litigation services Court Case Summaries IN THIS ISSUE 2 Reducing Client Costs in Civil Litigation 3 Damages Expert Can Present Alternative Theory of Damages 4 Expert s Unconventional Method to Forecast Lost Profits Satisfies Daubert 5 Patent Experts Have Limited Latitude to Comply with New Damages Standards 6 Expert s Damages in Cookie Case Crumbles Katz, Sapper & Miller, LLP Certified Public Accountants
Reducing Client Costs in Civil Litigation Jay R. Cunningham cpa/cff, cva Director Litigation Services Group jcunningham@ksmcpa.com While one of the primary objectives of the United States civil justice system is to provide the parties with speedy and inexpensive resolutions, those that have been involved in litigation know this is rarely the case. As a result, there has been a topical interest in exploring and reducing the factors that contribute to prohibitive costs and excessive delays in court cases. Recently, the Institute for Advancement of the American Legal System (IAALS) sought insights from financial experts into providing potential solutions to help improve inefficient practices encountered in the civil litigation process. Because financial experts frequently provide forensic accounting services and testimony in litigated matters, they were able to offer a unique perspective in a recent white paper: Another Voice: Financial Experts on Reducing the Costs in Civil Litigation. This white paper, submitted by the IAALS in collaboration with the American Institute of Certified Public Accountants (AICPA) and its Forensic and Valuation Services (FVS) membership section, offers five recommendations for increasing both the effectiveness and efficiency of using a financial expert in the civil pre-trial process, as follows: 1. Judges should implement early and consistent active case management Costs of financial experts are directly impacted by court continuances, or postponements. A survey conducted by the FVS indicates that some 98 percent of respondents claim continuances increase the number of hours for the financial expert s preparation for a trial. Any delays in a litigated matter due to continuances or untimely rulings on motions nearly always require the duplicative efforts on the part of the financial expert to get re-acclimated following the delay. Procedures that oppose continuances and support prompt rulings on motions will aid in reducing costs in financial expert time. 2. Clients and attorneys should involve experts early in the process Early engagement allows the financial expert to be involved in assisting with defining economic issues, assessing relevant approaches to be used in preparing expert opinions, and requesting required and beneficial information during discovery. Not only does engaging an expert early in the process allow the expert to be properly screened, it also ensures the expert has sufficient time to do the best work. By avoiding incomplete disclosure requests and late engagement Continued on page 7. See Client Costs. 2 Katz, Sapper & Miller
Damages Expert Can Present Alternative Theory of Damages Illinois Tool Works, Inc. v. MOC Products Co, Inc., 2012 U.S. Dist. LEXIS 116471 (Aug. 17, 2012) The plaintiff, who owns patented technology for cleaning automotive intake systems, filed infringement claims against the defendant, which sells products for automotive maintenance and cleaning. Before trial in federal district court, the defendant challenged the plaintiff s expert under Daubert, particularly his first and primary report regarding lost profits and his second, supplemental report on a reasonable royalty under Daubert. The defendant claimed the expert s lost profits calculations were unreliable in particular, his calculations that the plaintiff held a 50 percent market share of the patented products, and thus, but for the defendant s infringement, the plaintiff would have been entitled to 50 percent of its net sales. The expert based his 50 percent market share assumption on discussions with the plaintiff s employees, including its director of technology. In addition, his report stated that, to his knowledge, the plaintiff and defendant were the only manufacturers of the patented product and that in a but for scenario, it was likely that all of the defendant s customers would have bought the plaintiff s product. However, to keep his assumptions (and calculations) conservative, he elected to adopt a 50 percent, rather than a 100 percent, market share estimate. Since the expert conceded that he did not conduct any additional research or investigation to evaluate the 50 percent market share estimate, not one single iota of economic evidence supported the expert s estimate, the defendant claimed, and asked the court to strike his entire lost profits opinion. After hearing all of the evidence, the court was inclined to agree with the defendant, but only to a degree. The expert s testimony was admissible to the extent that his lost profits damages testimony was based on an underlying factual assumption that [the plaintiff] held 50 percent of the market share and assuming that the information provided to the damages expert by the technical experts is supported by proper factual predicates, the court held. The defendant was free to challenge the expert s assumption on cross examination and through the testimony of its own experts. At the same time, the expert could not state an opinion as to the plaintiff s market share. Bare reliance on a rough estimate by the plaintiff s technology director did not rise to the level of reliability that Daubert envisioned, the court observed and permitted the expert to testify to only those portions of his lost profits damages arising from the factual assumption of a 50 percent market share. Continued on page 7. See Alternative Theory. 3 Katz, Sapper & Miller
