Presented by Saul Solomon and Caroline Neuhaus

1
Advanced Lost Profits
Presented by Saul Solomon and Caroline
Neuhaus November 7, 2003
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Overview

• Definition of Lost Profits
• Lost Profits Strategic Issues
• Methods of Determining Lost Profits
• Future Lost Profits
• Relevant Case Law Updates
• Case Study
• Summary

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Lost Profits Defined

• An entity suffers lost profits when one of the
  following occurs
• Due to the acts of the defendant . . .
• 1. Revenues are lower than they would have
  been
• 2. Costs are higher than they would have
  been
• 3. Some combination of the two

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Basis for Recovery of Lost Profits?

• Proximate cause
• The defendants wrongful conduct must have
  proximately caused the damage(s).
• Reasonable certainty
• The plaintiff must prove damages with reasonable
  certainty
• Foreseeability
• The plaintiff must demonstrate that lost profits
  were a foreseeable result of the wrongful conduct

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Lost Profits Strategic Issues
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Lost Profits Strategic Issues

• Net profits projected had the alleged acts not
  occurred (without / but for)
• Net profits considering the alleged acts (with
  / projected)

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Lost Profits Strategic Issues

• Projecting Revenues
• Growth Rates
• Historical
• Industry guideline measures
• Projections

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Lost Profits Strategic Issues

• 4. Understand Cost Drivers
• Historical
• Industry guideline measures
• Projections
• Fixed, variable, semi-fixed
• Account analysis

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Lost Profits Strategic Issues Understand Cost
Drivers
Estimating Costs What are They?

• Fixed costs
• Costs that remain the same regardless of how much
  revenue a company generates
• Variable costs
• Vary with a companys revenues
• We only use variable costs

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Lost Profits Strategic Issues Understand Cost
Drivers

• Fixed Costs
• Wages
• Depreciation
• Dues and subscriptions
• Interest
• Telephone and utilities
• Insurance (non-payroll based)

• Variable Costs
• Sales commissions
• Insurance (payroll based)
• Supplies
• Purchases
• Labor costs
• Sales tax
• Payroll tax

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Lost Profits Strategic Issues

• 5. Damage Period
• 6. Discount rates
• Future periods must discount
• Risk free vs. Risk adjusted
• Adjust for risk and uncertainty

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Lost Profits Strategic Issues Discount Rates

• Discounting future losses to present value is
  required in all federal and most state cases.
• Little agreement among jurisdictions as to the
  correct methodology used to determine an
  appropriate discount rate.
• There is minimal case law to turn to in
  determining an appropriate discount rate.

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Lost Profits Strategic Issues Discount Rates

• Rates commonly used
• Risk free rate of return
• Plaintiffs cost of debt
• Plaintiffs equity rate of return
• Plaintiffs Weighted Average Cost of Capital
• Hybrid rate

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Methods of Determining Lost Profits
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Methods of Determining Lost Profits

• Before and After Method
• Yardstick Approach
• Sales Projections (But For)
• Market Share

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Methods of Determining Lost ProfitsBefore and
After Method

• Operations are projected from historical results
• Best suited for established businesses
• Requires analysis of pre and post damage
  operations
• Identify seasonal, unusual or non-recurring
  assumptions

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Methods of Determining Lost ProfitsYard Stick
Approach

• Uses guideline company or industry benchmarks
• Best when insufficient track record
• Use regression analysis to correlate comparables

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Methods of Determining Lost ProfitsSales
Projection Method

• Sales and profits projected based on expected
  future results without the incident
• Projected profits then compared to actual results
  during the damage periods

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Methods of Determining Lost ProfitsMarket Share
Approach

• Assumes companys market share to total industry
  sales before injury is known and would have
  remained similar but-for defendants actions
• Applicable with larger businesses
• Frequently requires use of an economist

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Future Lost Profits
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Determining Future Lost Profits

• 1. Construct a forecast of the projected future
  gross revenues and variable costs assuming the
  damaging act did occur and will continue to
  impact the entity for a period of time into the
  future.
• 2. Construct a forecast of the projected future
  gross revenues and variable costs assuming the
  damaging act did not occur for the same period
  into the future.
• 3. The plaintiff still has a duty to MITIGATE
  damages.

