TBA Law Blog


Posted by: Charles Baum II on May 1, 2018

Journal Issue Date: May 2018

Journal Name: May 2018 - Vol. 54, No. 5

Businesses could be damaged by various actions. When the act is improper, it may result in litigation that provides compensation for the losses. Improper acts that may lead to litigation in Tennessee include inducement to breach a contract (e.g., violation of a non-compete agreement) and intentional interference with business relationships and prospects (e.g., unfair competition).[1] In these cases, the pecuniary value of the damage will likely be calculated and presented to the fact-finder. Plaintiffs may elect to perform this calculation themselves, or their attorneys may hire a forensic economist to provide this calculation. Opposing counsel should be sufficiently familiar with acceptable methodologies for valuing commercial damages to gauge the validity of the plaintiff’s calculations. Opposing counsel may even hire a forensic economist of their own to double-check the plaintiff’s calculations. If an economics expert uses a flawed methodology or applies an acceptable methodology incorrectly, then their testimony is unreliable.[2] This article presents a summary of several key issues that should be addressed when measuring compensatory commercial damages in Tennessee, along with any guidance provided by Tennessee statutes and case law.

When Are Commercial Damages Awardable?

In Tennessee, compensatory damages in commercial cases are awarded to restore the injured party fully to their position before the wrongdoing.[3] Damages in commercial cases cannot be awarded if their existence is speculative, but recovery is not prevented if an element of mere uncertainty exists or if their amount is not known with certainty.[4] If the existence of damages is not speculative, then damages are awardable if their amount is estimated with reasonable certainty.[5] Tennessee courts prefer to award damages to an injured party even when the amount is not known with certainty than to deprive that injured party of an award because the amount is not known with certainty.[6]

The Correct Measures of Losses

No specific mathematical formula has been endorsed to measure losses in commercial cases,[7] but it is almost certain that the appropriate measure for compensatory awards in Tennessee includes lost net profit.[8,9] Net profit equals revenue minus business expenses. Lost net profit should typically be based on the loss from the action to the plaintiff rather than on the gain from the action to the defendant.[10] Lost net profit is awardable in Tennessee even when the plaintiff’s business was not necessarily profitable.[11] This is because even an unprofitable firm can suffer economic damage — in the form of larger losses — from wrongdoing.[12]

Awarding sales revenue or gross profit for damages, instead of net profit, would seem to overcompensate the plaintiff because it would be an amount that is greater than what would have been earned after paying business expenses. Revenue and profit are not even necessarily correlated: revenue could increase with additional sales while net profit decreases.[13] Nevertheless, in several Tennessee cases, the court based damage awards on lost sales revenue. In B & L Corp. v. Thomas & Thorngren Inc., the court explicitly declined to consider lost profit and awarded compensatory damages for intentional inducement to breach a contract equal to lost contract revenue.[14] Similarly, in Pinson & Associate Insurance Agency Inc., v. Kreal, the damages awarded in a contract breach case were one-half of commissions on sales of insurance policies — essentially a measure of revenue — without any deduction for business expenses,[15] and in Dorsett Carpet Mills Inc. v. Whitt Tile & Marble Distrib. Co., the damages awarded were lost commissions without any apparent adjustment for business expenses.[16] Although not stated, it is quite possible that the court believed the lost revenue in these cases could have been earned without incurring any additional business expenses.

Fixed Versus Variable Costs

Economists define fixed costs to be those that do not change with output. Variable costs are those that increase as more is produced or sold. For example, a factory’s cost would be fixed if increases (or decreases) in production do not change the cost of the factory (e.g., if the property tax on the land on which the factory sits is unchanged by increased production, or if the loan payments on the factory’s construction do not change with production levels). A variable cost would be worker wages if more workers are required to produce more output. However, the economist must carefully review the business’s production process because inputs whose costs are fixed for some businesses are instead variable for others (and vice versa). For example, it may be that an additional factory is required to produce additional output because existing factories are otherwise operating at capacity, in which case factory costs would be at least partially variable. In another example, if employees are not working to capacity, then it may be possible to produce a bit more output without paying higher wages, in which case labor costs would be fixed.

