The case of the discredited damage study.

One of the best ways to understand damage studies is to examine one t at doesn't work. John Leslie Livingstone, CPA, PhD, owner, Livingstone Associates, West Palm Beach, Florida, offers an example.

CPAs frequently are engaged either by the plaintiff in a lawsuit to prepare a damage study or by the defendant to evaluate the plaintiff's study. This article takes CPAs through the steps of building a case and then determining what is wrong with it. The case is a hypothetical one adapted from a number of cases. Although fictitious, it is a realistic representation of an actual damage study.

This article begins with a description of the plaintiff's damage study. CPAs with experience in this area should be able to detect some of the flaws in the study as they read about it.

THE REDLED MINING CASE

The Redled Mining Corp., Inc. is a tightly held, family-owned operator of a South Texas lead mine. The mine produces lead ore, which Redled converts into lead ingot and sells to gasoline refineries located in southern and eastern Texas. Less than 5% of Redled's sales are made to refineries outside Texas.

Redled filed an antitrust suit alleging price fixing by its five largest customers, which it said conspired to fix and hold down the prices they were paying Redled for lead ingot. Redled retained a firm of consulting economists to prepare testimony, including a damage study.

The following discussion focuses on the lost-profits portion of the claim, which differs little, if at all, from lost-profits claims in other types of cases (such as breaches of contract, patent violations, trademark infringements, dealer terminations or price discrimination suits). Therefore, the study is quite generic and representative of a wide range of cases.

THE "BUT FOR" TONNAGE 

A lost-profits damage study involves a financial projection that estimates what sales quantities would have been if the alleged price fixing had not taken place. This is a "but for" projection.

The "but for" tonnage projection is shown in column E of exhibit 1 below. It was based on adjusting the actual tonnage using the index of petroleum production (IPP), which reflects national refinery output. The IPP has a base value of 100 (1981=100). It is important to understand how the index was used to adjust the actual tonnage. For example, consider the 1989 "but for" tonnage in column E. It was calculated as follows:

Actual 1981 tonnage times

1989 IPP/1981 IPP, or:

1,609 times 124/100 = 1,995

The 1990 "but for" tonnage is:

1,609 times 128/100 = 2,060

Every year of the "but for" projection was based on the 1,609 actual 1981 tonnage, since the plaintiff alleged price fixing began to occur in 1982.

Consequently, the "but for" tonnages for 1982 through 1990 were estimated using the actual results of a single year, 1981, which might be considered too small a foundation to support a nine-year projection. A better approach would have been to use a three- or five-year average for the base-year tonnage, compiled from the uncontaminated past years.

THE "BUT FOR" AVERAGE PRICES

To project actual prices without the price fixing, the economists made a "but for" adjustment using the UMWA (United Mine Workers of America) national index of average hourly wages. What do wages have to do with prices? Wages often are subject to COLA (cost of living allowance) adjustments, which are based on price levels as reflected in the consumer price index, for example. In general, it is plausible for wage rates and prices to move in parallel.

The UMWA index was applied to the 1981 base year to compute the "but for" price. For example, the "but for" price shown in exhibit 1 (column K) for 1985 is $3,159 per ton. It was calculated by multiplying the 1981 actual price of $1,938 by 163 divided by 100. Of course, the "but for" prices that are shown in exhibit 1 for 1982 through 1990 are higher than each year's actual price.

LOST REVENUES

The "but for" tonnage and prices were multiplied to estimate "but for" revenues (see exhibit 2, columns A to D, page 86). Then actual revenues were deducted from "but for" revenues to estimate lost revenues (column F, exhibit 2). Note that lost revenues don't begin to exceed actual revenues until 1985, but, by 1990, they are about 55% greater than actual.

The next step was to calculate lost profits.

ESTIMATING LOST PROFITS

The economists chose the five years before 1981 as a base period because they preceded the alleged price fixing. During this period, Redled operating profits averaged 4% of sales. This 4% operating profit margin was multiplied by lost revenues to calculate lost profits (column G, exhibit 2), which total almost $1 million for the 1982-90 damage period. It's now time for the defense's expert witness to evaluate the plaintiff s damage calculation.

THE "BUT FOR" TONNAGE INDEX

It is not unusual to use an index to arrive at a "but for" projection of sales volume. The first and most important question to ask, however, is, Why should it be reasonable to expect the index to reflect sales volume?

In the Redled case, for instance, is there good reason to believe lead ingot sales to refineries should correlate with refinery output? If the plaintiffs lack sound evidence for this connection, defense experts will emphasize that it is an unsupported assumption. They probably will attack it on both a conceptual and a factual level. The conceptual attack may point out that leaded gasoline is only one part of output from refineries, which also produce unleaded gas, diesel oil, kerosene and a variety of chemicals. Further, leaded gas was probably a steadily declining portion of refinery output in the 1980s, given the trend toward unleaded gasoline. In the circumstances, it does not seem a reasonable assumption for refinery output to be appropriately representative of lead ingot sales volume.

A factual attack might track the correlation, if any, between the index and lead ingot sales before the alleged price fixing. This is done in exhibit 3 on page 88, which shows the U.S. IPP between 1976 and 1990. Before the alleged price fixing, this index does not track well with actual Redled sales volume, so why should it be a good reflection during the price fixing? This kind of factual attack is highly potent in court and goes a long way toward discrediting the plaintiff s use of the U.S. IPP.

In addition, an index should match as closely as possible to whatever is being adjusted against it. In the Redled case, the index is national, but Redled sales are almost all made within Texas. A CPA engaged to evaluate the plaintiff's case should turn to a Texas 1PP, which shows a close correlation to Redled ingot volume during the price-fixing period. It is plausible to assert that the difference between the Texas and the national IPPs may be due to the 1980s recession in the oil and gas industry, which was particularly severe in Texas.

