Prosecuting and Defending Insurance Claims

PROSECUTING

AND
DEFENDING

INSURANCE
CLAIMS

 

 

ROBERT
F. CUSHMAN, Esquire

BRUCE
ROZNOWSKI Esquire

WILLIAM
E. SIMPSON, C.P.A.

Editors

 

 

 

Coopers

&
Lybrand

 

 

 

 

 

 

 

 

 

 

 

 

 

WILEY

Wiley
Law Publications

JOHN
WILEY & SONG

New
York • Chichester • Brisbane • Toronto • Singapore

 

 

CHAPTER 20

USE OF EXPERT

WITNESSES

 

William
E. Simpson, C.P.A.

Thomas
M. Neches, C.P.A.

 

 

 

 

 

 

William E. Simpson is a partner in the Los Angeles
office of the national accounting and consulting firm of Coopers & Lybrand.
As partner in charge of the Litigation Services practice, he offers attorney
clients a wide range of assistance, from document gathering and analysis to
damage determination and expert witness testimony. Mr. Simpson bas testified on
numerous occasions on accounting, auditing, business, and statistical issues.
He has taught graduate and undergraduate courses at three universities. He
received BS and Ms degrees from California State University, Northridge, and a
JD degree from UCLA School of Law. He is a certified public accountant, a
certified management accountant, a certified fraud examiner, and a member of
several professional organizations.

 

Thomas M. Neches is partner in Coopers &
Lybrand, where he is responsible for working with trial attorneys to develop
financial, economic, statistical, and other analyses for use in the resolution
of claims and in litigation. Mr. Neches specializes in the application of
computer–based analytical techniques to litigation issues. He has testified as
an expert in state and federal court and in administrative hearings in
California, Nevada, and Oregon. Mr. Neches received his BA in mathematics and
literature from the University of California, San Diego, his MS in operations
research from the University of California, Los Angeles, and is a certified
public accountant.

 

 

§    20.1     Introduction

§    20.2     Cases Requiring Expert Assistance

§    20.3     Selecting an Expert

§    20.4     –Fee Arrangements

 

 

ASSISTANCE IN DISCOVERY

§    20.5     Complaints, Interrogatories, and Requests
for Documents

§    20.6     Deposition Testimony and Assistance

§    20.7     Case Management

 

PREPARATION AND ANALYSIS OF DAMAGES CLAIMS

§    20.8     Overview

§    20.9     Lost Profits

§    20.10   –Profit Per Unit

§    20.11   –Number of Units Lost

§    20.12   –Projection Methodologies

§    20.13   –Adjusting to Present Value

§    20.14   Loss of Equity

§    20.15   –Valuation Methodologies

§    20.16   Principles for Preparing Damages Claims

§    20.17   –Assumptions and Estimates

§    20.18   –Establishing Proximate Cause

§    20.19   –Principle of Conservatism

§    20.20   –Flexibility and Responsiveness

§    20.21   –Substantiation of Damage Testimony

 

FORENSIC ACCOUNTING

§    20.22   Definition of Forensic Accounting

§    20.23   Forensic Accountants versus Traditional Accountants

§    20.24   Advantages of Forensic Accountants

§    20.25   Forensic Accounting Techniques

 

COMPUTERIZED ANALYSIS OF INFORMATION

§    20.26   Computers in Litigation

§    20.27   Discovery of Computerized Information

§    20.28   Computer Data Base Analysis

§    20.29   –Tracing Cash Flow

§    20.30   –Distributions in Bankruptcies and
Receiverships

§    20.31   –Statistical Data Bases

§    20.32   Financial Modeling

§    20.33   Statistical Analysis

§    20.34   Computers Graphics, Visual Aids, and Displays

 

TRIAL ASSISTANCE

§    20.35   The Accountant as Expert Witness

§    20.36   Other Trial Assistance

 

 

WORKING EFFECTIVELY WITH EXPERTS IN MAJOR LITIGATIONS

§    20.37   Bring Experts in Early

§    20.38   Work in Concert on Strategy and Approach

§    20.39   Preliminary Analysis of Damages

§    20.40   Establish and Monitor a Budget

§    20.41   Confer Frequently

§    20.42   Expert’s Primary Contact

§    20.43   Involve the Insurance Company

§    20.44   Rules Governing Discovery of Expert Opinions

§    20.45   Rehearse Testimony

§    20.46   Conclusion

 

 

§ 20.1 – Introduction

 

Major
insurance litigation frequently boils down to a battle of experts. The side
with the better experts—more thorough, better prepared, more credible, more
convincing—is likely to prevail. The more complex the case, the more vital
experts become: law firms do not maintain a staff of consultants, certified
public accountants (CPAs), and other experts with the depth and breadth of
experience to evaluate all the business, technical, financial, and economic
aspects of a case. Similarly, law firms’ clients do not have the resources to support
major litigation without risking serious impairment to ongoing operations.

 

An
expert is an individual with “special knowledge, skill, experience, training or
education sufficient to qualify him as an expert on the subject to which his
testimony relates.”[1]
Attorneys rely on experts to assist in all phases of litigation. Experts
provide knowledge of the industry and its terminology. They assist in drafting
or responding to complaints, interrogatories, and requests for documents. They
perform investigations, verify and discover information, reconstruct
transactions, determine values, calculate damages, render opinions, and testify
as expert witnesses.

 

This
chapter discusses the use of experts in major insurance litigation. Because of
the universal need in these cases, the chapter emphasizes accounting and
analytical expert assistance provided by CPAs and other business experts.
Indeed, this is the most common type of expert assistance utilized in insurance
litigation. However, most of the concepts discussed apply to the use of all
types of experts, including scientific, technological, or medical experts.

 

The
chapter is organized to follow the chronology of expert assistance throughout a
litigation: initiation of the case, selection of an expert, drafting of
complaint, discovery, trial preparation, expert testimony, and appeal. The
chapter concludes with several observations on how to work effectively with
experts in major insurance litigations involving multiple parties.