Expert s Unconventional Method to Forecast Lost Profits Satisfies Daubert RMD, LLC v. Nitto Americas, Inc., 2012 U.S. Dist. LEXIS 158107 (Nov. 5, 2012) Each party disputed a breach of a 2003 exclusive distribution agreement. The plaintiff s expert, a certified public accountant and credentialed business appraiser, prepared an initial report that assumed the contract would have remained in effect indefinitely and projected lost profits over 70 years. Following rebuttal from the defendants two experts, he supplemented his report to establish the reasonableness of his theory and methodology. In pretrial rulings, the federal district court of Kansas found the 2003 agreement expired without renewal on June 30, 2008, but its nonsolicitation provision continued for another five years. Each side filed Daubert motions to exclude the other s testimony. The plaintiff s expert categorized the losses stemming from the defendants breach of the exclusivity contract in the following way: The defendants sale of the exclusive product to the plaintiff s competitors from 2004-2009; The defendants denying the plaintiff the most favored nation prices for the same product, but requiring prepayment for it; The plaintiff s losing sales from 2008-2010, due to the defendants sale to direct competitors and to the subsequent sale to third parties, as well as the plaintiff s inability to add the competitors customers to its customer base; and The plaintiff s future losses from projected sales (2010-2080). To quantify the diminished sales, the expert used Oracle s Crystal Ball Predictor software and the Holt-Winters method. Both tools formulate trends based on historical data and predict future sales, he explained, and in particular, the Holt- Winters method reflects the seasonal changes in the data without increasing the effects of seasonality over time. He used it to forecast damages only through 2010; after that, he extrapolated damages due to reduced future sales growth for 70 years, assuming constant amounts of increasing sales. To calculate the present value, he made assumptions on the plaintiff s business records as well as information from its owner and discounted future damages using the company s equity cost of capital, which he estimated to be 20.6 percent. Ultimately, the plaintiff s expert determined total damages of $2.7 million, assigning $2.2 million to future lost profits and $270,000 to past losses. The defendants offered two rebuttal experts in econometrics, who did not present an opinion as to the actual damages or critique the accounting method the plaintiff s expert used. Continued on page 8. See Unconventional Method. 4 Katz, Sapper & Miller
Patent Experts Have Limited Latitude to Comply with New Damages Standards Joyce v. Armstrong Teasdale, LLP, 2012 U.S. Dist. LEXIS 114847 (Aug. 15, 2012); and Joyce v. Armstrong Teasdale, LLP, 2012 U.S. Dist. LEXIS 137905 (Sept. 26, 2012) The first decision in this malpractice case concerns the defendant s Daubert motion against the plaintiff s damages expert; the second involves a motion to dismiss all claims based on the same alleged flaws in the expert evidence. Armstrong Teasdale represented the plaintiff, James Joyce, in his application for a patent related to software firewall technology. In 2000, the same attorneys helped the plaintiff form a company, with his wife and another couple, and prepared an exclusive, royalty-free license for the company to sell the patented software for its remaining life. Several years later, the plaintiff divorced and gave up a 50 percent interest in the patent to his wife; their co-owned company also terminated his employment and reduced his ownership interest. The plaintiff sued the law firm for malpractice. The plaintiff retained a damages expert to assess the value of the patent as of the trial (2009). Applying a relief from royalty approach, the expert estimated the amount of licensing fees the plaintiff s firewall software would have generated in the computer security industry but for the defendant s malpractice. Although the industry was quite competitive, he believed that 10 percent of existing security products could use the patented technology. Assuming that major licensees aggressively pursued this potential, another 10 percent of the products would actually use the software, resulting in a net royalty base of 1 percent of the entire market. The risk that the patent would achieve such penetration totaled 30 percent, he said a moderate risk. This 30 percent risk factor was also the discount rate, he explained, which incorporated both the discount to present value and the risk of market failure or displacement of the technology. The expert also estimated that the patent would achieve commercialization by the end of 2010, with a five-year ramp-up period in which it would penetrate an additional 20 percent of the market annually, remaining at this utilization rate until the patent expired in 2020. Finally, the expert reviewed computer software licenses from general industry sources and derived a reasonable royalty rate of 10 percent. Applying all of his estimates to the entire computer security products market which was expected to generate revenues of $13.5 billion in 2009 and annual growth rates of 5 percent to 9 percent he believed the Continued on page 8. See Limited Latitude. 5 Katz, Sapper & Miller
