Ex-Ante Versus Ex-Post Damages Calculations
Damages Before? Or Damages After?
For those that perform lost profits and other commercial damage calculations, you are most likely familiar with the ex-ante versus ex-post approaches and applications when it comes to applying discounts to present value calculated damages. But what about the application of the ex-ante and ex-post theories and approaches to the damages calculations themselves? This article addresses this topic.
For those that perform lost profits and other commercial damage calculations, you are most likely familiar with the ex-ante versus ex-post approaches and applications when it comes to applying discounts to present value calculated damages. But what about the application of the ex-ante and ex-post theories and approaches to the damages calculations themselves? This article addresses this topic.
Introduction
Economics damages awards in litigation serve two purposes: (1) they compensate for the damages suffered from wrongful acts and (2) they act to deter future wrongful acts. Ideally, an economic damages compensation award should put the plaintiff in the same economic position it would have been “but for” the wrongful act. In addition, the deterrent award should be equal to the ill-gotten gain derived from the wrongful act.
Consider the following example:
“… I steal $100 from you. If my immediate apprehension and the return of your money to you were certain … then your economic loss would be eliminated and my ill-gotten $100 would have been repaid.”
In this example, the compensation amount would equal the deterrent amount. I would have no incentive to steal again, and you would have no incentive to incur extensive legal and other costs and time on this matter.
There is a delay between the date of the wrongdoing and the date of the damages analysis or when the plaintiff receives restitution. During this lag time, information becomes available which can change the perception of the economic damages.
Further, consider this example:
“… suppose that you buy a lottery ticket for $1. Then suppose I steal it from you before the lottery drawing occurs and the winner becomes publicly known. Assume that on the date of the injury all lottery tickets had an equal chance of winning and there was no shortage of tickets available for $1. Time passes and it turns out that the ticket I stole from you is the lottery winner and is now worth $32 million.”
In this example, do I owe you the fair market value of $1 for the ticket I stole, the ex-ante value; the price you paid before the theft? Or do I owe you the lottery ticket winning amount of $32 million, the ex-post value; the value after the theft?
This article discusses the ex-ante and ex-post approaches and the advantages and disadvantages of each.
Source
Credit for this article goes to Elizabeth A. Evans, Roman L. Weill, Michael Wagner, and Michael Durbar, who are authors of Chapter 5 published in the Litigation Services Handbook, Sixth Edition. The authors reference and present case law that support the application of both the ex-ante and ex-post theories and approaches.
I provide no opinions on the use of either approach in this article as each case depends upon its own facts and circumstances.
The Application of the Ex-Ante Approach in Litigation
The authors presented the following example to illustrate the mechanics of the ex-ante approach.
“Suppose that on New Year’s Day 1999, the defendant stole the victim’s 1997 first edition of Harry Potter and the Philosopher’s Stone. At the time, the victim, the defendant, and others could have bought an identical replacement for $300. The market value of this rare first edition increased steadily so that by 2010 it was worth $40,000 …”.
The first edition’s original owner filed a lawsuit with a trial date of December 31, 2010. The plaintiff’s expert used the ex-ante approach and calculated damages of $300 and applied prejudgment interest on the $300 from January 1, 2000, to December 31, 2010. Three hundred dollars was the expected value and the then-current market price of the book. If the plaintiff had a different expectation for the book’s value, the plaintiff could have mitigated any damages by buying another book for $300 after the theft.
Proponents of the ex-ante approach point out that using the ex-ante information limited to the date of the wrongful act properly allocates risk. They argue that the award of $40,000 would improperly reward the plaintiff for the full current value of the book without considering the risks avoided by the plaintiff such as the avoided costs and risks of ownership. The costs and risks of ownership equal $39,700 (= $40,000 – $300).
Advantages of the Ex-Ante Approach to Damages Calculations
Proponents argue that the ex-ante approach properly allocates risk. They argue that awarding a plaintiff of all the benefits of a successful project by using the ex-post approach without the plaintiff assuming the risk would overcompensate the plaintiff. In theory, it may give the plaintiff an incentive to seek harm and induce a defendant to deprive the plaintiff of the right to, say, drill for oil on a site that is a dry hole than to spend $1 million to take the risk on the venture. If the plaintiff can induce a defendant to deprive the plaintiff of the right to drill, the plaintiff can save the $1 million of drilling costs but still collect the value of the oil if, contrary to expectation, the well turns out to be a gusher. There is no incentive for a plaintiff to attempt to “game the system” of the court by attempting to time a potential lawsuit to maximize damages awards. Further, the ex-ante approach does not penalize the plaintiff for a decision to either pursue or not pursue mitigation.
Disadvantages of the Ex-Ante Approach to Damages Calculations
The ex-ante approach often requires a complex reconstruction of the known and knowable information at the time of the wrongful act. The expert will need to reconstruct both the actual and a “but-for” contemporaneous database of information. Another disadvantage of the ex-ante approach lies in its use of contemporaneous markets for valuation at the time of the wrongful act. The idea that the market value at any given time reflects the present value of future cash flows assumes efficient markets and perfect information, neither of which usually exists.
Application of the Ex-Post Approach in Litigation
The Latin definition for ex-post is “from after.” The ex-post approach calculations rely on actual outcomes considering all information. This approach looks back from the time of trial or analysis and uses actual information back to the date of the wrongful act and before. Unlike the ex-ante approach, the ex-post approach uses all available information prior to trial or analysis. The measurement date in the ex-post approach is the date of trial, restitution, or analysis. Past cash flow damages are brought to the present value using an appropriate interest rate. Future cash flow damages are discounted back to the date of judgement using an appropriate discount rate.
