Lost Profits: Fifth Circuit Decision Clarifies Reasonable Certainty
for the Modern New Business Rule
A recent Fifth Circuit Court of Appeals decision has thrown additional light on the reasonable certainty standard used to assess lost profits for claims made by new or unestablished businesses. The decision helps put into perspective what information can and, more importantly, cannot be used to calculate lost profits for a new or unestablished business. While sometimes a daunting task, calculating lost profits for new or unestablished businesses should not be an impossible task. But for the protection of the expert and the product of his or her work, knowledge of what courts have accepted and rejected is essential in meeting the higher standard to which these calculations are held. This article reviews the new business rule, the modern new business rule, and the impact of this decision on experts in meeting the reasonable certainty standards in these type cases.
A recent Fifth Circuit Court of Appeals decision, Mansour v. Youtoo Media, has thrown additional light on the reasonable certainty standard used to assess lost profits for claims made by new or unestablished businesses.[1] The decision helps put into perspective what information can and, more importantly, cannot be used to calculate lost profits for a new or unestablished business. This decision is helpful in the ongoing conflict between plaintiff and defense sides over whether a new or unestablished business can have lost profits and, if so, how does an expert calculate them with reasonable certainty. This article will review the new business rule, the modern new business rule, and the impact of this decision on helping experts in meeting the reasonable certainty standards in these type cases.
The New Business Rule
Older case law shows adherence to the “new business” rule which stated lost profits of a new or unestablished business cannot be recovered. This rule was well explained in the 1955 Maryland decision, Evergreen Amusement Corp. v. Milstead.
“Under the great weight of authority, the general rule clearly is that loss of profit is a definite element of damages in an action for breach of contract or in an action for harming an established business which has been operating for a sufficient length of time to afford a basis of estimation with some degree of certainty as to the probable loss of profits, but that, on the other hand, loss of profits from a business which has not gone into operation may not be recovered because they are merely speculative and incapable of being ascertained with the requisite degree of certainty. … While this court has not laid down a flat rule (and does not hereby do so), nevertheless, no case has permitted recovery of lost profits under comparable circumstances.”[2]
Even under the “old” new business rule, there were exceptions. This was noted in the 2000 Virginia decision, Lockheed Information Management Systems, Co. v. Maximus, Inc. “Virginia’s new-business rule does not prevent established business that had not previously operated in state from recovering lost profits damages for intentional interference with ‘contract expectancy.’”[3]
The Modern New Business Rule
Fewer and fewer states apply the new business rule for denying recovery of lost profits by a new or unestablished business. Most jurisdictions have moved to the modern new business rule. The modern new business rule allows new or unestablished businesses to recover lost profits when they have been proven with reasonable certainty.
This change of status was addressed by QuickRead in 2015. “While the vast majority of 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 financial 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 scrutiny.”[4]
A review of financial literature confirms this statement. “A difficult proposition for an expert will be the lost sales or revenue for a newly established or never established business. … Regardless of the method used to estimate the plaintiff’s lost sales, the expert should have some economic underpinning for the assumptions.”[5]
Fannon and Dunitz go even further explaining the reasoning behind this additional scrutiny of an expert’s analysis. “The reasons are obvious. The majority of new businesses never achieve significant success. They either fail completely or they limp along, never earning enough to compensate their owners for the time, effort, and money they put into the businesses. Still, entrepreneurs are, by nature, optimistic and adept at transmitting their enthusiasm to others. As a result, they usually make great witnesses. All too often, they are able to convince a jury that what was really, in fact, a long shot, would have become the next Google but for the actions of the defendant. Without the courts’ skepticism of new ventures, considerations of potential liability would make established businesses (who have a lot to lose) reluctant to deal with new ventures.”[6]
Reasonable Certainty and the Modern New Business Rule
As courts have moved from the new business rule to the modern new business rule, one of the main questions has been, “How does an expert show reasonable certainty when calculating lost profits for a new or unestablished business?”
In the Energy Capital case, the defendant argued the court should have denied lost profits based on the new business rule. “The defendant argues that because Energy Capital was engaged in a new business, any measure of lost profits is unreliable and speculative. The defendant relies on the first decision by the Court of Claims in Neely v. United States, 285 F.2d 438, 443, 152 Ct. Cl. 137, 146 (1961). ‘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.’”[7]
The court went on to express support for the modern new business rule in its decision. “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.’”[8]
This decision focused on the ability of the plaintiff to not only show causality, but also show reasonable certainty in its lost profits claim.
