Reasonable Certainty in Lost Profits Calculations
Prepare, Verify, and Excel at Trial
In order to recover lost profits in a commercial damage case, three standards must be met. First, plaintiff must show proximate cause; second, the foreseeability; and third, reasonable certainty. This article will focus on the third standard, reasonable certainty. Experts seeking to provide realistic lost profit estimates must be aware of this standard. The following discussion will review literature, court decisions, and practical efforts that may assist experts in addressing reasonable certainty.
Three general standards must be met in order to recover lost profits in a commercial damages case. The first is proximate cause. The proximate cause principle (the nearest or closest) governs recovery for all compensatory damages. In general, the recovery of damages must be proximately caused by the wrongful conduct of the defendant. Wording relating to the proximate cause principle may be found in a large volume of cases as well as in some state statutes (e.g., California, Oklahoma, South Dakota)[1]
The second standard is foreseeability. Foreseeability has been discussed in numerous state and federal cases. This standard requires “the losses resulting from a breach of contract, a tort, or other actionable conduct are foreseeable and probable. Foreseeability does not require that the specific breach of contract or other conduct that caused the injury was foreseeable—or that particular injury itself was foreseeable, only the breach or conduct was likely to cause damage.”[2]
The third is reasonable certainty. Reasonable certainty has also been discussed in numerous state and federal cases. Generally, this standard maintains that lost profits must be proven with reasonable certainty. But, reasonable certainty’s definition is not clear. To meet the standard, “absolute certainty in proving quantum of damages is not required.”[3] However, “reasonable certainty requires more than guess work, but less than absolute exactness or mathematical precision.”[4]
This article will focus on the third standard, reasonable certainty. Experts seeking to provide realistic lost profit estimates must be aware of this standard. The following discussion will review literature, court decisions, and practical efforts that may assist experts in addressing reasonable certainty.
What is Reasonable Certainty?
How do you prove something that never happened? That is the burden of a business claiming lost profits. Over the years, courts have sought to assist parties making such claims by establishing rules that, in general, state lost profits are not recoverable beyond an amount that the evidence permits to be established with reasonable certainty. These rules are beneficial, but do not provide a clear definition of reasonable certainty.
“This does not mean, however, that the ‘reasonable certainty’ test lack clear parameters. Profits which are largely speculative, as from an activity dependent on uncertain or changing market conditions, or chancy business opportunities, or on promotion of untested products or entry into unknown or unviable markets, or on the success of a new and unproven enterprise, cannot be recovered. Factors like these and others which make a business venture risky in prospect preclude recovery of lost profits in retrospect.”[5]
Dunn notes, “It would be misleading to discuss the reasonable certainty rule without stating its most important qualification. Those courts that have gone further than a simple statement that ‘reasonable certainty’ is required have almost invariably recognized that the rule applies only to the fact of damages, not the amount of damages. Proof of the fact of damages in a lost profits case means proof that there would have been some profits. If the plaintiff’s proof leaves uncertain whether plaintiff would have made any profits at all, there can be no recovery. But, once this level of causation has been established for the fact of damages, less certainty is required in proof of the amount of damages.”[6]
Therefore, experts hired to address lost profit issues should first assess the ability of the damaged business to generate a profit before moving forward with estimating an amount of lost profits. “At a minimum, opinions or estimates of lost profits must be based on objective facts, figures, or data from which the amount of lost profits can be ascertained.”[7]
Seeking Realistic Estimates
For years, the doctrine of proving a company would have generated profits prevented new businesses from recovering lost profits. That view has shifted in recent years. Under what has been called the “modern rule,” unestablished businesses can claim lost profits if profitability can be proved with reasonable certainty. This concept was addressed in the Energy Capital Corp. v. U.S. decision. “We do not agree that lost profits should be precluded as a matter of law for new ventures… Whether or not one considers AHELP to have been a ‘new venture’ or merely an extension of Energy Capital’s existing loan business, Energy Capital was required to demonstrate its entitlement to lost profits by showing the same elements that any business must show: (1) causation, (2) foreseeability, and (3) reasonable certainty… While the nature of a new venture may make it difficult to recover lost profits by establishing all of the elements of the general rule, such damages are not barred as a matter of law. This is consistent with the weight of modern authority…”[8]
Courts have been more consistent in allowing businesses that historically have not generated a profit to seek the recovery of lost profits. The ability of a business to seek recovery of lost profits is determined by the facts of the case and not its history. “The problem is not whether the roofing company has made profits in the past, or whether as a business, it will produce profits in the future; rather, the issue to be determined is whether the company was reasonably certain to make a profit under this particular contract.”[9]
Whether estimating lost profits for a new business, a firm that does not have a history of generating profits, or an existing business with consistent profits, an expert will have to rely on the damaged company’s financial records. These records may include tax returns or annual reports. As measurements of past performance, they may be reasonable indicators to use when projecting future performance. In addition, many companies will provide projections made prior to the damaging event. Projections provided by the damaged business may also give reliable data from which to work. But even the best projections contain an underlying level of uncertainty.
