Expert Discusses Contract Audit And IP Damages Calculation

Monday, January 28, 2013 - 12:51

The Editor interviews Dana Trexler Smith, Partner, EisnerAmper LLP.

Editor: Please tell us about your background and experience.

Smith: I graduated from Bucknell University with a bachelor of science in accounting and completed the requirements for a bachelor of arts in French. I received my masters in business administration from the Wharton School at the University of Pennsylvania, and I’m a certified public accountant in Pennsylvania.

I began my career as an auditor for Coopers & Lybrand, which later merged and became PwC. After three years in the audit practice, I spent 15 years in PwC’s forensic services practice, specializing in calculating damages in complex commercial and intellectual property disputes. I also performed contract compliance examinations. In 2012, I joined EisnerAmper as a partner in our litigation services practice, where I continue to provide the same type of forensic services.

Editor: Please explain what a contract compliance examination is.

Smith: A contract compliance examination (CCE) involves the testing of a third party’s underlying records that support its payments to a receiving party under a contractual agreement. The purpose of the CCE is to assess whether the payments were made in compliance with the terms of the agreement. The types of contracts that typically lend themselves to CCEs include licensing agreements, supply agreements, manufacturing agreements, tolling agreements and profit-sharing arrangements. Because the financial terms in these types of agreements are often based on a metric under the control of the payer, the only way for a payee to validate the amount paid under the agreement is to exercise its audit rights.

The risk of not performing a CCE is that a payee could be leaving money on the table. For example, in a contract that is based on net sales, the payee is relying on the payer to calculate the amount due under the agreement. Absent a CCE, there is no way to verify that the payer has adhered to the definition of “net sales” within the contract – versus obtaining net sales amounts from its own financial statements, which may define the term differently. We often see situations in which parties interpret contract language differently, resulting in payment discrepancies.

Editor: Please briefly explain the role of a damages expert in a legal dispute.

Smith: Damages experts perform an analysis of the financial information in a legal dispute to calculate the dollar amount owed by a defendant, assuming liability is established. The analysis operates in what is commonly referred to as the “but for” world, which is a quantification of economic damages assuming the alleged “bad act” did not occur.

The work of a damages expert is performed in three fundamental phases. The first is analyzing the underlying facts, formulating a damages opinion based on those facts and expressing that opinion in a written report. The second is defending your opinion on damages to a specialized audience, including the opposing damages expert. Then the third is communicating a complex financial theory in simple terms to an audience, such as a jury, that may not have a strong financial background.

Editor: Are there any variations when disputes are handled through ADR versus litigation?

Smith: The rules are a little different under ADR, but the process is essentially the same; however, the idea of “understanding your audience” may take on different proportions. For instance, if the arbitrators are lawyers, it’s important to understand that they may require additional explanations for financial issues, whereas, the expert might explain concepts differently if the arbitrator is an accountant. Generally speaking, the audience in ADR proceedings tends to be very sophisticated, so you can modify your approach to writing the report and presenting your position in these situations.

Editor: How do your MBA, CPA and audit experience benefit you in your role as a damages expert?

Smith: My audit experience coupled with an MBA allows me to bring a business perspective to an analysis of damage issues, backed up by 16 years of experience in delivering damages opinions. As a CPA, I have a thorough understanding of how detailed financial records fit into the overall financial picture and of the types of economic and market decisions that companies face. This combined perspective enables me to consider issues from both sides – as a defendant and as a plaintiff – when assessing various damages theories, as well as to strategically overlay real-world issues onto hypothetical damage scenarios based on the facts of a case.

Editor: What type of information does an expert typically analyze in formulating an opinion on damages?

Smith: The damages expert must analyze circumstances that occur before and after the defendant’s alleged wrongful act to asses the trends and to make inferences about the plaintiff’s financial position in the “but for” world.

Because we live in an imperfect world and information in the litigation context is often limited, the expert analyzes both matter-specific information and information that’s available in the public domain to derive assumptions about financial trends, competition, the market, the macro economy, etc. From here, the expert creates the financial circumstances in the “but for” world.

In order for experts to be credible and permitted to testify, the assumptions should corroborate the factual information, and the findings should be based on methodologies that are commonly accepted in the field. I describe it as solving a puzzle with missing pieces where there is no picture on the box to serve as a guide. Damages experts must find the missing pieces and create a financial picture that would serve as the cover of the puzzle box, using the pieces that are available.

