Lost Profits, Modern New Business Rule
and Defense Strategies Beyond Reasonable Certainty
Experts estimating lost profits under the modern new business rule know that lost profit estimates in these cases are held to a higher reasonable certainty standard than calculations for lost profits in cases with established businesses. Failing to meet this higher standard may cause an expert’s calculations to be ruled as speculative. To this level of greater scrutiny, Victor Goldberg has introduced additional defense strategies for reviewing new or unestablished businesses claims. His strategies move the focus away from assessing what revenues and profits would have been “but for” the wrongful act to non-cash flow related issues. This article will review strategies put forth by Goldberg seeking to limit or exclude lost profits recovery by new or unestablished businesses under the modern new business rule.
In a recent QuickRead article, I discussed a 2018 Fifth Circuit Court of Appeals decision and how it limited using certain data for establishing reasonable certainty under the modern new business rule.[1] The appellant court confirmed a district court opinion that the appellee failed to show lost profits with reasonable certainty. The Fifth Circuit went on to say, “The profit calculations defendants would have presented at trial were ‘projections that were presented to investors,’ calculations which Texas courts have held insufficient when not supported with more reliable indicators of profitability.”[2] The court notes that finding lost profits based on an investor prospectus insufficient to support a damages award. “The ‘evidence’ of lost profits was speculative.”[3]
As is not unusual in a commercial damages case, the plaintiff and defendants sued and counter-sued each other with both claiming economic damages. The plaintiff, an investor, had his claim upheld. While the defendant, a limited partnership and general partner, had their loss claims denied as speculative by a lower court. The appellant court upheld that finding. In this situation, the plaintiff made a successful defense argument against the claims of loss made by the defendant. So, it is not always a defendant using a defensive strategy.
This article will review strategies seeking to limit or exclude claims of lost profits made by new or unestablished businesses under the modern new business rule. It will review the modern new business rule and approaches used to limit or deny recovery of lost profits under this rule.
Modern New Business Rule
Throughout much of the 20th century, the new business rule was applied in the courts across the country. That rule stated a new or unestablished business could not recover lost profits. In the last quarter of that century, courts began to apply a new standard, the modern new business rule. “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.”[4]
In his article for Business Law Today, Mark Gauthier addressed the change this way, “Changing attitudes towards jurors, a consensus focused on the inherent injustice to new businesses, and recognition of the economically nonoptimal allocation of resources that the new business rule encouraged may have played a role in the shift in the interpretation of the rule away from a finding of law to a finding of fact.” Gauthier goes on to note, “calculations of lost profits need no longer confirm to ‘absolute certainty’ requirements; the ‘reasonable certainty’ standard as applied to existing businesses with a history of profits has been applied to new enterprises as well.” But he closes by saying that courts give lost profits claims “heightened scrutiny when the party has no financial history.”[5]
In the Gauthier article, several scenarios for lost profits under the new modern business rule are discussed. Without going into great detail, the scenarios are:
- Post-Breach Profits for Injured Business—In this situation, a damaged business may be able to resume business along the projected growth curve that existed prior to the alleged wrongful act. As an example, if a supplier breached a contract to provide a certain product, the business harmed by the breach may not be able to replace the supplier’s product immediately. This could lead to lost sales and ultimately lost profits. On finding a replacement supplier, the injured business may be able to return to its prior level of sales, growth path, and profits. If so, the lost profits would be for only the time the business was unable to find a replacement supplier and the time it took to return to its prior growth and sales trend. So a “but for” analysis compares what could have happened had the breach of contract not occurred and the difference in profits (projected and actual) before the business is back to its prior growth.
- Post-Breach Profits by Successor Business—In this situation, the injured business vacates its location and a comparable business takes its place (e.g., convenience store for convenience store). Provided all other market factors have remained the same, the profits generated by the successor business may be used as a substitute for calculating the injured business’ lost profits.
- Business Enterprise Ceases—In some situations, the damaged new business will not be able to continue in its operations. For assessing lost profits in theses situations, identifying critical success factors are important in meeting the reasonable certainty standard. “Critical success factors, as the name implies, are those elements that are absolutely necessary for a particular business to succeed.”[6] These critical success factors will vary from business to business and are determined by the nature of each enterprise.
