Lost Profits and Other Commercial Damages
A Case Study (Part I of II)
Most commercial damages assignments call for the calculation of lost profits or lost business value. However, some cases, particularly those relating to lost profits, contain elements of additional economic damages. These situations require the expert to focus on multiple areas of loss while insuring each element does not contain losses claimed by another. In this two-part article, Dr. Needham shares how he approached a case that went from report preparation to deposition, and ultimately trial testimony. In the second part of this article, Dr. Needham discusses the jury verdict and settlement. The purpose of this two-part article is to share with aspiring expert witnesses how this case was approached and highlight how the jury used the information provided by the experts. QuickRead thanks Dr. Needham for sharing this case.
[su_pullquote align=”right”]Resources:
Elements of Lost Profits and Introduction to Lost Profits
Special Considerations for Lost Profits Calculations
Advanced Concepts in Lost Profits Calculations
Measuring Business Interruption Losses and Other Commercial Damages
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Most commercial damages assignments call for the calculation of lost profits or lost business value.[1] However, some cases, particularly those relating to lost profits, contain elements of additional economic damages. These situations require the expert to focus on multiple areas of loss while insuring each element does not contain losses claimed by another.
At the beginning of 2016, I was retained as an expert in a commercial damages matter that required more than a simple lost profits analysis.[2] Most commercial damages cases with which I have been involved settle prior to trial. This case, however, went to trial and a jury verdict rendered. Because of the somewhat uniqueness of the case and the fact the jury arrived at a verdict regarding damages, I felt a review of the analysis and outcome would provide insight to those making similar calculations.
Highlights of the Case
The case involved two corporations. The plaintiff was an insulation installation contractor whose employees worked on major construction projects in Texas, Louisiana, and Oklahoma. The defendant was a wholesale distributor of insulation materials and products with locations across the U.S. and Canada.
Most of the plaintiff’s work came through the bid process. The company would submit a proposal to an upstream sub-contractor or general contractor providing its dollar cost to perform certain work as part of a larger project. If the plaintiff’s bid was accepted, the bid was included in the sub-contractor or general contractor’s overall work bid. If the overall bid was accepted, the plaintiff was notified of having won the work and given a perspective time table for performing its portion of the project. If the bid was rejected, the plaintiff may or may not be notified. In most situations, the plaintiff would not know if their bid had been rejected because of their pricing, the overall bid’s pricing, or other factors not relating to its bid.
During the fourth quarter of 2012, the defendant approached the plaintiff with an agreement that would provide a “win-win situation.” As a part of the agreement, the plaintiff agreed to purchase $1,000,000 of materials and products annually from the defendant and in exchange, the defendant would price the materials and products at “competitive market prices.”[3] Unfortunately, the term “competitive market prices” was not defined in the agreement. The agreement was attractive to the plaintiff because they had been purchasing materials from a manufacturer in bulk and this agreement would reduce inventory and warehouse costs. A five-year agreement was signed in December 2012, which became effective at the beginning of 2013.
During the first year (2013), the agreement appeared to work successfully. The plaintiff generated revenues comparable to the prior five years average annual revenues and it purchased more than $1,000,000 in materials and products. During the first two years of the contract (2013–2014), the defendant’s prices increased at least three times. As pricing increased, the plaintiff noticed a significant drop in the acceptance rate of its bids. Even long-term customers were not hiring them and turning to other sub-contractors. During this time, the plaintiff continued to use the defendant as its primary source of materials and products. But due to the decline in accepted bids and therefore, revenue generating work, the plaintiff did not purchase $1,000,000 in material and products from the defendant in 2014.
At the beginning of the third year of the contract (2015), the plaintiff saw a continued decline in accepted bids. It contacted other suppliers of insulation materials to compare prices. They found the defendant was charging the plaintiff greater prices than other large volume purchasers were being charged. The plaintiff came to believe the price increases had “priced them out of the market.” They reasoned the greater material costs caused them to submit bids more expensive than the ones proposed by their competitors. These less competitive prices had caused them to no longer be competitive in the bidding process and subsequently led to the plaintiff’s revenue decline. Therefore, the non-competitive pricing charged by the defendant had caused them to lose business.