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Issues in Discounting Future Lost Profits

• Issues related to measurement date
• Issues related to whether subsequent information
  is used or not
• Issues related to treatment of risk
• Issues related to taxes in discount rate

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Discounting Future Lost Profits Issues Related to
Measurement Date
Possible Dates

• Date of judgment / trial
• Date of injury / wrongdoing
• Date of expert witness report

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Discounting Future Lost Profits Issues Related to
Whether Subsequent Information Is Used or Not
Ex Ante vs. Ex Post

• Ex Ante measures expectancy damages
• No subsequent information is used
• This also applies to the discount rate to be used
• Ex Post measures outcome damages trial
• Subsequent information is used
• This also applies to the discount rate to be used

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Discounting Future Lost Profits Issues Related to
Whether Subsequent Information Is Used or Not
Arguments for Ex Ante

• Although plaintiff lost the opportunity, the
  plaintiff avoided the risks
• Allows plaintiff less options to decide to file a
  lawsuit
• Adds more consistency to quantification of
  damages
• More consistent with finance / valuation theory

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Discounting Future Lost Profits Issues Related to
Whether Subsequent Information Is Used or Not
Arguments for Ex Post

• More certainty and reality are obtained
• Actual data rather than estimates reduces risks
• Courts and juries believe in the book of wisdom
  

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Discounting Future Lost Profits Issues Related to
Whether Subsequent Information Is Used or Not
The Book of Wisdom
Sinclair Refining Co. v. Jenkins Petroleum
Process Co., 289 U.S. 689 53 S. Ct. 736 (1933)
a different situation is presented if years
have gone by before evidence is offered.
Experience is then available to correct uncertain
prophecy. Here is a book of wisdom that the
court may not neglect. We find no rule of law
that sets a clasp upon its pages, and forbids us
to look within.
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Discounting Future Lost Profits Issues Related to
Whether Subsequent Information Is Used or Not
Arguments for Ex Post

• More certainty and reality are obtained
• Actual data rather than estimates reduces risks
• Courts and juries believe in the book of wisdom
  
• Even finance theory admits hindsight is useful
  as a reasonableness check
• The wrongdoers rule

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Discounting Future Lost Profits Issues Related to
Whether Subsequent Information Is Used or Not
The Wrongdoers Rule
Story Parchment Co. v. Paterson Parchment Co. et
al, 282 U.S. 555 51 S. Ct. 248 (1931)
whatever of uncertainty there may be in a
mode of estimating damages, is an uncertainty
caused by the defendants own act and justice
and sound public policy alike require that he
should bear the risk of the uncertainty thus
produced.
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Discounting Future Lost Profits Issues Related to
Treatment of Risk
Where do you treat risk?

• Handle risk in the damage model
• Handle risk in the discount rate
• Handle risk in both the damage model and discount
  rate

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Discounting Future Lost Profits Issues Related to
Discount Rates
Possible Discounting Methods

• Method 1
• After-tax cash flows, after-tax discount rate,
  gross up for taxes

• Method 2
• Pre-tax cash flows, after-tax discount rate

• Method 3
• Pre-tax cash flows, pre-tax discount rate

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Discounting Future Lost Profits Issues Related to
Discount Rates
Single Period Example

• 1,000 pretax loss one year in the future
• Risk-adjusted after-tax cost of capital 15
• Tax rate 35
• What is the correct present value taxable damage
  award?

