Opposing Discounted Cash Flow Analysis

Writing in the May issue of the newsletter of the Business Litigation Committee, James D. Nelson of Betts, Patterson & Mines, Seattle, advises doing your own homework: Legal doctrines like Daubert's requirement that an expert's analysis be reliable and the "new business rule" that once prohibited businesses without a track record of profits from claiming damages for lost profits are seldom helpful in attacking an opposing expert's discounted cash flow analysis. Doing your own homework and analyzing the opposing expert's forecast of expected future cash flows and choice of discount rates with basic finance theory yield better results. Daubert seldom useful There is no question that, as the U.S. Supreme Court elaborated in Kuhmo Tire Co. v. Carmichael, 526 U.S. 137, 141 (1999), "Daubert's general holding-setting forth a trial judge's general `gatekeeping' obligation-applies not only to testimony based upon 'scientific' knowledge, but also to testimony based on `technical' and other 'specialized' knowledge. " In addition, Daubert's reasoning has long since been held-to apply to experts in business valuation cases. Frymire-Brinati v. KPMG Peat Marwick, 2 F.3d 183 (7th Cir. 1993). The problem is that the Daubert standard is too easy to satisfy. The FrymireBrinati court said: Admitting Hassett's "fairly simple pass" into evidence just because he is an expert in accounting is problematic, for Hassett conceded that he did not employ the methodology that experts in valuation find essential. A "trial judge must ensure that any and all testimony or evidence admitted is not only relevant, but reliable. " [Citing Daubert. ] The Federal Rules of Evidence require a judge to undertake "a preliminary assessment of whether the reasoning or methodology underlying the testimony is scientifically valid and of whether that reasoning or methodology properly can be applied to the facts in issue. " Id. at 580, 113 S.Ct. at 2790. See also Mid-State Fertilizer Co. v. Exchange National Bank, 877 F.2d 1333, 1339-40 (7th Cir. 1989); Deltak, Inc. v. Advanced Systems, Inc., 574 F. Supp. 400, 40506 (N.D. 111. 1983), vacated on other grounds, 767 F.2d 357 (7th Cir. 1985). The trial court did not conduct such a "preliminary assessment" before permitting Hassett to testify about his method. Although district judges possess considerable discretion in dealing with expert testimony, Carroll v. Otis Elevator Co., 896 F.2d 210, 212 (7th Cir. 1990), on this record the court could not properly have admitted Hassett's valuation. Fed. R. Evid. 702. [2 F.3d at 186-87] Unfortunately, most opposing experts do not characterize their testimony as a "fairly simple pass" or concede that they have failed to apply methodology that experts in valuation find essential. For this practical reason, Daubert and its progeny are seldom useful in attacking an opposing expert's discounted cash flow analysis in business cases. New business rule seldom useful The new business rule once precluded a business with no track record of profit from claiming lost profits. But the Washington Supreme Court stated in Tiegs v. Watts, 954 P.2d 877 (Wash. 1998): "The modem view is that lost profits are properly recoverable as damages when (1) they are within the contemplation of the parties at the time the contract was entered, (2) they are the proximate result of defendant's breach, and (3) they are proven with reasonable certainty. " Prior to 1964, a plaintiff who owned and operated a new business was unable to recover lost profits in a breach of contract claim because of the new business rule. The rationale was that "where a plaintiff is conducting a new business with labor, manufacturing and marketing costs unknown, prospective profits cannot be awarded. " Larsen v. Walton Plywood Co., 390 P.2d 677, 687 (Wash. 1964). However, Larsen recognized the inequity of the rule and held that "lost profits will not be denied merely because a business is new if factual data is available to furnish a basis for computation of probable losses. …