- Short-Term Pre-Breach Operations—Some businesses may have operated for a short period of time before being impacted by the alleged wrongful act. “Even if the business operated for less than one year, sufficient information may exist to extrapolate lost profits as a result of the breach.”[7] Even a few months of data may help for a comparison to industry statistics. Gauthier points out, “It is not necessary in all cases to demonstrate the existence of profits during that abbreviated period. (Brookridge Party Center v. Fisher Foods, Inc., 12 Ohio App. 3d 130 [1983]). For example, most new businesses experience an initial period of diminishing losses followed by a gradual progression to profitability as the business moves up the learning curve.”[8]
Defense Strategies for Disproving Lost Profits
The prevailing notion from many defense lawyers is to argue the lost profits calculation does not meet the standard for reasonable certainty. This was true in the Fifth Circuit Court of Appeals case discussed earlier. Other arguments to show lack of reasonable certainty have been used in cases across the U.S. In Georgia (Trimax Medical Management, Inc. v. Hibernation Therapeutics USA, Inc., F.Supp.3d , 2018 WL 2014080 [M.D. Ga., 2018]), a plaintiff was not entitled to lost profits because “it was not [an] established business and had no track record of profitability—indeed, it had no profits at all, nor even any revenues; evidence of anticipated profits were rejected as speculative and unsupported by properly qualified expert testimony.”[9]
In Oregon (Rubicon Global Ventures, Inc. v. Chongqing Zongshen Group Import/Export Corp., 226 F.Supp.3d 1141 [D. Or. 2016]), “factors [used] in the court’s determination that plaintiffs failed to prove lost profits damages included inexperienced managers, lack of proven market acceptance, and general high failure rate of new businesses, supported by defense expert’s testimony that 75% of new businesses fail.”[10]
Finally, in New York (Kallista, S.A. v. White & Williams, LLP, 51 Misc. 3d 401,423, 27 N.Y.S.3d 332 [N.Y. Sup. St. 2016]), a claim for lost profits denied in a legal malpractice matter. The court felt the lost profits calculations were only “conclusory allegations.” “The plaintiff failed to allege how many products they expected to sell, what they would have earned, whether they would have obtained the trademark had the attorneys acted properly, or whether they could have marketed their products outside the United States; therefore, their allegations of lost profits were too speculative.”[11]
Besides the traditional pleas of speculation or not meeting the reasonable certainty standard, Victor Goldberg[12] has developed additional strategies for attacking lost profit claims made by new or unestablished business. Goldberg believes the modern new business rule is wrong and has clouded the issue in determining damages to new or unestablished enterprises.
“I argue that this so-called ‘modern’ view is wrong. The damages for a new business ought not be viewed as merely a matter of whether the evidence is sufficient to surmount the ‘reasonable certainty’ hurdle. By ignoring the underlying economics, the courts have lumped together a disparate set of problems under the new-business rubric and have attempted to treat all of those problems alike.”[13]
He believes many new businesses have been overcompensated in their lost profits claim. He further believes a more “nuanced” approach to measuring damages would allow for damage claims to be more accurate and precise.
Goldberg discusses four areas in which the defense may make objections and possibly be able to prevent new businesses from claiming lost profits. Conversely, Goldberg also argues some of these situations will allow for new businesses to successfully claim losses following his same strategy.
The first of these areas relates to the injured business’ opportunity cost. Simply stated, the opportunity cost of an action is the value of the foregone alternate action. As an example, I have a choice of picking blueberries or strawberries on a Saturday afternoon. If I choose to pick blueberries, my opportunity cost is the number of strawberries that I did not pick while I was picking blueberries. Goldberg argues that when arguing lost profits for a new business “the relevant question is not whether the project would be profitable but rather would be more profitable than its next-best alternative.”[14]
The new business continues to have its idea, funding, and opportunity to continue in that or another enterprise. What mitigating profits may this new business generate under these circumstances? Is it possible the new enterprise will be as successful as the now “doomed” effort? These are questions Goldberg believes will reduce or fully eliminate a new business claim for lost profits.
Goldberg demonstrates this with an example from franchise cases. “[T]he relevant question is not whether the franchisee’s operations would be as successful in that location as they would be anywhere else. Rather, it should be whether there is reason to believe that it would do better, and the answer to that should be negative. Indeed, the very notion of using the earnings of a comparable franchise as a basis for compensation presumes that the plaintiff’s operations would not outperform others. Nor should the plaintiff expect to earn more than the opportunity cost of his capital and time. That does not mean the plaintiff should not be compensated,” but the basis should not be lost profits.[15]
The second area of defense is nonpayment of royalties. In this situation, the licensor has committed money, time, and human capital to the product or service. The licensee has failed to market and exploit the product or service. Goldberg offers that unless it can be demonstrated the licensee made efforts to market the product or service and there was no market demand, the claimant has an easier road in recovering lost profits (in the form of royalties). He argues the method of calculating the loss, whether based on sales or net income, should be greatly reviewed. This is to determine if the projected sales and/or net income are without foundation and therefore, speculative.
The third area of defense relates to cases where there was a delay in performance or defect in the provided product. If the reason for loss was a delay in performance, the question is, “How did the injured business perform after delivery of the product or service started?” Arguments may be made for market change due to delayed timing and/or loss of customers or contracts due to the delayed performance, but the best way to demonstrate lost profits is to show profits through the operation of the business after the delivery of the delayed performance.
Goldberg notes that in some cases, the parties may have a disclaimer or damage limitation clause in their contractual agreement. If present, these clauses could limit or eliminate damages. This could also be a factor in cases relating to product defects.
