Lost Profits in Commercial Litigation: Proving and Defending DamagesLeveraging Calculation Methodologies, Documentation and Expert Evidence

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WEDNESDAY, SEPTEMBER 25, 2019

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Dr. Allyn Needham, Ph.D., CEA, Partner, Shipp Needham Economic Analysis, Ft. Worth, Texas

Jeffrey C. Totten, Partner, Finnegan Henderson Farabow Garrett & Dunner, Washington, D.C.

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Lost Profits in Commercial

Litigation: Proving and

Defending Damages

Allyn Needham, Ph.D., CEA

Shipp Needham Economic Analysis, LLC

Fort Worth, TX

Jeffrey C. Totten

Finnegan, Henderson, Farabow,

Garrett & Dunner LLP

Washington, DC

Outline

I. Define Lost Profits

II. Review Court’s Standards

a. Foreseeability

b. Probable Cause

c. Reasonable Certainty

III. Modeling Financial Statements – Yes or No

IV. Discounting Future Losses to Present Value

V. Lost Profits Due to IP Infringement or Misappropriation

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What are lost profits?

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What are Lost Profits?

• Profits plaintiff would have made, but did not make due

to a breach of contract, a tort, IP infringement, or other

actionable conduct

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Lost Profits are Net Profits.

• “Net profits are generally computed by estimating

the revenues (gross and net) that would have been

earned ‘but for’ the alleged acts reduced by avoided

costs (or incremental costs) that did not occur

because of the subject lost revenues.

The Comprehensive Guide to Lost Profits and Other

Commercial Damages, 3rd Ed., Vol. 1, Nancy Fannon,

Jonathon Dunitz,, BVR, 2014, Page 210

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To recover lost profits in most

commercial damages cases, three

legal standards must be met:

1. Foreseeability

2. Probable Cause

3. Reasonable Certainty

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Foreseeability

• In a lost profits case, the plaintiff must show the claimed losses resulted from a breach of contract, a tort or other actionable conduct that was foreseen and probable.

• As an example, a contractor may order materials from a supplier needed to provide a product or service to a third party buyer. If the supplier does not deliver the purchased materials, the contractor may not be able to fulfill the third party buyer’s order and lose the anticipated sales. Based on these facts, the contractor may sue the supplier for the lost profits. In this litigation, one of the key questions becomes, “At the time the materials were purchased, did the supplier realize failure to deliver materials would result in damages to the contractor? Was the damage to the contractor foreseeable?

• Financial experts are seldom involved with proving foreseeability in lost profit cases.

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Probable Cause

“Did the defendant’s wrongful conduct produce

the damage allegedly suffered by the plaintiff?”

In personal damages cases, the damages expert seldom, if ever, discusses causation. It is assumed. In commercial damages cases,

an attorney may instruct a damages expert to assume causation but do so at your own risk.

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The U.S. 5th and 8th Circuit Courts of Appeal have stated experts

should consider other reasons for causation.

“The comparison of profits before and after a period of alleged

illegal activity, without proof, does not prove causation.” Arthur J.

Gallagher & Co. v Babcock, 703, F.284 (5th Cir. 2012)

In overturning a plaintiff verdict, the U.S. 8th Circuit Court Appeals

stated the plaintiff’s damages expert’s model “was not grounded

in the economic reality of the … relevant market, for it ignored

inconvenient data. [The expert’s model] failed to account for

market events that both sides agreed were not related to any

anticompetitive conduct. Concord Boat Corp. v. Brunswick Corp.,

207 F.3d 1039 (8th Cir. 2000)

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When presenting lost profits to a court, an expert

cannot simply report a decline in revenue or profits as

an indication of the impact of the alleged wrongful act.

Other factors must be considered including

competition, the general economy, and the plaintiff’s

specific industry. An analysis may not consider all the

possible “other” causations but the consideration of

some factors will indicate to the court and trier-of-fact

the effort made to consider other reasons for the lost

profits.

