In a unanimous opinion, the California Supreme Court clarified that trial courts may use either California Evidence Code Sections 801(b) or 802 to admit or exclude the expert's testimony. Potentially, the Opinion widens California judicial authority to exclude expert testimony by placing California closer to the federal Daubert standard and the majority of other states that follow such standard.
In Sargon Enterprises, Inc. v. University of Southern California, et al. (No. S191550, 11/26/2012), the Court held that Evidence Code section 801(b) permits California courts to review the substance of the information relied upon by the expert in determining admissibility. Evidence Code section 801(b) provides, in relevant part:
"If a witness is testifying as an expert, his testimony in the form of an opinion is limited to such an opinion as is:... based on matter... that is of a type that reasonably may be relied upon by an expert in forming an opinion upon the subject to which his testimony relates, unless an expert is precluded by law from using such matter as a basis for his opinion."
The Court also held that Evidence Code section 802 permits California courts to review the reasons for the expert's opinion in determining admissibility. Section 802 provides, in pertinent part:
"A witness testifying in the form of an opinion may state on direct examination the reasons for his opinion and the matter... upon which it is based, unless he is precluded by law from using such reasons or matter as a basis for his opinion. The court in its discretion may require that a witness before testifying in the form of an opinion be first examined concerning the matter upon which his opinion is based."
The underlying case involved a breach of contract and resulting award of lost profits. The trial court held an eight-day evidentiary hearing in which the proffered accountant witness was the primary witness. In its related lengthy written Opinion, the trial court disallowed testimony of the accountant regarding the amount of lost profits because the conclusions were inherently speculative and relied on unreasonable assumptions. In a 2 to 1 decision, the Appellate Court reversed the evidence exclusion. The Appellate Court noted that the defendant's conduct had made the measurement of damages more difficult and that, although difficult, the measurement of lost profits damages need not be precise. Accordingly, the Appellate Court concluded that the testimony would be "better left for the jury's assessment".
The Supreme Court decision reported in the rest of this article upheld the trial court's exclusion. In reaching this decision, the Supreme Court quoted at length from the trial Court's factual finding. As an initial matter, it is important to understand the plaintiff's small size compared to what Plaintiff was claiming as lost profits. The trial court, and repeated by the Supreme Court, summarized this point as follows:
"Skorheim [the plaintiff's expert accounting witness who was calculating lost profits] believed that Sargon, unlike any of the other smaller companies, would, over time, have become a market leader, one of the Big Six [Six large companies that dominate this industry]. In calculating Sargon's lost profits, he had not considered profits Sargon had ever actually realized, but instead considered the market leaders' profits. He believed that Sargon's profits would have increased over time until they reached the level of one of the market leaders. ... Skorheim believed that Sargon's net profits, which in actuality peaked at $101,000 in 1998, would have grown to $26 million per year in 2009 under the least profitable of the scenarios, and to $142 million per year in 2009 under the most profitable of the scenarios. ...
For each of these four scenarios, Skorheim had calculated lost profits from 1998 to 2009, then added what he calculated to be post-2009 lost profits. ... Thus, Skorheim had projected total lost profits of $220 million if the jury found Sargon's innovation was comparable to that of the least innovative market leaders, making what he described as a "meaningful contribution to innovation"; of $315 million if the jury found Sargon's innovation was somewhat greater; of $600 million if the jury found Sargon's innovation was somewhat greater yet; and of $1.2 billion if the jury found Sargon's innovation was comparable to that of the market leaders, making what he described as "revolutionary industry changing technology."
