Measuring Business Interruption Losses and Other Commercial Damages

DR. PATRICK A. GAUGHAN is President of Economatrix Research Associates, an economic and financial consulting firm specializing in the application of economics and finance to litigated matters. Dr. Gaughan provides various consulting services in the field of litigation economics and finance as well as mergers and acquisitions. He is often called upon to serve as an expert witness in lawsuits and other litigated matters.

Chapter 1 Introduction 1

Development of the Field of Litigation Economics 2

Development of the Field of Forensic Accounting 3

Qualifications of an Economic Expert 5

Qualifications of an Accounting Expert on Damages 8

Interdisciplinary Nature of Commercial Damages Analysis 8

Difference Between Disciplines of Economics and Finance 10

Finding a Damages Expert 11

Critically Reviewing a Potential Expert’s Curriculum Vitae 12

Getting the Damages Expert on Board Early Enough 18

Courts’ Position on Experts on Economic Damages 19

Standards for Admissibility of Expert Testimony 21

Exclusion of Experts 25

Trends in Daubert Challenges to Financial Experts 25

Expert Reports 28

Defense Expert as a Testifying Expert, Not Just a Consultant 33

Quantitative Research Evidence on the Benefits of Calling a Defense Expert 35

Treatment of the Relevant Case Law 36

Legal Damage Principles 36

Other Types of Damages Cases 42

Summary 46

References 46

Chapter 2 Economic Framework for the Lost Profits Estimation Process 51

Foundation for Damages Testimony 51

Role of Assumptions in Damages Analysis 52

Hearsay 53

Approaches to Proving Damages 55

Causality and Damages 59

Using Demonstrative Evidence to Help the Client Understand Its Losses or Lack of Losses 67

Causality and Loss of Customers 68

Graphical Sales Analysis and Causality 69

Causality and the Special Case of Damages Resulting from Adverse Publicity 71

Length of Loss Period: Business Interruption Case 72

Length of Loss Period: Plaintiff Goes Out of Business 77

Length of Loss Period: Breach of Contract 78

Methodological Framework 79

Summary 82

References 83

Chapter 3 Economic Analysis in Business Interruption Loss Analysis 85

Economic Fluctuations and the Volume of Litigation 85

Macroeconomic Analysis 86

Definition of a Recession 86

Measuring Economic Growth and Performance 87

Business Cycles and the Movement of GDP Components 90

Business Cycles and Economic Damages 95

Varying Responses to Business Cycles Across Industries 97

Using More Narrowly Defined Economic Aggregates 99

Quantifying the Strength of the Relationship Between Selected Economic Aggregates and Firm Performance 101

Implementing Inflationary Adjustments 104

Regional Economic Trends 108

Quality and Timeliness of Regional Economic Data 109

International Economic Analysis 111

Globalization of Supply and Demand 113

Summary 115

References 116

Chapter 4 Industry Analysis 119

Sources of Industry Data 119

North American Industry Classification System 125

Retaining an Industry Expert 132

Conducting an Industry Analysis 133

Relating Industry Growth to the Plaintiff’s Growth 136

Other Industry Factors 138

Yardstick Approach and Industry Analysis 141

Summary 144

References 145

Chapter 5 Projecting Lost Revenues 147

Projections Versus Forecasts: Economic Versus Accounting Terminology 147

Using Graphical Analysis as an Aid in the Forecasting Process 148

Methods of Projecting Lost Revenues 153

Curve‐Fitting Methods and Econometric Models 158

Understanding Regression Output and Diagnostics 161

Common Problems Affecting Regression Models 162

Confidence in Forecasted Values 167

Frequency of the Use of Econometric Techniques in Commercial Litigation 169

Seasonality and the Forecasting Process 177

Capacity Constraints and Forecasts 179

Sensibility Check for the Forecasted Values 180

Projecting Lost Sales for a New Business 181

Projecting Losses for an Unestablished Business 186

Summary 188

Appendix 189

References 197

Chapter 6 Cost Analysis and Profitability 199

Presentation of Costs on the Company’s Financial Statements 200

Measures of Costs 201

Profit Margins and Profitability 201

Appropriate Measure of Profitability for a Lost Profits Analysis 202

Burden of Proof for Demonstrating Costs 206

Fixed Versus Variable Costs 207

Using Regression Analysis to Estimate Costs as Opposed to More Basic Methods 212

Pitfalls of Using Regression Analysis to Measure Incremental Costs 212

Possible Nonlinear Nature of Total Costs 213

Limitations of Using Unadjusted Accounting Data for Measuring Incremental Costs 217