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Reasonable Certainty

Legal standards maintain lost profits must be proven with

reasonable certainty. However, the definition of reasonable

certainty is not clear. Courts have sought to assist parties

making lost profit claims by establishing rules that state lost

profits are not recoverable beyond the amount that the

evidence permits.

How do you prove something

that never happened?

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Many courts look to the fact of damages and

the amount of damages in assessing

reasonable certainty. The proof of fact of

damages means there is proof profits would

have been made had the wrongful act not

occurred. The proof of the amount of damages

means, while estimates, the calculations must

be based on the evidence and fit to

customarily used methodology.

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“[B]oth the existence and the amount of lost profits

must be demonstrated with ‘reasonable certainty’;

amount of damages must be substantiated by

calculations based on ‘detailed evidence’ or be

rejected as ‘speculative and uncertain.’”

McGowan & Co. v Bogan, 93 F. Supp. 3d 624 (S.D.

Tex. 2015)

(Application of Texas and Ohio Law)

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How Do You

Calculate

Lost Profits?

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Calculating lost profits can be a two-step

process.

The first is projecting the revenue and costs

that would have generated the lost profits.

The second is determining an appropriate

discount rate and applying it to determine the

present value of future lost profits.

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Commonly used methods for

calculating lost profits are:

1. Before and After

2. Yardstick

3. But For

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The Before-and-After method compares the

company’s revenues and profits before and after

the alleged wrongful act. If there is a decrease in

revenue or profits, an assumption is made that the

company would have performed during the loss

period as it did prior to the alleged wrongful act.

It assumes that economic and industry conditions

during the loss period were similar to those during

the before period so that the data are comparable.

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The Yardstick method compares the plaintiff’s

earnings against those of a similar business,

product or other comparable measure.

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The But-For method considers all potential

factors working to affect the plaintiff’s profits

during the loss period and will, in turn, segregate

those caused by the defendant from those which

were not.

The But-For method offers an opportunity for a

more complex analysis of lost profits. It

considers market factors that would tend to

increase or decrease the plaintiff’s profits.

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How does a party work

to achieve reasonable

certainty?

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• The calculations must reflect the facts of the case.

• They must demonstrate the damaged business would have been profitable were it not for the alleged wrongful act.

• The expert does not have to “reinvent the wheel” and may rely on financial data and projections from the management of the damaged business. The resulting lost profits do not have to be provided with absolute certainty but must provide a reasonable certainty of accuracy

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Controversial Question

How much should an expert rely on

financial projections provided by the

management of the damaged business?

And should an expert adjust these

projections through modeling?

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Of the three methods for estimating lost profits discussed earlier,

the Before and After and Yardstick methods are fairly

straightforward. The But For method is the one commonly used in

more complex matters.

The But For method is ideal for estimating future lost profits

because it allows for the use of the financial projections made

by the damaged business.

.

It is also leaves the expert open to criticism for relying on

overly optimistic or unobtainable results.

Modeling may be used as a method for defending the expert’s

report when calculating future lost profits.

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“Some CPA experts project the plaintiff’s hoped-for income

stream, modify those losses to a realistic expectation by

factoring future risks and then discount the adjusted future

losses to a present value at a risk-reduced, relatively low

discount rate. Other experts project the hoped-for-but-lost

amounts and apply a higher discount rate that already

incorporates risk or uncertainty to determine the present

value. This article shows why the first approach is easier for

judges and juries to understand.”

Modeling and Discounting Future Damages, Robert Dunn,

Everett Harry, Journal of Accountancy, Online, January

2002

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Modeling is widely used

outside litigation.

Modeling is examining

the interactive

components of a financial

outcome and analyzing

various input factors.

Modeling allows an

expert to adjust cash

flows projections for

the impact of factors

not related to the

alleged wrongful act;

therefore, adjusting

cash flows to present

only the losses related

to the lawsuit.

