Foreseeability Standard in Lost Profits Litigation

The Objective and Subjective Tests Used to Determine Foreseeability

To recover lost profits in a commercial damages case, three standards must be met. They are proximate cause, foreseeability, and reasonable certainty. Of these three, foreseeability is the lost profits standard in which a financial expert will have the least involvement. But this does not mean the expert’s work would not benefit the trier-of-fact in assessing foreseeability. This article will review the foreseeability standard and discuss how financial experts may be able to assist the trier-of-fact in considering this standard through their work addressing proximate cause and reasonable certainty.

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To recover lost profits in a commercial damages case, three standards must be met.  They are proximate cause, foreseeability, and reasonable certainty.  Of these three, foreseeability is the lost profits standard in which a financial expert will have the least involvement.  But this does not mean the expert’s work would not benefit the trier-of-fact in assessing foreseeability.  This article will review the foreseeability standard and discuss how financial experts may be able to assist the trier-of-fact in considering this standard through their work addressing proximate cause and reasonable certainty.

Foreseeability Standard in Lost Profits Litigation

To recover lost profits in a commercial damages case, three standards must be met.  They are proximate cause, foreseeability, and reasonable certainty.  In two previous articles, the role of experts in considering proximate cause and reasonable certainty has been discussed.[1]  This article will address the last of these three standards: foreseeability.

Foreseeability

To meet the standard of foreseeability, the plaintiff must show the claimed losses resulted from a breach of contract, a tort, or other actionable conduct that was foreseeable and probable.  “The party breaching the contract is liable for those risks foreseen, or which should have been foreseen, at the time the contract was made.”[2]

 

The plaintiff may claim the defendant failed to perform in a transaction that resulted in a loss in another transaction that hinged on the performance of the first transaction.  “Damages resulting from such transactions may not be recoverable unless it can be demonstrated that the damages were foreseen and within the contemplation of the parties at the time of the agreement.”[3]

As an example, a contractor may order materials from a supplier needed to provide a product or service to a third party buyer.  If the supplier does not deliver the purchased materials, the contractor may not be able to fulfill the third party buyer’s order and lose the anticipated work and sales.  The failure of the first transaction brought about the failure of the second transaction.  Based on these facts, the contractor may sue the supplier for lost profits.  In this litigation, one of the key questions becomes, “At the time the materials were purchased, did the supplier realize failure to deliver the materials would result in damage to the contractor?”  Was the damage to the contractor foreseeable?

Foreseeability does not mean that each party discussed the impact of an injuring act during initial negotiations, but that such an action would have caused the defendant to see that it would have harmed the plaintiff.  “The existing rule requires only reason to foresee, not actual foresight.  It does not require that the defendant should have had the resulting injury actually in contemplation or should have promised either implied or expressly to pay therefore in case of breach.”[4]

Generally, foreseeability is tied to lost profits brought about by a breach of contract.  Lost profits brought under a tort claim, usually, do not require the demonstration of foreseeability.  When recovering for negligence, determining whether the defendant anticipated that such an injury would cause lost profits is “irrelevant.”[5]

Tacit Agreement Test

Justice Oliver Wendell Holmes provided a straightforward understanding of foreseeability in his Globe Refining opinion (1903).  His opinion created what has been called the tacit agreement test of foreseeability.

“When a man makes a contract he incurs by force of the law a liability to damages, unless a certain promised event comes to pass.  But unlike the case of torts, as the contract is by mutual consent, the parties themselves expressly or by implication, fix the rule by which the damages are to be measured.  The old law seems to have regarded it as technically in the election of the promisor to perform or pay damages.  [cite omitted]  It is true that people when contracting contemplate performance, not breach, they commonly say little or nothing as to what shall happen in the latter event, and common rules have been worked out by common sense, which has established what the parties probably would have said if they had spoken about the matter.  But a man never can be absolutely certain of performing any contract when the time of performance arrives, and in many cases, he obviously is taking the risk of an event, which is wholly, or to an appreciable extent, beyond his control.  The extent to liability in such cases is likely to be within his contemplation, and whether it is or not, should be worked out on terms which it fairly may be presumed he would have assented to if they had been presenting to his mind.”[6]

The tacit agreement test was applied in most U.S. courts before the adoption of the Uniform Commercial Code (UCC).  The UCC rejected the tacit agreement test and most courts moved away from its language.  However, a few state courts continue to apply the tacit agreement test.

