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Looking Back to Go Forward

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

This is the fourth article in a series reviewing the basics for lost profits. Important in any assignment for calculating lost profits is understanding standards set by the courts. The three standards that courts use in assessing lost profit calculations are foreseeability, proximate cause, and reasonable certainty. In this segment, these court standards for providing a lost profits analysis are reviewed.

Read Part I, Part II, and Part III.

Looking Back to Go Forward: A Review of the Basics for Lost Profits (Part IV)

This is the fourth article in a series reviewing the basics for lost profits. In this segment, the court standards for providing a lost profits analysis are reviewed.

To assess lost profits, the basic principles of finance and accounting are used for reviewing a business’s financial data and projecting losses it incurred due to the alleged wrongful act of the defendant. Applying commonly used methods is part of the work required of an expert in presenting his or her findings to the trier of fact. But another important and essential part of the analysis is meeting the standards required by the courts. These standards fall into three categories: foreseeability, proximate cause, and reasonable certainty.

Experts ignoring these standards put their results in jeopardy and certainly set themselves in a position for a Daubert challenge—a motion to exclude or limit the expert’s testimony. By keeping these standards in mind, an expert may avoid needless challenges and difficult cross examinations.

Foreseeability

 “Foreseeability refers to the requirement that losses claimed by the plaintiff are the predictable consequence of defendant’s alleged misconduct (i.e., are foreseeable and probable). In some cases, foreseeability is assessed based on the contemplation of both parties. In other cases, it is assessed based on more objective information.”[1]

Financial experts are seldom asked to opine on this court standard. In most cases, foreseeability is a legal argument made by opposing counsels before the judge. Claims made for lost profits may be for general damages or consequential or 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 nonbreaching party.”[2]

Proximate Cause

“Proximate is defined as ‘coming or happening immediately before or after something in a way that shows a very close and direct relationship’ or in other words, an event or something ‘immediately preceding or following (as in a chain of events, causes, or effects).’”[3]

To fulfill the proximate cause standard, “the plaintiff must demonstrate that the defendant’s wrongful conduct proximately caused the plaintiff to suffer lost profits. If the situation resulting in lost profits would have existed absent the defendant’s wrongful conduct, the plaintiff may not be able to prove that the defendant proximately caused the loss.”[4] Based on this definition of proximate cause, experts must consider other causes for the losses in commercial damages cases.

In personal damages cases, economic or financial experts are not expected to consider causation. From the financial expert’s perspective, the losses brought about by the injury to the person, or the death of an individual are assumed to have been caused by the accident that allegedly caused the injury or death. Through trial testimony, the trier-of-fact decides if the defendant is negligent for causing the injury or death and therefore, liable for the damages. The financial expert is seldom asked to address if the accident caused the estimated loss.

In lost profits analyses, financial experts are expected to consider other potential causes that would have led to a reduction in profits for the plaintiff’s business. Failure to consider these factors can be detrimental to an expert’s findings.

“Two questions are commonly encountered in proof of proximate cause of lost profits damages. The first: Has the plaintiff excluded or explained other possible causes of the claimed loss? The cases generally hold that failure to do so is fatal to the claim. The second: Has plaintiff shown only that the claimed loss followed in sequence after the asserted cause of it? This is the logical fallacy called post hoc ergo propter hoc, roughly, ‘after therefore because.’ The cases generally hold that post hoc proof is inadequate to demonstrate proximate cause.”[5]

An expert properly addressing proximate cause may be seen in the Memorial Hermann Health System v Gomez case.[6] In this matter, the appellant court affirmed the jury award saying that the forensic accountant’s testimony was based on the downturn of plaintiff’s surgical business following the defendant’s defamatory conduct on plaintiff’s business records by showing the volume of patients before and after defendant’s conduct and used evidence of lack of market decline to show causation.[7]

Some of the questions an expert could ask to determine other potential proximate causes are:  

  1. Has there been any changes to the plaintiff’s market (i.e., increase or decrease in the number of customers seeking the plaintiff’s products or services)?
  2. Did new competitors enter the plaintiff’s market just before or after the alleged wrongful act?
  3. Did any new products or services enter the plaintiff’s market that took business away from the plaintiff?
  4. Have there been any supply chain problems for the plaintiff (again, just before or after the alleged wrongful act)?
  5. Were there changes in management or loss of key employees during the alleged loss period?
  6. Have there been any local, state, or federal regulations that impacted the plaintiff’s business or industry during the alleged loss period?

Answers to these questions may lead to others or allow the expert to report no other causations were found that would have led to the plaintiff’s decline in profits.

Experts do not have to make an exhaustive list of potential causes, but must be able to demonstrate that other likely causes were considered.

As an example, the COVID-19 pandemic impacted some businesses in a negative way and others in a positive way. Whether looking at historical financial data that includes 2020 for revenue, expenses, and profit trends or estimating losses for a claim of lost profits that includes 2020, experts must consider and adjust the financial data or loss estimates for the COVID-19 impact.

It has been my policy to include one to two paragraphs in lost profit reports discussing how 2020 data or the 2020 portion of the loss estimate included COVID-19 consideration. In addition, the discussion includes how the pandemic may have affected the plaintiff’s business in 2021 and/or 2022. Including a discussion of the COVID-19 impact in a report demonstrates to the court and opposing counsel that you have considered other causations beyond the alleged claimed wrongful act.

Should an expert’s research find that additional competition entered the market or there were problems for the plaintiff in getting products needed to serve its clients, the lost profits calculations should be adjusted or modeled to reflect any reduction in revenue and ultimately profit brought about by these issues.

