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 1Development of the Field of Litigation Economics 2Development of the Field of Forensic Accounting 3Qualifications of an Economic Expert 5Qualifications of an Accounting Expert on Damages 8Interdisciplinary Nature of Commercial Damages Analysis 8Difference Between Disciplines of Economics and Finance 10Finding a Damages Expert 11Critically Reviewing a Potential Expert’s Curriculum Vitae 12Getting the Damages Expert on Board Early Enough 18Courts’ Position on Experts on Economic Damages 19Standards for Admissibility of Expert Testimony 21Exclusion of Experts 25Trends in Daubert Challenges to Financial Experts 25Expert Reports 28Defense Expert as a Testifying Expert, Not Just a Consultant 33Quantitative Research Evidence on the Benefits of Calling a Defense Expert 35Treatment of the Relevant Case Law 36Legal Damage Principles 36Other Types of Damages Cases 42Summary 46References 46Chapter 2 Economic Framework for the Lost Profits Estimation Process 51Foundation for Damages Testimony 51Role of Assumptions in Damages Analysis 52Hearsay 53Approaches to Proving Damages 55Causality and Damages 59Using Demonstrative Evidence to Help the Client Understand Its Losses or Lack of Losses 67Causality and Loss of Customers 68Graphical Sales Analysis and Causality 69Causality and the Special Case of Damages Resulting from Adverse Publicity 71Length of Loss Period: Business Interruption Case 72Length of Loss Period: Plaintiff Goes Out of Business 77Length of Loss Period: Breach of Contract 78Methodological Framework 79Summary 82References 83Chapter 3 Economic Analysis in Business Interruption Loss Analysis 85Economic Fluctuations and the Volume of Litigation 85Macroeconomic Analysis 86Definition of a Recession 86Measuring Economic Growth and Performance 87Business Cycles and the Movement of GDP Components 90Business Cycles and Economic Damages 95Varying Responses to Business Cycles Across Industries 97Using More Narrowly Defined Economic Aggregates 99Quantifying the Strength of the Relationship Between Selected Economic Aggregates and Firm Performance 101Implementing Inflationary Adjustments 104Regional Economic Trends 108Quality and Timeliness of Regional Economic Data 109International Economic Analysis 111Globalization of Supply and Demand 113Summary 115References 116Chapter 4 Industry Analysis 119Sources of Industry Data 119North American Industry Classification System 125Retaining an Industry Expert 132Conducting an Industry Analysis 133Relating Industry Growth to the Plaintiff’s Growth 136Other Industry Factors 138Yardstick Approach and Industry Analysis 141Summary 144References 145Chapter 5 Projecting Lost Revenues 147Projections Versus Forecasts: Economic Versus Accounting Terminology 147Using Graphical Analysis as an Aid in the Forecasting Process 148Methods of Projecting Lost Revenues 153Curve‐Fitting Methods and Econometric Models 158Understanding Regression Output and Diagnostics 161Common Problems Affecting Regression Models 162Confidence in Forecasted Values 167Frequency of the Use of Econometric Techniques in Commercial Litigation 169Seasonality and the Forecasting Process 177Capacity Constraints and Forecasts 179Sensibility Check for the Forecasted Values 180Projecting Lost Sales for a New Business 181Projecting Losses for an Unestablished Business 186Summary 188Appendix 189References 197Chapter 6 Cost Analysis and Profitability 199Presentation of Costs on the Company’s Financial Statements 200Measures of Costs 201Profit Margins and Profitability 201Appropriate Measure of Profitability for a Lost Profits Analysis 202Burden of Proof for Demonstrating Costs 206Fixed Versus Variable Costs 207Using Regression Analysis to Estimate Costs as Opposed to More Basic Methods 212Pitfalls of Using Regression Analysis to Measure Incremental Costs 212Possible Nonlinear Nature of Total Costs 213Limitations of Using Unadjusted Accounting Data for Measuring Incremental Costs 217Treatment of Overhead Costs 220Must a Plaintiff Be a Profitable Business to Recover Damages? 224Mitigation of Damages 225Cash Flows Versus Net Income: Effects on the Discounting Process 230Recasted Profits 232Firm‐Specific Financial Analysis 238Cross‐Sectional Versus Time Series Analysis 240Summary 240References 241Chapter 7 Time Value of Money Considerations 245Determination of Interest Rates 246Types of Interest Rates 246Financial Markets: Money Market Versus Capital Market 247Money Market Securities and Interest Rates 247Capital Market 249Real Versus Nominal Interest Rates 250Determinants of Interest Rates 255Prejudgment Losses 261Components of the Cost of Capital 263Discounting Projected Future Profits 269Should the Risk‐Free Rate Be Normalized? 272Common Errors Made in Discounting by Damages “Experts” 276Summary 282References 283Chapter 8 Business Valuations 287Legal Standard for Business Valuations in Business Interruption and Business Failure Lawsuits 287Lost Profits Versus Lost Business Value 290Business Valuation Framework 292Public Versus Private Companies 293Business Valuation Parameters 294Revenue Ruling 59–60 and Factors to Consider in Valuation 294Valuation Concepts 298Capitalization of Earnings 304Adjustments and Discounts 308Summary 314References 316Chapter 9 Intellectual Property 319Patents 319Computation of Damages for Patent Infringement 325Legal Requirements Necessary to Prove Lost Profits 325Royalty Arrangements 333Copyrights 341Measurement of Damages for Copyright Infringement 344Trademarks 347Trade Secrets 352Summary 355References 357Chapter 10 Securities‐Related Damages 361Key Securities Laws 361Damages in Securities Litigation 366Fraud‐on‐the‐Market 367Comparable Index Approach 380Event Study Approach 383Examining the Variation in Abnormal Returns 386Limitations of the Event Study Model 391Broker Raiding Cases 394Merger‐Related Damages 400History of Mergers in the United States 400Client‐Broker Claims 405Churning 407References 415Chapter 11 Antitrust 419Antitrust Laws 421Antitrust Enforcement 423Economics of Monopoly 425Interpretation of Antitrust Violations: Structure Versus Conduct 429Changing Pattern of Antitrust Enforcement 429Antitrust and the New Economy 434Monopolization and Attempts at Monopolization 436Market Definition and Microeconomic Analysis 440Market Power 440Measures of Market Concentration 442Areeda and Turner’s Marginal Cost Rule of Predatory Pricing 452Summary 461References 462Chapter 12 Economics of Punitive Damages 467Evolving Position of the U.S. Supreme Court on Punitive Damages 467Frequency of Punitive Damages 470Frequency of Punitive Damages and the Shadow Effect of Punitive Damages 471Purposes of Punitive Damages 473Compensatory Versus Punitive Damages 474Criminal Penalties and Punitive Damages in Civil Lawsuits 475Punishment of Corporations and Corporate Governance 475Spillover Effects and Punishment of Corporations 476Deterrence Theory and the Changing Litigation Environment 487Deterrence and Regulatory Processes 490Typical Financial Measures Used in the Determination of Punitive Damages 493Net Worth 494Market Capitalization 497Uncertain Litigation Environment 503Summary 508References 508Index 513