When using financial expert witnesses, clients and attorneys sometimes ask: Do we really need to spend time and money on a comprehensive report that explains the expert's analyses?
Compared to detailed written reports, oral or letter reports can usually be done faster and at a lower cost — but those savings presume that the expert is even allowed to testify. Before your expert is sworn in, he or she might be subject to a Daubert challenge. If so, there's a substantial risk that his or her testimony could be excluded from evidence, which could be costly over the long run.
A comprehensive written report can help demonstrate that a financial expert applied proven theories and techniques to arrive at the conclusions. This lesson was reinforced in a recent federal district court case. (MSKP Oak Grove, LLC v. Venuto, U.S. Dist. N.J., No. 10-6465, June 29, 2016.)
Case in Point
The defendants in this case were four shareholders in Hollywood Tanning Systems (HTS) who each received distributions of about $5.8 million when the company was sold in 2007. HTS operated tanning salons and sold franchises and tanning equipment to independent salons. Shortly after its assets were sold, the buyer filed for bankruptcy.
The plaintiff was a landlord that HTS had leased retail space from in Florida long before the company was sold. In 2003, the landlord consented to a sublease to a franchisee, but, in accordance with the terms of the lease agreement, HTS remained liable in case of the franchisee's default.
In 2008, the landlord notified HTS that the sublessee had defaulted on its lease. It subsequently sued HTS for breach of contract and obtained a judgment of about $412,000.
When the judgment remained unpaid, the landlord subsequently brought another action, contending that the distributions to the shareholders represented a fraudulent transfer. The plaintiff argued that HTS made excessive distributions to its shareholders, even though it didn't have the funds to pay all of its creditors.
The landlord hired an expert who produced two reports: a fraudulent conveyance report and a valuation report. The expert concluded that:
- HTS didn't receive reasonably equivalent value for the shareholders' cash distributions,
- Its remaining assets were unreasonably small with respect to its operations,
- HTS knew (or should have known) that the distributions would result in debt beyond its ability to pay,
- The distributions left HTS insolvent immediately or soon after, and
- The buyer's liabilities exceeded its assets the day before the sale and at closing.
HTS's shareholders filed a Daubert challenge, which claimed that the fraudulent conveyance report cited no reliable methodology.
The U.S. District Court for the District of New Jersey considered the experts two reports together as one cohesive report. The court concluded that, "taken together, and augmented with [the expert's] explanation, the combined report supplies an ample summary of [her] methodology." During the Daubert hearing, the expert testified that the valuation methodologies and valuation approaches sections in her valuation report, as well as the AICPA standards and valuation treatises attached as exhibits, were intended to cover both reports.
The court, therefore, concluded that the expert adequately described her application of reliable, recognized principles of accounting and valuation analysis. Accordingly, it denied the defendants' motion to exclude her testimony under Daubert and Kumho Tire. (See Understanding Daubert Challenges below.)
Comprehensive written reports can help before, during and after expert witness testimony. In this case, the written report helped persuade the court to deny the defendant's Daubert challenge.
Now the expert will be allowed to testify if this case goes to trial — and the same written report will likely be entered into evidence to help the parties understand the expert's analysis and serve as a resource when the judge finally deliberates the case. Though written reports may require more resources on the front end, they're often money well spent over the long run.
Understanding Daubert Challenges
According to Federal Rules of Evidence Rule 702, an expert witness is permitted to testify if scientific, technical or other specialized knowledge will help a judge or jury understand evidence.
Courts use the standard set forth in Daubert v. Merrell Dow Pharmaceuticals, Inc. to assess whether an expert's testimony is based on a theory or technique that is scientifically valid and can be properly applied to the facts at issue. Kumho Tire Company v. Carmichael extended the scope of the Daubert standard to business appraisers and other financial experts.
Attorneys may challenge the reliability and relevance of expert witness testimony based on the four-prong Daubert standard:
- The theory or technique in question must have been tested.
- The theory or technique must have been peer reviewed by other practitioners and published in professional journals.
- The potential error rate — as well as the standard for controlling the application of the technique — must be known.
- The theory or technique must have attracted widespread acceptance within a relevant scientific community.
The risk is substantial if an expert's testimony is excluded during a Daubert challenge. It precludes the judge and jury from deciding on the efficacy of the expert's techniques and theories at trial. The evidence might otherwise prove that the party to a legal challenge position is right, but, without the expert's testimony, the party has no way to prove value or damages.
DOUGLAS P. SOSNOWSKI, CPA/ABV, ASA, CFF
Douglas P. Sosnowski provides business valuation, forensic accounting, and litigation support services for Brisbane Consulting Group. He has extensive valuation experience and has served as an expert witness, testifying in courts of law throughout the state of New York. Doug has experience consulting with publicly traded entities and valuing a variety of closely held companies in connection with mergers, acquisition and divestitures, business combinations, estate and gift tax planning, ESOPs and purchase price allocations. He also has experience in the quantification of lost income in determining business interruption claims for insurance adjusters. Doug is a member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and the American Society of Appraisers. Doug is a licensed financial advisor holding Series 7 and 66 securities licenses. He graduated with honors from the State University of New York at Buffalo earning his Bachelor of Science degree in business administration with concentrations in accounting and finance.