December 05, 2018 Articles

Causation and the Role of the Damages Expert

What legal and analytical traps do experts often fall into when misapplying the concept of proximate causation?

by Peter Rybolt

The question can seem deceptively simple: Did defendant’s actions cause plaintiff’s losses? Yet courts, lawyers, experts, and juries often struggle to find a clear and satisfying answer, particularly when faced with multiple possible explanations for plaintiff’s apparent losses and a dizzying array of legal terms and concepts—proximate cause, cause-in-fact, intervening causes, sufficient and insufficient causes, dependent and independent causes, preemption, and more.

It is well established that a plaintiff seeking recovery of lost profits must persuade the trier of fact that the defendant’s actions were the proximate cause of the losses it claims. Proximate cause, however, is not always the direct, immediate, or factual cause of a plaintiff’s loss; rather, it is a legal construct defined—sometimes ambiguously—by statute and legal precedent. Moreover, the standards by which proximate cause is adjudicated may differ according to the specific causes of action asserted by the plaintiff, as well as applicable law in the jurisdiction where the case will be heard.

The role of the expert can be ambiguous as well:

  • Plaintiff A, a successful manufacturer, complains of errors in the design of a new factory, which the plaintiff contends has led to less-than-optimal output. Does the damages expert have a role in establishing that the flawed design was the proximate cause of the plaintiff’s losses?
  • Plaintiff B, with a history of solid sales growth, complains of a precipitous decline in sales following defamatory statements made by the defendant. Yet, the decline in sales coincided with the emergence of a significant new competitor. What is the role of a damages expert in distinguishing between the losses (if any) attributable to the alleged defamation and the losses attributable to the shift in competition?
  • Plaintiff C, a successful composer, complains that the defendant’s song borrowed key melodic elements from her original composition. What is the role of the damages expert in identifying the plaintiff’s losses? What is the role of the expert in identifying the profits of the defendant that are attributable to the infringement?

It is important to be familiar with the basic legal concepts related to causation and to understand how and when establishing causation may fall within the purview of the damages expert. The following is hardly a thorough treatment of the many relevant terms and concepts, but it should provide a framework for understanding causation in many contexts.

Proximate Cause versus Cause in Fact

The proximate cause of a plaintiff’s harm is that cause that is legally sufficient to establish a defendant’s liability: “[Proximate cause is] an act or omission that is considered in law to result in a consequence, so that liability can be imposed on the actor.” Bryan A. Garner, Black’s Law Dictionary (10th ed. 2014) (quoted in United States v. Burkholder, 816 F.3d 607, 612 (10th Cir. 2016)). It need not be the cause in fact of the plaintiff’s harm, however. A classic example from criminal law helps to illustrate the distinction:

  • A shoots B; B dies. A shooting B is both the cause in fact and the proximate cause of B’s death.
  • A shoots at B but misses; B runs, trips, and hits his head on the pavement. He dies of injuries sustained in the fall. While A shooting at B is not the cause in fact of B’s death, A’s actions may nonetheless be held to be the proximate cause.

The same kinds of questions may distinguish proximate cause and factual cause in business litigation. For example:

  • Company A sells a fire suppression system to Company B. An arsonist sets fire to Company B’s factory, the fire suppression system fails, and Company B incurs a loss.

The factual cause of Company B’s losses is the fire, and the arsonist would presumably be charged with a crime. In addition, however, Company B may have a claim against Company A for negligence or other wrongful conduct. As before, whether the failure of the fire suppression equipment constitutes the proximate cause of Company B’s losses is a question of fact, and whether Company A faces liability for all or a portion of Company B’s losses is a question of law.

Tests of Causation

Causation is most clearly and consistently tested through application of the “but-for” rule—that but for the act or omission of the defendant, no injury to the plaintiff would have occurred. The but-for rule gives rise to the but-for world, the starting point for many lost profits damages calculations.

