Unique Circumstances When Calculating Lost Profits Reviewed by Momizat on . Reliability of Client’s Data This article discusses how experts can handle the unique situation of receiving unreliable data. Litigation and appraisal literatur Reliability of Client’s Data This article discusses how experts can handle the unique situation of receiving unreliable data. Litigation and appraisal literatur Rating: 0
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Unique Circumstances When Calculating Lost Profits

Reliability of Client’s Data

This article discusses how experts can handle the unique situation of receiving unreliable data. Litigation and appraisal literature will be reviewed as will the author’s handling of unreliable data in a recent lost profits case. In the end, warning signs will be reviewed to alert the expert to potential problems with the projected data.

 

This article discusses how experts can handle the unique situation of receiving unreliable data.  Litigation and appraisal literature will be reviewed as will the author’s handling of unreliable data in a recent lost profits case.  In the end, warning signs will be reviewed to alert the expert to potential problems with the projected data.

When given an assignment to assess lost profits in a commercial damages case, an expert will request financial data for the injured business.  This information may be obtained through a phone call to the hiring attorney’s client or through a discovery request made to the opposing side.  In most cases, the financial data will be contained in documents that have been kept as a regular course of the company’s business.  This may include corporate or partnership filings with the IRS, income statements or profit and loss reports, accounts receivable and payable aging reports, outstanding bids, orders and work in progress, and similar information that provides a picture of the business before and after the alleged wrongful act.

However, not all cases allow an expert to rely solely on these traditional business and financial records.  Some situations require an expert to ask for data that is not a part of the regular course of business.  These reports have probably not been compiled by a CPA, much less audited.  This data may relate to the anticipated sales and costs related to a new product, product line, or business that has been damaged by the alleged wrongful act.  Even if the injured business provides a complete set of historical records, the information will give only a part of the answer to the question, “What are the lost profits from this new product, production line, or business not being able to move forward as projected?”  To answer this question, the expert must rely on projections provided by the management of the damaged business.  When an expert must rely on management’s projections or forecasts, the next question becomes, “Is this data reliable?”

“Countless experts have faced motions to exclude their testimony because they relied on data supplied by the client.  In theory, the test for whether the expert can rely on these data is the same as that for other data: Is this the type of data that an expert in the field would rely on in a nonlitigation setting?  However, courts are justifiably suspicious when the expert relies uncritically on data supplied by the client.”[1]

Courts are suspicious because they are aware management has an incentive to give the expert favorable data while conveniently omitting harmful information.  However, the courts also know, in most situations, the client is the only source for this information.  Without it, the expert would not have a basis for making these future loss calculations.  Therefore, when an expert requests forecasts or projected financial information (sales, cash flow, etc.), it creates a unique situation.  How does the expert rely on the data and protect his or her report from being excluded?

Actual Experience

I was recently involved in a lost profits case in which I had to rely on sales and expense projections made by the management team of an injured business.  The firm was only in business for eighteen months.  It filed two tax returns, both were for partial years.  The start-up year ran for approximately nine months and the second year for another nine months.[2]

Following the precedence set by prior Texas court decisions, the judge in this case agreed to apply the Modern Rule for new businesses.  That rule states damages may be recovered on proof of reasonable certainty.[3]  “Where estimates are based on objective facts or data and there are firm reasons to expect a business to yield a profit, recovery is not prohibited simply because the enterprise is new.”[4]

This change from the older view that new businesses could not claim lost profits to the “Modern Rule” was noted in the Energy Capital Corp. v. U.S. decision.  “Most recent cases reject the once generally accepted rule that lost profits damages for a new business are not recoverable.  The development of the law has been to find damages for lost profits of an unestablished business recoverable when they can be adequately proved with reasonable certainty…What was once a rule of law has been converted into rule of evidence.”[5]

A review of the business’ original marketing plan and its initial income tax return showed the new business had been able to convince 50% of their listed prospects to become customers.  In addition, they had attracted nearly double that figure in new customers not initially listed as prospects.  I annualized their first nine months’ sales and determined the business was slightly behind their initial target of $1.5 million in sales for the first twelve months.  A review of the second year’s financial data showed a good start to its business operations before the actions leading to the lawsuit brought their marketing and sales promotions to a halt.  It appeared to me they had been on track to meet their initial sales goals.

