Accountants are often called upon to perform litigation support services, including expert testimony on valuation and economic damages. This includes valuation analyses related to shareholder disputes and shareholder appraisal rights; breach of contract and other types of commercial litigation; insurance claims and cases of federal income taxation; federal gift and estate tax; state and local property taxation; infringement and deprivation; eminent domain and condemnation; marital dissolution and family law; and other types of valuation-related disputes.
Accountant/valuation expert witnesses should be aware of several recent court cases that have applied and interpreted the Daubert guidelines with regard to expert testimony. For purposes of this discussion, the Daubert guidelines refer to the factors articulated by the U.S. Supreme Court in Daubert v. Merrell Dow Pharmaceuticals, Inc. (113 S.Ct. 2786, 125 C. Ed., 2d 469 ). These factors are applied by federal trial courts in their "gatekeeping" function of including--or excluding--expert testimony under the Federal Rules of Evidence Rule 702.
While the Daubert guidelines specifically apply in federal courts to expert testimony offered under Rule 702, accountants should realize that these federal guidelines might influence state and local trial courts as well.
It is the objective of the Daubert "gatekeeping" requirement to ensure the reliability and relevancy of expert testimony. The Daubert factors are used by the trial court to consider whether an expert witness, when basing testimony on professional studies or on personal experience, employs in the courtroom the same level of intellectual rigor that characterizes the practice of an expert in the relevant field. As will be discussed below, the Daubert case originally applied to scientific expert testimony, and the Daubert factors were used to help clarify what is science and what is "junk science."
Several recent published decisions (at both the Court of Appeals and the Supreme Court levels) have concluded that the trial court's "gatekeeping" inquiry into both relevance and reliability applies not only to scientific testimony, but also to all expert testimony. Accordingly, all valuation practitioners should be aware of--and should attempt to comply with--these expert testimony guidelines. This would include all accountants who offer expert testimony on the value of assets, properties, and business interests within the context of Federal Rules of Evidence Rule 702.
The Daubert Factors
Under Rule 702, trial judges have historically been the "gatekeepers" regarding the admission of expert evidence in federal cases. Traditionally, trial judges would rarely disqualify expert witnesses or exclude expert testimony. Rather, they would limit the areas in which the expert was allowed to offer testimony. And, they would allow witnesses to testify and then afford that testimony its "due weight" in their final deliberations. However, in Daubert, the Supreme Court articulated specific factors that trial judges should consider with regard to the admission or exclusion of expert testimony.
In the Daubert case, a doctor testified before the trial court and presented a radical medical opinion. That opinion was unsupported by either the relevant professional literature, the medical research scientific standards, the recognized professional organizations, or any concurring medical research colleagues. With regard to the admission of this testimony, the questions that trial court faced were: (1) Was the doctor truly a scientific expert or merely a "hired gun?" and (2) Was the expert testimony based on medical expertise or on "junk science?" With regard to the admissibility of expert testimony, the Daubert court wrestled with the following issues:
1. Whether the expert will be testifying as to scientific knowledge.
2. Whether the testimony based on scientific knowledge will assist the trier of fact in determining the ultimate issue.
3. Whether the proposed scientific method has demonstrated validity or reliability.
The Daubert court applied four factors to determine the reliability of a particular expert's scientific theory or technique:
1. Testing--can the theory or technique be tested, or has it been tested?
2. Peer reviews--has the theory been subjected to peer review or publication which aids in determining flaws in the method?
3. Error rates--are there established standards to control the use of the technique?
4. Acceptability--is the technique generally accepted in the relevant technical community?
In its decision, the Supreme Court noted that the Daubert factors should be applied flexibly, that the four factors were merely illustrative, and that other factors could argue in favor of testimony admissibility.
Sons of Daubert
During the last several years, numerous trial courts have applied the Daubert factors. Several appeals court decisions have sustained, expanded and interpreted the Daubert factors. First, we will reference a few illustrative Daubert applications. Second, we will summarize two recent decisions that make it clear that the Daubert factors apply to valuation and economic analysis testimony--as well as to scientific testimony.
