Tuesday, May 13, 2014

Recovering Lost Profits In Business Litigation

Today's post features a guest entry by James T. Hunt, Jr., a business litigator and a partner at Slater, Tenaglia, Fritz & Hunt, P.A.

Business lawsuits involving the claim of “lost profits” as damages can present unique challenges, especially if your business cannot identify specific transactions or deals that were lost due to the defendant’s wrongful conduct or breach of a contract. Some states have strict guidelines governing the ability to recover lost profits, while others actually prohibit lost profit recovery in certain circumstances.

A Tale Of Two States: New York vs. New Jersey

Despite their proximity and the similarity in contract caselaw, New York and New Jersey have somewhat different standards regarding recovery of lost profits. In New York, any business can recover its lost profits in a lawsuit, regardless of how long the company has been operating.  In fact, lost profits are somewhat treated the same way as any other type of damages.  New Jersey courts, however, have steadfastly refused to permit recovery of lost profits in cases involving a new business, which known as the “new business rule.”  Only an established business with a history of revenue and profits can recover lost profits.

New York

New York courts require a plaintiff to prove its lost profits in the same manner as any other damages. Lost profits, therefore, must be proven with a “reasonable certainty.”  This does not mean that absolute precise mathematical accuracy is required. Rather, courts are mindful that a prediction of future profit is inevitably speculative to some degree. 

In essence, there must be some rational basis on which to support an award of lost profits.  But a request based on pure speculation will most certainly be rejected.  Generally, three criteria need to be satisfied to obtain an award of lost profits: (1) the damages were actually caused by the breach, (2) the particular damages were fairly within the contemplation of the parties to the contract at the time it was made, (in other words, the damages were foreseeable), and (3) that the alleged loss is capable of proof with reasonable certainty.  New York falls in the majority of states that permit recovery of lost profits even if it is a new business with no track record of profitability.  A new business endeavor is held to the same standard – it must prove lost profits with reasonable certainty.  At the same time, however, a New York court will not allow an award to be based on pure conjecture or speculation. While the standard is the same for an existing business or new business, in the case of a new business a stricter standard is imposed because there is no experience from which lost profits may be estimated with reasonable certainty and other methods of evaluation may be too speculative. The more risky and speculative the industry, the less likely a new business could prove lost profits with such certainty. 

What constitutes “reasonable certainty” can be nebulous and difficult to pin down. For example, in a leading New York case, the court rejected a claim for lost profits arising from a domed stadium that was never constructed. The court concluded that the multitude of assumptions required to quantify the lost profits award contained an impermissible level of “speculation and conjecture.”  Some of these questionable assumptions included that the facility would be completed, available for use, and operating profitably for over 20 years. In another federal New York case, the court rejected as speculative a lost profit calculation that assumed the occurrence of numerous successive hypothetical transactions. The court found this constituted precisely the sort of conjecture that the reasonable certainty standard prohibits.

In a Second Circuit Court of Appeals case, Trademark Research Corp. v. Maxwell Online, Inc.,  a trademark search service brought suit against a software design firm for alleged breach of a contract that required the defendant to create for the plaintiff a trademark database and search system. The Second Circuit held that plaintiff's claim for future profits from in-house trademark searches and sales of disks providing direct access to plaintiff's database should not have been presented to the jury because it was incapable of proof with reasonable certainty as a matter of law.  For example, the plaintiff's accounting expert had assumed an abrupt expansion of the market for trademark search services, assumed that plaintiff would reverse the long decline in its market share, assumed that plaintiff's historically aggressive competitors would take no measures to counter plaintiff's ascendancy, and predicted which choices customers would make among a variety of new and old search technologies. To cap it off, all of these assumptions were reduced to speculative exact dollar amounts and spun out to the year 1998. Even though there was a significant amount of evidence submitted, the court found that it consisted of a “network of conjecture.”

By contrast, an established business often is in a good position to offer evidence of past experience as a reasonable basis from which a jury may determine lost profits with the requisite degree of certainty. For example, in a case involving a sidewalk cafĂ© seeking lost profits for breach of contract, the New York Court of Appeals upheld a jury award for lost profits. The Court of Appeals held that the evidence of the past experience and profits of the established restaurant to which the cafe would be attached was sufficient “to remove plaintiff's lost profit claim from the realm of impermissible speculation.”  In a federal New York case, a company in the business of selling costume jewelry through the mail brought suit for breach of contract to distribute 8,000,000 advertising supplements in newspapers. The company had been in business for over forty years.  The company offered statistical evidence of its past performance in a remarkably similar advertising program. The court found this evidence was sufficient to prove its lost profits with reasonable certainty.

