As forensic CPAs, we are often requested to build (or rebut) financial models that estimate lost profits. During our work, it’s very important that we don’t lose sight of the legal principles governing lost profits with the goal of assisting the trier-of-fact. Recovering lost profits generally requires the plaintiff to successfully address the following legal rules:
- The Proximate Cause Rule: The recovery of damages for lost profits is subject to the general principle that damages must be proximately caused by an event, breach or wrongful act of the defendant. This requirement is expressed in numerous cases and governs the recovery of all compensatory damages;
- The Reasonable Certainty Rule: A second requirement for the recovery of damages for lost profits is that the damages must be proven with reasonable certainty. It requires that the damages be capable of measurement based upon reliable factors without undue speculation. Again, this legal principle is expressed in several cases and is unquestionable;
- The Foreseeability Rule: There is also a key question presented by cases looking for recovery of damages for lost profits on contract claims. The question is whether those damages were reasonably foreseeable as the expected and likely result of a breach of the contract at the time the contract was made.
These governing legal principles, which have been well established and reinforced by case law, should be woven into arguments and financial models in a manner that shows their applicability to the case at hand. Further discussion and supporting case law for each rule is offered below.
The Proximate Cause Rule
As stated, damages for lost profits are recoverable only if the event, breach or wrongful act was the proximate cause of the loss. Proximate cause is an act from which an injury or damage results as a natural, direct, uninterrupted consequence and without which the injury or damage would not have occurred. In other words, there must be a close link between the event, breach or wrongful act and the resulting damages. Furthermore, to demonstrate proximate cause, the plaintiff must establish both “transaction causation” and “loss causation”. Transaction causation relies on the concept that “but for” the event, breach or wrongful act, no damages would have been incurred. Loss causation requires that the plaintiff prove that their loss is related to the event, breach or wrongful act. The fact that an event occurred or the defendant breached a contract or performed a wrongful act does not alone support damages.
For example, in Universal Commodities, Inc. v. Weed, 449 S.W. 2d 106 (Tex. Civ. App. 1969), plaintiff leased a seafood processing plant from defendant, who was obligated to supply the seafood to be processed. Defendant breached the contract, but the court denied lost profits damages because plaintiff had been unable to secure financing for the business and would not have had sufficient capital to operate and make a profit even if defendant had performed as required by the contract.
The fact of damage is required to be proven with reasonable certainty. The fact of damage relates to whether the plaintiff can prove that the event or the acts of the defendant caused damage to the plaintiff. Once the fact of damage has been established, the amount of damage can be calculated. The event or defendant’s acts need not be the sole cause of the plaintiff’s lost profits; however, they must be a significant or material factor in the cause of that loss.
Although other factors may also be partially responsible for the plaintiff’s lost profits, in some cases, it may not be practicable, or possible, to eliminate the effect of all other possible causes of loss. However, it is necessary to show that these other factors have been considered, to the extent possible.
Sufficient evidence must be presented to the trier of fact to allow a determination to be made as to what portion of the plaintiff’s damages may be properly assigned to the event or defendant. As an example, nearly 20 years ago, we handled a business interruption loss for a General Motors car dealership. The dealership suffered a devastating fire loss at the same time a union strike had stopped production at 30 GM assembly plants and 100 parts plants across North America. Through national and regional research of other “non-interrupted” GM dealerships we could assess the probable impact of the strike on the dealership’s historical car sales and related departmental profits and adjust our “but for” projections accordingly. The plaintiff should present calculations in a manner that shows how the various factors causing the plaintiff’s losses contributed to that loss.
The Reasonable Certainty Rule
The reasonable certainty principal is addressed in many cases and is usually successfully met when damages have been calculated using assumptions that are not speculative; however, the calculated damages may be an approximation. Courts mostly agree that proving reasonable certainty doesn’t require mathematical precision.
In Palmer vs. Connecticut Railway & Lighting Co., 311 U.S. 544 (1941), the U.S. Supreme Court concluded that certainty as to the amount of the damages goes no further than to require a basis for a reasoned conclusion. The decision goes on to state that certainty in the fact of damages is essential.
In Ameristar Jet Charter Inc. vs. Dodson International Parts, 155 S.W. 3d 50 (2005), the issue of reasonable certainty arose. In fact, appeals were made regarding the calculation of lost profits damages in the matter. It was concluded that the claimant must establish the fact of damages with reasonable certainty, but it is not always possible to establish the amount of damages with the same degree of certainty.
In Ashland Management vs. Janien, 82 N.Y. 2d 395, 624 N.E. 2d 1007, 604 N.Y.S. 2d 912 (1993), damages are to be reasonably certain, but does not require absolute certainty. Damages resulting from the loss of future profits are often an approximation. The law does not require that they be determined with mathematical precision. It requires that damages be measured based on known reliable facts and not speculation.
In DSC Communications v. Next Level Communications, 107 F.3d 322, 329 (5th Cir. 1997), the Court upheld recovery of lost profits because plaintiff’s damage expert presented a damage model that included an assumption of future market share based on data obtained from respected sources in the telecommunications market and upon a showing that the plaintiff’s history of strong performance in the field was indicative of likely success.
