FORUM: Quantifying damages in international arbitration

December 2018 | SPECIAL REPORT: INTERNATIONAL DISPUTE RESOLUTION

Financier Worldwide Magazine

December 2018 Issue

FW moderates a discussion on quantifying damages in international arbitration between Simon Braithwaite, Yusuf Abdoollah, Javier Espel, Andy Cottle and Gervase MacGregor at BDO.

FW: Could you outline some of the key challenges involved in defining, assessing and quantifying damages in international arbitration?

Braithwaite: In relation to construction damages calculation, there are numerous types of damages to be assessed, such as delay damages, productivity damages and disputes extra work. Some less sophisticated methodologies used in some jurisdictions may not be considered sufficient. There is often a lack of consistency with the information experts may rely upon, even if they are provided with the same information through discovery. Experts from different jurisdictions may also interpret their obligations differently.

Cottle: The reluctance of tribunals to order appropriate disclosure often hampers the ability of claimants to pursue meaningful claims, particularly where the respondent has control of the asset or business. Inexperienced parties often fail to understand the dispute resolution process and have unrealistic expectations of the likely damages.

Espel: First of all, it is important to highlight that the process will entirely depend on the specific sector and context in which you have to address a damages quantification. For example, the approach will vary whether the quantification refers to a regulated or a free market or you need to quantify damages in an intensive, upfront capex investment, for example. In any case, the key point when defining the approach for quantifying damages is having a deep understanding of the context in which you have to quantify and identify the main issues around the exercise. Obviously, a strong theoretical experience and knowledge are essential when quantifying damages in complex international arbitrations.

Abdoollah: There are three main challenges. First, evidencing the contractual breaches, which often depends on the knowledge and intentions of the parties involved. Second, consistency between the data provided to experts and the terms of the sale and purchase agreement (SPA). Third, accounting terms can be interpreted differently.

MacGregor: The quantum expert needs to have a strong understanding of the legal framework underlying the case, as this affects the damages calculation and what can actually be claimed. For example, a decision is needed on whether the damages should be based on the net present value of the future cash flows, or on the loss of profits.

“A party may realise early on that it really is not able to substantiate a case for losses at all. Alternatively, it may realise that its case is too weak for it to be financially worthwhile bringing a case.”

— Gervase MacGregor

FW: Could you highlight any recent cases which exemplify the difficulties involved in quantifying damages? What lessons can parties take from these cases?

Espel: We have seen several recent cases where it was discussed whether or not the risk profile of the actual and but-for scenarios and, therefore, the discount rates for each scenario were the same. Discount rate calculation is always a key issue when quantifying damages and even more if the risk profile of the different scenarios is affected by different elements, resulting in different discount rates. The conclusion is that the complexity of quantifying damages requires a very deep analysis of all the different economic, financial or legal elements that are involved in the claim, especially when drawing on hypotheticals.

Abdoollah: In Pope & Talbot Inc v. Canada, the tribunal denied a claim for the cost of management time devoted to the claim on the basis that the management were paid annual salaries that “did not vary in respect of the issue or matters to which each of them devoted his or her working time” and “would have been paid no matter what work related activities those managers undertook”. By contrast, in Pegler v. Wang, a case in the English High Court relating to a failed IT system implementation, the claimant was successful in recovering wasted management time. Pegler claimed £1m in respect of time spent investigating and installing additional hardware and software to remedy some of Wang’s breaches, and investigating an integrated replacement system. The judge allowed half of the amount claimed, taking what he described as “a broad-brush approach”, despite a lack of detailed records. This appears to have been awarded on the basis that the time was diverted from the managers’ proper job of managing the company and that this represented a loss.

Braithwaite: Experts are often requested to meet and try to reach agreements on issues such as facts and figures. Sometimes an expert may be reluctant to take part in this process, as they may see it as undermining their opinions and evidence. It may also be seen as one expert challenging the other. This process should be seen by the experts as a part of the process, per an instruction by the tribunal. In an effort to narrow the differences of opinion, this process is a positive for both the clients and the arbitration process.

“A realistic assessment of the loss should enhance the prospects of achieving a settlement through mediation.”

— Andy Cottle

FW: In what ways can the early calculation of damages affect a party’s approach to international arbitration?

