Are You Playing Russian Roulette With Your Client s Damages Award?

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1 Are You Playing Russian Roulette With Your Client s Damages Award? Prepared by: David Majors, Director, RSM McGladrey, Inc. david.majors@mcgladrey.com John Tira, Senior Associate, RSM McGladrey, Inc. john.tira@mcgladrey.com An attorney s strongest weapon during a civil trial for damages can be a qualified expert who can communicate the intricacies of computing damages clearly and convincingly to judge, jury and counsel at trial. Without one, you could be playing Russian roulette with your client s damages case. Economic damages can take many forms, but perhaps the easiest way to illustrate them is through lost profits. Lost profits measures the present value of cash flows that would have been earned by the plaintiff but for the damaging event caused by the defendant. This loss in profits can occur over a distinct period of time or it can be assumed losses will continue into perpetuity. Lost profits cases usually result from a breach of contract or a tort. The following example of a simple breach of contract dispute involving the calculation of lost profits for a damages period of four years will help bring the concept to life: Company A contracted with Company B to provide the lumber needed to manufacture baseball bats for the next four seasons. For various reasons, Company B couldn t provide lumber to Company A for any of the seasons. After mitigation, Company A incurred significant costs because of the breach of contract by Company B, including much higher costs of goods sold, administrative costs and other operating expenses that it otherwise would not have incurred. Company A estimated its actual lost profits prior to trial of $100,000 in year one and $300,000 in year two. Future lost profits were

2 estimated to be $500,000 in year three and $100,000 in year four. Total lost profits were estimated at $1 million. The amount of lost profits is calculated as the difference between the but-for performance (the income that should have been earned by the plaintiff) and the actual performance (the income actually earned by the plaintiff) during the damage period. (See Figure 1 below) Figure 1 In our example, Company A (the plaintiff in this case) might require the assistance of a qualified litigation and financial expert to assist counsel in building a logical and supportable damages case. The typical steps in constructing a supportable case include: Step 1: Establishing causation Causation establishes the connection between the damages being claimed by the plaintiff and the particular event(s) that allegedly caused the plaintiff to incur lost profits. It should also be shown that the damages were not caused by factors other than the event itself, such as poor cash flows, increased market competition or negative economic or industry trends. The defense may try to prove contributory comparative negligence on the part of the plaintiff, which means the damaged party contributed in some way to the damaging event. Likewise, the defense may argue that the plaintiff did not properly mitigate its losses after the damaging event. A qualified and experienced damages expert could assist counsel in establishing causation by reviewing financial records, correspondence and other relevant information. Step 2: Reviewing documents Initially, the expert may collaborate with counsel to gain a general understanding of the business, the industry in which the plaintiff and defendant operate and both parties historical financial performance. An expert typically requests documents from both the plaintiff and defendant. Examples include pre- and post-litigation cash flow projections; audited financial statements; audit work papers; trial balances, general ledgers and other accounting records; any legal filings such as depositions of fact and expert witnesses; trade and industry data regarding competitors, industry outlook and general business risk; and interviews of company personnel. 2

3 Step 3: Projecting but-for sales or revenues The expert uses the information from Step 2 to create a model that projects revenues or sales the plaintiff would have realized but for the damaging event or the actions of the defendant. There are various methods of determining but-for projections the sales forecast method, the yardstick approach, the before-and-after method and the market share approach. A damages expert who is well versed in a wide array of damages theories can help counsel determine which method is most appropriate for each case. Step 4: Projecting incremental costs The projected but-for sales are reduced by the related costs the plaintiff would have incurred to achieve the additional sales but for the damaging event or actions of the defendant. These costs are measured in a variety of ways, but often they can be calculated as the marginal, incremental, or variable costs of producing the additional units plus other additional business or operational expenses the company would have incurred had the damaging event not occurred. The damages quantified may now be restated to present value by applying a discount rate that accounts for the risk-adjusted time value of money. Step 5: Determining the discount rate At times, the discount rate may be dictated by law or legal precedent, but calculating a discount rate is perhaps the most complex and debated aspect of quantifying damages. In order to appropriately estimate the present value of a stream of future cash flows, the cash flows for the specific future periods should be converted to their present value equivalents through the application of a discount rate. The discount rate should reflect both the time value of money and the underlying risks associated with achieving the future cash flow streams. Calculating a discount rate depends on several risk factors, but basically, the greater the risk of the company not realizing future cash flows, the higher the discount rate. The key components of a discount rate are the cost of equity (K e ), the cost of debt (K d ) and the capital structure. Cost of equity (K e ) The cost of equity is the rate of return paid to stockholders (i.e., equity holders) for their investment. Basically, the riskier the investment, the greater return an investor demands. The cost of equity is comprised of a series of risk premiums that incrementally increase the rate of return received by an investor, such as: Risk-free rate of return Based on the rate of return from perceived riskless investments Equity risk premium Based on the risk of investing in the stock market, in general 3

