Lost Profits Evidence Precluded for Failure to Disclose Calculation Under 26(A)(1)(C) — Automatic Nature of Sanctions under Rule 37(c)(1) —Factors — Good Quotes — “Abuse of Discretion” Defined — Design Strategy
Design Strategy, Inc. v. Davis, 469 F.3d 284 (2d Cir. 2006):
Plaintiff-counter-defendant-appellant Design Strategies, Inc. ("Design") appeals from a judgment entered in the United States District Court for the Southern District of New York (Marrero, J.). The action arises out of the alleged diversion of a corporate opportunity by defendant-counterclaimant-appellee Marc E. Davis ("Davis") during the course of his employment with Design. According to Design, the corporate opportunity was diverted to defendant-appellee Info Technologies Web Solutions ("IT Web"), with the collusion of defendants-appellees Info Technologies, Inc. ("Infotech") and John Goullet ("Goullet"), Chief Executive Officer of both Infotech and IT Web (collectively, the "IT Defendants"). Davis was employed by IT Web following the alleged diversion.
The District Court, in an order dated April 27, 2005, precluded Design from presenting evidence in support of its claim for lost profits, pursuant to Fed. R. Civ. P. 37(b), on the ground that it had not disclosed the computation of those lost profits, as required by Fed. R. Civ. P. 26(a)(1)(C). In that same Order, the District Court also rejected a demand by Design for a jury trial, the District Court having found that all of Design's remaining claims were "equitable" and therefore that no jury trial right existed. Following a bench trial, the District Court concluded, in an Order dated August 11, 2005, that Davis (a) had not diverted a corporate opportunity; (b) had not engaged in unfair competition; (c) had breached a fiduciary duty of loyalty, requiring the forfeiture of four weeks of salary; (d) was not liable for overpaid commissions; and (e) had not been unjustly enriched; and that (f) the IT defendants had not aided and abetted Davis's breach of fiduciary duty; and (g) a claim for punitive damages was unsupported. ***
I. Exclusion of Lost Profits Evidence
A. On October 22, 2002, Design filed its Initial Disclosure, as required by Rule 26(a)(1) of the Federal Rules of Civil Procedure. Design listed as claimed "damages":
1. All monies paid to Marc Davis for salaries based upon breach of fiduciary relationship with Plaintiff.
2. All monies earned by Marc Davis as a result of unlawful diversion of business from Design Strategy to the corporate Defendants.
3. All profits earned by the Defendants as a result of the unlawful diversion of business from the Plaintiff to the Defendants, which business was generated with Microsoft Corporation.
4. Attorneys' fees for the prosecution of this action.
5. Punitive damages.
6. Interest costs and disbursements.
The IT Defendants' First Set of Interrogatories and Request for the Production of Documents, dated November 5, 2002, requested a statement
in detail [of] each financial expense or loss allegedly incurred by plaintiffs as a result of any acts or omissions of [the] IT Defendants in this action[,] giving:
(a) a description of its nature; (b) the amount; (c) the date incurred; (d) the amount of similar estimated future expenses or losses, if any.
Design responded to this request on March 26, 2003, repeating the language of its Initial Disclosure, and adding the descriptive category of "[l]oss of sale of Design Strategy," under which it affixed various "not less than" amounts for each descriptive category of claimed "damages."
Well after the close of discovery, in a proposed pretrial order submitted shortly before trial, Design disclosed two witnesses -- one of whom it disclosed as an expert witness -- to testify regarding Design's "lost profits." The defendants filed a motion in limine to preclude Design from offering these witnesses or any other evidence of its lost profits on the ground that "lost profits" had not been listed as a category of claimed damages in Design's Initial Disclosure or at any point during discovery, and thus, the offering of evidence or testimony as to "lost profits" was in violation of Rules 26(a)(1)(C) and (a)(2). The District Court held a telephone conference on April 5, 2005, to resolve objections to these two witnesses and to resolve "a question concerning the evidence of lost profits and the extent to which damages can be proven in" this case. The District Court noted that
although Design indicated that it might seek lost profits by referring to lost revenues in the first cause of action in the [C]omplaint for breach of employment agreement and thereby arguably put the defendants on notice that lost profits might be sought, Design has not provided any specific computation of lost profits nor provided any evidence on the basis of which such computation might be made.
