Economic Analysis Thought Leadership

Thought Leadership Discussion A Primer on the Fundamental Elements of Economic Damages Analysis Fady F. Bebawy

This discussion summarizes some of the fundamental elements that go into an economic damages measurement analysis. This discussion considers that the related to breach of contract claims and tort claims are complex. This discussion recognizes that many of the participants to a judicial action are not attorneys. Economic damages analysts (“analysts”) are among these participants. Understanding some of the elements to a judicial action provides background information and context to the legal aspects that touch on many economic damages analyses. This in turn aids analysts in performing damages analyses and selecting the most appropriate damages measurement methods. Because measuring economic damages is sometimes related to quantifying business value, business valuation analysts are often qualified to perform economic damages analyses.

ntroduction The wide and expansive nature of the is I complex, and the terminology used by participants Economic damages awards in judicial actions are in a lawsuit is often used loosely. This fact can leave meant to achieve two goals. participants to a lawsuit (other than the attorneys) The first goal is to compensate the damaged unclear about the legal process and uninformed party by putting that party in the same economic about many elements to a lawsuit. This lack of clar- position it would have been in but for the wrongful ity even extends to the professional practitioners act. who may be involved in providing testifying expert The second goal is to deter future wrongful acts services. from being performed by the defendant. This goal Conceptually understanding the elements to a is accomplished by putting the defendant in the judicial action can assist the forensic analyst (“ana- same economic position it would have been in (i.e., lyst”) in identifying the measurement methods to by disgorging its ill-gotten gain) but for the wrong- apply in the economic damages analysis. ful act. Of course, the law also provides for other The scope of the economic damages measure- remedies to encourage deterrence, such as punitive ment analysis should not extend beyond the exper- damages awards. tise of the analyst. While an understanding of the This discussion presents an overview of the ele- elements of a court action is important, the analyst’s ments of a judicial action that are relevant to the work should be performed under the direction of the analysis and measurement of economic damages. client’s legal counsel. The judicial action is based on a wrongful act com- The following discussions relate to various legal mitted by a “bad actor” that results in damages areas surrounding a judicial action. Of course, these to another party. The damaged party seeks relief discussions do not represent legal opinions or legal through the courts from this wrongful act by filing guidance. a lawsuit.

www .willamette .com INSIGHTS • SUMMER 2018 3 he lements of a udicial address other factors that could have caused the T E J plaintiff’s damages and (2) to proffer some explana- Action That Are Relevant to tion as to why these factors are not relevant in the subject case. Economic Damages Because the legal standard of causation may dif- The elements of a judicial action that are relevant to fer by jurisdiction, and given the nature of the legal the analysis and measurement of economic damages claim (wrongful act), causation may be established include (1) legal standards, (2) types of courts, (3) by specifically addressing the following criteria. types of claims, and (4) types of remedies. Each of these elements is addressed in the following sections. First, causation may be established by simply linking the defendant’s wrongful act directly to the plaintiff’s damages in a way that demonstrates a Legal Standards Related to a Judicial relationship of cause and effect—rather than just Action correlation. An economic damages measurement analysis is Second, it is important for the analysis (1) to informed by a number of important legal standards provide a discussion of the rationale that clearly that should be met to support the economic dam- links the defendant’s wrongful act to the plaintiff’s ages claim. These legal standards are important as damages and (2) to establish a reasonable expecta- they affect determinations in a claim with respect to tion that the plaintiff’s damages are the result of the culpability and veracity. defendant’s wrongful act. The legal standards are usually addressed in a Third, establishing causation involves (1) later stage of the lawsuit. However, if the facts and addressing any and all other factors that could also circumstances of the lawsuit do not satisfy these have harmed the defendant and (2) discussing why legal standards, while the lawsuit may be valid in these factors are not relevant. terms of the defendant’s performance of a wrongful Finally, it is important to understand that a act, the plaintiff may not be eligible to receive any plaintiff’s economic damages may not be caused pecuniary relief. entirely by the defendant’s wrongful act. For exam- Prior to filing the judicial action, the plaintiff’s ple, consider a shareholder action against a corpora- counsel will evaluate the lawsuit based on the mer- tion where wrongful conduct resulted in a reduction its of addressing these legal standards (as well as of stock price. If the wrongful conduct occurred in other considerations). The legal standards discussed times where the whole market experienced declin- below are (1) causation, (2) reasonable certainty, ing returns, then part of the plaintiff’s economic (3) economic loss doctrine, (4) proximate cause, (5) decline may be related to the overall market decline. foreseeability, and (6) duty to mitigate. The overall market decline would not be includ- ed as economic damages, and the additional por- Legal Standard of Causation tion of the plaintiff’s economic decline would be related to the defendant’s wrongful act. That is, The legal standard of causation relates to the con- the non-market-based decline would be related to, nection between the defendant’s wrongful acts and or caused by, the defendant’s wrongful act. In this the damages suffered by the plaintiff. It is notewor- scenario, any market economic decline should be thy that causation is not established by mere corre- (1) addressed and separated from the plaintiff’s lation, even if the correlation is logical, strong, and total economic decline and (2) excluded from the direct. Causation is more than correlation. concluded economic damages. Causation is established only when the wrong- In commercial litigation, while causation should ful acts of the defendant are the primary reason be demonstrated in a lawsuit, causation does not for the plaintiff’s damages and there are no other necessarily need to be established by the plaintiff’s factors that could have caused or contributed to the damages analyst. Depending on the nature of the plaintiff’s damages. This latter consideration may business and the nature of the legal claims, causa- be subtle, but it is important. Some courts have tion may be established by other constituents to the challenged the analyst’s credibility and even admis- lawsuit, such as an industry expert, a fact witness, sibility of the expert’s testimony because the analyst the defendant’s legal counsel, and so forth. did not convincingly establish the link between (1) the defendant’s wrongful act and (2) the plaintiff’s economic damages. Legal Standard of Reasonable Certainty It is in the best interest of the plaintiff’s legal The legal standard of reasonable certainty is guided counsel team (including all retained experts) (1) to by Section 352 of the Restatement (Second) of Contracts (1981) that reads, “Damages are not