It is unlikely that an expert will learn about these issues and the opposing expert does not. Therefore, better prepared to answer questions with how these other causations did or did not impact the resulting lost profit losses than addressing why such issues were not considered. 

Reasonable Certainty

The reasonable certainty standard applies directly to the work performed by 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), but also the amount of damages, though somewhat more uncertainty is allowed in establishing the amount of damages versus the fact of damages.” [8]

This means financial experts must first show that the plaintiff’s business would have been profitable during the loss period. Then, must show the amount of lost profits using reliable methods that follow the facts of the specific case in arriving at the loss amount.

“Damages for net lost profits are recoverable only if the plaintiff establishes legally sufficient proof that the financial expert’s economic damages are reasonable and that the expert has used reliable factors in his or her analyses without undue speculation. However, it is important to recognize that the calculations of net lost profits pursuant to the standard of ‘reasonable certainty’ does not require exact precision.”[9]

To better define reasonable certainty, the Fifth Circuit Court of Appeals noted “reasonable certainty means more probable than not.”[10] In this case, no recovery of lost profits or lost business opportunity was allowed. The plaintiff had no final contract with a third party business prospect. This is because the contract was still under negotiation and no letter of intent had been signed. Many details remained outstanding. Therefore, it was determined the damages were improperly based on speculation.[11]

A Second Circuit Court of Appeals decision shows how data may be used to provide a non-speculative, reasonable certain estimate of lost profits.[12] According to the appellant court, the plaintiff’s claims for lost profits were not unduly speculative. The plaintiff claimed the damages resulted from the defendants’ direct boycotting of plaintiff’s business and other anticompetitive behavior. “The value of each lost opportunity might be calculated based on the plaintiff’s historical sales data without undue speculation; in contrast, calculation of more indirectly caused damages, such as those caused by an alleged boycott of plaintiff’s customers rested on multiple layers of speculation and would require the creation of an alternative universe.”[13]

Meeting the reasonable certainty standard is similar to meeting the proximate cause standard. Experts must look beyond the plaintiff’s financial data and interviews with management to make sure the loss calculations match up with the financial data and reality.

“A financial expert needs to differentiate between the legal requirements of causation and the proof of the amount of economic damages. The fact of damage is required to be proven with reasonable certainty. The fact of damage relates to whether the plaintiff can prove the acts of the defendant caused damages to the plaintiff. Once the fact of damages has been established, the amount of damages can be calculated. Although the defendant’s act need not be the sole cause of the plaintiff’s lost profits, they must be a significant or material factor in the cause of loss. Other causes for the plaintiff’s losses should also be taken into consideration in the damage calculation, however. The methodologies that a financial expert uses to calculate the amount of lost revenues should consider and address the reasonableness of his or her analyses, including the documents and assumptions upon which they are based.”[14]

Putting Proximate Cause and Reasonable Certainty Together

One method for adapting projected lost profits calculations to meet the proximate cause and reasonable certainty standards is modeling the cash flow numbers. In 2002, Robert Dunn and Everett Harry published an article explaining how modeling can be a benefit to experts.

“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 discounting 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.”[15] They went on to say the first approach is easier for judges and juries to understand.

Their article discusses how to adjust the cash flow figures (revenues, expenses, and ultimately profits) to reduce the risk in the calculations thus allowing for a lower discount rate. This same method may also be used to adjust revenues, expenses, and ultimately profits for other causations, lack of confidence in management projections, and other factors an expert believes would affect the profitability of the plaintiff’s business during the loss period.

By modeling the projected financial data to show realistic revenue, expenses, and profits, experts will demonstrate expertise in addressing the complex issues that are found in many lost profits assignments. If done properly, modeling will provide the expert an opportunity to show his or her results are both relevant and reliable. Thus, meeting these two standards found under Daubert.

Conclusion

Financial experts need to not only know the common methodologies used to estimate lost profits but also the standards set by the courts for providing lost profits results to the trier-of-fact. A general understanding of these three standards benefits an expert in his or her analysis. Researching other potential causes for a decline in the plaintiff’s profitability will allow the expert to provide a calculation of loss with reasonable certainty. By meeting the standards set by the court and using commonly used methods, experts will continue to benefit their clients and build a reputation as a competent and knowledgeable financial expert.

 

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

[2] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd Ed., Vol. 1; Nancy Fannon, Jonathan Dunitz; BVR, 2014, p. 200.

[3] Harry, Kinrich, p. 175.

[4] Ibid, p. 47.

[5] Recovery of Damages for Lost Profits, 6th Ed., Supplement March 2023; Robert Dunn; Lawpress Corp., 2023, p. 10.

[6] Memorial Hermann Health System v Gomez, 584 S.W.3d 590 (Tex. App. 2019).

[7] Dunn, p. 553.

[8] Harry, Kinrich, pp. 34–35.

[9] Fannon, Dunitz, pp. 213–214.

[10] Cedar Lodge Plantation, LLC v CSHV Fairway View I, LLC, 753 Fed. Appx, 191, 200 (5th Cir. 2018).

[11] Dunn, pp.582–583.

[12] IQ Dental Supply, Inc. v Henry Schein, Inc., 942 F.3d57, 67-68, (2nd Cir. 2019).

[13] Dunn, p. 582.

[14] Fannon, Dunitz, p. 216.

[15] Modeling and Discounting Future Damages; Robert Dunn, Everett Harry; Journal of Accountancy, Online, January 2002.


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. In 2021, Dr. Needham received a NACVA Outstanding Member Award. He is also 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.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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