By Michael Hoenig - New York Law
Journal - March 11, 2013
At what point in a breach of
contract action for lost profits does an economic expert's
evidence become vulnerable to "gatekeeping," a form of
reliability analysis performed by the trial judge to keep
untrustworthy evidence from the jury? Normally, many contract
disputes involve experts retained by each side. The battle
between them is rarely viewed as one of unreliable evidence that
will be precluded. Most persons likely assume that each side
simply will pitch their case to the jury as best they can.
But not all contract issues are
routine. Thus, for example, when an expert concludes that the
seller's market share would have grown substantially but for the
breach of contract, or perhaps, that the seller's profits would
have increased steadily over 10 years, how is the economic
expert's reliability index to be measured? When does the
evidence the expert offers go from mundane to profane?
In late November 2012 the
California Supreme Court decided an important contract case
Sargon Enterprises v. University of Southern California.1
The court used the occasion to recognize the "gatekeeping" role
U.S. Supreme Court decisions such as Daubert have
achieved with expert testimony and noted that California courts
have a substantial responsibility as well.2 The court
in Sargon, by focusing on a contract case, picked a
rather tough assignment. The California case is a good one,
however, with which to learn lessons.
In 1991, plaintiff Sargon
Enterprises patented a dental implant that its president and
chief executive officer had developed. The U.S. Food and Drug
Administration approved the implant for use in the United
States. This meant that Sargon's implant could be implanted
immediately following an extraction and the unit contained both
the implant and full restoration. In the 1980s the standard
implant was the Branemark implant developed at the University of
Gothenburg in Sweden. But that was a multi-stage implant and
relied upon integration with the bone.
Sargon's implant was a
one-stage implant: it expanded immediately into the bone socket
with an expanding screw, and this mechanism permitted the
implant to be "loaded" with a crown the next day. In 1996,
Sargon contracted with defendant University of Southern
California (USC) for the School of Dentistry to conduct a
five-year study of the implant. After initial success in the
clinical trials, the university failed to present the reports
required by the contract. In May 1999, Sargon sued USC and
faculty members of its dental school involved in the study,
alleging breach of contract and other causes of action. In 2003
the contract action was tried to a jury. The trial judge
excluded evidence of Sargon's lost profits on the ground that
USC could not have foreseen them. The jury found USC had
breached the contract and awarded Sargon $433,000 in
Sargon appealed. The California
Court of Appeal reversed the judgment holding that the trial
court had erred in excluding evidence of Sargon's lost profits
on the grounds of foreseeability. On remand, the case proceeded
to retrial. Defendant university moved to exclude as speculative
one of Sargon's experts, James Skorheim. He was the primary
witness at an eight-day evidentiary hearing on expert testimony.
Skorheim testified that he was
a certified public accountant and an attorney. He had been an
accountant for 25 years and "worked as business and industry
analyst and forensic accountant." He testified that Sargon's
lost profits "ranged from $220 million to $1.18 billion." In
preparing his opinion, Skorheim reviewed litigation materials
(including deposition transcripts and reports of USC's damages
experts), financial information from Sargon and its competitors
(including annual reports) and market analyses of the global
implant market prepared by Millennium Research Group.
Skorheim used a "market share"
approach by which he determined what share of the worldwide
dental implant market Sargon would have gained had USC completed
a favorable clinical study, and he calculated future profits
based on that market. Skorheim used the market share approach to
lost profit damages because the methodology had been used in
complicated patent cases, antitrust cases, and unfair
In the 1990s the dental implant
market began to grow dramatically. Some were expecting the
market to grow from 1998 to 2009 at an annualized rate at 18.5
percent. At the time the market craved technological innovation
aimed at shortening healing time, cost and treatment time.
Sargon's innovation lay in the
use of an "immediate load implant," the "holy grail of dental
implantology." According to the expert Skorheim, Sargon was an
innovator that rapidly would fairly have commanded the
significant market share. Three key "market drivers" were: (1)
innovation, (2) clinical studies, and (3) outreach to general
practitioners. Skorheim said that, "the greater the
technological achievement in the product mix, the greater the
likelihood for revenues."
Skorheim's market share was
based on a comparison of Sargon to six other large,
multinational dental implant companies that were the dominant
market leaders in the industry, and which controlled in excess
of 80 percent of global sales. Although some 96 companies
worldwide make dental implants, Skorheim believed the "Big Six"
were the top innovators among the reports. Smaller companies
were described by Skorheim as "copy cats" and "price cutters."
The expert acknowledged that
Sargon was a very small company whose annual profits peaked in
1998 at around $101,000 and, unlike the big companies, had no
meaningful marketing or research and development organization
and no parent company to assist it. Skorheim, however, believed
that these factors were "incidental" to innovation and played
little role in achieving market share. And because innovation is
the key factor, the expert had compared Sargon to the "Big Six"
rather than the smaller companies in computing lost profits. He
considered them "comparable companies." He also said that
"assuming the jury finds the new implant was a superior
innovative product," Sargon had a very good chance of becoming
the market leader maybe in a 10-year period of time.
When the trial court asked
whether it mattered that any of the big companies had many
different products, Skorheim said Sargon "would have to remain
competitive" by investing significant amounts of money in
research and development like other major manufacturers. He was
confident Sargon would be able to expend the necessary
resources. Skorheim established a hierarchy which would place
Sargon equal to one of the benchmark six competitors if Sargon's
level of innovation was found by the jury to be equal to that of
the comparison company. Depending on Sargon's vote with the jury
in terms of innovative market leaders, based on what Skorheim
told them as an expert, Sargon's lost profits could be $220
million, or $315 million, or $600 million and, even, $1.2
billion if the jury found Sargon's innovation were comparable to
the market leaders.