4 INSIGHTS • SUMMER 2018 www .willamette .com recoverable for loss beyond an amount that the jurisdictions extend the damages available to plain- evidence permits to be established with reasonable tiffs to include monetary losses. certainty.”1 In other words, the damages should be In cases under tort law, the damages expert may provable, and not speculative. seek specific guidance from counsel regarding the There remains no consensus on the measure of scope of eligible damages prescribed under the eco- reasonable certainty as individual state courts and nomic loss doctrine. federal courts have advanced their own opinions as to the nature of reasonable certainty. The courts Legal Standard of Proximate Cause should strike the right balance in evaluating wheth- er reasonable certainty is established or not. If the The legal standard of proximate cause limits the bar is set too high, this would encourage potential plaintiff’s economic damages to the point at which unscrupulous actions of the defendant. If the bar is the defendant’s actions cease to “proximately cause” set too low, this would encourage the plaintiffs to harm to the plaintiff. In other words, damages suf- undertake judicial actions, because the burden of fered by the plaintiff do not continue indefinitely. proof is easier to establish. The determination of proximate cause can be understood in the context of the two components Legal Standard of Economic Loss Doctrine of causation: (1) actual (but-for) cause and (2) legal (proximate) cause. The recoverability of damages—and the nature of Actual cause has been defined by some courts damages—differ between a tort case and a breach of in terms of a but-for test, “The defendant’s con- contract case. The legal standard of economic loss duct is a cause of the event if the event would not doctrine sets out the extent of loss a plaintiff can have occurred but for that conduct; conversely, the recover in a tort case. defendant’s conduct is not a cause of the event if the Under a contract, the parties to the contract event would have occurred without it.”4 determine the respective rights and duties. If one Said another way: party believes the other has breached a duty under the contract, a suit can be raised against the breach- n There is causation if the following state- ing party. In addition to the contract, the Uniform ment is true: if there was no defendant, Commercial Code also provides guidelines for the there would be no damages to the plaintiff. rights and responsibilities of the parties to a con- n There is no causation if the following state- tract.2 ment is true: if there was no defendant, On the contrary, a tort involves a breach of a there still would be damages to the plaintiff. civil duty (not a contractual duty). Torts are some- times thought of as personal injury cases, but the While actual cause can cast the universe of wrongful act extends beyond this. Torts include factors that caused the plaintiff’s damage wholly such wrongful acts as assault, battery, false impris- on the defendant, legal cause acts in a manner onment, defamation of character, interference with that “tempers the expansive view of causation.”5 business, unfair competition, tortious interference In other words, legal cause puts a limit on the with contract, trespass, negligence, and infringe- defendant’s liability to a demarcation point beyond ment of protected intellectual property rights. which “the law arbitrarily declines to trace a series Under tort law, an injured party can bring a civil of events.”6 lawsuit to seek compensation for a wrong done to Another court explained legal cause as follows: the party or to the party’s property. In other words, 3 The law does not undertake to charge a per- the plaintiff can only recover the losses related to son with all the possible consequences of a personal injury or property loss based on the eco- wrongful act, but only with its probable and nomic loss doctrine in a tort case. Thus, recovery of natural result; otherwise, the punishment actual monetary losses is precluded under tort law would often be entirely disproportioned to based on the economic loss doctrine. the wrong, thereby impeding commerce and Under a breach of contract claim, the economic the ordinary business of life, and rendering loss extends to monetary losses. This definition of the rule [of causation] impracticable.7 the economic loss doctrine is by no means invari- able. While this narrow definition of the economic loss doctrine—that plaintiff’s recovery is limited to Legal Standard of Foreseeability losses related to personal injury loss or property In general, the legal standard of foreseeability loss—is the majority view held by most states and limits the plaintiff’s ability to recover damages federal jurisdictions, a minority of states and federal from the defendant to the extent that the results or

