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January 19, 2012

International arbitration has often been cited for lacking the ability to offer a quick and cost-effective resolution to global disputes. Many see international arbitration evolving into a U.S.-style litigation process, with a large number of disputes taking years to resolve at considerable professional and legal expense. How can experts assist the arbitration court, counsel and their clients in efficiently understanding the quantum of damages?

The primary role of the quantum expert in an international arbitration is to prepare an independent and objective analysis of the financial impact resulting from alleged bad acts. Part of the expert's role is to explain the inputs included in the damage model, as well as the impact of these inputs on the damage calculation. Sensitivity analysis is a useful tool to demonstrate and assist the tribunal to understand the impact and the interrelationship of the variables. Utilizing different permutations to determine the hierarchy and importance of the inputs on the calculation can be useful in focusing the time and effort spent on a particular argument, input or issue. By prioritizing the inputs to the damage model, the various analyses prepared by the financial experts can be focused, thereby assisting the parties within the arbitration process and potentially reducing costs.

It is important to note that a sensitivity analysis is not a range of damages, because an economist or financial expert opines on the appropriate inputs for the purpose at hand. The analysis provides an indication of the power or weight associated with a particular input. Ultimately, it is up to the tribunal to ascertain which of the experts has most convincingly supported his or her assumptions and bases for opinions in preparing their respective calculations. Once this is done, the tribunal can create a hybrid valuation model or update one or both experts' models with the new inputs.

Providing a Unique Perspective
Sensitivity analysis can also provide a unique perspective and understanding of an expert's damage model. Choosing a key variable and performing this analysis across a range of values for that variable (while leaving all other variables constant) can reveal flaws in underlying assumptions or calculations performed. For example, if damages are a function of $X per widget, then the tribunal will, most likely, have different quantum calculations from the claimant and the respondent. The two different price assumptions provide a limited amount of information (i.e., the range) to the tribunal and, as a result, may not prove to be entirely suitable -- possibly leading to the perception that the damages experts are advocates for their clients. However, damage provisions in contracts are often complex and include tiers or other contractual limitations, which directly impact the calculation and assumptions embedded within the calculation methodology. With a single point of reference, it can be very difficult, if not impossible, for the tribunal to completely understand the impact of the damages calculation for either party. By preparing a sensitivity analysis across a range of "widget" prices (or quantities), it may be clear that one of the damages expert's calculations either fails to be valid or fails to make economic sense across a range of prices (or quantities).

Damage calculations can be sensitized across an array of inputs and variables, yielding potentially hundreds of reference points. Instead of being helpful, exhaustive data analysis and excessive sensitivity analysis can often quickly become overwhelming and burdensome. We refer to this type of approach as "analysis paralysis," meaning that excessive analysis of the data and inputs overwhelms the user and, ultimately, provides limited to no value, typically with excessive costs to the parties. A balance must be struck by the damages experts in identifying which inputs are fundamental to the calculation and which are not. Both the key and secondary inputs should be communicated to the client and counsel. Narrowing down the sensitivity analysis to a few key inputs and variables can provide the tribunal and the parties with useful, valuable information to guide the case strategy and, ultimately, determine the appropriate award based on the tribunal's decisions on the legal merits.

Some of the benefits to the parties, legal counsel and, ultimately, the arbitration tribunal are discussed below.

In-House Counsel
An understanding of how the damage calculation is affected across different ranges of inputs will identify the key inputs to be highlighted for the legal team. Identifying the key inputs up front and developing a legal strategy emphasizing those inputs provides an informed roadmap of where to focus resources. Accordingly, professional and legal fees can potentially be estimated and managed more efficiently.

Legal strategy can also be shaped by understanding the impact of various inputs into the damage model. Cost-benefit decisions can be made regarding the pursuit of certain claims or additional claims, and arguments could potentially be identified through the sensitivity process. It may become apparent that spending significant time arguing a particular legal theory linked to an input or variable may not prove to be cost effective if that variable has minimal impact on the ultimate damage calculation.1 Alternatively, it may be possible to simplify the damage model by accepting certain assumptions that may not be disputed, thus saving legal and professional costs.

Outside Counsel
By understanding the sensitivity of the damage model across various inputs and identifying the key inputs, outside counsel can better prepare and budget the professional and legal fees. Furthermore, outside counsel may be better equipped to manage client expectations through a better understanding of the value drivers and sensitivity of those drivers on the ultimate damage calculation. This knowledge may, ultimately, influence the legal strategy and allow the legal and professional teams to more efficiently allocate their time and the client's resources.

In guiding the quantum experts, the Demand for Arbitration and the Terms of Reference become the guideposts by which the financial experts prepare their analysis. Accordingly, the planning and budgeting of the assignment, as well as the resulting expert report, have a framework that matches up with the legal questions being arbitrated. The sensitivity analysis can have a direct impact on the crafting of these important documents.

Arbitration Tribunal
Sensitivity analysis of the damage models can assist the arbitration tribunal in rendering its decision. By understanding the inputs into the calculation, the tribunal is able to make an economically informed award by understanding the impact of its legal conclusions on the damage amounts. While the arbitration tribunal may not agree with one expert on every conclusion or input, the court has the tools to create its own (composite or hybrid) damages calculation using the building blocks provided by the experts. This may be viewed as risky by some, because arbitration tribunals may lack the modeling and financial expertise to develop their own stand-alone damage model. However, well-built models designed to be user friendly mitigate much of the risk and facilitates the court's decision making. In some instances, a tribunal may hire its own financial expert who can build on a well-designed model, thereby reducing the cost of the court-appointed expert.

Expert conferencing is sometimes used to narrow the financial issues in dispute. Such conferencing can be done before, during and after the hearing on the merits. (Such conferencing can often be used in lieu of the tribunal hiring its own expert). When conferencing occurs before the hearing, the initial focus is on describing the methodology and the inputs into the calculation. The experts next determine the parts of the methodology and inputs upon which they can agree and cannot agree. A joint report may be used to memorialize their agreement and disagreement. By narrowing the issues and agreeing on the methodology, and as many inputs as possible, the experts may narrow the damage calculation range, potentially assisting the court with determining an award if appropriate.2 A sensitivity analysis can often be used to create a "menu" of damage amounts from which the tribunal can select as it makes decisions regarding the relevant legal and financial issues.

While not appropriate in all instances, sensitivity analysis can prove helpful to the client, counsel and the arbitration tribunal. This analysis can provide considerable value in the context of understanding the key value drivers of a financial model and potentially assist all parties in an arbitration proceeding. However, should an expert conduct a sensitivity analysis focusing on a particular calculation input, this should not provide any indication that he or she has doubt (nor should it be construed as such) as to the correct input value to use in the financial model. Sensitivity analysis is a tool that may demonstrate the variability of a model, the economic consequences of selecting one input over another, and the underlying logic embedded within a particular damage methodology.


1 We recognize that it may be important for legal reasons to make an argument that has little economic effect. Sensitivity analysis may provide counsel with insight to be more explicit in making such decisions.

2 For this process to work efficiently, the experts must be intellectually honest and prepared to concede a point if demonstrated to be simply wrong.