Compensation for Pecuniary Losses in Breach of Contract Cases L

Compensation for Pecuniary Losses in Breach of Contract Cases L. Kenneth Hubbell* I. Introduction Contract law, in a practical sense, has to do with the voluntary exchange of goods and services in a private market economy° It includes the buying and selling of goods and services in money terms, and such related transactions as borrowing and leasing° The fundamental function of contract law is to encourage market efficiency~ that is, market transactions which direct economic resources toward their most valuable uses. Welfare theory provides the economic foundation for this statement and goes as follows: A voluntary exchange between two parties which can make at least one of the parties better-off without making the other party worse-off is an economically efficient exchange° Furthermore, assuming such an exchange exists, the exchange also facilitates the allocation of the goods in question to the use in which they are most valuable, thereby maximizing social welfare. This conclusion, of course, rests on a number of familiar assumptions, two of the most important being that "value" is measured by the marginal rate of substitution of the two goods (the amount of good Y that would be exchanged for one more unit of good X), and that the distribution of income and wealth is known and accepted by both parties. Within this context, contract law facilitates the process of exchange and hence efficiency in three ways: First, in extended exchanges (over time) it deters individuals from behaving opportunistically toward their contracting parties (see Posner, 1986, p° 81)o Put differently, provides a sanction against those who would terminate a contract at some point simply because they have an advantage over the other party at that time or because it is to their benefit not to fulfill the contract° For example, A enters into a contract to buy goods from B at some future date: the price of B’s goods falls, A refuses to honor the contract. Clearly, the process of economic exchange would be retarded under such conditions. Second, under both extended and instantaneous exchanges, transactions costs may be significantly lowered if substantive rules exist for risk-allocation when the actual exchange turns out to be different than what was expected. Transaction costs and time are reduced, for example, by the existence of the uniform commercial code which canonizes the contractual conduct. Third, contract law discourages "careless" behavior in the contracting process by imposing costs on those who would act in such a fashion. To illustrate the point, it discourages A from inducing B to incur costs in reliance on the existence or promise of a contract which A, in fact, never intended to extend° The purpose of this paper is two-fold: to discuss appropriate remedies in breach of contract cases and to examine the methodology of contract loss computations. Remedies, in the form of monetary compensation, can and do occur under a variety of possible sanctions. The *The author is Professor of Economics at the University of MissouriKansas City. 28 JOURNAL OF FORENSIC ECONOMICS following section introduces three of the basic principles applied in contract damages--reliance, restitution and expectation or loss-ofprofits. Damages adjudicated under the latter principle, "loss of expected profits" have produced by far the most controversy. How the "profit" concept is defined and applied is a recurring theme in contract law cases. Section III addresses the question directly by reviewing the concept and its application. Section IV continues the loss of profit issue by discussing alternative methods of empirically estimating such losses. Some concluding comments are offered in the last section. II. General Principles of Contract Damages Once a breach of contract occurs, the issue becomes that of determining the proper remedy. Damage awards can normally be classified under one of the following three contract damage principles: reliance, restitution and expectation of loss. Let us discuss each of the approaches in turn, starting with reliance. A. Reliance Loss The reliance principle relates to breaches wherein a promisee incurs costs in the reasonable expectation that the contract will be honored by the promisor. Professors Fuller and Perdue (1937) in an influential 1937 article in the Yale Law Journal provided a succinct definition and the appropriate remedy for reliance breaches. They stated: The plaintiff has in reliance on the promise of the defendant changed his position. For example, the buyer under a· contract · · · · I· for the sale of land has zncurred expense ~n the ~nvestlgatlon of the seller’s title or had neglected the opportunity to enter other contracts. We may award damages to the plaintiff for the purpose of undoing the harm which his reliance on the defendant’s promise has caused him. Our object is to ~ut him in as good a position as he was in before the promise ~as made. The interest protected in this case may be called the reliance interest. From a compensation standpoint, this simply means that a plaintiff in a contract action is entitled to any monies paid to third p~rties in expectation of the contract. 