Litigation Services Handbook: The Role of the Financial Expert

CHAPTER 4

DEVELOPING DAMAGES THEORIES AND MODELS

Elizabeth A. Evans
Joseph J. Galanti
Daniel G. Lentz

4.1 INTRODUCTION
This book describes approaches, issues, and nuances associated with damages claims of many types—intellectual property, antitrust, government contracts, and accountant liability, to name a few—and provides guidance to practitioners involved in those types of cases. To set the context for a deeper understanding of these areas, this chapter provides a general framework for selecting a damages theory and developing a model to calculate damages. This chapter contains an overview of the various standards under which U.S. courts assess damages claims, summarizes the most commonly accepted damages theories and models, and describes accepted methods and damage elements that practitioners use in measuring damages claims.

Accepted damages theories and elements can differ widely between state and federal court systems, in different jurisdictions, and for various types of matters. We cannot cover all potential differences in this chapter. Practitioners should discuss the appropriate standards and elements of damages with counsel before investing time and effort on a wrong approach. Accordingly, this chapter provides a general framework to prepare an effective analysis and will help practitioners identify the right questions when they begin to assess damages.

Historically, based on the English court system, two types of civil courts existed in the United States: courts of law and courts of equity. Courts of law made their judgments in accordance with federal or state law and awarded monetary damages as their remedy. Courts of equity, on the other hand, used a set of principles based on fairness, equality, moral rights, and natural law, rather than a strict interpretation of the law. In a court of equity, relief came in the form of an action, rather than the payment of money.¹ The wide variety of equitable remedies includes the following:²

• Rescission: undoing (or reversing) the actions taken under a contract;
• Reformation (or rectification): restructuring the terms of a contract to prevent an inequitable outcome;
• Specific performance: requiring performance of the contract according to its terms;
• Injunction: requiring a party to refrain from certain acts;
• Subrogation: providing that one party can assume the rights of another;
• Account of profits: determining profits improperly gained by a fiduciary that breached its duty; and
• Declaratory relief: seeking a preemptive court ruling as a common mechanism of relief in divorce and certain contract matters. For example, in insurancecoveragedisputes, aparty can preemptively seek the court’s decision as to whether an insurance policy provides coverage for certain types of losses.

In the United States, most states have merged their law and equity courts. As a result, courts now administer both legal and equitable remedies and often consider a combination of the two depending on the matter at hand. While this chapter focuses on the legal remedy of damages, it will address several equitable remedies because they commonly involve expert services and often relate to damages claims.

Whether the remedy sought is legal, equitable, or contains elements of both, legal standards exist that affect the veracity of a claim before one considers a remedy. Section 4.2 addresses these standards.

4.2 LEGAL STANDARDS

The judge or jury should award damages in cases where the harm

1. Will occur with reasonable certainty;
2. Can be measured by the appropriate contract or tort (referred to as economic loss doctrine) standard;
3. Is the proximate cause of the damage and
4. Was foreseeable; in addition,
5. The harmed party has taken reasonable efforts to mitigate the damages.

This section explains these five legal concepts.

(a) Reasonable Certainty. Section 352 of the Restatement (Second) of Contracts (1981) states, “Damages are not recoverable for loss beyond an amount that the evidence permits to be established with reasonable certainty.”³ Yet while all courts require reasonable certainty for the award of damages, no single measure of reasonable certainty exists. Individual states and federal courts have all issued their own opinions as to the nature of reasonable certainty.⁴

Most cases concur on certain points:⁵

• The court must be certain that some injury to the plaintiff occurred.
• The defendant must not benefit from its wrongful actions and courts generally resolve doubts in favor of the plaintiff.
• Intentional or willful action by the defendant can result in a court requiring a lesser degree of certainty from the plaintiff.
• The plaintiff can estimate the amount of damages, but the court should have confidence in the accuracy of the estimate.
• For a well-established business, past performance reasonably predicts the future.
• For a new or speculative business, parties can establish the measure of damages with reasonable certainty by the use of expert testimony, business records, economic and financial data, and other verifiable data.
• The plaintiff must use the best available evidence.

Most important, the court must balance its judgment: it cannot favor the defendants to a contract by requiring too high level of proof that would encourage unscrupulous actions on the their part, nor should the court favor the plaintiff by requiring too little proof, which would encourage the parties to undertake costly actions to avoid loss to plaintiffs who might file a lawsuit in the future.

(b) Economic Loss Doctrine. The economic loss doctrine sets out the extent of loss that the plaintiff can recover in a tort case. When the facts of a case could result in either a damages award under a contract or under a tort, practitioners should know the distinctions between the two. We will first discuss the basic difference between contract and tort law in order to set the place for a discussion of their differing damages measures.

