Author: Mr. Dennis Frankeberger, CPA/CFF, CFE
Before and After
Court paints picture of lost profits and other calculations
In Floorgraphics Inc. v. News America Marketing In-Store Services Inc., No. 04-3500 (D.N.J. 02/04/2008) the U.S. District Court for the District of New Jersey sketched guidelines concerning several lost profit and valuation issues.
In rejecting a Daubert challenge against the plaintiff’s damages and valuation experts, the court provided valuable insight into the “before-and-after” method, guideline company use, and marketability discount availability.
Framing the issues
The plaintiff, Floorgraphics, a closely held company, and the defendants, News America et al., competed in the “in-store marketing” industry. Floorgraphics sued the defendants, alleging the defendants had engaged in illegal and tortious acts designed to disrupt Floorgraphic’s retail contracts, “poison” its relationships with advertising customers and otherwise “run it out of business.” Among other things, Floorgraphics accused the defendants of disseminating false and misleading information about its business and products to its customers.
Floorgraphics offered six expert witnesses to support its liability and damages claims. The defendants moved to exclude the testimony of every one of them as unreliable under the Daubert standard. This article focuses on the plaintiff’s damages and valuation experts, both of whom were permitted to testify.
Broad brushstrokes
The first expert calculated Floorgraphic’s damages under the assumption that News America would be found liable on every count in the complaint. Using a before-and-after method, he concluded that the defendants’ conduct “negatively impacted” Floorgraphic’s sales between 2003 and 2007 by $180.2 million. After accounting for interest, he placed lost profits at $55.64 million.
The defendants maintained the expert’s testimony was flawed and failed to fit the facts of the case. The before-and-after method estimates damages by comparing a plaintiff’s profits both before and after a defendant’s alleged misconduct. But in this case, the defendants argued, at least a significant portion of the decline in Floorgraphic’s profits was attributable either to the defendants’ lawful conduct or to other parties or events.
According to the defendants, the expert made only two minor adjustments to his findings to reflect the impact of several Kmart store closings. Other than that, they said, his “stubborn insistence that all of the losses were caused solely by defendants’ alleged conduct” and his failure to consider “real-world conditions” rendered his testimony inadmissible.
The court disagreed. For one thing, the expert went beyond “minor adjustments” to account for other factors responsible for the plaintiff’s losses. For example, he “assumed flat economic growth during the damages period relative to the benchmark year of 2002” without even considering inflation. And he assumed that Floorgraphics would not have won any new customers after that year. These and other assumptions resulted in “a restrained damage estimate as opposed to an inflated one,” the court said.
More important, however, even if the plaintiff’s expert had failed to consider real-world conditions, it was incumbent on the defendants to show that “those factors mattered.” When challenging expert testimony, the court went on, “a party must move beyond empty criticisms and demonstrate that a proposed alternative approach would yield different results.”
Finally, even assuming that all the defendants’ objections were valid, they went to the weight of the testimony, not admissibility. When an expert using the before-and-after method projects future earnings growth based on the plaintiff’s previous growth rate, the court explained, a defendant “may dispute this with their own study that projects that earnings would have declined even without a breach.”
In this case, the expert’s methodology was sound and his calculations, to the extent that his assumptions were “wrong,” could be adjusted. “[M]aking adjustments,” the court explained, “is not analogous to unreliable.”
Painting by numbers
Floorgraphics retained its second expert to provide an opinion on whether the defendants’ alleged wrongdoing caused the company to lose business value. He, also relying on a before-and-after methodology, concluded that it had.
In calculating damages for lost value, the expert relied on the previous expert’s estimates of lost revenues and earnings, using valuation multiples derived from two guideline companies. He selected these companies because an investment banker had used them to value Floorgraphics for possible sale in 2001. The investment banker had actually relied on three companies, but the expert felt the third was not sufficiently comparable to Floorgraphics.
The defendants sought to exclude this expert’s testimony on several grounds. They argued that his opinions were inadmissible because he “blindly accepted” the previous expert’s work. They argued that, if the first expert’s calculations require revision, the second expert’s calculations must also be revised. As before, however, the court found that the need to adjust calculations doesn’t demand that evidence be excluded.
The defendants also claimed the guideline companies the expert used were insufficient. The court acknowledged that an expert should conduct an “exhaustive search” for comparable companies, but also recognized that a company may be so unique that good guideline companies are difficult to find.
In such cases, a valuator may find a group of companies that shed light on the subject company’s value, focusing on “one or a few” companies that are more directly comparable than the others.
In Floorgraphics, it was appropriate for the expert to give the greatest weight to the two companies he relied on. The defendants asserted that those companies were not sufficiently similar to Floorgraphics to support the expert’s conclusions. Although the defendants would have an opportunity to raise their objections on cross-examination, the objections were not grounds for exclusion.
The art of appraisal
In addition, the defendants attacked the plaintiff’s valuation expert for relying on guideline companies selected by others rather than conducting his own analysis. The court pointed out, however, that the expert merely used the investment banker’s selection as a starting point, making his own determination of comparability — and even rejecting one of the selections.
Finally, the defendants found fault with the expert for failing to apply a discount for lack of marketability. But, as the court explained, while valuators commonly use such discounts when valuing a minority interest in a closely held company, the discounts may or may not be appropriate when valuing a controlling interest, as in this case.
Expert defense
In addition to demonstrating that your expert’s methods are reliable, it’s important to emphasize how he or she contributes to the process. Daubert challenges are becoming almost routine in cases involving complex expert analysis. Fortunately, the Floorgraphics case provides valuable guidance for defending your experts against attacks on their reliability.
Disclaimer: The above article has been contributed by Dennis Frankeberger, CPA/CFF, CFE, and has been published with permission.
ABOUT DENNIS FRANKEBERGER, CPA, CFF, CFE
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Mr. Dennis Frankeberger has been a CPA for 37 years and an expert witness for 23 years. He is Certified in Financial Forensics, Certified Fraud Examiner. Areas of expertise include Forensic Accounting, Fraud Investigations, Business buy/sell’s, Accounting Due Diligence and Shareholder/Partner disputes. View extended profile |
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