 

§ 20.2 — Cases Requiring Expert Assistance

 

Accounts
can provide beneficial services in virtually any litigation. However, for
certain types of major insurance litigations, the use of an accounting expert
is essential. These types of litigation include:

 

Accounting malpractice. When lawyers first think of an
accounting expert, they usually imagine themselves prosecuting or defending a
lawsuit against an accountant. Accountants may find themselves as defendants in
cases of alleged securities law violations, violations of common law, or liability
for improper tax advice. In such cases, the plaintiff’s attorney should hire an
expert before drafting a complaint or agreeing to file suit. Without an expert
CPA’s guidance on the applicable standards of the profession, the plaintiff’s
claim may never get to a jury. Similarly, the defendant needs an objective CPA
to assess and prepare the case and act as an expert witness.

 

Improper financial reporting. Accountants can be invaluable in
cases involving financial reporting, such as lawsuits alleging fraud under the
provisions of the federal securities laws and actions for breach of contract or
fraud based on allegations that financial statements were not fairly presented
in accordance with generally accepted accounting principles. In these matters,
accounting experts can assist both the plaintiff and the defendant in analyzing
alleged wrongdoings and preparing or analyzing damage claims.

 

Director and officers liability
claims. Lawsuits
alleging breaches of the duties and responsibilities of officers and directors
frequently involve analyses of the financial condition and results of
operations of a company. Sustaining or rebutting these claims frequently
requires CPAs to make sophisticated analyses which utilize accounting,
business, financial, economic, marketing, and other areas of expertise.

 

Personal liability suits. Claims resulting from personal
injury, wrongful death, and wrongful termination often require accounting
analyses of lost income. In addition to determining damages, accountants may be
called upon in wrongful termination matters to address whether the plaintiff’s
dismissal was justified based upon objective measures of her performance.

 

Damage determination. Damages issues arise in virtually
every major insurance litigation. If a case involves as complicated damages
issue, accountants may be indispensable. An action to recover losses incurred
during a business interruption, for example, may require analyses of production
costs, sales patterns, inventory valuations, and other areas familiar to
accountants. Similarly, if a case involves valuations of assets, such as in a
buy-out, it may be necessary to evaluate an ongoing business enterprise,
including its inventory, plant and equipment, goodwill, and liabilities, all of
which involve the application of typical accounting analyses. Because of its
importance, §§ 20.8 through 20.21 are devoted to damage analysis.

 

§ 20.3 – Selecting an Expert

 

An
attorney may have the choice of using an expert from her client’s organization
or an independent expert. Compared to an outside expert, an in-house expert mat
be more knowledgeable about the client’s operations and the particular issues
of the case and may be less costly for the client. On the other hand, the
in-house expert appears to have a personal stake in the outcome of the
litigation. Her objectivity and credibility will no doubt be called into
question. Further, ordinarily it is not cost-effective for an expert who has
responsibility for the client’s ongoing operations to be tied up to the extent
required in litigation.

           

In
most cases, the use of an independent expert in preferable. Sources of experts
include officers or employees of other firms in the same industry, college and
university professors, and representatives from research organizations, accounting
firms, and consulting firms. Each source has advantages and disadvantages.
Industry experts may possess detailed business and technical knowledge
essential to the case, but competitive considerations may mar their testimony.
College professors and researchers have an air of academic authority and
independence, but often they are unfamiliar with the practical business aspects
of an organization and the key issues of the litigation. An accounting or
consulting professional, especially one who specializes in litigation
assistance, may be best suited to perform the analyses and provide competent
testimony. However, she may be expensive and may appear to be a hired gun or
professional witness.

                                   

The
personal characteristics of the expert, which determine to a large degree
whether she will be a credible and effective witness, should be paramount in
selecting the expert. The expert should possess excellent credentials, of
course. But a long list of academic honors or professional qualifications will
not prevail in court if the expert appears arrogant, indecisive, unorganized,
inarticulate, or frightened. The expert witness must have god courtroom
demeanor and a professional appearance. She must possess the ability to
articulate positions precisely and concisely in clear and simple language. In
addition, the expert must be able to stay calm under pressure.

 

Natural
abilities may make an expert good, but her capabilities are enhanced through
practice. This is why trial attorneys prefer experienced expert witnesses. A
trial attorney is better served by an expert with outstanding courtroom
presentation skills than an expert with better credentials but a poor courtroom
manner.

 

§ 20.4 – Fee Arrangements

 

Ordinarily,
experts are reimbursed on a time and expenses basis in which fees are charged
on an hourly or daily rate. Some types of expert services, for example lost
income analysis in wrongful death, may lend themselves to fixed fee or standard
cost arrangements.

 

Attorneys
should approach with caution a contingency fee for any expert. Knowledge that
an expert has a financial stake not only in winning the case but in the amount
of any damages awarded may undermine the expert’s credibility in the mind of
the trier of fact. However, there may be circumstances involving litigation
funding considerations when the attorney is willing to take this risk to obtain
the expert assistance necessary to prevail in the case.

 

Currently,
the American Institute of Certified Public Accountants (AICPA) does not allow
CPAs to accept litigation engagements on a contingency fee basis.[2] However, the AICPA voted
recently to lift its 82-year ban on contingent fees and has submitted a
proposed agreement to the Federal Trade Commission for approval. Views on the
proposed changes to the AICPA’s code of professional ethics are mixed, and it
is not clear at the time of this writing what form of contingency fees, if any,
will be available for accountants. Many states will continue to bar contingent
fee arrangements.

 

           

 

ASSISTANCE IN DISCOVERY

 

§ 20.5 – Complaints,
Interrogatories, and Requests for Documents

 

 

Experts
can assist in fashioning detailed allegations that make complains motion-proof.
Federal courts, for example, impose stringent requirements under Rule 9(b) of
the Federal Rules of Civil Procedure with respect to the degree of
particularity in the pleading of fraud. An accounting expert can identify
specific items presented in financial statements, sections of authoritative
pronouncements on auditing standards and accounting principles, provisions of
financial reporting principles, and other details of the alleged wrongdoing.
This can prompt early settlement or avoid the dismissal of an otherwise solid
claim.