Expert s Damages in Cookie Case Crumbles In a new Daubert decision, Judge Richard Posner of the U.S. Court of Appeals for the 7th Circuit continues on his judicial quest for tightening the gatekeeping role in patent cases. Although the plaintiff s expert was highly qualified and competent to estimate damages in the case which involved a patented formula for creating cookies free of trans fats she made several critical errors in her opinions and calculations. First, after speaking with the plaintiff s scientific expert, she concluded there was no acceptable, noninfringing substitute for the patented formula, a factor that substantially boosted her royalty rate. Her reliance was allowable, the judge ruled, but her inquiry failed to establish whether cookies made with a substitute would actually sell. For that information, she could have talked to the plaintiff s industrial baking expert as well as its marketing and consumer experts. I don t understand why she didn t talk to these experts, Posner said, and struck her conclusion that there was no noninfringing alternative that would have cost the defendant something less than a hefty royalty to implement. Even if there was no perfect substitute for the patented formula, any royalty for infringement would depend on the cost, in higher production costs and loss of business to competitors, of the best imperfect substitute, the judge observed, and [the plaintiff s expert] offered no evidence about either cost. Instead, she relied on three comparable licenses to project the maximum amount of profits the defendant put at risk by failing to secure a license. However, one of the agreements involved a lump-sum payment and a licensee wholly dissimilar to the defendant; another concerned a complex litigation settlement that the expert failed, in any way, to analyze. Only the third license might possibly support a reasonable royalty, the judge held, limiting the expert s testimony to this basis, but dismissing her market share calculations as unreliable. 6 Katz, Sapper & Miller
Client Costs (Continued from page 2) inefficiencies, the small upfront costs of involving an expert early can pay for itself many times over. 3. Attorneys should target, focus and streamline expert depositions and discovery Many expert respondents in the FVS survey indicated that depositions should be dedicated to substantive questions regarding the expert s report and opinion. Cutting the deposition to focus on content not extraneous topics allow for case preparation without the unnecessary costs. Also, the timing of expert disclosure and discovery should be scheduled to make best use of information exchange. This includes completion of non-expert discovery before the financial expert formulates an opinion and separate opposing expert report deadlines. Better timing of information exchanges reduces the likelihood of supplemental expert reports. 4. Attorneys Daubert-like challenges should be appropriately targeted and acted upon promptly by the court Daubert-like challenges have become an increasingly used method for excluding some or all of the financial expert s testimony. If a Daubert-like challenge has been brought before the court, the financial expert should be notified of the challenge and given an opportunity to participate in the challenge process. Not only can the outcome of the Daubert-like challenge have a considerable impact on the expert s career, the client will benefit from the most effective defense of the challenge. 5. Attorneys and the court should develop a process for the collaboration and cooperation of opposing experts where appropriate Most attorneys recognize that when opposing counsel are collaborative and professional, efficiencies are gained and costs are saved for the client. In the same way, attorneys and courts looking for costeffective ways to narrow the issues in dispute can turn to financial experts to assist. When financial experts collaborate with opposing financial experts, it can decrease the number of hours for experts to prepare for trial by coming to a consensus on as many issues as possible. Everyone in the legal community has a stake in the civil justice system to provide parties with a timely, cost-effective determination to every action. Judges can incorporate the above recommendations into their case management and pre-trial order practices. Attorneys can manage their civil litigations by streamlining discovery, identifying financial experts early in a case, and encouraging collaboration between experts. The legal environment