www .willamette .com INSIGHTS • SUMMER 2018 5 consequences of the defendant’s wrongful acts are equitable rights (such as trusts and duties) reasonably foreseeable. and equitable remedies (such as and The legal standard of foreseeability is related to ).”9 the legal standard of proximate cause. Foreseeability is one of the fundamental tests that can be applied to aid in determining proximate cause. In other Types of Claims words, proximate cause can be tested by reasonable There are three types of claims that can arise in a foreseeability. judicial action: 1. A contract claim Legal Standard of Duty to Mitigate 2. A tort claim The legal standard of the duty to mitigate is another 3. A statutory claim condition placed on the plaintiff in order to be awarded damages. This condition means that the plaintiff is required to take reasonable steps to A Contract Claim reduce or altogether eliminate the loss that was A contract claim arises when the dispute relates caused by the defendant’s wrongful act. Failure to to a contract entered into by two or more parties. take reasonable steps to minimize damages may These parties to a contract—parties in privity or result in the damages award being reduced. parties with privity—and third parties identified in the contract are the only parties who can raise con- tract claims. Thus, parties not in privity cannot seek Types of Courts remedies in a contract claim. However, the parties The U.S. court system, historically originating from may seek remedies in a tort case or a statutory case the English court system, is made up of civil courts depending on the nature of the circumstances. and criminal courts. Civil courts render compensa- Elements that should exist in a judicial action tory and equitable remedies. Criminal courts pri- of a contract claim, in addition to the applicable marily render the remedy of incarceration. Disputes, legal standards discussed previously, include the where analysts are brought in to perform a damages following: analysis, are tried as civil disputes in the U.S. civil n The existence of a bona fide contract court system. n The party claiming the breach must per- Within the U.S. civil court system, two discrete form the contract or demonstrate intent to types of civil courts have historically existed: (1) perform the contract courts of law and (2) courts of equity. Courts of n A material breach of the contract by the law, awarding remedies (relief) based on pecuniary defendant to the contract claim damages, adjudicate disputes in accordance with federal and state law. Courts of equity adjudicate n Damages that are caused by the breach disputes in accordance with a set of principles based on fairness, equality, moral rights, and natural law, In a contract claim, the purpose of the damages rather than a strict interpretation of the law. Courts award is to place the injured party in substantially of equity award remedies in the form of an action, the same position as the party would have been in rather than a monetary payment.8 had the contract been performed and not breached. Most states have merged their courts of law A list of types of typical contract claims include, and courts of equity. Consequently, courts now but are not limited to, the following: administer both pecuniary remedies and equitable n Breach of contract remedies. Depending on the nature of the dispute, courts may also administer a combination of pecu- n Fraud in the inducement niary remedies and equitable remedies. n Misrepresentation However, there still remain some state courts n Breach of express or implied warranty that have not merged their courts and have retained n Breach of covenant of good faith and fair their courts as either courts of law or courts of equi- dealing ty. Perhaps the most notable state court that has retained its court of equity is the Delaware Court of Chancery. Its website states, “Delaware’s Court of A Tort Claim Chancery is the nation’s preeminent business court. A tort claim is a civil wrongful act that arises when a As a court of equity, the Court of Chancery has dispute is not related to a contract. The party com- jurisdiction to hear and determine cases involving mitting the tort is the tortfeasor. While a contract

6 INSIGHTS • SUMMER 2018 www .willamette .com claim relates to a breach of contract, a tort claim its of the infringer that are attributable to typically relates to a breach of a fiduciary duty. the infringement and are not taken into Generally, in a tort claim, the purpose of the dam- account in computing the actual damages.” ages award is to place the injured party in substan- n Trademarks – covered under the Lanham tially the same position as that which was occupied Act, trademarks are generally governed by prior to the tortious activity. This purpose of the 15 U.S.C. section 1117. Trademarks are also damages award in a tort claim is essentially the governed by state trademark registration same purpose as that in a contract claim. acts. Similar to copyrights, infringement The three common elements that should be pres- damages is measured as the sum of the ent in every tort claim are as follows: actual damages of the trademark holder and n The existence of a legal duty to the plaintiff the infringer’s profits. n The breach of that legal duty by the defen- n Patents – governed by 35 U.S.C. section 284. dant This statute awards the patent holder ade- n The plaintiff experienced harm or damages quate compensation for the patent infringe- as a result of the breach of duty ment. Damages can range from a reasonable royalty payment on the infringed patent to the lost profits the patent holder would A list of types of typical tort claims include, but have earned but-for the patent infringement are not limited to, the following: by the defendant. n Defamation n Trade secrets – solely governed by state n Tortious interference with contract statutes. In court actions related to trade n Theft of trade secrets secrets, counsel should advise the analyst of the relevant trade secret statutes and any n Breach of fiduciary duty relevant judicial precedent. In most states, n Negligence some version of the Uniform Trade Secrets n Conversion Act has been adopted. n Infringement n Expropriation Types of Remedies n Condemnation There are three types of remedies that can be n Misappropriation awarded in a judicial action. These remedies gener- ally relate to the types of courts in which the judicial n Wrongful termination actions are filed. These three types of remedies are (1) compensatory remedies, (2) punitive remedies, A Statutory Claim and (3) equitable remedies. A statutory claim arises when the wrongful act is Historically, compensatory remedies and puni- performed in violation of a federal or state statute. tive remedies have been awarded in courts of law, Therefore, the guidelines vary by state or local juris- while equitable remedies, as its name suggests, have diction. been awarded in courts of equity. Since these two Cases that commonly result in statutory dam- courts have been merged in most states, all three ages include the following: types of remedies may be awarded in civil court actions. Also, all three types of remedies may be n Breaches of intellectual property or copy- awarded in both contract cases and tort cases. right law n Public policy violations Compensatory Remedies n Tax evasion Compensatory remedies are pecuniary and involve measurements of economic damages. There are a Common judicial actions that arise based on number of types of compensatory remedies. The statutory claims relate to the following: main types of compensatory remedies are (1) n Copyrights – governed by 17 U.S.C. section expectation remedies, (2) reliance remedies, (3) 504. According to section 504(b), “The or disgorgement remedies, (4) anticipa- copyright owner is entitled to recover the tory breach remedies, (5) ex ante remedies and ex actual damages suffered by him or her as post remedies, (6) consequential remedies, and (7) a result of the infringement, and any prof- statutory remedies.