 

A
CPA can help ensure that appropriate documents are sought and that they are requested
in the correct nomenclature. An expert familiar with a particular industry can
suggest sources of information which may not have occurred to the attorneys. In
addition, the expert can review the opposition’s document production.

 

Lawyers
should not turn over documents without knowing what they contain and how they
may affect the case. A CPA can assist by advising lawyers about the contents of
financial documents and many other business records. The CPA also can help the
attorney narrow document requests and can provide another opinion about the
potential jeopardy to a litigant because of the materials. If damaging
documents are identified, a timely settlement offer can be made before the case
deteriorates.

 

The
expert can be invaluable in reviewing the opposition’s document production. An
expert may identify missing material which should have been produced by the
opposition. For example, the absence of supporting schedules or a memorandum
file may be obvious to the CPA, but not to the lawyer.

 

The
accounting expert also can assist in preparing and responding to
interrogatories. When the opposition’s document production does not provide the
information which the expert needs to complete her own analysis, a specific
interrogatory drafted by the expert is often the most efficient method to
obtain the necessary data. Expert assistance is often essential to respond to
interrogatories involving complex accounting or business issues.

 

§ 20.6 — Deposition Testimony and
Assistance

 

A
lawyer should not take the deposition of the opposition’s expert without expert
assistance. The depositions of certain fact witnesses,
such as a financial vice-president or controller, may be more thorough when
taken with the assistance of an expert accountant. Financial officers and employees
of a company can be interrogated more effectively with precise questions, using
the correct technical language and terms of art. The expert may also help to
prepare witnesses for depositions. The skepticism and expertise of an
accountant can help to prepare a witness by probing vulnerable areas and
anticipating questions that may cause the witness the greatest discomfort and
the lawyer’s case the most adverse result.

 

§ 20.7 – Case Management

 

Major
litigation cases may tax the resources of even the largest law firm. Case
management often can be accomplished more cost-and time- effectively by
litigation experts, freeing the attorneys to focus on legal rather than on
administrative issues. Experts can assist litigators by:

 

1.         Establishing procedures to track and
control document discovery

2.         Managing and staffing discovery sites

3.         Recommending and implementing document
indexing and computer support systems

4.         Developing and tracking case plans and
budgets.

 

 

PREPARATION AND ANALYSIS OF

DAMAGES CLAIMS

 

§ 20.8 – Overview

 

One
of the most substantial contributions of an accountant providing assistance in
a litigation is the determination of damages. Developing a reasonable approach
to damages which considers all relevant information and which can be modified
quickly as the case shifts benefits both the attorney and the attorney’s
client. Equally important is evaluating and finding weaknesses in the
opposition’s damage claims.

 

Sections
20.8 through 20.21 discuss the determination of damages as encountered most
frequently in major insurance litigation. The damage claim principles covered
apply equally in rebutting damage claims for the defense or developing damage
claims for the plaintiff.

 

The
types of damages found in major information litigation can be categorized into
three groups: physical damages, lost profits, and loss of equity. Because
physical damages often are easily determined through appraisal or a compilation
of invoices, they are not discussed further in this chapter. The determination
of lost profits and loss of equity, however, typically requires expert
accounting assistance due to the complex issues which may arise.

 

§ 20.9 – Lost Profits

 

Profit,
not revenue, is the measure of damages.[3] Revenue is the total proceeds from sales. Profit is the excess of sales revenue after deducting the expenses
(such as labor, materials, and rent) associated with generating the revenue.
Although these terms are associated generally with businesses, these concepts
are equally applicable to claims associated with individuals (for example,
personal injury, wrongful death, and wrongful termination.) There are different
ways profit can be computed, and these differences are significant at trial.

 

Conceptually,
determining lost profits is easy: multiply profit per unit by the number of
units lost. Unfortunately, this simple formula disguises a number of
complications. To determine the amount of profit lost when an adverse event
occurs may involve complex and sophisticated analyses requiring advanced
techniques of cost accounting, mathematics, statistics, and economics. To
understand this better, §§ 20.10 and 20.11 cover the two parts of the lost
profits equation, profit per unit and number of units lost, in more detail.

 

§ 20.10 – Profit Per Unit

 

In
most cases the appropriate measure of damages is the marginal profit per unit (that is, profits earned by selling one
additional unit) rather than the average
profit per unit (revenue minus expenses divided by the number of units
sold). The distinction is important. In most business situations, some
expenses, called fixed expenses (for example, rent), do not increase with a
significant increase in sales. As a result, the marginal profit made by selling
extra units typically is greater than the average profit of all units sold. Of
course, this is not always the case. A factory operating at full capacity may
not have been able to produce significant additional units without significant
capital expenditures, in which case the marginal profit for the additional
units may be close to the average profit.

 

To
calculate marginal profit, the accountant undertakes an analysis in which
expenses are segregated into fixed, variable, and semivariable
components. As mentioned above, fixed
expenses do not vary when production varies within the range considered in
the analysis. Variable expenses (for
example, direct labor and direct materials) vary directly with the quantity of
units produced. Semivariable expenses (for example, indirect labor
and indirect materials) vary incrementally as production levels cross certain
thresholds. Variable and some semivariable expenses
are deducted from incremental revenue when determining marginal profit; fixed
expenses are not. Assigning expenses to these categories is not a mechanical
process. It requires a CPA’ judgement and an in-depth understanding of the
workings of the business.

 

Because
marginal profit is central in calculating damages, it is often the subject of
intense cross-examination during deposition or trial. The opposing attorney may
attack the use of marginal profit rather than average profit or may attempt to
demonstrate that certain costs excluded by the accountant should have been
considered. The expert witness must be prepared to rebut these inquiries by
having available immediately the supporting rationale for the calculation of
marginal profit.

