In Sargon Enterprises v. University of Southern California, S191550, November 26, 2012, a case of great import to business litigators, the California Supreme Court held that a court of appeal (California Second District) incorrectly overturned a trial court decision excluding plaintiff's expert testimony regarding lost profits as speculative evidence. Although plaintiff won a jury verdict that defendants failed to honor a contract to include plaintiff's patented dental implant in a clinical study, during the trial the judge disallowed plaintiff’s expert testimony discussing lost profits as a result of the breach. The trial court correctly acted “as a gatekeeper to exclude speculative or irrelevant expert opinion”; and any opinion regarding plaintiff's lost profits, as an un-established and small enterprise, would necessarily be “conjectural and speculative.” The Supreme Court reversed the court of appeal and remanded the case.

Facts and Evidence at Trial

Sargon Enterprises, a small dental implant company with net profits of $101,000 in 1998, sued the University of Southern California (USC) for breach of a contract that obligated the university to clinically test a new implant the company had patented. Sargon sought damages for lost profits beginning in 1998, ranging from $220 million to more than $1 billion. It claimed that but for the university’s breach of contract, the company would have become a worldwide leader in the dental implant industry and made many millions of dollars a year in profit. USC moved to exclude the proffered opinion testimony of Sargon’s damages expert, James Skorheim, as speculative. An eight-day hearing ensued regarding the admissibility of the opinion of plaintiff’s expert.

Skorheim, a certified public accountant and an attorney, testified that Sargon’s lost profits “ranged from $220 million to $1.18 billion.” In preparing his opinion, Skorheim reviewed litigation materials, financial information from Sargon and its competitors, and market analyses of the global dental implant market. Skorheim based his opinion on a “market share” approach, by which he determined the share of the worldwide dental implant market Sargon would have gained had USC completed a favorable clinical study, and he calculated future profits based on that market share.

While assuming for purposes of its ruling “that a ‘market share’ analysis is appropriate and warranted under California law,” the court found that Skorheim’s “market share opinion is not based on any actual historical financial results or comparisons to similar companies, and therefore, is not based on matter of a type [on which] an expert may reasonably rely.”

Sargon’s Appeal of the Trial Court’s Order Excluding Expert Testimony

Sargon appealed the trial court’s order excluding Skorheim’s testimony. The court of appeal (Second District) overturned the exclusion of testimony order and found that “Sargon has the better argument” because of the difficulty in calculating claimed future lost profits. “We acknowledge the difficulty in determining lost profits when an established business is built upon the sale of an innovative, revolutionary, or world-changing product. The factor of innovation - what the trial court described as a ‘beauty contest’ - is not easily converted into dollars and cents. But exactitude is not required.”

California Supreme Court Overturns the Court of Appeal and Upholds the Original Order Excluding Speculative Expert Opinions

The California Supreme Court noted at the outset of its opinion that the case involved the intersection of two legal principles: (1) expert testimony must not be speculative and (2) lost-profit damages must not be speculative. Moreover, the Supreme Court emphasized that the trial court serves a gatekeeper role against speculative or irrelevant expert opinion. Under California Evidence Code sections 801 (b) and 802, the trial court acts as a gatekeeper to exclude expert opinion testimony that is (1) based on matter of a type on which an expert may not reasonably rely, (2) based on reasons unsupported by the material on which the expert relies or (3) speculative. The high court warned, however, that the gatekeeper’s focus “must be solely on principles and methodology, not on the conclusions that they generate.”

In addressing the calculation of lost profits, the Supreme Court cited to the general rule that “no damages can be recovered for a breach of contract which are not clearly ascertainable in both their nature and origin.” (Civ. Code. § 3301; see Greenwich S.F., LLC v. Wong (2010) 190 Cal.App.4th 739, 760.) Regarding lost business profits, the cases have generally distinguished between established and un-established businesses, recognizing that the practical burden of proving profits for the latter is often more difficult.

Applying these principles to the case at hand, the Supreme Court reasoned that the flaw in Skorheim’s opinions was that he relied “on data that in no way is analogous to Plaintiff.” The expert assumed that Sargon was comparable to the “big six” of established implant companies rather than smaller ones it more closely resembled. The expert also calculated lost profits based on market share that had never been achieved as well as assumed the share would have grown “spectacularly over time to levels far above anything it ever had reached.” The Supreme Court concluded that the trial court properly found that the expert's methodology was too speculative to be admissible into evidence.

In a colorful portion of her opinion, Justice Chin likened the expert’s projections to other speculative and counterfactual “what-if” scenarios, including: What if a star linebacker had not been injured – would his team have advanced to the Super Bowl and thereby generated greater profits for its owners? What if Alexander the Great had been killed in the Battle of Granicus River – would Greece had expanded its empire as far? Coming to a conclusion in any counterfactual scenario suffers from speculation, including the plaintiff's claim for more than $1 billion in lost profits based on market share it never acquired.

Conclusion

Defendants will undoubtedly rely on Sargon v. USC in an effort to exclude speculative or overly “innovative” expert opinions in a wide range of business disputes. The decision will have the greatest impact in cases involving breach of contract or the often-pleaded business torts such as negligent and intentional interference with prospective business advantage. All told, this is a favorable decision for defendants in California, the land of the startup enterprise.