The District Court's written Order of April 27, 2005 further explained that Design's Initial Disclosure Statement, though describing the damages it sought with some specificity, did not mention lost profits. The District Court ruled that Design's failure to abide by Fed. R. Civ. P. 26(a)(1)(C) meant that evidence of lost profits would not be admissible.
Design objected that it had, in fact, turned over evidence from which a computation of damages could be made -- its financial records. When pressed, Design argued that it was not obligated to provide a calculation of damages because the calculation of damages from these records would be "simple arithmetic" -- "If our revenue is $ 100 and our expenses are $ 50, then we have a 50 percent profit margin, and that is the basis on which I would have our people testify." The District Court corrected Design, noting that Rule 26 required more of plaintiffs:
THE COURT: Mr. Dweck [Design's counsel], it is not as simple as simply providing the [financial statements] to the defendant without your providing as well a specific formula indicating how your theory of damages is supported. That is not something that the defendant is in a position to do for you.
The only way that you can establish that you suffered damages is to be able to set it forth in some theory and then support the theory with facts. Simply providing documents to the defendant and assuming that somehow the defendant will divine what your alleged lost profits are by having documents is not sufficient. This Court on that basis is persuaded that this record does not support that theory.
MR. DWECK: . . . I didn't think we were obligated to do their homework.
THE COURT: It is quite the opposite, Mr. Dweck. You, the plaintiff, are the one who [is] asserting the damages. If you assert the damages and you claim that you suffered a certain amount of injury, it is for you, you have the burden of proof on injury and the amounts thereof, and they have to be calculated with reasonable certainty. So your saying that you provided documents to the defendant doesn't go far enough in meeting your burden of proof on this issue.
In its written Order of April 27, 2005, the District Court again found that Design had not complied with Rule 26. The District Court determined that "Design has not provided any justification for its failure to disclose information regarding the amount of, or basis for computing, its alleged lost profits," noting specifically Design's failed argument at the telephone conference. The District Court further found that this failure was not harmless because discovery had been closed since October 2003 and because the trial date had already been postponed in part at Design's request. ***
The District Court also noted that
[i]n violating Rule 26(a)(1)(C), Design has also failed to provide the [c]ourt with any basis on which to determine whether or not its alleged lost profits are "capable of measurement based upon known reliable factors without undue speculation," Ashland Mgmt. Inc. v. Janien, 82 N.Y.2d 395, 403, 624 N.E.2d 1007, 604 N.Y.S.2d 912 (1993), as New York law requires. The absence of any basis on which to make this determination further supports the [c]ourt's holding that Design may not pursue a lost profits theory of damages at trial."
In a lengthy footnote, the District Court determined that it lacked discretion to decline to impose sanctions pursuant to Rule 37(c)(1). Specifically, the District Court held that
the plain language of Rule 37(c)(1), indicate[s] that, while trial courts have discretion to determine whether or not a substantial justification exists and whether or not a failure to disclose is harmless, if the trial court finds that there is no substantial justification and the failure to disclose is not harmless, preclusion is mandatory.
B. A district court has wide discretion to impose sanctions, including severe sanctions, under Federal Rule of Civil Procedure 37, and its ruling will be reversed only if it constitutes an abuse of discretion. See Patterson v. Balsamico, 440 F.3d 104, 117 (2d Cir. 2006) ("This Court reviews the district court's exclusion of testimony under Rule 37(c)(1) for abuse of discretion."); Daval Steel Products, a Div. of Francosteel Corp. v. M/V Fakredine, 951 F.2d 1357, 1365 (2d Cir. 1991) (discussing discretion under Rule 37(b)(2)). "A district court 'abuses' or 'exceeds' the discretion accorded to it when (1) its decision rests on an error of law (such as application of the wrong legal principle) or a clearly erroneous factual finding, or (2) its decision -- though not necessarily the product of a legal error or a clearly erroneous factual finding -- cannot be located within the range of permissible decisions." Zervos v. Verizon New York, Inc., 252 F.3d 163, 169 (2d Cir. 2001) (footnote omitted).