 

§ 20.11 – Number of Units Lost

 

The
number of units lost, the second component in the lost profit equation, is also
likely to be a topic of controversy. Units lost fall typically into two
categories: historical units lost,
that is, sales that can be shown to have been lost up to the time of trial, and
future units lost, that is, sales
that would have been realized in the future had the damage not occurred.

 

The
expert is called upon to determine what historical and future sales levels
would have been but for the opposition’s actions. Typically, this is
accomplished by projecting unit sales based on sales trends before and after
the damage event, as demonstrated in Figure 20-1. In Figure 20-1. A damage event
which occurred in early 1986 caused the trend of sales to be reduced
significantly. The top line of the shaded portion of the figure, which
represents projected unit sales but for the damage event, is determined by
continuing the trend of unit sales established before the damage event. The
bottom line of the shaded portion, which represents actual and projected actual
unit sales, is determined by identifying and continuing the trend of unit sales
after the damage event. The shaded area between the two lines represents lost
unit sales.

 

§ 20.12 – Projection Methodologies

 

The
projections shown in Figure 20-1 are linear. Linear projections are used
frequently in court because they are easy to demonstrate graphically and
because they can be generated using linear regression, a standard statistical
technique. Using approaches like linear regression reduces subjectivity in
developing the projection, thereby increasing the credibility of the
projection. Of course, linear projections are not the only type used.
Non-linear projection techniques based on percentage changes in sales or other
statistical methods are also available. As shown in Figure 20-2, the choice of
projection methodology used can make an enormous difference in the amount of
damages calculated, as does the decision as to how far into the future damages
are calculated.

 

 

 

 

 

§ 20.13 – Adjusting to Present
Value

 

Regardless
of the method used to determine lost profits, a value in today’s dollars should
be computed for historical and future los profits.  This process, adjusting to present value, recognizes
that historical lost profits could have been invested in the operations of the
company or else-where, generating additional profits. Similarly, a future loss
can be paid off by a smaller amount invested today. A failure to adjust damages
to present value will overstate future damages and understate historical
damages. The factor used to adjust damages is called the discount rate. The choice of the discount rate has a major impact
on the magnitude of damages calculated. The principle of discounting has often
been approved by courts.[4]

 

§ 20.14  — Loss of Equity

 

Accounting
experts are called upon frequently to determine damage to the equity, or
goodwill, of a company. Before reviewing the methods used commonly to determine
these damages, it is important first to clarify the concept of goodwill and to
distinguish between loss of future profits and damage to goodwill. These are
separate and district damages, although the difference is subtle. One practical
difference is that damages awarded for lost profits are generally taxable as
income, but awards for damage to goodwill generally are treated as a nontaxable
return of capital.[5]

 

The
value, or equity, of a company is its tangible and intangible assets less its
liabilities. Goodwill, an intangible asset, is part of this value. Tangible
assets are physical objects or objects which have a readily determined market
value. Examples include cash, receivables, property, and equipment. Intangible
assets are items such as patents, copyrights, franchises, organization costs,
and trademarks. Goodwill represents the conglomeration of other resources and
conditions that make the overall value of a company greater than the sum of the
net fair market values of its individual tangible and intangible assets. Like
other intangible assets, it is possible to place a value on the goodwill of a
company. However, unlike other assets that can be sold or exchanged individually,
goodwill can be identified only with the business as a whole. Elements of
goodwill might include:

 

1.         Superior management

2.         Outstanding sales personnel

3.         Effective advertising

4.         A secret process or formula

5.         A good reputation in the marketplace.

 

When
the opposition’s actions cause a litigant’s business to lose sales, this also
reduces the value of the business. Simply put, a company which sells 200,000
units per year is less valuable than one which sells 250,000 units per year,
all other factors being equal. This reduction in value is a loss of goodwill
and does not overlap lost profits. This point is most clearly seen when the
defendant’s actions caused the termination of the plaintiff’s business.

 

§ 20.15 – Valuation Methodologies

 

Determining
the loss of goodwill requires valuing the business twice: before and after the
damage event. There are several generally accepted methods used to determine
the value of a business. The approach used to determine loss of goodwill
depends on the individual circumstances of the case. Often, more than one
approach is used to develop a range of valuations. The three most commonly used
methods are the market approach, the adjusted book value approach, and the
income approach.

 

The
market approach compares the company to similar companies. The expert develops
ratios based on statistical and financial data of comparable companies. To
determine the value of the company, these ratios are applied to the company’s
earnings, its cash flow, its book value of assets, or other accounting
measures.

 

In
the adjusted book value approach, appraisals are first completed on the
underlying tangible assets of the company. Rates of return experienced normally
in the industry are applied to these appraised values to determine how much
income these assets should generate. This amount is subtracted from the firm’s
actual earnings. The difference is attributable to goodwill.

 

The
income approach is based on the theory that the value of a business depends on
the future benefits it will produce. This approach may use the discounted
present value of future cash flows to determine the value of the company.
Although the market and adjusted book value approaches are based primarily on
the company’s past experience, the income approach can be used when it is
necessary to determine the value of a business based upon projected performance
which may differ from the historical trend.

 

§ 20.16 Principles for Preparing
Damages Claims

 

Sections
20.9 through 20.15 underscored the necessity for expert assistance in dealing
with the complex analytical issues which may arise in preparing damage claims.
A good technical analysis alone does not necessarily translate into a winning
presentation in court, however. Sections 20.17 through 20.21 present several principles
which have been applied successfully in developing damage claims and assisting
the expert in cross-examination.

 

§ 20.17 –Assumptions and Estimates

 

Preparing
lost profits or lost equity damage claims requires necessarily making
assumptions and estimates. Typical and basic assumptions and estimates which
play a major role in the calculated damage amount include:

 

1.         The methodology chosen to project
future sales volume

2.         How far into the future damages are
calculated

3.         The factor used do discount damages to
present value

4.         Assumptions concerning pricing and
expenses.

 

The
use of estimates and assumptions is valid in court. Courts have ruled
consistently that a litigant cannot be denied compensation for lossesmerely because the damages cannot be quantified
precisely.[6] Damages may be awarded
based on reasonable assumptions. However, the expert witness can expect a
vigorous attack on these assumptions.

