Looking Back to Go Forward

A Review of the Basics for Lost Profits (Part I)

Those who have worked in the forensic field for many years begin to take for granted how we approach and handle certain situations. We have a level of knowledge and experience that lets us move forward without much research. But, with this level of experience and understanding comes a level of forgetfulness. Not that we forget how to perform the analysis, but we forget why we need to perform an analysis a certain way. I believe it is good from time to time to stop and ask, “Why do we do it this way?” This is the first article in a series which will review the basics for making lost profit calculations. In this article, we will take a broad-brush view of this topic. In future articles, we will cover each topic in more detail, addressing definitions, controversies, and court decisions. It is my hope that this series will allow its readers to look back at why we apply these techniques when calculating lost profits and use this review to move forward with better confidence and understanding of why we do it this way.

Those who have worked in the forensic field for many years begin to take for granted how we approach and handle certain situations. We have a level of knowledge and experience that lets us move forward without much research. It is the same in any specialized field; the longer you work in that area, the more you have seen and the better prepared you are to be able to address any problem that arises. But, with this level of experience and understanding comes a level of forgetfulness. Not that we forget how to perform the analysis, but we forget why we need to perform an analysis a certain way. I believe it is good from time to time to stop and ask, “Why do we do it this way?”

This is the first in a series of articles that will hopefully answer the ‘why’ question for many aspects of lost profits analysis. It is a return to the basics to remind experienced readers or, for the first-time readers, to explain the foundation for estimating lost profits. In subsequent articles, I hope to provide insight into specific areas of lost profits work. These articles will go over what financial literature and the courts have said on those topics. Today, this article starts with the basic question, “What are lost profits and what are the tools and standards we use to calculate them?”

Defining Lost Profits

The simplest definition found in financial literature is in Recovery of Damages for Lost Profits. “Net profits are recoverable, not gross profits without deduction of expenses.”[1] This definition is straight forward but not overly useful in explaining what lost profits are.

A more detailed explanation for net profits expands on the prior statement. “Only lost ‘net profits’ are allowable as economic damages. This means that lost profits is the net amount that results from a calculation (the lost revenue less the relevant avoided costs equal the net lost profits) to be used in claiming an element of economic damages in a litigation matter involving a business dispute. Net lost profits (hereinafter referred to as ‘lost profits’) are generally computed by estimating the revenues (gross and net) that would have been earned ‘but for’ the alleged acts reduced by avoided costs (or incremental costs) that did not occur because of the subject lost revenues. From that predetermined ‘but for’ amount, the actual/anticipated profits are deducted to compute the economic damages.”[2]

But having the general description of how to calculate lost profits is only the beginning. “In the financial expert community, the definition of lost profits is much broader. Lost profits are based upon the alleged harm suffered by the injured party. In a business setting, lost profits are calculated as an amount necessary to place the injured party in a position that it would have been had the injury/incident not occurred. Accordingly, lost profits damages analyses represent the amounts that are potentially recoverable due to the specific actions/inactions or incidents.”[3]

These two sources tell the expert the calculated lost profits must be net profits (lost revenues less avoided costs) and must be only the lost profits that may be attributed to the alleged wrongful act(s). This means if the injured business incurred losses due to something else (e.g., closures caused by the COVID-19 pandemic), those losses cannot be included. These thoughts frame the expert’s work when estimating lost profits.

Methods for Calculating Lost Profits

Once an expert accepts an assignment, he or she must determine the best method for quantifying the losses. All the methods applied are based on the same concept: “but for” the wrongful act, the injured company would have made additional profit that has now been lost.

Four approaches are most often discussed in financial literature. They are: before and after, yardstick, sales projection method, and market model.

“The ‘before-and-after’ method determines economic revenue for the damages period by comparing the performance of the business before the event occurred and after the effects of the damaging event are over. The underlying theory is that, ‘but for’ the event, the plaintiff would have experienced the similar revenues and anticipated lost profits during the damages period before the event occurred and/or after the event has subsided.”[4]

Experts using the before and after method must be aware of other business and economic factors that could have impacted the revenue or profits during the damages period. “A practitioner should consider factors that could influence performance measures in a before-and after analysis. For example, in McClinchy v Shell, the appellate court excluded the expert witness because he did not relate the plaintiff’s damages to alleged antitrust acts: ‘the cause of the decline in sales theoretically could have been anything [citation omitted].’”[5]

“The yardstick method utilizes guideline company or industry measures to serve as the proxy for what the revenues and profits of the affected business would have been ‘but for’ the damaging event.”[6]

Experts must be careful to select businesses or the industry statistics that are sufficiently similar to the injured business. The comparability of the yardstick data is common fodder for Daubert challenges in lost profit cases.

