It is important for the research and literature in our field to advance. Books, articles, and presentations help us improve and perfect the work we provide to the courts. It is also important that we review the history of our field to remind us “why we do things the way we do.” When reviewing the Energy Capital Corp. v United States case, financial experts will find several discussions regarding calculating lost profits that continue to provide a guide for other court opinions. This article will review three of those discussions: whether lost profits may be awarded to a new venture, date of discounting (ex post or ex ante), and whether an expert needs to include risk in the discount rate.
It is important for the research and literature in our field to advance. Books, articles, and presentations help us improve and perfect the work we provide to the courts. It is also important that we review the history of our field to remind us “why we do things the way we do.” In the personal damages field, the U.S. Supreme Court decision in the Jones and Laughlin Steel Corp. v Pfeifer case provides the outline for financial expert work. In bankruptcy matters, the U.S. Supreme Court decision in the Till v SCS Credit Corporation gives informative and instructional information regarding interest rates for cram down situations. While there is no Supreme Court decision to provide a framework for experts calculating lost profits, the Energy Capital Corp. v U.S. appellant decision provides the informative and instructive insight experts may be seeking.
When reviewing the Energy Capital Corp. v United States case, financial experts will find several discussions regarding calculating lost profits that continue to provide a guide for other court opinions. This article will review three of those discussions: whether lost profits may be awarded to a new venture, date of discounting (ex post or ex ante), and whether an expert needs to include risk in the discount rate.
This article will revisit the Energy Capital Corp v U.S. (Energy Capital) decision reviewing information from the decision to provide experts with an insight as to how the court reasoned issues relating to estimating lost profits and discounting future lost profits to present value.
The Nature of the Case
Energy Capital was formed in the middle of 1994. It provided financing to allow various institutions to optimize their energy consumption. Eventually, Energy Capital came to recognize that there was significant need for energy improvements in Housing and Urban Development (HUD) properties and that the primary obstacles to financing loans for such improvements were regulatory restrictions. Energy Capital believed that if it could solve the regulatory problem, it would be able to originate a significant number of loans that would provide financing for improvements to reduce energy costs in HUD properties.
Over a period of 15 months, Energy Capital negotiated with HUD to eliminate the regulatory restrictions. Energy Capital and HUD agreed to an agreement known as the Affordable Housing Energy Loan Program (AHELP). Under this agreement, Energy Capital would originate loans to owners of HUD properties for three years. In exchange, HUS promised to treat AHELP loans in a way that gave Energy Capital security for its loans.
Energy Capital agreed to structure each loan’s payments in a way that anticipated utility cost savings would equal 110% of annual loan payment. AHELP set an interest rate of 3.87% (based on U.S. Treasury rates) for each loan. Energy Capital, under a separate agreement, was being funded by Fannie Mae with a borrowing rate of 1.87%.
The AHELP agreement was signed in September 1996. In the following months, Energy Capital provided training to HUD employees and made sales presentations to various property owners. In February 1997, the Wall Street Journal stated that certain principals at Energy Capital were major fund raisers for President Clinton. Additional reports stated that it appears HUD officials were not aware of that.
On February 14, 1987, HUD terminated the AHELP agreement, 5.5 months after it was signed. At that time, Energy Capital had not completed processing any originating loans. The AHELP agreement did not have a termination for convenience clause.
Trial Court Decision
Energy Capital sued the U.S. government for terminating the agreement. The trial court found in favor of Energy Capital. Lost profits of $12,111,000 were found. When this amount was discounted to present value, the resulting loss figure was $8,787,000. Errors were found in the present value calculation. When those were corrected, the final lost profits figure became $10,082,000. The U.S. government timely appealed.
Appellant Court’s Findings
For financial experts, the appellant court addressed several issues; three of which will be discussed in this article. They are whether lost profits may be awarded to a new venture, date of discounting (ex post or ex ante), and discounting for risk.
Can Lost Profits be Awarded to a New Venture?
The U.S. government argued lost profits could not be recovered by Energy Capital because it was a new business venture that had not performed. The court did not accept that argument.
“We do not agree that lost profits should be precluded as a matter of law for new ventures that have not been previously performed by a third party. 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. [cite omitted] 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.”
The government made the argument that the new business rule must be applied. The court applied what has been called the modern new business rule. For most of the 20th century, most courts followed the new business rule, which stated a new or unestablished business could not seek lost profits. Other remedies may be available but not lost profits. Toward the end of the last century and continuing into this century, courts have become more open to allowing new or unestablished businesses to seek lost profits.
In the jurisdictions where the modern new business rules are applied, the lost profit claimants “must meet a higher evidentiary burden in satisfying [the reasonable certainty] standard for the obvious reason that there does not exist a reasonable basis of experience upon which to estimate lost profits with requisite degree of reasonable certainty.”
In the Energy Capital case, the appellant court went on to say, “Most recent cases reject the once generally accepted rule that lost profits damages for a new business are not recoverable. 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 a rule of law has been converted into a rule of evidence.”
What is the Appropriate Date to Begin Discounting?