 

It
is important for the damage expert to distinguish clearly between assumptions
resulting from uncertainty concerning the amount of damages as opposed to the
occurrence of damages, particularly when calculating lost future profits.[7] A mere contingency will
not support a claim for damages. For this reason, establishing damages due to
lost anticipated profits of a start-up business is difficult. Many courts have
classified these damages as speculative and have denied recovery.[8] This rule is not absolute,
however, and lost prospective profits may be recovered if reasonable certainty
is demonstrated both to occurrence and extent.[9]

 

If
alternative assumptions are equally probable and reasonable, the attorney may
ask the expert to provide the judge or jury with a range of damage amounts,
together with the expert’s best estimate. This provides the trier of fact with
additional information which may be used to pick an alternative damage amount
when, for whatever reason, the trier of fact does not accept a testified-to
damage amount.

 

§ 20.18 – Establishing Proximate
Cause

 

An
explicit assumption underlying analyses of lost profits and loss of equity is
that the defendant’s actions proximately caused the damage.[10] In personal injury cases,
proximate cause is often clear; in business litigation, the issues may be more
complex. Defendants argue that other factors, such as increased competition in
the marketplace, product obsolescence, or general economic trends explain some
or all of the losses experienced by the business for
which the plaintiffs seek recovery.

 

Defenses
concerning proximate cause must be countered by testimony on behalf of the
plaintiff. Often testimony by the damages expert is coupled with testimony from
marketing and industry experts as well as fact witnesses from the client’s
company. Statistical analyses are often applied to issues of proximate cause
(see § 20.33).

 

§ 20.19 – Principle of Conservatism

 

Experts
developing damage claims often combine a series of assumptions favorable to the
client’s position to reach an unrealistically high (or low) damage amount. This
type of overreaching can be self-defeating. For example, the credibility of an
inflated damage calculation may be undermined easily, simply by adjusting
certain assumptions within a reasonable range, so that one can arrive at a
dramatically different damage amount. Similarly, the credibility of a strong
damage claim may be hurt when it is accompanied by additional claims for
tangential and speculative damages.

 

Plaintiffs
can be very imaginative in enumerating all the different ways the defendants’
actions have hurt their business. The attorney must work with the accounting
expert to make sure the damage analysis avoids over-reaching and speculative
claims. A conservative, fully documented analysis better server the litigant.

 

§20.20 – Flexibility and
Responsiveness

 

Decisions
by the court during the course of trial may require rapid recalculation of the
damage amount. For example, the judge may rule on the damage period or
categories of damages allowed. The expert must be able to respond or categories
of damage allowed. The expert must be able to respond as the facts of the case
shift. Use of computerized damages schedules capable of rapid adjustment is
perhaps the best method to deal with fact changes. Alternatively, the expert
should prepare alternative approaches based on anticipated decisions of the
court.

 

§ 20.21 – Substantiation of Damage
Testimony

 

When
testifying to very simple or very complex damage issues, there is a temptation
simply to state a final damage figure without explaining the calculation which
led up to this value. This can be grave error, as courts have repeatedly denied
such damage estimates ad speculative or uncertain.[11] On the other hand, a
lengthy, technical dissertation by the witness, discussing every detail of the
damage analysis, is more likely to bore than inform the judge or jury. The
plaintiff or the plaintiff’s expert is more likely to fall into this error than
an independent expert.

 

An
effective damage presentation may be the following. State the final damage
amount (or range of amounts) and provide a brief explanation of the overall
approach to calculate it. In more complex cases, a further discussion of issues
raised in the overall explanation may be necessary, Frequently, the damage
expert would need to testify on damages in direct examination for less than one
hour.

 

Although
the damage expert may not discuss all the details of her damage calculation on
direct examination, she must be able to respond quickly to cross-examination
concerning any portion of the analysis. The expert also must be able to produce
any business records on which her testimony is based.[12] To accomplish this, all
damage calculations and supporting documentation should be organized in
cross-referenced working papers. An effective format for working papers is
hierarchical structure in which the main results are broken down into a series
of subsidiary calculations, each in turn supported by further calculations and
original source documentation. Cross-referencing each level of the calculations
helps to assure the overall integrity of the damage calculation and eliminate
errors and inconsistencies which undermine the overall credibility of the
calculation.

 

 

FORENSIC ACCOUNTING

 

§ 20.22 — Definition of Forensic Accounting

 

Broadly
speaking, forensic, accounting, also
called investigatory accounting, is any accounting activity for use in a court
of law. Forensic accounting can be the acquisition, reconstruction, review, and
analysis of the books and records of an entity, and the development of
evidentiary materials. In this sense, damage claims preparation and analysis is
forensic accounting. Table 20-1 presents several examples of forensic
accounting services.

 

§ 20.23 – Forensic Accountants
versus Traditional Accountants

 

Although
many of the tasks of the forensic accountant appear similar to those of the
traditional accountant or auditor, there are significant differences. Unlike
the traditional CPA, who typically reviews well-documented audit trails, the
forensic accountant must work with the sketchy, inaccurate, or even
deliberately falsified information often encountered in litigation. Frequently,
the accountant must develop missing information based on reasonable assumptions
or on analytical techniques applied to the information available. The forensic
accountant must apply creativity and perseverance to reconstruct transactions
and records of an entity.