proposed in the above recommendations enables the financial expert to increase effectiveness and efficiency thereby saving client costs and providing the most defensible financial assessment in a civil litigation. Alternative Theory (Continued from page 3) In the second challenge, the defendant claimed the expert inflated his lost profits calculations by using the defendant s selling price, but then subtracting the plaintiff s costs. Commingling or mixing and matching the inputs was improper and warranted exclusion, it said, particularly since the defendant charged a price that was 30 percent higher than the plaintiff did for the patented products. In his report, the expert explained that he used the defendant s average sale price with the plaintiff s costs to reflect [the defendant s] market pricing and channel mix, but as manufactured under [the plaintiff s] cost structure. This was also the way he did it in virtually every case, he said. Moreover, additional evidence suggested the defendant may have manipulated the pricing structure for related products to boost sales of the patented product, creating an aberration the expert sought to accommodate in his mixed/matched inputs. In general, the measure of lost profits is the difference between the patent owner s cost of production and the price at which it would have sold the product, absent the defendant s infringement, the court explained. However, estimating the two variables of cost and price can be done in any number of ways. In this case, the court did not find any case law supporting the expert s methodology but neither did it find any discrediting his choice of variables. As a result, his calculations were admissible, the court ruled, subject to vigorous cross examination at trial. The defendant s third and final challenge was that not only was the second report untimely because it was disclosed eight months after the expert s initial lost profits report, but it was also prejudicial because it introduced a new theory of calculating damages (i.e., a reasonable royalty analysis) and should be disallowed. The plaintiff defended the report by saying it was an appropriate and timely, supplemental response to the defendant s challenge of its main theory of damages (i.e., lost profits). The court doubted the veracity of this defense. Nevertheless (and without specifying why the plaintiff s expert might have failed to disclose his reasonable royalty analysis within the original discovery deadlines), the court permitted the expert to present this alternative theory of damages at trial, subject to the plaintiff making him available for deposition by the defendant and assuming all costs. 7 Katz, Sapper & Miller
Unconventional Method (Continued from page 4) Instead, they criticized his use of the Holt-Winters model, which, they claimed, was not accepted in the statistical and economic community, and which no one had used to calculate damages in litigation. Instead, the plaintiff s expert should have used ARIMA, a statistical tool that uses regression analysis. Overall, his report showed a profound ignorance of regression analysis, they concluded. Moreover, when they ran regressions based on the defendants alleged actions, they found the effect on the plaintiff s sales was not statistically significant. However, when the plaintiff s expert ran his calculations under ARIMA, he found the results differed from his original conclusions by only $2,500. The defendants challenged the expert s report on several grounds, which the court considered in turn: 1. Expiration date. The expert s calculations were inconsistent with the court determined 2008 expiration date, rendering the entire analysis inadmissible. In response, the plaintiff pointed out different ways to breach the agreement after the initial 2008 term, and some of the defendants conduct caused residual, long-term effects. Since its expert simply assumed breach, the court s order required the plaintiff to prove the defendants specific violations to the jury, but it did not disqualify his opinion, particularly since his analysis permitted the jury to reduce any future damages according to their findings on a breach and its effects. The court held the expert s projections complied with the reasonable certainty standard for admitting lost profits evidence. 2. Qualifications. The expert used forecasting tools that required a background in econometrics and statistics, which, as a CPA, he did not have. This was analogous to arguing the expert was not qualified to use a computer because he cannot explain how a computer is programmed, the plaintiff responded. The court agreed. 