By Scott Evans, CPA, ABV, CFF, Managing Director
Evaluating your client’s lost profit damages can be a difficult but crucial task in developing your litigation strategy, because the extent of damages may dictate how you pursue the case. Moreover, evaluating damages can be difficult if your client has a lot of emotion wrapped up in the alleged wrongful act.
Therefore, it is important to get clarity on the “Big Three” damages issues (Should Have Been analysis, Causation analysis, and Mitigation analysis) when attempting to understand your client’s damages.
Below is a short check list to make sure you have a solid foundation when developing a damages case for your client. Also included is a “bonus” discussion about how present value analyses impact damages calculations.
Determine What Should Have Happened
As an overview, lost profit damages are generally calculated using the following simple formulas:
Should Have Been Profits – Actual Profits = Lost Profits
Lost Profits – Mitigating Profits = Final Damages
Therefore, the first step in evaluating damages is to determine what should have happened, often referred to as the “Should Have Been” scenario or the “But For” scenario—i.e., but for the bad act, the Plaintiff would have been in a better position.
Sometimes it is clear what should have happened, such as “the welders should not have burned down the building,” but other times, it can be difficult to determine what the “Should Have Been” actually is.
In complex business situations, it is common that the client is very aware of the bad act but has not fully thought through all the implications had the bad act not occurred. For example, if the client lost a business opportunity, what would have happened had they gotten the business? Some basic questions to ask include: Would the company have been able to fulfill the business, did they have capacity? Would the company need to hire more employees to do the work? Would the company have to borrow money to complete the project? Would other projects have to be postponed or foregone to accommodate the lost project? Would there have been any follow-up work?
It is important to be specific in your analysis of what should have happened so that there are no surprises that may impact your damages. Sometimes there may be several possible outcomes had the bad act not occurred. In these cases, it is particularly important to think through these scenarios and develop a game plan as to how to address these variables. Sample questions to ask your client include: Is one outcome more likely than the others? Should you prepare several damages scenarios?
Because your Should Have Been scenario is the foundation of your damages claim, it is critical to perform the thought experiment promptly to precisely determine what the world should have looked like if the bad act had not occurred. Bringing in a damages expert early can help you and your client think through these issues to make sure nothing is overlooked, and assist with any discover issues.
Just as important as determining specifically what should have happened, is determining that the bad acts were the proximate cause of the resultant losses. However, it is easy to overlook causation issues in the early stages of a case.
Causation can be very obvious (e.g., the welder set the building on fire) or very complex (e.g., the former employee’s disparagement caused your client to lose customers). The latter claim leads to important questions such as: Would the customer have been lost anyway? Was there also a decline in service or quality that impacted customer relationships? Did a competitor start a relationship with the customer before the disparagement? Did the competitor offer a better product?
When evaluating causation, it is important to evaluate if there are possible causes for the losses other than the bad acts. For example, was there a decline in the overall market where your client operates? If so, how much did the bad act contribute to the post-incident decline? During and after the Great Recession, it was often difficult to separate how much of any decline in revenues were caused by bad acts as opposed to the general decline in revenues due to the recession.
Graphing pre- and post-incident revenues can often provide a reference to show that a decline occurred concurrent with the bad act.
Another important question to ask early on is: How will you prove causation? Will your damages expert address causation? Do you need an industry-specific expert? Will your client or client’s employees have to prove causation at trial? Referring to the above referenced disparagement example, perhaps your client’s sales manager will have to testify as to how the customer relationship was damaged.
Because the inability to prove causation can eliminate damages, it is extremely important to start your causation analysis as soon as possible.
In most lost profits cases, mitigation is a necessary deduction from damages. However, determining whether a client took sufficient steps to mitigate damages may not be easy if the situation is complex. In any event, it is important to evaluate your client’s mitigation efforts early on to ensure that necessary mitigation steps are being taken. Early attention to the question of mitigation will also help you to better understand what the expected damages might be, which may impact how you pursue the litigation.
For example, a dentist installed a dental appliance in many of his patients, but the appliance failed, and he subsequently lost many patients. The dentist believed that the patient losses were caused by the failed appliance. However, an analysis of the dentist’s records indicates that although he did lose patients likely because of the failed appliance, he acquired just as many new patients during the same time. Additionally, it was clear that he was working at capacity, i.e., he was seeing as many patients as possible. Therefore, he had fully mitigated any damages because he ended up making the same amount of revenue in both the Should Have Been scenario and the actual case.
In other words, although the dentist lost patients, he had already replaced the lost patients with new patients, and he did not have the capacity to treat both the lost patients and the new patients. If the dentist was not working at capacity, he could then argue that the new patients were not mitigating patients because he would have been able to treat both the lost patients and the new patients. Therefore, because he fully mitigated, the dentist in this scenario ultimately did not pursue a lost profits claim.
As the above example illustrates, when evaluating mitigation efforts, you must determine if sales occurring after the bad act replaced the lost sales (i.e., mitigating sales,). If these sales would have occurred regardless of the bad acts, then they are not mitigating sales.
Because there can be many different mitigation scenarios, it is important to evaluate mitigation early on to ensure you have proper time to address any questions and to avoid unwanted surprises.
Bonus: Be Aware that Future Damages Will be Reduced to
Most clients are not familiar with the concept of reducing future damages to present value and are often surprised when damages projected to occur in the future are worth much less than they expected. While I’m sure most attorneys would love to dive into a dissertation on the time value of money (i.e., present value), and the use of the mid-point convention, suffice it to say for the purposes of this article that damages occurring in the future will generally be worth much less on a present value basis.
For example, if a damages analysis reveals that a client incurred lost profits of $100,000 per year for ten years into the future, damages would be $1,000,000 on an undiscounted basis. But, if a 20% discount rate is applied to that lost profit stream, the present value of the lost profits is less than half that amount.
Therefore, understanding that future damages will need to be discounted to present value is imperative in setting proper expectations for your clients. Although determining the proper discount rate, which can make a significant difference to the final damages amount, is often disputed in lost profits matters, simply understanding that your client’s damages will need to be adjusted back to present value puts you and your client ahead of the game.
Promptly addressing the “Big Three” issues relevant to most lost profit damages cases (Should Have Been analysis, Causation analysis, and Mitigation analysis) will help keep your damages case on track. In addition, acknowledging that any future lost profits will be reduced to present value and may be significantly less than the undiscounted losses your client may have in mind will help to avoid any unexpected surprises.
Scott Evans, CPA, ABV, CFF is a Managing Director at Simon Consulting, LLC with over 30 years’ experience as a financial professional specializing in litigation support matters. Mr. Evans is a Certified Public Accountant, licensed in Arizona, with extensive experience in the calculation of economic damages, forensic accounting/embezzlement, and business valuations. He is also Certified in Financial Forensics and Accredited In Business Valuation by the American Institute of Certified Public Accountants.