Lost Profits and COVID-19
A Unique Take on Causation
Experts are becoming aware of how the COVID-19 pandemic has affected lost profit analyses that include 2020 and 2021. The pandemic and the slow recovery have created separate causations which may or may not become the proximate cause of a damaged business’ loss. For this reason, the effects of COVID-19 must be considered as an alternative causation to lost profits. The lockdowns across the country, the shuttering of non-essential businesses, and the overall fear which gripped the nation even as the economy was reopening caused a loss of revenue and profits to many businesses and exacerbating the lost profits of those injured due to other’s wrongful acts. Recently, the author was retained in connection with a lost profits assignment, this assignment provided a new twist to the “COVID-19 related” causation scenario. This article discusses how the author attempted to include the effects of COVID-19 in his analysis.
Much has been written about the impact the COVID-19 pandemic has had on the U.S. economy. This pandemic will continue to have impact moving forward on estimating lost profits. This is because the pandemic caused many businesses to lose revenue and ultimately profits. If an injured business’ projected losses include 2020 and/or 2021, the effects of COVID-19 must be considered as an alternative causation to lost profits. The lockdowns across the country, the shuttering of non-essential businesses, and the overall fear which has gripped the nation even as the economy has been reopening caused a loss of revenue and profits to many businesses and exacerbating the lost profits of those injured due to other’s wrongful acts.
Recently, I accepted a lost profits engagement that provided a new twist to the “COVID-19 related” causation scenario. This article discusses its uniqueness as well as how I attempted to include the effects of COVID-19 in my analysis.
Three Legal Standards for the Recovery of Damages
There are three legal standards that must be met for recovering lost profits: foreseeability, reasonable certainty, and proximate cause. The concept of foreseeability is “at the time the parties entered into the contract, the defendant reasonably could have anticipated from the facts or circumstances that the plaintiff would incur these damages in the event of a breach of contract.” In other words, at the time the parties entered a contract “they knew or should have known that lost profit damages would probably result from the breach.”[1]
To meet the courts’ standards, lost profits calculations must be provided with reasonable certainty. There is no specific definition of reasonable certainty. Court opinions have addressed reasonable certainty in this way: “absolute certainty in proving damages is not required” and “reasonable certainty requires more than a guess, but less than absolute exactness.”[2]
The remaining standard is the focus of this article. Proximate cause or causality[3] is the standard that asks, “Did the defendant cause the injured business to incur lost profits?” Courts have explained the standard this way. The “contract breach must be [the] direct and proximate cause of the lost profits damage, which must be naturally and directly traceable to the act of the wrongdoer.” And “Lost profits must be proximately caused: that is, they must be a natural, proximate, probable or direct consequence of the defendant’s actions, not a remote consequence thereof.”[4]
In a case last year, proximate cause came into play. An after-school learning center had sued a sub-contractor for lost profits due to its closure in 2020. The subcontractor’s workers had caused a flood in the learning center. The damage had closed the facility for several months. The learning center claimed loss of equipment and learning materials, costs for repairing damaged walls and floors, and lost profits. The claims for the reimbursement for repairs and costs were not contested. However, the lost profits claim was disputed because it appeared excessive.
The plaintiff’s expert had assumed monthly growth in revenue and expanding profit margins throughout 2020. During the deposition of the learning center owner, he noted the business had been classified as non-essential during the pandemic and was forced to close for several months in 2020. When this causation was factored into the business’ performance, the learning center had only two or three months of possible lost profits. The losses depended on when the local governmental authorities allowed the business to re-open and how quickly they were able to re-enroll their students.
Being classified as non-essential became the proximate cause for the learning center’s closure during most of 2020. The subcontractor’s damage to the business and the down time to repair the facility (which occurred during the COVID-19 mandated shutdown) became a remote causation. This is because even if no damage had been incurred by the learning center, that center would have been closed and profits lost during most of 2020 due to its non-essential status.
New Lost Profits Assignment with Unique Twist
Recently, I was hired for a new assignment. This was a start-up company who was suing a vendor for breach of contract. The start-up company had a sister company that had been in existence for several years. It purchased the vendor’s waste materials at bulk and sold the materials to other users. Some of the materials could be sold “as is.” Other material had to be refined or purified before re-use.
The sister company generated a strong cash flow from its operations. This cash flow was used to begin the start-up company which had developed a use for one of the materials purchased and sold by its sister company.
The start-up company was in the process of getting government regulatory approval to market and sell its product when the vendor chose to not renew the buy/sell agreement. The sister company claimed the vendor had assured the company it would renew the agreement for two years. This would have extended the agreement to the end of 2021. Due to the argument over the extension of the agreement or lack thereof, the vendor ceased selling the waste materials to the sister company prior to maturity of the existing contract. This was the foundation for the breach of contract suit which was brought by the sister company.
The start-up company joined the suit in 2021. The start-up company claimed the cash flow funding the research and development for the new product and the costs for testing and seeking regulatory approval was coming from the sales of the waste materials. With the vendor not following through with its alleged commitment to extend the buy/sell agreement, the start-up company had lost its cash flow support from its sister company and had to start seeking investors. This had taken time away from management’s focus on business development that included the testing and filing for regulatory approval.
One claim made by the start-up company was unique. Had the cash flow not stopped due to the actions of the vendor, it would have been able to complete its testing and applications prior to the arrival of COVID-19. That is, all its application work would have been completed prior to March 2020. The start-up company argued that with the start of COVID-19, governmental agencies and regulators began working virtually, mostly from home. These employees had limited access to laboratories and testing facilities. This greatly slowed any firm’s applications.