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Discounting Future Lost Profits Issues Related to
Discount Rates
Method 1
Method 2

• Adjust cash flow to after-tax
• 1,000 (1 - 0.35) 650
• Discount at after-tax discount rate
• 650 / (1 0.15) 565.22
• Gross up for taxes
• 565.22 / (1 - 0.35) 869.57

• Discount pre-tax cash flow at after-tax discount
  rate
• 1,000 / (1 0.15) 869.57

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Discounting Future Lost Profits Issues Related to
Discount Rates
Method 3

• Adjust after-tax discount rate to pre-tax
  discount rate
• 15 / (1 - 0.35) 23
• Discount pre-tax cash flow at pre-tax discount
  rate
• 1,000 / (1 0.23) 813.01

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Discounting Future Lost Profits Issues Related to
Discount Rates
Proof of Correct Answer

• Plaintiff pays tax on award
• 869.57 (1 - 0.35) 565.22
• Plaintiff invests at pre-tax return
• 565.22 (1 0.23) 695.22
• Plaintiff pays taxes on gain
• 695.22 - 565.22 130.00 35 45.22
• Plaintiffs after-tax cash in one year
• 695.22 45.22 650.00
• Plaintiffs pre-tax cash in one year
• 650.00 / (1 - 0.35) 1,000.00

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Discounting Future Lost Profits Issues Related to
Discount Rates
Summary of Results
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Relevant Case Law Updates
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Relevant Case Law Updates

• Energy Capital Corp v. United States, 302 F. 3d
  1314 (Fed. Cir. 2002)
• Energy Capital Corp. was formed in 1994.
• Energy Capital entered into a new contract with
  the Department of Housing and Urban Development
  to develop a loan program known as AHELP
  (Affordable Housing Energy Loan Program)
• Energy Capital would originate 200 million in
  loans for upgrading the energy efficiency of
  government subsidized housing.
• It had been responsible for originating
  approximately 250 million prior to the AHELP
  program.
• The Government breached and terminated the
  contract before any loans were placed.

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Relevant Case Law Updates

• Energy Capital Corp v. United States (continued)
  
• Energy Capital sued HUD for breach of contract
  seeking lost profits.
• The U.S. Court of Appeals disagreed with the
  Governments position that the Affordable Housing
  Energy Loan Program (AHELP) was a new venture and
  that it is impossible to measure lost profits
  with reasonable certainty.
• The Court determined that Energy Capital would
  have been able to originate the full 200 million
  allowed under the program.
• Energy Capital was to price the loans at the
  Treasury rate plus 3.87 and keep 2 of the 3.87
  as repayment.
• Lost profits of 12.1 million were awarded by the
  Court before discounting to present value.

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Relevant Case Law Updates

• Energy Capital Corp v. United States (continued)
  
• The Court declined to adapt a per se rule that
  lost profits may not be recovered for a new
  business.
• The Court stated We do not agree that lost
  profits should be precluded as a matter of law
  for new ventures that have not previously been
  performed by a third party. Whether or not one
  considers AHELP to have been a new venture or
  merely an extension of Energy Capitals existing
  loan business, Energy Capital was required to
  demonstrate its entitlement to lost profits by
  showing the same elements that any business must
  show (1) causation, (2) foreseeability and (3)
  reasonable certainty.
• while the evidentiary hurdles to recovering
  lost profits are high, such profits may be
  recovered if the hurdles are overcome.

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Relevant Case Law Updates

• Schonfeld v. Hilliard, 62 F. Supp 2d 1062, 1074
  n. 6 (S.D.N.Y. 1999)
• Breach of oral agreement case involving an
  agreement to fund a closely held cable television
  station
• Plaintiff sought lost profits of 112 to 269
  million, lost asset value of 17.1 million and
  punitive damages
• The U.S. 2nd Circuit Court of Appeals agreed with
  the trial court to dismiss lost profits as being
  speculative but allowed for lost asset value.
• Included in lost asset value was an agreement to
  pay programming rights equal to 100,000 per year
  for 10 years.
• A discount rate of 8 was used, approximately
  equal to the 10 year treasury bond rate at the
  time.