“The cash flows themselves usually come from management’s estimates of the firm’s future performance. As such, they are necessarily subject to uncertainty relating to matters specific to the firm as well as to broader issues such as the general state of the economy, advances in technology, effectiveness of management, labor issues, actions of competitors, price of raw materials, etc. Given the inherent uncertainty in predicting the future, one generally only uses three to five years of projections in performing a DCF (discounted cash flow) analysis.”[10]
Even with this uncertainty, these projections may be beneficial. They may provide insight as to the profit expectations anticipated by the business prior to the damaging event. However, this is not true with every situation. Therefore, experts must make their own assessment of the projected cash flows to insure reasonable certainty.
A review of recent cases shows several courts have found management projections to be overly optimistic, manipulated, and at times, completely fraudulent. “As a matter of common sense, DCF works best (and, arguably, only) when a company has accurate projections of future cash flows; when projections are not tainted by fraud; and when at least some of the cash flows are positive.”[11]
When possible, experts should compare prior financial records to earlier management projections for that same time period. This comparison of prior projections with actual results will assist an expert in deciding whether or not to adjust management’s future projections. The explanation of the analysis, the findings, and adjustments, if any, to future projections will assist in demonstrating that an expert’s calculations are based on reasonable certainty.
If profit projections for the recovery period are not available, the expert should review historical financial records and question management regarding the expected financial performance had the damaging event not occurred.
These questions should include, but not be limited to, the following:
What were the expected annual sales or revenues prior to the damaging act?
What expenses would have been incurred to generate those sales or revenues?
What capital expenditures (e.g., the purchase of new equipment) would have been needed?
How would the business have funded this work; new debt, new investors, or out of cash flow?
How would the new funding have impacted the overall cash flow of the business?
If a new product or service, what market share did the business expect to obtain?
Ultimately, what were the operating profits the damaged business expected?
After obtaining this data, Dunn and Harry recommend the following process:
- “Obtain or prepare a spreadsheet model of the plaintiff-envisioned ‘success’ outcome, which reflects the lost sales revenue, saved expenses, and lost net profits.”
- “Identify the risks the plaintiff likely will attain lower-than-hoped-for results. For example, could the future economic returns be less than projected because unit sales would be lower, unit prices would be lower, or variable expenses would be higher?”
- “Adjust the spreadsheet model for these identified risks with the objective of generating a stream of undiscounted lost profits that reasonably approximates the most likely or ‘expected’ (in a probability sense) but-for outcome.”[12]
A recent Delaware Chancery case provided an example of adjusting management data to provide more realistic cash flow estimates. At trial, the expert testified the management’s five year projections were biased by “over optimism.” The expert reduced the revenue by five percent, ultimately reducing the projected profits as well. The judge noted, “He [the expert] believed this reduction was appropriate because, although management thought their projections were ‘reasonable,’ a DCF model requires projections that are expected.”[13]
Making adjustments to management’s projections may run contrary to an expert’s normal practice. This is because not all experts approach estimating lost profits in the same way. “Some CPA experts project the plaintiff’s hoped-for income stream, modify those losses to a realistic expectation by factoring in future risks, and then discount the adjusted future losses to a present value at a risk-reduced, relatively low rate. Other experts project the hoped-for-but-lost amounts and then apply a higher discount rate that already incorporates risk or uncertainty to determine present value.”[14]
Estimating a Range of Loss
There are times when an analysis will allow for more than one realistic outcome. In these situations, the expert may provide a range of lost profits. This range can benefit the trier of fact in assessing damages, while meeting the reasonable certainty standard. These lost profit estimates may be based on differing levels of market penetration reflected in varying sales revenue and the costs related to generate those levels of sales. Ultimately, the net profits from these differing projections provide a reasonably expected range of performance for the business over the loss period.
Many courts have accepted these “high/low” ranges when the expert has provided estimates supported by data relative to the case. “Nevertheless, courts should, and generally do, look much more favorably on an estimate of lost profits when the court is confident that the amount of profits the claimant actually lost falls within a defined range and the claimant’s estimate is also within that range, even though it may be at the high end.”[15]
Reasonable Certainty in Changing Markets
Many lost profit estimates project a continuation of revenue, expenses, and net profits based on historical records. This but-for (before and after) assessment assumes there would have been “business as usual” were it not for the damaging event.