In matters where defective products have been involved, losses should be limited to the time between the alleged wrongful act and when the claimant was able to replace the defective product. This should make for a shorter loss period. This loss period may allow for profits, or may not, due to the start up nature of a new business.
Should the claimant not seek to replace the defective product and leave the industry, research should determine what alternatives for replacing the defective product were available and, returning to the opportunity cost argument, what the damaged business has done with the money committed to the portion of its businesses served by the defective product. This would limit the loss period to when a replacement could have been found and perhaps reduce or eliminate lost profits when it determined how the injured business’ money has been used to mitigate its loss.
His final area of discussion are cases in which the buyer has repudiated a long-term contract when the sell has only partially performed. Goldberg argues a key issue in these cases is market conditions at the time the contract was signed and change in market conditions between the contract signing and the breach. The question is, “Have market conditions changed leading up to the time of the repudiation?”
“Suppose … that market conditions had not changed at all. If that were the case, should the seller receive any compensation? … There is no reason to believe that subsequent performance of the contract would be any more profitable for [the damaged business] than its alternatives. … There should be no recovery for future lost profits. Because market conditions had not changed, the expected value of the future stream of profits has not changed.”[16]
Goldberg goes on to argue that the costs incurred by the damaged enterprise to fulfill this contract may be recoverable. However, he states if an alternative buyer has or may be found, then the loss related to these costs could fall to zero.
In another example, Goldberg states if the market has collapsed, then the wronged business may have a claim for lost profits, even if a new business. He notes, “The contract was an asset for the seller; when the market collapsed, the value of that asset went up. How much? That is the measure of what the seller lost at the time of repudiation. It would be the difference between the expected net revenues had the market conditions not changed and the net revenues given that there had been a change. The difference is precisely what the experts [would attempt] to quantify under the lost-profit rubric—the net present value of the difference between two projected-revenue streams.”[17]
Conclusion
Goldberg argues that the courts’ focus on speculativeness and reasonable certainty is wrong. He believes the problem is not that the courts have trouble measuring economic damages, but they are measuring the wrong thing.
He closes by saying, “In cases that involve a claim for the future stream of profits on a project that never launched, the presumption should be that there were no lost profits. Any recovery should be based on whether the plaintiff had assets—either preexisting ones or those acquired in reliance on the contract—the value of which was contingent on the performance of the project.
For other cases, such as those involving nonpayment of a royalty stream, delivery delay, or a defective product, claimants have suffered a real loss. Whether those claimants should recover damages does not depend on the newness of the business or the certainty of proof. The Hadley rule provides one constraint. Ex ante contract language—that is, liquidated damages, warranty disclaimers, and remedy limitations, provide another.”[18]
Experts estimating lost profits under the modern new business rule know that lost profit estimates in these cases are held to a higher reasonable certainty standard than calculations for lost profits in cases with established businesses. Failing to meet this higher standard may cause an expert’s calculations to be ruled as speculative.
To this level of greater scrutiny, Victor Goldberg has introduced additional defense strategies for reviewing new or unestablished businesses claims. His strategies move the focus away from assessing what revenues and profits would have been “but for” the wrongful act to non-cash flow related issues. These issues are economic and are matters courts will expect experts to be able to address.
As the defense bar has more time to digest his ideas, I believe experts will see more questions related to these issues. As Goldberg admits, none of these concepts prevent the wronged new business from recovering lost profits. They merely make the analysis more complicated. Those experts receiving an assignment to estimate lost profits for a new or unestablished business should keep these factors in mind. Forewarned is forearmed.
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 can be contacted at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.
[1]Lost Profits: Fifth Circuit Decision Further Clarifies Reasonable Certainty for the modern new business rule, Allyn Needham, QuickRead.
[2] Mansour Al-Saud v. Youtoo Media, LP, Christopher Wyatt, 2018 U.S. App. LEXIS 29680, 18–19.
[3] Ibid., 19.
[4] Recovery of Damages for Lost Profits, Volume 1, 6th Ed., Robert Dunn, 4.3, 378, 2005.
[5] Recovering Lost Profits for Start-Up Companies, Mark Gauthier, Business Law Today, 12/14/2017, 2, https://BusinessLawToday.org
[6] Ibid., 5.
[7] Ibid.
[8] Ibid., 6.
[9] Dunn, Supplemental September 2018, 4.6, 239.
[10] Ibid.
[11] Ibid., 4.6, 239–240.
[12] Victor Goldberg, Jerome Greene Professor of Transactional Law, Columbia Law School.
[13] The New Business Rule and Compensation for Lost Profits, Victor Goldberg, The Criterion Journal on Innovation, Vol. 1, 2016, 342.
[14] Ibid., 345.
[15] Ibid., 353.
[16] Ibid., 369.
[17] Ibid., 370.
[18] Ibid., 371–372, The Hadley rule generally prevents the victim of a breach of contract from recovering lost profits. (Hadley v. Baxendale, 9 Ex. 341, 156 Eng. Rep. 145 [1854]).