Design argues that it was not in violation of Rule 26(a)(1)(C) because "[i]n the instant action there was no direct order to the Plaintiff to calculate damages. The simplicity of taking Design's revenue and deducting the cost of operations from the financial statements would have yielded the gross profits." This is a misstatement both of the facts of this case and of Rule 26(a)'s requirements.
Rule 26(a)(1)(C) of the Federal Rules of Civil Procedure provides that
a party must, without awaiting a discovery request, provide to other parties: . . . a computation of any category of damages claimed by the disclosing party, making available for inspection and copying as under Rule 34 the documents or other evidentiary material, not privileged or protected from disclosure, on which such computation is based, including materials bearing on the nature and extent of injuries suffered . . . . (emphasis added).
The District Court's finding that Design had failed to comply with this rule was well within the proper range of its discretion.
First, as correctly noted by the District Court, nowhere did Design ever disclose "lost profits" as even a "category" of "damages" sought on its Initial Disclosure Statement. Although Design's Complaint does include a generic reference to "damages" in its Initial Disclosure, Design omitted any reference to its own lost profits as a measure of recompense, focusing instead on "monies earned" by the defendants. Moreover, the Record does not reflect any supplemental disclosures as required by Rule 26(e) of the Federal Rules of Civil Procedure. The defendants were, therefore, without notice that such claims would be an issue until they were provided, shortly before the commencement of trial, with the names of two witnesses who would testify as to lost profits.
Second, by its very terms Rule 26(a) requires more than providing -- without any explanation -- undifferentiated financial statements; it requires a "computation," supported by documents. The need for computation and supporting documents is especially necessary in a case like this, where the damages claim is for lost profits from a project of a type with which the plaintiff had little-to-no prior experience. Design's "simple arithmetic" calculation is wholly inadequate as a measure of damages, given that it is undisputed that, in order to perform on the project, Design would have had to establish an entirely new computer lab and hire all new personnel in the space of two weeks. At the late point in the proceedings when Design disclosed that it would be presenting lost-profits witnesses, much greater detail than previously provided would have been necessary to satisfy Rule 26(a). See City & County of San Francisco v. Tutor-Saliba Corp., 218 F.R.D. 219 (N.D. Cal. 2003) (recognizing that Rule 26(a)(1)(C) anticipates supplemental disclosures with ever-greater level of detail as discovery progresses).
Third, Rule 26(a) requires a party to provide a computation of any category of damages voluntarily, i.e., "without awaiting a discovery request"; Design's failure to comply with this requirement was especially troubling because, as noted by the District Court, the IT Defendants specifically requested a calculation of damages.
Fourth, Rule 26(a) requires a party -- in addition to providing a calculation of damages -- to make "available for inspection and copying as under Rule 34 the documents or other evidentiary material . . . on which such computation is based." The Advisory Committee Notes to Rule 26(a)(1)(C) accompanying its promulgation make clear that the rule "imposes a burden of disclosure that includes the functional equivalent of a standing Request for Production under Rule 34. A party claiming damages or other monetary relief must, in addition to disclosing the calculation of such damages, make available the supporting documents for inspection and copying as if a request for such material had been made under Rule 34." Fed. R. Civ. P. 26 Advisory Committee Notes to 1993 Amendments. Design failed to disclose both a calculation of damages and the documents supporting that calculation.
Design next argues that, even if it did violate Rule 26, the District Court applied the wrong standard to preclude its evidence under Rule 37. Specifically, Design asserts that, before a court may preclude evidence as a discovery sanction, it must find "bad faith and callous disregard of the Federal Rules." See DiPirro v. United States, 43 F. Supp. 2d 327, 340 (W.D.N.Y. 1999) ("Precluding expert testimony under [Rule 37(c)(1)] is a drastic remedy and should only be applied in cases where the party's conduct represents flagrant bad faith and callous disregard for the requirements of Rule 26(a)(2)(B)."). As noted above, the District Court decided there was no such requirement and observed that this Court had not yet passed on this issue. See Hein v. Cuprum, S.A., de C.V., 53 F. App'x 134, 137 (2d Cir. 2002) ("We express no opinion as to whether a showing of bad faith is required before evidence may be excluded under Rule 37(c)(1)."). Since Rule 37(c)(1) by its terms does not require a showing of bad faith, we now hold that such a requirement should not be read into the Rule.