www .willamette .com INSIGHTS • SUMMER 2018 7 Expectation Remedies Courts can award multiple remedies—such as restitution, expectation, and others—so long as the Expectation remedies are measured from the plain- restitution does not overlap any of the other remedy tiff’s perspective and are related to the plaintiff’s measures. Accordingly, counsel may seek a com- loss. Expectation remedies typically apply in con- bination of expectations remedies and restitution tract claims in which the harming party breaches remedies and direct the analyst to quantify both of a contract with the harmed party. Expectation these damages. remedies seek to make the plaintiff whole as if the defendant had fulfilled the promise or bargain of the contract in full.10 Anticipatory Breach Remedies Courts sometimes refer to expectation remedies As the name implies, an anticipatory breach occurs as the “benefit of the bargain” because it seeks to when either party to a contract notifies the other compensate the plaintiff for the benefit of the bar- that it will not perform its duties under the con- gain that was lost as a result of the wrongful act. tract. An anticipatory breach also occurs when the nonbreaching party assumes there will be a breach because of the actions of the breaching party. In Reliance Remedies this case, the nonbreaching party may sue when Reliance remedies are also measured from the plain- the anticipatory breach occurs and does not need to tiff’s perspective and are also related to the plaintiff’s wait until the actual breach.12 loss. Reliance remedies typically apply in tort claims and in some contract claims as well. Reliance rem- Ex Ante Remedies and Ex Post Remedies edies unwind a transaction and restore the harmed party to the same position had the transaction not Ex ante remedies and ex post remedies primarily existed in the first place. In the case of torts, com- have to do with considerations of available infor- pensation for nonpecuniary losses such as pain and mation and the measurement date. In an ex ante suffering would also be included. Reliance remedies analysis, the measurement date is the date of the often may include out of pocket costs, and, when wrongful act and the available information is the appropriate, may even include compensation for information that is known or knowable at the date lost opportunities. of the wrongful act. Information about subsequent events are not considered in an ex ante analysis. Reliance remedies that strictly involve the In an ex post analysis, the measurement date unwinding of a transaction as if it did not exist is the date of the analysis (a current date) and the may result in an economic damages estimate that available information is all the information that is is less than that of expectation remedies. However, known or knowable as of the current date. Thus, in cases where lost opportunities are included in events subsequent to the date of the wrongful act the damages measurement, reliance remedies may are considered in an ex post analysis. approach expectation remedies. The simplest example to illustrate the implica- tions of an ex ante analysis versus an ex post analy- Restitution or Disgorgement Remedies sis is the lottery ticket example. The harmed party Restitution or disgorgement remedies are measured purchases a lottery ticket for one dollar, which is from the defendant’s perspective, instead of from the stolen by the harming party. One week later, this plaintiff’s perspective. These remedies are related to ticket is the winning lottery ticket and the harming the defendant’s gain, instead of the plaintiff’s loss. party receives $100 million. Also known as or ill-gotten gains Based on an ex ante analysis, the harmed party remedies, collectively, these remedies are referred is awarded one dollar to be made whole, given what to here as “restitution” remedies. was known or knowable at the date at which the Restitution remedies act in the same way as reli- ticket was stolen. Based on an ex post analysis, the ance remedies, except from the perspective of the harmed party is awarded $100 million to be made defendant. Restitution remedies unwind a transac- whole, given at the time of the lawsuit, it was known tion and restore the breaching party to the same that the stolen ticket was worth $100 million. position had the transaction not existed in the first Note that either of these analyses is not a com- place. plete damages analysis method on its own. Instead, each method includes certain considerations, name- The compensatory remedy of restitution is anal- ly information and damages date, that are included ogous to the equitable remedies of specific perfor- in a damages analysis method. For example, in a lost mance and injunctive relief (discussed in subse- profits method, the selected damages date and the quent sections). 11 information known on the damages date determines