The sales projection approach is commonly used in more complex lost profit matters. “The sales projection method utilizes company-specific forecasts for certain items, preferably by using forecasts that the company prepared in the ordinary course of business or for some purpose other than the litigation. Some businesses are more sophisticated than others, and their projections (formatted like a typical income or operating statement) may specify revenues by product lines, detailed expenses, income taxes, and miscellaneous income/expenses.”[7]

Good sources for these projections are income statements used in annual budgeting, projections provided to leaders, or projections given to investors. These documents cannot be accepted as being accurate and correct. They must be reviewed by the expert for their usefulness. Because they have been prepared by the injured company’s management (even if prepared prior to the alleged wrongful act), the statements must be assumed to be optimistic.

If several years of forecast sales and profits are available, the expert may compare projections prior to the alleged wrongful act against the actual performance of the company prior to the wrongful act. This can demonstrate whether the management’s projections are reliable or not.

The fourth approach is not used as often of the prior three approaches. For the market approach, “the expert considers the plaintiff’s market share prior to the defendant’s alleged act to determine lost revenues/sales.”[8] The expert will assess the plaintiff’s market share prior to the alleged wrongful act and the plaintiff’s market share during the damage period. Calculations will then show the additional revenue/sales the plaintiff would have achieved if it had maintained its market share. From revenue/sales projections, avoided costs are then subtracted from the lost revenue to estimate the injured business’ lost profits.

“Using this method requires identifying the plaintiff’s historical market share trends, the entrance/exit of competitors in the marketplace, and other changes that might affect a particular company’s market share.”[9]

Damages Period

For any assignment, the expert will have to determine the length of the damage period. In most cases, the date of injury (i.e., the date on which the injury to the business began) is straight forward. Such a date is usually identified in the complaint or pleading filed by the plaintiff. It can also be determined by interviewing the hiring attorney and/or the injured business’ management. Determining when the damages will end is many times more difficult.

“In practice, identifying the beginning of the damages period is often easier than establishing the end because the negative effects of the unlawful business conduct may extend well beyond the point when the unlawful conduct ceases. … From an economic perspective, the damages period should continue until the unlawful conduct ceases to affect the profits of the injured party, which depends on the specific circumstances of the case at hand. From a legal perspective, however, the damages period may be limited. In a breach-of-contract case, for instance, lost profit damages often, may extend only through the life of the breached contract, not beyond.”[10]

This is an issue which the expert needs to discuss with the hiring attorney. The expert can provide information as to when the injured business’ economic damages will cease, and the attorney can provide information as to the legal limits on the length of damage periods for the claims being made by the injured business.

Discounting Future Lost Profits to Present Value

“Future damages must be discounted to present value. It is part of the plaintiff’s burden of proof to offer evidence of the present value of a future stream of lost income. Without evidence of the appropriate discount rate, plaintiff has not made out its case. An award of undiscounted future lost income should be set aside.”[11]

One of the most important court cases addressing the discounting of lost profits to present value is Energy Capital Corp v United States case.[12] This opinion is important because numerous courts had provided diverse opinions regarding the appropriate discount rates to be applied in lost profits matters. This decision provided a detailed assessment which continues to provide a guideline for courts reviewing arguments over the discounting of future lost profits.

In its review of the lower court decision, the federal court of appeals discussed the day to use to begin discounting and the appropriate discount rate. The appellant court stated, “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 judgement (ex-post). The courts routinely discount to the date of judgement and only rarely discuss the issue.”[13]

The appellant court went on to state that the discount rate depends on the facts of the case. In the Energy Capital case, the trial court applied a risk-free rate to discount future losses 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 particulate venture and that such rate must incorporate any risk that cash flows would not be realized.

The appellant court held, “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 this case where lost profits have been awarded, each party may present evidence regarding the value of those lost profits, including an appropriate 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.”[14]

The appropriate discount rate is a controversial issue among financial literature and experts. This issue was initially addressed by Robert Dunn and Everett Harry. They observed, “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 present value.”[15]

An expert should use the method with which he or she is comfortable and can defend as appropriate for the specific calculation to which it was applied.