In General Electric Co. v. Joiner, (118 S.Ct. 512 139 C. Ed. 2d 508) the Supreme Court concluded that federal courts of appeals must apply an abuse-of-discretion standard when they review a trial court's decision to admit or exclude expert testimony. That standard applies as much to the trial court's decisions about how to determine reliability as to its ultimate conclusion, the Supreme Court ruled. The Supreme Court also concluded that whether the specific Daubert factors are appropriate measures of reliability in a particular case is a matter the law grants the trial judge broad latitude to determine--the same broad latitude that the trial judge enjoys with respect to his or her ultimate reliability determination.
Several trial courts (and appeals courts) have applied the Daubert factors to exclude valuation-related expert testimony. For example, in Andrew J. Whelan, eta!. v. Tyler Abell, et al., (U.S. District Court, District of Columbia, civil action nos. 87-442 and 87-1763) the judge excluded the financial valuation expert testimony of a PricewaterhouseCoopers partner, Hugh Penny, CPA. The damages issue in the case involved the fair market value of the plaintiffs' shares of a closely held corporation (Animated Playhouse Corporation). The plaintiffs' expert used only one valuation method (a discounted cash flow method) that relied upon speculative financial projections. Applying the four Daubert factors to test the admission of the expert testimony under Rule 702, the District Court judge concluded: "The undue prejudice that would be caused to Defendants by allowing the highly speculative testimony of Mr. Penny is clear. Accordingly, the Court has excluded his testimony."
In Frymire-Brinati v. KPMG Peat Marwick, 3F.3d 183 (7th Circuit, 1993), the Court of Appeals excluded the testimony of another CPA valuation expert. The damages issue in this case involved the fair market value of plaintiff's partnership interests in a real estate development company. Again, the plaintiff's expert used only one valuation method (again, a discounted cash flow method) to value the subject partnership interests. Explaining its exclusion of the valuation-related expert testimony, the Court of Appeals specifically noted that the CPA valuation expert "conceded that he did not employ the methodology that experts in valuation find essential."
Kuhmo Tire Company, Ltd.
In Kuhmo Tire Company, Ltd., et al. v. Patrick Carmichael, et al., (119 S.Ct. 1167 [(March 23, 1999]) the Supreme Court clearly ruled that the Daubert factors--and the trial court's "gatekeeping" function regarding the admission of expert testimony--do not apply only to "scientific" experts. Rather, they apply to all "technical" or "other specialized" experts.
The Kuhmo Tire case involved personal injury damages and manufacturer's liability. When the tire on the vehicle driven by Patrick Carmichael blew out and the vehicle overturned, one passenger died and other passengers were injured. The plaintiffs claimed that the blown-out tire was defective. The claim was based upon the deposition testimony of tire failure analyst Dennis Carlson, Jr. Carbon intended to testify at the trial that, in his expert opinion, a defect in the tire's manufacture or design caused the blow out. This expert opinion was based on a visual and tactile inspection of the tire.
The defendants moved to exclude Carlson's testimony at trial, on the ground that his methodology failed to satisfy Rule 702 of the Federal Rules of Evidence. Applying the four Daubert factors, the District Court judge excluded Carbon's expert testimony The plaintiffs appealed.
The Eleventh Circuit reversed the District Court's decision. The Court of Appeals held that the District Court had erred as a matter of law in its application of the four Daubert factors. The Court of Appeals ruled that Daubert was limited only to a scientific context and that the Daubert factors could not be applied to Carlson's testimony because that testimony is characterized as "skill-or-experience-based." The defendants appealed.
Writing for the Supreme Court in the Kuhmo Tire opinion, Justice Beyer states unambiguously:
"The Daubert "gatekeeping" obligation applies not only to "scientific" testimony, but to all expert testimony. Rule 702 does not distinguish between "scientific" knowledge and "technical" and "other specialized" knowledge, but makes it clear that any such knowledge might be the subject of expert testimony. It is the Rule's word "knowledge," not the words (like "scientific") that modify that word, that establishes a standards of evidentiary reliability."