Hadley v. Baxendale (1854)

Prior to the Globe Refining case, the foundation for foreseeability was provided in an 1854 lost profits decision in England.  This case, Hadley v. Baxendale, continues to be the foundation for foreseeability and to be cited in many lost profits cases.  One of its most quoted sections states:

“Where two parties have made a contract which one of them has broken, the damages which the other party ought to receive in respect of such breach of contract should be such as may fairly and reasonably be considered wither arising naturally, i.e., according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract, as the probable result of the breach of it.  Now if the special circumstances under which the contract was actually made were communicated by the plaintiffs to the defendants, and thus known to both parties, the damages resulting from the breach of contract, which they would reasonably contemplate, would be the amount of injury which would ordinarily follow from a breach of contract under special circumstances so known and communicated.”[7]

This statement lays the foundation for objective and subjective standards for foreseeability, and general and special damages.

Objective and Subjective Foreseeability Tests

The most commonly applied test to determine foreseeability is the objective one.  The objective test requires the plaintiff show that the claimed lost profits are the result of the actions of the defendant, and both the plaintiff and defendant would have been contemplated at the time they entered into the contract, that such actions by the defendant would have resulted in a loss to the plaintiff.  In many cases, the plaintiff need only point out the nature of the transaction, which if not completed, would result in a loss to one of the parties.  Other cases require additional information to demonstrate the damage was foreseeable.

The subjective test is generally used as an alternative to the objective test.  This can be particularly true if a contract that was breached did not have language regarding damages due to the actions of either party.  The subjective test allows for communications and conversations during the negotiation of the contract, and communications after agreeing to the contract to demonstrate a knowledge between the parties that failure to perform would result in a loss to the plaintiff.  These facts show that the loss was contemplated through the dialogue between parties and, therefore, foreseeable.

General and Special Damages

“The issue of foreseeability in contract actions also requires a determination of whether the plaintiff seeks an award of general damages or an award of special or consequential damages.  General damages are those that flow directly and necessarily or are a natural result of the breach of contract.  Consequential or special damages, on the other hand, are those that are collateral to the contract; they are secondary or derivative, rather than those that restore the benefit-of-the-bargain to the non-breaching party.”[8]

An example of general damages would be the plaintiff requesting the payment stated in the contract for whatever service or product that was or was to be provided to the defendant.  These payments would have to be adjusted for any costs saved by the contract not being completed, if any.  An award of the resulting lost profits would make the plaintiff whole, as if the contract had been fulfilled as agreed.

Special damages arise from the plaintiff’s inability to fulfill other agreements or operate its business due to the breach of contract by the defendant.  The burden of proof is on the plaintiff to show the lost profits were a result of the defendant’s actions and that the defendant knew through communication or should have known that such a breach of contract would damage the plaintiff’s business.

These special damages tie back to the language in Hadley v. Baxendale.  “Now if the special circumstances under which the contract was actually made were communicated by the plaintiffs to the defendants, and thus known to both parties, the damages resulting from the breach of contract, which they would reasonably contemplate, would be the amount of injury which would ordinarily follow from a breach of contract under special circumstances so known and communicated.”[9]

Recent courts have continued to address the differences between foreseeability for general damages and special damages.  “Lost profits are legally foreseeable only if, at time of contracting: 1) loss was natural and inevitable upon breach so that the defaulting party may be presumed to have foreseen it; or 2) if breach resulted in lost profits because of special circumstances, those circumstances must have been known to the defaulting party at time of contracting; it is enough that the loss was foreseeable as probable, as distinguished from necessary, result of breach.”[10]

Role of the Expert

Lost profits literature is consistent in noting the trier-of-fact (judge or jury) is responsible for determining if foreseeability exists.  So the question becomes, “How can an economic expert assist the trier-of-fact in assessing the foreseeability argument?”

