Daubert & Damages Experts
One of the most useful things we do is rein in poorly supported “expert” damage calculations.
When a business entity fails and a stakeholder in the entity claims some wrongdoing by another party, it is often pretty easy for a damages expert to spin a little anecdotal evidence into a plausible story of the value of a firm (and therefore the value of the stakeholder’s stake) as it would have been, in the absence of the claimed wrong. If the expert can make those numbers large enough, the fear of ruin can induce rational value maximizing defendants to settle largely no meritorious claims for millions of dollars rather than committing a like sum to defending the claim.
I have a different view of expert testimony. We evaluate the damages testimony early on, and, to the extent that it is junky, exclude it. Much litigation that fits this mold folds immediately upon the exclusion or substantial modification of the damages testimony.
Of course, not all damages testimony is junk, but all that the model actually requires is that experts understand that the more profitable is their performance for the lawyer or client who hired them, the more likely are they to receive future work through that source. As a result, even when the damages testimony is not actual junk, we can still chip away at its hopeful assumptions more than enough to justify our fees, and usually many times over. The following section uses a standard junk damages model to demonstrate this assertion.
The Received Doctrine of Junk Damages
Law reviews discuss the economic incentives for a brand of shakedown litigation that requires only (1) a plaintiff with a story about a potential defendant corporation that has underperformed in the estimation of the plaintiff and (2) a damages "expert" to place the "loss" in the hundreds of millions of dollars. As commentators and law reviews see this, even absent any damages, if the "expert’s" damage calculation is large enough, even a 10% chance of winning a verdict incentivizes entrepreneurial lawyers and plaintiffs to file suit in hopes of shaking down a nuisance settlement. Symmetrically, a 10% chance of suffering a ruinous verdict has had the power to coerce rational, value-maximizing corporate managers into multi-million dollar settlements of abjectly non-meritorious claims. The model generalizes to work equally well for nonruinous verdicts and more meritorious claims.
That the damages testimony is the cornerstone of this junk litigation strategy can be seen most easily by recognizing that, because junk litigation is junk, there is only a small chance that the plaintiff can litigate it to a verdict, so there must be a large reward for the success. So, as the Law & Economics received doctrine explains it, and as the example below shows, even if there is only a small chance of a verdict, if the potential verdict is very large, then the resulting small chance at a huge verdict incentivizes junk plaintiffs and their lawyers to file junk litigation. And the models show why rational corporate managers had to stand ready to settle such matters.
Because now, a Daubert motion in limine can knock out the damages expert testimony that is the critical central element of this shakedown strategy.
The Daubert Solution to Shakedown Litigation.
To oversimplify for ease of exposition, continue to imagine an utterly baseless claim as described supra and that there exists a mere 10% chance of litigating that claim to a $100 million outcome by putting on an expert who will testify that damages are $100 million. A 10% chance at $100 million is worth $10 million. Fundamental financial analysis instructs that if the prosecution of such claims to such outcomes can be done for less than $10 million, then litigating such nonmeritorious claims to settlement is what financial analysis calls a positive net present value project. There is sufficient history of similarly motivated litigation that law reviews publish sophisticated versions of this model (hereinafter, the "junk-litigation model"). But that is all old news; the received doctrine, so to speak.
What is interesting here is that this same law review model generalizes immediately to finding the value of a sophisticated Daubert motion filed in response to such a claim.
Proceeding with the same claim, if a Daubert motion to exclude the junk expert testimony has only a 10% chance of successfully disposing of the matter, the Daubert motion is a positive net present value undertaking to the defendant if it can be done for under one million dollars (ten percent of ten percent of $100 million). This condition on the cost of the motion is almost always met, and usually by many (perhaps nine and a half) hundreds of thousands of dollars, making the Daubert motion what those financial analysts (and more importantly, your sophisticated clients) call a positive net present value project (hereinafter a "positive NPV project"). Your sophisticated clients will have learned in business school that this simply means that its expected value exceeds its expected cost. They will have also learned that undertaking positive net present value projects increases the value of their firms and its stock.
The beautiful intellectual irony in this is that, modeled in this way, the Daubert motion is shown to be a positive NPV strategy that is precisely symmetric to the positive NPV strategy that incentivized the junk litigation in the first place. In other words, the exact same financial arithmetic that makes junk litigation a financially attractive cottage industry makes Daubert motions to exclude the junk testimony upon which the junk litigation is based a financially compelling undertaking to the target of the junk litigation.
Junk in expert’s clothing.
A recent case illustrates how this junk-litigation-with-Daubert model compares with the original junk-litigation model of the received doctrine. The alleged expert in this case is somewhat typical of professional experts. He is an Economics Ph.D. from a top Ivy League university and Vice President and Director of Economic Services for a Big-4 firm. He was clearly "qualified," even under a fairly strict Daubert standard. If he had been allowed to take the stand the jury would have received him as a well-credentialed expert who had a pretty convincing story to tell them. Nice hair. Smooth delivery. A fairly typical situation.
