Australia: The Use Of Financial Modelling In Expert Evidence

Last Updated: 11 January 2004

Article by Sid Wang and Jacqueline Deane

Key Points:

  • Caution needs to be exercised when experts employ "modelling" techniques in reports which are prepared for the purpose of establishing quantum of economic loss.
  • The validity of the assumptions used by the expert in the model will need to be proved, either through the expert providing the report, or another expert or lay witness.

Recently, a Federal Court Judge in South Australia was quite critical of the use of financial modelling by an expert in a report provided to the Court to assess the amount of loss of profits.

Financial modelling is a technique employed by forensic accountants which involves the construction of a model based on historical data to simulate and forecast the future. When used to calculate the quantum of damages in litigation the forensic accountant compares the actual profitability of the plaintiff that resulted after, and which was caused by, the violation of its rights, with the hypothetical financial position of what would have resulted had that violation not occurred. There is a comparison of what did happen, with what would have happened but for the intervening event. The model must take account of the possibility that the plaintiff could have mitigated its losses, or that the losses were not caused by the breach.

The case of Dowdell v Knispel Fruit Juices Pty Ltd in the Federal Court in South Australia was a claim for damages which had been commenced as representative proceedings. Knispel Fruit Juices (trading as "Nippys") was the Respondent to a class action brought by persons who suffered injury after drinking fruit juice which had been infected with salmonella. The juice had been produced by Nippys and the source of the salmonella was found to be the oranges which had been supplied to Nippys by Peter and Theo Constas. The representative proceedings were settled and Nippys cross-claimed against Peter and Theo Constas.

Claims based on negligence and breach of statutory duty against Peter and Theo Constas were not successful, though the claim for breach of contract was successful. In addition to ordering that Peter and Theo Constas pay to Nippys the amount which Nippys had been ordered to pay to resolve the personal injuries claim bought against it in the class action, the Court ordered that Nippys was entitled to payment for a sum for loss of profits suffered by it as a result of the salmonella outbreak.

Evidence was given by officers of Nippys of the financial operations of Nippy's Fruit Juices, the evidence of the loss suffered and the circumstances giving rise to the losses. In order to assess the quantum of damages referable to loss of profits each of the parties (Nippys and the Constas) called expert witnesses. These experts were called to explain what the evidence of the company officers meant in terms of the assessment of the quantum of damages. Each of the expert witnesses used a modelling technique to assess the amount of the loss of profits. The technique employed by the experts was to model what the profits of a business would have been based on various assumptions.

The Judge was quite critical of the use of this modelling exercise and was concerned of the risk that the assumptions would not reflect any meaningful reality. The Judge also went so far as to say that, in this case, the modelling evidence was not evidence at all, but rather was, "submissions dressed up as evidence".

His Honour's critical stance resulted from problems inherent in the expert evidence that was led in this case. For example, one of the expert accountants had excluded from his analysis income from a particular source. Another expert had made various assumptions in his report that were simply not true. Figures were chosen and starting dates for analysis of past performance were chosen that were completely arbitrary, with no reasons given as to why they had been chosen. Another expert had made adjustments to deal with seasonal adjustments. However, that expert did not claim any expertise in relation to statistics and, in the absence of that expertise, was unable to explain that these adjustments had any validity. The Judge did find some of the experts' evidence in terms of marketing of the product to be useful.

His Honour was of the view that the assessment of damages should be a matter of law based on fact. Those facts are to be found in the evidence and the question of what that evidence means in terms of damages was said to be a matter for the Court. The Judge conceded that experts have a role to play in giving evidence as to assumptions used in a model. However, in this case the experts did not give evidence in relation to the assumptions made in the model and, in fact, those experts had no expertise to do so. Their evidence was largely limited to the modelling itself.

Because neither party objected to the evidence given by the experts of the other, the Judge heard what he described as purported evidence and accepted it as evidence, albeit not helpful evidence. He was critical of the exercise and stated that the trial had been prolonged because the parties had accepted the reports of the experts (based on the modelling technique) as evidence.

It would not appear that his Honour's comments are intended to convey that the reports of experts when assessing the quantum of a plaintiff's economic loss completely lack utility. However, they do serve to highlight the need to ensure that the assumptions made by an expert in the model on which the report is based are proved to be valid.

Accordingly, in cases in which it is necessary to employ a modelling technique, such as when it is necessary to prove expectation loss or loss of opportunity, it is essential that evidence is also led to support the assumptions on which the predictions in the modelling exercise are based. In some cases that evidence will be given by other witnesses, or experts other than the expert who provides the report on quantum of damages.

Equally, from a defendant's point of view, any assumptions made by the plaintiff's expert must be carefully examined to determine whether there is a proper factual basis for them or whether they should be challenged by lay or expert evidence.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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