December 03, 2012 Articles

Economic Damages and Financial Experts: What You Need to Know

A financial expert well-versed in assisting counsel with building a logical damages case can be the difference between a successful judgment and a disappointing result.

By David Majors and John Tira

An attorney’s strongest weapon during a civil trial for damages can be a qualified expert who can communicate the intricacies of computing damages clearly and convincingly to judge, jury, and counsel at trial. Without one, you could be jeopardizing your case and placing your clients at monetary risk.

Economic damages can take many forms, but perhaps the easiest way to illustrate them is through lost profits. Lost profits measure the present value of cash flows that would have been earned by the plaintiff but for the damaging event caused by the defendant. This loss in profits can occur over a distinct period of time or it can be assumed losses will continue into perpetuity.

The amount of lost profits is calculated as the difference between the but-for performance (the income that hypothetically should have been earned by the plaintiff) and the actual performance (the income actually earned by the plaintiff) during the damages period. In most cases, lost profits usually result from a breach of contract or a tort, but are certainly applicable to a variety of matters.

There is no doubt that securing a damages award requires the assistance of a qualified and skilled litigator. And while navigating the legal issues of a case can be a time-consuming affair, it is critical that an attorney recognize that a financial expert well-versed in assisting counsel with building a logical and supportable damages case can be the difference between a successful judgment and a disappointing result. The following are the typical steps in constructing a supportable case.

Step 1: Establishing Causation and Proper Mitigation
Causation establishes the connection between the damages being claimed by the plaintiff and the particular event(s) that allegedly caused the plaintiff to incur lost profits. A qualified and experienced financial damages expert can assist counsel in establishing causation by reviewing financial records, correspondence, and other relevant information, essentially piecing together a complex web of financial data into a succinct and logical summary.

An attorney should be concerned that the damages were not caused by intervening factors other than the event itself, such as poor cash flows due to increased market competition, mismanagement, negative economic indicators, or industry trends. In addition, the defense may try to prove contributory negligence, which means the damaged party contributed in some part to either causing the damaging event or worsening the effects caused by the damaging event. The plaintiff must prove a direct causal link between the damaging event and the damaging party while minimizing any contributory negligence or the effects of other independent factors that may have played a role in the damages suffered.

The defense may also argue that your client did not properly mitigate their losses after the damaging event and that the earnings that would have otherwise been realized by the plaintiff should be reduced accordingly. For example, the defendant may try to prove that the plaintiff could have mitigated its losses by locating another supplier in the event of a breach of contract. In this case, the defendant might argue that damages be limited to the difference between the supplier contract price and the current market price.

Be prepared to defend your client against these arguments; don’t forget that a financial expert can assist you with this effort.

Step 2: Reviewing Documents
Initially, a damages expert should collaborate with counsel to gain a general understanding of the business, the industry in which the plaintiff and defendant operate, and both parties’ historical financial performance. An expert typically requests documents from both the plaintiff and defendant. When identifying and requesting documents from opposing counsel, collaboration and communication with your expert is critical. In certain situations, there may be a brief, limited window in which documents can be obtained. Make sure that you involve your expert in this process. An experienced expert will be able to quickly identify the financial records necessary to effectively analyze your specific litigation.

Examples of documents typically reviewed by financial experts include:

  • Pre- and post-litigation cash flow projections
  • Audited financial statements
  • Audit work papers
  • Bank, brokerage, and credit card statements
  • Trial balances, general ledgers, and other accounting records
  • Trade and industry data regarding competitors, industry outlook, and general business risk
  • Legal and regulatory filings
  • Depositions and expert witness reports
  • Interviews of company personnel
  • Relevant contracts and other agreements

Step 3: Projecting But-For Sales or Revenues
The expert uses the information supplied in Step 2 to create a model that projects sales or revenues that the plaintiff would have realized but for the damaging event and/or the actions of the defendant. There are various methods of determining but-for projections, such as:

  • Sales forecast method (but-for): This approach uses a model to forecast how the plaintiff would have performed “but-for” the effects of the damaging event. These results are then compared to the actual profits of the plaintiff during the damage period.
  • Yardstick approach: This approach compares plaintiff’s actual profits during the damage period to those of comparable companies or to the industry at large.
  • Before-and-after method: This approach calculates plaintiff’s profits (a) prior to the damaging event and (b) after the effects of the damaging event. Either or both (a) and (b) is/are compared to plaintiff’s actual profits during the damage period.

Attorneys should understand that creating financial projections is a very complicated and critical process. Financial projections rely on many assumptions and in certain situations can be very sensitive to even slight changes in those assumptions (e.g., macroeconomic growth rates). Therefore, it is imperative that both counsel and the damages expert communicate with one another so that both parties fully understand the basis and reliability of the assumptions selected. A damages expert with experience in a wide array of damages theories can help counsel determine which methods and assumptions are most appropriate for your case.