In determining whether the District Court abused its discretion in imposing the sanction under Rule 37, we are governed by the standard set forth in Patterson v. Balsamico, 440 F.3d 104 (2d Cir. 2006). In Patterson, two defendants violated Rule 26(a)(3) by not timely disclosing the names of witnesses they planned to call at trial. Id. at 117. The District Court granted the plaintiff's motion to preclude, except as to one witness who was named in the original complaint and whose testimony reasonably could have been anticipated. Id. On appeal to this Court, we held that "[i]n determining whether the district court acted within its discretion, this Court [must] consider '(1) the party's explanation for the failure to comply with the [disclosure requirement]; (2) the importance of the testimony of the precluded witness[es]; (3) the prejudice suffered by the opposing party as a result of having to prepare to meet the new testimony; and (4) the possibility of a continuance.'" Id. (citing Softel, Inc. v. Dragon Med. & Scientific Commc'ns, Inc., 118 F.3d 955, 961 (2d Cir. 1997)) (brackets in Patterson). Thus, although a "bad-faith" violation of the Rule 26 is not required in order to exclude evidence pursuant to Rule 37, it can be taken into account as part of the party's explanation for its failure to comply.
Applying Patterson to this case, we cannot say that the District Court abused its discretion when it determined that the sanction imposed was warranted under Rule 37. Although the second Patterson factor favors Design because Design's evidence of lost profits was essential to proving these damages, all of the other factors weigh heavily in favor of exclusion. Design has not yet explained why it omitted "lost profits" as a category of damages in its Initial Disclosure. The prejudice to the defendants in having to prepare for this evidence would have been severe, as discovery would have had to be reopened to determine whether Design's calculations were proper. The "expert" witness that Design wanted to call also would have had to (a) prepare a report; and (b) be qualified as an expert with regard to the calculation of damages. Finally, weighing heavily on both the prejudice and possibility of continuance factors was the fact that discovery had been closed for "approximately one and a half years," and at the time of the offer of expert testimony there was only a "short time left before trial." On the facts before us, the District Court did not abuse its discretion in determining that sanctions, including severe sanctions, were warranted for Design's failure to abide by Rule 26(a)(1)(C).
The District Court did, however, err in its determination that "preclusion is mandatory" under Rule 37(c)(1) once "the trial court finds that there is no substantial justification and the failure to disclose is not harmless." The language in two cases from our sister circuits is in conformity with this viewpoint: Finley v. Marathon Oil Co., 75 F.3d 1225 (7th Cir. 1996), and Wilson v. Bradlees of New England, Inc., 250 F.3d 10 (1st Cir. 2001). In Finley, the plaintiffs failed to disclose "expert testimony intended for use as rebuttal evidence" to the defendants "within 30 days of the [defendant's] disclosure of his expert testimony" in violation of Fed. R. Civ. P. 26(a)(2)(C) -- indeed, the plaintiffs "missed the deadline [for disclosure] by months." Id. at 1230. The Seventh Circuit held that the district court in that case had not "abused his discretion in refusing to permit the introduction" of this evidence. Id. The Seventh Circuit reasoned that
Rule 37(c)(1) provides that "a party that without substantial justification fails to disclose information required by Rule 26(a) . . . shall not, unless such failure is harmless, be permitted to use as evidence at a trial . . . any . . . information not so disclosed" (emphasis added). The sanction of exclusion is thus automatic and mandatory unless the party to be sanctioned can show that its violation of Rule 26(a) was either justified or harmless.
Id. (alterations in original).
