Quantifying financial loss involves a hypothetical exercise of placing the injured party in the position they would have occupied but for the wrongdoing. In the case of breach of contract, this involves placing the injured party in the position they would have been in had the contract been fulfilled; in the case of tort, the exercise involves placing the party in the position they would have occupied had the tort not occurred.
In most circumstances, the financial loss is based, at least in part, on the diminution in the injured party's revenues from the wrongdoing. However, it is also common that the injured party has experienced increased costs as a result of the wrongdoing and this is typically quantified as a separate head of damages.
The plaintiff bears the burden of proving its loss, and damages are intended to be compensatory, not punitive. 'There are two essential principles in valuing that claim: first, that the plaintiffs have the burden of proving their loss: second, that the defendants being wrongdoers, damages should be liberally assessed but that the object is to compensate the plaintiffs and not punish the defendants.'2
At its highest level, the damages framework calculates the financial loss as the difference between the incremental revenue that the injured party would have realised net of the incremental costs that would have been incurred to realise that incremental revenue.
The analysts' work is governed by common principles and practices of financial analysis together with common law that addresses such issues as the date of assessment, mitigation, remoteness and foreseeability.
However, it is almost always the case that the analyst's professional judgement will play an important role in the assessment. The purpose of this chapter is to set out key components and considerations governing the analyst's work.
When determining the course of action that the plaintiff would have undertaken in the 'but-for' world, the use of hindsight is not generally permitted. For example, when considering whether the plaintiff would have manufactured and sold the product itself, only the information available to the plaintiff at the time should be considered.
Having established the injured party's course of action in the but-for world, hindsight is then permitted to determine the monetary value of this but-for scenario. For example, in the case of a patent infringement, the royalty rate that would have been charged is based on a hypothetical negotiation, the assumed terms of which are based only on the information available to the parties at the time the rate was set – without the use of hindsight. However, the product sales revenues (on which the royalties are payable) may be determined with the benefit of hindsight (based on, for example, actual volumes sold during the loss period).
iii Incremental Revenue
At the core of most damages analyses is the projection of the revenue that the entity would have realised but for the alleged wrongdoing. We say this because the expenses that would be incurred to earn that incremental revenue can usually be determined based on the analyst's assessment of the cause-and-effect relationship between revenues and expenses, commonly referred to as a cost-volume-profit analysis.
Lost revenues can arise from decreased sales volumes, price suppression, or both.
By its nature, projecting lost revenues can be a somewhat subjective exercise because one is hypothesising about the financial performance of the business absent the event.
Past financial performance can be a useful proxy to project the financial performance during the loss period, particularly in circumstances where the industry the entity operates in is stable. But, in most circumstances, the analyst will also have to consider the impact of circumstances existing during the loss period. The analyst will consider industry and economic factors and how they have changed over time, together with the plaintiff's circumstances, including, but not limited to, the plaintiff's efforts at mitigating its losses.
An often-quoted case on mitigation is British Westinghouse Electric and Manufacturing Co. Ltd v. Underground Electric Railway Co. of London Ltd, in which the court stated:3
The fundamental basis for the assessment of economic damages is that compensation for pecuniary loss naturally flows from the breach: but this first principle is qualified by a second, which imposes on the plaintiff the duty of taking all responsible steps to mitigate the loss . . . and bars him from claiming any part of the damage which is due to his neglect to take such steps.
What constitutes reasonable attempts at mitigation is fact specific and while the determination is often based on argument presented by counsel, the financial analyst can play an important role in assessing what constitutes reasonable courses of action from a business risk and cost perspective – important considerations for the court to evaluate in its deliberations.
iv Incremental Expenses
Revenues and expenses exist in a cause-and-effect relationship. Having first assessed the effect that the wrongdoing has had on revenues, the analyst can then turn his or her attention to the expenses that would be incurred to realise those lost revenues. The analyst will typically undertake what is termed a cost-volume-profit analysis that seeks to identify the underlying relationship between revenues, costs and production volumes. Simply stated, the analyst examines how costs change at various levels of revenue and production. Having established the relationship between these variables, it is usually straightforward to project the incremental costs that would have been incurred to realise the lost revenues (i.e., absent the alleged wrongdoing).
