The legal principles in lost profits cases, Part 2

Steohen L. Ferraro and Charles S. Amodio
BridgeTower Media Newswires

As forensic CPAs, we are often asked to build (or rebut) financial models that estimate lost profits. Recovering lost profits generally requires the plaintiff to successfully address the following legal rules: the proximate cause rule, the reasonable certainty rule, and the foreseeability rule.

Having addressed the proximate cause rule in Part 1 of this two-part column, we offer discussion and supporting case law for the reasonable certainty and foreseeability rules below.

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The reasonable certainty rule

The reasonable certainty principle is addressed in many cases and is usually successfully met when damages have been calculated using assumptions that are not speculative. The calculated damages may be an approximation, as courts mostly agree that proving reasonable certainty doesn't require precision.

In Palmer v. Connecticut Railway & Lighting Co., 311 U.S. 544 (1941), the U.S. Supreme Court concluded that certainty as to the amount of the damages goes no further than to require a basis for a reasoned conclusion. The decision goes on to state that certainty in the fact of damages is essential.

In Ameristar Jet Charter Inc. v. Dodson International Parts, 155 S.W. 3d 50 (2005), the issue of reasonable certainty arose and appeals were made regarding the calculation of lost profits damages. It was concluded that the claimant must establish the fact of damages with reasonable certainty, but it is not always possible to establish the amount of damages with the same certainty.

Based on Ashland Management v. Janien, 82 N.Y. 2d 395, 624 N.E. 2d 1007, 604 N.Y.S. 2d 912 (1993), damages should be reasonably certain, but do not require absolute certainty. Damages resulting from lost future profits are often approximate. The law doesn't require that they be determined with mathematical precision, but that they be measured based on known, reliable facts.

In DSC Communications v. Next Level Communications, 107 F.3d 322, 329 (5th Cir. 1997), the court upheld recovery of lost profits because the plaintiff's damage expert presented a damage model that included an assumption of future market share based on data obtained from respected sources in the telecommunications market and upon a showing that the plaintiff's history of strong performance in the field was indicative of likely success.

However, in Holt Atherton Ind., Inc. v. Heine, 835 S.W.2d 80 (Tex. 1992), the defendants sold a bulldozer to the plaintiffs that the defendants later refused to repair because they did not recognize the warranty. The court held lost profits were not recoverable because the plaintiffs failed to show they had enough work to fully utilize the bulldozer.

Reasonable certainty in damages cases is a question of whether the plaintiff has evidence and can value the impact by the probability of success. There is a line between permissible speculations and that of intolerable guesswork. A damage calculation need not prove that all elements are certain, but such calculations must:

- Be based on facts or the best available evidence to prove damages;

- Use sound methodologies and show consideration of alternative methodologies; and

- Show confidence in the accuracy of estimates and yield reasonable results.

Damages for lost profits are recoverable only if the plaintiff can prove the damages are reasonable and have been calculated using reliable factors. The applicable federal or state laws regarding the required degree of certainty should also be addressed.

In summary, the calculation does not require precision. An estimate of damages can be made, but the loss cannot be based on speculation. Lost profits that are deemed speculative, such as those calculated using unreasonable growth rates for business sales or personal income, are not recoverable.

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The foreseeability rule

Damages for lost profits are recoverable only if they are reasonably foreseeable by the breaching party at the time of contracting. This rule dates to the famous English decision Hadley v. Baxendale (156 Eng. Rep. 145, 151 (Ex. 1854)) and remains law today.

In Hadley, the court set out that damages are recoverable only if they were reasonably foreseeable by both parties at the time of the contract and that they arose naturally from the breach.

For example, in Hampton v. Federal Express Corp., 917 F. 2d 1119, 1125-26 (8th Cir. 1990), the court found that damages resulting from the failure to deliver blood samples of cancer patients in need of bone marrow transplants were not recoverable if the defendant had no knowledge of the package's contents.

The courts are consistent in giving responsibility for the determination of foreseeability to the trier-of-fact. Of the three rules, foreseeability is the legal principle for lost profits in which forensic CPAs have the least involvement, though that doesn't mean our work cannot aid in the assessment.

As mentioned in our previous column, through industry research we could show a GM strike represented an "other factor" of causation, in addition to a fire, that was a probable contributor to a loss. This "other factor" would have made it difficult for the plaintiff to prove foreseeability under the insurance contract.

Conversely, if the forensic CPA can identify "other factors" related to the plaintiff's industry or the economy that would have made a positive impact on the business during the loss period, the trier-of-fact can see how an event, breach or wrongful act may have caused a loss and should have been foreseeable.

Providing lost profit calculations that meet the reasonable certainty rule may also assist in assessing foreseeability. For example, we recently prepared a lost profits model for plaintiffs that had acquired a business with environmental clean-up issues. The purchase agreement required the sellers to perform the cleanup within a "reasonable" period.

Only a partial cleanup was ever completed - and nearly 10 years after the acquisition date. The plaintiffs had a business plan that included multiple interdependent projects and was allegedly reliant on the seller's environmental cleanup. Therefore, the business plan was not realized.

Our lost profits model was built to reflect the plaintiff's business plan and show the financial interdependency of the various planned projects. A well-constructed financial model, which contemplates both the reasonable certainty and foreseeability rules, will allow the trier-of-fact to make an educated assessment of each rule.

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Conclusion

There are three legal principles governing the recovery of lost profits: proximate cause, reasonable certainty and foreseeability.

Proximate cause evaluates if the event, breach or wrongful act of the defendant caused the plaintiff's loss.

Reasonable certainty establishes that there is reasonable certainty the estimated lost profits would have been produced had the event, breach or act not occurred.

Foreseeability measures whether the defendant party, when entering a contract, would have foreseen that the event, breach or act would have caused the lost profits claimed by the plaintiff.

Each rule is measured separately, but they are interrelated. A forensic CPA must not lose sight of these principles in working to assist the trier-of-fact.

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Stephen L. Ferraro and Charles S. Amodio are partners at Ferraro, Amodio & Zarecki CPAs, based in Saratoga Springs, New York. Ferraro can be contacted at sferraro@fazcpas.com. Amodio can be contacted at camodio@fazcpas.com.

Published: Thu, Apr 11, 2019