The trial court issued a
33-page ruling excluding Skorheim's testimony. He said, "Mr.
Skorheim's opinion leaves the determination up to a billion
dollars of lost profit damages to pure speculation." While the
court assumed that a "market share" analysis is appropriate
under California law, it found that Skorheim's opinion is not
based on any actual historical financial results or comparisons
to similar companies and, therefore, is not based on a matter of
time upon which an expert may reasonably rely. The "fatal flaw"
in Skorheim's reasoning is that it starts off assuming, without
foundation, its conclusion. The fatal flaw in his analysis is
that he relies on data that is no way analogous to plaintiff.
Skorheim deems plaintiff's historical data, such as past
business volume, "not relevant" to his lost profits projections.
The trial court believed that
asking a jury to rank innovativeness "is no different than
deciding whether Miss Oklahoma or Miss Colorado should wear the
Miss America crown." Skorheim's question calls for nothing but a
subjective and speculative response. Whether an implant is good,
better or best can only be answered in the marketplace, not the
jury room. To the trial judge there were two independent grounds
to rule Skorheim's evidence inadmissible: (1) no damage award
can be based in speculation; (2) evidence that cannot assist the
trier of fact in the resolution of an issue is not relevant.4
After the court excluded
Skorheim's testimony, Sargon appealed again. By a 2-1 vote, the
Court of Appeal reversed and remanded for a trial on the issue
of lost profits. The appellate court found that Sargon "has the
better argument here." The intermediate court accepted the
comparisons Skorheim had made with competitors. The court
acknowledged the difficulty in determining lost profits when an
established business is built upon the sale of an innovative,
revolutionary or world-changing product.
The factor of innovation—what
the trial court described as a "beauty contest"—is not easily
converted into dollars and cents. But exactitude is not
required. Lost profits may be based on a comparison of similar
companies; they need not be identical in all respects.
Skorheim's expert opinion was based on economic and financial
data, market surveys and analyses, business records of similar
enterprises, and the like. If USC had not sabotaged the clinical
study of the Sargon implant, it would have had a successful
clinical trial to its credit and a prominent university using
the implant at its dental school. The dissenting judge of the
Court of Appeal, however, sided with the trial judge.
In the California Supreme
Court, the court said that expert testimony must provide a
reasonable basis for the particular opinion offered, and that an
expert opinion based on speculation and conjecture is
inadmissible. The trial court acts as a gatekeeper to exclude
speculative or irrelevant expert opinion. The opinion may not be
based "on assumptions of fact without evidentiary support, or on
speculative or conjectural factors." A court may "inquire into
not only the type of material on which the expert relies, but
also whether that material actually supports the expert's
reasoning." A court "may conclude there is too an analytical gap
between the data and the opinion proffered."
Courts must also be cautious in
excluding expert testimony. The court must simply determine
whether the matter relied on can provide a reasonable basis for
the opinion or whether that opinion is based on a leap of logic
or conjecture. The goal of gatekeeping is to simply exclude
"clearly invalid and unreliable" expert opinion. The courtroom
should employ the same level of intellectual rigor that
characterizes the practice of an expert in the relevant field.
No damages can be recovered for
a breach of contract when such damages are not clearly
ascertained in both their nature and origin. Lost profits are
recoverable where the evidence makes reasonably certain their
occurrence and extent. They must be proven as to occurrence and
their extent. The cases have generally been distinguished
between established and unestablished businesses. For
established businesses, damages for loss of prospective profits
may be recovered because their occurrence and extent may be
ascertained with reasonable certainty from the past volume of
business and other provable data relevant to the probable future
sales. The lost profit inquiry is always speculative to some
degree. Inevitably, there will always be an element of
In this case, the trial court's
exclusion of Skorheim's expert testimony was correct. The
expert's methodology was too speculative to be admissible and
too circular. Skorheim's lost profit projections were "wildly
beyond, by degrees of magnitude, anything Sargon had experienced
in the past." Skorheim's testimony was speculative in other ways
too. He assumed Sargon, which had virtually no marketing or
research and development, would have developed such departments
to allow it to compete with the "Big Six." He also assumed one
of the "Big Six" would leave and Sargon would replace it.
World history is replete with
fascinating "what ifs," says the California Supreme Court. What
if Alexander the Great had been killed early in his career at
the Battle of Granicus River (as he nearly was)? What if the
Saxon King Harold had prevailed at Hastings, and William, later
called the Conqueror, had died in that battle rather than
Harold? What might have happened is not the purpose of the
gatekeeper. The purpose is to consider what would have happened.
The California Supreme Court says that the trial court properly
acted as a gatekeeper to exclude speculative expert testimony in
this breach of contract case.
is a member of Herzfeld & Rubin.
1. 55 Cal. 4th at 747, 2012
Cal. LEXIS 10713 (Cal. Nov. 26, 2012).
Daubert v. Merrell Dow Pharmaceuticals, 509 U.S. 579
General Electric v. Joiner, 522 U.S. 136 (1977);
Kumho Tire v. Carmichael, 526 U.S. 137 (1999).
3. 55 Cal. 4th at 755.
4. 55 Cal. 4th at 765; 2012
Cal. LEXIS 10713, at *765.
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