The plaintiff contacted the defendant to complain about the prices it was being charged. The defendant responded that the plaintiff was receiving “competitive market prices”, but agreed to reduce its pricing on future purchases. After a series of pricing adjustments, the plaintiff’s business appeared to stabilize.
The plaintiff and defendant then began to negotiate the repayment of funds for what the plaintiff claimed to be overcharging on purchases made in 2013, 2014, and 2015. The defendant also made claims regarding the plaintiff failing to purchase $1,000,000 in materials and products during the second year of the contract and falling behind on paying some outstanding invoices. By June 2015, the plaintiff stopped purchasing from the defendant. Therefore, for the second year in a row, the plaintiff did not purchase $1,000,000 in material and products from the defendant.
Negotiations between the parties stalled and the plaintiff sued for commercial damages. The defendant then countersued for their own commercial damages. Both claimed breach of contract.
Analyzing the Damages
I was contacted by the attorney representing the plaintiff in February 2016.[4] He retained me to assess the damages incurred by his client and critique the economic damages calculations made by the defendant’s retained expert.
The financial information in this case was extensive. My office received over 20,000 pages of documents with the law firm retaining an additional 60,000 pages, which I reviewed at their office. The data forwarded to our office provided financial information for 2008 through 2015 and partial year information through May 2016. This data included income statements, balance sheets, job profitability reports, incomplete work reports, bid and acceptance summaries, and material and product purchases made by the plaintiff from January 1, 2013–June 30, 2015.
Initially, I met with the attorney to discuss the claims being made and the various ways of quantifying the damages. After reviewing the initial data that had been forwarded to me, I met with the attorney and the owner/operators of the plaintiff.[5] This meeting allowed me to get a better understanding of the plaintiff’s business, address issues related to the claims being made by the defendant, and focus on ways of assessing the damages. It also allowed me to ask questions about the plaintiff’s day-to-day operations and explain how an analysis of its losses would work.
The plaintiff’s financial records confirmed something had caused a negative impact to its business from 2013 into 2016. The primary focus became how to estimate the plaintiff’s damages and provide a reasonable, understandable assessment to the trier-of-fact.
After a series of conference calls with the attorney and his clients, it was agreed the analysis would be limited to two areas of loss: overcharges and lost profits. The reasoning for showing losses in this way was as follows:
- The plaintiff claimed the prices it was charged by the defendant were not “competitive market prices” but greater than those paid by their competitors.
- Therefore, the initial loss was from being overcharged on materials and products purchased by the plaintiff during the loss period.
- Because of the overcharging, the plaintiff also claimed its bids were not competitive and business was lost.
- Therefore, the plaintiff’s second loss was for lost profits from sales it was not able to make during the loss period.
Because the plaintiff stopped purchasing its materials and products from the defendant in 2015, the plaintiff claimed its loss period was from 2013 through 2015.
My main objective was to provide the trier-of-fact with reliable and reasonable loss figures that did not have the taint of double counting. To help achieve that goal, it was decided the assessment of overcharges would only include actual purchases. The lost profits would only consider lost sales (the difference between the plaintiff’s annual average revenue and the actual revenue generated in 2013, 2014, and 2015). No consideration would be given to profit margin deficits reported from actual revenue generated during the loss period. This meant no lost profit calculations related to the actual revenue generated in 2013, 2014, or 2015 would need to be adjusted for any estimated overcharges. Thus, the two loss calculations were completely separated and easy to identify and explain.
Other damage claims would be addressed through the owner/operators’ testimonies at trial. Ultimately, only one other damage claim was brought to the jury, that of interest costs on working capital borrowed by the plaintiff during the loss period.
Defining the Commercial Damages
The plaintiff claimed to have lost revenue due to the acts of the defendant. This lost revenue caused the plaintiff to incur lost profits. The plaintiff also claimed out-of-pocket expenses due to overcharges.
