Implications of Energy Capital for Discounting Lost Profits

Economists Ink: A Brief Analysis of Policy and Litigation


View Mosteller’s Profile
Gale Mosteller has calculated economic damages in many contexts including breach of contract, fraud, Lanham Act, Sherman Act, and Robinson-Patman Act.  She recently analyzed Enron’s indemnity policy claim against insurance companies for losses due to employee theft by Mr. Fastow.

Few court decisions discuss the details of discounting damages, but those details can significantly affect the size of the award. InEnergy Capital Corp. v. United States, 302 F.3d 1314 (2002), the Court of Appeals for the Federal Circuit commented on the date of discounting and the discount rate for a stream of lost profits. This lawsuit arose after the federal government breached its contract and caused Energy Capital to lose a profit stream. The government conceded liability but appealed the amount of lost profit damages awarded.

Discounting with a risk-adjusted discount rate (1) converts dollars earned in later years into equivalent dollars in earlier years by adjusting for inflation and the time value of money and (2) eliminates the expected premium on a risky investment. The court applied the same date of discounting for inflation and time value of money as for risk, even though the dates need not coincide. The court’s method also ignored risk during the prejudgment period. Failing to consider that risk might inflate the size of the award.

The date of discounting governs how far back to discount damages. The government’s method discounted the entire profit stream back to the date of breach. Due to sovereign immunity, the government need not pay prejudgment interest. For this reason, the government did not add interest to bring the damages forward to the date of judgment. By contrast, the plaintiff’s method discounted the post-judgment profit stream back to the date of judgment and left prejudgment profits undiscounted. The government argued that plaintiff’s method yielded higher damages because it implicitly included prejudgment interest.

The Federal Circuit supported the plaintiff’s method and noted that damages should be measured on the dates the plaintiff would have realized the profits, not as of the date of breach. Thus, discounting a profit stream back to the date of breach improperly removes inflation and the time value of money. Contrary to the government’s position, prejudgment interest does not accrue before the date of realization.

Although both parties presented experts who discounted future profits using a risk-adjusted discount rate, the plaintiff in post-trial briefing argued for a risk-free discount rate that increased damages. The Court of Federal Claims believed that precedent required using a risk-free rate, but the Federal Circuit found that the choice of discount rate depends on the facts. Because risk could affect post-judgment profits in this case, the Federal Circuit chose a risk-adjusted rate.

The court discounted post-judgment profits for risk because no one knows on the judgment date to what extent conditions will change profits in the future. Changes in demand, costs, or other factors could alter future profits. Due to the uncertainty of the venture’s post-judgment profits, people would trade a larger expected (but uncertain) pay-out stream in the future for a smaller pay-out with certainty on the date of judgment. Put another way, because the plaintiff will not bear the venture’s post-judgment risk, it does not receive a risk premium to compensate for bearing that risk.

The same argument might apply to prejudgment profits. When the defendant destroyed the business venture, the entire profit stream became uncertain, not just post-judgment profits. However, rather than discounting for prejudgment risk, the court may reduce uncertainty by incorporating post-breach information in the damages calculation. If the court uses post-breach information to adjust the projected profit stream, the plaintiff has in effect borne risk during the prejudgment period.

Yet using post-breach data cannot always eliminate prejudgment risk. Two kinds of information affect profits: some becomes known between the breach and the judgment, and some would become known only by actually running the business. If information learned after the breach largely determines how much profit a venture would realize, then not discounting prejudgment profits for risk may make sense.

The court did discount prejudgment profits for risk, but not for inflation and the time value of money, in Franconia Associates v. United States, 61 Fed. Cl. 718 (2004). An alternative to the court’s discounting method involves multiplying each year’s profits by (1+rf)n/(1+ra)n, where rf is the risk-free rate, ra is the risk-adjusted rate, and n is the number of years since the breach (assuming constant rates over time). The denominator in this discount factor removes inflation, the time value of money, and the risk premium, while the numerator returns inflation and the time value of money. On net, this method removes the risk premium alone.

Prejudgment risk affects not only prejudgment profits but also post-judgment profits. The risk premium in any year compounds the risk-adjusted discount rate in that year with the rates from previous years. If prejudgment profits are uncertain, then using a risk-adjusted rate to discount post-judgment profits back to the judgment date does not remove the entire risk premium. To remove the prejudgment portion of the risk premium from post-judgment profits, the court would need to apply a factor like the one above where n is the number of years between the breach and the judgment date. This adjustment would have reduced Energy Capital’s post-judgment damages by 14% or roughly $1.11 million. This calculation and examples illustrating the different methods of discounting discussed in this article can be found at Appendix.

In sum, even if damages include no prejudgment profits, risk during the prejudgment period affects damages by affecting post-judgment profits. Discounting or in some cases incorporating post-breach information can adjust for prejudgment risk. The date of discounting for risk can differ from the date of discounting for inflation and the time value of money because the reasons for discounting differ.