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Business Disruption - Calculating the Damages
The Law of Business Disruption
 
 
(outline for presentation at Boston Bar Foundation)
 
 
by Philip Saunders, Jr., Ph.D.
 
 
I. Measure of loss
 
A. Economic value lost

B. Difference between what happened and what would have
happened except for the disruption.

C. Concept is simple, but calculation can be complex, and
application of the law can be ambiguous.
 
II. Standard economic approach
 
A. Business disruption cases - fire, nuisance, strict liability,
negligence, municipal ordinance, loss of access, loss of utility
service.

B. Also used to estimate economic loss in other business
cases, e.g., breach of contract, personal injury to a business
owner, fraud, tortious interference.
 
III. Economic loss: lost profits
 
A. Net profits, not sales or gross profits

B. Pre-tax net profits - avoids double taxation and question of
which tax year's rates to use.

C. Definition of "net" - need to distinguish variable from fixed.

D. Variable items include sales, cost of goods sold, and other
variable operating costs.

E. Fixed costs - Predominant view is fixed are not deducted,
but there is the accounting allocation view. Usual fixed costs are
overhead, depreciation, and interest, although some may be
variable.

F. Distinguish accounting from reality. Actual behavior of
individual costs must be examined.

G. Mitigating costs are added to damages - costs incurred to
mitigate effects of disruption.

H. Estimating lost profits requires replaying history.
 
IV. Economic loss: lost value (lost capital)
 
A. Damages sustained that outlive the interruption include
reduced working capital, lost opportunity, permanently lost
customers.

B. Valuing a company to measure reduction in value.

C. Value alive - Quoted market value or normal business  valuation methods, e.g., quoted market guideline companies,  comparable sales, discounted cash flow, asset value. May need  to distinguish lost value method from estimation of lost profits for  court. Book value generally irrelevant.

D. Value dead - Worth more dead than alive because the assets are worth more to someone else or would be worth more  if put to another use (liquid assets, real assets, franchise value or goodwill).

E. Advantages of lost value approach are that return on capital is  not taxable as income and courts have treated capital loss more  leniently than lost profits.
 
V. Estimating lost net profits
 
A. What actually happened - Reconstructing pre-, during, and
post-interruption history.

B. Getting company records - Balance sheets, income
statements, cash flow statements, sales histories and
breakdowns, cost histories and breakdowns.

C. Getting information on the company - Descriptions of
operations, budgets and projections, marketing plans and
materials, market research, brochures and product descriptions,
information on competition.

D. History may have to be reconstructed.

E. Identifying period of disruption - Closed, open (disruption or
its effects are on-going), or infinite (company went out of
business).

F. Data - Choice of interval (daily, monthly, etc.),
understanding the data (how sales are booked, marketing,
ordering, and sales process).

G. What would have happened, absent the disruption -
Replaying history using marginal analysis (sales and variable
costs).
 
VI. Sales projections
 
A. Identification of cause and effect to produce reliable
estimates, gain credibility with trier of fact, and withstand
cross-examination.

B. Qualitative analysis - Description of products and services,
comparative advantage (how is company different from any other
company of its type), and customer profile and concentration.

C. Analysis of sales history - patterns, growth, product and
market shifts, seasonal and other periodic variations.

D. Quantitative analysis - Identification of cause and effect
relationships (seasonality, smoothing to eliminate random
fluctuations, correlation with external variables such as
macro-economic data, industry data, sales of competitors with
publicly available data, and business of customers).

E. Quantitative analysis - Projection through disruption period
based upon estimated relationships.

F. Evaluation of company projections made prior to loss -
Compare past projections to actuals to test for accuracy and
adjust projections for any consistent historical error.
 
VII. Costs
 
A. Relationship to sales

B. Historical ratios and relationships

C. Management experience

D. Industry norms
 
VIII. Net profit
 
A. Multi-period

B. Reducing to present value produces single number for award,
takes account of time value of money, and adjusts for risk or
uncertainty.
 
IX. Reality check - are the estimates consistent with:
 
A. Industry norms

B. Market share

C. Murphy's law

D. Common sense
 
X. Using an economic expert
 
A. Initial review for estimate of damages; identification of
potential line of argument, strengths and weaknesses, degree of
certainty with which loss can be demonstrated, and likely
response of other side; and coordination with legal arguments.

B. Assistance with discovery, identifying documents required
and developing questions for interrogatories and deposition.

C. Make sure the expert understands the evidentiary issues.

D. Make sure the expert has addressed the issues covered
above.

E. For plaintiff attorney - Consultation on economic and
business issues, estimation of damages, and expert testimony.

F. For defense attorney - Developing opposing opinion, critique
of plaintiff expert's opinion, assistance preparing
cross-examination, and testimony (estimate of loss, if expert's
estimate is low, and explanation of economic points where
plaintiff's case is weak).
 
XI. Summary
 
A. Calculation of damages is done with broadly applicable
methods of economic analysis.

B. Damages can be loss of profits or loss of capital.

C. Understanding the company, especially its market, is
critical.

D. Look for cause and effect.

E. Use quantitative methods to estimate lost profits but make
maximum use of information from qualitative analysis of the
company.

F. Economic expert can help evaluate, develop, and present the
case.
 
 
 
 
Based on presentation at "The Law of Business Disruption: Who's to Blame? Who can Claim?," Continuing Legal Education Seminar, Litigation Section, Boston Bar Foundation, Jan. 20, 1993.
 

 

 
     
 

                                   ┬ę 2014 Philip Saunders Associates

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