And he had a story that is routinely admitted: An alleged intellectual property wrong committed against the plaintiff’s business kept the business from becoming worth hundreds of millions of dollars, and instead caused its bankruptcy. Never mind that the firm had never made a real profit or that its product had never actually been produced, even as a full functioning prototype. Never mind that his valuation model would not have commanded a passing grade in a sophomore level university finance class or that his data was financial projections made by the company in efforts to raise financing for further needed R&D. Never mind that careful inspection of these financial projections showed them to be the subject of disclaimers sufficient to keep the company from being sued if they failed to produce those numbers. Now this company was going to sue someone that had allegedly kept them from making those numbers. And they were going to use the very numbers that they had disclaimed to value their loss. They and their contingent fee attorneys demanded tens of millions to settle.
The proposed testimony put damages at over $100 million, based upon plaintiff’s expert’s analysis of the firm's business plans and their projected financials.
The putative expert spun the company’s revenue projections, excerpted from business plans and private placement documents, through a "valuation model" to yield the alleged damages. His model used six years of projections of Revenues, from which he subtracted official-looking projections for Costs of Goods Sold, Gross Margins, expenses of Marketing and Customer Support, Research and Development, and General Expenses, all yielding EBITDA projections in the range of ten to twenty million dollar per year which, when reduced by the expert witness to a present value, yielded an inferred firm value of over $100 million. Other experts were ready to testify that all the remaining problems with the product were about to be fixed and a lucrative market existed for the product. It all looked very professional.
And to call their prosecution of the case a success, all the strike-suit plaintiff need accomplish is to keep the defense believing that there is a nontrivial chance that the jury will hear a damage estimate of over $100 million: Because once that happens, unless there is no straight-faced story for liability at all, juries are well-known to have a tendency to impose some kind of rough justice where they average together the $100 million that the Plaintiff’s expert claims as damages with whatever the defense expert estimates as damages. In short, so long as the strike suit plaintiff can anticipate that the hugely inflated damages testimony will reach the jury, the strike suit plaintiff rationally evaluates the settlement value of the claim as a small, but nontrivial, fraction of the $100 million. In the 10% world associated with completely non-meritorious claims, that value is around ten million dollars. But again, this is the received doctrine.
Appearances aside, this testimony was pure junk. The expert had really done nothing but spin the company’s ipse dixit revenue projections, excerpted from a management-produced business plan, through a funny kind of a "valuation model" to yield the alleged damages. The projected cost reductions that he subtracted from revenues were all simple percentages of revenues which resulted in all of his spreadsheet work coming down to taking a flat percentage of projected revenues as his projections for profits. This resulted in annual profit projections in the tens of millions of dollars for this company that had never made a dollar or sold one unit of its product. He calculated the present value of these cash flows (incorrectly) at over $100 million and this became his inferred value of the failed plaintiff firm.
A Daubert motion worth 10 million dollars?
To see that a Daubert motion can be worth $10 million, just compare the junk-litigation model of the received doctrine to the junk-litigation-with-Daubert model and compare their outcomes. To the extent that the Daubert motion cancels the junk testimony, it cancels its value by rendering its threat impotent. In this scenario, that value is $10 million, and even if it has one chance in three of success, its value is dramatically out of proportion to its cost.
In the case of the Ivy League Ph.D. expert witness, the defense filed a pretty simple but carefully aimed objection to his testimony and plaintiff literally dismissed within a week. We showed that, even if they could prove liability, damages were almost surely under a million dollars. And this was still junk litigation where they would have difficulty making liability. The simple calculus is this: The long shot at a hundred million was worth litigating over. The long shot at something under a million was not.
Tersely stated, the expert damages witness is the essential building block of the financial incentives that drive this very popular kind of junk-litigation. Interposing a Daubert practice into this kind of junk litigation strips it of its power to force settlement.
Initially, I marveled at how an "expert" proffering such unfounded testimony would even be offered, but in truth there are many just as bad or worse whose testimony looks good on untrained analysis, but need only be analyzed professionally and challenged by sophisticated Daubert analysis to be excluded and take the attendant junk-litigation matter with it. And this is not an isolated incident. Most folks’ intuition confirms the microeconomic theory notion that, in the expert-for-hire ranks, the most important skill may not be financial analysis. The most important skill may be the ability to wow a jury with a good story about a sure success laid low by some tortious action. While this ability may bear up well under cross-examination, it does not bear up well under a tough Daubert challenge.
Now of course, the junkier the testimony, the better is the chance of excluding it. There is enough full-fledged junk proffered to create a large class of damages testimony that is sufficiently junky to put the odds on a Daubert motion more in the "even money" range than the one-chance-in-ten range assumed by the analysis supra. There is a great deal of good, sound, damages testimony out there (although this does not seem to keep courts from excluding it), but there is also enough demonstrably unreliable pure junk proffered that in large numbers of cases Daubert motions are very strongly positive net present value projects.
So what if it isn’t junk?
The same analysis applies, just the numbers change. The chances of exclusion fall and sometimes are even replaced by the chances of constraining the testimony that the expert is allowed to give to the jury. What does not change is that we can almost always impact the opposing damages expert’s testimony more that enough to justify our fees and usually enough to justify our fees dozens of times over.
So what if it’s MY damages expert?
Most Daubert motions mouth the same superficial sound-byte legal analysis: its junk science, it does not pass the four factors, bla bla bla (yadda, yadda, yadda, for the Seinfeld fans). We can show that most of these arguments do not apply to damages experts. While courts can be unpredictable, we can usually improve your odds of getting reasonable testimony admitted.