To recap, the testifying expert must ensure an index reasonably represents the item being projected. The index should not be too broad--or too narrow--and should correlate reasonably well with the item before or after any alleged violation. In addition, rather than a plying index adjustments to a single base year, it is preferable to create a composite base line, probably from a five-year average taken from a violation-free period.

THE "BUT FOR" PRICE INDEX

The UMWA wage index, unlike the IPP, is not published. The defendants couldn't obtain needed information about it and, in depositions, the plaintiffs experts admitted they had not examined how the index had been calculated and had made no comparisons between the UMWA index and Redled prices, all of which discredited this index's use. The UMWA's secretiveness did not help the study's credibility and--as a union preparing a wage rate index--it might not have been seen as an objective source.

Federal and state governments, which produce and publish many economic indexes, obviously are more detached. The U.S. Commerce Department puts out indexes of wage rates by industry and by region, including an index of Texas mining wage rates (see exhibit 4 at right). This index shows Redled prices grew much faster than the Texas wage index, which remained more or less stagnant over the years concerned. This raised serious questions about use of the UMWA index, since Redled sales are predominantly limited to Texas. Again, the index appeared too broad to fit the item being projected. At this point in the case, the use of this index in the damage calculation was severely discredited.

"BUT FOR" REVENUES AND LOST PROFITS

The "but for" revenues were calculated by multiplying the "but for" tonnage each year by the "but for" average price. With both the "but for" tonnages and the "but for" prices discredited, the "but for" revenues likewise were clearly impeached.

The lost profits were calculated as 4% of lost revenues. Once the proof of "but for" revenues collapsed, so did the lost revenues (which were computed as "but for" revenues less actual revenues in exhibit 2). The lost-profits claim also seemed to evaporate.

At this stage in a lawsuit, the plaintiff's experts normally attempt, if possible, to repair or replace their faulty damage study. The plaintiff might even try to dismiss the current experts and hire new ones.

In such a case, the defendant's experts are likely to receive well-earned recognition for their effective examination and destruction of the damage study. Once the damage issue is resolved, many CPAs may consider their role to be finished. In fact, a new opportunity may have just arrived.

THE LARGER PICTURE

In business litigation, a plaintiff must complete three major steps to be awarded damages:

1. Liability, or proof of a violation.

2. Fact of damage, or proof of injury because of the violation.

3. Damage measurement.

CPAs normally are engaged for damage measurement, but they should be alert to the impact damage measurement--and particularly a flawed measurement study--might have on liability and fact of damage.

In the Redled case, the IPP evidence suggests the drop in Redled tonnage was probably due to the Texas recession rather than to the defendants' alleged price fixing, which means it should not be blamed on the defendants. This calls their liability into question.

In addition, Redled's average price per ton increased almost as fast as the U.S. national UMWA wage index and certainly much faster than the Texas wage rate index. Is this consistent with the allegation of price fixing, which supposedly lowered Redled prices? Again, the CPA's analysis has direct bearing on the liability issue and has substantial value outside of damage measurement. When the CPA keeps this wider perspective in mind, he or she can provide much greater value to the client than would be the case with a narrow focus on damage measurement alone.

DOES IT MAKE BUSINESS SENSE?

There is another important area relating to liability and fact of damages in which the CPA can make a substantial contribution. It requires practitioners examining damage studies to ask: Does this make business sense?

In the Redled case, a CPA might step back and ask why the damage study sought to inflate actual tonnage at all. If the defendants forced Redled's prices down in a price-fixing conspiracy, wouldn't tonnage have increased rather than decreased? Usually, price cuts tend to raise sales volume and price increases reduce volume. Thus, the damage study was badly flawed when it raised tonnage above actual to arrive at "but for" tonnage, since it should have done just the opposite. This is a fatal error because it raises a very serious fact-of-damage question: If the "but for" tons are less than actual tonnages, then even if "but for" prices are above actual prices, Redled might conceivably have achieved the same or greater profits as a result of the alleged price fixing.

Here is another significant challenge to the plaintiff s case that is found by asking one key question: Does this make business sense? This question should be asked about each component of every damage study.

KEY POINTS

The Redled damage study demonstrates the pitfalls CPAs should avoid in preparing damage studies and the problems they should consider when evaluating them. The checklist above will help practitioners remember some key points in approaching damage studies.

A damage study checklist

Note each assumption in the damage study, explicit or implicit, and answer the following questions: 1. Is there conceptual support? 2. What is the factual support? 3. Does it make business sense? 4. Is it consistent with the other assumptions used? 5. Is it consistent with the case's fact pattern? 6. Is it consistent with the liability allegations? 7. Is it consistent with fact-of-damage allegations? 8. Is there better support for an alternate assumption? 9. When an index is used, is it too broad? Too narrow? Does it track a violation-free period? Is the base period long enough?

EXECUTIVE SUMMARY

* CPAs FREQUENTLY ARE engaged either by the plaintiff in a lawsuit to prepare a damage study or by the defendant to examine the plaintiff's study. * WHEN PREPARING FOR evaluating a study, any index used to adjust actual figures must reasonably represent the item that the CPA is attempting to project. The index that is chosen should not be too broad--or too narrow--and should correlate reasonably well with the item before or after any alleged violation. * RATHER THAN APPLYING index adjustments to a single base year, a CPA should create a composite base line, probably from a five-year average taken from a violation-free period. * PRACTITIONERS SHOULD determine if every study assumption makes business sense. They should understand how their testimony affects liability and fact-of-damage issues.