The expert’s work with causation and reasonable certainty will hopefully provide insight to foreseeability.  In each case, the trier-of-fact is asked to determine if the plaintiff’s injury was caused by the defendant’s actions.  In commercial damages cases, an expert may provide information explaining the impact of market or economic changes on the plaintiff’s industry or in the plaintiff’s own limitations relative to its claim.  If some of the plaintiff’s losses can be shown to have been caused by “other factors,” it may be difficult to prove foreseeability in the loss claim.  On the other hand, if an expert can show the “other factors” would have been beneficial to the plaintiff during the loss period, the trier-of-fact may also see how the action of the defendant may have caused the loss and should have been foreseen that such an action would have been potentially injuring.

Providing the court with lost profit calculations that meet the reasonable certainty standard may also assist the trier-of-fact in assessing foreseeability.  This is especially true if general damages have been claimed.  The plaintiff may claim the defendant had agreed to pay for services rendered and when those services were provided, payment was not made resulting in lost profits.  The calculation for such a loss would be based on pricing written into the contract.  When appropriate, saved costs are deducted from the appropriate pricing; the results are the lost profits the plaintiff expected from the transaction with the defendant.  By not paying when the services were provided, the defendant should have known his action would result in economic damage to the plaintiff.  The loss figure may help confirm the foreseeability of the action.

For special circumstances losses, the expert’s causation and reasonable certainty assessments may be more detailed and include additional outside considerations (e.g., new competition or economic downturn).  This is because the failure of one transaction has prevented another transaction from being completed.  And the failure of the second transaction has caused the lost profits claimed by the plaintiff.  But a well thought out and presented analysis may provide the trier-of-fact with the information it can use in assessing, not only reasonable certainty, but foreseeability as well.

Conclusion

There are three general standards for recovering lost profits: proximate cause, foreseeability, reasonable certainty.  Each is considered separately, yet they are intertwined.  Proximate cause examines if the defendant’s actions caused the plaintiff’s loss.  Foreseeability assesses whether the defendant, while negotiating a contract with the plaintiff, would have foreseen or contemplated such actions would have caused economic damage to the plaintiff.  And reasonable certainty demonstrates there is reasonable certainty the estimated lost profits would have been generated had the “wrongful” actions not occurred.  All separate, but all tied to reviewing how the alleged action of one party impacted the profits of another.

Of these three, foreseeability is the lost profits standard in which a financial expert will have the least involvement.  But this does not mean the expert’s work would not benefit the trier-of-fact in assessing foreseeability.  Assessing proximate cause and projecting lost profits with reasonable certainty provides important information which can be used by the trier-of-fact to determine if a reasonable person would have contemplated their action taken would have caused economic damage to the plaintiff.

Any financial expert hired to consult in a lost profits matter must be aware of these three and realize the impact his or her conclusions may have on the assessment of these standards.  While the expert’s focus on providing lost profit calculations that demonstrate reasonable certainty, the assessment of other potential causes for the plaintiff’s losses will provide the trier-of-fact with important causation information.  Information that can be used, not only in assessing proximate cause and the reasonableness of the lost profit estimates, but in determining foreseeability as well.

[1] Reasonable Certainty in Lost Profits Calculations, Quick Read, 1/6/2016; Considering Proximate Cause in a Lost Profits Analysis, Quick Read, 4/20 /2016.

[2] Ashland Management, Inc. v. Janien, 82 N.Y.2d 395, 403 (1993).

[3] Measuring Business Interruption Losses and Other Commercial Damages, 2^nd Edition, Patrick Gaughan, John Wiley & Sons, Inc., 2009, page 35.

[4] Brandon & Tibbs v. George Kevorkian Accountancy Corp., 226 Cal.App.3d 442, 277 Cal. Rptr. 40, 458, (1990).

[5] Anthony Equipment Corp. v. Irwin Steel Erectors, Inc., 115 S.W.3d 191, 205 (Tex. App. 2003).

[6] Globe Refining, Co. v. Landa Cotton Oil Co., 190 U.S. 540, 543, (1903).

[7] Hadley v. Baxendale, 9 Exch. 341, 156 Eng. Rep. 145, 151, (1854).

[8] The Comprehensive Guide to Lost Profits and Other Commercial Damages, Vol. 1, Nancy Fannon, Jonathan Dunitz, Business Valuation Resources, 2014, page 200.

[9] Hadley v. Baxendale, 9 Exch. 341, 156 Eng. Rep. 145, 151, (1854).

[10] Gulf Group General Enterprises Co. W.L.L. v. United States, 114 Fed. Cl. 258 (2013).

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.