands.
The plaintiff’s expert did not provide an actual damages figure because he said he lacked the defendants’ most recent sales figures. Instead he set out a “simple” formula to calculate damages. He assumed that, “but for” the defendants’ wrongful conduct, all of their sales would have gone to the plaintiff. The calculation required multiplying the average sales price of the plaintiff’s product by the number of infringing units the defendants sold and subsequently multiplying the result by the incremental profit percentage on the plaintiff’s products.
The latter, he found, was instrumental in arriving at a damages figure. To compute it, he first determined the plaintiff’s fixed and variable costs, noting that only variable costs affected the production of additional units and, therefore, the profit arising from the sale of those units. He recognized that variable costs might be difficult to identify and “judgmentally” added 2.5 percent, to arrive at a total variable cost percentage. This adjustment,
Hark’n Technologies, Inc. v. Crossover Symmetry, 2013 U.S. Dist. LEXIS 24644 (Feb. 21, 2013)
he said, ensured “that the variable profit rate is not overstated.” Moreover, he relied on data for the plaintiff’s entire product line rather than that for the products at issue.
The defendants’ expert agreed with the formula because it was generally applicable in trade dress infringement cases. But instead of assuming the plaintiff would have obtained all of the infringing sales the defendants made, he proposed factors (unspecified) to reduce the number of lost sales.
In their pretrial Daubert motion, the defendants claimed the plaintiff’s expert’s testimony was inadmissible because: 1) he lacked requisite experience; 2) his expert report was incomplete; and 3) his data and methodology related to the incremental profit percentage were unreliable. The court considered the objections in that order.
1. The expert lacked experience in valuing intellectual property or analyzing lost profits in infringement cases and, therefore, was unqualified, the defendants alleged.
The court disagreed. Given his nearly 30 years of working in the accounting
Continued on page 8.See “Product Line Data.”
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Book Value Accurately Reflects Fair Market Value of Departing Partner’s Interest
A withdrawing member of a limited liability company unsuccessfully appealed the trial court’s decision to use the book value of the company’s assets, rather than rely on his expert’s going concern analysis, to capture the fair market value (FMV) of his share.
The plaintiff owned a one-third interest in the LLC. He joined the company in 2008 and brought with him critical business from his earlier work as a consultant. When he had a disagreement with the other two partners a year later, he filed for withdrawal and a value determination of his interest. At that time, his contact was the company’s primary source of business.
The trial court allowed the withdrawal as of May 2009, but the remaining issue was how to determine the FMV of his interest on that date. At trial, he presented expert testimony from a CPA, who based his valuation on company tax returns and year-end financial statements for 2008 and 2009.
There were three ways to value a business, the income, asset, or market approach, the expert stated. The income, or discounted cash flow, method involved projecting future company earnings and applying a discount to arrive at the present value. In this case, he performed a going concern analysis, assuming the
company would continue its operations, and computed an FMV of $2 million. Accordingly, the plaintiff’s share was worth $666,666. The expert did not apply discounts.
But he also stated that the company’s unadjusted book value was approximately $37,800 as of Dec. 2008. He said he did not receive information about the assets the company owned on May 2009. To compute the adjusted, or fair market, value of the assets, he used estimates of the company’s inventory and accounts receivable based on published Internal Revenue Service (IRS) ratio data and arrived at a total value of $636,400.
The market approach required data of prior sales of comparable companies in the same industry, he noted.
The company’s accountant also testified, saying he had prepared year-end financial statements and federal tax returns for the company for 2008, 2009 and 2010. In 2009, the company showed a loss of nearly $98,000 because of declining business in the second half of the year. At the same time, there was “a lot of money in the bank” in May 2009 and June 2009, which led him to recommend a salary increase for the remaining members.
Continued on page 9.See “Book Value.”
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Reasonable Certainty(Continued from page 2)
plans to issue a practice aid in the near future to help add some clarity to the issue. Some of the key issues that the DTF is considering are as follows:
Is the alleged wrongdoing linked to the economic damages?The plaintiff has the burden of establishing that the wrongful conduct is linked to the amount of damages. While the damage expert does not establish a defendant’s liability, he or she should be able to not only explain how the defendant’s actions caused the plaintiff’s damages, but also account for other factors that contributed to the loss. For example, a small business that lost revenues because of a defendant’s breach of contract may also have experienced the decline due to the global recession. An expert unaware of other factors contributing to the plaintiff’s loss may be open to critique from the opposing counsel and expert.
Do the client data and/or representations need to be tested?Another question that remains unsettled is this: To what extent should the expert rely on data and/or representations from the client? In almost any case, the client will represent certain facts upon which the expert will rely to assist in calculating damages. However, what is the extent of the analysis the expert needs to undertake to accept the representation?
How to calculate lost profits for newly established businesses?The DTF is also considering the question of what additional analyses does the expert need to perform when the loss is alleged by a business with little to no historical operating results? When there is not sufficient historical data to project future cash flows, the expert is often required to make extra assumptions to compute the loss amount. In these situations, courts will often employ greater scrutiny; as such, experts should be aware of the ways courts are likely to scrutinize their calculations.
