Accounting for risk in economic damage calculations: 4 things you should know if you are a non-expert

Commercial dispute resolution has become an undeniable certainty in business. Anyone who has even remotely heard of litigation in a breach of contract case knows that it can lead to a serious loss of profits and/or business value for the harmed party (plaintiff). The key to a successful litigation is often a thorough and fully documented analysis of economic damages. Such an analysis helps quantify the amount of loss caused by (an) allegedly harmful act(s), aiming to compensate the plaintiff so that it achieves the same economic position it would have been in but for the harmful act(s). Over the course of time, courts have offered little guidance as far as the appropriate methods to apply in order to achieve this aim, which means that it is up to financial experts to implement one method or another based on the details of each individual case. Here are four useful facts about economic damage calculations.

1) Legal norms

Damages are awarded according to a number of legal principles. Those are: reasonable certainty (damages related to lost profits must be reasonable and non-speculative); proximate cause (damages have been directly caused by the defendant’s wrongful conduct); mitigation (the plaintiff’s ability to mitigate depends on factors such as costs and timing), and foreseeability (at the time the engagement was made, damages were a foreseeable result of the defendant’s wrongful actions).

2) Time value of money

In addition to these, damage calculations are centered around the notion of time value of money, which defines the value of money at one point in time as compared to the value of money at another point in time. The core idea behind it is that a dollar invested today will be worth more in the future. Either it can earn interest at an interest rate and be worth more in the future if invested today, or a future dollar can be discounted with a discount rate to determine the present value of that future dollar. The concepts of compounding and discounting are of utmost importance when discussing the time value of money, since the financial expert usually determines losses as of the award date as a sum of past losses -to be compounded- and future losses-to be discounted.

3) Capital markets vs. cash flow

When it comes to accounting for risk in a damage calculation, there are two basic approaches that can be implemented, each having its own strengths and weaknesses, and it is up to the experts to decide which approach best suits each case. The capital markets method implies a risk-adjusted discount rate, while the expected cash flow method requires adjusting the cash flow projection to estimate the outcome. The former has the advantage of having been tested and being flexible to adjust to company-specific uncertainty. However, it does not properly capture high risk in certain investments and does not apply to all breaches of contract cases. At the same time, the latter does have a wider potential to capture certain breach of contract cases and it is more flexible, but on the other hand lacks empirical support. Alternatively, some experts gravitate towards a hybrid approach, which accounts for both the risk in the discount rate and the risk in the cash flow. The overriding principle for such an approach is the parity of risk, i.e. to account for elements of risk either in the discount rate or in the cash flows. Adjusting both elements would lead to an underestimation of damages.

4) Ex ante vs. ex post

Another element experts must take into account is the knowledge regarding the events that occurred subsequent to the date of the damage, in cases where some or all the cash flow amounts occur after the date of the alleged harmful act. The two methods of evaluation are ex ante (implies project lost profits based on what is known at the damage start date, disregarding what happens afterwards) and ex post (implies consideration of income post losses taking into account all known/knowable information as of the award date).

In summary, litigation and, by extension, the calculation of economic damages, have an inherent element of risk and uncertainty. The element of risk is centered around the concept of time value of money, and a credible damage estimate must be based on sufficient facts or data, as well as solid principles and consistent methodology that caters to the facts of the case. While there is no consensus regarding the best method and the decision to apply one or the other depends on the specific issues and circumstances in each individual case, the capital market and expected cash flow methods or any hybrid method are appropriate approaches as long as parity in risk is sustained.