Quantifying lost profits in the COVID-19 world

Shawn Fox
BridgeTower Media Newswires

One of the key issues attorneys need to consider in a damages assessment is the impact of the 2020 coronavirus disease pandemic for cases involving plaintiff’s lost profits for breach of contract matters or insurance policyholder’s business-interruption claims for a covered cause of loss. The COVID-19 pandemic has significantly disrupted all types of businesses.

According to Insurance Law Analytics’ COVID Coverage Litigation Tracker, there have been approximately 1,100 COVID-19 coverage-related litigation cases filed through August 15. Approximately 85 percent of these cases involve claims for lost business income, and 76 percent involve extra expenses.

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Loss period

Typically, the length of the loss period depends on the type of business and magnitude of the loss. Lost profits are generally claimed only over the loss period. The insurance company is generally liable only for the loss of business income during the period of restoration, which is the length of time to rebuild or repair the business.

In business-interruption claims, the loss period is typically measured from the beginning date of the loss event until the sales or profits of the business have recovered or stabilized, which is known as the period of restoration. COVID-19 will impact the determination of the loss period because the business may not recover to pre-COVID-19 financial performance level.

In breach of contract matters, the loss period is generally measured from the date of the alleged wrongdoing through the end of the contract. If the contract dispute involves early termination or non-renewal issues, the loss period is based on counsel’s legal interpretation of the contract. If the parties have a history of contract renewals or assurances were provided regarding future renewals, the loss period potentially could extend beyond the end of the current contract term.

If the business is destroyed, the loss period is indefinite. The measure of damages for these types of claims may be based on diminution of the value of the business instead of lost profits. Occasionally, there are situations in which damages may be based on lost profits during the interim period until the date the business was destroyed, which then is measured based on diminution of fair market value.
It is important that you and your damages expert analyze COVID-19-specific factors for the determination of the loss period. The first area of focus should be to review the supporting documentation for specific dates that sales and operations were impacted by COVID-19 (government-mandated shutdowns; federal, state and local regulations; COVID-19-related exposure shutdowns, etc.).

The second area of focus is to review the terms of the loss period-determination provisions of the relevant insurance policies (business interruption, property, civil authority, supply chain coverage, infectious disease coverage, etc.). In cases involving insurance, the policy generally will provide a loss-period definition and limits for coverage for business income and extra expenses.

It also is important to review the key terms of important contracts impacting operations (customer, lease, franchise, supplier, etc.) in the determination of the loss period.

Each business is affected differently by COVID-19. It is important to analyze the impact of industry, consumer behavior, economic trends and outlook. Damages should be directly related to the alleged defendant’s wrongful conduct and/or policyholder’s covered cause of loss.

Other factors to consider include the ability of the business to obtain financing, including Paycheck Protection Program funds and other government disaster recovery and stimulus program funds, and the ability of the business to mitigate or offset damages from insurance and stimulus payments. Plaintiff and policyholder both have a duty to mitigate their damages.

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Lost profits and continuing expenses

Lost profits generally are calculated by comparing the financial performance of the plaintiff’s (policyholder’s) business pre-impairment to the financial performance of the business post-impairment and adjusting for any other impacts to the business unrelated to the impairment.

Models used by damages experts generally are computed by calculating net revenue lost less incremental costs avoided (saved costs) or the calculation of but-for profits, net of actual or mitigating profits realized by the plaintiff.

The first step is to quantify the lost units sold and lost net revenue. There are several acceptable methodologies to quantify lost net revenue, including: before-and-after method, yardstick method, but-for method and terms of contract method, along with other methods.

After quantifying lost net revenue, the related incremental cost of goods sold and operating expenses are calculated and deducted from lost net revenue to arrive at lost profits. Incremental expenses are considered to be variable in nature during the loss period.

Any future lost profits should be discounted to present value using a risk-adjusted discount rate. The discount rate is typically based on a company’s weighted average cost of capital or cost of equity.
Discount rates using a present value date after Feb. 24, 2020 should include the impact of COVID-19.

