Book Review—Lost Profits Damages

Principles, Methods, and Applications

Everett P. Harry, III and Jeffrey H. Kinrich assembled 45 authors, chosen for their expertise in lost profits damages, and contributed and co-edited this comprehensive lost profits damages “how to” book. The authors pay tribute to Robert L. Dunn, among others, for his vision in identifying the need for this book. The book marks an attempt by the authors to provide a single-source reference for practitioners who are tasked with selecting an appropriate methodology for determining lost profits, carrying out the analysis, and potentially defending their work during proceedings. In this book review, we provide an overview of what is covered and answer whether the co-editors deliver.

[su_pullquote align=”right”]Resources:

Taking a Deeper Dive into the Lost Profits “But-For” World

The Reasonable Certainty Requirement in Lost Profits Litigation—Best Practices for Proving Your Damages Calculation

10 Common Errors in Lost Profits Calculations and Business Damages

Elements of Lost Profits and Introduction to Lost Profits

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Everett P. Harry, III and Jeffrey H. Kinrich assembled 45 authors, chosen for their expertise in lost profits damages, and contributed and co-edited this comprehensive lost profits damages “how to” book.  The authors pay tribute to Robert L. Dunn, among others, for his vision in identifying the need for this book.  While Robert L. Dunn, who died in a 2013 automobile accident, did not survive to be co-editor and chapter author, the authors remark that “his fingerprints are still throughout this publication.”  The book marks an attempt by the authors to provide a single-source reference for practitioners who are tasked with selecting an appropriate methodology for determining lost profits, carrying out the analysis, and potentially defending their work during proceedings.  In this book review, we consider how successful the editors have been achieving this end.

The co-editors have sequenced the chapters broadly in the same order that work steps are performed and decision points are encountered in the typical lost profits engagement.  The chapters progress from an overview of the nature of lost profits damages and the broad legal principles for proof of such loss through the preparation of an expert report.  The intervening chapters—roughly Chapters 3 to 20—illustrate many alternative methodologies and techniques employed by practitioners for the determination of lost profits damages, as well as specific issues and types of calculations that will need to be included.  This includes detailing the strengths and weaknesses of the methodologies, which means that contrary or opposing viewpoints are presented, with their strengths and weaknesses.  This is a strength of the compilation.

Before discussing the later disclosures, it is worth pointing out the key points discussed:

Chapter 1: Introduction to Lost Profits—The authors here provide an overview of the context in which litigation arises—ranging from contract, tort, patent infringement, to antitrust—and discuss elements of a lost profits claim.  The challenge is identifying the beginning of the damages period and end since damages may extend well beyond when the unlawful conduct ceases.  The discussion is substantive, but what sets the chapter apart is the discussion involving how to go about proving incremental revenues and costs and evidence that the expert needs to consider.

Chapter 2: Legal Principles for Lost Profits Damages and Related Expert Testimony—The authors examine the legal framework for lost profits damages.  A roadmap is provided regarding the elements plaintiff must prove.  The authors also explain the role of a lost profits expert and the process of finding and evaluating an expert.

Chapter 3: Alternative Methodologies for Lost Profits Damages—The but-for projection is the primary foundation of the lost profits analysis.  Three methods are employed and those are the yardstick approach, the before-and-after approach, and the sales projection approach.  This chapter’s author shares his views on which to choose based on the facts and circumstances.  The author also discusses analyzing the costs saved and discounting.  He refers the reader to Chapters 11 and 19 where the subjects are discussed in more detail.

Chapter 4: Ex Ante versus Ex Post—This chapter educates readers about ex ante and ex post methods, including the respective collection of information to be considered or relied upon to determine the amount of lost profits.  The chapter also illustrates the ex ante and ex post approaches and reconciliation of the methodologies.

Chapter 5: Business Valuation Methodology—This is often referred to as the ex ante method.  The authors discussed when this measure of damages may be appropriate; these instances, not surprisingly, include the complete business destruction and government taking by eminent domain.  While the above is not new, the authors also discuss when to use total invested capital versus equity to calculate damages, when to use capitalized cash flow versus discounted cash flow, how to develop discount and capitalization rates (discussed in more detail in Chapters 17 and 18), the Market Approach (the Guideline Public Company Method and Guideline Company Transactions Method), Asset Approach, and the use of discounts and control premiums.  The authors conclude underscoring the potential issues with this methodology.

