Hindsight in Commercial Damages Analysis

Journal of Legal Economics, Mar 2008 by Bowles, Tyler J

Abstract Whether hindsight should and can be used in commercial damage calculations presents an interesting question from both an economic and legal perspective. A strong economic argument can be made that given certain restrictive assumptions hindsight should be ignored. Courts, however, appear rather eclectic in allowing damage calculations based on hindsight. This paper shows that in a model characterized by efficient markets hindsight results in overcompensation of the plaintiff. In a two-state model characterized by positive expected economic profits and litigation costs, however, hindsight can work for or against the plaintiff. It is shown that the advantage, if any, that hindsight provides the plaintiff is inversely related to litigation costs and the magnitude of expected economic profits, and directly related to the probability of the negative economic outcome and the absolute size of this negative outcome.

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Introduction

Among the many subtleties involved in estimating damages in commercial litigation, whether to apply hindsight presents a particularly interesting legal and economic question. From an economic perspective, should information that becomes available after the date of the alleged harm (e.g., firm-specific actual cash flows) be used in the damage calculation? Also, does legal theory support the use of hindsight? Let us motivate this issue with the following stylized example.

Assume that at time t = 0, firm A contracts to purchase asset X (or, equivalently, to engage in activity X) for price B. Restricting ourselves to a two state world, assume that at time t = 1 the value of X is V^sub 1^ should state 1 occur or V^sub 2^ should state 2 occur. Now assume that this opportunity was foreclosed to A at time t=1. If hindsight or ex post information (these two terms will be used interchangeably in this paper) is not allowed, damages are D =α^sub 1^V^sub 1^ α^sub 2^V^sub 2^ - B, whereα^sub 1^ andα^sub 2^ are the probabilities of states 1 and 2, respectively. (To focus on the issue of hindsight, the time-value of money is being ignored.) If hindsight is allowed, damages are either D^sub 1^ = V^sub 1^ - B or D^sub 2^ = V^sub 2^ - B. Which is the proper measure of damages?

Given the time that may have elapsed between the incident date and the trial date and the corresponding number of uncertainties that may be resolved, this is not a trivial issue. The current article was motivated by the author's involvement as the plaintiff's expert in a case where the initial incident occurred in 1986 and the trial ultimately was scheduled for January 2006. Whether to use hindsight in the damage calculation was a significant legal and economic question in that case. This paper focuses on this issue and is organized as follows: Section two reviews the economic literature on the topic. Although there remains differences of opinion, Patell et al. (1982) make a strong theoretical argument that hindsight should be ignored in commercial damage appraisals. Section three provides a review of legal opinions and analysis concerning the issue of hindsight. Courts appear willing to accept, and perhaps prefer, damages analysis based on ex post data as it is correctly perceived as less speculative compared to analysis based on ex ante information. Courts appear unaware or unimpressed with the economic arguments against the use of hindsight. This disagreement between economic analysis and legal theory regarding hindsight motivates section four, which discusses the error, defined as the difference between ex ante and ex post damages, and the determinants of the magnitude of this error. Section five provides a discussion of the use of hindsight from a public policy perspective. Section six contains a summary and conclusions.

Background and Previous Research

Patell et al. (1982) provide a useful conceptual framework to approach the question of the appropriateness of using hindsight. Their focus was on the correct interest rate to apply to past damages. They viewed the plaintiff on the date of the harm as exchanging rights to pursue a risky project for the right to seek compensation to damages through the courts. By assuming the court will not err in assessing liability and that a complete and perfect market exists for damage claims, these authors concluded that the correct prejudgment interest rate is the defendant's interest rate on debt. This conclusion follows from the fact that given the assumptions noted above, the damage claim has the characteristics of a promissory note issued by the defendant.

A significant contribution of Patell et al. was their focus on pre- and post-harm claims or "securities" owned by the plaintiff and the associated risk profile of each claim. Within this framework, they also addressed the issue of hindsight. To illustrate their conclusion, consider the example presented in Table 1, which is adapted from Patell et al.

As cash flows are presented for all states, the market value of the project at T = 0 is calculated based on the riskless discount rate, which is 11.11%. The riskless rate is 11.11% since at T = 0 one can purchase the right to $1.00 at T = 1 for $0.90, regardless of which state of the world occurs. Therefore, the market value of this project at T = 0 is $675 (i.e., $675 = [0.5(-$500) (0.5) ($2,000)]/1.11 = 0.45 (-$500) 0.45($2,000)), and the expected payoff at T = 1 is $750 (i.e., $750 = 0.5 (-$500) 0.5 ($2,000)). Assume that at T = 0, the plaintiff exchanges the rights to pursue the risky project for the right to demand $750 from the defendant at T = 1. If there is no risk of defendant default, a risk neutral1 plaintiff would be indifferent between these two securities, which implies that T = 0 damages (i.e., $675) should be accumulated at 11.11% (i.e., defendant's debt rate). If there is a risk of defendant default, the plaintiff would not be indifferent between the project and a $750 claim on the defendant. Indifference would require a higher promised payment from the defendant, which implies a higher prejudgment interest rate.