Explaining the Supreme Court's agreement with the trial court's decision, Justice Beyer concluded:
"In Daubert, this Court held that Federal Rule of Evidence 702 imposes a special obligation upon a trial judge to "ensure that any and all scientific testimony...is not only relevant, but reliable." The initial question before us is whether this basic gatekeeping obligation applies only to "scientific" testimony or to all expert testimony. We, like the parties, believe that it applies to all expert testimony."
Accordingly, in Kuhmo Tire, the Supreme Court concurred with the trial court and excluded the tire expert's testimony based on an application of the Daubert factors.
Target Market Publishing
In Target Market Publishing, Inc. v. ADVO, Inc., (136 F. 3d 1139, 1998 U.S. App. Lexis 2412) the Seventh Circuit decided the appeal of another case involving the exclusion of testimony by a CPA valuation expert witness. In this case, the Court of Appeals decisively concludes that the Daubert factors apply to valuation and economic damages testimony.
In 1993, Target Market Publishing, Inc. (Target) entered into a one-year contract with ADVO, Inc. (ADVO) to prepare and distribute a direct-mail advertising publication called Select Auto. The project involved selling automobile dealers exclusive advertising rights at a fiat rate in the monthly publication. The two companies were to share equally in any profits earned from the Select Auto enterprise.
In April 1994, Target brought suit against ADVO, claiming breach of contract and breach of fiduciary duty. After the close of discovery, ADVO filed a motion for summary judgment maintaining Target could not prove it's claim that it had sustained damages of at least $75,000 as a result of the failed Select Auto project.
In its response to the motion for summary judgment, Target relied upon an expert report prepared by Bruce W. Burton, an accountant and business appraiser from the accounting firm Deloitte & Touche. ADVO replied, "The Burton report is pure speculation, based on utterly implausible assumptions and unreliable methodology." In this statement, the District Court agreed with ADVO. The District Court disregarded the business valuation expert's report and granted summary judgment for ADVO. Target appealed.
The Court of Appeals had to decide whether the District Court had properly excluded the report of the plaintiff's expert under the Daubert factors and as part of the trial court's "gatekeeping" function. In concluding that the trial court had properly applied the Daubert standard, the Court of Appeals made an interesting analogy:
"If, for instance, an expert who was well qualified as an astronomer offered to testify based on lengthy and careful observation that the sun revolves around the earth, a court would not be obliged to submit the testimony to the jury. The Supreme Court recently upheld a district court's decision to exclude expert testimony on the ground that it "did not rise above 'subjective belief or unsupported speculation.'" (See General Electric Co. v. Joiner). This Court, moreover, has not hesitated in the past to uphold a district court's decision to exclude expert testimony on similar grounds."
Further explaining its agreement with the trial court's decision, the Appeals Court continued:
"We note first that the Supreme Court has recently resolved any ambiguities concerning the standard of review that the courts of appeals are to apply in reviewing a district court's evidentiary rulings under Daubert. The standard of review is the same one applied to other evidentiary rulings--that is, abuse of discretion. Applying the abuse of discretion standard, the Supreme Court affirmed, stating that "nothing in either Daubert or the Federal Rules of Evidence requires a district court to admit opinion evidence which is connected to existing data only by the ipse dixit of the expert. A court may conclude that there is simply too great an analytical gap between the data and the opinion proffered." (See General Electric Co. v. Joiner.)
The Appeals Court concluded that the District Court did not abuse its discretion in applying the Daubert factors to exclude the expert report of the CPA valuation expert.
The Accountant's Consideration of the Daubert Standard
There are no hard and fast specific rules that an accountant must comply with in order to ensure acceptance under the Daubert expert testimony standard. Rather, there is a general litmus test. As described in the Supreme Court's original decision in Daubert, the general litmus test is: What is the standard practice of an expert in the relevant field? The question remains pretty much the same for valuation and economic damages expert testimony: What is the standard practice of an expert in this particular analytical discipline?