Yet, the but-for test is not without its conceptual weaknesses. One can imagine an almost limitless array of facts or events but for which a plaintiff’s losses might not have occurred. For example: But for the cold front, the defective furnace would not have kicked on, and the fire would never have started.

More problematic is when a plaintiff’s harm can be attributed to two or more independently sufficient causes, as in the case of two fires started simultaneously from independent causes, each sufficient to destroy the building. Under a strict interpretation of the but-for test, both potential defendants might escape liability. Multiple causes may also be independently insufficient. Suppose the fire was started not by an arsonist, but in a container of solvent negligently left uncovered by a contractor, which in turn was ignited by a spark from a faulty light fixture. Neither act by itself would have led to the fire—again failing the but-for test—yet each negligent act was a necessary element in the sequence of events that led to the fire.

Some jurisdictions have therefore dropped the but-for test in favor of other standards. California, for example, relies on the substantial factor test:

A substantial factor in causing harm is a factor that a reasonable person would consider to have contributed to the harm. It must be more than a remote or trivial factor. It does not have to be the only cause of the harm.

California Civil Jury Instructions 430.

Background notes for this instruction explain the rationale:

The substantial factor standard . . . has been embraced as a clearer rule of causation—one which subsumes the “but for” test while reaching beyond it to satisfactorily address other situations, such as those involving independent or concurrent causes in fact.

Id.

Building on similar themes, legal scholars in the 1980s argued that a cause was legally sufficient if it was a necessary element of a set of conditions that were jointly sufficient for the observed result. Although not without its critics, the “NESS test” (for “necessary element of a sufficient set”) has gained momentum in recent years as a preferred method of evaluating causation in cases involving multiple causes. (For more information, see David. A. Fischer, “Insufficient Causes,” 94 Ky. L.J. 277 (2006)).

Both the substantial factor test and the NESS test shift the analytical emphasis from the sufficiency of a particular factor to the sufficiency of a set of conditions, of which the defendant’s wrongdoing is a necessary element.

The Role of the Damages Expert

We now shift from legal terms to economic concepts and consider causation from the perspective of the damages expert.

It is the plaintiff’s burden to demonstrate that the defendant’s actions were the proximate cause of its losses. The plaintiff, however, may or may not enlist the damages expert in support of that effort.

First, the causal issues may lie beyond the expertise of the damages expert. In our example of the flawed fire suppression system, experts in fire suppression technology may be needed to explain the specific failure of the defendant’s device; experts in the spread of fires or building construction may be needed to explain the damage done to the building. These topics are beyond the ken of most damages experts. Damages analysis would likely focus on the cost of repair or replacement of the plaintiff’s facility and on consequential damages, such as those arising from business interruption.

In other cases, matters of case strategy, budget, state law and precedent, or facts specific to the case may limit the role of the damages expert with respect to causation.

When the subject turns to lost profits, however, causation will typically stand front and center before the damages expert. Often, lost profits analyses will hinge on an attempt by the expert to model the cash flows that the plaintiff would have enjoyed in the absence of the defendant’s wrongful conduct. In some cases, such efforts will include projections into the future. These efforts call upon the expert not only to estimate the effect of the defendant’s actions on the plaintiff’s business but also to account for other industry and economic factors that may have affected (or may yet affect) the plaintiff’s business. Because many damages experts have backgrounds in accounting, finance, or economics, such analyses generally lie within their expertise.

Indeed, the role of the plaintiff’s damages expert is often not to establish causation per se but to refute or dismiss other factors that may have explained the plaintiff’s losses. Defense counsel and opposing experts will try to undermine the credibility of a plaintiff’s expert who willfully ignores alternative explanations for the plaintiff’s losses. The well-prepared expert will have considered other causes and adjusted his or her analysis accordingly. A preemptive, rather than reactive, approach by the plaintiff’s expert will generally be more credible.

Finally, sorting through the many potential explanations for the plaintiff’s losses may require coordination with other experts and reliance on percipient witnesses or representations from counsel.