Cottle: An early heads up on the likely quantum of damages permits a party to focus effort on those heads of claim that are likely to offer a realistic prospect of a yielding a favourable award, and to drop those heads of claim that are too speculative or are unlikely to have sufficient corroborative evidence. A realistic assessment of the loss should enhance the prospects of achieving a settlement through mediation.

Espel: Obviously, an early calculation of damages will give the potential claimant enough information to decide whether it is worth initiating legal process which will require a large investment of time and money. This early calculation will indicate whether it is worth commencing an international arbitration case or not. It is sometimes also important to seek an expert opinion in a pre-litigation context, for this early calculation of damages, in order to collect essential information for a potential arbitration or to make appropriate decisions that may be useful in the potential arbitration.

Abdoollah: Bringing a financial expert on board early – ideally with some experience in transaction advisory and financial due diligence – assists in identifying gaps and inconsistencies in the data, gives an independent perspective on the financial consequences of any breach and may even assist with the legal strategy and costs of the dispute resolution process.

Braithwaite: The early appointment of an expert is key to both the position of a party and the outcome of an arbitration proceeding. The early appointment of an expert allows the expert to provide advice on issues regarding documentation to be relied upon, inconsistencies with any data provided and interviewing fact witnesses. The late appointment of an expert witness may result in an unreliable analysis that may not be completely based on reliable factual information, rather an expert opinion based on assumptions.

MacGregor: A party may realise early on that it really is not able to substantiate a case for losses at all. Alternatively, it may realise that its case is too weak for it to be financially worthwhile bringing a case. It may also be necessary to calculate damages early on in order to calculate the amount of the fees to be paid to the arbitrators or the fee to the arbitral institution, in cases where fees are based on the amount of the claim.

“Sometimes expert reports are difficult to follow even for another expert. Robustness, clarity and the ability to convey findings to a tribunal can be advantageous in the process.”

— Javier Espel

FW: What methods and frameworks are popular when quantifying damages? What steps should parties take to ensure they reach a figure that is logical, justifiable and defendable?

MacGregor: The basic framework used in quantifying damages is the counterfactual or ‘but for’ framework, in which the damages are equal to the difference between what would have happened but for the intervening event which gave rise to the claim and what actually happened. When damages are based on the valuation of the company in question, the standard methods of calculating the fair market value are based on the net present value of the company’s future cash flows, comparison with other comparable companies or transactions and the net asset value of the company.

Cottle: All too often, the underlying forecasts used in a DCF approach are not sufficiently robust and experts are often guilty of benchmarking, using inappropriate comparable companies to derive a beta, or using small company and country risk premiums in a cavalier manner, resulting in spurious accuracy.

Abdoollah: The most popular methods are the income discounted cash flow, or DCF approach, the market earnings approach and the net assets approach. With regard to the most logical method, this should be decided on a case by case basis. Where a claimant has lost all its business, such as in an expropriation, the normal method of valuation is the fair market value of the business immediately before the expropriation, which is normally calculated using the income, market or assets approaches.

Braithwaite: There are various types of damages, such as productivity damages. There are a few methods of measuring productivity and calculating damages, and some methods are more realistic and reliable than others. The most reliable and accepted method is the measured mile. The measured mile is the most reliable approach because it is based on actual events and impacts. It therefore provides a comparison of unimpacted productivity, where the work is similar in nature, under similar conditions with the same labour and on the same project as the work that is experiencing an impact to productivity. A good example is pipework on a refinery project, where two pieces of the same equipment are being analysed – one impacted and the other unimpacted. To ensure this evidence is defendable, the expert should demonstrate that the methodology is reasonable by showing that the work is the same or similar, the labour used is the same and the conditions of installation are the same. The cause of the loss of productivity should then be shown along with its impact on productivity.

Espel: The most appropriate methodology will vary depending of the damages you are calculating. DCF methodology to estimate present values of future cash flows in different scenarios is commonly used in order to quantify damages. However, a DCF methodology has shortcomings, as the inputs used in the methodology are sometimes subjective and may result in different or unreasonable figures, especially when forecasting long periods. Thus, it is imperative to use and cross-check the inputs and results obtained from a specific methodology with alternative methods, in order to ensure the DCF’s figures are logical, which will also let you fine-tune the inputs to produce solid results. Cost based and market comparable methods are also very popular methods to quantify damages. We always recommend not using any methodology in isolation and adopting as many cross-checks as possible.

