Complex Litigation

'Gatekeeping' Economic Experts in Contract Litigation

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 called 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 compensatory damages.

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.

'Market Share'

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 competition cases.3

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.

Testimony Excluded

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 uncertainty.

Conclusion

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.

Michael Hoenig is a member of Herzfeld & Rubin.

Endnotes:

1. 55 Cal. 4th at 747, 2012 Cal. LEXIS 10713 (Cal. Nov. 26, 2012).

2. See Daubert v. Merrell Dow Pharmaceuticals, 509 U.S. 579 (1993); 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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