When measuring commercial damages in Tennessee, the economist should consider not only the extent to which additional revenue and sales would have been obtained by the business, absent the wrongdoing, but also the extent to which costs would have risen.[17] Essentially, the economist should differentiate between fixed and variable costs — to identify marginal or incremental costs — to project how costs would have changed (e.g., how costs would have increased with additional sales) without the wrongdoing.[18] Courts have been critical when economics experts have failed to distinguish between fixed and variable costs,[19] and courts have required damage awards to be recalculated when variable costs were not adjusted for sales.[20] In Fen Hin Chon Enterprises Ltd. v. Porelon Inc., the court required damages for lost profit to be recalculated using variable (or marginal) costs instead of historical average costs.[21] Somewhat differently, in one Tennessee case, a court found expert economic testimony where no business expenses were deemed to be variable to be admissible, leaving the challenge to this assumption for cross-examination in court.[22]

Methodologies

One of the approaches used most commonly by economists is the “before-and-after” or “but for” methodology.[23] With this approach, the economist will project what the business’s profit would have been absent the wrongdoing and will compare that to what the business’s profit has actually been, given the wrongdoing. The difference between the profit streams with and without the wrongdoing constitutes the commercial damage.

Economists have based what profit would have been on average profit prior to the wrongdoing. For example, Tennessee courts have found a three-year average to be admissible.[24] However, using a multiyear average will overstate damages when net profit was declining over time.[25] Using financial information from the year prior to the wrongdoing will overstate damages when net profit that year was anomalously high.

Economists have also implemented the “before-and-after” method using multivariate regression analysis (rather than historical averages) to estimate the trends in profit before and after the wrongdoing. The loss is then the difference in the trend lines over time. Regression analysis is a statistical tool that estimates the relationship (e.g., correlation) between two variables, the dependent variable (e.g., profit) and a key independent variable (e.g., the wrongdoing). Including multiple independent variables allows the regression to estimate this relationship holding these other factors constant. Courts have found this methodology to be acceptable for determining damages.[26] However, omitting a correlated variable from the regression will result in statistical bias — making the impact of the omitted factor falsely appear to be caused instead by the wrongdoing — and the regression estimates being unreliable.[27]

A second methodology economists use is the “yardstick” approach.[28] The economist will first identify a comparable business and then will compare the plaintiff company’s actual profit (or trend in profit) after the wrongdoing with the profit (or profit trend) of the similar business that was not affected by the wrongdoing. The commercial damage is the difference in the plaintiff firm’s performance and the performance of the comparable business.

The “before-and-after” methodology and the “yardstick” methodology both have shortcomings. Defendants may challenge the “before-and-after” approach by arguing the periods before and after the wrongdoing are different in ways other than the defendant’s actions. For example, perhaps weaker economic demand — or even a recession — is to blame for diminished net profit. Defendants may challenge the “yardstick” approach by arguing the comparable firm is not truly similar to the plaintiff company — or that there is no reason to expect the two companies to perform similarly. The “yardstick” approach may be the only feasible alternative for plaintiffs who were not yet in business at the time of the alleged wrongdoing or for newly established plaintiffs. The “before-and-after” approach may be the only viable alternative for unique businesses without close competitors.

Duration of Losses

Compensatory damages are awardable on future anticipated losses in Tennessee. Tennessee courts recommend future losses be calculated based on past business trends before and after the wrongful conduct.[29] However, Tennessee courts do not provide rules for determining how far into the future to consider compensatory losses. In some cases, losses have been considered for 10 years after a breach.[30] Tennessee courts have even admitted expert economic testimony where lost net profit was assumed to continue indefinitely — into perpetuity.[31] This is based on the rationale that the wrongdoing could have diminished the value of the business to the owner, even upon the owner’s retirement, because the business could have then been sold and the wrongdoing would have reduced the business’s value in this sale.[32] Typically, when projecting losses into perpetuity, the economist will present separate losses year by year for, say, 15 or 20 years and then will lump all subsequent losses together in one amount as a capitalized value in the terminal year of the analysis.[33, 34]

Discounting to Present Value

Tennessee courts discount future losses (e.g., future lost net profits) to their present value to identify the lump-sum amount that when paid in the present and then invested will grow to the size of the losses in the future.[35] For example, $10,000 in projected lost profit in one year with a 5 percent interest rate (and annual compounding) could be replaced today with a $9,523.81 lump-sum payment. This illustrates that money is worth more today than in the future, so the present value of a future amount of money is less than that future amount. This is a first reason why economists discount future losses to present value.