One of the key considerations for meeting the reasonable certainty standard when calculating lost profits for a new or unestablished business is to demonstrate the ability to survive. An expert should look at factors such as size of the market, number of competitors, potential new competitors, management’s prior experience in the industry, capital adequacy, uniqueness of new or unestablished business relative to the industry, and general economic conditions at the launch of the new venture and/or at the time of the alleged wrongful act that damaged the business. This is not a comprehensive list but shows factors that may play a role in determining if the court finds an assessment of lost profits meets the reasonable certainty standard.
Once the ability to survive has been established, an expert will examine most of the same factors critical to any lost profit analysis. The list of factors to be considered will include, but not be limited to, the following:
- What were the expected sales or revenue prior to the alleged wrongful act?
- What expenses would have been incurred to generate those sales or revenue?
- What capital expenditures (e.g., the purchase of equipment) would have been needed?
- How was the new venture funded, through debt or investors?
- How was that funding to be repaid?
- What was the anticipated market share the new or unestablished business expected to obtain?
- What were the operating profits expected by the damaged business during the loss period?[9]
These questions provide the foundation for showing the damaged business would have been profitable were it not for the wrongful act. Or as Dunn has noted, “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.”[10]
Fifth Circuit Opinion
Many experts rely on management projections of future sales or revenue, expenses, and ultimately, the operating profits to be generated by the new or unestablished business when analyzing a lost profits claim. Some of these projections may have been provided to a lender as part of the lending process. Other projections may have been used for budgeting to determine the cash needs of the new organization. And finally, some of the projections may have been provided to investors to encourage them to invest in the new or unestablished business.
The recent Fifth Circuit Court of Appeals decision addresses the use of such projections in making calculations of lost profits under the modern new business rule. The appeal came from the Northern District of Texas, Dallas Division. The case had been tried under Texas law.
The case was between a new business, Youtoo Media, LP (Youtoo) and a Saudi investor, Mansour Al-Saud. The court noted, “Youtoo’s technology blended social media and television by allowing viewers to actively participate in broadcasts by sending texts, pictures, and videos that networks could insert into programs. … But to sell the platform to American broadcasters (its ultimate goal), Youtoo felt it had to demonstrate success in other markets, and to do that it needed capital. This search for markets and money brought these parties together.”[11]
The plaintiff (Youtoo) signed a letter of intent (LOI) to initiate operations in the Middle East and sell a portion of the company to Al-Saud. His down payment was three million dollars. Al-Saud ultimately chose not to invest in Youtoo. Youtoo defaulted on its debt. Youtoo’s primary lender forced the company to sell its intellectual property and assets to cover outstanding debt. Al-Saud sought the return of his down payment. Youtoo claimed it did not have to return the money. Al-Saud sued for breach of contract. Youtoo counterclaimed for breach of contract and other wrongful acts. Al-Saud was successful in court and the verdict was appealed by Christopher Wyatt, the General Partner of Youtoo, LP.
As a part of its opinion, the Fifth Circuit agreed with the lower court that the testimony provided by Youtoo’s damages expert was speculative.
“The Middle East entity never earned a profit. Parties cannot recover anticipated profits when ‘there is no evidences from which they may be intelligently estimated.’ [cite omitted] Those profits must be ascertainable with a reasonable degree of certainty based on objective facts, figures, or data.”[12]
The decision goes on to say that Texas courts have held “a lack of profit history does not preclude a business from recovering of lost future profits. Yet, the ‘mere hope of success of an untried enterprise, even when that hope is realistic, 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.”[13]
The court closed this part of its analysis by saying, “Many of these same problems also characterize Youtoo Middle East. It was a new venture with no history of profitability. The joint venture had few signed agreements with regional broadcasters or governments. Defendant’s damages estimates had to rely in large part on hoped for partnerships, and speculation about the profits those 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 with more reliable indicators of profitability.”[14]
The appellant court stated the evidence was speculative, upheld the lower court’s decision to exclude testimony in District court of Youtoo or Christopher Wyatt’s damages, and dismissed Youtoo’s counterclaim. This decision confirmed the higher standard scrutiny for achieving reasonable certainty in cases involving the modern new business rule.
Addressing the Higher Standard of Review
In matters involving an established business, an expert may review historical financial and tax records, historical projections, and management projections made around the time of the alleged wrongful act. In addition, there should be industrial and market data available for review. This information provides an expert with the ability to compare and contrast historical and industry performance and use that data along with the injured business’ future projections to build an analysis based on facts specific to the case.
With a new or unestablished business, there are no historical financial records to use for comparison, no performance to review, no data points to provide a financial trend. So, the use of a business’ projections provided to potential investors, which are commonly known to be optimistic, provides results with no foundation.