Costs are commonly categorised by their behaviour and common categories include variable costs, fixed costs, semi-variable costs and step costs.
i Variable costs
Costs are categorised as variable costs if they vary in proportion to changes in revenue or production volume. Common examples of variable costs include sales commissions paid as a percentage of revenue and materials used to produce a product.
Identifying and segregating these costs from other types of costs is important because it provides insight into the profitability of incremental units of production or sales. The difference between revenues and variable costs is termed contribution margin.
ii Fixed costs
Fixed costs are incurred in set periodic amounts that do not fluctuate with changes in production volume or revenues. Stated another way, a fixed cost is incurred at a set amount regardless of whether the company earns US$1 of revenue or US$1 million of revenue. Common examples of fixed costs include rent, insurance and C-suite expenditures.
In most circumstances, where the plaintiff's business continues to operate during the loss period despite the alleged wrongdoing, fixed costs are excluded from the analysis of financial loss because these costs would have been incurred regardless of the wrongdoing. In other words, these are not incremental costs incurred to earn the lost incremental revenue.
iii Semi-variable costs
Semi-variable costs are a hybrid between fixed costs and variable costs in that a component of the cost is a fixed periodic amount, but other parts of the expenditure are variable with changes in revenues or production. Returning to the above example of the sales commission that was viewed to be a variable cost, it may be the case that a portion of the sales commission is a fixed periodic amount with a second component being based on sales volumes, in which case the expense would be considered semi-variable. Another common example involves utilities where a certain base amount of expenditure is required to keep the lights on, but additional energy may be expended to produce incremental units of the product.
The analyst will examine the nature of these semi-variable costs, and in particular how they behave at different levels of sales or production volume (as the case may be). Having already projected the incremental revenue, the analyst will project the change in the semi-variable cost amount required to earn the incremental revenue, and this amount is deducted from incremental revenues in the financial loss analysis.
iv Step costs
Step costs remain constant for a certain range of production volume or revenues but then change to a new plateau for revenue or production volume outside that range. For example, in a manufacturing facility, wages paid to production line workers on one production line would be a fixed amount, but if subsequent increases in production necessitate a second production line, the total wage cost will step up to reflect the additional costs paid to employ the second line of workers.
The analyst examines the entity's sales or production capacity and, based on his or her projection of the but-for revenues, projects the incremental step costs that would be incurred (to the extent existing capacity is determined to be insufficient to meet the projected but-for volumes or revenues).
v The Present Value of Future Losses
Future losses refer to the financial loss, arising from the wrongdoing, that will occur after the date of the trial. These losses are projected to the end of the loss period and then discounted back to the trial date using the appropriate 'discount rate'.
One should not read too much into the term 'discounted' – discounting future amounts is based on mathematical formulas, rather than a simple percentage reduction in the future dollar amounts. The formulas are well known and based in large part on the assumed rates of return employed therein.
It is axiomatic that a dollar received today is worth more than a dollar received a year from now because the dollar received today can be invested, earn income and grow to a larger amount by that future date. Furthermore, the risk of realisation of receiving a dollar today is nil whereas there may be some risk of realisation for amounts to be received on future dates.
The concept of present value equates a stream of future payments to a lump sum, which, if handed to the recipient today, would grow at a specified rate of return to exactly equal to future sum on the future date it becomes due. In effect, future loss amounts are 'discounted' to their present value.
Based largely on this premise, awards for future financial loss are discounted to their present value on the date of the award. As noted in the case of McCarter Burr Co Ltd v. Harris:4
If the choice had been given of accepting half of the sum in ready cash or going on and taking all the uncertain chances of the popularity of a patent medicine continuing, of going on with the business expenses in the way of persistent and costly advertising and of seeking and filling orders and paying salaries to its officers, I feel sure that it, the plaintiff, would have hesitated long before refusing it and would in its consideration of the offer, not have felt as much certainty about its future business as its officers seemed at trial to entertain.
From a damages perspective, the rates of return employed in determining the discount rate should reflect the risk that future loss amounts may not have been realised absent the actionable event. In effect, the discount rate reflects the risk-adjusted after-tax rate of return that an investor would require to be indifferent between receiving the present value of the future loss (i.e., the loss amount) or the right to receive the future loss amounts as they would have come due absent the alleged wrongdoing.