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Summary
1. Know Your Industry Company 2. What are the
Drivers of the Companys Operation? 3. Be Aware
of the Companys Economic Environment 4.
Understand the Cost Drivers 5. Dont Calculate
Your Analysis in a Vacuum 6. Review Results for
Reasonableness
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Case Study
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Case Study Overview

• Plaintiff - Kirby Inland Marine (Kirby) is in
  the business of inland transportation of
  petrochemicals, refined petroleum products and
  agricultural chemicals by tank barges.
• Defendant - TH Investments, Inc. (THI) is a
  Texas-based corporation formed by Mr. William
  Earl Thrift, Sr., and other individuals, around
  August 2002.
• Kirby conducts fleeting and shifting
  operations in the Port of Houston, including the
  Big Empty Fleet area that is the subject of
  this litigation.

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Case Study Overview (continued)

• In 1978, Kirbys predecessor, Western Towing
  Company, executed a lease to certain property
  (the 27 Acres) in the vicinity of the Big Empty
  Fleet area.
• In August 1991, Kirby entered into an amended
  Lease Agreement, which included a five-year term
  and a monthly rental rate of 1,000. The Lease
  Agreement expired in July 1996 and converted to
  month-to-month.
• In November 2002, THI bought the 27 Acres and was
  assigned the Lease Agreement. THI requested that
  Kirby pay rent of 35,000 per month to continue
  the Lease Agreement or vacate the property.

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Case Study Overview (continued)

• Kirby refused the rental terms and does not
  believe its operations are conducted on property
  owned by THI.
• On November 27, 2002, THI sent a letter to Kirby
  terminating the Lease Agreement effective
  December 7, 2002.
• Kirby filed a lawsuit against THI maintaining it
  does not reside or conduct operations on the 27
  Acres.
• THI subsequently filed a counterclaim against
  Kirby seeking damages related to claims of breach
  of lease agreement, tortious interference with
  prospective contracts, and loss of use and
  enjoyment of property, among others.

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Defendants Damages Claim
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Case Study Defendants Damages

• Damages in an amount ranging from 1.1 million to
  1.5 million for incremental profits (before
  prejudgment interest.
• Lost business opportunities during the time that
  the Plaintiff has refused to vacate the Leased
  Property
• Calculated the incremental lost profits due to
  THI by projecting the activities of THI from
  December 7, 2002 through January 31, 2004, the
  estimated time of trial
• Capital costs estimated in the amount of 137,900

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Case Study Defendants Damages
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Rebuttal Analysis
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Case Study Key Rebuttal Points

• No basis for alleged lost business opportunity
• Not supported by any documents, information or
  testimony
• No due diligence was undertaken prior to
  acquisition of 27 Acres
• No reliable information indicating that THI
  acquired the 27 Acres with the intention to
  operate a fleeting and shifting business
• Inadequate support for damages calculations
• Failed to provide sufficient support for the
  calculated damages

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Case Study Key Rebuttal Points

• Failure to consider requisite capital investment
  
• THI requested Kirby remove the improvements that
  they made to the Big Empty Fleet area
  (expenditures totaling over 2 million)
• Did not include sufficient costs related to
  replacement of the improvements, such as sunken
  perimeter barges which form the embankment and
  prevent area from silting
• Did not plan for the substantial upfront capital
  costs necessary to conduct fleeting and shifting
  operations

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Case Study Key Rebuttal Points

• Deficient calculations of lost profits
• Fleeting shifting businesses are independent
• Assume an intrinsic relationship between the
  fleeting and shifting businesses
• Projected fleeting customer base
• Projected customers are currently customers of
  existing fleets in Houston
• No information or underlying documents that
  support the fleeting revenue projections and
  assumed customer base

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Case Study Key Rebuttal Points

• Deficient calculations of lost profits
  (continued)
• Projected Fleeting Capacity
• Overstated available fleeting capacity in the Big
  Empty Fleet
• Projected Fleeting Revenue
• Projected Shifting Revenue
• Assumed Freedom to Operate
• Projected Operating Expenses - understated

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Thats a wrap! Thank you!
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