Chapter 6: Contrasting the Lost Business Value and Lost Profits Methodologies—The objective of this chapter is to explain the differences and relative merits of lost profits and lost business value methodologies.  Issues raised and addressed include: whether lost profits can exceed the lost business value, whether undiscounted past losses represents a flaw of the lost profits methodology, whether lost business value is a better measure of damages, and identifying negative damages.

Chapter 7: Proving Loss Causation—This chapter addresses the general analytical framework for proximate cause analysis and describes many of the particular legal and factual considerations that may be relevant to determining proximate causation.  Topics covered include: factual cause of loss and scope of liability considerations, the but-for test, substantial factors and sufficient cause, insufficient cause, multiple sufficient cause, non-necessary non-sufficient factors, superseding cause, contributory cause, multiple wrongdoers, divisible and indivisible harm, common errors and potential challenges in causation analysis.  The authors include a Chapter 7 Appendix: Proving Loss Causation, that includes case decisions involving causation issues.

Chapter 8: Industry and Economic Research—This chapter addresses the types of information generally needed to analyze lost profits incurred by a plaintiff.  It also identifies the data the expert will need to quantify lost profits.  Topics covered in this chapter include: a comparison of the CPI to the PPI, a comparison of the PPI to the GDP Price Index, a comparison of the CPI to the PCEPI, information available at the St. Louis Federal Reserve Bank, marketing techniques to survey consumers, a brief introduction to conjoint analysis, the role of sampling, and criteria for validating data.

Chapter 9: Statistics in Lost Profits Measurements—The authors provide an overview of statistical analysis and an introduction to a range of statistical tools that can be applied in lost profits damages quantification.  The authors propose that a carefully constructed statistical analysis, such as a simple or multiple regression analysis, can be used to quantify lost profits damages in a but-for analysis.  A regression can likewise be used with the yardstick method to establish the strength of the relationship of plaintiff’s financial performance to its peer group of benchmark companies and provide a basis for forecasting its but-for performance during the damage period.

Chapter 10: Analysis of Projected Lost Revenue—Projecting lost revenue is one of the first steps in calculating lost profits and this chapter discusses the mechanics of the revenue projection and issues to be considered in determining the revenues that would have been earned by the plaintiff absent the alleged damaging event.  Topics discussed include: selecting data, analytical tools and documentation, use of management sales projections, projecting but-for unit sales price, other factors to consider when projecting lost sales quantities and unit prices, considering mitigation of damages, period of damages, data limitations, alternative methods of measuring lost revenue testing the sensibility of the projection, common counterarguments, and rebuttal analysis considerations.

Chapter 11: Analysis of Cost Behavior—This chapter covers concepts and issues underlying the estimation of avoided costs and is divided into roughly four parts: i) an overview of fundamental cost concepts and related terminology, ii) underscoring the distinction between fixed and variable costs, iii) the development of a conceptual framework for analyzing cost behavior, and iv) quantitative approaches to analyzing cost data.  The authors provide a regression analysis to illustrate a regression analysis to identify how to use the same and the issues that arise from its use.

Chapter 12: Mitigation of Damages in the Lost Profits Calculation—There is no absolute duty to mitigate.  However, failure to do so could result in a reduction of the damages award.  To the extent that the defendant is able to demonstrate that the plaintiff could have avoided or limited its damages by taking reasonable mitigation actions, it may be possible to eliminate the defendant’s obligation to pay for damages.  This chapter discusses the types of mitigation, factors impacting the plaintiff’s ability to mitigate losses, the lost-volume seller principle, and consideration of mitigation by damages expert in lost profits calculations.

Chapter 13: Using Net Cash Flows Versus Net Income—Financial statements can be prepared flowing the accrual or cash method.  The damages calculation can differ dramatically.  This chapter examines how to adjust financial statements prepared under these methods and the conditions under which the difference in estimated lost profits will tend to be larger are identified.  The authors also present the main arguments for and against each approach.

Chapter 14: Period of Damages—The authors in this chapter focus on estimating the period of loss.  Occasionally, that means the expert will develop multiple scenarios.  The authors discuss contract actions, insurance coverage limitations to the period of damages, and personal injury.  The authors also cover market considerations (market factors could impact the length of damages period) and projected full mitigation.

Chapter 15: The Ability to Achieve Lost Sales as a Consideration in Damages Analyses—The chapter first reviews the legal landscape for assessing a plaintiff’s ability to achieve lost sales and profits in various types of legal cases, including patent, trade secret, copyright, trademark, and other intellectual property cases, as well as contract disputes and antitrust litigation.  The chapter then presents an economic framework for considering the capabilities of a firm and key supply constraints that may have limited its ability to have made sales and profits in the but-for world.