The analyst plays a large role in assessing these risks of realisation; the analysis is based in large part on the analyst's assessment of the risks and opportunities in the industry in which the entity operates, the entity's historical financial performance and prospects, as well as those of its peers to the extent that such information is publicly available.
As noted in the case of Murano v. Bank of Montréal:
[I]n assessing the reliability of projected future profits, a record of past earnings will obviously increase the certainty of such a prediction. However, a lack of evidence of past earnings does not automatically preclude a new business from recovering for lost profits. Rather, a new business must be allowed to prove lost profits to a reasonable level of certainty by expert testimony, by evidence of actual profits of similar businesses, by evidence of proven managerial experience and expertise, and by evidence of subsequent earnings if such evidence is available. Nevertheless, damages should not be awarded for lost profits which are entirely speculative and uncertain.5
The analyst's risk assessment will evaluate the reliability of the financial projections prepared by the analyst or the company, as the case may be. Relevant considerations may include, but are not limited to, the following:
- the extent to which the projections were prepared by persons with knowledge of the industry;
- the extent to which the plaintiff's financial projections were corroborated by the defendant's own information;
- the extent to which the analyst has softened the impact of the projections. The analyst should have good reason before adjusting the financial projections but, if done, the fact remains that by forecasting financial results less than those indicated in the financial projections prepared at the time, the risk that the injured party would not realise the amount forecast in the analyst's report is reduced;
- availability of corroborating third-party, arm's-length data, such as industry growth projections prepared by an industry association that corroborates the assumptions and analysis included in the financial projections; and
- the scope and rigour of the analyst's analysis to test the reasonableness of the assumptions employed in the financial projections.
Given that the analyst is tasked with determining the financial effect of the 'but-for' scenario, he or she will necessarily employ assumptions in his or her analysis. In broad terms, assumptions can be segregated into those that pertain to law, those that pertain to facts, and those that are required to frame the analyst's damages model.
Assumptions pertaining to matters of law are outside the expertise of the analyst and, in most cases, such assumptions are provided by counsel. For example, the analyst may be instructed to assume that the terms of a signed contract are binding.
Some assumptions regarding assumed facts will address events. For example, the analyst may be asked to assume that a binding verbal representation was given during a meeting between the litigants. In most cases these assumptions will be taken as given by the analyst because it would be inappropriate for the analyst to provide commentary and opinion on findings of fact and legal interpretation, which, by their nature, are the purview of the court.
That said, in other circumstances the analyst will be able to assess the reasonableness of these assumptions by, for example, evaluating contemporaneous documents such as emails, agreements and meeting memorandum. For example, the analyst may have been asked to assume a certain volume of lost sales but may be able to establish the veracity of the assumption based on the terms specified in the correspondence between the parties.
The third category of assumptions are those required as parameters for the loss analysis, and in many cases these are developed by the analyst, possibly with some input from counsel. Examples of these types of parameter assumptions include, for example, the period of loss.
VII Accounting for Profits
This remedy is most commonly available in two types of cases:
- in a breach of fiduciary duty case where a competitor has had illegal access to the entity's trade secrets, customers or other proprietary systems; and
- in a case involving the infringement of intellectual property rights.
The objective in an accounting for profits is to require the defendant to disgorge all profits made as a result of the infringement.
i Breach of fiduciary duty
In many jurisdictions it is common that remedies for breach of fiduciary duty are discretionary, and depend all on all the facts before the court. The remedies are designed to address not only fairness between the parties, but also the public concern about the integrity of fiduciary relationships.
Many of these cases revolve around an employee that leaves the business to compete, unfairly, by utilising confidential corporate information or resources to gain a competitive advantage in the marketplace, or by soliciting corporate customers in violation of non-compete agreements or other statutory or contractual obligations.
Although the case law varies by jurisdiction, from a financial perspective the case of de Florio v. Con Structural Steel Ltd sets out a common arithmetic process to quantify the ill-gotten profits, as follows.