8 INSIGHTS • SUMMER 2018 www .willamette .com whether the lost profits damages measurement is ex will pursue the compensatory remedy of restitution ante or ex post. to disgorge the harming party of its ill-gotten gains. Generally, the analyst will perform either an ex The restitution remedy, then, will result in ante analysis or an ex post analysis based on (1) placing the harming party in the same economic the information available, (2) what makes economic position it would have been in but for the wrongful sense given the facts and circumstances of the case, act it performed. This remedy may or may not suc- (3) what makes economic sense based on analysis of cessfully deter the wrongful acts of harming parties. the data, (4) instruction from counsel, and (5) what Punitive remedies are special damages awarded the courts have accepted in the particular jurisdic- in addition to actual damages. As such, punitive tion in which the case is being litigated. remedies are specifically designed to punish wrong- ful acts as a further deterrent. Punitive remedies Consequential Remedies are not tied directly to the plaintiff’s losses or the Consequential remedies, as the name implies, are defendant’s gains. additional damages that arise as a consequence of Courts often award punitive remedies when the damages directly related to the wrongful act. the harming party exhibits deceitful, malicious, arising from a breach of reprehensible, or reckless conduct. Courts do not contract claim can be reasonably foreseen at the award in breach of contract court time the parties entered into the contract.13 actions.15 A classic example of a breach of contract conse- This is because the policy of contract law is quential damages is a construction contract where not to compel adherence to contracts, but only to the builder completes the construction of a hotel. require each party either to perform under the con- However, the building has plumbing issues such that tract or compensate the other party for any result- (1) the owner incurs costs to fix the plumbing issues ing injuries.16 (direct damages) and (2) the owner losses profits because the plumbing issues delayed the opening of Courts may also award punitive remedies in the hotel (consequential damages). addition to compensatory remedies in connection with a tort claim.17 Statutory Remedies Statutory claims are discussed above in the section Equitable Remedies related to types of claims. Statutory remedies refer Historically, equitable remedies were the remedies to standard payments that compensate for injuries, that were awarded in courts of equity and could losses, or civil violations. Statutory remedies accel- not be awarded in a court of law where damages erate judicial actions because there is no require- awards were pecuniary. Even though courts of law ment for a measurement of actual economic dam- and courts of equity are merged in most U.S. states, ages and the support for the calculations. these merged courts continue to render equitable The following are examples of common statutes remedies. 14 and their : Equitable remedies include the following:18 n Copyrights – statutory damages for copy- n Rescission – undoing or reversing actions right violations range from $750 to $30,000 taken under a contract n Trademarks – statutory damages for trade- n Reformation or – restructuring mark violations, including unfair compe- the terms of a contract to prevent an ineq- tition, infringement, and willful dilution, uitable outcome range from $1,000 to $250,000 n Specific performance – compelling per- formance of the contract according to its Damages analysts may or may not be involved in terms the calculation of statutory damages. n – compelling a party from refraining from certain acts Punitive Remedies n – providing that one party can As mentioned above, one of the main goals of an assume the rights of another economic damages award is to deter future wrongful acts from being performed by the harming party. A n Account of profits – assessing profits improp- damages analysis will seek to quantify the ill-gotten erly gained by a fiduciary that breached its gains achieved by the harming party and counsel duty (disgorgement or unjust enrichment)

www .willamette .com INSIGHTS • SUMMER 2018 9 n Declaratory relief – seeking a preemptive because, in the fluid and changing landscape of court ruling as a common mechanism of many litigation cases, the appropriate damages relief in divorce and certain contract mat- method may not be evident at the beginning of the ters case. If at an advanced stage in the case it becomes clear that the best damages measurement method is the lost business value method, this creates a Although rescission is a nonpecuniary, equitable potential problem for the analyst who does not have remedy, depending on the facts and circumstances experience performing business valuations. of the case, a pecuniary restitution remedy may be applicable—in addition to the of Fourth, because analysts who are not also busi- rescission.19 ness valuation specialists are less experienced in performing a lost business value method, they are A landmark Delaware Supreme Court decision less likely to select this damages measurement concluded that in the context of a self-dealing trans- method—even if it may be the most appropriate action involving the duty of loyalty, the rescissory method. damages standard is based on requiring a disloyal fiduciary to disgorge any unjust enrichment derived from his wrongdoing. The court stated: Considerations [T]he absence of specific damage to a ben- The analyst should examine the following consid- eficiary is not the sole test for determining erations when selecting the appropriate damages disloyalty by one occupying a fiduciary measurement methods: position. It is an act of disloyalty for a fidu- 1. The type of claim that is set forth in the ciary to profit personally from the use of judicial action information secured in a confidential rela- 2. The requisite legal standards supporting tionship, even if such profit or advantage is the types of claims set forth in the judicial not gained at the expense of the fiduciary. action The result is nonetheless one of unjust 3. The type of asset or business that is subject enrichment which will not be countenanced to the damages analysis by a Court of Equity.20 4. If applicable, the existence of (a) case law, (b) judicial precedents, or (c) a particular With the exception of some rescissory damages judge’s precedents with respect to preferred cases, equitable remedies may not involve the ana- methods lyst performing an economic damages analysis. 5. Statutory measures 6. The input and instruction of counsel

Economic Damages Analysis As a condition for commencing a judicial action, Performing the economic damages analysis is the counsel may either assume or determine that the final element of this discussion. All of the ele- types of claims being advanced in the lawsuit satisfy ments previously discussed have a direct or indi- the required legal standards. However, this may not rect impact on the nature of the damages analysis be true in every case. Also, such determinations and the types of damages methods the analyst will may not be definitive until the case is underway adopt. Analysts who are also business valuation and the documents become available through dis- specialists are often qualified to perform damages covery. For this reason, counsel may ask the analyst measurement analyses. This is the case for several to perform some initial analyses in order to ensure reasons. that the remaining legal standards can be satisfied First, measuring economic damages is often before going further into the lawsuit. Conversely, related to quantifying the value of a business. This the analyst may raise these issues with counsel early relationship can be seen by comparing (1) the meth- in the case. The analyst may perform some of these ods of measuring economic damages and (2) the initial analyses before investing too much time and methods of valuing a business. expense into the case, in order to ensure that any of the legal standards that relate to the damages analy- Second, business valuation analysts frequently sis are satisfactory and supportable. enter the field of economic damages analyses. It is important to note the inherent scope and Third, one of the damages measurement meth- objectives that should be part of the analyst’s ods is the lost business value method. This measure- work. First, the analyst provides an independent ment method can be very problematic for analysts and impartial analysis and is not an advocate for who are not trained in business valuation. This is the client. Second, the analysis performed by the