A second reason forensic economists frequently discount future losses is to incorporate risk. This is because it is not with certainty that the firm would have lost sales or profit. In some cases, there is at least some probability that the company would not even have remained in business absent the wrongdoing. Risk can be incorporated into the analysis through the discount rate. Unless risk is explicitly incorporated elsewhere in the analysis, greater risk (and more uncertainty) will result in a larger discount rate. A lower risk level is represented with a smaller discount rate and less discounting.

Many economists believe that the investment closest to being risk-free is a U.S. government treasury security, so good examples of risk-free rates would be those on Treasury bills, notes, or bonds. Discount rates for investments with risk, such as business ventures, should be larger than those on treasuries. Economists may use the build-up method to identify the appropriate discount rate to use in a commercial case. With the build-up method, the economist typically starts with a measure of the risk-free rate and then increases that rate with the equity risk premium for publicly-traded companies[36] and for firm size, the firm’s industry, and other firm-specific factors to arrive at the discount rate to use in the analysis. All else equal, smaller firms are considered to be riskier than large ones, so the risk-free rate is increased more for small firms. Some industries are considered to be riskier than others, and larger increases to the discount rate are added for firms on those industries. Ultimately, the discount rate can be “built-up” for a number of factors.

An alternative approach to identify the appropriate discount rate would be for the economist to use the comparables method. Here, the economist will use as the discount rate the average risk premium for similar companies. “Similar” companies may be selected based on size, industry, age or other factors. Of course, this method requires the existence of similar companies. It also requires data on the equity risk premia for those companies.

In practice, economists in Tennessee cases have used discount rates based on the real rate of return and an equity risk premium with an adjustment for firm size, but the courts have not required expert economists to also adjust for all possible factors, such as company sales trends, industry factors, or future economic conditions, leaving any unaddressed factors for cross-examination.[37] Economists have been permitted to discount losses “ex-post,” defined as beginning with the date of the trial, and “ex-ante,” defined as beginning with the date of the wrongdoing.[38] All else equal, ex-ante discounting will result in smaller losses.

Pre-judgment Interest

Just as a lump sum paid today can grow when invested with interest to a larger amount in the future — which motivates present value discounting of future losses — past losses could have grown to a larger amount today if invested with interest. In turn, economists may include interest on past losses in their damages calculations.[39] Tennessee courts have the discretion to award pre-judgment interest in most civil actions and have done so on compensatory damages in commercial cases.[40] Tennessee statutes do not specify the rate to use, but Tenn. Code Ann. §47-14-123 limits interest to not more than 10 percent.[41] Economists may use the rate on a market investment (e.g., treasuries), the rate the plaintiff pays on its debt (since the lost profit could have been used to pay down debt), or the rate of return on investments in the plaintiff corporation (since the lost profit could have been reinvested). In Stewart Title Co. of Memphis v. First American Title Co., the court used the rate on one-year treasury bills.[42]

Mitigation

Generally, those damaged by wrongdoing have a duty to use reasonable care to mitigate their losses, if doing so is not unduly burdensome or impossible.[43] However, case law provides that this does not hold in a Tennessee breach of contract case.[44] Regardless, the plaintiff’s economics expert is not necessarily required to consider mitigation.[45] In fact, compensatory damages may even be awardable when the plaintiff’s business earned more profit after the wrongdoing than before.[46] Ultimately, it is the defendant’s burden to prove the amount that should be deducted from the compensatory damages as mitigation.[47]

Taxes

Unlike damage awards for personal physical injuries, awards for compensatory damages in corporate cases will be taxed as ordinary income.[48] It is possible for the tax on these awards to be different than what the tax would have been on the profit that would have been earned absent the wrongdoing. This is because tax rates periodically change. For example, the 2017 Tax Cuts and Jobs Act lowers the federal corporate tax rate from 35 percent to 21 percent, effective January 1, 2018. However, Tennessee statutes do not mention tax adjustments in damage calculations, and essentially no evidence exists of tax adjustments by economics experts in Tennessee case law.

