Proving and Defending Lost Profit and Business Interruption Damages

1. Proving and Defending Lost Profit and Business Interruption Damages CLM003 Monday April 28, 2014 2:00 PM - 3:00 PMCCC, 501/502

2. Lee Wertz is a Partner at Harrison Bettis McFarland LLC whose practice includes civil litigation and insurance matters. • Jeffrey (Jeff) W. Spilker, JD, CPA/ABV is a partner at Hill Schwartz Spilker and Keller, LLC. Jeff specializes in financial forensics, economic damage analysis, and real estate and business valuation

3. What to Expect • After attending this session you should be able to: • Understand generally accepted lost profit calculation models; • Understand the difference between lost profit and business interruption claims; • Use these models to evaluate lost profit claims.

4. What are “lost profits”? Lost profits are damages for the loss of net income to a business. The claim is for income from lost business activity, less expenses that would have been attributable to that activity.

5. Permanent or Temporary • Permanent Loss means no resumption of operations. The measure of damages for a permanent loss is diminished value: Value at Event - Value After the Event Damages

6. Permanent or Temporary • Temporary Loss means that the business will resume normal operations in the future. • There can be cases of mixed loss, i.e., loss of profits until business terminates.

7. Permanent or Temporary • “Damage Period” defines the time it will take Plaintiff to be put back into the position prior to the wrongful event. • Facts: Contract period, historical relationships, historical retention rates, etc. If no case facts establish a damage period, future losses become more speculative

8. Simple Lost Profits Example Recovery Event Lost Profits Loss Period

9. You must prove something that never happened!

10. Reasonable Certainty • Profits that would have been obtained, “but for”… [the breach, interference, etc.] • … to a “reasonable certainty” • … more than a scintilla of reasonable certainty

11. The Standard • Restatement (Second) of Contracts §352 (1981) “Damages are not recoverable for loss beyond an amount the evidence permits to be established with reasonable certainty.”

12. The Standard • New York – “It must be demonstrated with certainty that such damages have been caused by the breach …” Kenford Co., Inc. v. County of Erie, 67 N.Y.2d 57, 493 N.E.2d 234, 502 N.Y.S.2d 131 (1986) • Texas – “Uncertainty as to the fact of legal damages is fatal to recovery, but uncertainty as to the amount will not defeat recovery.” Southwest Battery Corp. v. Owen, 131 Tex. 423, 115 S.W.2d 1097, 1099 (1938)

13. California – “Lost profits … Not only must such damages be pled with particularity …, but they must be proven to be certain both as to their occurrence and their extent, albeit not with ‘mathematical precision.’” Greenwich S.F., LLC v. Wong, 190 Cal.App.4th 739, 754, 118 Cal.Rptr.3d 531 (2010) • But case law also references “reasonable certainty.” • And BAJI 3903N – “The amount of lost profits need not be calculated with mathematical precision, but there must be a reasonable basis for computing the loss.”

14. BUT. . . . . • New York Federal Court Anomaly: Tractabel • Direct Damages: “stable foundation for a reasonable estimate.” • Consequential Damages: “reasonable certainty.” • Defendant intentionally breached contract to avoid larger loss over time. Not likely to change New York law.

15. Southwest Battery Corp. v. Owen, 115 S.W.2d 1097, 1098-99 (Tex. 1938) • “The amount of the loss must be shown by competent evidence with reasonable certainty.” • Business sold car batteries • Industry was well established -- Sale of car batteries not uncertain or speculative • A short history of profits combined with an established industry was sufficient

16. Causation • Plaintiff has the burden to prove proximate cause: • 1. But-For • 2. Foreseeable Causation is often assumed by the expert.

17. Quantifying Lost Profits

18. Accepted Models • Discounted Cash Flow (Before and After):Compare historical trend -- past profits, growth rates, assumed growth rates, markets, competition, infrastructure, etc. • Yardstick: Comparable companies, industry trends or data. • Market Share or Specific Contract.