10 INSIGHTS • SUMMER 2018 www .willamette .com analyst is theoretically intended for the court’s In this case, the analyst may consider two dam- benefit, even though the analyst is retained, and ages measurement methods: (1) the lost profits paid, by the client. Therefore, the analyst should method and (2) the lost business value method. be judicious about what assumptions he or she Let’s say the damages measurement using the lost is willing to accept and the scope of his or her profits method results in $30 million. On the other opinions. hand, the damages measurement using the lost busi- A less than cautious approach by the analyst may ness value method results in $5 million. This dam- (1) put the damages analysis at risk in the subject ages measurement is so much lower than the lost lawsuit, (2) expose the analyst to a Daubert chal- profits measurement because the company was still lenge, and (3) compromise the credibility of the ana- in the start-up stage. Even though both calculations lyst. The damages analysis prepared by the analyst were performed correctly and relied on appropriate is not necessarily required to address all, or maybe damages measurement methods, based on the facts any, of the legal standards related to the claims of the and circumstances of the case, the true measure- lawsuit so long as these legal standards are addressed ment of the damages suffered by the plaintiff may by other constituents to the case. For example, coun- favor the lost profits method result of $30 million. sel, another expert, a fact witness, or some other constituent may address the required legal standards. Damages Measurement Methods General judicial precedent and a specific judge’s The selected damages measurement methods should precedent may both play a role in the selection of comport with the types of claims and the types of the appropriate damages measurement method. remedies in the subject lawsuit. Determining the Examples of generally accepted methods used in objectives of the judicial action may guide the selec- certain types of cases include royalty rate and lost tion of damages measurement methods. profits calculations in patent cases, trendline analy- There are a number of damages measurement sis in business interruption insurance cases, event methods available to the analyst. Depending on the studies in securities cases, and market share analy- type of claim, there are generally accepted damages ses in antitrust cases. measurement methods. There are primary damages In other types of cases, there may be multiple measurement methods and there are supporting appropriate damages measurement methods and damages measurement methods. each of these methods may yield different results. For example, in patent cases, if there are not enough data to apply the lost profits method, an alternative Primary Damages Measurement Methods method may be a royalty rate method. This discussion addresses three primary damages Thoughtful consideration should be exercised measurement methods: (1) the lost profits method, in selecting the appropriate damages measurement (2) the lost business value method, and (3) the rea- method to apply. If the analyst selects a damages sonable royalty method. These three damages mea- measurement method that will simply generate a surement methods do not represent the universe of higher economic damages calculation than alterna- all damages measurement methods.21 tive methods, but the analysis includes assumptions that may be questionable, this may result in the dam- The Lost Profits Method ages analysis being rejected by the court. The analyst Perhaps the most common damages measurement should rely on a set of assumptions and supporting method is the lost profits method. The lost profits data that are clear, understandable, logical, and sup- method quantifies the additional profits (above portable both (1) in written form in the expert report actual profits) that the plaintiff would have achieved and (2) orally in deposition and trial testimony. but for the wrongful act of the defendant. In per- A final consideration regarding the selection of forming a damages measurement analysis by apply- a damages measurement method is that of making ing the lost profits method, other supporting dam- a concerted effort to determine the true harm to ages methods and calculations may be involved. the plaintiff—and not just performing a calculation. These analyses may include the before-and-after For example, let’s say a start-up company enters method, the projections (but-for) method, the yard- into a contract with a party to sell its products at stick method, the market share method, the ex post both specified contractual prices and specified con- method, and the ex ante method. tractual volumes over the term of the contract. If, Instead of lost profits on lost sales, the claim as a result of the defendant’s breach, the plaintiff could be that the plaintiff’s loss relates to lower becomes financially distressed and is forced to file product pricing. In this case, the lost profits meth- for bankruptcy, the plaintiff may file a lawsuit for od would still be applied in measuring damages. breach of contract.

