'EVENT STUDY' TOO SPECULATIVE TO PROVE DAMAGE TO PRODUCT'S REPUTATION

August 4, 2004

Steven P. Garmisa
Hoey & Farina Attorney
garmisa@hoeyfarina.com
1-888-425-1212

The reputation of a brand of products can be damaged if the manufacturer uses a defective component. But, in a lawsuit against the supplier of a defective component, how does the manufacturer prove this kind of reputational injury?

That was the key question for a claim filed by several companies that manufacture water heaters. These firms, referred to as "the Tank Manufacturers," attempted to prove damage to the reputation of their products in a case against a company that supplied a defective component by hiring an economist to perform the kind of "event-study methodology" that is used in proving damages in securities cases involving so-called fraud on the market.

The late Cook County Circuit Judge Lester D. Foreman ruled that this evidence was too speculative to support a claim for reputational injury to a brand of products, and the Appellate Court affirmed, with an opinion that provides useful insight into event-study analysis. Perfection Corp. v. Lochinvar Corp., 2004 WL 1373728 (1st Dist., June 18).

The Tank Manufacturers filed a claim against Perfection Corp. -- the company that manufactured defective "dip tubes" that were used as a component in water heaters. In addition to other damages incurred by the Tank Manufacturers, they allegedly suffered damage to their "brand" reputations. But the hard part was in quantifying the alleged reputational damage.

The Tank Manufacturers hired an economist to perform an event-study analysis, but Foreman concluded that this methodology was too speculative to prove the claimed reputational injury.
Here are some highlights of Justice Calvin C. Campbell's opinion (with various omissions not noted in the quoted text):
"Dr. Williams, a professor and economist, employed a technique called the 'event-study methodology' to analyze whether Tank Manufacturer A.O. Smith, a publicly traded company, suffered damage to its reputation as a result of public comments relating to the dip-tube litigation and, if so, to quantify the magnitude of any such damages.

"Dr. Williams described the event-study methodology as a 'commonly and widely accepted method used by economists to estimate the change in the market value of a company as reflected in the change in the market value of the company's equity.'
"Dr. Williams explained that the event-study methodology is 'based on the widely accepted principle that publicly available information relevant to the valuation of a company is rapidly incorporated into stock prices such that the market value of a company's equity responds quickly to information that is relevant to the company's market value.'

"An 'event' is an informational disclosure, such as an appearance in a newspaper, television or radio. Dr. Williams established an 'event window,' i.e., the period of time over which that disclosure is deemed to have an 'effect.' Dr. Williams described the methodology as using 'statistical techniques in order to isolate stock price effects resulting from relevant information disclosures, in this case those related to defective dip tubes, as opposed to general market-wide stock price movements or random variance in stock prices.'

"In other words, Dr. Williams calculated the 'loss' based on the 'event.' Dr. Williams explained that a premise of the event-study methodology is that the market value of a firm, the sum of the value of all of its assets, broadly defined, is equal to the market value of its equity plus the market value of its debt.

"Dr. Williams analyzed the measure of changes in the price of A.O. Smith's publicly traded stock during three separate three-day periods and determined that a decline in the stock price was solely the result of two newspaper reports in the Kansas City Star and a local Detroit radio broadcast about the dip-tube claims and class-action litigation against the Tank Manufacturers (the 'events').

"For each event, Dr. Williams calculated the total change in the closing stock price of A.O. Smith for the three-day period from what he deemed public dissemination of these local media reports. He then translated the net change in stock price of A.O. Smith into a change in the aggregate 'market value' of the company's stock by multiplying the per share price change by the number of shares outstanding.

"In rendering his opinion, Dr. Williams produced his calculations of the change in A.O. Smith's stock value for the three separate three-day periods selected between March 1999 and April 2000. Dr. Williams totaled these amounts and concluded that, on these nine days, A.O. Smith's stock value had decreased by over $115 million. Deducting all non-reputational damage claims that A.O. Smith asserted in the counterclaim, i.e., its alleged direct costs, Dr. Williams reduced his aggregate stock value decrease to $80 million and identified this result as A.O. Smith's 'reputational' or 'brand' damage.

"None of the other Tank Manufacturers are publicly traded and there is no published source of their stock prices. Dr. Williams therefore extrapolated the A.O. Smith stock price study to the other four corporate counter-claimant Tank Manufacturers, and assumed a 'reputational' impact proportionately equal to that calculated for A.O. Smith stock.

"Totaling the figures for each corporation under five alternate methods of comparison, Dr. Williams estimated that the 'average' aggregate business reputation damage allegedly incurred by the Tank Manufacturers was $195 million."

"Initially, the Tank Manufacturers contend that the trial court erred in granting summary judgment in favor of Perfection and in ruling that Dr. Williams' expert opinion was inadmissible under Frye v. U.S., 54 App. D.C. 46, 293 F. 1013, 34 A.L.R. 145 (D.C. 1923).

"The Tank Manufacturers argue that under Frye, expert opinion is admissible if it is based upon a generally accepted methodology or technique (Donaldson v. Central Illinois Public Service Co., 199 Ill.2d 63, 76-77 (2002)), and that Williams' event study is an accepted method of determining loss of profits as a result of damages to reputation.

