Demystifying the damages assessment in international arbitration (2024)

This chapter summarises key economic considerations when deriving a proper assessment of damages, and provides a corresponding checklist for arbitrators. The objective is to demystify the damages analysis, thereby easing the burden on arbitrators who must evaluate whether the damages estimates presented by the parties are reasonably accurate reflections of economic damage suffered by the claimant.

Introduction

Damages analyses have become increasingly complex and will become even more complex as disputes arise in new areas including climate change, human rights, seabed and space mining, and satellite constellations. Damages experts have to adapt their assessments to the continuously evolving nature of these topics and must be able to present their analyses in a clear and precise manner. However, many fail to do so, which has the potential to leave the arbitral tribunal confused and unable to reach a fair and reasonable determination in the matters they must consider. This chapter highlights key economic considerations in a proper damages assessment. It also provides a checklist for arbitrators that clarifies the general building blocks of a damages analysis that would assist tribunals in rendering an informed decision as to whether the damages estimates presented by the parties are reasonably accurate reflections of economic harm. This list considers the following elements:

• type of dispute: expropriation (valuation), lost profits or hybrid;
• evaluation framework: ex ante or ex post analysis;
• fair market value (FMV): income approach, market approach and cost approach;
• counterfactual world: focus on expectations;
• causation analysis: linkage of wrongdoing to economic harm;
• mitigation: plausible actions needed to minimise damages;
• revenue projections: accounting for competitive dynamics and regulatory constraints;
• costs: considering reinvestment as technology constantly changes;
• legal instructions and the responsibility of the damages expert;
• damages model: transparent, understandable and documented;
• source of information: responsibilities of experts regarding internal data;
• discount rate: reflecting the risk of the underlying investments;
• prejudgment interest: choosing the correct rate;
• reasonableness tests: independent validation of the amount of damages; and
• presentation of findings: how to structure reports.

Type of dispute: expropriation (valuation), lost profits or hybrid

The first step in assessing economic harm involves determining the appropriate damages framework. International arbitration disputes frequently involve claims of asset expropriation, lost profits or a combination of the two standard claim formats (e.g., lost profits leading to full expropriation).[2]

The expropriation framework is often appropriate in matters in which the legal claims involve the full or near full destruction or taking of an asset. If a dispute involves the expropriation of an asset, it may have a record of financial success or other contemporaneous projections of future economic value and profits. A government that expropriates privately owned property effectively eliminates the claimant’s opportunity to earn any future profits from that asset. Thus, that action alone eliminates the entire future economic value of the asset (from the date of the expropriation onwards). In these circ*mstances, a valuation-based economic framework is often suitable to determine the amount necessary to make the claimant financially whole. A valuation analysis typically determines the value of the asset as at the date of the expropriation (i.e., ex ante valuation).

Certain types of disputes, however, may not involve the full or partial destruction or taking of an investment by the government. Instead, a dispute may allow the claimant to continue to operate the asset but less profitably because of certain claimed actions allegedly inconsistent with the guiding agreement. In such cases, the economic approach might entail a lost profit analysis that compares revenues, costs and resulting profits in the actual scenario (which incorporates the effects of all the claimed wrongful acts) and the estimated revenues, costs and resulting profits in the counterfactual scenario (which excludes the effect of all the claimed wrongful acts).[3]

Typical features of expropriation valuation and lost profits analyses

All cases do not necessarily fit neatly into either of the two categories identified and may need uniquely tailored hybrid solutions as ‘reparation must, as far as possible, wipe out all the consequences of the illegal act and reestablish the situation which would, in all probability, have existed if that act had not been committed’.[4]

Evaluation framework: ex ante or ex post analysis

When determining the economic value of an asset as at the expropriation or wrongdoing date, experts typically select one of two approaches: ex ante or ex post valuation. Ex ante refers to the use of data known or knowable before the event or decisions took place (i.e., ex ante data is based on historical data or on forecasts that existed as at the valuation date, not actual results occurring after that date; for example, results that were known when damages were being calculated). Ex post refers to the incorporation of data after an event has taken place or a decision has been made (i.e., after the valuation date). It involves assessing the actual value or performance of an asset, investment or project based on historical data and realised outcomes.