“This method (before and after) compares the revenue and profits before and after an event… A diminution in revenues or profits may be established based on the difference between the before and after levels. This method assumes that the past performance of the plaintiff is representative of its performance over the loss period. It also assumes that sufficient historical data are available from which to construct a statistically reliable forecast. In addition, it assumes that economic and industry conditions during the loss period are similar to what they were during the before period so that the data are comparable.”[16]
Of course, the assumption of continuing economic or industry conditions will not always be accurate. The sharp decline in oil prices has prevented those practicing in Texas and other oil and gas producing states from assuming business as usual for those involved in the oil and gas industry. Any projections for such businesses should include adjustments for current market conditions and anticipated future oil prices.
Applying Theory to Practice
In my practice, I have found it important to accept management’s projections and then verify. Management’s revenue projections may be reasonable or optimistic. Variable costs may or may not be in line with historical figures. And, their vision of the future rosier than the past. This is why it is important to question management after reviewing historical data and profit projections.
In a recent Oklahoma breach of contract case, the CFO of the damaged business presented me with a spreadsheet containing eight loss calculations. Some of the losses were for additional out of pocket expenses incurred by his firm. Others reflected past and future lost profits.
To start my analysis, I reviewed the firm’s historical financial data and annual projections. Read the claims being made by both the plaintiff and defendant. And, met with three members of the executive committee to discuss the loss estimates. After going over my results with the attorney representing the damaged business, it was agreed only two of the estimated losses could be calculated with reasonable certainty. One of the estimates was for past out of pocket expenses. The second was an estimate for lost profits.
Before completing my analysis, I further discussed with executives from the damaged firm issues relating to the underlying assumptions for the loss estimates. This was done to provide the most realistic loss figures possible. In the end, I adjusted the lost profit figures to provide estimates, I believed, were based on reasonable certainty. My report was allowed into evidence. And when I testified at trial, this front end work gave weight and validity to my opinion.
Conclusion
Financial experts must make numerous decisions when making estimates of lost profits. To recover lost profits, a damaged firm must show proximate cause, reasonable certainty, and foreseeability. In demonstrating reasonable certainty, an analysis must show that the damaged business would have been able to generate profits (or would have had a lesser loss) were it not for the damaging event. With that established, calculations may be made to quantify the profit loss.
After reviewing the damaged business’ historical financial data and profit projections, experts must accept management projections for the recovery period as reliable or adjust them based on their findings. The resulting lost profit figures do not have to provide losses with absolute certainty but must provide figures that have a reasonable certainty of accuracy. Experts must be aware of court rulings on this standard and how the reasonable certainty standard can be applied to the facts of the case at hand. Understanding this basic principal increases the expert’s ability to successfully provide the trier of fact with information needed in assessing damages.
[1] Recovery of Damages for Lost Profits, 6th Ed., Vol. 1, Robert Dunn, 1.1, 2005
[2] The Comprehensive Guide to Lost Profits and Other Commercial Damages, Vol. 1, 3rd Ed., Nancy Fannon, Jonathan Dunitz, 199, 2014
[3] TG Plastics Trading Co. v. Toray Plastics (America), Inc., 775 F.3d 31, 40 (1st Cir. 2014)
[4] Precision Pine & Timber, Inc. v. United States, 596 F.3d 817. 833 (Fed. Cir. 2010)
[5] Texas Instruments, Inc. v. Teletron Energy Management, Inc. supra, 877 S.W.2d 276, 279-280 (Tex. 1994)
[6] Dunn, 1.8
[7] Holt Atherton Industries, Inc. v. Heine, 835 S.W.2d 80,84 (Tex. 1992)
[8] Energy Capital Corp. v. United States, 302 F.3d 1314, 1326-1327 (Fed. Cir. 2002)
[9] Stark v. Shaw, 155 Cal. App. 2d 171, 181 (1957)
[10] Valuation Methodologies: A Judge’s View, Christopher Sontchi, ABI Law Review, Vol. 20:1, 2012, 8
[11] Adelphia Recovery Trust v. FPL Group, Inc. et. al., 02-41729-reg-11, (S.D. New York, 2014)
[12] Modeling and Discounting Future Damages, Robert Dunn, Everett Harry, Journal of Accountancy, January 2002, 3
[13] Merion Capital, LP et. al. v. BMC Software, Inc., 8900-VCG, Delaware Chancery, 8 (Oct. 21, 2015)
[14] Dunn, Harry, 1
[15] Fannon, Dunitz, 275
[16] Measuring Business Interruption Losses and Other Economic Damages, 2nd Ed., Patrick Gaughan, 49-50, 2009
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. Dr. Needham has been in the banking, finance, and insurance industries for over 20 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.