1 A reliance claim is thus synonymous with reimbursement of out-of-pocket expenses. B. Restitution Loss In addition to out-of-pocket expenses, the plaintiff is also entitled to recover any monies paid directly to a defendant party in a breach of promise suit. To illustrate, the plaintiff makes a good faith payment to the defendant pursuant to a contract wherein the plaintiff agrees to pay 1Economists would also argue that the plaintiff is intitled to recover the opportunity cost or foregone interest on the identified loss. Not all jurisdictions, however, permit such an allowance in damage cases. Hubbell 29 the balance upon delivery of the goods° In a contract action, the plaintiff is entitled to restitution of the downpayment, if the defendant failed to complete the transaction. Richard Posner argues that the principle can also be extended to include restitution to the promisee of the promisor’s profits from a breach (Posner, 1986, p. 106). He states that in the case of an opportunistic breach--a promise broken in order to make money--restitution of the promisors’ profits is a proper and fitting sanction. It is important to note that in both examples the restitution amount is known or easily identified. Put differently, future or expected losses are excluded under the this concept of damages. C. Expectation Loss Simply stated, the plaintiff in a breach of contract suit is entitled to recover from the defendant what he would have received had the contract been completed as agreed. In the words of Professors Fuller and Perdue (1937), "Here, our objective is to put the plaintiff in as good a position as he would have occupied had the defendant performed the promise." The expectation or loss-of-profit concept of damages focuses on the economic gain which the plaintiff anticipated from performance of the contract° Damages awarded under this principle are readily understood by economists since foregone opportunities lie at the heart of the issue. From an economic standpoint, for manufacturer A, who has been harmed by the default action of his major supplier B, the proper measure of loss is the amount of profit he could have earned had the breach not occurred. More will be said about the calculation and measurement of loss-of-profits in the next section. D. Liquidated Damages Liquidated damage clauses are normally written in contracts at the time of contracting and stipulate the approximate dollar value of losses which would be sustained in the event of a breach of contract. They may become a damage issue in default cases if the actual damages suffered by the plaintiff are less than those stipulated in the contract. When actual damages are the lesser amount, the reasonableness of the liquidated damage clause may be challenged because penalty clauses are not enforceable under contract law. This type of damage award is of interest to economists for two reasons. First, it is generally recognized that penalities may produce inefficient results in the market place since a party may provoke a breach in order to profit from the action° For example, the buyer would have an incentive to induce the seller to breach a contract if the penalities for breaking the contract were significantly greater than the buyer’s expected profit from said contract. Second, when evaluating or calculating liquidated damage claims proper attention should be paid to the issue of loss-of-profits or other expected cost items. This latter point is developed more fully below. III. Loss of Profits: Some Further Considerations As noted above, in a loss-of-expected-profit claim the plaintiff in essence demands to be made whole; i.e., placed in the same position as if the contract had been executed. A review of case law suggests plaintiffs may assess their damages in one of two ways (Pitch, 1985): (1) in terms 30 JOURNAL OF FORENSIC ECONOMICS of the difference in value between what they contracted for and that which they received; (2) based on the cost of rectifying or curing the defective performance. The former approach tends to view the damage claim in terms of loss of expected profits, whereas the latter focuses mor~ on the reliance loss concept. The two approaches merge, however, ~f the plaintiff’s reliance measure is an equally profitable foregone contract. When the two assessment approaches yield different results, the basis of the award poses an economic conundrum. From the plaintiff’s as well as from an economic standpoint, if the reliance award is less ~han the calculated loss-of-profit assessment, the real economic losJ to society and the plaintiff have been understated in the award actionJ Reliance costs basically measure out-of-pocket expenses which by definition ignore real economzc costs. Economic costs are equated with opportunity costs and provide the basis upon which goods and services are efficiently produced and exchanged in a market economy. Thus, adhering to the lossof-profit principle in this situation benefits both society and the plaintiff. What about the converse case, where the loss-of-profit measure is determined to be less than the reliance calculated loss? Assuming that the damage costs are reasonably based, a conflict now exists between the plaintiff’s best interest and that of society. In essence, following the reliance principle produces an unsound economic result because from an ..... I economic viewpoint, the plaintiff would have been over-compensated. Both reason and case law support this conclusion. In the Oklahoma Supreme B 2 Court decision of Peeveyhouse v. Garland Coal and Mining Company the Court assessed damages based on economic value when it awarded the plaintiff $300, the market value of the leased farm land, rather than the $29,000 cost of restoring the land to its original state. Assuming the plaintiff approaches the land restoration issue in a rationale way, a $29,000 award over-compensates the plaintiff some $28,700. Faced with the decision of spending $29,000 on th~ restoration of the land, which when fully restored has a market value o~ $300, or leaving the land in its present state replacing the damagedlproperty with a comparable piece of property for $300 and pocketing the difference · ($28,700), there is no doubt as to the rationale businessmanIi choice. s Besides being irrational, the poor business decision is contrary, to society’s best interest. It is an inefficient use of the nation’s / resources to spend $29,000 restoring an asset which has a market value of $300. Society is better served if the equipment, labor and raw material necessary to restore the land is channelled into the production of goods which society values more. The cost of land restoration exceeds its market value (price) to society, hence represents an unsound economic decision if it were to occur. 2peeveyhouse v. Garland Coal and Mining Company, 382 P. 2d (Oklahoma Supreme Court), 1962. Hubbell A. Mitigation 31 An inevitable question when the loss-of-profit concept is applied is that of the appropriate period of analysis° The doctrine of mitigation provides the economist with some general guidelines on this important issue. Simply stated, the doctrine requires that the wronged party in a breach of contract action take immediate and reasonable steps to mitigate their losses once the breach is known. Normally, the facts of the case will dictate when a plaintiff should have acted to mitigate damages. For example, in a straightforward breach of contract involving the sale of goods, the plaintiff, when confronted with non-delivery of the goods~ should take immediate steps to purchase substitute goods in the open market. By logical extension~ this principle implies that a reasonably determined time frame must be employed when assessing damages. Loosely defined, this would be the period from when the breach becomes known and mitigative action is initiated, and when the necessary corrective action is completed. In many cases, if not most, the plaintiff’s mitigation efforts can be assessed prior to adjudication° For damages pursued under the expectation principle, this means the expected loss-of-profits measure must relate to a finite time period and can not be assumed to continue indefinitely. Having said this, it falls to the economist to justify the time horizon selected and to evaluate the timing of mitigation° B. Defining Lost Profits While the principle of lost-profit is well understood by economists and adjudicators alike, its measurement is much less so. Much of the difficulty can be traced to confusion over whether "gross profit" or "net profit" is the appropriate measure of the plaintiff’s damages° In business law, the gross profits of a firm are defined as the difference between the firm’s total sales and the direct cost of sales° For a typical manufacturing, firm, it is total sales minus the cost of producing the goods. The latter figure represents "variable costs" and includes labor costs, raw material expenses and other allocatable costs° Net profits, on the other hand, are defined as the difference between gross profits and indirect business expenses° Items normally identified as indirect expenses are management salaries, mortgage expenses, property taxes, insurance, and other "fixed expenses." Richard Posner argues that in the very short-run if a seller loses a particular sale, only variable costs should be subtracted from the contract price to determine the value of the breach of contract to the seller (Posner, 1986, p. 111). His reasoning is as follows: Assume the stated contract price is $11 per widget, the seller’s