In Wilson, the plaintiffs disclosed two videotapes, prepared by expert witnesses, reenacting the injury-causing accident at issue in that case. Wilson, 250 F.3d at 18-19. These disclosures occurred months after the close of discovery. Id. In affirming the district court's exclusion of those two videotapes from evidence the First Circuit called Rule 37(c)(1)'s preclusion sanction "near automatic." Wilson, 250 F.3d at 20 (emphasis added). The First Circuit explained that
it is the obligation of the party facing sanctions for belated disclosure to show that its failure to comply with the Rule was either justified or harmless and therefore deserving of some lesser sanction. This is a burden that plaintiff made no attempt to shoulder, and the district court did not abuse its discretion in imposing Rule 37(c)(1)'s 'self-executing' sanction.
Id. at 21 (internal citations omitted). Both Finley and Wilson find some support in the 1993 Advisory Committee Notes accompanying Rule 37, which refers to Rule 37(c)(1) as an "automatic" sanction:
Paragraph (1) prevents a party from using as evidence any witnesses or information that, without substantial justification, has not been disclosed as required by Rules 26(a) and 26(e)(1). This automatic sanction provides a strong inducement for disclosure of material that the disclosing party would expect to use as evidence . . . .
Fed. R. Civ. P. 37 Advisory Committee Notes to 1993 Amendments (emphasis added). To the extent that the Advisory Committee Note calls Rule 37(c)'s exclusion of evidence "automatic," however, that characterization cannot be squared with the plain language of Rule 37(c)(1) itself. Rule 37(c)(1) itself recognizes that "[i]n addition to or in lieu of this [preclusion] sanction, the court, on motion and after affording an opportunity to be heard, may impose other appropriate sanctions." Thus, the plain text of the rule provides that if an appropriate motion is made and a hearing has been held, the court does have discretion to impose other, less drastic, sanctions.
In another part of its Order, the District Court did recognize this discretion when it precluded another Design expert, John Doughty, from testifying about the nature of the solutions and staffing business:
Given that Defendants have moved to preclude Doughty's testimony and that the [c]ourt held a telephone conference on this matter, it is not necessary to invoke Rule 37(c)(1)'s automatic sanction in order to preclude Doughty's testimony. Rather, Rule 37(c)(1) provides that "[i]n addition to or in lieu of [the automatic sanction], the court, on motion and after affording an opportunity to be heard, may impose other appropriate sanctions." The Court precludes Doughty's testimony in an exercise of this discretion.
This is a correct statement of the Rule and of the court's discretion in applying it.
In prior cases in which a district court erroneously imposed a sanction against a party, this Court has indicated a preference for remanding the case to the district court to reconsider whether to sanction, and, if so, the appropriate sanction. See, e.g., Simon DeBartolo Group, L.P. v. Richard E. Jacobs Group, Inc., 186 F.3d 157, 177 (2d Cir. 1999) (stating, in case involving sanctions pursuant to Fed. R. Civ. P. 11, that "were this an ordinary case, we would likely remand it to the district court for a determination as to whether it will persist in its decision to impose sanctions at all, and only if so for a determination of what those reconsidered sanctions should be"); Hernandez v. Conriv Realty Assocs., 116 F.3d 35, 41 (2d Cir. 1997) (concluding, in case involving sanctions pursuant to Fed. R. Civ. P. 16(f), that district court "should reconsider whether to impose sanctions" and that "[i]f the court decides to impose sanctions, the court should also reconsider what sanctions are appropriate"). Here, however, remand is inappropriate because Design has not, to this day, presented any evidence of lost profits. As when a district court abuses its discretion by erroneously excluding evidence under the Federal Rules of Evidence, we look to whether this exclusion was likely to have affected the outcome of the case. See Fed. R. Evid. 103(a); Phoenix Associates III v. Stone, 60 F.3d 95, 104-05 (2d Cir. 1995). As late as oral argument before this Court, Design has persisted in characterizing its bare financial statements and the "simple arithmetic" of figuring its overall profit margin as adequate evidence of its lost profits. For the reasons discussed above, that evidence is insufficient to prove lost profits in this case and therefore the exclusion of that evidence cannot have prejudiced Design nor have affected the outcome of the case.
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