New Jersey

Just across the river, New Jersey courts allow recovery of lost profits but not if the business is new and has no history of generating revenue.  This rule is called the “new business rule,” and is the law in a minority of states. Generally, profits lost by reason of breach of contract may be recovered if there are any criteria by which probable profits can be estimated with reasonable certainty. Indeed, New Jersey courts do permit considerable speculation by the trier of fact as to damages. As one court has stated, “[t]he rule relating to the uncertainty of damages applies to the uncertainty as to the fact of damage and not as to its amount, and where it is certain that damage has resulted, mere uncertainty as to the amount will not preclude the right of recovery.”  Courts have pointed out that the mere fact a plaintiff cannot pinpoint its damages with laser preciseness should not get a breaching party off the hook, since the breaching party caused the problem in the first place.  Accordingly,  the  fact that a plaintiff may not be able to fix its damages with precision will not preclude recovery of damages. But a request for damages that is based on pure speculation and on mere opinion evidence without factual support will not succeed. Again, “reasonable certainty” is the touchstone.

A lack of past performance is why New Jersey continues to apply the New Business Rule, which prohibits a new business from recovering lost profits. The reasoning behind the new business rule is that lost profits cannot be determined with a reasonable degree of certainty because there is not an established history of revenue and profits. Under the New Business Rule,  prospective profits of a new business are considered per se too remote and speculative to meet the legal standard of reasonable certainty.  The short existence of the entity makes a determination of lost profits too speculative. A New Jersey appellate court acknowledged it is in the minority of states that preclude lost profits in new business cases, and conceded that it was without any power to award such damages unless the New Jersey Supreme Court changed the law.

So what constitutes a “new business”?   The answer is decided upon a case-by-case analysis of the individual factual circumstances involved and the type of industry in which the business operates. For example, in one case an appellate court deemed a 2 ½ year old business to be “new.” The business offered educational, recreational and entertainment services for children, teens, and adults in one modern community center.  In so doing, the court deemed the business “new and unproved.” Under other circumstances, courts have permitted an award of lost profits where the business had operated only two years (from 1996 to 1998). In fact, the Third Circuit Court of Appeals has permitted lost profits for a business operating for only 1 ½ years. Obviously, the more risky and speculative the industry, the less likely a newer business could prove lost profits.

Past Is Prologue

So how important is it to demonstrate past performance? In fact it is the key to recovering lost profits. Past experience of an ongoing, successful business can provide a reasonable basis for the computation of lost profits with a satisfactory degree of definiteness.   Past profit experience on other projects is widely accepted as relevant to a determination of damages based on lost profits.  Courts have held that evidence of such a past performance may form the basis for a reasonable prediction as to the future.  In addition, courts have accepted other evidence of the profitability of a business, such as industry-wide information and projections and even revenue data of a competitor. While a newer business with no track record may ultimately be able to recover lost profits, it will be a much more difficult task than a business with a solid, several-years record of profitable performance.

Proving Your Damages: The Battle of the Experts
Proving a company’s lost profits to a reasonable degree of certainty will most likely require expert testimony. In most cases, if the stakes are high, a battle of the experts will ensue, where both parties retain experts who submit differing and contradictory expert opinions.  Victory will then hinge on which side retained the most convincing expert.  While it is possible to use the owner of the business as a sort of “expert” given his or her deep knowledge of the business and the industry, it is far too risky to go it alone without a qualified expert. Experts will have to analyze the company’s operating and revenue history, its costs and expenses, and forecast a lost profit figure that can pass muster. Retaining a highly competent, qualified, and trial-experienced accountant as your expert is a necessity. 

Jurisdiction is Important

If you have the option to file a lawsuit in several different jurisdictions, it is always important to confer with an experienced business law attorney to determine which jurisdiction will be most beneficial to you. This is especially true if you have a new business that intends to claim lost profits as part of the damages suffered. Certain factors may dictate where you can sue and what state law applies to the case. For example, if the matter involves an inter-state transaction across jurisdictional lines, determining “where” the transactions occurred as a legal matter will impact your case. Further, your contract may contain a choice of law provision that requires application of the law of a particular state.  You need an experienced business lawyer to assess the ramifications of such a provision and the hurdles the applicable state’s law would raise in your case.

About the author: James Hunt is a business litigator and a partner at Slater, Tenaglia, Fritz & Hunt, P.A., a commercial and business litigation firm with offices in NY and NJ. To learn more about claiming lost profits, contact Slater, Tenaglia, Fritz & Hunt, P.A., to schedule a free initial consultation