Are We All Hired Guns? How and Why Financial Experts Differ
Why Experts Working from the Same Facts Generate Varying Opinions
Financial experts can differ wildly in their opinions and findings because of differences in their underlying financial and economic assumptions, differing legal interpretations, differing theories on damages, and different access to information. Jim Gravitt explains.
At a recent seminar we presented to the local bar association, a lawyer asked the following question: â€śHow is it,â€ť he said, â€śthat when there are two experts in a case, the expert who is supposed to come up with the high number is always higher than the expert who is supposed to come up with the low number?â€ť It was a humorous question, but generally accurate. The question was also somewhat embarrassing, since we financial experts are supposed to be objective, unbiased, and independent. Of course, one possible reason is that experts arriving at unhelpful conclusions probably never get to testify!
Still, how is it possible for different financial experts to arrive at significantly different conclusions when working from the same set of facts? This article is an attempt to understand the reasons for differences between financial experts and to discuss whether those reasons are appropriate from the perspective of purportedly objective, unbiased, and independent financial experts.
Case Studyâ€”Purchaser Corp v. CBM, Inc.
To help illustrate these points, consider the following hypothetical damages study. Circuit Board Manufacturer (CBM), the defendant, allegedly did not fulfill a signed contract in which it would be acquired by Purchaser Corporation. Instead, CBM sold out to Purchaserâ€™s main competitor. Purchaser (plaintiff) has sued CBM for breach of contract, claiming damages for the profits and business value it would have gained if the transaction had been completed.
Shown below is a summary of the damages (in thousands) as calculated by each partyâ€™s financial expert. Each expert has assumed that CBM is liable for damages due to the alleged contract breach. The detailed calculations underlying the totals are not presented, so assume there are no mathematical errors in the work.
Note that both experts have used a â€śbut forâ€ť damages model with a capitalized terminal value at the end of a discrete forecast period. Somehow, using the same type of model, the experts have arrived at net losses that are $8 million apart! Neither expert had access to the other partyâ€™s executives; however, both experts read depositions from the case. How are such dramatically different conclusions possible?
The answer likely lies in differences in one or more of the following areas:Â
- Economic and financial assumptions
- Legal assumptions
- Damages theory and application
- Available budget, data, and other resources
Economic and Financial Assumptions
Each expert made assumptions concerning the rate of sales growth, annual price increases, gross profit margins, operating expenses, and net cash flows. Letâ€™s look at the reasons behind the assumptions. The plaintiffâ€™s (Purchaserâ€™s) expert relied primarily on Purchaserâ€™s assumptions in projecting CBMâ€™s â€śbut forâ€ť sales. In fact, the expertâ€™s report states that managementâ€™s sales forecast is assumed but â€śhas not been examined, and, furthermore, there will usually be differences between forecasted and actual results.â€ť The defendantâ€™s expert predicts lower sales growth based on an analysis of expected industry growth published in a trade publication. Also, after reading depositions of CBM management, the defendantâ€™s expert concluded that the sales decline in 2002 reflects increased competition and has used 2002 as the starting point.
Plaintiffâ€™s expert treated the 2002 sales decline as an anomaly and based sales on increases over the higher 2001 figure. CBMâ€™s gross profit margin dipped in 2001 due to higher raw material costs, but recovered in 2002 as these costs declined. Plaintiffâ€™s expert has ignored 2001 and uses 2002 as the starting point. Defendantâ€™s expert believes that higher raw material costs will recur and has factored this possibility into its damages model by using 2001 as the starting point with gradual margin improvement in future years. Both experts believe that operating expenses will decline in future years due to the synergies of an effective business combination. However, plaintiffâ€™s expert assumes rapid synergies and greater improvement based on its analysis of Purchaserâ€™s prior acquisitions. Defendantâ€™s expert foresees a more gradual reduction of expenses based on its discussions with an industry expert.
â€˘ The different operating assumptions flow from different expectations of what would have happened if the merger had gone forward. The validity of each expertâ€™s projections should turn on the credibility of the information sources and the reasonableness of the informed judgments made by each expert. Bias may creep into the analysis; however, if an expert tends to resolve every judgment call in favor of one party while apparently turning a blind eye to conflicting information.