FW: In your opinion, how important is it to engage external experts to calculate damages or at least offer an opinion? What are the benefits of doing so?

Abdoollah: We have seen numerous cases where SPAs have failed to define a clear hierarchy between the terms of the SPA, consistent with prior practice and accepted accounting principles. This is common when financial experts were not involved in drafting the terms.

Espel: Quantifying damages is a very complex matter that requires the involvement of external experts. When a company understands that it has suffered damages from a third-party’s conduct and decides to initiate an international arbitration, quantification should be made by an experienced expert; otherwise it will rarely result in reasonable or robust figures, and the tribunal will not give credibility to the amount claimed. A tribunal will rely on expert evidence and opinion when quantifying damages. Therefore, we always recommend using economic experts when quantifying damages.

Braithwaite: The use of an external expert to provide damages calculation or an opinion is often a vital part of the resolution process. An expert witness not only provides opinion to the tribunal, but also to the engaging legal representation. Reliance on a fact witness can often be damaging to a case, as such a witness potentially has a biased view of events which may influence the calculation and assessment of damages. An expert witness has a duty to the tribunal and will provide independent expert evidence and quantification of damages. Therefore, the main benefits of an expert witness are the impartial assessment of damages and their experience in presenting their findings and opinions to a tribunal.

Cottle: Inexperienced parties with a vested interest in the case are frequently incapable of being realistic or objective regarding the merits of the claim or the quantum of the damages. An external expert should assist parties and their legal advisers to assess the merits and quantum of a claim, and identify what should be sought or provided by the disclosure process.

MacGregor: The major advantage of engaging external experts is that the experts are experienced in the arbitral process and will be aware of some of the issues that need to be considered in every case – such as the accuracy of forecasting and mitigation and the standard valuation methods of DCF, comparable companies or net assets. The other major reason for engaging external experts is their independence – which will be very important to arbitrators in an era where the independence of arbitrators is being increasingly challenged. An external expert is also likely to be valuable to the parties, because their own internal accountants may not be aware of the issues which commonly arise in international arbitrations.

“One can expect to see more use of stochastic approaches like the Monte Carlo method in damages.”

— Yusuf Abdoollah

FW: To what extent are you seeing greater use of technology to assist and expedite the process of calculating damages?

Braithwaite: Computer technology has provided great support to damages assessment, particularly to the construction industry. Advances in software to present evidence related to construction projects, along with events that may have caused delay and damages, have somewhat streamlined the process of preparing and presenting evidence. Graphical presentations have become much more sophisticated over the past 15 years.

MacGregor: Predictive coding is the main technology which is transforming international arbitration, in terms of the ability to efficiently locate relevant documents for use in the quantum aspects of the case, as well as the liability and facts aspects.

Abdoollah: Spreadsheets have traditionally been used in the valuation of damages and I cannot see this being replaced in the near future.

Cottle: Technology permits tasks to be performed that would otherwise be simply uneconomic and permits experts to evaluate large data sets that are increasingly common among parties to even the most basic of disputes. E-disclosure, data mining techniques and the hosting of virtual data rooms mean that work can increasingly be undertaken remotely from the jurisdiction in which parties are located, improving efficiency and expediting the process.

Espel: I do not see any greater use of technology to expedite the process of quantifying damages. So many variables are generally involved when calculating damages that the reasoning of the expert is essential. However, in some instances where massive volumes of information need to be analysed in order to quantify damages, it may require the use of technology.

FW: To what extent might quantified damages alter post-decision? What factors could influence the recalculation of an arbitral award?

Espel: In our experience, clerical errors would lead to recalculation of an arbitral award. If a tribunal finds the existence of liability, damages finally awarded to the claimant usually differ from what is originally calculated by the parties. The new calculation made by the tribunal in a complex economic environment can sometimes result in an error in the damages awarded, leading to a recalculation. It is important to differentiate between clerical errors and specific methodology adopted by a tribunal. The award may not be fully aligned with the methodology adopted, but this will rarely lead to recalculating damages.