An ex ante analysis is based on the estimated return investors anticipate earning from an investment or a company expects to earn at the end of a specific period, in line with all known risks and opportunities. Ex ante analysis typically considers only the facts and information known or knowable as at a certain date and ignores all information known after that date. The rationale for relying on ex ante information is simple – ex post information would not have been available on the date of the alleged wrongdoing and, thus, could not have been used to assess the FMV on that date. Most expropriation cases rely on this approach. The ex post valuation approach considers data and information available from the wrongdoing to the hearing date, which might encompass many years after the date of the claimed wrongful acts.

The lottery ticket example illustrates the distinction between an ex ante and an ex post valuation approach.[5] Suppose you pay $1 for a lottery ticket and someone steals that ticket before the draw is made.[6] Now assume this lottery ticket is lost or destroyed. Further, suppose the ticket is the winning ticket for $1 million. Under the ex ante approach, because the date of the breach was before the date of the results, the FMV could be $1, because that is what you were willing to pay to participate in the draw. This not only corresponds to the price of the ticket but could also correspond to the expected value of the lottery gain, which is what you were willing to pay for an expected gain of $1 million. Under the ex post approach, the asset value is not $1 but $1 million; however, the ex post approach reduces the uncertainty (and therefore the risk) of losing, which was not the case at the time the harmed party bought the lottery ticket. Exposure to the risk of losing occurs at the time a party invests (i.e., buys a ticket).

Although expropriation matters typically apply the ex ante approach, arbitrators have held, in select instances and as a matter of fairness, that claimants should be entitled to the higher of the damages calculated ex ante at the date of breach and ex post at the time of the award.[7] In the case of the lottery ticket, this would imply the claimant could request an award of $1 million even though the economic harm under the ex ante approach was $1.

Ex ante versus ex post[8]

Fair market value: income approach, market approach and cost approach

The first step in calculating the FMV of the claimant’s alleged expropriated asset as at the date of wrongdoing is to determine the proper valuation approach or approaches. The valuation literature describes three primary approaches: the income approach, the market approach and the asset-based (or cost) approach.[9]

• The income approach discounts a business’s expected future cash flows to the valuation date, typically using a discounted cash flow method. It relies on the fundamental principle that economic agents value assets based on the expected future cash flows derived from the assets.[10]
• The market approach relies on market transactions data or other relative value indicators of comparable businesses.[11] It is an implicit valuation approach that relies on the transaction prices as a means to reflect the economic attributes ascribed by the buyer and seller of the value of the asset in question.[12] As such, this approach only results in reliable FMV estimates if there are companies (or transactions) that are sufficiently comparable to use as reliable benchmarks for the valuation of the asset being valued.
• The asset-based or cost approach is a valuation method that could involve, to the relevant extent, using the value of a company’s assets minus liabilities to estimate the market value.[13] Under the cost approach, the costs incurred to purchase or construct the asset are used as a benchmark for valuation. As a result, the cost approach is also considered an implicit valuation method because it does not explicitly assess the future expected benefits from the asset, company or project.

The choice of the proper valuation method, or methods, requires careful consideration of the nature of the claim and the operational status of the claimant at the time of the wrongdoing. Increasingly, the income approach to valuation has become the primary damages approach used by claimants in international arbitrations, despite the availability of other approaches; however, determining damages with a reasonable degree of certainty might be difficult under the income approach if there are no established historical operating results, contemporaneous business plans with profit and loss projections, or other financial records that an expert can use to project future performance. To add a cautionary note, the income approach relies on a discount factor to convert future cash flows into present-day, lump sum values. If an expert does not properly estimate the discount factor, there may be errors in the resulting claim for damages. Further, experts often attempt to rationalise the lack of explicit economic assumptions with a blanket assertion that they are somehow accounted for in the discount rate.

The market approach is an implicit valuation approach that relies on transaction prices to reflect the economic attributes ascribed by the buyer and seller regarding the value of the asset in question. This approach only results in a supportable FMV estimate if there are sufficiently comparable companies to derive a reliable benchmark for the asset being valued.[14] The comparability of the nature, size, scope of projects, geographical locations, operating environments, and financial and economic conditions (such as the bargaining power of participants) is a factor to consider when applying the market approach. Therefore, this method may apply when it is possible to identify listed companies (or private deals involving the purchase or sale of companies, assets or projects) that are similar in the myriad of economic, regulatory and other financial circ*mstances to the target project or company whose value needs assessment. Not every example is an appropriate benchmark. Finally, whenever the market-based method relies on the market value of listed companies (as measured by their market capitalisation), it is helpful to analyse market characteristics because low trading volumes or market inefficiencies might affect value in certain circ*mstances. Ultimately, the expert must consider the specific relevant facts and circ*mstances of each case in determining the value.