â€˘ Plaintiffâ€™s expertâ€™s 100%Â reliance on Purchaserâ€™s sales forecast could be troublesome for a jury, particularly if the forecast was prepared after the dispute ensued. The Purchaser might just have an agenda! Plaintiffâ€™s expert likely will not be able to escape responsibility for the forecast, despite the disclaimer contained in its report.
The experts have applied different views of allowable recovery under the law, based on instructions from the attorneys. Again, letâ€™s look at the reasons behind the different assumptions. Plaintiffâ€™s expert was asked to assume that net income is the measure of recoverable loss while defendantâ€™s expert has been asked to use net cash flow. Also, the plaintiffâ€™s expert has not considered price increases and does not reduce damages for the time value of money. The defendantâ€™s expert has done both. Why? Plaintiffâ€™s expert has been instructed by the attorney to use the total offset method in accordance with the attorneyâ€™s interpretation of applicable state law. Under this assumption, inflation and interest rates (the time value of money) are assumed to offset each other and thus are not explicitly considered in the analysis. The defendantâ€™s expert has been instructed to discount future losses to net present value, and to consider inflation, interest rates and the business risk associated with the cash flows. The resulting discount rate exceeds the inflation rate, so the net effect is to reduce the damages amount considerably below the plaintiffâ€™s expertâ€™s amount. The plaintiffâ€™s expert has developed a five-year model, while the defendantâ€™s expert uses a three-year model. Why? Plaintiffâ€™s expert believes that five years can be forecast with reasonable certainty while defendantâ€™s expert is more comfortable with three years of discrete projections.
â€˘ A financial expert is not an attorney, but still needs to understand the risks associated with the legal position adopted in their analysis. Even if it is clearly labeled as a legal assumption, an extreme legal position may â€śtaintâ€ť other portions of the expertâ€™s work, diminishing overall credibility.
â€˘ Net cash flow is usually less than net income for a growing business (as assumed by plaintiffâ€™s expert) because of the need for cash to finance growth in working capital and fixed assets. While net income is the traditional measure of loss in many jurisdictions, measuring lost net cash flow may improve the accuracy of the analysis.
â€˘ Legal conventions for the effects of inflation and the time value of money can substantially affect the damages quantification. If not prescribed by law, the discount rates governing recovery must be supported by the expertâ€™s informed judgment.
â€˘ Does having an extra two years in the plaintiffâ€™s expertâ€™s analysis increase the damages? Ordinarily, the answer would be â€śno.â€ť This is because the terminal amount received at the end of year five has a lower present value than the terminal value received at the end of the third year. In this case, however, under plaintiffâ€™s expertâ€™s â€śtotal offsetâ€ť assumption, increasing the number of undiscounted years adds to the damages amount. This is because capitalizing the terminal year damage amount into perpetuity is the same as discounting each yearâ€™s future amount into perpetuity. A higher damages total results from including more undiscounted discrete years in the analysis.
â€˘ Notice again how each expert has taken advantage of every position that would result in a damages figure more favorable to the party by whom they have been retained. Whatâ€™s really going on here? Is a pattern beginning to emerge?Â
Damages Theory and Application
A variety of other issues could affect each expertâ€™s findings. For instance, neither analysis considers mitigation. Were other alternatives available for Purchaser to develop this capability itself, or to acquire another company like CBM? Both experts have assumed that the damages last forever by including a terminal value calculation. Is this scenario realistic, or is it more likely that the plaintiff will recover all losses at some future date? Are plaintiffâ€™s damages limited solely to CBM, or was Purchaser also damaged in other ways, for example, in the loss of market share on its other products? Any so called â€ścollateral lossesâ€ť may need to be related to the defendantâ€™s alleged actions in order for Purchaser to prevail. Technical differences between the experts can be an issue. For example, in discounting future cash flows, did the experts assume cash flows to occur at the beginning, the end or throughout the year? Do the discount and capitalization rates properly match the measure of earnings (net income or net cash flow)? There may be other ways to measure the damages. For example, the â€śyardstickâ€ť method might consider the experience of plaintiff or similar companies with similar types of acquisitions. Accounting for defendantâ€™s profits (if a legally allowed recovery measure) would look to CBMâ€™s performance as a division of its actual acquirer, Purchaserâ€™s competitor.