Common Errors in Causation Analysis

Effective evaluation of causation often requires a healthy skepticism, in both affirmative and rebuttal opinions. This section discusses a few of the most common errors experts make in lost profits analysis. Each can be considered a failure by the expert to establish a critical causal link between the alleged wrongdoing and the diminished financial performance of the plaintiff.

Confusing correlation with causation. Nearly every introductory text on statistics cautions the reader not to confuse correlation with causation. Yet, in the analysis of lost profits, many experts fall victim to this fundamental error in interpretation. A plaintiff’s expert, for example, may observe a negative correlation between the plaintiff’s sales and certain allegedly anticompetitive behavior of the defendant, and assume, without further testing or analysis, that the defendant’s behavior is the cause of the plaintiff’s declining sales. While establishing a causal link through quantitative analysis alone can be challenging, the expert should work to test other possible explanatory variables, in hopes of persuading the finder of fact that no other observable factors adequately explain the observed decline in sales. Testimony of witnesses, contemporaneous documents, and third-party analysis may bolster the causation argument.

Overreliance on industry and macroeconomic data. It is tempting to assume that the plaintiff’s but-for performance would have mirrored some industry or economic benchmark, such as gross domestic product or employment. While some companies may track such benchmarks closely, even for extended periods, the relationship may be weak, spurious, or easily disturbed by other factors. An assumption that the plaintiff’s but-for sales will continue to mirror a given benchmark assumes no change in the competitive landscape; no changes in consumers’ buying preferences; no product obsolescence or innovation; no functional or practical limits on growth; and no degradation of the plaintiff’s financial, managerial, and productive capacities. The expert should be prepared to defend such assumptions as reasonable.

Overreliance on flawed or limited data. Often due to limited information, damages experts may be forced to develop projections of but-for financial performance from relatively few years of financial data, from records with missing data, or for companies that have yet to achieve stable financial performance. Often, such limitations preclude a fair assessment of the plaintiff’s operational capability and expected financial performance, undermining any claim that the defendant’s actions were the sole cause of the plaintiff’s subsequent poor performance. Using the performance of comparably positioned companies, industry and macroeconomic data, and testimony and evidence produced in the case may help fill the gaps in the causation argument.

Simple extrapolation. Even when sufficient data exist for more complete or rigorous analysis, damages experts often resort to simple linear projections of revenue and expense. Simple extrapolation of pre-injury financial performance into the but-for world often lacks prima facie credibility. Here too, the presumptive failure is the failure to account for the many factors that may be expected to affect the plaintiff’s financial performance, leading to the reasonable inference that causation has not been established.

Model specification errors. Thousands of industry and economic variables are available to the damages expert. Presented with an abundance of choices, the expert may be tempted to “overfit” the model, inadvertently creating the appearance of statistical significance (which may in turn suggest a causal relationship) where none in fact exists. An overfit model is also a poor predictor of future results; in essence, the model has been “trained” to explain most of the observable variation in historical data without regard to the model’s ability to perform well on untrained, or unseen, data.

Other model specification errors that may give rise to false indications of significance include multicollinearity, endogeneity, and autocorrelation, as well as data selection bias.

Conclusion

Most damages experts are familiar with the general legal principle that the defendant’s wrongdoing must be shown to be the proximate cause of the plaintiff’s losses. Yet, the topic is far more complex than this simple restatement might suggest. The well-prepared expert will be familiar with the nuances of causation analysis from both a legal and an economic perspective and, as a result, be better prepared to reach meaningful and well-supported conclusions.

 

Peter Rybolt is a vice president of Analysis Group Inc. in Los Angeles, California. This article is abridged and adapted from the author’s contribution to Lost Profits Damages: Principles, Methods, and Applications, edited by Everett P. Harry III and Jeffrey H. Kinrich (Valuation Products and Services, LLC, 2017).


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