Sargon Enterprises, Inc. v. University of Southern California

Citations: 55 Cal. 4th 747; 288 P.3d 1237; 149 Cal. Rptr. 3d 614; 2012 Cal. LEXIS 10713Docket: S191550

Court: California Supreme Court; November 26, 2012; California; State Supreme Court

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Sargon Enterprises, Inc., a small dental implant company, has filed a lawsuit against the University of Southern California (USC) for breach of contract related to clinical testing of its patented dental implant. Sargon, which reported net profits of $101,000 in 1998, claims damages for lost profits ranging from $200 million to over $1 billion, arguing that it would have become a leader in the dental implant industry without USC's breach. The trial court excluded expert testimony regarding these lost profits as speculative, asserting that while lost profits do not require precise calculation, they must be grounded in non-speculative evidence. The court upheld its discretion to exclude opinions about Sargon's potential extraordinary success due to the breach. The Court of Appeal previously reversed this decision, stating the trial court erred in excluding the lost profit evidence based on foreseeability. 

The factual backdrop includes Sargon obtaining FDA approval for its innovative one-stage implant in 1991, which simplified the implantation process compared to the traditional Branemark implant. In 1996, Sargon entered a five-year clinical study agreement with USC, which later failed to fulfill its reporting obligations after initial success in trials. The jury found USC liable for breach of contract, awarding Sargon $433,000 in damages, but this judgment was later reversed by the Court of Appeal. The Supreme Court of California is now tasked with determining the correctness of the trial court’s exclusion of speculative lost profit testimony.

The in limine hearings addressed foreseeability rather than the quantification of lost profit damages, making it premature to ascertain if such damages could be calculated with reasonable certainty. Following the remand, a retrial occurred on Sargon Enterprises' breach of contract claim, during which the University of Southern California (USC) sought to exclude expert testimony from James Skorheim as speculative. An eight-day evidentiary hearing was held, with Skorheim being the main witness. Skorheim, a certified public accountant and attorney with 25 years of experience, estimated Sargon's lost profits to range between $220 million and $1.18 billion. His analysis incorporated litigation materials, financial data from Sargon and competitors, and market studies prepared by Millennium Research Group, employing a market share approach to determine potential profits had USC conducted a favorable clinical study.

Skorheim highlighted the dental implant industry's historical context, noting limited market penetration in the early 1990s, with only 1% of potential patients receiving products, presenting significant growth opportunities. He referenced a projected annual market growth rate of 18.5% from 1998 to 2009, with immediate load implants anticipated to grow substantially. By 2009, such implants were expected to comprise 14.9% of the U.S. market, up from 0.4% in 2000. Sargon's innovation in immediate load implants was seen as a potential catalyst for rapid market share acquisition, especially given that all major competitors, except Nobel Biocare, were relatively new. Skorheim identified three critical factors for success in the dental implant industry: innovation, clinical studies, and outreach to general practitioners, underscoring the dual benefits of clinical studies for establishing device efficacy and facilitating educational integration into dental practices.

Skorheim opined that the clinical success of the Sargon implant would likely translate into commercial success, emphasizing that innovation is crucial for market success and revenue generation. He noted that the dominant players in the dental implant industry, referred to as the "Big Six" (Nobel Biocare, Straumann, Biomet 3i, Zimmer, Dentsply, and Astra Tech), control over 80% of global sales and are the leading innovators. In contrast, he characterized smaller companies as "copycats" and "price cutters" that lack genuine innovation. 

During cross-examination, Skorheim acknowledged that the Millennium report did not explicitly state that the Big Six were the most innovative; this was an inference he made based on their market performance. He claimed that while smaller companies often assert innovation, their market share does not support these claims. Skorheim maintained that market dynamics ultimately determine what constitutes innovation, as evidenced by companies being rewarded for their innovative products. 

Despite acknowledging Sargon's limited resources and small size, with its peak annual profits around $101,000 in 1998, he argued that these factors were incidental and did not hinder Sargon's potential for market share growth. He compared Sargon to the Big Six in assessing lost profits, believing that if the jury found the new implant to be a superior innovative product, Sargon had a strong chance of becoming a market leader within approximately ten years.