To be able to move forward with my calculations, I requested and received the management team’s five-year sales projections.  These sales were based on anticipated sales to existing customers, future sales to prospects with whom they had outstanding bids at the time of their closing and customers who they had not contacted or may not even have met.  In addition, there was a separate sales figure for what was called a “set-aside” contract.

The damaged business produced parts for the aerospace and defense industries.  A “set-aside” contract is a program specific to the defense industry.  It is an attempt by the U.S. Department of Defense to team small suppliers with major defense contractors for the completion of a contract.  The contract allows the two firms to share the work with the smaller firm performing most of the work and receiving the majority of the revenue.  The estimated total revenue to be generated by this specific “set-aside” contract was $100 million.

In meeting with the marketing executive who developed the sales projections, I was told his firm had a good relationship with the large defense contractor and his firm was on the verge of being signed to the “set-aside” contract when their business closed.  The contract, he stated, would have brought $60 million in revenue to his firm over a five-year period.

As a part of the case, an executive from the large defense contractor was deposed.  He confirmed a good relationship between his company and the damaged business.  He also stated the damaged business was one of two small supplier finalists being considered for the “set-aside” contract.  However, he went on to say that his employer (the large defense contractor) had decided to withdraw from the bidding prior to the contract being awarded.  Therefore, the smaller firm would not have been able to receive the contract and the $60 million in revenue over five years.

Because this sequence of events happened more than a year prior to my being hired as an expert in this case, it was obvious the marketing executive knew the large defense contractor had “pulled out of the bidding.”  He had given me only favorable information, not the harmful part.  He had not only done this to me but his attorneys as well.  Documents filed with the court addressed this lost “set-aside” contract as a part of the commercial damages claimed by the firm.

These findings presented me with the following questions:

How do I move forward in calculating lost profits?

How can I rely on the data given me by the marketing executive?

What adjustments should be made?

Research

A review of litigation support literature shows this situation is, unfortunately, all too common.  Experts working with all aspects of commercial damages and corporate bankruptcy have run into situations questioning the reliability of management supplied information.  As one article noted, “Management projections have attracted extra scrutiny in several recent court opinions, particularly in the appraisal context.  But recently, questions as to the reasonableness and reliability of management projections were at the heart of a complex bankruptcy case in which the trustee argued constructive fraud related to a merger that led to a company that filed for Chapter 11 bankruptcy just one year after its formation.”[6]

In the case mentioned in that article, the judge found the management’s projections were reliable contrary to the trustee’s arguments.[7]  However, not all courts have found management’s projections useful.  In In re PetSmart, Inc., the court found management projections “at best, fanciful.”[8]  Perhaps the strongest criticism of the use of unreliable management projections comes from the Adelphia Recovery Trust litigation and bankruptcy.  In this case, management projections were unavailable.  But as the judge noted, had they existed, they would have been unreliable.  This is because many of the management team “were subsequently convicted on multiple counts of fraud in connection with their management of the company.”[9]

An expert in the case chose to not rely on discounted cash flow (DCF) projections based on the company’s historical financials or future projections, but relied on his own projections created from third party analysts’ reports.  The bankruptcy judge agreed with this method going on to state, “As a matter of common sense, DCF works best (and arguably, only) [i] when a company has accurate projections of future cash flows, [ii] when projections are not tainted by fraud, and [iii] when at least some of the cash flow is positive.”  The court concluded that the dispute, before it was a “poster child” for a situation in which “the propriety of any use of DCF, becomes debatable at best.”[10]

Appraisal and litigation literature also provides warning signs for an expert to consider when needing to rely on management projections.  The following warning signs are an example of things to look for when analyzing management projections.

  1. Ulterior motives—who was to be the recipient of the forecast or projection and would optimistic or pessimistic figures have benefitted the company.
  2. Past forecasts have been inaccurate—they do not compare with historical results—if management has been unreliable in the past, what makes the current figures reliable?
  3. No assumptions back up the projections, especially when the future is expected to be different from the past.
  4. Only income statements are provided—where is the consideration for capital expenditures and/or additional financial needs?
  5. The forecast is predicated on some unusual assumption.[11]

In my case, it appeared the projections given to me checked the boxes for at least four of the five warning signs.  The ulterior motive was to provide optimistic revenue figures which would provide for greater lost profits.  The projections showed a future that was different from the past (although that would be expected for a start-up business that was growing).  Only revenue was provided.  Cost discussions did not include capital expenditures to purchase equipment to expand capacity until brought up by the expert.  Finally, the forecast was predicated on the assumption the company’s revenue would grow, not just from existing customers, but also through a group of not yet identified prospects.

