Lost Profits
Modern New Business Rule and How it Has Been Applied by the Courts
Earlier this year, the author published two articles that appeared in QuickRead discussing calculating lost profits and defense responses for lost profits calculations in cases falling under the modern new business rule. The foundation for the article on defense strategies was an article published by Victor Goldberg. Following publication, the author was contacted by Mr. Goldberg, who recommended additional reading on this topic. That has led to this article.
Under the new business rule, a new or unestablished business could not recover lost profits. This rule was applied throughout most of the twentieth century. Toward the end of the century, the modern new business rule began to be applied by the courts. This rule states that there is no rule, per se, to prevent a new or unestablished business from recovering lost profits so long as the lost profits may be determined with reasonable certainty.
As the application of the modern new business rule has varied from state to state, experts must be aware of the higher standard for reasonable certainty in these cases. This article revisits the new business rule, the modern new business rule, and reasonable certainty. It also reviews how two states (Texas and New York) have attempted to create openings for the modern new business rule in their courts.
[su_pullquote align=”right”]Resources:
Lost Profits, Modern New Business Rule and Defense Strategies Beyond Reasonable Certainty
Lost Profits: Fifth Circuit Decision Clarifies Reasonable Certainty for the Modern New Business Rule
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Earlier this year, I wrote two articles that appeared in QuickRead discussing calculating lost profits and defense responses for lost profits calculations in cases falling under the modern new business rule.[1] The foundation for my article on defense strategies was an article published by Victor Goldberg.[2] I was contacted by Mr. Goldberg following the publication of my article. His recommendations for additional reading on this topic led to this article. I want to thank him for reaching out to me and directing me to additional information.
Revisiting the Modern New Business Rule
For most of the twentieth century, courts followed a policy cited as the new business rule when addressing lost profit claims made by new businesses. It said, lost profits could not be recovered by new or unestablished businesses. This was because most of those businesses had not been operating long enough to show damage to its profits with reasonable certainty.
This position changed during the last part of the twentieth century. Courts began to apply what has been called the modern new business rule. The rule states new or unestablished businesses can recover lost profits provided they can show the profits have been lost with reasonable certainty.
“While most jurisdictions have moved away from the new business rule and adopted the modern new business rule, by which new/unestablished businesses can recover damages, such adoption does not diminish the requirements under the reasonable certainty standard. Given the lack of historical performance data, and under the lens of the reasonable certainty standard, estimates of lost profit damages to new/unestablished businesses are subject to a higher level of certainty.”[3]
Reasonable Certainty and the Modern New Business Rule
Three general standards must be met for a business to be awarded lost profits. The first is proximate cause. The second is foreseeability. And, the third is reasonable certainty. In all lost profits cases, experts have the difficulty of proving with reasonable certainty losses for events that did not happen. In other words, the lost profits experts must estimate are tied to an activity that did not occur due to an alleged wrongful act.
Reasonable certainty has been discussed numerous times in state and federal decisions. Unfortunately, there is no clear definition for reasonable certainty. “To meet the standard, ‘absolute certainty in proving quantum of damages is not required.’ However, ‘reasonable certainty requires more than guess work, but less than absolute exactness or mathematical precision.’”[4]
Providing loss calculations for new or unestablished businesses is even more difficult. This is because there are few historical records that may assist in showing profitability and therefore, lost profits.
This issue was addressed in the Energy Capital case. “Profits are uncertain; they depend on so many contingencies, especially in a new enterprise, that it is, in most cases, impossible to say that the breach was the proximate cause of the loss of them, or that a profit would have been realized, in any event; nor is there any basis to determine what they might have amounted to.”[5]
The decision goes on to say, “A new venture must establish its entitlement to lost profits by showing the same elements that any business shows: (1) causation, (2) foreseeability, and (3) reasonable certainty. A new business will probably encounter more difficulty in establishing that its lost profits were reasonably certain. … The development of the law has been to find damages for lost profits of an unestablished business recoverable when they can be adequately proved with reasonable certainty. … What was once the rule of law has been converted to the rule of evidence.”[6]
State Views Vary on the Modern New Business Rule
Adoption of the modern new business rule has varied from state to state. Research shows Illinois and Georgia continue to follow the new business rule doctrine. It appears the majority of states have adopted the modern new business rule and while doing so, set higher standards for reasonable certainty in these cases. Connecticut and Alaska are examples of this.
Texas and New York have also adopted interpretations of the modern new business rule. The following are examples of how they have attempted to define this new rule.