19. Discounted Cash Flow Recovery Event Lost Profits Loss Period

20. Discounted Cash Flow • Astrostaff – an established PEO wants to go independent • Seeks Worker’s Compensation coverage from broker • You don’t need a policy, you just need a number! • UNTIL someone gets hurt.

21. Discounted Cash Flow Basic Economic Research – industry, markets, etc. Specific PEO Industry Research • NAPEO Surveys • Articles • Data from public companies • Interviewed PEO WC Insurance expert • Analyzed WC Market and Issues Construction & Manufacturing Industry Research (industries served by AstroStaff)

22. Company • Interviewed all management • Reviewed all financial data • Reviewed all operating history – client list, retention, revenues per site • Business Plan • Infrastructure – Sales Rep’s • Computer hardware and Software • Expansion Plan • Compared growth in past to plan • Compared growth to industry and other data • Compared to other public PEOs (Administaff, etc.)

23. Discounted Cash Flow • Expert had been used by nation’s largest PEO when valuing the business for Initial Public Offering. Deep knowledge. • Models ranged from $34 million to $68 million. • Defense expert claims negative value. • Documents in Defendant’s expert file suggested after-tax sales “value” of $7.3M, which converted to a pre-tax lost profits value of $38M.

24. Discounted Cash Flow Issues • Discount Rates • Start with “risk free” rate then build up • Can dramatically effect result • Growth Rates • Why do they always grow? • Support with historical rates, industry data, economic forecasts for the area or the market

25. Yardstick Method America’s Favorite Chicken Co. v. Samaras 929 S.W.2d 617 (Tex. App. – San Antonio 1996, writ denied) • Two build-to-suit restaurants. • Never opened because of company finances. • Used data from Popeye’s other franchises • “… more than a scintilla of evidence…”

26. Market Share Brennan’s Inc. v. Dickie Brennan & Company, Inc., 376 F.3d 356 (5th Cir. 2004) • No “Reasonable Royalty”- Not licensing dispute. • Used customer counts as a percentage of attendance at the New Orleans Convention Center.

27. New Business

28. New Business The success of a new and unproven enterprise. “The focus is on the experience of the persons involved in the enterprise and the nature of the business activity, and the relevant market.” The enterprise is the “activity” not the entity.

29. New Business Speculative: • An activity dependent on uncertain or changing market conditions • Chancy business opportunities, • Promotion of untested products • Entry into unknown or unviable markets Texas Instruments v. Teletron, 877 S.W.2d at 279

30. Teletron The T-2000 – a voice-prompted programmable thermostat No sales, no production, not even a prototype “Teletron’s expectations were at best hopeful, in reality, they were little more than wishful.”

31. VingCard v. Merrimac • VingCard gives Merrimac exclusive right build workstations with hotel keycard readers. • Merrimac has plans to modify for food service industry with Ibertech. • VingCard terminates agreement. • Lost profits for hotel business AND food service business.

32. Merrimac • Through its president, Merrimac put on evidence of: • Experience in the industry • Established customer base • Production and sales of the product • Marketing and distribution capability of VingCard and Ibertech

33. It’s the facts … • Look at the activity. Is it an established activity? • Yes! --fried chicken, car batteries, hotel door key/credit card readers • No! – voice prompted thermostats • What are the facts of the entity/activity? Things your expert needs to “drill down into.” • Management Expertise and Experience • Availability of labor • Availability of capital • The Business Plan • Competition and Markets

34. Evidence and Documentation

35. Evidence /Documentation – What do you need? • Business Records … Literally • Business financial forecasts -- Management budgets (New Business) • Historical Financial Statements (For every entity, subsidiary, etc.) • Balance Sheets, Profit & Loss Statements • Revenue by Customer Reports • General Ledger • Three to five years prior to the event (annually) • 12 months prior to the alleged event (monthly) • Monthly financial statements since the date of the event to current