 

Table 20-1

 

SAMPLE FORENSIC ACCOUNTING SERVICES

 

Type of Litigation

Forensic Accounting Service

Lender liability                          Embezzlement                          Trademark infringement        Wrongful death                          SEC fraud                                   Partnership dispute                             Antitrust                                     Wrongful dismissal                  Corporate takeover                 Dissenters’ rights

Determine whether records show bad faith of lender Determine nature and scope of defalcation by controller Determine damages suffered by plaintiff   Determine impact that the death of an executive had on his business   Trace investor funds, assist in asset recovery, and develop plan of liquidation Determine whether books and records of general partner reflected improper expense allocations Determine damages in antitrust claim and also in false advertising counterclaim Develop methodology for determining comparative performance Determine whether tender offer materials contained false financial information Conduct cash flow analysis to determine ability of company to pay judgment

 

 

Typically,
the forensic accountant begins with only a general idea of the objectives while
facing tremendous numbers of records and documents. Often placed under strict
time constraints, the forensic CPA must work quickly to obtain an overview of
the relevancy of the documents and proceed to formulate a strategy. Although
attorneys usually have reviewed at least some of the documents prior to
retaining the forensic accountant, they rely on the accountant’s greater
familiarity with financial and accounting documents to guide the process of
selection of documents for review.

 

For
example, in insurance litigation involving a multi-million
dollar entity, the litigation team may have access to thousands or even
millions of documents. The accountant may first obtain a quick understanding of
the entity and its history by arraying five to 10 years of historical profit and
loss statements. This in turn may lead to areas requiring further
investigation.

 

Finally,
forensic accountants are familiar with the legal system and comfortable working
within it. They understand the laws pertaining to discovery and the
presentation of opinions in court. They are familiar with, and may even relish,
the rigors of cross-examination, an experience the traditional accountant can
fairly be said to dread.

 

§ 20.24 – Advantages of Forensic
Accountants

 

Forensic
accountants and their staffs typically are better equipped to review large
numbers of records than are litigators and their staffs. Because of their
greater familiarity with financial and accounting records, the forensic CPA is
in a better position to detect and extract critical information from the
records. For example, faced with a large stack of computer printouts from a
general ledger, the forensic accountant could identify quickly critical
accounts and enter monthly subtotals into a worksheet to identify trends.

 

Forensic
accountants at major CPA firms can marshal enormous resources when needed to
perform large tasks in a short time. In one litigation, for example, in a
two-month period nearly 40,000 hours of special audit work was performed in 21
cities around the country to meet a tight deadline.

 

Finally,
because the investigatory tasks are performed by staff personnel under the
direction and supervision of the forensic accountant, the CPA is in a position to testify as to her findings.

 

§ 20.25 – Forensic Accounting
Techniques

 

The
forensic accountant may apply a variety of techniques to perform her analysis.
These techniques, which encompass a broad spectrum of accounting and general
knowledge, can be adapted strategically to strengthen the case. Forensic
accounting techniques include:

 

1.         Audits

2.         Reviews

3.         Agreed-upon procedures

4.         Investigation

5.         Inspection

6.         Observation

7.         Interviews

8.         Sampling

9.         Comparison.

 

In
addition to these techniques, which are associated with traditional accounting
and auditing, the forensic accountant relies on the work of other specialists
in performing certain technical analyses (for example, statistical analyses,
valuations, cost and price analyses, or economic analyses).

 

COMPUTERIZED ANALYSIS OF
INFORMATION

 

§ 20.26 – Computers in Litigation

 

When
computers are discussed in relation to litigation, attorneys usually think
first of automated records management. Indeed, this is an important
contribution of computers to litigation. However, the ability of a computer to
facilitate the types of analyses discussed in §20.25 is in many ways more
significant. Sections 20.26 through 20.34 discuss briefly how experts use
computers to enhance their effectiveness in litigation.

 

§ 20.27 – Discovery of Computerized
Information

 

Attorneys
often seek to discover computerized information. In particular, the financial
records and documentation of transactions of most businesses are stored on
computers. Hard-copy printouts seldom provide the information in the format
needed for analysis by the accounting expert. Large amounts of expensive,
error-prone, and time-consuming manual entry of data frequently are required.
Expert assistance can make this process more efficient by obtaining information
directly in machine-readable format, usually in the form of a computer disk or
tape.

 

§ 20.28 – Computer Data Base
Analysis

 

A
data base is information organized in
a logical manner to facilitate retrieval of individual data elements as well as
analysis of data through sorting, grouping, selecting, and other manipulation
of the data. Data base software programs available on computers, from
mainframes through microcomputers, allow analysts to create and analyze
millions of individual records quickly and efficiently. Examples of the use of
data base analysis in major insurance litigations are discussed in §§ 20.29 though 20.31.

 

§ 20.29 – Tracing Cash Flow

 

Tracing
the cash flow between entities is a common task in many litigations. For
example, one way to establish that different companies which appear to be
unrelated are in fact alter egos of one entity (that is, piercing the corporate
veil) is to analyze the cash flows between the entities involved. Organizing
payments and receipts between entities into a computer data base is an
efficient method to discover and demonstrate patterns of payments.

 

            For example, based on a review of
cash disbursements as shown in Table 20-2, at first glance there appears to be
no relationship between Company A and Company C. These are no payments between
them, although both do business with Company B. Table 20-3, however, shows the
result of a computer data base analysis of payments which would demonstrate
Company B’s role as a conduit through which Company A directs funds to Company
C.

 

Table 20-2

DISBURSEMENTS FROM COMPANY A TO
COMPANY B AND FROM

COMPANY B TO COMPANY C (UNGROUPED)

 

 

Table 20-3

DISBURSEMENTS FROM

COMPANY A TO COMPANY B AND FROM

COMPANY B TO COMPANY C (GROUPED)

 

 

 

 

 

§ 20.30 – Distributions in

Bankruptcies and Receiverships

 

Claims
of investors in bankruptcies and receiverships may be maintained on a computer
data base. The data can be used to

 

1.   Create claim forms for investors

2.   Perform analyses of the impact on classes of
investors and other claimants of alternative distribution plans

3.   Calculate distributions payments

4.   Write checks

5.   Perform other administrative procedures.

 

§ 20.31 – Statistical Data Bases

 

Computer
data bases may be used as the basis of nonfinancial or statistical analyses in
litigation. For example, data base have been used to perform analyses of market
share of commercial first-run theaters in support of antitrust motions;
analyses of sales, deliveries, and prices in unfair competition disputes; and
analyses of terms of lending in actions involving alleged discrimination in
lending practices.