Other court opinions have addressed similar concerns with expert’s calculations of lost profits for new or unestablished businesses. In Florida, an appellant court upheld a lower court decision that a plaintiff failed to support its lost profits claim because the plaintiff’s expert failed to “evaluate any comparable facility’s profitability as a ‘yard stick’” making the resulting lost profits figure purely speculative.[15] An Alaska court vacated a $51.3 million lost profit verdict because the plaintiff relied solely on statistical projections and, therefore, failed to satisfy the reasonable certainty standard for proving lost profits.[16]
So, how can an expert show lost profits with reasonable certainty under the modern new business rule? Two Texas decisions may shed light on helping experts make such calculations. In 2013, a Texas appellant court stated that to meet the reasonable certainty standard inquiry, one should focus on the experience of the people involved, the nature of the business activity, and its relevant market.[17] The prior year a Texas appellant court said, “Where estimates are based on objective facts or data and there are firm reasons to expect a business to yield a profit, recovery is not prohibited simply because the enterprise is new.”[18]
It appears courts are expecting to see that the new or unestablished 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 contact with potential clients, and the ability to delivery the business’ 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 can be no loss.
Conclusion
One of the most difficult assignments for an expert is calculating the lost profits for a new or unestablished business. The modern new business rule allows a new or unestablished business to recover lost profits even if the business had not generated a profit prior to the alleged wrongful act or opened its doors. When calculating such lost profits, an expert’s report is held to a higher standard of reasonable certainty than may be found in cases involving established businesses.
Over the years, court decisions have shown ways experts may bolster the foundation of their financial calculations. These include providing support for the business survival, the strength and experience of management, adequate capital funding, a need for the product or service to have been provided, and the ability of the injured enterprise to have made a profit.
On the other hand, many opinions have excluded these kinds of lost profit calculations due to their speculative nature. This recent Fifth Circuit Court of Appeals decision adds to that list. However, even the decisions excluding expert’s opinions provide insight in how to prepare an acceptable report. In this decision, the appellant court stated only relying on projections made by management used in presentations to investors does not provide adequate foundation for making lost profit calculations in modern new business rule cases. This opinion shows where additional research is needed to strengthen an expert’s analysis.
While sometimes a daunting task, calculating lost profits for new or unestablished businesses should not be an impossible task. But for the protection of the expert and the product of his or her work, knowledge of what courts have accepted and rejected is essential in meeting the higher standard to which these calculations are held.
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] Mansour Al-Saud v. Youtoo Media, LP & Christopher Wyatt, 2018 U.S. App. LEXIS 29680
[2] Evergreen Amusement Corp. v. Milstead, supra, 206 Md. 610, 618, 112 A.2d 901, 904-05 (1955).
[3] Lockheed Information Management Systems, Co. v. Maximus, Inc., 259 Va. 169, 413 S.E.2d 347 (1992).
[4] Lost Profits: The Reasonable Certainty Standards and the Modern Business Rule, Josefina V. Tranfa-Abboud, QuickRead, 9/9/2015, www.quickreadbuzz.com
[5] Litigation Services Handbook, 5th Ed. The Role of the Financial Expert, Roman Weil, Daniel Lentz, David Hoffman, John Wiley & Sons, Inc., 2012, 4.15.
[6] The Comprehensive Guide to Lost Profits and Other Commercial Damages, Nancy Fannon, Jonathan Dunitz, BVR, 2014. 270-71.
[7] Energy Capital Corp v. United States, 47 Fed. Cl. 382, 393; 2000 U.S. Claims LEXIS 168.
[8] Energy Capital Corp, at 394.
[9] Reasonable Certainty in Lost Profits Calculations, Allyn Needham, QuickRead, 1/6/2016, www.quickreadbuzz.com
[10] Recovery of Damages for Lost Profits, 6th Ed., Vol. 1, Robert Dunn, 2005, 1.8.
[11] Mansour Al-Saud v Youtoo Media, LP & Christopher Wyatt, 2018 U.S. App. LEXIS 29680, 1-2.
[12] Youtoo Media, LP, at 17.
[13] Youtoo Media, LP, at 18.
[14] Youtoo Media, LP, at 18–19.
[15] Victoriana Building, LLC v. Fort Lauderdale Surgical Center, LLC, 166 So.3d 861 (Fla. App. 2015), reh’g denied, (Fla. App. 2015).
[16] Recreational Data Services, Inc. v. Trimble Navigation, Ltd., 404 P.3d 120, 137 (Alaska 2017).
[17] Peterson Group, Inc. v. PLTQ Lotus Group, 417 S.W.3d 46 (Tex. App, 2013).
[18] DaimlerChrysler Motors, Co. v. Manuel, 362 S.W.3d 160, 191 (Tex. App. 2012).