The issue of reasonable certainty in damages can take many shapes and sizes, as demonstrated by the case summaries included in this issue of our Litigation Services Bulletin. The first case examines the question of whether the expert’s lost enterprise value calculation is appropriate based on the facts in the case (and whether claiming past lost profits is mutually exclusive of present lost enterprise value). The second case discusses a Daubert motion (ultimately granted) against the plaintiff’s expert arguing that the expert did not perform a reasonable economic analysis when he assumes that customers who purchased infringing “knockoff” handbags for $20 to $50 would have paid more than $200 for the plaintiff’s handbag. The third case, involving trade dress infringement, involves the defendant challenging the plaintiff expert’s lost profits methodology when he bases his lost profit calculation on the plaintiff’s entire product line rather than isolating it to the products at issue. Finally, the fourth case discusses an expert’s consideration of different valuation approaches of a business when a key partner departs.
In the end, all lost profits calculations require experts to calculate damages using assumptions of what would have happened “but for” the alleged actions of the defendants. The key for experts then, is to make those assumptions with as much information as possible to support their position. An analysis that is well supported by both internal and external data and consistent with generally accepted approaches will increase the likelihood of meeting and surpassing the reasonable certainty threshold.
All lost profits calculations require experts to calculate damages using assumptions of what would have happened “but for” the alleged actions of the defendants.
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Lost Business Value(Continued from page 3)
• He did not consider revenue from other club nights and the plaintiff’s other clubs that could have offset the losses specific to Thursday and Saturday nights;
• He failed to consider additional factors that might have reduced revenues, including the entry of a new and strong competitor;
• He omitted 2005 revenue data; • His conversion of lost sales for
Thursday and Saturday nights to lost profits, using a variable cost-to-sales ratio that applied to all nights, was problematic;
• His reliance on information he obtained from the plaintiff’s counsel raised questions about his numbers; and
• Cross-examination revealed at least one mistake in his lost profits chart.
There was “nothing mysterious” about the expert’s calculation, the court stated. Daubert merely requires that an expert’s testimony be relevant and reliable. Here, the expert’s explanation as to “how he went about” calculating lost profits would be helpful to the jury. Saying that challenges to his assumptions and even mistakes in his calculations were issues for cross-examination, it admitted this part of the testimony.
Lost enterprise value. The expert stated that there were three standard methods to determine the value of a business: 1) calculation of net asset value; 2) comparable sales; and 3) capitalization of earnings (income method). He rejected the first method because it did not account for goodwill, which he considered a significant component of the value of the plaintiff’s business. Also, he could not find comparable sales. This left the third method.
The expert’s calculation rested on the assumptions that the plaintiff intended to sell the two clubs around December 2010 and that events occurring after
Dec. 31, 2010, would not be relevant. He relied on the plaintiff’s deposition testimony that, in 2006 or 2007, both parties had conversations to the effect that the defendant might buy one of the plaintiff’s clubs and turn the other into a condominium. “They were pretty close to the numbers,” the plaintiff stated. Given the reduction in profitability, the plaintiffs lost $2.1 million in enterprise value, the expert concluded.
The defendants did not challenge the expert’s method or his capitalization rate (not specified). But the court found his opinion left too many issues unanswered. The question, it said, is “fit,” that is, whether there was a logical relationship between his calculation of lost enterprise value and the facts of the case. “Vague” testimony about conversations between the plaintiff and the defendant, before the defendant even left the plaintiff’s business, was not necessarily relevant to establishing the value of his clubs at the end of 2010. Even assuming the plaintiff wanted to sell at that time, “is the alleged loss in enterprise value perpetual?” Moreover, the court asked: “What is the value today?” And if the plaintiff prevailed in this action, “would damages for lost enterprise value as of Dec. 31, 2010 permit [him] to have his cake and eat it too?”
The court noted that in their motion to supplement the expert’s opinion — which it granted — the plaintiffs argued that, under the law, past lost profits and present lost enterprise value were not mutually exclusive. But this proposition still did not answer its basic questions and reserved final judgment of this part of the testimony for trial.
Lost Profit(Continued from page 4)
determining lost profits was “grounded in plaintiff’s sales data,” whereas the expert’s theory focused exclusively on the number of the defendants’ sales. The latter number normally is relevant to a different measure of damages based on
Product Line Data(Continued from page 5)
industry, he was capable of analyzing the plaintiff’s financial data and making conclusions about profitability. His report did not attempt to value intellectual property, but identified a method for determining lost profits from the sale of goods.
2. Because the expert’s report lacked an actual damages figure and did not include a methodology, it violated Rule 26 of the Federal Rules of Civil Procedure, which requires a complete statement, the defendants claimed. As to the damages figure, even if he lacked the most recent sales data, he should have calculated
Continued on page 9.See “Product Line Data.”
a defendant’s wrongful gain. The expert failed to show a rational connection between the distinct measures.
