CHALLENGING ECONOMIC DAMAGES

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CHALLENGING ECONOMIC DAMAGES

• Presented by Rob Hancock
• ASA CPA/ABV CVA
• Oral Presentation

US Law ConferenceMarch 27, 2003Orlando, FL
____________ Mann
Frankfort Stein
Lipp Advisors, Inc.
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Errors in Business Damage Calculations Are Rooted
In Two Categories

• 1. Experts Damage Methodology the primary
  subject of Daubert / Kuhmo Tire challenges
• 2. Experts Damage Assumptions the primary
  subject of Reasonable Certainty reviews

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1. Experts Damage Methodology Common
Components Subject to Challenge

• Parties Damaged Who was damaged? Are the
  parties with or without standing? Is the damage
  calculation linked to the proper party?
• Mitigation How did the plaintiff mitigate
  damages, if at all?
• Damage Date and/or Damage Period When did the
  damage occur? Is the damage calculation linked
  to the proper damage date or damage period?
• Lost Profits vs. Lost Value Was the business
  interrupted, destroyed or did a slow death occur?

Business Interruption Lost Profits Methods -- But
for method -- Yard stick method -- Before and
after method
Business Destruction Lost Value Methods -- Going
concern premise (income and market
approaches) -- Liquidation premise (asset
approach)
Slow Death Lost Profits and Lost Value
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The Use and Abuse of Discount Rates

• Personal Injury Risk free rate is the generally
  accepted rate.
• Lost Profits
• Risk free or risk adjusted discount rate for
  business losses? It depends on whether the
  discount rate is applied to risk inclusive cash
  flows or risk free cash flows.
• Pre-tax lost profits factored by an after-tax
  discount rate The theory serves to compensate
  the plaintiff for income taxes on the damage
  awards.
• Lost Value
• After-tax lost profits factored by an after-tax
  discount rate is generally accepted, but an issue
  with pass through entities, such as S
  corporations, exists.
• Ibbotson Associates certification In response to
  increasing challenges on the correct utilization
  of Ibbotsons data for computing discount rates,
  Ibbotson recently introduced a new certification
  service. For a fee, Ibbotson will review an
  experts report and issue a letter certifying
  that the Ibbotson data was used properly in the
  computation of the discount rate.

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Lost Profits Risk Adjusting the Discount Rate or
Cash Flow
Note Damage calculation models usually include
an adjustment for risk by adjusting the lost
profits or the discount rate. Double-counting
risk, or not counting risk at all, will calculate
damages that are too low or too high.
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The Effect and Consideration of Taxes on Damage
Awards
By using pre-tax lost profits with an after-tax
capitalization rate, lost profits calculations
gross-up the award value to compensate the
plaintiff for the tax liability on the damage
award. Typical business valuations do not.
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2. Experts Damage Assumptions Common
Components Subjectto Challenge

• Ideal Scenario for the Plaintiffs Expert The
  alleged damaged party serves, on a silver
  platter, a full blown, fully researched business
  plan (prepared in the pre-damage period)
  inclusive of meaningful balance sheets, income
  statements and cash flow statements.
• Ideally, the expert is also provided the
  following information
• Market research
• Management bios and resumes
• Prior valuations
• Marketing material
• Fixed asset appraisals
• Organization chart and plan
• Operations plan and description
• Description of competition
• Risk management strategy
• It is a plus if the business plan has been
  blessed and/or adopted by others (such as
  bankers, investors, bonders, etc.).
• If a full, pre-damage period business analysis is
  not available, then the expert must supplement
  and/or document any existing oral or written
  assumptions.

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Experts Assumptions Unreasonable Certainty as
to the Quality of the Business Plan

• Notwithstanding the presence of a completed,
  documented business plan, the quality of the plan
  raises reasonable certainty issues for example
• Adequate Working Capital and Financing?
• Blue Sky Sales Projections?
• Unrealistically Low Production Costs?
• Unbudgeted Spending Required, but not Budgeted,
  for Growth?
• Unforeseen Regulatory Restrictions on Business
  Operations?

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Applications in Non-Judicial Settings
Generally, an experts methodology will sustain a
Daubert challenge if the methodology is accepted
in

• Academic Theory
• Industry Practice

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Effect of Risk on Investor Returns -Typical
Discount Rates

• Financial instruments (above inflation rate)
  Inflation
• Rate Plus
• Treasury bills, money market, CDs 0 -
  5
• Risk free long-term bonds (i.e. U.S. Treasury)
  2 - 3
• Long-term investment grade corporates
  2.5 - 3.5
• Junk bonds 6 - 10
• Common stock of established public companies
  7 - 10
• Common stock of speculative and small capital
• public companies, minority
  10 - 15
• Equity in private companies, minority interest
  25 - 30
• Bridge stage companies
  25 - 35
• Growth and expansion stage companies
  30 - 50
• Development and expansion stage companies
  40 - 60
• Start-up companies 50 - 80