Treatment of Overhead Costs 220

Must a Plaintiff Be a Profitable Business to Recover Damages? 224

Mitigation of Damages 225

Cash Flows Versus Net Income: Effects on the Discounting Process 230

Recasted Profits 232

Firm‐Specific Financial Analysis 238

Cross‐Sectional Versus Time Series Analysis 240

Summary 240

References 241

Chapter 7 Time Value of Money Considerations 245

Determination of Interest Rates 246

Types of Interest Rates 246

Financial Markets: Money Market Versus Capital Market 247

Money Market Securities and Interest Rates 247

Capital Market 249

Real Versus Nominal Interest Rates 250

Determinants of Interest Rates 255

Prejudgment Losses 261

Components of the Cost of Capital 263

Discounting Projected Future Profits 269

Should the Risk‐Free Rate Be Normalized? 272

Common Errors Made in Discounting by Damages “Experts” 276

Summary 282

References 283

Chapter 8 Business Valuations 287

Legal Standard for Business Valuations in Business Interruption and Business Failure Lawsuits 287

Lost Profits Versus Lost Business Value 290

Business Valuation Framework 292

Public Versus Private Companies 293

Business Valuation Parameters 294

Revenue Ruling 59–60 and Factors to Consider in Valuation 294

Valuation Concepts 298

Capitalization of Earnings 304

Adjustments and Discounts 308

Summary 314

References 316

Chapter 9 Intellectual Property 319

Patents 319

Computation of Damages for Patent Infringement 325

Legal Requirements Necessary to Prove Lost Profits 325

Royalty Arrangements 333

Copyrights 341

Measurement of Damages for Copyright Infringement 344

Trademarks 347

Trade Secrets 352

Summary 355

References 357

Chapter 10 Securities‐Related Damages 361

Key Securities Laws 361

Damages in Securities Litigation 366

Fraud‐on‐the‐Market 367

Comparable Index Approach 380

Event Study Approach 383

Examining the Variation in Abnormal Returns 386

Limitations of the Event Study Model 391

Broker Raiding Cases 394

Merger‐Related Damages 400

History of Mergers in the United States 400

Client‐Broker Claims 405

Churning 407

References 415

Chapter 11 Antitrust 419

Antitrust Laws 421

Antitrust Enforcement 423

Economics of Monopoly 425

Interpretation of Antitrust Violations: Structure Versus Conduct 429

Changing Pattern of Antitrust Enforcement 429

Antitrust and the New Economy 434

Monopolization and Attempts at Monopolization 436

Market Definition and Microeconomic Analysis 440

Market Power 440

Measures of Market Concentration 442

Areeda and Turner’s Marginal Cost Rule of Predatory Pricing 452

Summary 461

References 462

Chapter 12 Economics of Punitive Damages 467

Evolving Position of the U.S. Supreme Court on Punitive Damages 467

Frequency of Punitive Damages 470

Frequency of Punitive Damages and the Shadow Effect of Punitive Damages 471

Purposes of Punitive Damages 473

Compensatory Versus Punitive Damages 474

Criminal Penalties and Punitive Damages in Civil Lawsuits 475

Punishment of Corporations and Corporate Governance 475

Spillover Effects and Punishment of Corporations 476

Deterrence Theory and the Changing Litigation Environment 487

Deterrence and Regulatory Processes 490

Typical Financial Measures Used in the Determination of Punitive Damages 493

Net Worth 494

Market Capitalization 497

Uncertain Litigation Environment 503

Summary 508

References 508

Index 513