Pay Me What I Would Have Earned: The Impact Of COVID-19 Shutdowns On The Legal Measurement Of Future Lost Profits
As New York State moves forward with its phased reopening and the state and federal courts resume more regular activity, current commercial litigants or parties contemplating litigation may be curious about how the economic fallout from COVID-19 might impact claims for lost profits, particularly where the underlying breach of contract or tort occurred before the pandemic arose. Prior to March 2020, a claimant seeking damages in the form of lost profits or expected future earnings likely would have believed that its business and revenues would follow a predictable forecast. But adverse parties may argue that expectation damages must now take into account the claimant’s future profits or expected earnings in the context of the COVID-19 pandemic, which will likely be considerably lower than at the time the claim was first brought.
State or Federal courts have yet to directly answer this question, but well-established jurisprudence strongly suggests that defendants cannot capitalize on the actual economic impact of COVID-19 on a plaintiff’s business to alter damages calculations for expected lost profits or future earnings arising from claims accruing before the pandemic.
Lost Profits Based on Breach of Contract
Under New York law, contract damages are measured at the time of the breach. “Loss of future profits as damages for breach of contract [has] been permitted in New York under long-established and precise rules of law.” Kenford Co., Inc. v. County of Erie, 67 N.Y.2d 257, 261 (1986). As a general corollary to this rule, the Second Circuit has held that “events subsequent to the breach, viewed in hindsight, may neither offset nor enhance . . . general damages.” Merrill Lynch & Co. v. Allegheny Energy, Inc., 500 F.3d 171, 185 (2d Cir. 2007). In so ruling, the court determined that the district court’s consideration of market conditions, which included the 2001 fall of Enron, in measuring damages was “improper.” Id; see also Oscar Gruss & Son, Inc. v. Hollander, 337 F.3d 186, 196 (2d Cir.90 2003) (“New York courts have rejected awards based on what ‘the actual economic conditions and performance’ where in light of hindsight.” (quoting Aroneck v. Atkin, 90 A.D.2d 966 (4th Dep’t 1982)); Coventry Enterprises LLC v. Sanomedics International Holdings, Inc., 191 F.Supp.3d 312, 321 n. 11 (S.D.N.Y. 2016) (similar).
In light of these decisions, it is also likely that a court will reject a defendant’s attempt to invalidate a liquidated damages provision as an unenforceable penalty based on changed market conditions arising from the pandemic. As with many jurisdictions, New York law requires a party seeking to enforce a contractual liquidated damages provision to show that at the time the agreement was executed, (1) the harm caused by the anticipated breach was incapable or difficult to estimate, and (2) the amount of liquidated damages was a reasonable forecast of just compensation. Since New York courts do not generally consider post-breach market conditions—and in the context of liquidated damages, post-execution market conditions—there is reason to believe that COVID-19 will not impact the enforceability of liquidated damages provisions entered into before the pandemic occurred. Thus, even if a claimant’s expected revenues and profits drop precipitously as a result of the pandemic, courts are unlikely to disturb private parties’ contractual liquidated damages provision. Naturally, however, this is an area of law that could change and develop as courts begin to face disputes over the reasonableness of liquidated damages in the context of a COVID-19 world. The MHH COVID Litigation Task Force will stay abreast of any such developments and report them on this blog.
Lost Profits for Business Interruption Under Insurance Law
Significantly, New York’s rule that post-breach market conditions do not impair lost profit damages calculations could conceivably have applications beyond contract law. For insurance coverage purposes, business interruption losses are generally calculated by measuring the profits a business would have earned had certain regional or global catastrophic events not occurred. This rule—adopted in many jurisdictions beyond New York—has been applied most commonly in the context of industries that have suffered business interruption as a result of hurricanes. For instance, in Catlin v. Syndicate Ltd. v. Imperial Palace of Mississippi, Inc., the Fifth Circuit, applying Mississippi law, held that “business-interruption loss will be based on historical sales figures, and that we should not look prospectively to what occurred after the loss.” 600 F.3d 511, 516 (5th Cir. 2010). In Catlin, the interruption was caused by Hurricane Katrina, and importantly the court stuck to this profit measurement rule even where the hotel’s actual profits upon its eventual re-opening were higher than its historical averages. Id.
Similarly, the Fourth Circuit, applying South Carolina law, ruled that a business interruption loss clause in a policy held by a hotel did in fact include lost profits the insured would have received had Hurricane Hugo not shuttered the business. Prudential LMI Commercial v. Collection Enterprises, Inc., 976 F.2d 727 (4th Cir. 1992). In Prudential, the Fourth Circuit was swayed by the fact that the policy in question explicitly stated that coverage would apply to “the earnings of the business before the date of damage or destruction and to the probable earnings thereafter, had no loss occurred.” Id. at *3. Irrespective of this express language, the Prudential court recognized that this coverage rule “is the proper measure of business interruption coverage in any case.” Id. Nonetheless, it is important for policy holders to examine the business interruption loss clauses carefully to examine whether the language conflicts with this default interpretation embraced by many jurisdictions.
Whether a business is seeking to recover lost profits in litigation as a result of a breach of contract or through an insurance policy’s business interruption loss provision, courts will likely look to the business’s historical performance before the disrupting event occurred. In the context of the present pandemic, that means businesses should exercise diligence in retaining data and documentation reflecting their revenues and profits before COVID-19. As the Fourth Circuit explained, “the strongest and most reliable evidence of what the business ‘would have done’ is likely to be what it ‘had been doing’ in the period just before an interruption. Not only [does] this [have] obvious probative force, but this information is likely always to be readily accessible and verifiable.” Prudential, 976 F.2d at *3.
While COVID-19’s impact on the economy and businesses has been severe, applicable case law suggests that New York courts and Federal courts will likely decline to use pandemic-impacted market conditions to measure lost profits or earnings damages for pre-pandemic breaches of contract, or pandemic-caused business interruption losses in the insurance coverage context. Conversely, if your business has seen increased profits during COVID-19, this will not likely increase your damages for lost profits on a claim arising before the pandemic.
We are available to advise you on COVID-19 litigation related issues. For more information contact either James P. Chou at email@example.com or (212) 239-5523 or Alex D. Corey at firstname.lastname@example.org or (646) 880-5327.