Sunday, October 14, 2012

Measure of damages for lost income revisited: net profits and a new rebuttable presumption to deduct variable expenses

Although Law 75 characterizes the infringing act giving rise to a claim as a tort, the computation of damages for lost profits arising from an unjustified impairment or termination of a dealer’s contract has its origins in contract principles derived from the civil or common law. For as long as I can remember, reputable experts in Law 75 cases have offered contradictory opinions on whether the computation of lost profits should be made after deducting fixed or only variable expenses, or some formulation in between. These formulations are tagged as the “straight line” approach or a modified approach etc. This area of the law has provoked one of the last few “accounting” or ‘economic” damages controversies that remains under Law 75. It should be settled by now that recovery of lost profits and goodwill is not per se duplicative (but there is substantial authority that recovery of goodwill is not necessarily permissible even if not duplicative). It is also settled that recovery is pre-tax. The last remaining frontier that still divides franchise lawyers and experts had been the allocation of costs to compute lost profits. The reason should be obvious: less deductions equals more profits and vice versa. For their part, courts have largely declined to adopt bright line rules, and in federal cases tried to juries, the weight of conflicting expert opinions has been left for juries to resolve as a matter of credibility. This is a tall task for laymen or lay women sitting in juries producing in some cases “split the baby” awards. Not to digress too much, but if you read the First Circuit's Rubbermaid case carefully you will see what I mean when a jury faces two party appointed experts and one court appointed expert on damages. It split the award down the middle.

While the Supreme Court of Puerto Rico’s recent and thoughtful opinion that I am about to discuss still leaves work ahead for both accountants and lawyers alike, it does offer substantially more clarity as to the proper methodology to compute claims of damages for lost income in all civil cases. I anticipate that, after this decision, courts have greater leeway and more responsibility as the gatekeepers to ensure reliable expert opinions to determine whether experts have the adequate foundation (e.g.,evidentiary basis of the operational costs) before allowing opinions to reach the jury. This is not fundamentally different from what has existed since Daubert, but at least now, the proper computation of damages is not necessarily a jury issue.

In El Coqui Landfill Inc. v. Municipio de Gurabo, 2012 TS 141 (P.R. Sept. 20, 2012)(Fiol-Matta, J.), the Court’s holding has four components, first, the proper computation is net, not gross profits; second, the expenses that must be deducted from the gross are those costs that claimant saved because of the impairment or termination of the contract (stated differently, those are generally called variable expenses in that claimant would have incurred those costs had defendant performed the contract and those costs may vary with the volume of sales); third, the definition of what is a variable or fixed cost is not rigid and may change depending on the industry or the business; fourth, and perhaps most important, claimant has the burden to overcome with business records and analysis the newly-created rebuttable presumption that costs are variable and should proportionally (depending on sales volumes) be deducted to compute net profits. In other words, claimant has the burden to prove that the costs are fixed or that it saved no costs because of the termination or impairment (two Justices dissented on this point).

The facts of El Coqui illustrate that the Court’s holding has far-reaching implications in Law 75 and tortious interference cases. There, plaintiff, a waste disposal company, had an exclusive contract to provide waste disposal services at the municipality’s landfill. The defendant municipality breached the contract with a third party who was liable in solidum for tortious interference. Plaintiff’s accounting manager, who was a CPA, testified that he computed the damages for the income lost during the duration of the contract, but did not deduct any costs from the gross because he said the costs of providing services were fixed not variable. The trial court awarded damages of $1.2 million plus interest at 4.25%, a judgment affirmed by the appellate court. The flaw in the accountant’s analysis, which caused the Supreme Court to modify and remand the judgment, was that the accountant’s conclusory testimony was devoid of business records, data, and analysis of the operational costs of the claimant’s business.

It remains unclear the quality or quantum of the evidence that a claimant must offer to overcome the rebuttable presumption that the costs are variable with the volume of sales and should be deducted from gross profits. I predict that there will be collateral litigation, as there has always been, over the allocation and amount of costs to determine the proper measure of lost profits. Another point that may go unnoticed is that the opinion of damages need not necessarily rest on an independent expert, but may rely on a certified public accountant employed by the company who has personal knowledge of the business. This may not bode well for independent experts at least when the claimant can count on a reliable in-house accountant or finance manager to testify about the measure of damages.