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Modeling also allows for

flexibility.

“Business damages may be determined using alternative methodologies and

discount rates. The expert’s choices are not necessarily limited or

constrained by certain ‘purported’ laws or principles of finance and

economics when derived from ‘immediate situations’ not germane to a

plaintiff forced away from its but for world. Instead, an expert

may select from a range of theories, practices, and metrics

developed outside the litigation system.”

Lost Profits and Lost Business Value – Differing Damages Measures,

Everett Harry, Dunn on Damages, Issue 1, Winter 2010

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Discounting to Present Value

Future lost profits must be discounted to present value.

The discount rate to be applied and how it is determined are points of great disagreement in the

litigation support field.

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Shannon Pratt and Roger Grabowski have argued discount

rates applied to lost profits should be consistent

with business valuation principles.

Robert Dunn and Everett Harry have argued for a discount

rate reflective of the reasonableness of the adjusted stream

of profits. The more confidence in the reasonableness of

the lost profits calculation the lesser the discount rate. The

greater the uncertainty, the greater the discount rate.

Courts have ruled the appropriate discount

rate is a question of fact.

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A critical court decision regarding discounting future lost profits is

Energy Capital Corp. v. United States.

“When calculating the value of an anticipated cash flow stream pursuant

to the DCF method, the discount rate performs two functions: (i) it

accounts for the time value of money; (ii) it adjusts the value of the cash

flow stream to account for risk.”

“We do not hold that in every case a risk-adjusted discount rate is

required. Rather, we merely hold that the appropriate discount rate is a

question of fact. In a case where lost profits have been awarded, each

party may present evidence regarding the value of those profits,

including an appropriate discount rate.”

Energy Capital Corp. v. United States, 302 F.3d 1314 (Fed. Cir. 2002)

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Lost Profits Due to IP

Infringement or Trade

Secret Misappropriation

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• Profits plaintiff would have made, but did not make due

to infringement of patent, trademark, copyright, or theft

of trade secret

Lost Profits in the IP Context

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Lost Profits in the IP Context

• Profits plaintiff would have made, but did not make due

to infringement of patent, trademark, copyright, or theft

of trade secret

• Federal statutes dictate available remedies

• State remedies may also be available

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Federal Statutes

• Patents: 35 USC §284

• Trademarks: 15 USC §1117(a)

• Copyrights: 17 USC § 504

• Trade Secrets: 18 USC § 1836

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Damages for Infringement

• Lost profits is one remedy for IP infringement/theft

• The Patent Act provides for no less than a reasonable royalty

• Lanham Act and Copyright Act allow for statutory damages or

disgorgement and lost profits

• Defend Trade Secret Act allows for injunction, civil seizure, and

damages

• Injunctive relief

• Enhanced damages for willful infringement

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• But-For method typically used for complex fact patterns

Establishing Lost Profits

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Simple Before-and-After Analysis

• Damages equal the profits the plaintiff would have earned from selling 60 units, less

its actual profits from selling 40 units

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But-For Analysis: Market Share Rule

• Sales are divided in proportion to the market share of the firms remaining in the market

• Damages equal the profits the plaintiff would have earned from selling 50 units, less its

actual profits from selling 40 units

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• Evidence of the plaintiff’s and defendant’s business strategies

–Marketing materials, press releases, product reviews/ratings, RFPs and customer testimonials

–Reports and/or surveys of customer preferences for features of the accused product(s)

• Historical data on the prices, costs, sales and market shares of the accused

product(s) and all competitive substitutes

• Forecasts of future prices, costs, sales and market shares of the accused

product(s), including NPV analysis and scenario modeling

• Historical data regarding patentee’s manufacturing capacity

Establishing Lost Profits

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• To determine whether an expert’s theory of damages is admissible, courts look to Rule 702 of the Federal Rules of Evidence and the analysis set out in Daubert v. Merrell Dow, 526 U.S. 137, 141-42 (1999), which requires the district court ensure that any expert testimony “is not only relevant, but reliable.”