Based on a synthesis of the various courts' decisions in the various sons of Daubert cases, accountants should consider the following suggested guidelines when presenting valuation and economic damages expert testimony. These guidelines are only suggestions and compliance cannot assure a trial court's acceptance of the accountant's testimony. These guidelines are presented as a handy "top ten list" of considerations to help improve the accountant's work product and to help the accountant comply with the standard practice of an expert in the valuation and economic damages field.
Guideline #1. Know the relevant professional standards. The accountant should be aware of--and be familiar with--the promulgated professional standards that are applicable to the analysis. These standards may be promulgated by government or regulatory agencies (e.g., the Uniform Standards of Professional Appraisal Practice, or USPAP), or they may be issued by professional organizations or societies (e.g., the American Institute of Certified Public Accountants). In order to comply with the professional standards in the field, an accountant first has to be knowledgeable of the relevant professional standards.
Guideline #2. Apply the relevant professional standards. Whenever possible, the accountant should apply the recognized and promulgated professional standards to the analytical work product and to the proffered expert testimony. Of course, there may be extraordinary circumstances in which the relevant standards may not apply--or, practically, cannot be applied. For example, there maybe data availability limitations. Or, there may be an agreement between the analyst and the client limiting the scope of the professional engagement--such that the engagement will not comply with recognized standards. When the accountant cannot comply with professional standards, (due to data limitations, contractual agreement, or some other reason) that fact normally should be disclosed in the analysis work product and expert testimony. Similarly, when the accountant does comply with all relevant professional standards, that fact should be attested to in the analysis work product and expert testimony.
Guideline #3. Know the relevant professional literature. Professionals in any discipline generally know the most authoritative textbooks in their field. They also join the most authoritative journals (whether refereed or popular). Valuation and economic damages experts may not be expected to agree with all of the leading textbooks or periodicals, but they would be expected to recognize the leading textbooks and periodicals. The leading publications will generally discuss the recognized theories, procedures and standards within a particular discipline or profession.
Guideline #4. Know the relevant professional organizations. Professionals in any discipline generally know the recognized organizations, societies and associations in their profession. Within a given profession, a practitioner is not expected to join every single institute or society. That may be duplicative and cost prohibitive. However, practitioners should be familiar with the names of the leading professional organizations in their discipline. This is particularly true with regard to organizations or associations that grant professional designations, promulgate professional standards, or publish authoritative journals.
Guideline #5. Use generally accepted analytical methods. There is usually a reason why some analytical methods and procedures become generally accepted over time and others do not. The accountant should be able to distinguish between (1) the generally accepted methods within the discipline and (2) those not the generally accepted within the discipline. Normally, the accountant should use the profession's recognized methods and procedures. In such cases, the accountant should assert such compliance with generally accepted methodology. Occasionally, with regard to a unique set of facts and circumstances, an accountant may not be able to use the profession's recognized methods and procedures. This may occur. When the accountant has to develop a de novo methodology, that departure from the disciplines generally accepted practices should be disclosed--and the reasons for such explained--in the analytical work product and in the expert testimony.
Guideline #6. Use multiple analytical methods. Whenever possible, the accountant should use multiple approaches, methods and procedures in a valuation or economic damages engagement. The use of multiple methods allows for mutually supportive evidence upon which to derive an analytical conclusion. It also helps to identify an aberrational outlier conclusion and mitigates the perception that the accountant has selected the one particular procedure that would result in a biased analytical conclusion. Of course, the analytical methods that are used should be ones that are generally used by experts in that particular discipline.
Guideline #7. Synthesize the conclusions of the multiple analytical methods. In virtually any type of quantitative or qualitative analysis, the use of multiple methods also allows for a reconciliation and synthesis of alternative indications in the process of deriving a final analytical conclusion. This synthesis should involve an assessment of the relative strengths and weaknesses of the alternative methods used. This synthesis should involve some form of weighting or reconciliation (whether implicit or explicit) of the results of the alternative methods used. And, this synthesis should involve some explanation (or justification) for why certain analytical methods were selected--and why certain analytical methods were rejected.