The U.S. appealed the date used to discount future lost profits to present value. The government argued the damages should have been discounted to the date of the breach of contract instead of the date of judgment. This issue is generally referred to as the difference between ex ante and ex post.
“The question has occasionally been raised whether future damages are to be discounted to the date of the wrongful act (ex ante) or to the date of judgment (ex post). The courts routinely discount to the date of judgment and only rarely discuss the issue.”
The Energy Capital appellant court had to address this issue. “The time when performance should have taken place is the time as of which damages are measured. [cite omitted] That rule does not apply to anticipated profits or to the other expectancy damages that, absent the breach, would have accrued on an ongoing basis over the course of the contract. In those circumstances, damages are measured throughout the course of the contract. To prevent unjust enrichment of the plaintiff, the damages that would have arisen after the date of judgment (future lost profits) must be discounted to the date of judgment. [cite omitted] Discounting future lost profits to the date of judgment merely converts future dollars to an equivalent amount of present dollars at the date of judgment … .”
Should the Discount Rate Applied to Future Lost Profits Include Risk Premiums?
In the Energy Capital case, the trial court applied a risk-free rate to discount the future lost profits to present value. The government argued this was incorrect. They argued the discount rate should represent the return an investor would require to risk investing capital in a particular venture and that such a rate must incorporate any risk that cash flows would not be realized.
The appellant court response was “It depends.” “We do not hold that in every case a risk-adjusted discount rate is required. Rather, we merely hold that the appropriate discount rate is a question of fact. In the case where lost profits have been awarded, each party may present evidence regarding the value of those lost profits, including an appropriate discount rate.”
In explaining its reasoning, the appellant court said, “Energy Capital argues that once the Federal Claims Court determined that its profits were reasonably certain, no further consideration of risk was appropriate, because risk already had been considered in determining whether there would be any profits. We disagree. … Therefore, the fact that the trial court has determined that profits were reasonably certain does not mean that risk should play no role in valuing the stream of anticipated profits. In other words, by finding that Energy Capital’s lost profits were reasonably certain, the trial court determined that the probability that the AHELP venture would be successful was high enough that a determination of profits would not be unduly speculative. The determination of the amount of those profits, however, could still be affected by the level of riskiness inherent in the venture.”
This position echoes the common position in state and federal courts. It then went on to explain the function of the discount rate.
“Energy Capital argues that the sole purpose in discounting is to account for the time value of money. Again, we disagree. When calculating the value of an anticipated cash flow stream pursuant to the DCF [discounted cash flow] method, the discount rate performs two functions: (i) it accounts for the time value of money; and (ii) it adjusts for the value of the cash flow stream to account for risk.”
Adjusting for risk when valuing a future cash flow has been addressed by Robert Dunn and Everett Harry. They argue the assessment of the discount rate begins with the preparation of the spreadsheet estimating the lost sales less expenses associated with the generation of those sales. The difference between these sales and costs are the lost profits. The level of reasonable certainty may impact the discount rate used. They observe that: “[s]ome 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 present value.”
With the discount rate being based on evidentiary data, the weight falls on the expert to be able to explain why the appropriate discount should be what he or she has calculated.
It is important for the research and literature in our field to advance. Books, articles, and presentations help us improve and perfect the work we provide to the courts. It is also important that we reviewed the history of our field to be reminded “why we do things the way we do.” In this article, we reviewed the Energy Capital Corp. v United States case. Financial experts will find at least three discussions in this decision regarding our field that continue to provide the foundation for other court opinions.
By being familiar with this and other court rulings, financial experts may avoid potential errors which could jeopardize their work. By having a general understanding of these opinions, an expert can also assist attorneys who are not familiar with the nuances of presenting lost profits in litigation. Staying abreast of court decisions relating to lost profits and litigation related business valuation is a way for experts to be well informed and provide an added value to those retaining them.
 Jones and Laughlin Steel Corp. v Pfeifer, 462 U.S. 523 (1983).
 Till v SCS Credit Corporation, 541 US 465 (2004).
 Energy Capital Corp. v United States, 302, F.3d 1314 (Fed. Cir. 2002).
 This section has paraphrased background information found in the Energy Capital appellant decision.
 Energy Capital Corp. v United States, 302, F.3d 1314, 1326-1327 (Fed. Cir. 2002).
 The Comprehensive Guide to Lost Profits and Other Commercial Damages, Vol. 1, Fannon, Dunitz, Business Value Resources, LLC, 2014, p. 203.
 Energy Capital Corp. v United States, 302, F.3d 1314, 1327 (Fed. Cir. 2002).
 Recovery of Damages for Lost Profits, 6th Ed., Supplement March 2021, Dunn, Rutberg, Makin, James Press, 2021, p. 405.
 Energy Capital Corp. v United States, 302, F.3d 1314, 1330 (Fed. Cir. 2002).
 Energy Capital Corp. v United States, 302, F.3d 1314, 1333 (Fed. Cir. 2002).
 Modeling and Discounting Future Damages, Journal of Accountancy, Dunn, Harry, January 2002.
 Ibid., p. 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 email@example.com.