• “When the methodology is sound, and the evidence relied upon sufficiently related to the case at hand, disputes about the degree of relevance or accuracy (above this minimum threshold) may go to the testimony’s weight, but not its admissibility.”

Admissibility in Federal Court

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Lost Profits from Patent Infringement

• Experts often analyze lost profits damages based on the four Panduit1 factors

– Demand for the patented product/technology

– Absence of acceptable non-infringing substitutes

– Manufacturing and marketing capability to meet the demand

– The profits that would have been made

• Although lost profits must be apportioned to cover the patented invention, the Panduit test

typically satisfies this requirement2

1 Panduit Corp. v Stahlin Bros. Fibre Works, Inc. 575 F.2d 1152 (6th Cir. 1978)2 Mentor Graphics v. EVE-Synopsis, 851 F.3d 1275 (Fed. Cir. 2017).

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Convoyed/Derivative Sales

• Defined:

• Convoyed sales: those made of separate products sold simultaneously with the infringing product

• Derivative sales: those made of separate products sold subsequent to the infringing product

• Rule:

Lost profit damages for convoyed/derivative sales recoverable so long as they are functionally related such that patentee would anticipate selling these unpatented products.

Rite-Hite Corp. v. Kelley Co., 56 F.3d 1538, 1550 (Fed. Cir. 1995) (en banc) (denying recovery for lost profits on collateral sales where nonpatented product lacked a functional relationship to the patented product)

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IP Ownership May Impact Lost Profits

• Holding companies may impact damages

• Only a patent owner or an exclusive licensee has constitutional

standing to bring an infringement suit. Mars, Inc. v. Coin Acceptors,

Inc., 527 F.3d 1359, 1367 (Fed. Cir. 2008).

• A patent owner may not be able to collect the lost profits of a subsidiary

that has only a nonexclusive license to a patent. Poly-America L.P. v.

GSE Lining Tech., Inc., 383 F3d 1303, 1311 (Fed. Cir. 2004)

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Extraterritoriality

• “The presumption that U.S. law governs domestically but does not rule the

world applies with particular force in patent law”

• Microsoft Corp. v. AT&T Corp., 550 U.S. 437 (2007)

• Section 284 of Patent Act permits the award of lost foreign profits based

on infringement under §271(f)(2)

• WesternGeco LLC v. ION Geophysical Corp., 138 S. Ct. 2129 (2018)

BUT …

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Thank YouAllyn Needham Jeff Totten

Shipp Needham Finnegan, Henderson,

Economic Analysis, LLC Farabow, Garrett & Dunner,

LLP

6320 Southwest Blvd., Ste 113 901 New York Ave, NW

Fort Worth, TX 76109 Washington, DC 20001

www.shippneedham.com www.finnegan.com

aneedham@shippneedham.com jeffrey.totten@finnegan.com

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Disclaimer

These materials are public information and have been prepared solely for educational andentertainment purposes to contribute to the understanding of American intellectual property law.These materials reflect only the personal views of the authors and are not individualized legaladvice. It is understood that each case is fact-specific, and that the appropriate solution in anycase will vary. Therefore, these materials may or may not be relevant to any particular situation.Thus, the authors, Finnegan, Henderson, Farabow, Garrett & Dunner, LLP and Shipp NeedhamEconomic Analysis, LLC cannot be bound either philosophically or as representatives of theirvarious present and future clients to the comments expressed in these materials. Thepresentation of these materials does not establish any form of attorney-client relationship withthe authors, Finnegan, Henderson, Farabow, Garrett & Dunner, LLP or Shipp NeedhamEconomic Analysis, LLC. While every attempt was made to insure that these materials areaccurate, errors or omissions may be contained therein, for which any liability is disclaimed.

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