variable costs are $6, and his fixed costs are $4. Based on these facts, the cost to the seller of the breach is calculated to be $5 ($11 contract price minus $6 of variable costs). According to Posner, because the allocated $4 of fixed costs must be paid by the seller, regardless of what happens to the sale, he is entitled to receive this expense in damages. Therefore, gross profits are the appropriate measure, the loss of sale reduces costs by $6. The pivotal issue in this example is whether the seller actually incurred all the allocated fixed costs° In other words, did the seller 32 JOURNAL OF FORENSIC ECONOMICS mitigate his damages by shifting to other contracts or by covering the fixed portion from existing contracts. In a recent New York Supreme Court decision, 3 the trigl Court was found to have erred in computing a plaintiff’s losses when~it awarded damages based on gross rather than net profits. It remanded the case for I a new trial limited only to the issue of the loss of net profits. In I. contrast to Posner’s example, the New York Supreme Court evidently reasoned that the loss of business to another firm in thislaction had no appreciable effect upon the plaintiff’s fixed expenses, hence was not recoverable. That is to say, net profits were deemed the ~roper measure of damages. If the loss of expected profits is defined in terms o~ "net profits," it is possible to combine this measure with a claim for restitution and/or reliance damages. Such a combination is consistent with economic’ theory · I since expense items included under restitution and reliance claims are normally excluded from the net profit measure. Thus, double accounting or recovery is avoided. One can think of many situations where both a reliance and a loss-of-net-profit claim are justified. To illustrate, a start-up or new business could incur a significant amount df reliance costs as well as a loss of net profits in a breach of contract situation. IV. Calculating Loss of Profit Damages / Compared to the bewildering variety of contractual arrangements, and hence by extension contractual damage situations, the determination of economic losses in a breach claim is a rather straightforward I calculation. The basic approach is one of present value· analysis. How it I is applied, however, depends upon whether the harmed business is viewed as an ongoing establishment or as a failed business. For an ongoing business, lost profits are essentially evaluated in terms ~f the foregone net income (profits) of the contract. When the breach is ~lleged to have caused the business to cease operations, the appropriate measure of damages is the market value of the business at the time of the breach to a willing buyer in an arms’ length transaction. The reasons Ifor drawing such a distinction and for the technique of analysis are the subjects of the remainder of this section. A. Present Value Analysis The concept of present value analysis is well-known bM economists and widely applied in adjudicated economic damage cases. In a breach of contract case, the analysis involves two simple steps. First, the incremental costs and incremental revenues associated with lthe contract are estimated separately. If the contract period is for more than a year, net profits are calculated by taking the annual difference between these two estimated values. Second, the annual net profit measures are discounted to present value based on an assumed and defensible discount rate. 3See: McRoberts Protective Agency v. Lonsdell Protective 403. New York Supreme Court 2d. 511. Agency, Ct. Hubbell Formally, the net present value expression is: n 33 NPV = Z (Rt-C~) t=1 (1+ i )t where Rt and Ct represent incremental revenues and incremental costs in each future period; i is the opportunity rate of return~ t = 1, 2, 3, o .; n is the number of time periods over which the revenue stream is expected. As one might guess, the difficulties associated with the application of this concept in damage cases lie not with the technique, bat with the calculation or estimation of the important variables--incremental costs and revenues, the opportunity rate, and in some cases, the time horizon. The incremental costs of a contract are all those costs, expressed in expected-present value terms, which are expected to be incurred as a result of completing the terms of the contract° Costs which have been incurred already (sunk costs) are not incremental costs and should not included. To be more specific, incremental costs consist of direct material expenses, labor costs, supplies, services, and variable overhead expenses. Capital items are not normally part of this cost measure, but if the purchase of a specialized piece of equipment is necessary and it is unlikely that it would be used elsewhere after the contract, all or a portion of it should be allocated as an incremental cost° Another consideration is the capacity utilization of the business’ plant or facilities. In other words, some consideration should be given to the fact that incremental costs tend to rise as the firm approaches full capacity. For example, overtime rates for labor, outside subcontracting, penalty charges for late delivery, and premium payments for raw materials may occur. Clearly, if plant and equipment are idle or underutilized, no such consideration is necessary. Looking at the receipt side of the ledger, incremental revenues are all those revenues expressed in present-value terms which the firm expected to receive from completing the contract° Present period contract revenues are expressed in nominal dollars, and all future period receipts are per the contract. Adjustments for foregone opportunity revenues in other identifiable business areas are also appropriate. A cancelled contract may, for example, trigger a chain reaction when expected cashflow projections are unmet and the firm must accordingly pare back sales or pass up new business opportunities. As stressed previously, the calculated net profit figure by definition excludes fixed costs, i.e., the costs which the firm faces irrespective of the contract. Therefore, care must be exercised to expunge such costs from the analysis. In general, property taxes, rents, interest on long-term debt and the like, fall into this category° In most cases, it is improper to include such items, since doing so would overstate the firm’s real economic loss by understating its indirect costs. An ongoing business establishment, unless severely damaged, is normally able to cover their fixed costs from existing sales or production levels. 34 B. JOURNAL OF FORENSIC ECONOMICS Breach Imposed Business Failures What about the case of irreparable harm? When this happens, damages must be stated in terms of the loss of the business per se and may be assessed from three different perspectives: book value of ~he assets, replacement value of the assets, or fair market value. 4 Th~ latter has been defined by the courts as "the price at which property would change hands in a transaction between a willing buyer and a willin~ seller, neither being under compulsion to buy or sell and both bein~ reasonably informed as to the relevant facts. 5 Of the three, the fair~market value approach has been the most commonly cited method of valuation in damage caSeSwhen’ the "fair market" approach is employed, the business is normally viewed from two different vantage poznts. In relative terms, the · . . I . , performance of the sub3ect business is compared to that of the firm s industry as a whole. An assessment is also made of the ind~stry’s overall outlook and performance vis-a-vis other industries. Neglecting either ! dimension of the firm’s business environment could seriousl~ flaw the valuation. Practically speaking, this means in addition to the traditional financial data on the firm’s sales, expenses and earnings, basic information is also gathered on the firm’s industry and its position within that industry. How many firms there are in the industry by employment size and total sales, the number and type of substitute goods for the firm’s product, the firm’s market share and its geographical market area, the availability of capital and other importan~ resources, the level of the industry’s capacity utilization, and the phase of the industry’s growth path (new or mature industry) are some of the pertinent questions which may be raised in the valuation process. Clearly, when such questions are addressed, the scope of the inquiry is pashed beyond a simple income projection analysis, and furthermore seems ne:essary if one is to satisfy the court’s mandate for a reasonable assessment. While different valuation methods are used, two "fair market" evaluation techniques are generally applied and accepted in failed business cases -- capitalized historical net profits (earnings) and loss of future net profits (earnings). The latter technique is forward looking and seeks to value the business in terms of the loss value of future profits. Where the plaintiff’s business has been terminated, the business’s prior profit history may provide a useful benchmark for such a projection. In the absence of reliable or relevant earnings data, the earnings history of comparable businesses may be required ih order to construct the firm’s projected profits. As in the case of the present value calculations discussed earlier, the profits projected must be net profits. .... I 4See Frank M. Burke, Jr. Valuation and Valuation Planning for Closely Held Businesses (Englewood Cliffs, NJ: Prentice-Hall, Inc., 1981) for fuller discussion of the techniques and the approaches. 