To determine the validity of the expert’s theory, equating infringing sales with lost profits on a scale of 1-to-1, the court researched case law. When the theory held up, it found the plaintiff had “convincing evidence from a customer” that she bought the defendant’s counterfeit product in place of the plaintiff’s. In this case, however, the expert offered no data demonstrating there was a reliable correlation between the defendants’ sales and the plaintiff’s profits. “The expert has not provided a nexus from the knockoff customer to [the plaintiff’s] typical customer who would spend $240 or $400 on one handbag.”
The court rejected the suggestion that the opinion could serve as a “framework” for the jury, noting the expert was unable to point to a factual basis for his assumptions or verify that his method was accepted in the field. Given the “analytical gap between the data and the opinion,” the testimony was not helpful. The court granted the defendants’ motion.
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Product Line Data(Continued from page 8)
damages through 2011. In terms of the methodology, he did not explain the origin of his formula or provide evidence that it had undergone peer review or was accepted in the industry.
The plaintiff countered that a damages figure based on incomplete sales data would have been inaccurate. Concerning the methodology, the defendants’ expert had proposed the same formula, albeit with adjustments. Also, its expert’s assumption that all the infringing sales would have gone to the plaintiff was valid; in any event, as the fact-finder, the jury, not the expert, would decide the number of sales the plaintiff lost due to infringement.
The court agreed that the plaintiff’s expert had information to make a preliminary damages calculation. But his failure to do so did not prejudice the defendants. Although he “did not do the actual math,” he provided the formula with which the defendants could have performed the calculation themselves. Also, the defendants’ objection to the methodology had no traction considering their expert used the same formula.
3. The defendants also attacked the reliability of the expert’s methodology for developing the incremental profit percentage. Both his variable cost estimate and his use of the entire product line, instead of the products at issue, made the computed figure unreliable.
The plaintiff argued the incremental profitability for the infringed products actually was higher than the number the expert proposed and the aggregation of data, in fact, was a windfall to the defendants, as evidence at trial would show.
The court found the plaintiff failed to support its assertion of a windfall and noted that aspects of the expert’s computation of the incremental profit
percentage were “troubling.” On the one hand, the defendants’ concerns about the variable cost estimate went to the weight of the testimony and were the subject of cross-examination and competing expert testimony.
But using the wrong data as the basis for the damages conclusion represents “a more serious deficiency.” Different products generate different profitability, depending on cost and the manufacturer’s strategy, and “lumping all of the costs together” may distort the profitability number of the products at issue, the court noted. Moreover, the incremental profit percentage was a “key component” of the expert’s damages formulation and “the primary reason” his testimony would be helpful to the jury. Ultimately, the court decided this issue also leaned toward weight than admissibility and should be challenged at trial.
In admitting the testimony, the court dismissed the plaintiff’s suggestion that the expert might discuss evidence at trial that he did not include in his report to support the argument that the use of the full product line did not prejudice the defendants. “This will not be permitted,” the court said, because it would deny the defendants the opportunity to prepare.
Book Value(Continued from page 6)
The trial court rejected the income approach in this situation. Considering the plaintiff provided “almost the exclusive source of business” to the company, his leaving meant one could not assume the company’s future cash flow. The market approach did not apply because the business was a small, closely held company whose profits depended on the skills of its members. Holding a minority interest in the company meant the plaintiff could not make business decisions or require distributions, the court found. Also, his interest was not marketable “because its value was indistinguishable from the plaintiff himself.”
Therefore, the trial court determined, the book value of all company equity best reflected its FMV. Adopting the expert’s $37,800 value, it found the plaintiff’s share was worth approximately $12,500.
The plaintiff contested the valuation at the Louisiana Court of Appeals, saying the trial court erred because it failed to consider all of the company’s assets at the time of the withdrawal. Specifically, the court incorrectly applied a minority discount and failed to take into account that, at the date of his withdrawal, the company’s bank account showed an additional $500,000 in cash. At a minimum, the trial court should have credited his expert’s testimony that the adjusted book value was $636,400.
The appellate court found no merit in the arguments. The trial court made the requisite factual findings before deciding on the asset approach. Although it discussed discounts when it described the nature of the plaintiff’s interest in the company, it did not apply a discount when it used the book value. Even though the company accountant testified to there being “a lot of money in the bank” in May 2009, he did not say it was $500,000 precisely.
As to the adjusted book value, the appellate court pointed out that the trial court specifically noted there was no evidence that the inventory amount the plaintiff’s expert proposed was accurate considering the company leased most of its equipment and provided services. It did not need to keep an inventory of goods. Also, the expert failed to show that the IRS data corresponded to the company’s actual accounts receivable. Accordingly, the trial court did not err in discrediting his adjusted book value. The appellate court upheld the $12,500 valuation of the plaintiff’s share.
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About Katz, Sapper & Miller
Jay Cunningham is a director in KSM’s Litigation Services Group. Jay’s background includes providing a wide range of consulting services in the context of disputes or litigation. He has extensive experience in the application of accounting, finance and economics to commercial damage analyses. Full bio.
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Ron Lenz is the partner-in-charge of KSM’s Litigation Services Group. He offers consultation in matters related to litigation, including, but not limited to, damages arising from employee fraud and dishonesty schemes, contract disputes and lost wages. Full bio.