Court Standards

Experts accepting an assignment to calculate lost profits must understand that their work will not only be reviewed relative to the use of appropriate financial techniques, but also for following the standards that have been set by the courts. These standards generally fall into three categories: foreseeability, proximate cause, and reasonable certainty.

Financial experts are seldom asked to opine on foreseeability. The foreseeability standard “requires that 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 that the breach or conduct was likely to cause damage.”[16]

As an example, the actual breach of a contract by one party did not have to be foreseeable. The fact that the breaching of the contract by one party would damage the other party must be foreseeable.

Proximate cause is a standard that can be tricky for financial experts. Proximate cause “requires that the plaintiff tie damages to the wrongful act; lost profits are recoverable only when they can be traced to and result directly from the wrong to be redressed. This makes establishing causation essential to the plaintiff’s case because lost profit damages are not recoverable unless they ‘are directly and proximate[ly] caused by a defendant’s wrongful act [cite omitted].’”[17]

This means other causes for a loss of profits during the damage period must be considered and if found, must be factored into the lost profits calculation. As an example, in many recent lost profits assignments, I have considered the COVID-19 pandemic as the cause of a plaintiff’s lost profits in 2020, unless market data support success for the plaintiff’s business sector during the pandemic. Other proximate causes may be an increase in competition during the damage period or an overall decrease in customer demand for the plaintiff’s products or services.

The reasonable certainty standard applies directly to the work of the financial expert. “Reasonable certainty refers to the requirement that lost profits damages must be estimated using reliable methods and evidence. Although absolute precision is not required, the lost profits claim must not be remote, speculative, or hypothetical (i.e., it must be within the realm of reasonable certainty).

“In seeking lost profits damages, a plaintiff is required to establish not only the fact of damages (i.e., that some profits were lost due to the alleged wrongdoing), also the amount of damages, though somewhat more uncertainty is allowed in establishing the amount of damages versus the fact of damages.”[18]

This means an expert must first show that the plaintiff would have been able to be profitable during the damage period. Then, the expert must show the amount of lost profits using reliable methods that follow the facts of the case for arriving at the loss amount.

These three standards provide the basis for any challenges made by the opposing side relative to the work, opinions, and conclusions of the financial expert. Therefore, it is incumbent on an expert to keep these standards in mind when preparing a report.

Conclusion

This is the first article in a series which will review the basics for making lost profit calculations. This article has taken a broad-brush view of this topic. In future articles, we will cover each topic in more detail, addressing definitions, controversies, and court decisions.

Regardless of an expert’s level of experience, it is always good to review the foundation for the techniques to be used in his or her analysis. It is my hope that this series will allow its readers to look back at why we apply these techniques when calculating lost profits and use this review to move forward with better confidence and understanding of why we do it this way.

[1] Recovery of Damages for Lost Profits, 6^th Ed., March 2022 Supplement, Editors Sharon Rutberg, Wendy Malkin, LawPress, 2022, p. 393

[2] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3^rd Ed., Vol 1, Nancy Fannon, Jonathan Dunitz, BVR, 2014, p. 210

[3] Ibid. 210

[4] Ibid. 219

[5] Litigation Services Handbook, The Role of the Financial Expert, 5^th Ed., Roman Weil, Daniel Lentz, David Hoffman, John Wiley & Sons, Inc., 2012, p. 26.21

[6] The Comprehensive Guide to Lost Profits and Other Commercial Damages Vol 1, p. 220

[7] Ibid. 223

[8] Ibid. 226

[9] Ibid. 226

[10] Lost Profits Damages: Principles, Methods, and Applications, Everett Harry, III, Jeffrey Kinrich, Valuation Products & Services, LLC, 2022. p. 35

[11] Recovery of Damages for Lost Profits, Supplement March 2022, p.430

[12] Energy Capital Corp. v United States, 302 F.3d 1314, (Fed. Cir. 2002)

[13] Recovery of Damages for Profits, Supplement March 2021, p. 405

[14] Energy Capital Corp. v United States, 302 F.3d 1314, 1333, (Fed. Cir. 2002)

[15] Modeling and Discounting Future Damages, Journal of Accountancy, Dunn, Harry, January 2002

[16] The Comprehensive Guide to Lost Profits and Other Commercial Damages, p. 199

[17] Ibid. pp. 198–199

[18] Lost Profits Damages: Principles, Methods, and Applications, pp. 34-35

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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.