Step 4: Projecting Incremental Costs
The projected but-for sales are reduced by the related costs the plaintiff would have incurred to achieve the additional sales but for the damaging event or actions of the defendant. These costs are measured in a variety of ways, but often they can be calculated as the marginal, incremental, or variable costs of producing the additional units plus other additional business or operational expenses the company would have incurred had the damaging event not occurred (e.g., additional shipping or manufacturing costs). The damages quantified may now be restated to present value, which is today’s value of the cash flows expected to be earned in the future. Present value is calculated by applying a discount rate to the future cash flows that incorporates various factors (e.g., risk and inflation), which directly contribute to the difference in the value of the cash flows over time.

Step 5: Determining the Discount Rate
At times, the discount rate may be dictated by law or legal precedent, but calculating a discount rate is perhaps the most complex and debated aspect of quantifying damages. In order to appropriately estimate the present value of a stream of future cash flows, the cash flows for the specific future periods should be converted to their present value equivalents through the application of a discount rate. The discount rate should reflect both the time value of money and the underlying risks associated with achieving the future cash flow streams.

Calculating a discount rate depends on several risk factors; basically, the greater the risk of the company not realizing future cash flows, the higher the discount rate. Attorneys and experts should carefully analyze the discount rate chosen, keeping in mind that in some instances, a small change in the discount rate can have a dramatic impact on the damages calculation.

Discount rates are often challenged in court due to factors such as poor comparable company and benchmark selections, failure to consider assumption sensitivity, and the non-consideration of overarching economic influences. The key components of a discount rate are the cost of equity, cost of debt, capital structure, and, when combined, the weighted average cost of capital.

Step 6: Quantifying Damages 
As discussed in Steps 4 and 5, to accurately quantify damages, future cash flows must be discounted to their present value. In certain situations, damages could be discounted to a variety of dates including the event date, trial date, judgment date, or payment date. Damages incurred between the event date and judgment date may be subject to pre-judgment interest to reflect the time value of money as well as opportunity costs. In addition, different discount rates may be applied during different time periods as mandated by law and/or precedent.

The discount rate and discount date are often hotly debated issues in litigation since each can have a significant impact on the damages award. Oftentimes using the same information, the plaintiff’s expert and the defendant’s expert calculate significantly different damages amounts. This is often attributable to the application of different discount rates and different discount dates. Accordingly, it is very important for counsel to collaborate with its expert to obtain a solid understanding of the discount rate and discount date selected and the rationale of those applications.

Deciding When to Involve a Financial Expert 
While it is essential to retain a financial damages expert when preparing a case for the plaintiff, damages experts are commonly used by both the plaintiff and the defense. An expert retained by the defendant often prepares a rebuttal report, identifying any errors or inconsistencies and analyzing weaknesses in the plaintiff’s expert report. Both experts may assist their respective counsel in preparing questions for cross-examination of the opposing expert witness for deposition and trial testimony.

Critical factors affecting the decision to involve a financial expert in civil damages litigation often include the complexity of the calculations, quantity and quality of available data, analysis of financial projections, and determination of a discount rate.

The following are litigation matters that often require the assistance of financial experts:

  • Contract disputes: Use of the benefit-of-the-bargain approach to determine expected profits from a proposed contract or deal. Examples: Breaches of sales contracts and warranty agreements.
  • Torts: The actual loss incurred is calculated as the difference between what the plaintiff paid for something and the actual value received. Examples: Fraud and conversion.
  • Business interruption claims: Applies the same basic methodology as a lost profits damages calculation to determine the amount of loss sustained by the affected company due to natural or man-made disasters.
  • Intellectual property: Applies the same basic methodology as a lost profits damages calculation to determine the damages suffered by the patent, copyright or trademark holder as a result of infringement. Examples: Thefts of trade secrets and patent infringement.
  • M&A post-acquisition disputes: Damages focus on whether the buyer received the economic benefit that was represented during deal negotiations. Examples: Working capital disputes and indemnity claims.
  • Antitrust: Damages can be recovered by the plaintiff for increased costs caused by the anti-trust violation, lost profits, or reduction in the value of the business.
  • Securities litigation: Damages are generally calculated as the difference between the price paid by the plaintiff for the security and the fair market value of the security at the time of the initial purchase or at the time the suit was brought. Securities litigation often involves allegations of false or misleading statements or alleged omissions in the information underlying the purchase or sale of securities.

A well-supported, accurate, logical, and methodical financial analysis is the cornerstone of a damages award case. One of the best ways to protect your client’s interests is to retain a damages expert early in the litigation process. This allows the attorney and the expert to collaborate in addressing the complex damages issues discussed above.

David Majors and John Tira are consultants in the Financial Investigations and Disputes practice at McGladrey. David is based in Chicago and John in San Francisco.