Battle of the exes: Understanding the Effect of the Ex Ante and Ex Post Approaches on Damage Calculations

By Eric Holzman The intent behind compiling an expectation damages calculation is to return the injured party to the same economic position in which it would have been but for erIC hoLZMAN an unlawful act. While most damages experts agree on this point, the approach employed to achieve this stated goal can have a tremendous effect on the result. A major determinant of the amount of damages is whether one employs an ex ante or ex post approach. The ex ante approach uses only information available at the time of the injury to calculate the damages incurred by the injured party. The ex post approach uses all information available up to the date of the damages analysis, which includes information available after the injury. In an instantaneous legal system there would be no difference between ex ante or ex post damages calculations. For example, assume your business experienced economic damages of $10,000 due to breach of a contract by a supplier. If the supplier was found liable for damages at the moment the breach occurred and paid you accordingly, then you would have returned to the same economic position but for the breach. In reality, there is a period of time between the illegal or improper act and the ultimate compensation awarded to the injured party. As time passes, the parties expectations regarding risks and cash flows change and therefore the damages calculations change. This lag between the act and the ultimate restitution creates the difference in damages calculations performed using an ex ante or ex post approach. To demonstrate some of the differences that occur between the two approaches, consider
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the following hypothetical example. Business A has a contract to buy a chain of convenience stores from Business B. The contracted purchase price is $1 million. Business B breaches the contract and does not give Business A title to the stores. ex Ante Approach The ex ante approach relies only on information known at the time of the breach. Presumably both parties know all public information and it is debatable whether they both know private information. If we assume that Business A is already in the convenience store business and, as part of the contract, it had access to Business Bs books and records, then it would be reasonable to assume both parties were privy to a significant level of private information at the time of the breach. An expert calculating the damages under this approach should use contemporaneous information in his or her modeling. The expert should derive an estimate of the value Business A placed on ownership of the convenience stores. One way of estimating this value relies on contemporaneous estimates of future cash flows generated by the convenience stores. If such information is available its possible that several estimates had been made to account for best case, most likely case, or worst case scenarios. A robust estimate would take all of the information into consideration and weigh the estimated cash flows appropriately, based on the expected business risks at the time of the breach. To further analyze the posited hypothetical, assume the following information is determined based on a review of the contemporaneous information. The convenience stores will yield approximately $250,000 in profits for each of the next 10 years after the sale1, after which profits will be de minimis. The risk-adjusted rate of return

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It is assumed that the cash flows will be received at the end of each year.

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for Business A is 10%.2 The present value of this stream of cash flows is approximately $1,536,000.3 This represents the present value as of the date of the breach to Business A of convenience store ownership. The analysis would subtract from the present value the amount Business A was contractually obligated to pay, $1 million, to calculate Business As damages as of the date of the breach. The resulting damages in this hypothetical situation would be $536,000.4 If allowed by the court, the expert should account for prejudgment interest. The interest should be calculated from the date of the harm to the date of recovery. However, because the date of recovery is uncertain given that awards may be subject to appeal, frequently the date of trial is substituted for the date of recovery. Depending on the court system, there may be a statutory interest rate5 that is applied to calculate prejudgment interest or a rate may have been stipulated in the contract. If there is no statutory or contractual rate, frequently a cost of borrowing rate is used. Assuming the trial occurs exactly three years from the date of the breach, the $536,000 in damages increase to approximately $620,000 using a 5% interest rate, compounded annually. Proponents of the ex ante approach argue it properly accounts for risk because either a contemporaneous market price or

contemporaneous analysis accounts for the risks the injured party expected at the time of injury. When the investment or project at issue appreciates more than expected at the time of injury, advocates of the ex ante approach argue that a plaintiffs award that does not account for the expected business risk at the time of injury overcompensates the plaintiff because the award would convey all of the benefits of the investment or project at issue without conveying the risks. However, if the risks anticipated at the time of injury were grossly underestimated the opposite position could be argued. The largest challenge to implementation of the ex ante approach is information availability and reliability. There may be a shortage of contemporaneous documentation reflecting the expectations and risks faced by Business A. In addition, fact witnesses knowledgeable of the contemporaneous analysis and expectations of the parties at the time of the illegal or improper act may have imperfect memories or their recollection may be clouded by subsequent or intervening events. ex Post Approach The ex post approach endeavors to assess the damages as of the date of restitution. It relies on all known information up until the time of trial. If forecasts are still needed to calculate the damages due to future lost profits that occur after the trial date, then the most upto-date forecasts are used. Additionally, any mitigation efforts made by the injured party subsequent to the injury are taken into account. The ex post approach also adjusts for the time value of money differently from the ex ante approach. Instead of discounting cash flows to the date of the breach, all cash flows are adjusted to equivalent value at the date of restitution (or more practically, a date such as the trial date). Ex post takes past lost profits and grosses them up to the restitution date, frequently using a prejudgment interest rate. Future lost profits are discounted back to the restitution date using a risk-adjusted rate of return.
3 4 $250,000 [(1-(1/(1.110))/.1] = $1,536,142. $1,536,000 less $1 million.