 

§ 20.32 – Financial Modeling

 

Financial
modeling is one of the most common applications of computer analysis in
litigation. Models are usually developed using spreadsheet software packages.
Spreadsheet software creates an environment for the user equivalent to columnar
paper – rows and columns that create cells into which the user may enter data
of formulas. Changing an entry in one cell automatically updates all the
formulas in the spreadsheet. The results are displayed in table and graphic
form for review.

 

A
common application of financial modeling is to automate the financial
statements, particularly the balance sheets and income statements, of an
entity. Once the basic information has been entered into the computer, it is
simple to develop and analyze trends, forecasts and projections, proforma
statements, hypothetical scenarios, and other applications required frequently
in litigation.

 

§ 20.33 – Statistical Analysis

 

Statistical
analysis is used frequently in litigation, often in conjunction with data base
analysis and financial projections. Linear regression analysis is the most
commonly used technique. It is the basis of many projections of future sales and
income. Additionally, multiple regression analysis and correlation analysis are
applied to liability issues. These techniques may be utilized to provide
statistical evidence concerning whether the defendant’s actions proximately
caused the plaintiff’s sales to decline or whether the decline is explained by
other factors.

 

Statistical
sampling is used for such diverse applications as public opinion surveys, fraud
audits, and other verification procedures. Statistical hypothesis testing, used
in conjunction with sampling, is applied in cases where it is necessary to
demonstrate whether there are significant differences between two populations.

 

 

§ 20.34 – Computer Graphics, Visual
Aids, And Displays

 

The
ability of computers to generate graphs, charts, tables, displays, and other
visual aids is of tremendous importance in litigation, The
ability to create graphs which present summarized data is of great value in
performing the analysis itself. A moment’s review of a graph can reveal trends,
differences, boundaries, and other relevant information to the analyst.
Similarly, computers allow the expert to display the results of the analysis to
the judge or jury in an easy-to-understand format. Many rulings allow the
introduction of charts and graphs in trial.[13]

 

TRIAL ASSISTANCE

 

§ 20.35 – The Accountant as Expert
Witness

 

The
Courts uniformly have accepted the accountant, in particular the certified
public accountant, as an expert.[14] Trial attorneys, however,
have considered the accountant to be a poor expert witness. This perception is
often justified. Accountants often seem unable to avoid the use of arcane
terminology and detailed qualifications to explain accounting issues. This may
make a bad impression on the judge or jury. After all, accounting deals with
numbers, and it would seem reasonable to expect a decision based on numbers to
be clear, precise, and unqualified.

 

Accountants
are not entirely at fault, however. Often the issues facing accountants are not
simple. Most laypersons do not understand the large role that subjective
judgment and assumption play in the development of accounting and financial
statements. An example of the role of judgment in what at first appears to be a
simple arithmetic task is valuing inventory, If the costs of supplies and
manufacturing are known, the value of the product would seem easy to calculate,
But which value should be used, cost or market? If cost is used, then is
historical or replacement cost appropriate? If historical cost is chosen, then
what method should be used to compute historical cost: last-in-first-out,
first-in-first-out, or some other cost method? If market value is used, should
it be based on normal selling price or liquidation selling price? Should the
cost to complete the inventory and selling cost be included? The expert witness
testifying to the value of inventory clearly has to do more than add up columns
of numbers. She must make difficult accounting decisions and explain them to
the judge or jury.

 

For
their part, in presenting complex issue in court, accountants often take for
granted that the judge or jury understands accounting principles and
terminology. Accountants may use technical terms without explaining them
adequately, and may dwell on subsidiary issues of minor importance in their
overall conclusions. This is a frequent problem among accountants, most of whom
spend their time working with other financial professionals. Most accountants
are more comfortable with the familiar role of practicing their craft than with
the often more difficult task of explaining it to nonaccountants by testifying
in a trial.

 

Many
accountants make excellent witnesses. As is true with most technical subjects,
accounting transactions can be explained in terms understandable to judges and
jurors who have no background in accounting, The attorney should retain the
accountant who says, “They bought the tractor with a cash down payment and
borrowed the rest,” instead of, “the acquisition of the farming machinery
resulted in a debit to fixed assets and credits to cash and notes payable.”

 

§ 20.36 – Other Trial Assistance

 

In
addition to providing her own testimony, the accounting expert should be
present for the testimony of the opponent’s expert. In addition, it may be wise
to have a CPA present during the testimony of  business-related fact witnesses on
both sides. The CPA can provide a specialized audience whose critical and
objective comments may be most helpful, if not crucial, For
example, in one case a witness for the other side testified that certain
withdrawals of funds he made from his company were payments of salary for
services rendered. The expert accountant, who was present for this testimony,
quickly passed a note to his client suggesting he ask whether the witness had
declared these payments in his income taxes. The attorney followed up this line
of questioning, forcing the witness to recant his testimony, badly hurting the
other side’s case. During trial, the expert should also prepare for rebuttal
testimony, if needed, and review relevant testimony for aspects useful in
post-trial motions and potential appeals.

 

 

WORKING EFFECTIVELY WITH EXPERTS IN
MAJOR LITIGATIONS

 

§ 20.37 – Bring Experts in Early

 

Often,
attorneys delay bringing in an expert until only weeks or even days before
trial. The result of such last-minute calls is usually extra effort and cost as
well as a weakened ability to present an effective case. The expert may have to
redo work already performed by the attorney or the attorney’s client because
the expert must be able to testify as to her independent analysis of the facts.
Experts brought in after the close of discovery may find the credibility of
their analyses undermined because important information is not available to
them, information which could have been obtained readily if an expert had been
available to point out its significance earlier.

 

Both
attorneys and client benefit by bringing in experts early. On a cost basis
alone, the expert’s ability to help attorneys avoid unnecessary discovery by
pinpointing key documents justifies early involvement.

