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Economic Damages

damage / ˈdamɪdʒ/
  1. 1. physical harm that impairs the value, usefulness; 2. a sum of money claimed or awarded in compensation for a loss or an injury

    from Latin damnum ‘loss or hurt’

Breach of contract & Tort

Economic damages claims are often made in breaches of contract and or tort. In a breach of contract claim, a party sustains economic damages by reason of a breach. Under the claim, the party is to be placed in the same situation, with respect to damages, as is if the contract has been performed (1). Contracts and terms that get breached include employment contracts, a sale of business and sale of goods contract, non-compete clauses and insurance contracts.

In a tort claim, the party is awarded a sum of money to put them in the same position as they would have been if they had not sustained the wrong (2). Damages claims in tort include negligent misstatement, negligence, injurious falsehood, inducing a breach of contract, passing off, fraud and theft, patent infringement and defamation.

In both contract and tort claims, from a simple layman’s perspective, the plaintiff must prove in essence that there was

  1. a cause of action, ie. there was a breach or the damaging conduct occurred
  2. economic damages were caused as a result of the breach or the damaging conduct
  3. the economic damages are not remote and directly relate to the defendant’s actions, and
  4. the plaintiff made a reasonable attempt to mitigate the damages

The legal principle is that claimants must prove loss of profit to a reasonable degree of certainty to be awarded damages. To establish a causal connection between a breach of contract and the damage suffered, a plaintiff needs only to show that the breach was a cause of the loss (3). If the defendant’s conduct is a cause of the plaintiff’s loss, the existence of another concurrent cause that combines to produce the loss is of no relevance (3).

If the loss in question is the apparent or likely result of the breach, the onus shifts to the contact-breaker to prove that it was not (4). The reasonable certainty principle is not usually applied to the quantum of economic damages (5). Lost profit from a breach of contract must also be foreseeable in order to be compensable. The wrongdoer could have reasonably anticipated the other party’s loss of profits in the event of the contract breach.

Other claims

Compensation for economic damages seeks to reverse the plaintiff’s loss, the alternative is a restitution claim.  Restitution seeks to reverse the defendant’s gain.

An equity claim for a civil wrong, for example, a breach of fiduciary duty, results in an account of profits. Rather than an award of compensatory damages, the plaintiff seeks to disgorge the defendant of a profit. The plaintiff need not have suffered any loss.

Alternatively, there could be a claim for rescission.  In common law, contracts can be rescinded for fraudulent misrepresentations and in equity, for innocent misrepresentations, mistake and breach of fiduciary duty.

Computation of lost profits

 “Lost profits are generally defined as the revenues the plaintiff would have made but for the wrongful action, less the costs saved”

Economic damages related to businesses often take the form of lost profits. Lost profits are generally defined as the revenues the plaintiff would have made but for the wrongful action, less the costs saved.

According to Niamh Brennan and John Hennessy (6) the lost profit computation can be broken into the following steps:

  1. Define the damage period
  2. Estimate lost revenue for that period
  3. Subtract cost associated with the lost revenue
  4. Subtract net profits for efforts made to mitigate losses
  5. Express lost profits in present value terms
  6. Estimate and add any other of worth arising from the defendant’s wrongful acts

Lost Profit methods

Lost profits are often calculated using one or a combination of the following three methods (7,8):

  1. Before and After method
  2. Yardstick or Comparable method
  3. Sales Projection or “But For” or Market method

Under the before and after method, revenue and profit are compared before and after an event, eg. a business interruption. A reduction in revenue and or profit may be ascertained based on the difference between performance in the two periods.  The method assumes:

  • performance prior to the event represents potential performance during the loss period
  • economic and industry conditions during the loss period are comparable to the period prior to the event
  • sufficient historical financial information is available to construct a reliable forecast

The yardstick method makes a comparison of the financial performance during the loss period to comparable businesses during that period. The key issue is how comparable are those businesses.

The defendant can challenge the Before and After method by claiming that the after period is different from the before period. The difference is not due to any actions of the defendant but, for example: the plaintiff’s mismanagement, a weaker economy and changes in the industry

The defendant can challenge the Yardstick method by asserting that the comparable firms are not truly comparable and that the plaintiff’s performance would be expected to be different.

The components of the Sales Projection method includes a detailed analysis of relevant economic, industry and firm-specific factors (8). The method requires a justified assessment of revenue and costs and converting projected future profits to a current value. In this sense, there are similarities to the approach taken when valuing a business.

Assumptions

Assumptions need to be made about what direction the revenues would have taken, but for the event, for example:

  • Were revenues prior to the act trending up or down?
  • Were there any other factors, apart from the act, that would have impacted revenue after the event? For example, was there a change in the industry, was there more or less competition, slower or faster economic growth?
  • Was anything done by the plaintiff to mitigate losses?
  • Consideration also needs to be given to the period of trading prior to the event. How long had the business been trading?
  • How well established and consistent was revenue prior to the act?

Once the lost revenue has been established, the variable costs need to be calculated.  These are the costs that would have been incurred had the revenue not been lost.

A common metric cited in economic damages claims is gross margin, defined as sales less cost of sales, divided by sales. The gross profit margin incorporates the fewest costs.