www .willamette .com INSIGHTS • SUMMER 2018 11 However, instead of the “loss” being the difference the reasonable royalty method may be applied instead between but for sales and actual sales, the loss due to the simplicity of the analysis (which involves a would be the difference between the but for price of revenue assumption and a royalty rate assumption). product sales and the actual price of product sales. There are a number of methods that may be applied to If counsel is seeking restitution remedies in the estimate the royalty rate. These royalty rate measure- judicial action, then an unjust enrichment dam- ment methods are discussed below. ages measurement may be involved in the economic damages analysis. Measuring damages for unjust Supporting Damages Measurement Methods enrichment is similar in manner to estimating lost Supporting damages measurement methods are profits. However, instead of applying the lost profits used as inputs into one or more of the primary dam- method in analyzing the plaintiff’s business, the lost ages measurement methods. We categorize these profits method is applied in analyzing the defen- supporting damages measurement methods by what dant’s business. they typically measure. If counsel is seeking convoyed sales based on the entire market rule, these lost sales that the plaintiff suffered will also be estimated by applying the lost Estimating Revenue profits method. There are four methods that may be employed to project the damaged entity revenue. These methods can be applied to all of the damages measurement The Lost Business Value Method methods discussed above. They are as follows: This damages measurement method is often applied 1. The before-and-after method – This method when the defendant’s wrongful act results in the involves comparing the revenue perfor- destruction of the plaintiff’s entire business. In this mance of the business before and after the instance, the analyst will perform a business valu- alleged wrongful act. ation of the plaintiff’s whole business as of a date 2. The projections (but-for) method – This prior to the commission of the wrongful act.22 method involves comparing the actual In an instance where the defendant’s wrongful revenue to revenue projections that were act did not result in the destruction of the plaintiff’s expected to take place but for the wrongful entire business, it may also be appropriate to apply act. the lost business value method. In this case, the dam- ages analysis involves measuring the loss to the plain- 3. The yardstick method – This method tiff’s business value from the defendant’s wrongful act involves comparing actual revenue as a by performing a business valuation as of a date prior result of the wrongful act with the revenue to the wrongful act and another business valuation as of comparable businesses that were not of a date immediately after the wrongful act. The dif- affected by the wrongful act. ference between these two business value indications 4. The market share method – This method represents a measurement of damages. involves comparing the plaintiff’s market Facts and circumstances will dictate whether it share prior to the wrongful act with its is more appropriate to measure damages by apply- actual market share after the wrongful act. ing the lost profits method or the lost business value method. Most analysts may tend to favor the lost Timing profits method over the lost business value method Timing refers to the ex post method and the ex ante due to the complexities of performing a business method. This factor was discussed above. Both of valuation. these methods can be applied to all damages mea- There is a body of professional literature that surement methods. discusses the generally accepted business valuation approaches and methods. These business valuation Business Valuation Approaches and Methods approaches and methods are summarized below. There are three generally accepted business valuation approaches. These generally accepted The Reasonable Royalty Method approaches are the (1) income approach, (2) market This method is usually applied in intellectual prop- approach, and (3) asset-based approach. erty (“IP”) cases where the measurement of dam- The income approach methods include (1) the ages considers licensing the IP for royalty income. discounted cash flow (“DCF”) method and (2) the In cases where the lost profits method cannot be direct capitalization method. Both of these income applied because of a lack of financial information, approach methods are based on the principle that

12 INSIGHTS • SUMMER 2018 www .willamette .com the value of the business is equal to the present can be used in the reasonable royalty method. value of the future income to be derived by the These estimation methods are listed below: owners of the business. Both of these methods 1. The incremental profit method – This meth- require the following analyses: revenue analysis, od involves applying the weighted average expense analysis, investment analysis, capital struc- cost of capital of comparable companies ture analysis, residual value analysis, and discount that do not operate the IP to all the assets rate analysis. of the plaintiff. The DCF method involves a projection of the This process results in an estimate of the subject company results of operations for a discrete, profits the company would expect to earn multiyear period. The discrete cash flow projec- if it did not use the IP. These profits are tion is then converted to a present value. The DCF subtracted from the profits earned by the method also involves a terminal value analysis at plaintiff to arrive at incremental profit from the end of the projection period. The direct capital- the IP. This measure of incremental profit is ization method involves dividing a market-derived divided by the defendant’s wrongful sales to direct capitalization rate into a normalized estimate arrive at a reasonable royalty rate. of future income. 2. The differential income method – This meth- The market approach methods include (1) the od involves applying two DCF methods, one guideline publicly traded company method and with the effects of the wrongful act and one (2) the guideline merged and acquired company without the effects of the wrongful act. method. Both of these market approach methods Subtracting the lower projected cash are based on the principle that the value of a busi- flow from the higher (but-for) cash flow and ness interest may be estimated based on what astute dividing these each year by sales will result and rational capital market investors would pay to in an estimate of a reasonable royalty rate. own an equity interest in a company similar to the subject company. Particular attention is paid to the 3. The comparable uncontrolled transaction appropriate discounts and premiums for controlling (“CUT”) method – This method involves ownership interest, noncontrolling ownership inter- comparing the subject IP to third party IP est, lack of marketability, cost of an initial public found in arm’s-length license agreements of offering, and so forth. CUTs. The royalty rates of the third-party CUTs provide an estimate of a reasonable In applying the guideline publicly traded com- royalty rate. pany method, capital market pricing multiples of publicly traded guideline companies are used 4. Comparable profit margin method – This to estimate the value of the subject company. In method involves subtracting the expected applying the guideline merged and acquired com- profit margin of the subject company from pany method, the value of the subject company is the normal profit margin of comparable estimated by analyzing the prices paid for control- companies that do not use the subject IP. ling ownership interests in guideline merged and The difference between these two profit acquired company transactions that have occurred margins provides an estimate of a reason- over a reasonably recent time period. able royalty rate. The asset-based approach considers the values of the subject company assets (both tangible and intangible) and the values of the subject com- Summary and Conclusion pany liabilities (both contingent and recorded). This discussion addressed four elements to a judi- The asset-based approach encompasses a valuation cial action and provided background information (either discrete or collective) of the subject compa- and context to some of the legal aspects that affect ny (1) current assets, (2) tangible real property, (3) every damages analysis. tangible personal property, and (4) intangible assets. This valuation approach also encompasses a valu- Understanding these elements should better inform ation (either discrete or collective) of the subject the analyst about a judicial action and the nature of company (1) current liabilities, (2) notes payable, the claims and remedies in the court action. In turn, and (3) contingent liabilities. this knowledge should aid the analyst in performing the damages measurement analysis and selecting the appropriate damages measurement methods. Estimating Royalty Rates It is important that the legal standards in the liti- There are four generally accepted methods to esti- gation be addressed by one or more participants to mate royalty rates. Any one of these four methods the lawsuit. Failure to satisfy these legal standards

