Page 44 - Economic Damage Calculations

Chapter 7

Example Case Law

Courts have reached varying conclusions on the application of discount rates in damages analyses. Some
rulings have required the inclusion of a risk component in the determination of a discount rate, while
other rulings have called for the use of a risk-free rate. The following discussion summarizes several
cases that deal with the determination of an appropriate discount rate. The cases described in this chapter
do not constitute an exhaustive list on this topic. Many cases involving discount rates are not appealed or
published, or they are settled by the parties prior to appeal. Finally, jurisdictional considerations of these
issues may differ widely due to precedent or specific statutes.

Experts should consider visiting the AICPA’s website for information regarding any additions or up-
dates to the case law discussed in this chapter.

A Comprehensive Illustration of the Diversity in Case Law

Energy Capital Corp. v. United States, 302 F.3d 1314 (Fed. Cir. 2002)

This case provides insight into the ambiguity in the case law regarding the issue of discount rates in a
damages computation. It includes many of the elements presented in this practice aid: the adoption of a
risk-free rate by the trial court despite risk-adjusted rates presented by experts for both the plaintiff and
defendant, the rejection by the appeals court of the risk-free rate, as well as an the high alternative dis-
count rate put forth by the defendant’s expert, and ultimately the acceptance by both courts of a risk-
adjusted discount rate.

Under a 1996 agreement between Energy Capital and the Federal Housing Administration, Energy Capi-
tal anticipated that it would originate loans to owners of U.S. Department of Housing and Urban Devel-
opment (HUD) properties for 3 years or until a cap of $200 million in loan originations was reached.
Approximately 5½ months after the agreement was signed, The Wall Street Journal reported that Energy
Capital had received the agreement in return for significant fund-raising efforts for President Clinton. A
few days later, HUD terminated the agreement before Energy Capital had originated any loans.

Energy Capital filed a complaint for breach of contract in the Court of Federal Claims in April 1997.
The government conceded liability, and in a damages trial the court found that Energy Capital would
have originated the maximum amount of $200 million in loans. The court determined that lost profits
were $12,111,000, to be earned over 12 years. At trial, both Energy Capital’s and the government’s
damages experts used risk-adjusted rates to compute damages. Energy Capital’s damages expert testified
that the most appropriate risk-adjusted rate was based on the average rate of return on mortgage real es-
tate investment trusts, approximately 8.5 percent. Energy Capital’s damages expert then added 2 percent
to account for "debt and profit components," which yielded a discount rate of 10.5 percent. The govern-
ment’s damages expert opined that a 25 percent discount rate was appropriate. The court, however, ap-
peared to disagree and discounted lost profits at a risk-free rate of 5.9 percent, arriving at $10,082,000.

The government appealed the decision, stating that (1) lost profits should not be awarded to a new ven-
ture; (2) Energy Capital would not have realized profits from the agreement; and (3) damages should not
be discounted using a risk-free rate and should be discounted back to the date of the breach. The appeals
court found that the trial court did not err either in its determination of lost profits or by discounting lost

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