ex Ante Approach Inputs and Calculations

Assumptions Purchase Price Annual Cash Flow Years 1 10 Risk Adjusted Rate of Return Prejudgment Interest Rate damages Calculation Damages at the Time of Trial $620,000 $250,000 10% 5% $1,000,000

2 The courts have provided limited guidance as to what defines an appropriate discount rate. Some courts have ruled that an appropriate discount rate should incorporate both an inflationary component and a risk component and others have required the use of a risk-free rate. Without concrete guidance from a court, the expert should develop a discount rate using an accepted methodology and the facts of the case.

5 Statutory rates arent necessarily a given rate; rather, the statute might dictate the methodology to be used to calculate an appropriate interest rate.

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The ex post analysis of our hypothetical situation is greatly influenced by the conditions arising after the date of the breach. If, for example, during the three-year period leading up to trial, the U.S. economy fell into a deep recession causing some of the convenience stores to close, the damages calculation would reflect those conditions. Given the recessionary conditions, assume rather than the predicted operating profits of owning the convenience stores of $250,000 a year, the actual profits were $50,000 for each of the three years since the breach. Also assume that the most up-todate forecast of future profits is that the stores will generate $200,000 of profit in each of the next seven years. As a result of the economic conditions post-injury, the damages incurred by Business A are greatly reduced. Assuming a 5% borrowing rate, the present value (as of the date of trial) of the past lost profits equals approximately $158,000.6 The present value of the future lost profits cash flows, using a 10% risk adjusted discount rate, equals approximately $974,000.7 Therefore the total lost profits (past plus future) equal $1,132,000. Last, the expert must account for Business As mitigating actions. Instead of paying Business B $1 million per the contract, Business A put its money in a savings account earning 2% interest per year during this three-year period. The current value of that savings account is approximately $1,061,000, compounded annually.8 Consequently the damages incurred by Business A are the net of the lost profits

($1,132,000) and the value of the savings account ($1,061,000), or $71,000.9 By using the ex post approach, given the stated conditions, Business As damages decreased significantly due to the worsening condition of the economy (during the intervening period). Similarly, if the economy grew at a rate higher than expected it would be easy to conceive a situation in which Business As incurred damages were significantly greater than the ex ante approach. Advocates of the ex post approach argue it more accurately reflects the true economic reality of what would have occurred absent the illegal act. The passage of time has taken at least some of the guess work out of forecasts about the likelihood of future cash flows. The chief disadvantage of the ex post approach is that the damages are constantly changing as new information becomes available. This can create incentives for a plaintiff to game the legal system by filing extensions with the court to maximize its damages by waiting for an intervening act, such as the recovery of a stock market or the economy, to occur. Conversely, an arbitrarily assigned court date that happens to occur during an economic downturn could have the opposite effect. the take Away The time between the illegal act and the restitution will usually create disparity in the damages calculated depending on whether the ex post or ex ante approach is used. This disparity could be significant. It is important for counsel to understand these differences and research whether the particular court or arbitral body requires the calculation to use one of the two approaches. No damages calculation approach is appropriate for all situations. Rather, the choice of approach will depend on the facts and circumstances of each case. g Eric Holzman, CPA/CFF, is a Director at Veris Consulting in Reston, Virginia.

ex Post Approach Inputs and Calculations

Assumptions Purchase Price Annual Cash Flow Years 1 3 Years 4 10 Risk Adjusted Rate of Return Prejudgment Interest Rate Savings Account Rate damages Calculation Damages at the Time of Trial $71,000 $50,000 $200,000 10% 5% 2% $1,000,000

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$50,000[(1.053 -1)/.05] = $157,625. $200,000 [(1-(1/(1.1 ))/.1] = $973,684.

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$1,000,000(1.023) = $1,061,208. $1,132,000 - $1,061,000 = 71,000.

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