Under the common law of contracts, the seller and buyer decide between themselves the nature of their respective rights and duties. If the buyer believes that the seller has breached his duty or responsibilities under the contract, the buyer can bring suit against the seller. Similarly, the seller can sue the buyer for the breach of the buyer’s duties under the contract. In addition, one can find another source of contract law in the Uniform Commercial Code (UCC), which discusses the rights and responsibilities of parties to a contract among its nine articles.⁶ This chapter refers to both of these sources as contract law.

A tort involves the breach of a civil duty (not a contractual duty). Some define a tort as a personal injury. Torts include (but are not limited to) such wrongs as assault, battery, false imprisonment, defamation of character, interference with business, unfair competition, interference with contract, trespass, and negligence. Under tort law, an injured party can bring a civil lawsuit to seek compensation for a wrong done to the party or to the party’s property.⁷

In many cases, the line between a contract issue and a tort problem appears nebulous. Judge Richard Posner, of the Seventh Circuit Court of Appeals, notes that “almost any tort problem can be solved as a contract problem, by asking what the people involved in an accident would have agreed on in advance with regards to safety measures if transaction costs had not been prohibitive.”⁸ He goes on to say, “Equally, almost any contract problem can be solved as a tort problem by asking what sanction is necessary to prevent the performing or paying party from engaging in socially wasteful conduct, such as taking advantage of the vulnerability of a party who performs his side of the bargain first.”⁹

For a breach of contract that is also a tortious injury, what amount of damages should the injured party claim? Suppose a buyer in a contract receives and uses a defective machine, resulting in nonsalable goods, but none of the buyer’s other machines or property receives harm due to the use of the defective machine. Should the buyer bring a product liability suit (tort) or bring a lawsuit for breach of contract? Most states and federal jurisdictions hold that a party cannot recover in tort for economic loss damages when physical property damage did not occur. Where the harm causes damage only to the product itself (the defective machine in our example), the buyer should have protected itself under contract law. We refer to this majority view as the economic loss doctrine.¹⁰ On the other hand, a minority of states and federal jurisdictions hold that a party can recover additional losses related to negligence without the presence of damage to other physical property. See,for example, Sharon Steel Corp. v. Lakeshore, Inc.¹¹ An intermediate position has also evolved where courts permit a products liability action under certain circumstances even when the product harms only itself. The Supreme Court in East River v. Transamerican DeLaval Inc.¹² summarizes the intermediate position, as well as the majority and minority views.¹³

While the attorney will choose whether to bring suit under the contract or in tort, the practitioner should understand the distinctions of each and ensure that the damages analysis matches the type of lawsuit filed.

(c) Proximate Cause. Even though the plaintiff’s harm would not have occurred but for the defendant’s actions, courts nonetheless limit the plaintiff’s ability to recover under the concept of proximate cause. That is, recoverable harm from the chain of events caused by the defendant’s actions does not continue indefinitely.

At the point in which the court finds that the actions of the defendant did not proximately cause harm to the plaintiff, damages cease. Section 3.2 of Chapter 3 focuses on the two components of causation: actual (but-for) cause and proximate (or legal) cause and discusses proximate cause in greater detail. Courts decide proximate cause on a case-by-case basis.

(d) Foreseeability. One can test for proximate causation in several ways, but the most basic test involves foreseeability. If one cannot reasonably foresee the consequences resulting from the defendant’s actions, the plaintiff cannot recover for the harm related to those actions. For example, if the defendant throws a rock at Person A, but hits Person B standing next to Person A, a court would find that the harm to Person B was reasonably foreseeable. Hence, the defendant by throwing the rock proximately caused the harm to Person B, even if the defendant did not intend to hit Person B.

As with proximate cause, courts decide whether one can reasonably foresee the consequences of an action on a case-by-case basis. Section 3.2 of Chapter 3 further illuminates this concept.

(e) Duty to Mitigate. A victim to a breach of contract has a duty to mitigate the actions caused by the other party’s harm. That is, the plaintiff must take reasonable actions to avoid or reduce the damages. For example, assume that the defendant signed a contract for the purchase of 1,000 widgets from the plaintiff. The defendant breaches the contract and informs the plaintiff of the contract’s termination before the plaintiff obtains a source for the material needed to manufacture these 1,000 widgets. The plaintiff should sue for the loss of the profits on the breached contract, but should not sue for the cost of the material that it has not yet obtained at the time the defendant terminated the contract. The cost of the material is an avoidable cost. Alternatively, assume that the defendant breaches the contract after the plaintiff manufactures the widgets. If reasonably possible, the plaintiff must sell the widgets to another party; by selling the widgets to another party, the plaintiff can reduce the damages to the difference between the defendant’s price and the new party’s price plus the additional costs required to find the new purchaser.¹⁴

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