By Jeffrey T. Willoughby, CPA, CFF, CFE
When I was 10 years old, my dad asked how a window at our house had been broken. I replied, perhaps unconvincingly, “I don’t know.” He looked around and found broken glass inside the house and my baseball laying on the floor in our living room. Little did I know I was getting my first lesson in proximate cause.
According to the AICPA forensic services practice aid, Calculating Lost Profits, damages are only recoverable to the extent the action was the proximate cause of the loss. This leads to discussions as to whether the harm caused came as a direct consequence of an act, without which the harm would not have occurred. There has to be a direct link between the act and the injury. After finding no other possibilities and then finding my baseball in the house and glass on the floor inside means my dad had found the proximate cause of the broken window.
Experts on damages are often asked to assume causation on the part of a defendant and prepare an estimate of damages. However, this is not necessarily an area the expert can simply assume without further investigation. Experts have been precluded from testifying for failing to properly assess causation, including the individual components of proximate cause: transaction causation and loss causation.
To properly assess transaction causation, an expert should look at the event alleged to have caused the loss and perform a “but for” analysis. In a typical commercial damages dispute (if there is such a thing), the plaintiff enters into an agreement and but for the alleged wrongful conduct by the defendant, the plaintiff would not have sustained losses. In such a case there is transaction causation – the alleged wrongful conduct of the defendant.
Here is an example of a case that might not be as simple as it appears: the plaintiff enters into an agreement with defendant for 10 years, but it is cancelled after one year, resulting in lost revenue and loss of profit. Pretty simple, the agreement was terminated early and the plaintiff lost profit. But what if plaintiff failed to meet all the conditions of the agreement? What event caused the loss of revenue? A reduction in revenue may be obvious, but the cause for that reduction may not be.
In the example, an expert may need to look at the agreement to determine if all conditions were met, as well as historical and current revenue to determine if a decrease occurred, when it occurred, and whether it was directly related to a single event. The expert should consider, “but for the incident would the claimed damage have occurred?” If the answer is yes, it would have occurred regardless, then the first hurdle in demonstrating proximate cause, transaction causation, has not been cleared.
Once transaction causation has been determined, the next step is to demonstrate that a loss actually occurred. As explained in Robert Dunn’s Recovery of Damages for Lost Profits, once a loss is determined to exist (transaction causation), then it can be measured. In the example above, if the expected revenue from the cancelled contract was replaced, there may be no loss of profit. The second hurdle to clear in demonstrating proximate cause is that of an actual loss. The loss of a specific contract or customer could mean a loss of profit, but that loss must be demonstrated.
In a COVID-19 World
A blog on this subject would not be complete without discussing COVID-19 and its impact. One of the issues that will likely arise with regard to proximate cause will be identifying the cause of a loss as a result of COVID-19. By way of example, seasonal businesses are going to have to determine if reductions in revenue were due to seasonality or as a result of COVID-19. Also, sales that were lost for other reasons, such as a cancelled contract or a change in business model, will have to be separated from those resulting from COVID-19.
Another consideration will be mitigation and when a business returned to normal, or should have returned to normal. Many businesses are being allowed to reopen at full or reduced capacity while others are not. For those allowed to reopen, when are they believed to be back to normal and if not, when should they have been back to normal?
Many questions will get answered in the coming months, but for now the true impact COVID-19 will have on economic damages claims and proximate cause has yet to be determined.
Once an expert is able to demonstrate transaction causation, then it can be determined whether or not that transaction caused a loss. Both elements are required for measurement of economic damages. In addition to this already complex issue, COVID-19 will affect the way claimed losses are measured and their causes. Once an event occurs, it is important to know as much as you can about the claimed loss, including the how.
Jeffrey T. Willoughby, CPA, CFF, CFE, is a director with Forensic Resolutions Inc. He can be reached at firstname.lastname@example.org.
Sign up for weekly professional and technical updates from PICPA's blogs, podcasts, and discussion board topics by completing this form.