Skorheim predicted that one of the Big Six companies in the dental implant industry would likely have exited the market, allowing Sargon to emerge as a leading competitor. He emphasized that Sargon would need to invest heavily in research and development (R&D) to stay competitive, similar to the substantial investments made by the Big Six. Although Sargon was capable of utilizing its patented expandable root process for various applications, it lacked a significant R&D organization and a dedicated sales and marketing department. 

The Court of Appeal noted similarities and differences between Sargon and the Big Six, including their production of titanium implants, use of clinical studies, outreach strategies, and comparable pricing and cost structures. However, Sargon was not comparable to Astra Tech, the smallest Big Six member, on any objective business metrics such as sales, employee count, or distributor numbers.

A detailed comparison chart presented in the court illustrated stark disparities in employee count, R&D expenditures, net sales, net profits, and assets between Sargon and its competitors. For instance, while Sargon had approximately 20 employees and $1.7 million to $1.8 million in gross revenue in 1998, competitors like AstraZeneca boasted 55,000 employees and net sales exceeding $18 billion. Skorheim believed that Sargon, unlike other small companies, would have eventually become a market leader, achieving profits comparable to those of the Big Six.

In calculating Sargon's lost profits, Skorheim based his estimates on the profits of market leaders rather than Sargon’s past revenues, although he did account for its gross revenues from 1998. The Court of Appeal also mentioned that Nobel Biocare's acquisition of another company in 1999 enhanced its market share, and noted that Straumann had achieved a significant market share within a decade.

The trial court initially upheld USC's objection to Skorheim's testimony due to inconsistencies with his deposition and a lack of prior notice, which hindered USC's ability to cross-examine effectively. Nonetheless, the court allowed the testimony to be recorded. Skorheim, lacking expertise on Sargon's dental implant innovation, stated that the jury would need to assess Sargon's innovativeness. He could not provide a fixed sum for lost profits, indicating that the amount would vary based on the jury's perception of Sargon's innovation relative to market leaders.

Skorheim's damages model presented four alternative damage scenarios based on this assessment, establishing a hierarchy of innovativeness among comparator companies. The potential market shares for Sargon were as follows: 3.75% if deemed least innovative (like Astra Tech), 5% for lesser innovators (like Dentsply), 10% for mid-level innovators (like Biomet 3i), and 20% for the most innovative (like Nobel Biocare and Straumann). Skorheim assumed that higher market shares indicated greater innovation but acknowledged the possibility of exceptions.

He calculated lost profits from 1998 to 2009 and projected post-2009 losses, estimating that Sargon's profits could have reached $26 million under the least favorable scenario and $142 million under the most favorable scenario in 2009. The Court of Appeal summarized his calculations into a chart detailing lost profits across the four market share scenarios, with total potential lost profits ranging from $220 million to $1.2 billion depending on the jury's findings regarding Sargon’s innovation.

Additional testimony supported Skorheim's conclusion that innovation and clinical studies drive market share. Steven Hanson, former president of Calcitek, suggested that Sargon might have achieved a 15-20% market share if the USC study had been completed, though he did not conduct a market study or evaluate all necessary steps to realize that market share.

Robert Pendry, who worked with Straumann from 1992 to 2001 and Thommen Medical from 2002 to 2006, characterized the Sargon implant as 'absolutely revolutionary' and 'world-changing' upon its introduction in 1997-1998. Following an evidentiary hearing regarding USC's motion to exclude Skorheim's testimony, the trial court issued a 33-page ruling. It emphasized the importance of safeguarding juries from misleading data, referencing Judge Friendly's opinion on the issue. The court deemed Skorheim's reliance on data irrelevant to the Plaintiff's historical profits as unreasonable, concluding that his opinion on lost profit damages, potentially up to a billion dollars, was speculative. While the court acknowledged that a 'market share' analysis could be valid under California law, Skorheim's opinion lacked foundation in actual financial results or comparable businesses. His analysis was fundamentally flawed as it relied on unsubstantiated assumptions. The court also noted that Skorheim had introduced a new opinion at the hearing that was not disclosed in discovery and inconsistent with his previous statements. Ultimately, the court found that Skorheim's damage projections, which started from Sargon’s 1997 gross revenues of $1,700,000 and assumed a doubling in 1998 due to favorable studies, lacked factual support. It highlighted that his projections were significantly inflated compared to Sargon’s past performance and based on comparisons with large industry leaders that were fundamentally different from the Plaintiff in key aspects.

