The Accuracy and Manipulability of Lost Profits Damages Calculations: Should The Trier of Fact Be "Reasonably Certain?"

THE ACCURACY AND MANIPULABILITY OF LOST PROFITS DAMAGES CALCULATIONS: SHOULD THE TRIER OF FACT BE “REASONABLY CERTAIN?” Jonathan T. Tomlin & David R. Merrell* I. INTRODUCTION In commercial litigation, plaintiffs commonly seek lost profits damages. Many courts have allowed a degree of uncertainty in the calculation of damages and have articulated a standard that damages need to be calculated with only “reasonable certainty.”1 Intersecting with this standard is a commonly held perception that simple methods of calculating damages are often more understandable and persuasive to a judge or jury than more complex methods. When presented with the results of such simple methods, should the trier of fact be “reasonably certain” that the results are accurate? Moreover, should there be a concern that the lost profits damages presented have been manipulated to provide a favorable result? This article brings empirical evidence to bear on these highly important issues. The accuracy and manipulability of damages calculations influences whether the law will result in the attainment of such goals as just compensation, optimal deterrence of harmful acts, and efficient breach of contract. This article will evaluate several versions of the well established and often used “before and after” approach to damages calculations by applying this method to a large sample of undamaged United States firms. This sample simply assumes a fictional damaging event and damage date for these firms. Thus, unlike an actual litigation environment in which the damages are unknown and typically in dispute, the damages for this sample are known with certainty to be equal to zero. The certainty of the actual damages for the sample allows a comparison of the damages * Jonathan Tomlin: Principal, LECG, LLC, Los Angeles, California 90067. David Merrell: Analysis Group Inc., Dallas, Texas. The opinions in this article do not necessarily represent those of LECG or Analysis Group. 1 See, e.g., ATACS Corp. v. Trans World Communications, Inc., 155 F.3d 659, 668 (3d Cir. 1998); City of Greenville v. W.R. Grace & Co., 640 F. Supp. 559, 569 (D.S.C. 1986); Rombola v. Cosindas, 220 N.E.2d 919, 922 (Mass. 1966); RESTATEMENT (SECOND) OF CONTRACTS § 352 (1981); U.C.C. §1-106 comment 1 (2004); MARK A. GLICK ET AL., INTELLECTUAL PROPERTY DAMAGES: GUIDELINES AND ANALYSIS 35 (2003). 295 296 TRANSACTIONS: THE TENNESSEE JOURNAL OF BUSINESS LAW [VOL. 7 generated by a particular calculation method and, thus, for an assessment of the accuracy of the calculated damages. Any calculated damages are “phantom” damages that result from an inaccurate calculation. Damages methods that courts have previously used and accepted are highly capable of producing substantial “phantom” damages and are highly capable of manipulation. For example, out of the three methods employed in the sample, there exists at least one method that yields non-existent “lost” revenues that exceed 20% of actual revenues for about half of the sample firms. These results indicate that many damages methods should require additional evidence on their appropriateness, and courts should inquire as to why the litigants chose particular methods. Without such additional information, the trier of fact should have little certainty that the damages presented are accurate and have not been manipulated. Section I below provides an overview of the law and economics of lost profits calculations. Section II explains the theoretical sources of uncertainty that arise from the use of simple damages methodologies. This uncertainty can arise from the failure of a particular method to yield accurate damages calculations or from manipulation in applying the method or choosing data. Section III explains the data sample and the results obtained. As shown, the various methods often yield substantial damages when they do not, in fact, exist. Section IV assesses the prospects of courts excluding simple damages calculations when they are unreliable and explains factors to which courts should look in evaluating damages methods. Section V concludes the article. II. BACKGROUND ON THE CALCULATION OF LOST PROFITS: THE LAW AND ECONOMICS A. Economics of Lost Profits Calculations A plaintiff may incur lost profits due to a variety of harmful acts such as fraud, false advertising, antitrust violations, intellectual property infringement, and breach of contract. Lost profits are equal to the difference between the profits that the plaintiff would have received “but-for” the harmful act and the actual profits received by the plaintiff, appropriately adjusted to present value.2 For example, if a 2 See, e.g., ABA SECTION OF ANTITRUST LAW, ANTITRUST LAW DEVELOPMENTS 789-91 (4th ed. 1997); GLICK ET AL., supra note 1, at 35; Robert E. Hall & Victoria A. Lazear, Reference Guide on Estimation of Economic Losses in Damages Awards, in REFERENCE MANUAL ON SCIENTIFIC EVIDENCE 277, 281 (2d ed, 2000); Victoria A. Lazear, Estimating Lost Profits and Economic Losses, in LITIGATION SERVICES HANDBOOK: THE ROLE OF THE FINANCIAL EXPERT 5.4 (3d ed. 2001); Jonathan T. Tomlin, 2006] THE ACCURACY AND MANIPULABILITY OF LOST PROFITS DAMAGES 297 plaintiff would have earned $100 in profits had a harmful act not occurred (the “butfor” scenario), but it actually earned only $75 (the "real world"), then lost profits are equal to $25 ($100 minus $75 is equal to the profits the plaintiff lost as a result of the harmful act). Approaches to calculating damages include the “before and after” approach, the “yardstick” or “control group” approach, and other approaches based on the economics of the hypothetical “but-for” scenario.3 The “before and after” approach entails a comparison of the plaintiff's financial performance during the time period in which it was presumably impacted by the harmful act or acts of the defendant with another time period in which the plaintiff was presumably not impacted. The hypothetical “but-for” scenario is one in which the plaintiff would have performed in accordance with the benchmark time period chosen. The “yardstick” or “control group” approach entails comparing the plaintiff’s performance to a financial benchmark based on an alternative geographic area, product line, distribution channel, industry, or firm. For example, the “yardstick” approach may create a hypothetical “but-for” scenario in which one assumes that the plaintiff would have obtained profits consistent with other firms in the same industry. In applying the “yardstick” approach or the “before and after” approach, additional factors that may have impacted the plaintiff's performance may also be taken into account. In addition to the “before and after” approach and the “yardstick” approach, other methods are available that may include calculating costs incurred by a plaintiff as a result of the harmful behavior at issue. Methods for calculating damages range from simple to sophisticated. Simple methods used in litigation include compar (...truncated)