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Rules Of Thumb And Other Short-Cuts Are Dangerous For Damage Calculations

Financial Complexity Made Clear, November 2012

By: David Nolte
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Plaintiffs often desire short cuts to damage measurements. Given the cost of using experts employing proper methods and data, the temptation is obvious. For example, business valuation programs are commonly available that will spit out a result once the user inputs a few financial statistics for the subject company. Why pay thousands of dollars for a business valuation that follows valuation standards, when the program can be purchased for less than a thousand dollars, and the result can be obtained shortly after the program is loaded?

In McGinty vs. Hennen, 372 S.W.3d 625 (Tex. June 29, 2012), the Texas Supreme Court overturned a damages award using this type of software. This particular case involves the use of a commonly-used insurance-industry software program, but the principle is much broader. Damages cannot be calculated properly using rules of thumb or automated valuation models.

In the current case, Hennen (nominally, the defendant, but in reality the plaintiff based on the claims sought) was a homeowner who purchased a new home that was found to be defectively constructed. The issue on appeal involved the damages amount. The Texas Supreme Court was not sympathetic to plaintiff's calculation short cuts. The Supreme Court described the damage evidence as follows:

"Hennen's expert's testimony was the only evidence offered on reasonable remedial damages. He derived his estimated costs of repair from an "Exactimate" program "that's used widely in the insurance industry." The program had a Houston price guide, which he compared with Corpus Christi and found to be "within a percent or two difference." He further testified that because not every price issued by the program is right, "we have to cross-reference and double check all our pricing." And finally, he testified that "some of the other costs came from subcontractors or historical data or jobs."

Given this description, Hennen's damages case actually involved more care and analysis than we often see when rules of thumb or automated valuation programs are used. Nevertheless, the Supreme Court evaluated the trial court evidence as actually being no evidence at all, as follows:

"Hennen argues, however, that his expert testified extensively about how he derived his pricing estimate, which is the same as reasonableness. That explanation may explain how the figure was derived, but it does not in itself make the figure reasonable. In some cases, the process will reveal factors that were considered to ensure the reasonableness of the ultimate price. But that did not happen here. Hennen's expert established only that some of the pricing came from a widely used software program and some from "subcontractors or historical data or jobs. ...No evidence supports the reasonableness of the remedial damages awarded by the jury. As a result, the court of appeals erred in affirming the trial court's judgment ...."

Hennen also presented lay testimony from the claimant regarding his damages and the value of his property. While such testimony is generally allowed, the litigant used the wrong standard and dates of value, so this testimony was also disregarded.

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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