The Fifth Circuit Court of Appeals highlighted Texas’ position on the modern new business rule in its Youtoo decision. The appellant court’s opinion noted that Texas courts have held “a lack of profit history does not preclude a business from recovering lost future profits. Yet the mere hope of success of an untried enterprise, is not enough for recovery of lost profits. [cite omitted] The Supreme Court of Texas thus found a lack of reasonable certainty to project damages for a new venture when no working model of the product existed, its viability was in doubt, and the company that was supposed to produce it had never operated at a profit.”[7]
In rejecting the defendant’s claims of lost profits, the opinion went on to say, “Defendant’s damages estimates had to rely in large part on hoped for partnerships and speculation about the profits these agreements would generate. The profit calculations defendants would have presented at trial were projections that were presented to investors, calculations which Texas courts have held insufficient when not supported by achieving reasonable certainty in cases involving the modern new business rule.”[8]
New York courts appear less settled on how to apply the modern new business (as Goldberg points out).
“The recent treatment of the new business rule in New York revolves around the Kenford[9] litigation. In the Appellate Court’s first shot, it was confronted with two precedents. In 1918, the New York Court of Appeals took what had been the majority position, holding in the Cramer v Grand Rapids Show Case Co.[10] that a new business could not claim recovery for lost profits. Over a half century later, in Perma Research & Development Co. v Singer Co.,[11] the Second Circuit refined the test when interpreting a contract under New York law: ‘Although lost profits in a new venture are not ordinarily recoverable, they may be awarded where: the loss of prospective profits are the direct and proximate result of the breach; profits were contemplated by the parties when they entered the contract; and there is a rational basis on which to calculate the lost profits,’ the Appellate Division in Kenford interpreted Perma as qualifying Cramer: ‘What the court did in Perma Research, in essence, was to add a third requirement for new businesses by requiring them to establish some rational basis on which to calculate the lost profits. By so holding, the court converted the Cramer rule of non-recoverability into a rule of evidence.’”[12]
Goldberg’s concern is the Kenford opinion has been misapplied or misinterpreted by later courts: “How can we reconcile the court’s notion that on the one hand, it applies Kenford’s per se rule—which awards no lost profits for an unestablished business—and, on the other hand, it finds that plaintiffs must satisfy only the reasonable certainty standard?”[13]
He goes on to discuss both state and federal decisions involving New York cases in which the Kenford decision was applied. In Shelton v Sethna,[14] a federal court cited Kenford when stating lost profits are difficult to prove and recover when they concern a new and untested business. However, the court allowed for the claim to move forward stating that even though the plaintiff’s claim may fail on its merits, its weak claim does not warrant dismissal for lack of subject matter jurisdiction.[15]
Goldberg states that “[a]fter reaffirming Kenford’s per se rule, the Court of Appeals misapplied it” in the Janien case.[16] The court concluded “it is manifest from an examination of [the contract] that the parties contemplated that Janien could recover damages if the agreement was not completed and that those damages could include lost profits from the accounts using Eta.”[17]
Goldberg goes on to say, “The court then concluded that Janien had met the burden of proving lost profits with reasonable certainty. But, as in Perma, the basis of the court’s decision should not have been certainty. Janien had already developed Eta, and his investment was therefore sunk. His damage claim was only for the future stream of earnings from his investment. Had the court framed the question this way, it would have avoided the intellectual contortions that resulted from its attempt to conform to Kenford’s per se rule.”[18]
Even with the differing Kenford interpretations, it appears New York courts continue to set a high standard for allowing the recovery of lost profits under the modern new business rule. In the Pure Vegan, LLC v Electric Wonderland, Inc. case, a New York appellant court noted, “[A]lthough trial court found that defendant did not use its ‘best efforts’ to promote plaintiff’s line, the trial court properly concluded that plaintiff was not entitled to recover lost profits; to the extent plaintiff sought lost profits for a five-year period, such damages were speculative because the assumption that it would have remained in contract with defendant for five years could not be established with reasonable certainty; to the extent it sought lost profits in the amount of one million dollars for 2010, such lost profits were not within contemplation of the parties as a probable result of a breach at the time they entered into the agreement and could not be established with reasonable certainty; given the fact that plaintiff had been in business for only 15 months and both parties described the fashion industry as ‘fickle,’ plaintiff’s profit history did not support a finding of projected profits of one million dollars per year with reasonable certainty.”[19]
Meaning for Experts
Most, but not all, states have language in court decisions allowing for the application of the modern new business rule. These various decisions have language which goes something like this. The fact that a business is new does not absolutely preclude recovery of lost profits. Any calculation of lost profits must be made with reasonable certainty. The allowance of recovery is based on the rule of evidence and not the rule of law because there is no per se rule barring a new business rule.
An expert should discuss the local standard with the hiring attorney prior to beginning the assignment. Both the attorney and the expert should agree as to the standard of reasonable certainty that will be applied in that particular jurisdiction. This understanding will guide the analysis and hopefully, help the expert defend his or her report when faced with a challenge to exclude.
After reviewing decisions regarding the application of the modern new business rule, it appears courts will be expecting experts to determine if the new business “had an experienced and knowledgeable workforce relative to the industry of the business, customer demand for the product or service to be provided, and a market open to the entry of this business. Confirmation of funding for the business, contracts and/or contract with potential clients, and the ability to deliver the products or services as scheduled, also provide additional foundation. Finally, it is the ability to show the venture would have been able to make a profit; that is essential. Without the probability of profits, there is no loss.”[20]
Conclusion
Experts are often faced with the question, “Can a new or unestablished business recover lost profits?”