Skorheim's testimony indicated that among the 98 dental implant manufacturers, none could be identified that did not conduct clinical studies or target general practitioners, making these factors ineffective for comparison. He excluded smaller companies that also claimed innovation from his analysis, justifying the omission with the statement, "The proof is in the pudding," indicating that market acceptance determines innovation. The court criticized this reasoning as circular and noted that characteristics cited by Skorheim to establish similarity between the Plaintiff and industry leaders were common across most implant companies, rendering them insignificant for comparison. The court concluded that Sargon did not share relevant objective similarities with industry leaders and found this dissimilarity sufficient to exclude Skorheim's testimony.

Furthermore, the court identified issues with Skorheim’s evaluation of "degrees of innovation," stating that his approach lacked rational standards and was speculative, failing to assist the jury in making informed decisions. The potential market share percentages presented to the jury (ranging from 3.75% to 20%) were deemed problematic due to the absence of a rational basis for determining how to rank the Plaintiff's product against competitors. The court emphasized that any claims of relative innovativeness must be substantiated by evidence, asserting that without clear standards, the proposed market share rankings lacked validity.

The factual basis for ranking companies by innovativeness is solely derived from Dr. Lazarof’s opinion, with no evidence supporting that one company is inherently more innovative than another beyond their market shares. Mr. Skorheim’s observations suggest that smaller companies claiming innovation were excluded from his 'industry leader' list because the market did not support their claims. He posits that true innovation is reflected in sales and market share, implying that larger market shares equate to greater innovativeness, a conclusion the court deems tautological and lacking rational basis. The court argues that determining the most innovative product is subjective, dependent on individual practitioner and patient preferences, and that no jury, regardless of time, could adequately assess relative innovativeness due to its inherently subjective nature. Various implants serve different needs, with companies like Astra Tech offering products with specific advantages, but the subjective nature of "better" or "more innovative" means that no clear standard exists for juries to base their decisions upon. The court contrasts this with objective assessments in products liability cases, emphasizing that while juries can evaluate defects based on industry standards, they cannot objectively determine superiority between products. An analogy is drawn to a hypothetical scenario involving Miss Oklahoma, illustrating that while a jury could assess damages from a breach of contract, it could not speculate on her potential success in a competition had circumstances been different.

Juries can adjudicate complex issues, including comparative fault, guided by jury instructions and relevant case law. However, the court ruled that attempting to rank innovativeness is inherently subjective and speculative, similar to judging a beauty pageant. The court emphasized that determining the value of an implant is a market-driven decision, not one for a jury, and any potential damages exceeding a billion dollars based on speculative evidence are inadmissible. The court found that Mr. Skorheim lacked the qualifications to assert that, absent the defendant's breach, the plaintiff could have achieved market parity with leading companies like Nobel Biocare, which employed extensive sales strategies. Skorheim's assumptions about the plaintiff's future success and product development were deemed unsubstantiated and based on wishful thinking rather than factual evidence. Furthermore, his analysis failed to account for competitive market dynamics, leading to unrealistic expectations. The court concluded that expert testimony on lost profits must be grounded in historical performance or comparative analysis with similar companies, adhering to established legal standards.

A party cannot create its own comparison factors for jury evaluation of corporate similarity, as this undermines objective standards and may lead to arbitrary conclusions. In this case, expert Mr. Skorheim's criteria suggested that Sargon, a small company, was similar to much larger corporations, which is untenable. He disregarded historical performance and relevant size comparisons, opting instead to juxtapose Sargon with multinational giants, rendering his criteria vague and legally irrelevant. The court determined that Skorheim's opinions lacked a reasonable expert basis and did not reliably demonstrate lost profits. Consequently, the court excluded his testimony and ruled in favor of USC's motion.