www .willamette .com INSIGHTS • SUMMER 2018 13 may result in the rejection of the damages analysis contract); Bausch & Lomb, Inc. v. Bressler, 977 or even a cancelation of the judicial action. F.2d 720, 728-29 (2d Cir. 1992) (defining expec- tation damages as damages that put the injured It is important for the analyst to rely on a set party in the same economic position that party of assumptions and supporting data that are clear, would have enjoyed if the contract had been understandable, logical, and supportable both (1) in performed). Also, see Restatement (Second) of written form in the expert report and (2) orally in Contracts §344 cmt. a (1981). Expectation has the deposition and trial testimony. been called “a queer kind of ‘compensation,’” Although retained by one party to the judicial because it gives the promise something it never action, the goal of the analyst’s report and testimony had, i.e., the benefit of its bargain. L.L. Fuller & William R. Perdue, Jr., The Reliance Interest in is to aid the court in measuring the amount of dam- Contract Damages: 1, 46 Yale L.J. 52, 53 (1936). ages suffered by the plaintiff because of the wrongful The policy underlying expectation damages is act of the defendant. that they promote and facilitate reliance on busi- ness agreements. Id. at 61–62. Notes: 11. Caprice L. Roberts, “Restitutionary Disgorgement 1. Restatement of the Law Second, Contracts 2d, for Opportunistic Breach of Contract and Pamphlet No. 3 (Philadelphia, PA: American Law Mitigation of Damages,” Loyola of Los Angeles Institute, Student Edition, 1981), Sections 316- Law Review 42 (2008): 131–44. end. 12. Uniform Commercial Code, Section 2-610; 2. Henry R. Cheeseman, Business Law, 5th ed. Restatement (Second) of Contracts, Section 253. (Upper Saddle River, NJ: Pearson Education, 2004), 192–93. 13. Cheeseman, Business Law, 306. 3. Ibid., 74–81. 14. https://www.upcounsel.com/statutory-damages, dated May 9, 2018. 4. See, e.g., Dick v. Lewis, 506 F. Supp. 799, 805 (D.N.D. 1980) (applying North Dakota law) (cit- 15. Cheeseman, Business Law, 94–95. ing W. Page Keeton, et al., Prosser and Keeton 16. Richard R. Posner, Economic Analysis of Law, on Torts § 41 (4th ed. 1971)); Gercey v. United supra note 6, at 131. For an argument in favor States, 409 F. Supp. 946, 954 (D. R.I. 1976) of punitive damages in contracts, see William (Suits in Admiralty Act case) (citing W. Page S. Dodge, The Case for Punitive Damages in Keeton et al., Prosser and Keeton on Torts § 41 Contracts, 48 Duke L. J. 629 (1999). (4th ed. 1971)); Culver v. Bennett, 588 A.2d 1094, 1097 (Del. 1991) (same); Anderson v. St. 17. Mark A. Allen, et al., Reference Guide on Francis–St. George Hosp., Inc., 671 N.E.2d 225, Estimation of Economic Damages, in Reference 227 (Ohio 1996) (same). Manual on Scientific Evidence (Federal Judicial Center, ed. 3d ed. 2011), 437. 5. Paige v. Saint Andrew’s Roman Catholic Church Corp., 734 A.2d 85, 91 (Conn. 1999) (alterations 18. Cheeseman, Business Law, 311–13. in original) (internal quotations and citation 19. Roman L. Weil, et al., Litigation Services omitted). Handbook – The Role of the Financial Expert, 6. Palsgraf v. Long Island R.R. Co., 162 N.E. 99, 103 6th ed. (Hoboken, NJ: John Wiley & Sons, Inc., (N.Y. 1928) (Andrews, J., dissenting). 2017), chapter 4.4, p. 19. 7. Smith v. W. Union Tel. Co., 83 Ky. 104 (Ct. App. 20. Thorpe by Castleman v. CERBCO, Inc., 676 A.2d 1885) (emphasis in original); see also Doe v. 436, 445 (Del. 1996). Linder Constr. Co., 845 S.W.2d 173, 181 (Tenn. 1992) (“The consequences of an act go forward 21. Previously, we indicated that certain types of to eternity, and the causes of an event go back court cases have established precedents for very to the dawn of human events, and beyond. Any specific types of economic analyses such as mar- attempt to impose responsibility upon such a ket share analyses in antitrust cases and event basis would result in infinite liability.”) (altera- studies in securities cases. tion in original) (internal quotations and cita- 22. Previously, we explained an example where the tions omitted); Blue Chip Stamps v. Manor Drug lost business value method understated the true Stores, 421 U.S. 723, 729-55 (1975). damages because the plain- 8. Cheeseman, Business Law, 200. tiff’s business was a start- 9. https://corplaw.delaware.gov/delaware-court- up company at the time of chancery-supreme-court/, dated May 6, 2018. the wrongful act. 10. See John R. Trentacosta, Damages in Breach of Contract Cases, 76 Mich. Bus. J. 1068 (1997) Fady Bebawy is a vice president in (describing expectation damages as damages that our Chicago practice office. He can be place the injured party in the same position as reached at (773) 399-4323 or at if the breaching party completely performed the [email protected].

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