However, in Holt Atherton Ind., Inc. v. Heine, 835 S.W.2d 80 (Tex. 1992), defendants sold a bulldozer to plaintiffs that defendants subsequently refused to repair because they did not recognize the warranty. The court held lost profits were not recoverable because the plaintiffs failed to show they had enough work to fully utilize the bulldozer.
Reasonable certainty in damages cases is a question of whether the plaintiff has evidence and can value the impact by the probability of success. There is a borderline between permissible speculations to that of intolerable guesswork. A damage calculation need not prove that all elements are certain, but such calculations must:
- Be based on facts and/or the best available evidence to prove damages;
- Use sound methodologies and indicate consideration of alternative methodologies;
- Display confidence in the accuracy of estimates and yield reasonable results.
Damages for lost profits are recoverable only if the plaintiff can prove the damages related to lost profits are reasonable and that they have been calculated using reliable factors without undue speculation. The applicable federal or state laws regarding the required degree of certainty should also be addressed.
In summary, the calculation of lost profits does not require precision. An estimate of damages can be made; however, the loss cannot be based on speculation. Lost profits that are deemed speculative, such as those calculated using unreasonable growth rates for business sales or personal income, are not recoverable.
The Foreseeability Rule (contract damages only)
Damages for lost profits are recoverable only if they are reasonably foreseeable by the breaching party and at the time of contracting. The reasonably foreseeable rule dates to the famous English decision Hadley v. Baxendale (156 Eng. Rep. 145, 151 (Ex. 1854)) and is still law today.
In Hadley v. Baxendale, the Court set out that damages are recoverable only if they were reasonably foreseeable by both parties at the time of the contract and that they arouse naturally from the breach.
For example, in Hampton v. Federal Express Corp., 917 F. 2d 1119, 1125-26 (8th Cir. 1990), the Court found that damages resulting from the failure to deliver blood samples of cancer patients in need of bone marrow transplants were not recoverable if the Defendant had no knowledge of the package’s contents and therefore could not reasonably foresee any injury to patients.
The courts are consistent in giving responsibility for the determination of foreseeability to the trier-of-fact. Of the three rules, foreseeability is the legal principle for lost profits in which forensic CPAs have the least involvement. However, that does not mean our work cannot aid the trier-of-fact in the assessment of foreseeability. Our work related to proximate cause and reasonable certainty is intended to provide insight with respect to foreseeability.
As mentioned earlier, through industry research we could show a GM strike represented an “other factor” of causation, in addition to the fire, that was a probable contributor to the loss. The identification of this “other factor” would have made it difficult for the plaintiff to prove foreseeability under the insurance contract. Conversely, if the forensic CPA can identify “other factors” related to the plaintiff’s industry, markets or the economy that would have made a positive impact on the business during the loss period, the trier-of-fact may see how an event, a breach or wrongful act may have caused a loss and should have been foreseeable.
Providing lost profit calculations that meet the reasonable certainty rule may also assist the trier-of-fact in assessing foreseeability. For example, we recently prepared a lost profits model for plaintiffs that had acquired a business with environmental clean-up issues. The purchase agreement required the sellers to perform the clean-up within a “reasonable” period. Only a partial clean-up was ever completed, and nearly ten years after the acquisition date. The plaintiffs had a business plan that included multiple interdependent projects and was allegedly reliant on the seller’s environmental clean-up. Therefore, the business plan was not realized. Our lost profits model was built to reflect the plaintiff’s business plan and show the financial interdependency of the various planned projects. It was also based on industry and economic research, using conservative assumptions for growth and profitability. A well-constructed financial model, which contemplates both the reasonable certainty and foreseeability rules will allow the trier-of-fact to make an educated assessment of each rule.
There are three legal principles governing the recovery of lost profits; proximate cause, reasonable certainty and foreseeability. Proximate cause evaluates if the event, breach or wrongful act of the defendant caused the plaintiff’s loss. Reasonable certainty establishes there is reasonable certainty the estimated lost profits would have been produced had the event, beach or wrongful act not occurred. And foreseeability measures whether the defendant party, when entering a contract would have foreseen or contemplated that the event, breach or wrongful act would have caused the lost profits claimed by the plaintiff. Each rule is measured separately, yet they are interrelated. It’s important that a forensic CPA does not lose sight of these legal principles with the goal of assisting the trier-of-fact.
Stephen Ferraro and Charles Amodio are partners with Ferraro, Amodio & Zarecki CPAs (FAZ), based in Saratoga Springs, NY. FAZ is a boutique Forensic CPA firm committed to supporting, their clients, the legal community and team members in the successful resolution of financial disputes, fraud & financial investigations, economic damage assessments and business valuation matters by delivering valuable forensic accounting expertise and related expert services at an appropriate cost. We are a recognized leader in the forensic accounting profession serving clients in Albany and the Capital Region, New York City, Boston and the surrounding Metropolitan Areas. If you think you need assistance with a case or are interested in more information, please call us directly at (518) 288-2160.