MacGregor: Damages calculations are all based on certain assumptions. As the arbitral tribunal makes decisions in its award on each of those assumptions, this will inevitably affect the damages award itself. In at least one case we have seen, the arbitral tribunal made its decision on all the facts and assumptions by way of partial award, and then remitted the calculation back to the experts for them to assist with calculating the final award.

“The main benefits of an expert witness are the impartial assessment of damages and their experience in presenting their findings and opinions to a tribunal.”

— Simon Braithwaite

FW: Looking ahead, how do you envisage the damages quantification process evolving for future international arbitration cases? To what extent do you expect methods and accuracy to improve?

Cotttle: Increasing use of technology is a given, but I do not expect methods and accuracy to improve to any significant degree, as all too often the key issues are what the counterfactual future position would look like, and those are invariably subjective. The evidential gaps that often hinder truly accurate assessments of damages are likely to remain as long as parties continue to enter into commercial relationships with some sense of blind optimism and fail to document the basic commercial factors that determine the success or failure of a business opportunity or contractual arrangement.

Abdoollah: With low-cost add-ins increasingly available for spreadsheets, laptops have a powerful means of crunching vast amounts of data in stochastic approaches that attempt to model more accurately the effects of uncertainty. One can expect to see more use of stochastic approaches like the Monte Carlo method in damages.

Braithwaite: I can see the process becoming more streamlined and efficient. There is an increase in expert support globally, with firms having offices around the world, working on engagements around the clock.

Espel: I do not expect important changes to the quantification process, as today it is quite sophisticated. I would expect a simplification of the process in order to show a tribunal what the methodology, inputs and calculations are. Sometimes expert reports are difficult to follow even for another expert. Robustness, clarity and the ability to convey findings to a tribunal can be advantageous in the process.

MacGregor: Many of us are waiting to see the app that has been developed by the International Council for Commercial Arbitration (ICCA) and American Society of International Law (ASIL) working group on damages. The idea behind the app is to help arbitrators and lawyers to approach the quantification of damages in a logical and structured way.

Simon Braithwaite is a director in BDO’s construction & environmental advisory practice, where he provides advisory services for construction, engineering and infrastructure projects in trouble or dispute. Mr Braithwaite serves domestic, international, public and private clients, drawing on more than 15 years’ of professional experience in construction consulting, claims and disputes related to delay, disruption, productivity and damages. He can be contacted on +1 (212) 817 1734 or by email: sbraithwaite@bdo.com.

Yusuf Abdoollah joined BDO in Mauritius after having spent 17 years in the US and Europe. He has been involved in several major international financial investigations and other assignments, such as insurance investigations, breach of contract, loss of profits and compliance audits, including anti-money laundering audits. Mr Abdoollah regularly lectures on forensic investigations, and methods to prevent and detect fraud to auditors and government officials in Africa. He can be contacted on +230 202 9658 or by email: yusuf.abdoollah@bdo.mu.

Javier Espel is the lead partner for the forensic practice at BDO Spain. He has delivered forensic services over the last 18 years. Mr Espel has acted as expert witness in a wide range of legal proceedings and has given evidence in national and international arbitration procedures, including Spanish Arbitration Courts, the International Centre for Settlement of Investment Disputes (ICSID) and the International Chamber of Commerce (ICC). He can be contacted on +34 917 022 212 or by email: javier.espel@bdo.es.

Andy Cottle is a partner in the forensic accounting department of BDO and has over 20 years’ experience in expert witness and dispute advisory work across a wide range of cases and sectors, ranging from long-running, multi-party disputes down to single issue accounting determinations. He has given expert testimony on more than 20 occasions in court and arbitration hearings in Europe, the Middle East and the US. He can be contacted on +44 (0)20 7893 2699 or by email: andy.cottle@bdo.co.uk.

Gervase MacGregor is a partner in the forensic accounting department of BDO, and is one of the most experienced accounting expert witnesses in the UK, with extensive experience of both High Court litigation and international arbitration. He has acted as expert witness in hundreds of disputes and has given oral evidence 55 times. He has extensive experience of damages quantification and business valuation and has given evidence on the calculation of cash flows and discount rates. He can be contacted on +44 (0)20 7486 5888 or by email: gervase.macgregor@bdo.co.uk.

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