Lost Profits: The Reasonable Certainty Standards and the Modern New Business RuleSeptember 9, 2015 | Download PDF
While the vast majority of jurisdictions have moved away from the new business rule and adopted the modern new business rule, by which new/unestablished businesses can recover damages, such adoption does not diminish the requirements under the reasonable certainty standard. Given the lack of historical financial performance data, and under the lens of the reasonable certainty standard, estimates of lost profits damages to new/unestablished businesses are subject to a higher level of scrutiny.[i] [ii] As stated by Beaton and Farmer, “… legal and evidentiary requirements are often heightened when measuring damages for new businesses.”[iii] Because damages can only be recovered to the extent that the evidence permits,[iv] lost profits damages are denied more frequently for new/unestablished businesses, and it is even more so the case in breach of contract claims.[v]
The first article in this series discussed the reasonable certainty standard, and highlighted the importance of isolating the effects of the disputed incident from other unrelated factors. This article focuses on new/unestablished businesses and the importance of post-incident business-specific data/facts to isolate the effects of the disputed event, and to establish a measure of lost profits damages that can be considered reasonably certain. In other words, for new/unestablished businesses attempting to prove lost profits damages, ex post analysis can prove particularly helpful, where data permits, in enhancing the validity of the economic damages expert’s analysis and proving or disproving lost profits damages.
The general modern position of the courts is that lost profits damages are recoverable when (1) it can be demonstrated that the plaintiff was damaged, (2) that the actions of defendant are proximate cause of the plaintiff’s lost profits damages, and (3) that lost profits damages can be estimated within reasonable certainty.[vi] [vii] Accordingly, from the perspective of the economic damages expert two points must be addressed: (a) the portion of lost expected profits that are proximately caused by defendant(s)’s wrongdoing, and (b) the expert’s methodology must result in an estimate of lost profits damages that is reasonably certain.
In the case of more established businesses with sufficient historical financial performance data, historical internal and external data pre- and post-incident can be used to isolate the effects of unrelated factors from the effects of the disputed event.
In the case of a new/unestablished business, however, business-specific financial and non-financial data potentially exists only post-incident. For new/unestablished businesses, it is the post-incident data and facts that can allow the economic damages expert to construct an estimate of lost profit damages that isolates the effects of the disputed event from the effects of other, unrelated factors -both external and internal- that may have affected the business’ financial performance. In the case of a new/unestablished business, ex post analysis principles can be combined with the principles of the yardstick approach via the identification of two alternative proxy benchmarks:[viii]
1) External benchmarks: Data pertaining to unrelated comparable business situations.
2) Internal benchmarks: Data pertaining to alternative or parallel activities that the new business may have conducted post-incident.
For a new business, post-incident internal benchmarks are more critical because data on true comparables business endeavors and circumstances (external benchmarks) rarely exist. In addition, for a new/unestablished business it is more challenging to demonstrate that an unrelated business’ success constitutes a measure of the potential success of the business being analyzed. Internal benchmarks can demonstrate, or disprove, management’s resilience and ability to turn a profit in post-incident endeavors, either alternative or parallel. Moreover, while positive post-incident financial performance is many times considered as mitigation of damages, such information can actually prove useful in providing substantiation for a claim of lost profits damages. Put in simple terms, it is more difficult to prove that the enterprise would have been successful if there is no proof of post-incident accomplishments.
In constructing a lost profits damages model for a new/unestablished business, the economic damages expert can utilize post-incident internal data to address the following points:
- Identify mitigating business endeavors, i.e., business operations that occur in replacement of the lost business opportunity(ies), and measure corresponding profitability. A measure of lost profits is more credible when management has engaged in efforts and has been able to mitigate damages. Unless fully business justified, the absence of mitigation opens the door for significant cross-examination that can effectively render a lost profits damages estimate unreliable on the basis of sufficient doubts of management’s abilities.
- Identify parallel business endeavors, i.e., endeavors that could have occurred even if the disruptive incident had not occurred, and measure corresponding profitability. The presence of parallel business endeavors that can be demonstrated could have operated even in the absence of defendant’s actions can be utilized as an internal benchmark to proxy the potential success of the lost business opportunity.