Following this, the parties agreed on a $433,000 judgment for Sargon’s breach of contract claim, but Sargon appealed. The Court of Appeal, by a two-to-one decision, reversed the judgment, asserting that the trial court erred by excluding Skorheim's testimony. It acknowledged Sargon’s revenues in 1998 and noted that Astra Tech, a company used by Skorheim for comparison, had a revenue level that made it sufficiently similar to Sargon to warrant jury consideration. The appellate court emphasized that lost profits can be established through comparisons with similar companies, rather than requiring perfect similarity. Skorheim’s expert opinion was based on various relevant data sources, including Sargon's historical financial data. The trial court's exclusion of such evidence effectively barred lost profits claims in cases involving innovative products. The court also noted that USC's alleged interference hindered Sargon's ability to prove lost profits, further complicating the evidentiary challenges faced.

The trial court's criticisms of Skorheim's testimony were deemed appropriate for jury evaluation. Justice Johnson dissented, arguing that the trial court should determine the threshold for admitting evidence related to lost profit damages, as the law lacks precise parameters. He praised the trial court's methodical examination of contract law and its reasoning regarding lost profits, asserting that the trial court did not act arbitrarily or capriciously. Johnson expressed skepticism about Skorheim's optimistic market projections but maintained that the trial judge's authority in evidentiary matters should be respected. The dissent emphasized that the trial judge's ruling was clear and reasonable, supporting Johnson's position to affirm the exclusion of Skorheim’s testimony. The case involves the principles that expert testimony and lost profit damages must not be speculative. The discussion cites the need for careful consideration of what constitutes admissible evidence, particularly in avoiding misleading impressions of precision, as highlighted by Judge Friendly’s historical comments on evidence standards. This caution applies equally to both federal and California law.

California law mandates that trial courts fulfill a significant 'gatekeeping' role concerning expert testimony, as outlined in Evidence Code section 801. Expert opinions must relate to subjects beyond common experience and be based on reliable matters that experts can reasonably rely on, barring any legal restrictions on such matters. Courts are tasked with evaluating whether the materials an expert uses to form an opinion are appropriate and reliable. The court in Lockheed Litigation Cases clarified that an expert’s opinion is valueless if it stems from an unsound basis, emphasizing that the relevance and soundness of the underlying matter must support the specific opinion presented. Moreover, expert opinions cannot be founded on speculation or conjecture, as irrelevant or speculative information is inadmissible. The California Law Revision Commission has underscored that an expert may not base opinions on comparisons that lack reasonable comparability. Therefore, under Evidence Code section 801, trial courts are responsible for excluding expert testimony that does not meet these criteria to ensure that the testimony assists the trier of fact effectively.

Evidence Code sections 801 and 802 outline the trial court's gatekeeping role regarding expert testimony in California. Section 801 governs the acceptability of the type of information the expert relies on, while section 802 allows the court to examine the reasons behind the expert's opinion. Section 802 permits the trial court to assess whether the expert's reasoning is supported by the underlying material and to exclude testimony if there is a significant analytical gap between the data and the opinion. The court may also consider case law restrictions when determining the admissibility of expert testimony. The trial court must be cautious not to dismiss expert testimony based solely on competing opinions, as its role is to evaluate the principles and methodologies rather than the conclusions drawn from them. The guidance from Daubert emphasizes that the focus should remain on the reliability of the methods used rather than the opinions themselves.

A trial court's ruling that an expert's testimony is reliable does not imply that contradictory expert testimony is unreliable. In *People v. Leahy* (1994), the California Supreme Court maintained that the "general acceptance" test for the admissibility of expert testimony based on new scientific techniques remains applicable in California, despite the U.S. Supreme Court's rejection of a similar standard in federal courts (as seen in *Daubert v. Merrell Dow Pharmaceuticals*). The broad nature of the amendment allows for the inclusion of testimony derived from competing principles or methods within the same field of expertise.