Conclusions

Unavoidably, calculating commercial damages requires the economics expert to make several important decisions. Which methodology should be used to measure losses? Which costs would have increased with sales? Which discount rate adequately captures future risk? Given liability, attorneys potentially benefit their clients significantly by understanding the key elements of calculating commercial damages. A better understanding of these methodologies could prevent commercial damages from being over- or underestimated by significant sums of money. This is particularly important when compensatory damages are trebled.[49] This article has summarized the methods economists frequently use to measure commercial losses and has evaluated the extent to which Tennessee statutes and case law deem these approaches acceptable and reliable.

Notes

  1. Tenn. Code Ann. § 47-50-109; Givens v. Mullikin, 75 S.W.3d 383, 405 (Tenn.2002); Trau-Med of Am. Inc. v. Allstate Ins. Co., 71 S.W.3d 691, 701 (Tenn.2002).
  2. Waggoner Motors Inc. v. Waverly Church of Christ, 159 S.W.3d 42, 61 (Tenn.Ct.App.2004).
  3. Waggoner Motors, 159 S.W.3d at 57; Grantham & Mann Inc. v. American Safety Prods. Inc., 831 F.2d 596, 601 (6th Cir.1987).
  4. Waggoner Motors, 159 S.W.3d at 57; Pinson & Associate Insurance Agency Inc., v. Kreal, 800 S.W.2d 846, 488 (Tenn.Ct.App.1990).
  5. Ingram Barge Co. v. Century Aluminum of West Virginia Inc., 2012 WL 3945529, at *4 (M.D.Tenn.2012); Waggoner Motors, 159 S.W.3d at 51; Grantham & Mann, 831 F.2d at 601.
  6. Waggoner Motors, 159 S.W.3d at 58.
  7. Waggoner Motors, 159 S.W.3d at 57.
  8. Waggoner Motors, 159 S.W.3d at 58; Joy Floral Co. v. South Cent. Bell Tel., 563 S.W.2d 190, 192 (Tenn.Ct.App.1977).
  9. In Dorsett, the Tennessee Supreme Court declined to articulate a specific rule with which to measure economic losses and instead acknowledged that types of damage in addition to lost profit may exist (Dorsett Carpet Mills Inc. v. Whitt Tile & Marble Distrib. Co., 734 S.W.2d 322, 324 (Tenn.1987)). These include other consequential losses, emotional distress, and reputational harm from the wrongful act (Dorsett, 734 S.W.2d at 324).
  10. Dorsett, 734 S.W.2d at 325.
  11. Waggoner Motors, 159 S.W.3d at 59.
  12. Waggoner Motors, 159 S.W.3d at 60.
  13. Joy Floral, 563 S.W.2d at 192.
  14. B & L Corp. v. Thomas & Thorngren Inc., 162 S.W.3d 189, 221 (Tenn.Ct.App.2004).
  15. Pinson, 800 S.W.2d at 488 (Tenn.Ct.App.1990).
  16. Dorsett Carpet Mills Inc. v. Whitt Tile & Marble Distrib. Co., 734 S.W.2d 322, 326 (Tenn.1987).
  17. Waggoner Motors, 159 S.W.3d at 62, 65.
  18. Fen Hin Chon Enterprises Ltd. v. Porelon Inc., 874 F.2d 1107, 1113 (6th Cir.1989).
  19. Grantham & Mann, 831 F.2d at 604.
  20. Ricker v. Fanning, 1988 WL 55696, at *3 (Tenn.Ct.App.1988).
  21. Fen Hin Chon Enterprises, 874 F.2d at 1113.
  22. Jack Tyler Eng’g Co. v. Colfax Corp., 2013 WL 1500510, at *3 (W.D.Tenn.2013).