In an ex-post analysis, the expert believes events that happened after the date of the wrongful act provide information useful in understanding the economic effect of the wrongful act and, thus, affect the cost and value imposed by the wrongful act.
Using the authors’ stolen Harry Potter book example discussed above, the market value on the date of the theft was $300 whereas the December 31, 2010, market value was $40,000. Using the ex-post approach, the damages would be $40,000 less the avoided costs of ownership between the theft date and the date of trial (i.e., costs of storage and insurance) plus any lost benefits of ownership between the theft date and the trial date (i.e., exhibition fees in book shows).
Since the ex-post approach values the wrongful act as of the date of restitution (i.e., trial date or analysis date), more current information about the value becomes particularly important in assessing the current value. More recent available forecasts at the time of the calculations are more important than earlier forecasts, and adjustments may need to be made for differences in assumptions between the forecasts. Concerning the measurement date of restitution, the expert can use the trial date, the date of the analysis, or the date of expected final payment.
Advantages of the Ex-Post Approach to Damages Calculations
Proponents of the ex-post approach argue that the approach appeals to a plaintiff’s sense of justice. While proponents of the ex-ante approach argue that the ex-ante analysis makes the plaintiff whole as of the date of the wrongful act, proponents of the ex-post approach argue that the ex-post approach makes the plaintiff whole at any time after the wrongful act. The ex-post approach also provides a deterrent to violating the legal rights of others. It is doubtful that a plaintiff would bring a case to trial for the $300 stolen book as compared to the more current value of $40,000. Therefore, the ex-ante approach fails to deter a wrongdoer when the plaintiff has little incentive to bring the wrongdoer to justice. Additionally, the ex-post approach provides assurance that those who commit wrongful acts do not receive a windfall from doing so.
Disadvantages of the Ex-Post Approach to Damages Calculations
One disadvantage of the ex-post approach is that the damages amount changes over time as new data becomes available. Due to the changing environment and information that influences the ex-post damages, this approach may provide incentive to “game the system” and bring suit at a time to maximize damages. Secondly, the ex-post approach gives the plaintiffs the benefit of the proceeds from a risk that they did not bear, that is the risk of ownership of the Harry Potter book during the time that it was increasing in value.
The Hybrid Approach
Experts often apply a combination of both the ex-ante and ex-post approaches into a hybrid approach. For example, a common hybrid approach between the ex-ante and ex-post approaches is to consider ex-post information, which is consider all information, and apply it to an ex-ante measurement date, which is the date of the wrongful act. In this example, cash flow damages are discounted back to the date of the wrongful act, using a risk-adjusted discount rate based on actual volatility of the returns in the ex-post period. Discounting the ex-post cash flow damages back to the date of the wrongful act at the appropriate risk-adjusted discount rate moves the ex-post calculation closer to a risk parity with what would have happened but for the wrongful act.
The Wrongdoer’s Rule
Because precedent case law has accepted both the ex-ante and ex-post approaches, how do courts decide which approach to use? Both courts and experts often overlook the concept of the Wrongdoer’s Rule. In the Wrongdoer’s Rule, when the courts have found liability in favor of the plaintiff, the Wrongdoer’s Rule gives benefit of the doubt to the plaintiffs, leaving defendants with the burden of challenging any uncertainty.
The authors cited a Supreme Court ruling that:
“… whatever … uncertainly there may be in [a] mode of estimating damages, it is an uncertainty caused by the defendant’s own wrongful act; and justice and sound public policy alike require that he should bear the risk of the uncertainty thus produced.”
The courts can use the Wrongdoer’s Rule as a guideline and apply this rule to find in favor of the plaintiff’s damages calculations. Unless proven otherwise by the defendant, courts will not withhold a reasonable damages calculation from the plaintiff.
The authors cited another case wherein the Seventh Circuit granted a damages award based on the ex-post approach, opining that the defendant’s objections of speculation were not sufficient, as the:
“… defendants … should not benefit because their wrongdoing made it difficult to establish the exact amount of injury.”
Additionally, the court held that an ex-post analysis was a reasonable estimate of damages, as:
“… we know of no case that suggests that a value based on expectation of gain is more relevant and reliable than one derived from actual gain.”
Citing from another case:
“… to correct uncertain prophecies … is not to charge the offender with elements of value nonexistent at the time of the offense. It is to bring out and expose to the light the elements of value that were there from the beginning.”
Conclusion
The time lag between the date of the wrongful act and the date of restitution will cause debate as to the merits of using the ex-ante and ex-post approaches in calculating damages. No single approach will be appropriate for all situations; the decision to apply a particular approach will depend on the facts and circumstances of each case. For a more detailed discussion on this topic, I suggest readers of this article refer to the source of the information.
Jack W. Harris, CPA, is a forensic accounting expert with a focus on commercial damages, cost analysis, lost profits, accounting and auditing, construction contract damages, construction cost audits, and related areas. Mr. Harris has 44 years’ professional experience and has worked on numerous domestic and international projects. Mr. Harris serves as an independent expert and consultant and has also been admitted as a neutral panelist for the American Arbitration Association for commercial, accounting, and construction matters. Mr. Harris has also served as an arbitrator, mediator, and special counsel.
Mr. Harris can be contacted at (303) 324-5812 or by e-mail to jack@jackwharris.com. Please visit his website at www.jackwharris.com.