Those whose applications had been completed prior to the lock downs were better positioned to be approved as soon as work returned to a more normal pattern in late 2020 or early 2021. The start-up argued it would have received regulatory approval during the first quarter of 2021 had it been able to complete its application process prior to the start of COVID-19. Having to wait until the first quarter of 2021 to complete its application, the start-up believed it would not receive approval until the end of the fourth quarter 2021 or the first quarter 2022.
Therefore, the start-up had been delayed approximately 12 months in being able to start marketing and selling its product. This resulted in a 12-month delay in starting the business on the road to profitability.
Applying Proximate Cause to This Case
This case took the normal argument regarding other causations and turned it on its head. In the case regarding the learning center and its lost profits, the proximate cause of its lost profits for most of 2020 was the COVID-19 pandemic. The non-essential business shutdown rules overrode the causation of not being open due to the damage to the center. It was not until the shutdown was lifted was the proximate cause for these lost profits shifted to the damage to the facility. But even these few months had to factor the loss of students brought about by the pandemic and the economy’s slow opening to get back to be pre-COVID-19 levels.
In this matter, the start-up business was moving forward as planned. The cash flow from the sister company was paying for the testing and costs for regulatory approval. The early cancelation of the agreement with the vendor led to a dramatic reduction in cash flow which prevented the start-up from completing its testing and filing with the government before the start of 2020. This breach of contract was the proximate cause for the start-up’s lost profits.
When the pandemic hit, regulatory agencies began working virtually. This slowed the approval process. Regardless of the status of the start-up’s application, its product approval would have been delayed. The pandemic and the resulting office closures was the proximate cause of the delay in any applicant’s approval. This causation would have applied to any loss in 2020.
However, the start-up company claimed a different loss. The start-up argued, had its application been complete prior to the start of COVID-19, it would have been one of the first applicants to receive approval in 2021. Because of the loss of cash flow, it was not able to complete the application until the beginning of 2021. And due to that, the regulatory approval it sought would not be made until the end of 2021 or first quarter of 2022. This created a loss period for marketing, generating sales, and creating market share and possibly profit of 12 months. This means subsequent years of the start-up period were also delayed. This claim shifted the proximate cause of the start-up’s lost profits back to the actions of the vendor selling the waste materials.
To express this, I showed no losses prior to 2021. Over a three-year period (2021 through 2023), I showed the two sets of losses. Both relied on the start-up’s management projections for the first three years of operation. The loss for 2021 was based on the additional cost for purchasing the waste material used in the start-up’s product. Relying on the company’s research and testing, a factor reflecting the amount of waste material used in each one million dollars of sales were determined. I then multiplied the difference between the cost to purchase the waste material from the vendor and the cost to purchase the material from the new provider by the amount of waste material used for one million in sales. This amount was then multiplied by the projected number of millions in sales for 2021. The product of these calculations provided the estimated additional costs for 2021.
My interview with management showed that all other costs would have been the same. Therefore, the savings from the agreement had it continued through 2021 fell directly to operating profit.
I then assumed the agreement would have ended in 2021. I also assumed by 2024 the start-up company would fully mitigate its loss. In other words by 2024, its sales and profits would been in sic with the management’s projections. This left the losses for 2022 and 2023 to estimate. For these two years, I assumed a one-year delay in company development due to not receiving regulatory approval at the beginning of 2021 but the end.
Even though the sister company had been in operation for many years and the management of the start-up had years of experience in the chemical industry, the start-up was still a new business and they were trying to penetrate a new market.
I had to rely on the management’s research and projections. But because of the delay in getting approval, they were only beginning to reach out to customers in anticipation of approval, there was little actual sales results to review. Because I was basing my analysis on the management projections, I applied a 52.1% discount rate.
This size of this discount rate was based on a quote from Robert Dunn and Everett Harry. “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 discount 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 the present value.”[5]
Data were not available to allow me to model the future lost profits. Therefore, I was not able to use a risk-reduced rate. Because the projected profits were created by the start-up’s management, I needed to apply a higher discount rate. Based on my experience, training, and knowledge, the applied discount rate was the appropriate one.
Conclusion
Experts are aware how the COVID-19 pandemic has affected lost profit analyses that include 2020 and 2021. The pandemic and the slow recovery created separate causations which may or may not have become the proximate cause of a damaged business loss.
I found that there may be some unusual circumstances in which the pandemic delayed a business recovery and therefore, aided in the loss caused by another party’s action. Segregating the causation from COVID-19 and other sources may be difficult but could in the long run increase the period of loss.
As we move forward, experts must keep an open mind when assessing causation and losses. By doing so, the expert will be able to clearly explain his or her reasoning to the court and the trier-of-fact in a way that shows how proximate cause was separated and considered in arriving at the final lost profit figures.
[1] Recovery of Damages for Lost Profits, 6th Ed., Supplement September 2021, p.56.
[2] Ibid., p.11.
[3] Proximate is defined as immediate or closest in relationship.
[4] Ibid., p.5.
[5] Modeling and Discounting Future Damages, Robert Dunn, Everett Harry, Journal of Accountancy, January 2002, www.aicpa.org/pubs/jofa/jan/2005/dunn.htm, 1.
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 is a member of NACVA’s QuickRead Editorial Board.
Dr. Needham can be contacted at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.