The dilemma I faced was how to use management’s projections knowing they were the only figures providing insight into the potential sales and profitability of the firm and that their reliability was in question.

Modeling the Projections

Dunn and Harry noted, “CPA expert witnesses frequently testify in court about damages assessments when a plaintiff alleges future economic losses because of a defendant’s wrongdoing.  Some CPA experts project the plaintiff’s hoped-for income stream, modify those losses to a realistic expectation by factoring in future risks and then discount the adjusted future loses to present value at a risk-reduced, relatively low discount rate.  Other experts project the hoped-for-but-lost amounts and then apply a higher discount rate that already incorporates risk or uncertainty to determine the present value.”[12]  Realizing the management projections in my current case were “of concern,” it appeared some form of modeling was the only way to provide reliable and relevant loss figures.

Ultimately, my report provided a range of lost profits.  The lower end of the range was based on management’s future sales projections for only existing customers or with whom they had outstanding bids at the time their operations ceased.  In other words, unless products had been sold to a company or bids provided to a company to sell its products, an anticipated customer was not included in the projected future sales.  There were still problems with this data, but I could testify, as could management, that they had a relationship with each company on the list for future sales.

The upper end of the range contained all the potential sales included on the management team’s projections.  These were unadjusted figures that included existing customers, those prospects with which the damaged company had outstanding bids, and prospects not yet contacted by the damages company but assumed would become customers in the future.

Income statements were not helpful in determining average costs moving forward.  The first year’s tax return contained a few start-up costs.  The second year included the taking of equipment costs not yet discounted.  This was because of the business’ closing.

Research of the aerospace and defense industry provided expense averages for all levels of equipment and parts providers.  After discussing costs with the management team, a cost of goods sold average which was greater than the industry average was applied to the projected revenue.  General, sales, and administrative expenses charged to the income stream were slightly less than the industry average.  This is because of the low office, sales, and administrative costs of the damaged business.

The loss period was assumed to be ten years.  I divided the losses into five-year increments.  This provided two sets of losses for each range.[13]  The discount rates applied to the losses varied.  Following the outline provided by the Dunn and Harry article, a lesser discount rate was applied to the lower range figures and a greater discount rate to the upper range.  This was due to the greater risk of the latter.  In addition, the five-year discount rates and ten-year discount rates were adjusted for the time value of money.

Because the damaged business had been among the two finalists for the “set-aside” contract and had a good relationship with several large defense contractors, I added an additional loss for a “set-aside” contract in the second five-year loss period.  Facts from the initial “set-aside” opportunity were used to project the revenue and profits.  Due to the additional risk for this particular income stream, the discount rate applied to this loss estimate was twice that of the upper range’s ten-year loss discount rate.

Daubert Hearing

The opposing counsel filed a motion to exclude my testimony based, in part, on my relying on unreliable information from the management team.  The judge held a hearing in which I testified.  This gave me an opportunity to explain my methodology and my use of the management projections.

At the hearing, the judge took the lead in asking technical questions on how I could use the data knowing the clients had mislead their own attorneys and me.  I explained the use of the lower and upper range was an attempt to address this issue.  That I had applied both types of analysis discussed in the Dunn and Harry article and because of that, had greater discount rates on the upper end losses to reflect the additional risk in the management’s data.  In closing, I highlighted my use of industry data for costs and that the operating profit margins from these calculations was close to the mid-point for operating profit margins in the industry.

Similar arguments were made against the “set-aside” contract.  My response was similar to those defending my calculations of lost profits from daily operations.

In the end, I stated I was not taking a position as to which of the lower or upper range was more accurate and I would leave that decision to the trier-of-fact.  The judge denied the Daubert motion and allowed me to testify on all loss estimates.

Trial and Verdict

The trial went relatively smoothly.  After having been deposed and having testified at the Daubert hearing, the questions from opposing counsel were routine, as of course, were my answers.