Under the new business rule, a new or unestablished business could not recover lost profits. This rule was applied throughout most of the twentieth century. Toward the end of the century, the modern new business rule began to be applied by the courts. This rule states that there is no rule, per se, to prevent a new or unestablished business from recovering lost profits so long as the lost profits may be determined with reasonable certainty.
Experts must be aware of the higher standard for reasonable certainty in these cases. To support their calculations, experts need to provide support for the business’ survival. This could include strength and experience of management, adequate capital funding, a need for the product or service to have been provided, and the ability of the business, but for the injury, to make a profit. On the other hand, they must be aware calculations based on projections made by management and/or those presented to investors are flimsy foundations that have led to the lost profit estimates being judged as speculative.
Meeting the reasonable certainty standard is only the first step. As Victor Goldberg has argued, there are other defenses which may erode or eliminate the lost profits. These include opportunity cost. This analysis determines if the plaintiff can make a greater profit in an alternative venture. Another defense is non-payment of royalties. This type of analysis will review if the defendant failed to market a product or service, or marketed the product or service and found no market. No market, no lost profits.
An additional defense is delays in performance or defective products. This means if the plaintiff was delayed in providing services or was producing defective products, not related to the litigation, the plaintiff’s profits would have been limited and these profit limitations should be taken into consideration as a separate causality. Finally, repudiation of the contract by the buyer when it had only been partially performed may provide another defense. If the two parties had a long-term contract and the defendant left the contract prior to its end, the question becomes, “What has the plaintiff done to replace the lost customer?” The plaintiff has an obligation to mitigate (offset) its losses by trying to replace the lost business with other customers. Success from mitigating the loss should reduce the lost profits.
Experts asked to estimate lost profits for a new or unestablished business should be aware of the jurisdiction’s standards for the modern new business rule. This information, along with research into the business, its products or services, market, and financial backing will help any expert in determining if a set of lost profit calculations may be made; calculations that can be provided with reasonable certainty. Of course, the final decision will be up to the judge, but by being aware of the expectations of the court standards, will assist an expert in being prepared when questions regarding the foundation of the calculations come.
Allyn Needham, PhD, CEA, is a partner at Shipp Needham Economic Analysis, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp Needham Economic Analysis, 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 and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings.
Dr. Needham can be contacted at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.
[1] “Lost Profits: Fifth Circuit Decision Clarifies Reasonable Certainty for the Modern New Business Rule,” QuickRead, 2/27/2019 and Lost Profits, Modern New Business Rule and Defense Strategies Beyond Reasonable Certainty, QuickRead, 3/6/2019.
[2] “The New Business Rule and Compensation for Lost Profits,” Victor Goldberg, The Criterion Journal on Innovation, Vol. 1, 2016, 341–372.
[3] “Lost Profits: The Reasonable Certainty Standards and the Modern Business Rule”, Josefina V. Tranfa-Abbaud, QuickRead, 9/9/2015.
[4] “Reasonable Certainty in Lost Profits Calculations,” Allyn Needham, , QuickRead, 1/6/2016.
[5] Energy Capital Corp. v United States, 47 Fed.Cl. 382, 393; 2000, U.S. Claims LEXIS 186.
[6] Energy Capital Corp., at 394.
[7][7] Mensour Al-Saud v Youtoo Media, LP & Christopher Wyatt, 2018 U.S. App. LEXIS 29680, 18.
[8] Youtoo Media LP, at 18–19.
[9] Kenford Co, v County of Erie, 489 N.Y.S.2d 939, (App. Div. 1985), rev’d, 537 N.E.2d 176 (N.Y. 1989).
[10]Cramer v Grand Rapids Show Case Co., 119 N.E. 227 (N.Y. 1918).
[11] Perma Research & Development Co. v Singer Co., 402 F. Supp.881, (S.D.N.Y. 1975).
[12] “The New Business Rule and Compensation for Lost Profits,” Goldberg, 355.
[13] Ibid, 356.
[14] Shelton v Sethna, 2012 WL 1022895 (S.D.N.Y. Mar. 26, 2012).
[15] Goldberg, 356–357.
[16] Ibid, 358; Ashland Management, Inc. v Janien, 624 N.E.2d 1007, (N.Y. 1993).
[17] Janien, at 1011, Eta was a model created by Janien for stock selection.
[18] Goldberg, 358–359.
[19] Pure Vegan, LLC v Electric Wonderland, Inc., 116 A.D.3d 449, 983 N.Y.S.2d 506 (2014).
[20]“Lost Profits: Fifth Circuit Decision Clarifies Reasonable Certainty for the Modern New Business Rule”, Needham, 2/27/2019.