36. Evidence /Documentation • Historical Financial Statements. Depends on the accounting software/ version: • Native format (Quick books, Peachtree etc.) • Excel Download(MAS 90/2000, etc.) • Fail Safe – pdf. format • Tax Returns for the same period as Financials – Request all the schedules • Use to support financial statements that were produced • Possible differences due to cash versus accrual basis accounting

37. Evidence /Documentation • Contracts – (customer, equipment, facilities, long term obligations) • Debt and credit documentation -- Subpoena third-party banks • Corporate Formation Documents/ operating capacity limits • Meetings with management • Deposition testimony • Industry trade publications/ professional associations • Federal and government economic data • Public company and competitive resources • Economic/ market / local events

38. Business Interruption

39. Business Interruption Claims • Similar, but tied to language in insurance policy. • Must be familiar with policy to know what kind of damages to document. • Often has limitations of period of recovery.

40. Quality Oilfield • Quality's workplace was burglarized and engineering drawings, computer media disks, and design information used by Quality to process orders were stolen. “Nerve Center”. • “loss resulting directly from the necessary interruption of business caused by damage to or destruction of real or personal property ...”

41. Quality Oilfield • What does interruption of business mean? • “interruption of business” is an unambiguous term meaning “cessation or suspension of business.” Quality Oilfield Products, Inc. v. Michigan Mut. Ins. Co., 971 S.W.2d 635, 639 (Tex. App.- Hou. (14th) 1998)

42. GBP Partners • “GBP is in the business of owning and renting shopping center space. It is also undisputed that at least some of the tenants at Gulfbrook continued to pay rent, including one that continued to pay rent with no abatement.” • “Suspension of operations clause requires business to have completely ceased for some interval.”GBP Partners, Ltd. v. Maryland Cas. Co., 505 F. App'x 389, 392 (5th Cir. 2013)

43. Other Coverage • Extra Expense. • Contingent Business Interruption: Reimburses lost profits and extra expenses resulting from an interruption of business at the premises of a customer or supplier.

44. Contingent Business Interruption •  “The covered loss is caused by property damage that prevented the flow of goods or services to or from the insured and necessarily interrupted the insured's business.” • No evidence of an interruption (only generalized revenue shortfall) • No evidence of disruption in flow of goods and services • Arthur Andersen LLP v. Fed. Ins. Co., 3 A.3d 1279, 1288 (App. Div. 2010)

45. Defending Against Lost Profits • Qualified, Relevant & Reliable • The Expert – Qualifications /Lack of Independence • The Data – Is there a “Fit” or an Analytical Gap? • The Assumptions – Same • The Methodology – Failure to follow accepted methodologies – i.e. Discount to PV, faulty Yardstick, faulty cost analysis • The Opinions – Oversteps Expertise/ Causation • The Report – Federal Court (failure to comply with Rule 26) • The Disclosure/ Designation – follow the rules!

46. Defending

47. Analytical gap … • Capital Metro v. Central Tennessee, 114 S.W.3d 573 (Tex. App.- Austin, 2003) • History of losses; • No identifiable contracts; • Forecasts based on “old” contract with Capitol Metro; • No independent confirmation of 7550 carloads he assumed; • No evidence they could even process that many; • No verification of revenue per carload; • No investigation of management practices; whether it had a business plan; • Admitted that variable costs were running 160% of revenue, • And other problems

48. Apartment Expert • Not a CPA. • No education or classes in school regarding lost profit claims • No real estate specialization or designation. • Only one other lost profit model, totally unrelated to losses in this case. • Was “surprised” to learn that there are generally accepted models within the industry.

49. Saved Expenses • Q. Okay. It's also your belief that there are no saved expenses. Is that correct? •  A. That's right. • Q. All right. But just so that the jury understands your—the model that you've created and the approach you've taken, you have not undertaken to determine if there are any saved expenses. Correct? •  A. In this model. Right.

50. Absorption • Number of apartments rented per month. • Loss related to water event vs. loss due to other factors? Speculation! • Damage Model Absorption Rate: 20 • The higher the rate, the higher the damages. i.e., apartments would have leased more quickly. • Absorption Rate in Financing Documents: 16