 

§ 20.38 – Work in Concert on
Strategy and Approach

 

The
expert and the attorney must work together to develop the expert’s testimony.
The good expert witness makes it clear, albeit diplomatically, that she well
not say simply what the lawyer wants the witness to say. The attorney must take
care not to impose her preconceptions on the expert, In
complex litigations, the attorney is far more familiar with the facts of the
case initially than is the expert. However, the attorney often has only an
incomplete understanding of what the expert potentially could do to assist in
the litigation. The attorney should solicit the expert’s advice concerning the
tasks the expert will perform. At the same time, the expert must be guided by
the attorney, who is responsible for presenting the case.

 

§ 20.39 – Preliminary Analysis of  Damages

 

In
even the most complicated case, a good expert can develop a rough estimate of
damages in a matter of days. This analysis can be refined as further
information becomes available. Developing a preliminary damage estimate as soon
as possible in a litigation offers several advantages to the client. First, it
helps determine the appropriate level of further effort. If the exposure or
potential is lower than first thought, a more detailed damage analysis may not
be cost-effective. This information is also extremely useful in settlement
negotiations. Second, the preliminary analysis may reveal that further
discovery is needed.

 

A
third advantage of developing a preliminary analysis and subsequent updates is
that they provide the accounting expert with a basis to testify to her findings
even if time or budget constraints do not allow the expert to finish every
aspect of the analysis. In a sense it is an insurance policy against the
possibility (indeed, a real danger in large litigations involving numerous
documents) that the expert will run up large fees while collecting organizing,
and analyzing the data without reaching any opinions.

 

 

§ 20.40 – Establish and Monitor a
Budget

 

A
famous lawyer was once asked, “How much will this case cost to litigate?” His
answer was, “Everything you’ve got.” Experts rarely are, or should be, in a
position to treat budgets so cavalierly. Insurers take a dim view of exploded
budgets for experts, and they respond by refusing to pay the fees of the
experts and the attorneys who hired them. Estimated budgets can and should be
developed for any litigation task. Attorneys and insures should be informed
before budgets are exceeded so that they may react appropriately, either by
authorizing further expenditures or by scaling back the expert’s scope of work.
Doing this helps protect both the expert and the client against disputes
concerning fees. In major litigations, when budgets take a second seat to
frantic efforts to meet deadlines, the client and the insurance company should
be kept informed on a very frequent basis of fees incurred.

 

§ 20.41 – Confer Frequently

 

The
attorney must be informed of the progress the expert is making, both in terms
of the analysis and the fees being incurred. Experience shows that the experts
often must take the initiative to contact the attorneys to let them know what
they have accomplished and what they intend to do next. When dealing with
experts, many attorneys seem to take the attitude that no news is good news,
and they may be unpleasantly surprised when the expert’s findings or fees were
not as expected. Similarly, when using multiple experts, for example, a
marketing expert, an accountant, and an appraiser, information must be shared.
Lack of communication during preparation of the case can lead to disaster in
the courtroom.

 

§ 20.42 – Expert’s Primary Contact

 

Major
insurance litigations often involve multiple attorneys and law firms
representing different parties in the case. To save costs, several parties may
agree to share the services of an expert. Because the interests of parties in
litigation rarely converge exactly, the expert may be pulled in conflicting
directions. To avoid this potential problem, the litigations should establish
one attorneys as the primary contact to whom the expert reports and from whom
the expert receives her instructions. This attorney also should be responsible
for making sure that the experts are provided with the resources (documents and
access to individuals) they need to accomplish their tasks. Often this role is
delegated to a more junior attorney involved in the litigation. A better choice
is the litigator who will examine the expert on the witness stand.

 

§ 20.43 – Involve the Insurance
Company

 

Insurance
companies, who are paying the bills for attorneys and experts, frequently hire
an independent law firm whose sole role is to monitor the progress of the
litigation. Even when the insurance company or its counsel does not take an
active role in the litigation itself (and frequently they do not), they should
be kept informed of all activities of the expert and should receive copies of
any work products delivered by the experts to the attorneys. This helps to
reduce any later misunderstandings concerning the tasks the expert performed.

 

§ 20.44 – Rules Governing Discovery
of Expert Opinions

 

Both
experts and attorneys should be familiar with the work products doctrine and
attorney-client privilege as they relate to the discovery of expert opinions.
The laws can differ among states and from the federal rules of evidence.
Generally speaking, observations and opinions of an expert employed as a
pretrial consultant rather than a potential witness are deemed work product of the attorney and are
protected from discovery.[15] Once and expert is
employed to testify at trial, however, her opinions are relevant evidence and
generally are not protected by the work product doctrine.[16]

 

The
law can be complex and misunderstandings may have important consequences in a
litigation. For example, an expert’s examination and analysis of confidential
client documents may be privileged, but certain types of direct testimony may
constitute a waiver of the privilege and enable the adverse party to
cross-examine the expert on the subject of the privileged information.[17]

 

§ 20.45 Rehearse Testimony

 

Neither
the lawyer nor the expert should surprise the other at trial or during
deposition. The expert witness should work with the attorney in framing
questions in such a way that the expert can provide answers which are helpful
to the case. In complex testimony, attorneys may wish to take advantage of the
fact that it is permissible to lead an expert in direct examination. If the
expert is testifying for the first time, the expert should spend some time
prior to testifying sitting in on the trial (or another trial) to familiarize
herself with courtroom procedure.

 

§ 20.46 – CONCLUSION

 

Using
an expert witness is an integral part of virtually any major insurance
litigation. The expert can form an opinion or an inference on complex,
un-familiar, or specialized matters when the layperson would not be able to do
so.[18] Although expert witnesses
come from many fields, perhaps the most commonly used expert is the accountant.
Expert accountants perform valuable services both before and during trial.
Attorneys call upon CPAs to explain or interpret complex financial
transactions, to trace funds, to estimate value, to calculate damages, to
perform technical analysis, and to render opinions. Although most cases do not
reach the courtroom, attorneys should always look for an accountant who has the
right combination of professional skills and personal characteristics to be an
effective expert witness. Finding the right expert witness can make the
difference between winning and losing a case.