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The 2 P's of Disaster Planning- Part 2: Preparing for Business Continuation and Business Interruption Claims
Frank Rudewicz October 9, 2007 — 1,401 views
The crisis response plan should continue with the development of policies and procedures for business continuation and restoration of each department in the event of a disaster. A determination should also be made for the records that are needed to submit a claim for business interruption insurance, procedures for obtaining this information, and designation of persons responsible for retaining this information off-site and contacting the appropriate parties in the event of a disaster.
Civil litigation frequently sees claims for recovery of damages arising from business interruption. Generally, the courts have defined these damages to be the lost profits of the business during the period of interruption. If the business has been destroyed by the interruption, then the damage is typically the value of the business on the eve of the event causing the destruction (unless, of course, the ultimate destruction was the result of some cumulative event whose effects on profits can be traced to an earlier date).
Many businesses, if not most, are insured for business interruption losses and can look to their insurer for timely relief. The insurer, in turn, will subrogate the claim and bring an action against the party or parties allegedly responsible for the interruption. However, when the loss arises from a natural disaster the insurer must absorb the loss itself. In these instances the insurer and the insured may be at odds (as opposed to a defendant and the insured) with respect to what each believe the amount of the loss or coverage to be, and litigation will follow.
For example, one needs only to look at the massive amount of litigation in Florida, Alabama, Mississippi, Louisiana, and Texas following hurricanes Katrina and Rita. In many instances of lost profits arising from business interruption, the event causing the interruption will have been cured by the time the action finally makes it to court or the settlement negotiations. In these instances, a methodology commonly utilized to calculate the injured business’s lost profits is referred to as the before and after method. Assuming that sales and associated expenses before and after the damaging event are both comparable (or can be adjusted to be comparable) and measurable, the profits arising during “before” and “after” periods of time that are as equal as possible to the length of the damage period are analyzed. This analysis results in a projection of what profits should have been during the damage period. This value is compared to the actual profits during the damage period and the difference, if any, is assumed to be the “lost profits” but for the actions of defendant. (The actual calculations and analysis are hardly this simple, but are beyond the scope of our short discussion here. Also, seasonality and other issues must be addressed as well in insuring comparability of the “before” and “after” periods.) But what is the measure of profits if the “after” period will bear no resemblance to the “before” period?
Many businesses affected by Katrina and Rita have had their markets and supply infrastructure impacted as well as their direct business activities. It may be months or years, or not ever, before these businesses will look, feel, and operate as they did before these two, devastating storms. Another commonly accepted method of estimating lost profits when the before and after method is not suitable is the “projected sales method” (sometimes referred to as the “but for” method). This method is more commonly seen when the damaging event is incurable, not yet cured, or a “more precise estimation of the revenues lost by the plaintiff” 1 are needed. This method generally utilizes more sophisticated econometric modeling, and often involves extensive evaluation of the market, suppliers, competitors, political, and economic events that may affect the future of the plaintiff. Again, however, if the same event(s) that have caused plaintiff’s loss have also affected these elements, this method may not be appropriate. Other acceptable methodologies must be employed.
A third commonly accepted method, and applicable in this scenario, is referred to as the yardstick method. The yardstick method looks to the plaintiff’s industry, or another group of comparable businesses. The analysis assumes that but for the damaging event plaintiff would have enjoyed growth in sales within the same reasonable range as that enjoyed by its peers. Its expenses would have grown commensurate with its growth in sales (for those expenses associated directly with sales), been impacted by regional and national inflationary factors, and enjoyed the efficiencies associated with economies of scale (relative to those expenses relatively “fixed” in nature or benefiting from learning curve phenomena). Significant amounts of research are required to understand the particular niche and markets of the industry within which plaintiff actually operated. Further, careful analysis of plaintiff’s historical cost structure and business/ marketing plans actually in place at the time of the damaging event must be performed. Many insured and/or plaintiffs may find this a daunting task if their business records have been destroyed. Nevertheless, every effort must be made to establish a foundation from which a supportable claim can be made. Federal and state income tax returns can be retrieved from taxing authorities to analyze both revenues and expenses. Bank deposit records can be recovered from banks to establish sales patterns. Tangible property tax returns can be obtained to reconstruct, at least partially, the type and age of fixed assets owned by the business. Creditors and vendors can also be queried in an effort to reconstruct purchasing patterns. To attempt an opinion with respect to an estimate of loss with no reference to business records at all is an untenable position.
The following cases are but just a few that have rejected such opinion as being without foundation: Helena Chemical Co. v. Wilkins, 47 S.W.3d 486 (Tex. 2001); Wasco, Inc. v. Economic Development Unit, Inc., 461 So. 2d 1055 (La. App 1984) writ denied, 456 So. 2d 738 (La. 1985); Evergreen Farms v. First National Bank & Trust Co., 250 Neb. 860, 553 N.W.2d 728 (1996); and Racicky v. Farmland Industries, Inc., 328 F.3d 389 (8th Cir. 2003).
What do you do if the business has been totally destroyed? How do you prepare for the amount of lost profits to be sought in these instances? Generally accepted business valuation theory holds that the value of a business is equal to the discounted value of its future earnings (i.e., profits) plus a “terminal value” (an estimate of the value at which the business would ultimately be sold at some date in the future). And, indeed, the courts have recognized this as well: Sostchin v. Doll Enterprises, Inc., 847 So. 2d 1123 (Fl. App. 2003), review denied, 860 So. 2d 977 (Fl. 2003), “business that is destroyed cannot recover both [emphasis added] the value of the business and lost profits”2. Other recent cases in venues impacted by the hurricanes include:Fishbones, Inc. v. Southern Boat Service of Louisiana, Inc., 849 So. 2d 803 (La. App. 2003), “no business in addition to recovery of value of ship that was completely destroyed as recovery of the value of the ship compensates all other losses”3; and City of San Antonio v.Guidry, 801 S.W.2d 142 (TX App. 1990).
Appropriate recoveries can be obtained, reasonable settlements reached, and claims properly paid when preparatory initiatives have been thought out and implemented. To reach these goals requires careful and thorough analysis, application of the methodology appropriate to the facts and circumstances, and trained and experienced financial professionals. As the losses from Rita and Katrina mount into the billions of dollars, litigation and the need for supportable estimates of the business lost profits and the values of businesses totally destroyed will explode.
Please go to the industry reports section of CPA-Resource.com to view "The 2 P's of Disaster Planning: When You Can't Prevent, You Must Prepare" in its entirety.
Frank E. Rudewicz serves as Principal and Counsel of Marcum LLP and heads the Forensic, Investigative and Valuation Advisory practice for the New England area. He has more than 26 years experience conducting domestic and international investigations for anti-trust/anti-competitive issues, harassment, fraud, ethics and other employment related conduct.