â€śWhat if â€ť scenarios vary widely in the minds of creative plaintiffs and defendants. While creativity is encouraged, a danger for financial experts is blind acceptance of implausible damages theories. At what point does an â€śexpertâ€ť turn into a mere calculator? A judge may decide this question (adversely) for the expert. Experts may need to step back and critique the overall reasonableness of their work. Do the results seem to make economic sense? Here, Purchaserâ€™s expert has concluded that a total return of $10.2 million would result from an initial $1.5 million investment (purchase price). This begs the question: would CBMâ€™s owners have agreed to sell out for only $1.5 million so that Purchaser could realize $10.2 million of benefits? How would a jury react to this result? Locating, understanding, and correctly applying underlying source documents can be important. Amazingly, two experts can consider the same document and draw completely different conclusions as to its meaning and application. The expert must be able to explain which documents were relied upon, which were ignored, and why. Considering documents selectively and only in ways that produce the desired result must be avoided.
Available Information and Resources
An unfortunate fact of litigation is that often the largest wallet prevails in complex cases. The extent of information analyzed by financial experts may result in differences in their analysis. For instance, one expert may have been able to employ economic, industry, or operational consultants as part of the damages â€śteam.â€ť The other expert may not have these resources, leading to different analysis and conclusions. Have available independent published materials been consulted? Often, a time-consuming search could be performed to perhaps locate pertinent market research studies, but often is impossible to perform as well as one would like due to lack of time and resources. Have both sides of the dispute been consulted? An expert can be â€śblindsidedâ€ť by important information that is unknown or that is hidden from the expert. Being blindsided is generally not a pleasant experience for the expert. Objectivity and credibility are generally better served if the expert has the opportunity to consider both sidesâ€™ perspectives. Unfortunately, the nature of litigation and the timing of the expertâ€™s participation in the case often limit the extent of available information, again leading the experts to different conclusions.
â€˘ As an objective provider of findings to the court, an expert should make an effort to obtain all relevant information and, if not obtained, consider withdrawing from the engagement. An expert may perceive their role as that of helping the plaintiff or defendant, and may ignore inconvenient or unhelpful information in the process.
â€˘ Experts may need to â€śtake controlâ€ť of the information-gathering process to the extent possible in order to obtain sufficient relevant data upon which to base their work. Saying â€śMy attorney didnâ€™t provide that information to me,â€ť is not generally a valid way to escape responsibility for inadequate analysis.
Financial experts can differ wildly in their opinions and findings because of differences in their underlying financial and economic assumptions, different legal interpretations they are asked to adopt, different theories on damages and their effects, and differences in information and access to resources. Because of these differences, there are legitimate foundations for reasonable differences among experts. Attorneys and fact finders arenâ€™t surprised that experts differ in their opinions, but they may not understand the many valid reasons for these differences. A financial expertâ€™s mission is to identify legitimate differences in their opinion and why their opinion is preferred as a result. Financial experts should also not be surprised when those in advocacy roles attempt to push them over the edge of objectivity to become advocates themselves. Substantive advocacy often results from an accumulation of small decisions that collectively create an unbalanced position. In these situations, the expertâ€™s mission is to avoid advocacy and remain firmly on the solid ground of objective and credible analysis. Over time, experts that are able to sustain objective and credible positions will be the most helpful to themselves and to their clients.Â
Jim Gravitt provides services to a wide range of clients as Manager of Litigation and Valuation Services with Crowe, Chizek, a regional accounting and consulting firm. Jimâ€™s practice areas include damages causation and measurement, business valuation for litigation, tax and transactional purposes, divorce financial consulting, business interruption, and investigative accounting engagements. He can be reached via e-mail at firstname.lastname@example.org.Â Â This article first appeared in National Litigation Consultantsâ€™ Review (NLCR)