The trial court's initial assessment focuses on whether the expert's opinion is founded on sound logic, without weighing its persuasiveness or substituting its own opinion. The court does not settle scientific disputes but conducts a limited inquiry to determine if the supporting studies and information sufficiently validate the expert’s theory or technique. The primary aim of trial court gatekeeping is to exclude "clearly invalid and unreliable" expert opinions, ensuring that expert testimony reflects the intellectual rigor typical of the relevant field.

While appellate review of a trial court's decision to exclude or admit expert testimony is for abuse of discretion, a ruling may be deemed an abuse if it is so irrational that no reasonable person could agree with it. However, a trial judge's discretion is not boundless; it must adhere to applicable legal principles. Thus, if a ruling lacks a reasonable basis, it is subject to reversal on appeal.

Discretion in legal actions is determined by the governing principles of law relevant to the case. Actions that exceed these legal boundaries are deemed an 'abuse' of discretion. The legal standards guiding discretionary actions are context-dependent, rooted in common law or statutes. To assess whether a court has abused its discretion, one must evaluate the legal principles and policies that should have influenced the court's decisions. 

In this context, the focus is on a trial court's exercise of discretion in excluding expert testimony, which must align with legal limits. The review of the court's ruling involves ensuring it falls within the permissible scope of discretion.

Regarding lost profits as damages for breach of contract, they are recoverable if their occurrence and extent can be established with reasonable certainty, although not necessarily with exact mathematical precision. This requirement is rooted in Civil Code 3301, which stipulates that damages must be clearly ascertainable in nature and origin. Established businesses can claim lost profits due to interruptions in operation, as these can often be inferred from historical business data. Conversely, unestablished businesses cannot recover lost profits because such losses are too uncertain and speculative.

Anticipated profits, typically viewed as conjectural and speculative, can be admissible if supported by reasonably reliable evidence. In cases where the fact of damages is established, the exact amount does not require absolute certainty; a reasonable basis for computation suffices, and approximations are acceptable, especially if the defendant's wrongful conduct hampers the accurate calculation of lost profits. In *GHK Associates v. Mayer Group, Inc.*, the court allowed profit calculations based on actual income. Conversely, in *Greenwich S.F. LLC v. Wong*, lost profits claimed from a breach of a sales agreement were deemed uncertain and speculative, as the plaintiffs failed to demonstrate a history of successful property development. The projections relied on assumptions about construction and profitability that were inherently uncertain due to numerous variables. The court emphasized that while lost profit inquiries are always somewhat speculative, courts should not dismiss expert evidence solely because it lacks absolute certainty, as only a reasonable certainty is necessary. The case at hand focuses on whether the court improperly excluded expert testimony, with substantive law on lost profits guiding what an expert may rely on.

Lost profits can be substantiated through expert testimony, economic data, market analyses, and business records, but must show significant similarity to the underlying business opportunity lost. In the case discussed, the trial court found that the expert, Skorheim, relied on data that was not comparable to the plaintiff’s situation. Consequently, the court correctly excluded his testimony, as it was not based on reliable data that an expert could reasonably use to form an opinion (Evid. Code § 801, subd. b). The court's ruling was deemed rational and not arbitrary, having conducted a thorough evidentiary hearing. The Court of Appeal found no specific error in the trial court’s decision.

Additionally, the trial court ruled that Skorheim's methodology was overly speculative. Although a market share approach could be valid under certain circumstances, Skorheim's estimates were founded on a hypothetical increase in market share that Sargon had never achieved. He incorrectly posited that Sargon was comparable to leading dental implant companies based solely on his belief in Sargon's innovation, disregarding objective metrics like sales or employee count. The court noted that his reasoning was circular, concluding that smaller companies were unsuccessful due to a lack of innovation, which was a flawed basis for comparison. This circularity was a valid reason for excluding his testimony under Evidence Code § 802.