4 Size premium Based on the riskiness of a company due to its relative size Industry risk premium Based on the risk related to a company s industry Company-specific risk premium Based on other risks specific to an individual company Cost of debt (K d ) Generally, the company s average borrowing rate is used as the cost of debt. The cost of debt can vary widely, depending on the availability of credit, the company s size and stability and the industry in which it operates. For example, a large, publicly traded S&P 500 company will likely have a lower cost of debt than a small, familyowned shop. Optimally, an expert would obtain a company s audited financial statements or credit agreements to ascertain the cost of debt. The expert could also review the rating placed on the company s debt by ratings agencies such as Moody s or S&P (if the debt is publicly traded). If no audited financial statements, credit agreements or debt ratings exist, an expert might review the composite cost of debt within the company s industry or select a corporate borrowing rate based on the expert s understanding of the company s underlying risk levels. Weighted average cost of capital The weighted average cost of capital (WACC) is determined by reviewing the company s optimal capital structure (equity and debt), based on the company s historical financial information and the capital structures of comparable companies within similar industries. The expert will perform a detailed review of the cost of equity, the cost of debt and the optimal capital structure of the firm to determine a weighted average of the returns paid to debt and equity holders for their investments, known as the WACC. The WACC is typically the rate used to discount future cash flows projected by the firm, which includes any lost profits from damaging actions. Although this discussion has focused on the weighted average cost of capital discount rate methodology, other approaches may be dictated by law or precedent. It s essential to obtain guidance from counsel in order to determine the appropriate discount rate prior to discounting the future cash flows. Step 6: Quantifying damages To accurately quantify damages, future cash flows may be discounted to the present. To demonstrate the significance of the discount rate, consider the lost profits example below and what happens when different discount rates 20 percent and 30 percent are applied: Discount rate Year 1 Year 2 Year 3 Year 4 Total Undiscounted $ 100,000 $ 300,000 $ 500,000 $ 100,000 $ 1,000,000 Discounted at 20% $ 83,333 $ 208,333 $ 289,352 $ 48,225 $ 629,243 Discounted at 30% $ 76,923 $ 177,515 $ 227,583 $ 35,013 $ 517,034 4

5 Types of damages quantification cases Contract disputes: Use of the benefit-of-the-bargain approach to determine expected profits from a proposed contract or deal. Examples: Breaches of sales contracts and warranty agreements. Torts: The actual loss incurred is calculated as the difference between what the plaintiff paid for something and the actual value received. Examples: Fraud and conversion. Business interruption claims: Applies the same basic methodology as a lost profits damages calculation to determine the amount of loss sustained by the affected company due to natural or man-made disasters. Intellectual property: Applies the same basic methodology as a lost profits damages calculation to determine the damages suffered by the patent, copyright or trademark holder as a result of infringement. Examples: Thefts of trade secrets and patent infringement. M&A post-acquisition disputes: Damages focus on whether the buyer received the economic benefit that was represented during deal negotiations. Examples: Working capital disputes and indemnity claims. Antitrust: Damages can be recovered by the plaintiff for increased costs caused by the anti-trust violation, lost profits, or reduction in value of the business. Securities litigation: Damages are generally calculated as the difference between the price paid by the plaintiff for the security and the fair market value of the security at the time of the initial purchase or at the time the suit was brought. Securities litigation often involves allegations of false or misleading statements or alleged omissions in the information underlying the purchase or sale of securities. In certain situations, damages could be discounted to a variety of dates including the event date, the trial date, the judgment date, or the payment date. Damages incurred between the event date and the judgment date may be subject to prejudgment interest to reflect the time value of money. In addition, different discount rates may be applied during different time periods as mandated by law and/or precedent. The discount rate and discount date are often hotly debated issues in litigation since each can have a significant impact on the damages award. When calculating damages, it s crucial for an expert to consult with counsel to determine the proper discount rate and discount date. Deciding when to involve a financial expert While it s essential to retain a financial damages expert when preparing a case for the plaintiff, damages experts are commonly used by both the plaintiff and the defense. An expert retained by the defendant often prepares a rebuttal report, identifying any errors or inconsistencies and analyzing weaknesses in the plaintiff s expert report. Both experts may assist counsel in preparing questions for crossexamination of the opposing expert witness for depositions and trial testimony. 5

6 Critical factors affecting the decision to involve a financial expert in civil damages litigation often include the complexity of the calculations, quantity and quality of available data, the analysis of financial projections, and the determination of a discount rate. A well supported, accurate, logical and methodical financial analysis is the cornerstone of a damages award case. One of the best ways to protect your client s interests is to address these complex damages issues early in the litigation process by retaining a damages expert. About the Authors David Majors and John Tira are consultants in the Financial Advisory Services practice of RSM McGladrey s Chicago office. David and John have extensive experience assisting clients in commercial disputes, fraud investigations, claims management, restructuring and insolvency matters, M&A transactions and valuation services. RSM McGladrey consultants are regularly retained as expert witnesses and provide support to clients and their counsel in areas including financial and damages analysis, discovery and document management, responding to complaints, interrogatories and document requests, due diligence, interviewing witnesses, deposition preparation, participation and analysis, expert testimony supporting all analyses and conclusions, trial exhibit design and counsel preparation.. 6

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