However, during the loss period, the plaintiff continued to operate. By staying in business, it incurred normal business costs and was, therefore, not able to avoid some of the costs related to the lost revenue (e.g., it could not avoid paying overhead and office expenses).
Before moving forward with the analysis, the commercial damages being assessed needed to be defined. Through these definitions, it was easier to explain to all involved (plaintiffs, defendants, attorneys, retained experts, and the trier-of-fact) the nature of each loss.
Lost profits were defined as net lost profits; lost revenues less saved expenses. “Only lost ‘net profits’ are allowable as economic damages. This means that lost profits is a net amount that results from a calculation (the lost revenues less the relevant avoided costs equal the net lost profits) to be used in claiming an element of economic damages in a litigation matter involving a business dispute. Net lost profits (hereafter referred to as ‘lost profits’) are generally computed by estimating the revenues (gross and net) that would have been earned ‘but for’ the alleged acts reduced by the avoided costs (or incremental costs) that did not occur because of the subject lost revenues.”[6]
Determining what costs are to be included and left out of any lost profit analysis can be troubling. “No doubt volumes of accounting theory have been written on how properly to calculate net profit or net income. Obviously, direct costs of performance must be deducted, that is, those costs plaintiff would have incurred had defendant not breached a contract and excused plaintiff’s further performance or committed a tort that caused a loss. Is some allocable share of plaintiff’s overhead to be deducted? The courts are divided on this question. There is also a substantial split in the cases that consider whether other indirect costs must be deducted.
The question whether overhead must be deducted to reach net profits is frequently decided by default. Nobody thinks about it. The courts state only that the injured party is entitled to recover its lost profits, measured by the contract price less the cost of performance. Implicitly, cost of performance includes only the direct costs attributable to the contract. The court does not discuss or focus on the question whether indirect or overhead costs that may be properly allocated to the contract are to be added to the cost of performance to reduce the lost profits recoverable. The weight of authority, however, holds that fixed overhead expenses need not be deducted from gross income to arrive at the net lost profits properly recoverable.”[7]
Along with lost profits, the plaintiff claimed losses due to the defendant charging greater than market prices. This loss was more easily defined; the difference between the price paid and what the price should have been. This sort of analysis is commonly seen in assessing anticompetitive behavior. The analysis initially compares the plaintiff’s profits before, during, and after the loss period. In addition, a “but for” price must be determined to compare with the actual price paid during the loss period. The overcharge is “the difference between the actual price paid and the price that would have been paid but for the anticompetitive behavior.”[8]
[1] See Quick Read article “Lost Profits versus Lost Business Value” by Laura Pfeiffenberger for a discussion on the difference between calculating lost profits and the lost business value.
[2] Southwest Insulation, Inc. et al., v. General Insulation Company, 4:15-cv-00601-O. The trial was held in U.S. District Court for the Northern District of Texas, Fort Worth Division.
[3] The agreement called for the defendant to provide additional services, such as opening a local branch, to insure prompt deliveries of the plaintiff’s purchases.
[4] Dan Bates of Decker Jones, PC, Fort Worth Texas.
[5] The initial data included 2008 through 2015 income statements, the sales contract between parties, and the claims and counterclaims filed with the court.
[6] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd Edition, Vol. 1, Nancy Fannon, Jonathan Dunitz, BVR 2014, page 210.
[7] Recovery of Damages for Lost Profits, Volume 1, 6th Ed., Robert Dunn, Lawpress Corp., 2005, pages 482-483.
[8] Litigation Services Handbook, 5th Ed., Roman Weil, Daniel Lentz, David Hoffman, John Wiley & Sons, Inc., 2012, pages 26.22 and 26.23.
Allyn Needham, PhD, CEA, is a partner at Shipp, Needham & Durham, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp, Needham & Durham, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial economics and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation and bar association meetings.
Dr. Needham can be reached at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.