Editor: Tell us about the concept of time when performing these hypothetical analyses. Do broader macroeconomic circumstances play into your work?

Smith: They do. Take, for example, a case involving a company that was projecting certain profits over the next five years, but the starting point for this projection happens to have been right before an economic downturn. Here, a damages expert likely will have to consider those original projections as unrealistic, given a subsequent economic recession in which there was heightened competition for market share and increased pricing pressure. A damages expert has to overlay those actual macroeconomic events into the fact pattern when assessing damages.

Editor: How does experience in performing contract compliance examinations assist damages experts in performing litigation services in breach of contract and IP disputes?

Smith: In many disputes, having an understanding of contractual arrangements in the real world provides a basis for deriving damage theories in the “but for” world during a hypothetical negotiation between the parties. For instance, in IP matters where the plaintiff is entitled to receive damages not less than a reasonable royalty, case law currently allows the damages expert to consider royalty rates in comparable licensing agreements when assessing the reasonable royalty rate in the matter. Analyzing an existing contract provides insight into potential financial licensing arrangements that may be considered by both parties as of the date of the hypothetical negotiation.

Editor: Please explain what you mean by “hypothetical negotiation.”

Smith: During a hypothetical negotiation, you take a step back in time and assume that the parties would have willingly opted to negotiate before any dispute had arisen. You assume that there is no legal dispute and that parties will amicably negotiate an agreement on the payment terms for licensing the technology.

In approaching the calculation of damages, experts must be able to place themselves in the shoes of both parties at the date of the hypothetical negotiation. Viewing the situation from both sides allows you to develop a damages theory that fits the facts of the case and is defensible.

Editor: What are some available financial arrangements within licensing agreements? Why is it important to understand the range of options when analyzing the structure of a license agreement in the hypothetical negotiation context?

Smith: There are a variety of payment structures, including payments based on a percentage of sales, a per-unit flat fee or a tiered royalty-rate structure – in terms of either dollars or units – tied to sales volume. There are lump-sum royalty payments, milestone payments and cross-licensing agreements, or a hybrid or variation of these financial arrangements.

In the context of a dispute, having knowledge of the many available payment structures is critical to an assessment of the facts and circumstances, ultimately with the goal of determining for what terms the plaintiff and defendant would negotiate in the hypothetical negotiation. Industry knowledge also can be very helpful. For example, understanding the type of deductions made to calculate “net sales” in pharmaceutical disputes requires an understanding of the industry because there are industry-specific deductions for managed care rebates, Medicare/Medicaid rebates, chargebacks, etc.  

This process is further improved when damages experts have a real-world understanding, outside the dispute context, of different financial arrangements and the reasons that a company might select them.

All of these levels of knowledge and expertise lead to informed decisions regarding the appropriate reasonable royalty structure in the hypothetical negotiation, and this analysis provides the basis for determining the ultimate dollar value attributed to the damages in intellectual property and breach of contract disputes.

Editor: What qualities and skills should one look for in selecting a damages expert?

Smith: The damages expert should have an educational and experiential background commensurate with the matter at issue in order to be qualified by the court. The expert should be knowledgeable about the dispute process, the methodologies accepted by others in the field for computing damages, the underlying facts of the matter and the legal theories in the case. Also important is the ability to synthesize often incomplete or conflicting data into an economic and financial analysis that will withstand scrutiny by the opposing expert and the court. Finally, the expert must be able to simplify and explain the “but for” world in a way that’s understandable to a person or group of people, such as a jury, who are not intimately familiar with complex economic and financial theories.

It’s important for the damages expert to work closely with attorneys to ensure that they are asking the right questions and obtaining all relevant information available in the case. That said, the expert also must maintain critical distance and look at the entire spectrum of available information because his or her trained eye may find something essential to the analysis that counsel or a client might not have considered important.

Editor: What is your level of interaction with corporate counsel?

Smith: In litigation matters, we are typically hired by outside counsel as this preserves privilege for the client, though corporate counsel may recommend us to outside counsel because they have a history of working with us successfully on previous matters. In performing the work, we tend to deal mainly with outside counsel, and they, in turn, may connect us with company personnel to obtain the necessary financial, business and technical information.  We may interface directly with general counsel to understand other cases that are active within the company. This way, we can develop a consistent theory that is sensitive to the fact that our work may affect the company in other matters. In CCE matters, we are typically hired by corporate counsel, the compliance officer or the CFO. 

Please email the interviewee at dana.smith@eisneramper.com with questions about this interview.