Most construction disputes will involve a claim for lost profits at some point. Whether due to excessive change orders, unforeseen events, or wrongful termination: a wronged contractor will want to recover the maximum amount imaginable! Unfortunately, it’s not that simple. Claims for lost profits can be extremely hard to prove.
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What is a Lost Profits Claim in Construction?
A claim for lost profits argues that, due to the action (or inaction) of some other party, profits were lost and should be recovered by the party who lost them. Lost profits claims are pretty common in construction because the work of a construction business (and, therefore, their profit) is often based on some factors outside of their control. Unlike some other industries, it’s extremely easy for one construction business to cause another to lose out on profits.
How do you Prove Lost Profits?
To prove a claim for lost profits, a claimant must establish 3 things:
- 1) the conduct upon which the claim is based causing the lost profit damages(proximate cause);
- 2) the parties contemplated the possibility of lost damages, or that lost profit damages were a foreseeable consequence of the conduct (foreseeability); and
- 3) the lost profit damages can be proved with reasonable certainty (reasonable certainty).
Let’s break down each of these elements in a little more detail.
First, the damages must have been caused by the other party’s actions. There needs to be some direct or proximate connection. i.e. A pretty clear connection must exist between the lost profits and the wrongful act.
That doesn’t necessarily mean the act causing lost profits must be the sole cause of the damage. However, it should be a substantial contributing factor. Once a claimant proves this, it becomes the other party’s turn to show that there was some intervening cause that also contributed to the damages (i.e. “It wasn’t my fault!” or “It wasn’t totally my fault!”).
Next, it’s important to determine whether the loss of profits was foreseeable. That is, it’s time to determine whether the party who caused the lost profits could have reasonably foreseen the damage they caused. If the loss of profits was not a foreseeable result of their actions, it might be hard to put the party causing lost profits on the hook. Basically, it’s a simple question as to whether the issue that took place was likely to cause lost profits for the claimant. To whether lost profits were foreseeable, the court will look at the contract terms, industry norms, and surrounding circumstances.
Lastly, damages must be proven with reasonable certainty. Calculating damages within a reasonable certainty is where things begin to get murky. The court must be reasonably certain that, without the issue at hand, the profits would have been achieved. There are a few different methods that courts use to calculate what profits would have been received. We’ll explore those below.
Lost Profits Typically Come Into Play With a Breach of Contract Claim.
How do you Calculate Lost Profits?
Calculating lost profits should be relatively easy. Essentially, lost profits are just the lost revenues minus the costs that were also avoided. In theory, this seems pretty clear-cut, but there’s much more than meets the eye.
The basic formula for calculating lost profits damages is:
Lost Revenue – Costs That Were Avoided = Lost Profits
There are all sorts of external factors that can affect the calculation of damages. That’s why lost profits claims are incredibly difficult to prove. It requires a large amount of documentation evidence and expert analyses. The two most popular methods experts will use to calculate damages are explained below.
Note: Even if the business loses money, it could still have a claim for lost profits.
Before and After
The Before and After method compares the claimant’s profitability before and after the alleged wrongdoing. This gives a court a baseline for profitability, which helps to estimate what profits would have been generated if the wrongful act had not occurred. A before and after approach will also take into account any market trends or other factors that may require adjustments to the estimate. Given its simplicity, this is one of the most widely used methods of calculating lost profit damages.
The “yardstick method” is a comparative analysis used to calculate damages. Under this approach, an expert will compare the profitability and earnings of other companies in the industry. They’ll even look at specifics – like contracting for similar work and working in a similar geographic region. Calculating lost profits using this method is based on the assumption that the damaged company would have performed comparably to other businesses if not for the damaging event.
The yardstick method is typically used when there isn’t a reliable track record for profitability. However, using this method has its own challenges. It’s incredibly fact-intensive and requires expert calculations, market research, knowledge of industry trends, and more.
A Problem for New Businesses
What if you’re trying to argue that a new business lost profits? Based on the Before and After method described above, it’d be impossible to show earlier profits. Honestly, when a business doesn’t have an established track record, it can be hard to adopt the Yardstick method, too – there’s no way to show the business would be successful! What’s more, the impact of lost profits is profoundly more impactful than lost profits for an established business.
That’s what’s referred to as the “New Business Problem”. In the past, arguing that it’s impossible to calculate lost profits to a reasonable certainty actually barred some lost profits claims.
Lately, however, courts have been reluctant to let this “New Business Problem” stop lost profits claims. Of course, proving lost profits may be a little harder – and that’s probably fair. Be sure you know how your jurisdiction treats new businesses for lost profit claims.
Bottom Line: Proving Lost Profits Can Get Complicated
When a construction payment dispute erupts, suddenly, everyone involved becomes a lawyer. Legal terms get tossed around, and naturally, everyone assumes their opinion is right. In these situations, it’s easy to think that a construction business will be entitled to whatever profits they lose – but successfully recovering lost profits is an uphill battle. It’s important to understand potential remedies when planning for your construction business, and that means it’s important to understand the realities of claiming lost profits. At the end of the day, there are typically other (and better!) options for recovering payment.