Chapter 16: Present Value Concepts and Damages Modeling—The purpose of the chapter is to explore and explain the time-value-of-money concept as applied to the determination of lost profits damages, particularly with a focus on the primary calculation variables, the mathematical processes and techniques, and the resultant sensitivity of the computed results to changes in input variables.  The chapter includes a high-level anecdotal illustration of present values for past and future damages, a presentation of the mathematical formulas and related considerations for computing present values, a description of the capitalization methodology, and a two-part presentation of practical suggestions for modeling damages and computing present values.

Chapter 17: Discount Rates in Theory—The chapter focuses on the theoretical constructs of a discount rate and how that theory can be applied to different methodologies for the calculation of lost profits, including the business valuation methodology and lost profits methodology.

Chapter 18: Discount Rates in Practice—This chapter presents some academic reasons and practical considerations for selecting an appropriate discount rate and in it, the authors demonstrate that a particular type of discount rate (or a narrow range of such rates) does not apply to all lost profits or lost business value claims.  The goal is to challenge the expert to think critically about the discount rate and discounting process as applied to compute damages.

Chapter 19: Before-Tax Versus After-Tax Discount Rates—The objective of a damages award for lost profits is to make the plaintiff economically whole, but determining this amount may be more challenging than a simple present value calculation.  The expert may select among alternative computation factors, including: plaintiff’s before-tax cash flows, after-tax cash flows, before-tax discount rate, and after-tax discount rate.  In this chapter, the authors stress the need to understand the relationship among these variables and the proper application of the selected factors.  The chapter concludes with a discussion of a method to adjust the discount rate for the benefit of deferred taxes on past damages and the taxability of earnings when all or part of the damages award is invested to replace lost future cash flows.

Chapter 20: Pre- and Post-Judgment Interest—In practice, compensation to plaintiffs for the use of money is often separated into two components: pre-judgment interest and post-judgment interest.  The authors cite federal and state law to illustrate how courts award (or do not award) pre-judgment interest, the length of time for which interest will be paid, the pre-judgment interest rates used by practitioners, and other pre-judgment interest considerations, such as taxes and post-judgment interest.  The authors include an appendix for this chapter that summarizes state pre-judgment interest parameters.

Chapter 21: The Expert Report—This chapter provides a summary of the legal requirements related to an expert report, especially on civil matters; an overview of the report writing process; the required and suggested report sections and topical components of the written report, including detailed examples of the issues that should or could be addressed; and potential written report statements intended to either limit the expert’s exposure or preserve the expert’s ability to amend or use the report after issuance.

Chapter 22: Expert Reports and Business Valuation Standards—This chapter is intended for any expert rendering a lost business value opinion for litigation, especially through a written report.  The authors overarching objectives are two-fold.  First, the business valuation standards that are particularly relevant to an expert witness are summarized and explained.  Second, certain misconceptions the author has observed in practice about the application of business valuation standards to an expert witness report, either written or oral, are discussed.

Chapter 23: Legal Challenges to Lost Profit Damages Expert Testimony—The chapter summarizes the U.S. Supreme Court Daubert case and examines Daubert’s scientific roots and undertakes a nuanced examination of the Daubert standard, applying Daubert analysis to a common scientific method that appears frequently in cases.  The chapter closes with two cases that exemplify Daubert gatekeeping.  The author includes an appendix that contains the court’s analysis of an expert’s variable selection in scientific testimony based on a regression model and selected portions of decisions discussing and explaining the proper use of variable selection for proof of lost profits damages.

With respect to the co-editors contention that the book discloses the strengths and weaknesses of the methods, the answer is a resounding YES.  This book sets the bar and honors Robert L. Dunn’s legacy.  The contributors have delivered a book that provides great content and visuals to illustrate important concepts.  This comprehensive book is a must have for aspiring and experienced lost profits damages experts.

Roberto H Castro, JD, MST, MBA, CVA, CPVA, CMEA, BCMHV, is an appraiser of closely held businesses, machinery, and equipment and Managing Member of Central Washington Appraisal, Economics & Forensics, LLC, which provides appraisal and litigation support services. Mr. Castro is also an attorney with a focus on business and succession planning with offices in Wenatchee and Chelan, WA. In addition, he is Technical Editor of QuickRead and writes case law columns for The Value Examiner.

Mr. Castro can be reached at (509) 679-3668 or by e-mail to either rcastro@cwa-appraisal.com or rcastro@rcastrolaw.com.