Guideline #8. Disclose all significant analytical assumptions and variables. In virtually all analyses, (especially valuation and economic damages analyses) there are both implicit and explicit assumptions, variables and conditions. Some of these assumptions may be relatively insignificant or insensitive (i.e., a material change in the assumption will not materially affect the analytical conclusion). Some of these assumptions may be significant and sensitive. Generally, the accountant should (1) identify, (2) quantify (if possible), and (3) justify the most important analytical assumptions and variables. While this disclosure may not always occur in the analytical work product, (e.g., where the client has requested conclusionary opinions only) this disclosure is usually helpful to the trier of fact during expert testimony.
Guideline #9. Subject the analysis to peer review. Most accountants agree that the process of peer review (usually performed by a professional colleague within the analyst's firm) is extremely beneficial. The peer review (sometimes this is called a professional standards review) often identifies analytical weaknesses, internal inconsistencies, mathematical errors, logic flaws, or disclosure inadequacies. Obviously, this peer review should occur after the analysis is completed but before the expert testimony is presented. Such a peer review should give the accountant confidence to assure the trier of fact that there are no logical, methodological or mathematical flaws in the analysis.
Guideline #10. Test the analysis--and the conclusion--for reasonableness. Prior to offering expert testimony, the accountant should assess the overall acceptability of the analysis--and of the analytical conclusion. The accountant should consider the relevance of the methods selected and the data used. The accountant should consider the overall reasonableness of all assumptions and projections in comparison to the actual history (if any) of the particular fact set. And, by any logical or empirical standards, the accountant should assess the overall reasonableness of the indicated analytical results. If the accountant is not convinced of the reasonableness of the analysis, it is likely that the trier of fact will not be convinced of the reasonableness of the expert testimony.
To reiterate, these "top ten" guidelines are merely suggestions for valuation and economic damages analysts to consider with regard to compliance with the Daubert expert testimony factors. If a de novo theory or methodology is being used in the instant case, the accountant should disclose that, explain the departure from the traditional theories or methods, and justify the departure decision. Otherwise, the fundamental lesson of Daubert is that expert witnesses should (1) use generally accepted methods and procedures and (2) comply with the relevant professional standards that are generally recognized within their analytical discipline.
Summary and Conclusion
It is dear that trial courts and courts of appeal are broadly applying--and broadly interpreting--the general Daubert expert testimony principles. It is also clear that the courts have concluded that the Daubert principles apply to all expert matters that fall within Federal Rules of Evidence Rule 702. Rule 702, with respect to all expert matters, "establishes a standard of evidentiary reliability."
Accordingly, valuation and economic damage experts who provide expert testimony should be aware of and should comply with the four Daubert factors. The federal courts can, and will, broadly apply the Daubert factors (with appropriate modifications) to decide the acceptance or rejection of valuation-related and economic damages-related expert testimony.
Valuation and economic damage experts should also be aware that state and local trial courts may also be influenced by the Daubert factors. Accordingly, accountants should carefully consider the four Daubert factors when presenting valuation and/or economic damage testimony before all triers of facts.
Robert Reilly is a managing director of Willamette Management Associates, a valuation consulting, economic analysis, and financial advisory firm with regional offices in San Francisco, Chicago, Atlanta, Portland, Oregon, New York City, and McLean, Virginia.
Robert holds a BS in economics and an MBA in finance, both from Columbia University. He is a certified public accountant, certified management accountant, chartered financial analyst, accredited senior appraiser, certified review appraiser, and state certified general real estate appraiser.
He is a member of the American Economic Association, National Association of Business Economists, American Society of Appraisers, American Bankruptcy Institute, Institute of Property Taxation, The Institute of Business Appraisers, and several other professional organizations.…