- Build a solid distinction between the post-incident alternative business endeavors and business endeavors that could have operated in parallel to the alleged lost business endeavors. This allows for the detailed segregation of mitigating profits and what is to be considered an internal benchmark and proxy of but-for success and potential profitability.
- Compare the business plan pertaining to the business opportunity in dispute and the business plan(s) for the alternative and the parallel business endeavors. Measure the success (and timing of success) of post-incident business endeavors (alternative and parallel) relative to their corresponding business plans as a benchmark of the potential success of the business opportunity in dispute.
- Measure the success of alternative and parallel activities relative to the economy and relative to the relevant market’s business cycles data, and measure the new/unestablished business’ performance relative to its relevant market, industry, geographic location, etc.
- Fully consider elements important to the risk adjustment, such as the general and local economy, competition, and other factors.
While it is the case that ex post analysis faces disadvantages posed by the fact that the damages amount may change as new data becomes available,[ix] in the case of new/unestablished business, the post-incident data and available internal benchmarks may constitute the most viable approach to demonstrating lost profits damages. Because new businesses lack historical data, other methodological approaches are, most likely, not viable. In fact, the lack of historical financial performance data render the principles of the before and after approach and the market share approach typically not applicable. Moreover, if management’s abilities are not proven by performance in alternative or parallel business endeavors, the forecast approach may be subject to significant scrutiny and effective cross-examination. In breach of contract claims, for example, by new businesses, a contract does not imply guaranteed success of a new enterprise.
Because of the timing characteristics of the legal process, the involvement of the economic damages expert typically occurs at a date that is likely years removed from the date of the disputed incident. Given the lag between the incident and the timing of economic damages expert’s retention and analysis, the economic damages expert (regardless of whether the expert is retained by the plaintiff or by the defendant) can often take full advantage of the additional data available post-incident in demonstrating or disproving lost profits damages to a new business.
Similarly to any other situations in which economic damages are estimated, the reliability of the damages model and corresponding results hinges upon the quality of the data. The more reliable and the closer the data is to the specific circumstances analyzed, the higher the chances of constructing an economic damages estimate that can be defensible and withstand cross-examination. Lack of post-incident data on the activities of a new/unestablished business plaintiff can be effectively used by an opposing economic damages expert to disprove the reliability of the damages estimate on the grounds that the lack of data would unavoidably result in assumptions that may be unduly speculative.
[i] Fannon, Nancy J.: The Comprehensive Guide to Lost Profits and Other Commercial Damages, Third Edition, Volume 1, BVR, 2014; Chapter 12.
[ii] This is also the case for businesses with a long standing history of operations but with relatively new presence in a new business -and possibly unchartered- market segment. See TAS Distrib. Co. v. Cummings Engine Co. (7th Cir. 2007).
[iii] Fannon, Nancy J.: The Comprehensive Guide to Lost Profits and Other Commercial Damages, Third Edition, Volume 1, BVR, 2014; Chapter 12.
[iv] Weil, Roman L., Daniel G. Lentz & David P. Hoffman, Litigation Services Handbook – The Role of the Financial Expert, Fifth Edition, John Wiley & Sons, Inc., 2012; Chapter 4.
[v] Fannon, Nancy J.: The Comprehensive Guide to Lost Profits and Other Commercial Damages, Third Edition, Volume 1, BVR, 2014; Chapter 12.
[vi] Weil, Roman L., Daniel G. Lentz & David P. Hoffman, Litigation Services Handbook – The Role of the Financial Expert, Fifth Edition, John Wiley & Sons, Inc., 2012; Chapter 4.
[vii] While this assertion by the courts is made in reference to breach of contract matters, the same principle applies to other types of claims with allegations of lost profits.
[viii] For a good discussion on ex post analysis, see Weil & Hoffman.
[ix] Weil, Roman L., Daniel G. Lentz & David P. Hoffman, Litigation Services Handbook – The Role of the Financial Expert, Fifth Edition, John Wiley & Sons, Inc., 2012; Chapter 5.