5See O’Malby vs. Ames, 197 F.2d 256, 257 (8th Cir. 1952). Hubbell 35 Since the method of analysis is based on projected future events, the assumptions used to form the calculations are extremely important. Among the factors which may materially affect the damage estimate, three factors are particularily noteworthy: 1. the business forecast period for future profits; 2. the determination of the discount rate to be employed; 3. whether or not the projected future profits are discounted to present value. A~ with all discount type model~, given the stream of future net profits, the projected value of the business is directly related to the forecast period (t) and inversely related to the discount rate (i)o law suggests that reasonabliness is the guiding principle when e~timating these two parameters. Reasonable in this context is interpreted to mean consistent with the firm’s own historical record, the industry, and the economic environment. Normally, the damages award for a breach of contract evoked business failure would be the business’s value as a going-concern. To measure the firm’s going-concern value, the projected future profits of the firm should be discounted° The discount rate selected should reflect the expected or anticipated rate of return of an investment in that business, or that of businesses with comparable investment opportunities and risk. In essence, the discounting process calculates what someone would pay today to obtain, at a given expected rate of return, the stream of profits projected for a period of time in the future, plus the income the stream would generate, plus the amount of the principal of the investment which would remain at the end of the time period. Turning to the second approach, the capitalized historical earning technique is built around the concept of comparability. Put simply, it assumes that the fair market values of comparable firms bear some relationship to each other. This follows from the economic assertion that an investor, in a market economy, would offer the same price for two truly identical companies. The application of this technique involves three separate steps: 1) The initial step is to select a number of comparable companies from the identified industry based on earning patterns, sales growth, and capital structure similar to the plaintiff. 2) Next, the price-earnings multiple of the selected firms are calculated and reviewed. Those with ratios falling within a reasonably close range are selected and a composite price-earnings multiple determined. 3) The composite comparable companies price-earnings ratio calculated in step (2) is applied to the earnings of the subject firm. Similar to the discounted loss future profit approach, the capitalization of earnings technique is not without its drawbacks. The most transparent caveat is the valuation results are heavily influenced by the economists’ determination as to what are and are not comparable companies for analysis. Second, assuming a group of comparables is identical, there is still the problem of determining the appropriate 36 JOURNAL OF FORENSIC ECONOMICS multiple for the subject firm. For example, in determining the composite ratio should a weighted average of several years be used, or a simple average of the current year? How many years of earnings are appropriate and why? Hence, a range of price-earnings ratios can be generated from the same data set. V. Conclusions Pecuniary losses in breach of contract cases occur under a broad range of circumstances · The remedies or awards for damages[ in contrast, r fall into just three categories -- reliance, restitution, and expectation · · ° · I or loss-of-profits. The ob3ectlve of a breach of contract 9ward is to place the plaintiff in the same position that he would have,occupied had the contract been carried out by both parties. Thus, the f6ndamental ·I principle of law followed in damage cases is to make the innocent party whole. When properly calculated, the prescribed damage remedy produces what some may chose to call a "fair" or "equitable" solution. Perhaps equally as important though, the remedies are consistent wish economic theory· The principles of contract law discourage inefficient or uneconomic decisions, and when a breach of contract does occur, the damage payment reflects the economic cost of the breach. For the 9ngoing business, damages are essentially awarded based on opportunity costs· And for the failed business, fair market value or lost opportunity is the recognized rule of law. References Burke, Frank M., Jr., Valuation and Valuation Planning for Closely Held Businesses, Englewood Cliffs, NJ: Prentice-Hall, Inc. L 1981. F Fuller, R. and Perdue, R., "The Reliance Interest in Contra~t Damages," Yale Law Journal, Vol. 46, 1937. McRoberts Protective Agency Vo Lonsdell Protective Agency, Ct. 403, New York Supreme Court 2d. 511. O’Malby v. Ames, 197 F.2d 256, 257, 8th Cir., 1952. Peeveyhouse v. Garland Coal and Mining Company, 382 P. 2d, Oklahoma Supreme Court, 1962. Pitch, Harvin D., Damages for Breach of Contract, Toronto: The Carswell Company Limited, 1985. Posner, Richard, Economic Analysis of Law, 3rd edo, Boston: Little Brown & Company, 1986.