If the gross profit margin metric is adopted, then an appropriate rate needs to be calculated which is relevant to the claim.  Consideration may be given to historical rates, rates at the time and after the event.  Actual gross profit margin after the event may have been reduced. For example, if a breach led to increased competition for the claimant and prices had to be reduced, then the gross profit margin would reduce.

The gross profit margin may not sufficiently include all incremental costs.  If the event had not occurred the claimant may have incurred additional overhead expenses to support the higher revenue, for example, rental of a larger office or factory.

The true value of the economic damages is the lost incremental revenue, less the lost incremental cost associated with that revenue (9)

The role of the expert is not only to simply distinguish between fixed and variable costs but to identify the relevant incremental costs.

Consideration also needs to be given to the discount rate. The discount rate is use to calculate the net present value of a stream of cash flows.  The discount rate reflects both the time value of money and the risk profile of the cash flow. As such, as an assessment of the risks attached to the cash flow is required.

Lost Profit v Lost Value

Lost business value tends to apply where a business or part of a business ceases permanently as a result of the alleged act. The value of a business is the current, net present value of an earnings stream in perpetuity or for the life of the business.

The key difference between a loss of profit calculation and a loss of business value is the period. Whether the earnings were damaged for a limited specific period (loss of profits calculation) or earnings are damaged for the life of the business (loss of value calculation).

That does not mean that the methods are mutually exclusive. There could be an instance where the plaintiff continued struggling with the business (loss of profits) but the business eventually folded (loss of business value).

Care needs to take though not to double count. In theory, the present value of any claim of lost profits cannot exceed the value of the business at the date of the loss.

Assessment approach

The general rule is that damages are assessed at the date of breach of contract, but this rule is not universal (10). The rule is adapted to give the injured party the amount of damages which would most fairly compensate for the suffered wrong.

Under the ex post approach, lost profits are calculated to the trial date and prejudgment interest added to those losses. Such interest accrues from the time of each cash flow, eg. each financial year-end. Next, any future lost profits after the trial date are calculated and then discounted back to a net present value at the trial date.

Using the ex ante approach, all past and future lost profits are discounted back to a present value at the time of the injurious event.  Prejudgement interest is then calculated on the total value at the time of the event to the date of trial.

Assuming that a discount rate is higher than the statutory interest rate, lost profits damages using the ex ante approach will be lower compared to the ex post approach.

Principally, however, there is no difference between a past hypothetical event and a future hypothetical event (11). In both cases, there is uncertainty about the amount and timing of hypothetical cash flows.  Therefore, care needs to be taken that a discount rate is applied to reflect those uncertainties.

The terms ex post and ex ante can also be applied to the measurement date. The ex post perspective assumes all the facts as at the present time.  The ex ante perspective assumes only the facts available at the date of the event.

Ex ant and ex post measurement dates are compared in a hypothetical story (12):

A classmate of Janis Joplin obtains her signature in their graduation school yearbook.  Shortly after, someone steals the yearbook.  Years later the thief is caught and sued.  Should the loss be based on the yearbook’s value at the time of theft (ex ante), when Janis Joplin was unknown, or at the time of trial, when Joplin is famous?

Conclusion

Calculating economic damages is not straight forward.  Care needs to be taken that the appropriate approach is taken, that relevant and appropriate revenue and costs are used and valid assumptions made.

  1. Parke B Robinson v Harman (1984) 1 EX 850 at 855
  2. Lord Blackburn Livingston v Rawyards Coal Co (1880) 5 App Cas 25
  3. Alexander v Cambridge Credit Corporation Ltd (1987) 9 NSWLR
  4. Haviv Holdings Pty Limited v Howards Storage World Pty Ltd (2009) 254 ALR 273
  5. Crain, M et al (2015) Essentials of Forensic Accounting, American Institute of Certified Public Accountants
  6. Brennan, N and Hennessy, J (2001) Forensic Accounting and the Calculation of damages
  7. Pratt, S (2008) Valuing a business -The analysis and appraisal of closely held companies, McGrath Hill. Fifth Edition, p.1023
  8. Trugman, G (2017) A practical guide to valuing small to medium-sized businesses, Fifth Edition, p.1112
  9. Gaughan, P.A (2009) Measuring Business Interruption Losses and other commercial damages, John Wiley & Sons, Second Edition, p73
  10. Malec v JC Hutton Pty Ltd (1990) 169 CLR 638
  11. Fightvision Pty Ltd v Onisforou (1999) 47 NSWLR 473
  12. Fisher, FM and Romaine, RC (1990) Janis Joplin’s yearbook and the theory of damages, Journal of Accounting, Auditing & Finance

About the author

Simon Cook, Valuations, Forensic Accounting, Virtual CFO. CA Accredited Business Valuation expert, Chartered Accountant and Certified Fraud ExaminerSimon is a CA Accredited Business Valuer, Chartered Accountant, and a Certified Fraud Examiner. Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice.  He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the massive Bernie Madoff Ponzi scheme.

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Copyright © 2017 Lotus Amity Pty Ltd. All rights reserved. This article is the property of the author. This article is intended for general information purposes only and is not intended to provide, and should not be used in lieu of, professional advice. The publisher assumes no liability for readers’ use of the information herein and readers are encouraged to seek professional assistance about specific matters.