For cases involving business interruption, the insurance policy generally will include parameters for lost profits due to a coverage event. The policy typically will include a business income coverage form. A common business income definition is net income before taxes that would have been earned or incurred and continuing normal operating expenses incurred, including payroll, for the period of restoration. These normal operating expenses continue despite the policyholder’s operations being disrupted by the covered cause of loss.

The damages expert also should evaluate the financial condition of the business prior to the start of COVID-19, during the COVID-19-affected period and the period after COVID-19, and verify that the reduction in revenue was related to the covered cause of loss. This financial analysis may include reviewing monthly and weekly financial statements for the prior years and the current year (balance sheet, income statement, statement of cash flows); annual financial statements; tax returns; and business plans, marketing plans, budgets, forecasts, and/or projections.

In business-interruption matters, the experts for the policyholder and insurance company may disagree on which expenditures are necessary continuing expenses versus those classified as unnecessary continuing expenses. Examples of necessary continuing expenses include fixed expenses, such as rent, property taxes, equipment leases, insurance premiums, service contracts, ordinary payroll and software subscriptions, etc. Mortgage and loan payments may be included as necessary continuing expenses. Unnecessary operating expenses include incremental expenses that could be saved during the loss period, such as cost of goods sold, supplies, freight, and returns and allowances etc.

An interesting challenge will be analyzing the loss period for lost profits matters with legal claims unrelated to COVID-19. This situation may require apportionment of a plaintiff’s lost profits between COVID-19 factors and non-COVID-19 factors.

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Extra expenses

Among the potentially overlooked components in quantifying business-interruption claims are extra expenses incurred as a result of the COVID-19 interruption because policyholders may be more focused on loss of customer sales and the resulting impact on business profits. Extra expenses generally are defined as those expenses that are necessary to keep the business operating after the insurable event and are included as a common optional coverage. These expenses typically are in excess of normal operating expenses during the period of restoration that would not have been incurred but for the insurable-loss event.

Some examples of extra expenses include COVID-19-related expenses associated with planning, maintenance, testing, evacuation, event cancellation, order cancellations and supply chain disruption.
These expense categories include items such as temporary office rent, information technology expenses, overtime wages, subcontractors, advertising, public relations, consultants, shipping, leasing and other expenditures necessary to mitigate damages.

It is important for policyholders to establish policies and procedures, if possible, to properly account for and document extra expenses incurred so the insurance company will accept these claims more swiftly.

The verification process for extra expenses typically includes six steps:

• Review the relevant insurance provisions for extra expenses, including the period of restoration and extra expenses coverage form(s).

• Assess the policyholder’s supporting documentation for extra expenses incurred and any fixed assets directly related to the insurable-loss event (invoices, receipts, purchase orders, shipping records, contracts, quotes, labor/payroll reports and ledgers, and correspondence, etc.).

• Analyze the policyholder’s proof of payments to verify the policyholder actually has spent the money for the extra expenses (cancelled checks, credit card transactions, wire transfers, cash disbursement ledgers, etc.).

• Reconcile the identified extra expenses to the policyholder’s financial reporting entries (general ledger, inventory ledgers, fixed assets ledger, accounts receivable aging, etc.).

• Confirm that the policyholder’s extra expenses are related to the insurable-loss event.

• Analyze the classification of expenditures as extra expenses versus property/casualty expenses. Extra expenses generally are defined in the business-interruption policy. Certain expenditures also are covered in different provisions of the insurance policy, such as business personal property (contents) and/or building coverages.

Another key point to discuss with your clients is setting up, if possible, general ledger codes to track these extra expenses contemporaneously after the insurable-loss event occurs. In addition, the extra expenses may include significant labor costs, and policyholders should consider having their employees record time entries and detailed descriptions of any time related to the insurable-loss event.

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Shawn Fox is the founder and principal at Fox Forensic Accounting, which advises on legal and regulatory matters from its offices in Kansas City, Chicago and Dallas.