First, it is necessary to establish the length of the period during which the fiduciaries are obligated not to solicit former clients. Second, the plaintiff has the option to seek either the profits it has lost, or the profits the defendants have gained during the non-solicitation period. Third, the list of former customers successfully solicited during the non-solicitation period must be established. Fourth, the value of the solicited contract must be calculated. Fifth, it is generally appropriate to apply a discount to the calculation of the lost profits. The discount will account not only for the competitive nature of the business in question but will also account for the fact that the plaintiff would not have been guaranteed to receive the disputed contract if the defendant had not been present as a competitor in the marketplace (to the extent this is the case).
The defendant's cost structure will be different from that of the plaintiff, and therefore the profit that the defendant made from the wrongful act will be different from the financial loss suffered by the defendants, and the difference it is often material.
For example, the cost of inputs necessary to provide the services or produce the products may vary depending on the relationships with it the suppliers. Also, larger operations have efficiencies (economies of scale, etc.) that can reduce costs of production.
If the process permits, it behoves the plaintiff to assess both available remedies (damages and the accounting for profit) to determine which calculation yields a larger value. However, in some circumstances the plaintiff may be obliged to choose between an accounting of profits and a damages analysis at an early stage in the proceedings, in which case the analyst may provide judgement based on what can admittedly be only a preliminary understanding of the operations of the two businesses.
ii Patent, trademark and copyright infringement
Accounting for profits is also available in the context of patent, copyright and trademark infringement cases. While it is common for statutory provisions to provide authority for an accounting for profits, this remedy is also available as an equitable remedy in many jurisdictions. For example, see Siddell.6
In an accounting for profits, the inventor is only entitled to that portion of the infringer's profit that is causally attributable to the invention. There has been recent analysis regarding what is meant by the term 'profit' in this context.
Historically, the meaning of profit simply meant the difference between revenues and costs. 'Profit is the difference between expenditures made to produce and sell the infringing articles and the receipts therefrom.'7
However, more recently the framework has shifted to a differential approach. In Monsanto Canada Inc v. Schmeiser, the Supreme Court of Canada held that the preferred means of calculating profits is the differential profit approach, described as 'a comparison is to be made between the defendant's profit attributable to the invention and his profit had he used the best non-infringing option'.8
The practical significance of the difference between the two approaches is shown in Schmieser. The defendant infringed Monsanto's patent by growing genetically modified canola (which rendered it resistant to herbicide). However, the defendant claimed that it had gained no financial benefit from the use of the invention; there was no evidence to show that the defendant took advantage of the herbicide resistance by spraying the herbicide and, because the defendant sold the canola seeds for crushing rather than as seed, the sale price was no higher than it would have been had he planted unpatented seed. The trial judge measured the losses as the difference between the revenues from those crops and the costs incurred to grow the crops (i.e., the historical methodology). Upon appeal, the Supreme Court of Canada used a differential approach and found that the defendant's profits 'were precisely what they would have been had they planted and harvested ordinary canola . . . The appellant's profits arose solely from qualities of their crops that cannot be attributed to the invention'.9
At its highest level, the quantitative framework underpinning an accounting for profits or damages analysis is well established. The challenge in a particular case is for the analyst to populate the framework with parameter estimates and assumptions that are well-reasoned given the facts of the case, and supported by empirical or corroborating third-party evidence.
1 Errol Soriano is a managing director at Duff & Phelps.
2 For example, in the context of patent infringement, see Lord Wilberforce in General Tyre & Rubber Co. v. Firestone Tyre and Rubber Co. , RPC197 (UK HL), which cites Pneumatic Tyre and Puncture Proof Pneumatic Tyre (1899), 16 RPC 2019 (CA).
3  AC 673 (HLO).
4 (1922), 70 DLR 420  3 WWR 929, 18 Alta LR 609 (SC APP Div).
5 1995, 41 CPC (3d) 143 (Ont Gen Div).
6 Siddell v. Vickers (1892), 9 RPC 152 (CA).
7 P Preston in Teledyne, infra note 166 at 110, quoting Levin Bros v. Davis Mfg Co 72 F 2d163 (8th Cir, 1934) at 165.
8 Monsanto Canada Inc v. Schmeiser, 2004 SCC 34, 2004 CarswellNat 1391, 2004 CarswellNat 1392,  1 SCR 902, 31 CPR (4th) 161 (SCC).