By Jay R. Cunningham, CPA/CFF, CVA
Oftentimes, it is curious how opposing financial damages experts, when presented with the same set of facts in a contested matter, can arrive at opinions with such wide disparities in their respective quantifications of damages.
As damages experts, one of the first things we often do after receiving the opposing expert’s report is to identify where we agree and where we disagree. This allows us to see where our opinions diverge and effectively “boil down” our differences to the inherent assumptions upon which our opinion is based.
While differences are frequently found in the “mathematical” basis of the opinion – differences (or errors) in formulas, reliance on different sources and assumptions, even discrepancies in the underlying data – the source of many disagreements between litigation damage experts are conceptual in nature.
Generally speaking, the goal of the damage expert is to calculate the monetary award that would make the injured party whole again. Therefore, it is necessary to quantify how the alleged harmful act damaged the party making the allegation. Most damage calculation theory arises from what is commonly termed the “but-for” approach to damage quantification. That is, the damage model seeks to measure the loss suffered by the injured party (such as lost profits, lost earnings, lost royalties, etc.) by computing the difference in value between what would have transpired absent any wrongdoing (or the but-for scenario) versus what actually transpired. Simplistically, isolating the difference between the hypothetical but-for scenario as compared to the actual scenario accounts for the damages suffered by the injured party.
While the theory of the but-for approach in damage quantification may sound simple, it is the proper application of this approach that can lead experts astray. Differences in the way experts measure and define the but-for scenario often accounts for the large degree of variance between financial experts’ opinions. Such differences are often found in the expert’s application of the following concepts:
- Legal damage remedies
- Causation of damages
- Standard of reasonable certainty
Legal Damage Remedies
A common reason for disparities in financial experts’ damage opinions can be premised in the measure of damage applied. For example, contract law generally recognizes three separate theories of damages for remedying a breach of contract:1
- Expectation Damages: afford plaintiffs the benefit of the bargain by placing them in as good a position as they would have been in had the contract been performed by the defendant.
- Reliance Damages: compensate the plaintiff for losses caused by relying on a contractual obligation that the defendant did not perform. They return plaintiffs to the position they would have been in had they not entered into the contract.
- Restitution Damages: is the amount that returns defendants to their position before they entered into the contract. Unlike expectancy and reliance damages, it focuses on the breaching party, requiring that party to disgorge any benefits received from the plaintiff’s performance under the contract (often termed unjust enrichment).
As a result, the multiple legal damage remedies available for plaintiff to pursue can lead to wide variances in opposing financial experts’ damage opinions.
When the financial expert constructs the but-for scenario, measurement of the alleged wrongdoing requires an isolation of the harmful act in order to properly quantify damages. The resulting damage calculation must quantify only the loss caused by the wrongdoing. Financial expert testimony quantifying the amount of damages is not reliable if it cannot show how damages resulted from the defendant’s wrongful acts. In evaluating the admissibility of expert testimony under Rule 702, courts must consider whether “expert testimony…is sufficiently tied to the facts of the case that it will aid the jury in resolving a factual dispute.”2
Consideration of all factors impacting the but-for scenario is essential, including consideration of economic and market forces. One common observation of an expert failing to prove causation occurs when the expert ignores the impact of economic conditions at play in during the recent economic recession. The expert may project the but-for profits the plaintiff would have earned absent the defendant’s alleged wrongdoing, but failure to consider that these profits would likely have included depressed results as a result of the economy could render the expert’s report unreliable.
Standard of Reasonable Certainty
Generally, damage law prescribes that plaintiffs must prove their damages to a reasonable degree of certainty based on the preponderance of the evidence. Although the estimation of damages do not need to be mathematically certain, they cannot be held as speculative in nature. Expert opinions must be based on objective evidence from which the damage calculation can be determined.
Along those lines, the plaintiff is not permitted to recover damages that are deemed too remote. For example, as a result of a city’s delays in approving a new residential development, the residential development company claimed it has been denied lost profits from selling the lots during the period of the delay. However, if the plaintiff further claimed that it could have reinvested those lost profits into yet another venture, thereby denying them profits for the second investment, the defendant will assert that its damages are too remote and speculative and only limited to lost profits related to the timing of selling lots in the first development.
While there are a myriad of ways that discrepancies exist in opposing financial expert opinions, oftentimes there are conceptual differences that offer insight into reasons for the experts’ variances. For the reasons described above, it is critical that the financial expert pay careful attention to these conceptual legal standards to provide a credible and reliable expert report and opinion.
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.
1 Litigation Services Handbook: The Role of the Financial Expert, Fourth Edition, page 2.7.
2 United States v. Downing, 753 F.2d 1224, 1242 (3d Cir. 1985)