Valuation analysts who practice in the bankruptcy and reorganization disciplines are often called upon to perform litigation support services, including expert testimony. 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 (1993). 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.

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 upon professional studies or 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 cases (at both the court of appeals and Supreme Court levels) have concluded that the trial court's gatekeeping inquiry into both relevance and reliability applies not only to scientific testimony, but to all expert testimony. Accordingly, all valuation practitioners should be aware of—and comply with—these expert testimony guidelines. This would include appraisers, economists, accountants, financial analysts and other industry experts who offer expert testimony on the value of assets, properties and business interests within the context of Rule 702 of the Federal Rules of Evidence.

The Daubert Factors

Under Rule 702, trial judges have historically been the gatekeepers regarding the admission of expert evidence in federal cases. Traditionally, though, 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 Daubert, a doctor testified before the trial court and presented a radical medical opinion. That opinion was unsupported by the relevant professional literature, medical research scientific standards, recognized professional organizations or concurring medical research colleagues. With regard to the admission of this testimony, the questions that trial court faced were (1) was the doctor 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, and
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 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 its four factors were simply illustrative, and that other factors could argue in favor of admissibility.

Sons of Daubert

During the last several years, there have been numerous trial courts that have applied the Daubert factors, and there have been several appeals court decisions that have sustained, expanded and interpreted the Daubert factors. First, we will refer to 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 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 court also concluded that whether the specific Daubert factors are appropriate measures of reliability in a particular case is a matter the law grants to 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 et al. 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. The damages issue in the case involved the fair market value of the plaintiffs' shares of a closely held corporation (Animated Playhouse Corp.). The plaintiffs' expert used 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 [plaintiff's expert] is clear. Accordingly, the court has excluded his testimony."

In Frymire-Brinati v. KPMG Peat Marwick, 3 F.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 the plaintiff's partnership interests in a real estate development company. Again, the plaintiff's expert used one valuation method (also 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 Co. Ltd.

In Kuhmo Tire Co. Ltd. et al. v. Patrick Carmichael et al., 119 S.Ct. 1167 (March 23, 1999), the U.S. 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. (See ABI Journal, April 1999, p. 20-21.)

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. Carlson 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 Carlson'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 (1) Daubert was limited only to a scientific context and (2) the Daubert factors could not be applied to any of Carlson's testimony that was 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 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 testimonyŠis 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 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 concluded that the Daubert factors apply to financial valuation and economic analysis testimony.

In 1993, Target Market Publishing Inc. (Target) entered into a one-year contract with ADVO Inc. to prepare and distribute a direct-mail advertising publication called Select Auto. The project involved selling automobile dealers exclusive advertising rights at a flat rate in the monthly publication. The two companies were to share equally 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 its 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 firm of Deloitte & Touche. ADVO replied that "the Burton report is pure speculation, based on utterly implausible assumptions and unreliable methodology." The district court appears to have agreed with ADVO; it 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 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.

Summary and Conclusion

It is clear that trial courts and courts of appeal are broadly applying—and broadly interpreting—the general Daubert expert testimony principles. And it is also clear that the courts have concluded that the Daubert principles apply to all expert matters that fall within Rule 702. Rule 702, with respect to all expert matters, "establishes a standard of evidentiary reliability."

Accordingly, valuation and economic analysis experts who provide testimony in the bankruptcy and reorganization discipline should be aware of—and should comply with—the four Daubert factors. The courts can, and will, broadly apply the Daubert factors (with appropriate modifications) to decide the acceptance or rejection of valuation-related and economic analysis-related expert testimony.