  23. The court in Waggoner Motors endorsed the before-and-after approach as providing the best evidence of lost profit (Waggoner Motors, 159 S.W.3d at 59). For an example in an antitrust case, see In re Scrap Metal Antitrust Litig., 527 F.3d 517, 524 (6th Cir.2008).
  24. Jack Tyler, 2013 WL 1500510, at *2; Waggoner Motors, 159 S.W.3d at 51.
  25. Waggoner Motors, 159 S.W.3d at 62.
  26. Universal Coin & Bullion Ltd v. Federal Express Corporation, 2015 WL 12001264, *5 (W.D.Tenn.2015); Conwood Co. L.P. v. U.S. Tobacco Co., 290 F.3d 768, 793 (6th Cir.2002); Bazemore v. Friday, 478 U.S. 385, 398 (1986).
  27. Universal Coin, 2015 WL 12001264, *5.
  28. The “market share” methodology, where loss of market share is measured and then valued, is a third approach that may be used by economists in antitrust litigation.
  29. Waggoner Motors, 159 S.W.3d at 59.
  30. Pinson, 800 S.W.2d at 488 (Tenn.Ct.App.1990). See also Tennison Brothers Inc. et al. v. William H. Thomas Jr., 2017 WL 6403888, at *7 (Tenn.Ct.App. 2017).
  31. Jack Tyler, 2013 WL 1500510, at *4, *5.
  32. Jack Tyler, 2013 WL 1500510, at *4.
  33. Id.
  34. This capitalized value pertains to the period from the analysis’s terminal year indefinitely into the future and is discounted to a present value as of the trial date. Capitalizing requires the economist to divide an annual measure of forthcoming lost profit by the capitalization rate, which is the discount rate minus the annual growth rate for the firm’s profit. This approach necessarily assumes nominal lost profit is constant over this time, profits are lost indefinitely into the future, and the capitalization rate (e.g., the relationship between the discount rate to the profit growth rate) is constant. This approach is not sufficiently flexible to allow any of these factors to change.
  35. Pinson, 800 S.W.2d at 488 (Tenn.Ct.App.1990); Fen Hin Chon Enterprises Ltd. v. Porelon Inc., 667 F.Supp. 1174, 1186 (M.D.Tenn.1987).
  36. The equity risk premium is defined as the amount of the investment return on equities that is above the risk-free rate.
  37. Jack Tyler, 2013 WL 1500510, at *2.
  38. Jack Tyler, 2013 WL 1500510, at *5.
  39. Waggoner Motors, 159 S.W.3d at 49.
  40. Whalen v. Bourgeois, 2014 WL 2949500, at *15 (Tenn.Ct.App.2014); Stewart Title Co. of Memphis v. First American Title Co., 44 F.Supp.2d 942, 965 (W.D.Tenn.1999).
  41. Tenn. Code Ann. §47-14-123.
  42. Stewart Title, 44 F.Supp.2d at 965.
  43. Cummins v. Brodie, 667 S.W.2d 759, 766 (Tenn.Ct.App.1983).
  44. Tennison Brothers, 2017 WL 6403888, at *19; Howard v. Haven, 281 S.W.2d 480, 486 (Tenn.1955).
  45. Jack Tyler, 2013 WL 1500510, at *3.
  46. Id.
  47. State ex rel. Chapdelaine v. Torrence, 532 S.W.2d 542,550 (Tenn.1975).
  48. 26 U.S.C. § 104(a).
  49. Tenn. Code Ann. § 47-50-109.

CHARLES L. BAUM II CHARLES L. BAUM II earned a Ph.D. in economics from the University of North Carolina in Chapel Hill, N.C. and is a professor of economics at Middle Tennessee State University. He serves as an economics expert in litigation throughout the southeast. He can be reached at (615) 556-9287 or cbaum@baumeconomics.com.