Skorheim's estimates linked a company's level of innovation to its market share, suggesting that if Sargon had innovation akin to the smallest of the Big Six companies, it would only hold a corresponding market share. He detailed a hierarchy of innovation, where greater innovation correlates with increased market share and future profits. However, the trial court noted that Skorheim’s model required evidentiary support for this ranking, particularly proving that Nobel Biocare was significantly more innovative than its competitors, which Skorheim failed to establish. He acknowledged that a company with a smaller market share could still be more innovative than one with a larger share. The court critiqued Skorheim’s reliance on market observations to support his rankings, emphasizing that market acceptance of a product does not inherently validate its innovativeness. The court concluded that Skorheim's basis for ranking innovativeness against market share lacked rational support. Sargon argued its established profit record should bolster its claims; however, it lacked a history as a global leader comparable to the Big Six. The court referenced *Parlour Enterprises, Inc. v. Kirin Group, Inc.*, which reversed a multimillion-dollar lost profit award due to speculative expert testimony that failed to appropriately compare businesses, highlighting the necessity for evidence of similarity before using analogous businesses to prove prospective profits.

A substantial similarity exists between the facts underlying profit projections and the destroyed business opportunity, as noted in the referenced case. Unlike the larger companies, Sargon was not similar to the industry leaders in any relevant business measure. Skorheim's belief in Sargon's innovation did not hold against objective data, as his lost profit estimates lacked foundation in any historical business volume or relevant data for future sales. The trial court highlighted that Skorheim's projections were excessively inflated compared to Sargon's past performance. 

While the majority opinion stated that reasonable certainty in estimating lost profits suffices for recovery, the issue here was whether Skorheim’s methodology was logically sound. The court emphasized that a potential award of up to $1 billion could not be based on speculation. The Court of Appeal found a closer analogy in the case of Palm Medical Group, where the plaintiff's expert used the clinic's own profit margins and comparisons with similar clinics, which were valid. In contrast, the trial court correctly discerned that Sargon was not comparable to the Big Six.

Sargon's reference to Sanchez-Corea v. Bank of America was also deemed inappropriate. In that case, the court supported a damage award based on the plaintiff's historical growth, which was not contested by the defendant. The court did not discuss comparisons to larger companies, and the precedent has not been cited for such comparisons. Ultimately, the trial court noted that Skorheim's testimony was speculative in multiple respects.

Sargon lacked essential marketing and research and development departments, which were critical for competing with the established Big Six companies. The assumption was made that one of the Big Six would exit the market, allowing Sargon to take its place, and that the Big Six would not respond to Sargon as a new competitor. The trial court found Skorheim's testimony, which claimed Sargon would likely become a market leader within ten years, to be inherently speculative and not sufficiently grounded in historical data, thus supporting its exclusion. The court referred to the legal standard for lost profits, which must be "reasonably certain" to be recoverable, as established in prior case law. The complexities and numerous variables in predicting Sargon's future market performance rendered any calculations of lost profits uncertain. Analogies were drawn to hypothetical scenarios in sports and publishing to illustrate the challenges of predicting outcomes based on speculative expert testimony. The court emphasized the importance of a trial court's gatekeeping role in ensuring that testimony regarding future projections is based on logical foundations and historical precedents. Ultimately, while an accountant could estimate Sargon's potential profits had it achieved a market share similar to the Big Six, Skorheim's testimony failed to provide a credible basis for inferring that Sargon would attain such market position.

The trial court's ruling was supported by the lack of sound methodology in the expert's testimony regarding future projections. The Court of Appeal expressed concern that the ruling could effectively prohibit claims for lost profits in cases involving industry breakthroughs. However, alternatives exist to demonstrate lost profits, such as using actual profits, comparisons with similar companies, or other objective evidence. Sargon claimed that the record included evidence of specific lost sales and canceled contracts due to USC's failure to complete a study, which could substantiate lost profit estimates. The trial court's decision indicated that Sargon could not claim excessive damages based on speculative future success.

Additionally, the trial court had determined that some evidence was insufficient to support a claim of intentional interference with prospective economic advantage, finding no link between lost sales and USC’s actions. The implications of this ruling on a lost profit claim were unclear and not under appeal. The trial court acted within its discretion as a gatekeeper to exclude speculative expert testimony, a conclusion the Court of Appeal majority misjudged. The judgment of the Court of Appeal was reversed and the case remanded for further proceedings consistent with this opinion.