3. Statistical methods. The expert used a methodology that had not undergone rigorous testing for reliability. The ARIMA statistical tool, which uses regression analysis, would have been better. The plaintiff pointed out that Holt- Winters had been used to predict future sales for some 50 years. The court found that even though ARIMA might be the methodology of choice for statisticians, the defendants failed to show why accountants could not use Holt-Winters for their forecasts or why a regression analysis was the only way to forecast sales and lost profits. The already small $2,500 difference between the two results would be even less for projections covering a shorter time frame. In its motion, the plaintiff claimed the testimony by the defendants experts was inadmissible because it improperly introduced new arguments on causation instead of rebutting its expert s accounting method and actual damages determination. The court agreed that the experts failed to rebut, that is, address the same subject matter identified by the initial expert. By using the regressions in their report to suggest the plaintiff s expert damages were not statistically significant, they suggested there was no evidence of causation, a key element of the plaintiff s case. Because the plaintiff s expert did not testify on causation, but only on damages, the court struck these comments from the rebuttal report. Limited Latitude (Continued from page 5) plaintiff s patent had a present value of $37 million. In its Daubert motion, the defendant criticized the expert s methods and conclusions on several grounds. First, in valuing the patent, the expert did not account for the 50 percent ownership interest now belonging to the plaintiff s ex-wife and the exclusive licensing rights belonging to his former company. More importantly, the expert based his market segmentation and penetration estimates on generalizations about the computer security products industry without any quantitative analysis to demonstrate how those rates would be reasonable compared to related technologies. For instance, in his deposition, the expert admitted that he did not calculate his segmentation and penetration rates so much as base them on his experience. This speculation rendered his opinions inadmissible, the defendant argued, citing IP Innovation LLC v. Red Hat, Inc., 705 F. Supp. 2d 687 (E.D. Tex. 2010). Second, to derive his 10 percent royalty rate, the expert relied on sources that estimated average rates for the entire computer software industry without attempting to analyze whether those licenses were truly comparable to the technology at issue, as required by ResQNet.com v. Lansa, Inc., 594 F.3d 860 (Fed. Cir. 2010). In addition, the Federal Circuit s 2010 decision in Uniloc USA v. Microsoft Corp., 632 F.3d 1292, disallowed any general or theoretical royalty rates as running afoul of Daubert. Finally, the expert used the entire market value of the computer security products industry to calculate damages without any showing that the patented firewall drove the demand for such products, as Continued on page 9. See Limited Latitude. 8 Katz, Sapper & Miller
Limited Latitude (Continued from page 8) Uniloc also requires. Lacking sound economic and factual predicates for his calculations, the defendant said, the expert s present value calculations, including his reasonable royalty rates, were inadmissible. The court agreed that the expert s methods were speculative and failed to use any reliable, quantitative methodology to support his damages estimates. Moreover, his analysis contravened recent Federal Circuit precedent as well as its pronouncements on the entire market value rule in Uniloc. Exclusion would be appropriate, the court said, but it would also make it impossible for the plaintiff to prove damages at trial. The court granted the expert an extension to repair his opinion and testimony. The expert prepared a supplemental report, and this time, the defendant moved for summary judgment based on the lack of sufficient proof of actual damages. The expert still had not cured the substantial flaws in his analysis. The court found the plaintiff s evidence failed to establish a material factual dispute regarding whether damages were reasonably ascertainable, an essential element of [the] plaintiff s claim, and dismissed the case. About Katz, Sapper & Miller Because litigation often involves complicated financial and tax issues, many cases require the collection and analysis of accounting, financial, statistical and economic information. The professionals within Katz, Sapper & Miller s Litigation Services Group offer specialized, investigative research and analytical skills, as well as financial, business and tax knowledge. We serve as expert witnesses and consultants in the litigation process from discovery through trial and briefings or settlement. Our experts analyze financial records, prepare damages claims, critique opposition expert reports, assist with witness preparation and provide expert witness testimony. Our firm s multidisciplinary approach, drawing upon our team s in-depth experience across all industries, enables us to develop a litigation strategy that can stand up to the strongest scrutiny. Learn more about KSM s Litigation Services Group. Ronald M. Lenz cpa 317.580.2063 rlenz@ksmcpa.com Ron Lenz is the partner-incharge 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. Jay R. Cunningham cpa/cff, cva 317.452.1428 jcunningham@ksmcpa.com 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. 2013. No part of this newsletter may be reproduced or redistributed without the express written permission of the copyright holder. Although the information in this newsletter is believed to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal or consulting advice. 9 Katz, Sapper & Miller