"The Tank Manufacturers argue that Donaldson supports their position that the event-study methodology is generally accepted. In Donaldson, the plaintiffs, four sets of parents of children, brought an action against the defendant, the owner of a former manufactured gas plant, alleging that certain acts or omissions by the defendant and its contractors during the cleanup of the site certain chemicals and dusts emitted from the ground, causing their children to develop neuroblastoma, a rare form of cancer.

"The trial court allowed expert opinion testimony about a new medical epidemiological inquiry to establish a cause-and-effect relationship between coal tar and neuroblastoma; all of the experts utilized the method of 'extrapolation' a generally accepted method used in the fields of medical and scientific research. The defendant argued that the conclusion of the experts, that coal tar caused the cancer, was not generally accepted in the scientific community.

"This court disagreed with the defendant, and the Supreme Court affirmed, holding that 'the Frye standard does not demand unanimity, consensus or even a majority to satisfy the general acceptance test.'

"Perfection responds that the Tank Manufacturers misconstrue the ruling of the trial court. Perfection argues that the trial court did not find Williams' expert testimony inadmissible but, rather, granted summary judgment to Perfection because the Williams' evidence of damages to the Tank Manufacturers' reputation was speculative.

"In other words, summary judgment is proper because there is no disputed fact that the Tank Manufacturers cannot show the existence of lost profits as a result of damage to their reputation, notwithstanding the methodology used.

"The present case is distinguishable from Donaldson in this important aspect: In Donaldson, there was no dispute over the evidence that the children suffered from cancer, only whether the cause could be linked to the coal tar leakage.

"The party who seeks damages has the burden not only to establish that he sustained damages, but also to establish a reasonable basis for computation of those damages. Damages may not be awarded on the basis of speculation and conjecture.

"The present case is distinguishable from Donaldson in one important aspect: In Donaldson, there was no dispute over the evidence that the children suffered from cancer, only whether the cause could be linked to the coal tar leakage.

"The Tank Manufacturers' 'evidence' of consumer complaints and news media coverage about the failure of dip tubes does not constitute actual financial damages to their respective companies as a result of 'aspersions cast' upon them by these sources.

"We agree with Perfection that whether the event-study methodology is an accepted theory under Frye is not a dispositive issue in the present case.

"The event-study methodology has been universally rejected by federal courts in lawsuits for restitution other than securities fraud class-action litigation. In LaSalle Talman Bank F.S.B. v. U.S., 45 Fed.Cl. 64 (1999), affirmed in part and vacated in part on other grounds, 317 F.3d 1363 (2003), the federal appeals court ruled that the government was not permitted to use event-study methodology to disprove injury to Talman Bank as a result of the government's breach of contract with Talman under the Financial Institutions Reform, Recovery and Enforcement Act of 1989.

"The government contended that an analysis of the impact of FIRREA on the value of Talman's outstanding common stock demonstrated that no damages were due. In support, an expert witnesses testified that an event study of Talman's stock price in the two-week period surrounding the date of enactment of FIRREA demonstrated that plaintiff's market value increased as a direct result of the statute's enactment.

"The court rejected defendant's event-study argument, finding it 'flawed conceptually.' The court declined to accept 'this novel method of determining damages for breach of contract, either as a method of determining quantum per se, or as means of refuting plaintiff's calculations of damages under standard contract damages theories.'

"While acknowledging that event studies are 'a widely used tool in the academic field of economics to assess the impact of an event upon the value of a company's stock,' courts have frequently adjudicated breach of contract claims involving companies that are publicly traded and have done so without resorting to the use of event studies.

"The court noted that the government failed to cite any cases in which a court has adopted an event study to determine the quantum of damages for breach of contract. Courts which have adopted event studies have done so only in stockholder class-action or derivative suits alleging fraud on the market.

"In these cases, plaintiffs alleged fraud on the market: fraudulent misrepresentation or concealment of information regarding the defendant that improperly affected its stock price, to the injury of investors who were not aware of the fraud. The plaintiffs alleged they were harmed by purchasing stock at an inflated price, which they could not later recoup after the fraud was discovered.

"The courts considered event-study analysis to support or refute plaintiffs' claims that stock price movements were caused by the fraudulent acts and to measure the quantum of damages. The LaSalle court concluded: 'This methodology has never been employed to limit damages in the context of a breach of contract claim brought by a corporate plaintiff, as far as the court is aware. We see no reason to extend this concept to the case at hand, and decline to do so.'

"Here, the Tank Manufacturers have presented no evidence that they have suffered economic damage to their business reputations in any amount, let alone $182 million. The record shows that representatives of four Tank Manufacturers testified that they could identify no lost customers, profits, declines in revenues or loss of sales as a result of the dip-tube failure and associated media coverage.

"A representative of Rheem [one of the Tank Manufacturers] testified in a deposition that its profits had increased during that period. The Tank Manufacturers' claims, therefore, are entirely dependent on Williams' testimony which is insufficient to show a link between a specific event and loss of profits.

"The 'event window' alleges injury only to shareholders, not to the corporation. We see no reason to detour from the route of the federal courts and follow their lead in declining to extend the event-study methodology to this case to calculate alleged damages to the concept of the 'good will' of the Tank Manufacturers.

"The Tank Manufacturers have failed to point to any evidence of tangible loss of profits. We therefore find that entry of summary judgment in favor of Perfection was proper."

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