This case was a suit and countersuit situation.  The management team had attracted a golden angel to finance their enterprise.  The initial costs for the business were more than the financer had anticipated.  In addition, he was debt averse and insisted on paying cash for everything, including equipment (which could have been acquired through a lease/purchase agreement without heavy impact to his cash flow).

During the second year of the business operation, the financer withdrew his financial support from the business.  He said the venture was too expensive.  Without his financing, the business folded.  This would have been the end of the matter except, the next day, he and his wife opened an identical company offering the same products to the defense industry, just without the management team.  The management team contacted attorneys wanting to sue over breach of contract.  The financer beat the management team to the courthouse and sued the management team for mismanagement of funds.  Each side claimed multi-million-dollar losses.

The jury’s verdict “split the baby.”  The jury awarded neither side their claims, finding each side had lost in the venture.  Each side walked away without owing the other side.  Their only outlays were for a very expensive litigation.

Conclusion

Experts working in the areas of business valuation, corporate bankruptcy, and lost profits may need to rely on projections or forecasts made by the company’s management team.  On receipt of this information, the initial question facing the expert is, “How reliable are these projections?”

Litigation and appraisal literature provide resources for assessing the credibility of management’s figures and how to use the data for the expert’s calculations.  Experts should start their review of any projections by comparing them with the historical performance of the business.  They should also question, “Is this only the helpful information?  Has harmful information been left out or included?”  The answers to these questions may affect the courts assessment of the use of these projections and their impact on determining probable cause and/or reasonable certainty.

Even with their concerns, experts may work through these situations and complete the assignment they have been given.  Experts should remain constantly vigilant for projections that do not match the known facts of the case and be prepared to pivot to other options should concerns arise about the reliability of the data.  Ultimately, the expert must have a good understanding of how and why he or she used a certain method and how it and the data fit the facts of that specific case.  With that knowledge in hand, the expert will be better prepared to face the challenges that will come when faced with potentially unreliable data.

[1] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd Ed., Vol 1, Nancy Fannon, Jonathan Dunitz, BVR, 2014, p. 165.

[2] After lengthy discussions with the retaining attorneys and their clients, it was determined the best way to express the damages in this case was through lost profits and not business destruction.  The reasoning for this decision is not germane to this article and therefore has not been discussed.

[3] Recovery of Damages for Lost Profits, 6th Ed., Supplement March 2018, Robert Dunn, Supplement Editors, Sharon Rutberg, Wendy Malkin, p. 220.

[4] DaimlerChrysler Motors Co. v. Manuel, 362 S.W.3d 160, 191 (Tex. App. 2012).

[5] Energy Capital Corp. v. U.S., 302 F.3d 1314, 1327, (Fed. Cir. 2002).

[6] Insolvency case turns on reasonableness of management projections, BVWire, #180-3, 9/27/2017.

[7] Weisfelner v. Blavatnick (In re Lyondell Chemical Co.), 543 B.R. 417, (Bankr. S.D.N.Y., 2016).

[8] Court’s eyes are on management projections, BVWire, #181-1, 10/4/2017, In re Appraisal of PetSmart, Inc., Consol. C.A. No. 10782-VCS (Del. Ch. May 26, 2017).

[9] Always Sunny in Adelphia—Bankruptcy Court Rejects DCF with Unreliable Projections, Drops Some Valuation Knowledge, Doron Kenter, Weil Bankruptcy Blog, 5/28/2014, p. 2 of 5.

[10] Ibid. 2 of 5, Adelphia Trust v. FPL Group, Inc. (In re Adelphia Communications Corp.), 512 B.R. 447, (Bankr. S.D.N.Y., 2014).

[11] Ten tell-tale signs that a forecast is unreliable, BVWire, 182-2, 11/8/2017.

[12] Modeling and Discounting Future Damages, Robert Dunn, Everett Harry, Journal of Accountancy, Litigation Series, January 2002, www.journalofaccountancy.com

[13] In this article, I will not discuss how the ten-year loss period was determined.  It took several discussions with the hiring attorneys and their clients to settle on a loss period which they found acceptable and I was willing to defend.

Allyn Needham, PhD, CEA, is a partner at Shipp Needham Economic Analysis, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp Needham Economic Analysis, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings.

Dr. Needham can be contacted at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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