As summarized by the trial and Supreme Courts, the plaintiff's expert attempted to explain this enormous increase as explained below. But both Courts found this explanation too incredible to allow, as follows:
"Mr. Skorheim testified that, in the perfect world where there had been no breach, by 2007 Sargon would have made the seamless transition from a three-person operation to sharing industry leadership with Nobel Biocare, a multi-million dollar international corporation. Nobel Biocare touts, according to the annual reports he relied upon, many different product lines, including different types of implants. When asked how Sargon could be an industry leader with only one implant (he later testified that Sargon had developed seven) Mr. Skorheim testified that 'he would expect' Sargon to have invested in 'R and D' in the intervening years and also, by 2007, to have invented new products and coatings. Mr. Skorheim thus opined that not only would Sargon have invested in 'R and D' by 2007, but has also opined on what the results of that 'R and D' would be. It is not reasonable for any expert to make such a faith-based prediction so absolutely devoid of any factual basis about an industry where he has no expertise. ...
In its concluding portion, the court stated that "case law demands that to establish such lost profits through expert testimony, the expert must base his/her opinion on either historical performance of the company or a comparison to the profits of companies similar in terms of size, locality, sales, products, number of employees and other relevant financial factors. A party is not permitted to 'make up' its own factors as a basis for comparison and invite the jury to decide whether the corporations are similar. To allow this is to invite proceedings where there are no objective standards as there will always be some way to argue that companies are 'similar,' no matter how superficial or irrelevant. Here, for example, the factors Mr. Skorheim uses would lead to the absurd result that Sargon, one of the industry's smallest companies, was 'similar' to the largest. In assessing lost profit damages in this context, there is a meaningful difference between biggest and smallest. Mr. Skorheim admittedly shunned historical performance and comparison to companies of similar size and financial situation, choosing instead to compare Plaintiff to multi-national industry giants based upon his own criteria of 'similar.' His criteria, even assuming he has the qualifications to decide them, which he does not, are nebulous and legally irrelevant under case law. Accordingly, there is no issue of similarity to give to the jury to compare and decide."
The witness's lack of relevant industry expertise was problematic in a damage calculation involving the enormous amounts involved here. The Supreme Court, again by repeating the trial court's finding, explained:
"Skorheim claimed no expertise regarding how innovative Sargon's dental implant was, although he had testified that "the immediate loading of implants is kind of the so-called holy grail of dental implantology." He said the jury would have to "wrestle" with the question of how innovative Sargon was. Because of this lack of expertise, Skorheim could not give a single sum of lost profits. Rather, in Skorheim's opinion, the amount would depend on how innovative the jury found Sargon to be, compared to the market leaders. ...
At the hearing, Plaintiff changed its theory and attempted to show that it was similar to the industry leaders in ways other than possession of the three 'drivers.' The characteristics that Mr. Skorheim contended made Plaintiff 'similar' to the industry leaders, however, were characteristics common to most, if not all, implant companies. Obviously, if most share these 'common traits,' the traits are meaningless for comparison purposes. If, based upon these common characteristics, the very smallest is considered 'similar' to the very biggest, all cases that have required objective similarity would be effectively overruled, and the rule requiring 'similarity' would cease to exist. This Court finds that Sargon is not similar to the industry leaders by any relevant, objective business measure."
Finding that an abuse of discretion standard is the basis for overturning this decision, the California Supreme Court concluded:
"The trial court did not abuse its discretion in the sense of making a ruling that was irrational or arbitrary. It presided over a lengthy evidentiary hearing and provided a detailed ruling. The Court of Appeal majority identified no specific error in that ruling. As the dissenter in the Court of Appeal stated, "Nothing in the trial judge's reasonable, straightforward and clearly articulated evidentiary ruling bears even a smidgeon of arbitrariness or capriciousness." Indeed, the court could hardly have exercised its discretion more carefully."
The Supreme Court's unanimous decision is not actually surprising. What is surprising is that the two out of three Appellate Court justices let stand these large and wild lost profit conclusions. The Sargon case shows how far an expert witness can go in creating absurd conclusions.
Here are some practical suggestions when considering damages testimony:
David Nolte is a principal at Fulcrum Financial Inquiry LLP with over 30 years experience performing forensic accounting, auditing, business appraisals, and related financial consulting. He regularly serves as an expert witness.
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