Finally, the cost approach might not be appropriate when costs are not a good proxy to estimate value.

Counterfactual world: focus on expectations

Whether ex ante or ex post, a damages assessment requires projecting the claimant’s performance absent the alleged wrongdoing. There is a lot of debate about what constitutes expectations and whether they should differ from contemporary business projections. Subject to examining the reasonableness of contemporaneous business forecasts, these records can provide a robust basis for the counter­factual performance of the claimant; however, an examination of these records might entail comparing them with operational reports, accounting records and audited financial statements. Importantly, the damages expert cannot engage in speculation but must support the counter­factual world with robust evidence in line with legal considerations and instructions.

Causation analysis: linkage of wrongdoing to economic harm

Modelling the counterfactual world requires an understanding of how the alleged wrongdoing affected the claimant. This ‘causation analysis’ is a basic requirement of a proper quantum of harm assessment to ensure it measures not only the harm to the claimant but also the harm caused by the alleged wrongdoing. The expert must work closely with counsel to understand the applicable causation standard and ensure the quantification of damages is consistent with governing law. International arbitration literature describes these requirements:

It is uncontroversial that, barring highly unusual circ*mstances, a respondent’s liability is limited to damage that its conduct caused and, in general, a claimant bears the burden of proving that the respondent caused the claimant’s injuries.[15]

The Reference Manual on Scientific Evidence, a frequently referenced damages guide that has potential application in litigation and international arbitration alike, states:

The first step in a damages study is the translation of the legal theory of the harmful event into an analysis of the economic impact of that event.
Thus, a proper construction of the but-for scenario and measurement of the hypothetical but-for plaintiff’s value by definition includes in damages only the loss [16]

Causation analysis requires disentangling the impact of other concurrent events that may also have affected the claimant; however, concurrent events or economic parameters may not always result in economic harm to the claimant. During the covid-19 pandemic, for example, investors invoked bilateral treaties to challenge state measures that slowed down or harmed businesses. The economic damages must flow from the wrongdoing. In estimating the but-for scenarios in these cases, it is necessary to account for what would have been the state of the economy or sector in the absence of state measures but in the presence of the pandemic. The impact is specific to each case, not only to each sector but also to each region, or it may vary by individual project. What might be fatal for the prospect of one business might be manageable for another business.

It is common for damages experts to assume legal liability; however, in quantifying the economic harm, the claimant’s expert must evaluate how the alleged wrongdoing affected the claimant’s financial position from an economic standpoint. A common error in damages assessments is the omission of a causation analysis by the quantum expert or the reliance on legal instructions that assume the presence of economic harm; for example, legal instructions that the claimant would have launched service under an alleged expropriated licence and would have become a commercially successful market participant are not proper legal instructions because they effectively prescribe an economic conclusion.

Mitigation: plausible actions needed to minimise damages

The actual scenario needs to consider available methods for the claimant to mitigate financial harm. A mitigation analysis determines whether, and to what extent, the claimant took advantage of the options available to reduce economic harm. This evaluation should identify and assess actual or plausible actions the claimant took, or might have taken, to reduce damages (including the costs relating to those actions). In some cases, mitigating actions by the claimant may substantially affect the damages claimed.

Revenue projections: accounting for competitive dynamics and regulatory constraints

An expert might need to develop revenue projections for a valuation or lost profit analysis. These projections usually apply to the counterfactual world but could also entail projecting revenues in the actual world.

Revenue in the counterfactual world is determined by multiplying the assumed sales quantity (but-for quantity) by the assumed price (but-for price) in each historical and future period for which the claimant would have been active absent the alleged wrongdoing. Revenue in the actual scenario is known as at the historical period; however, future revenue requires a forecast that is determined by multiplying the assumed sales quantity by the assumed price in each future period in the presence of the alleged wrongdoing.

Forecasts of future sales quantities and prices in the but-for and actual worlds must reflect the competitive dynamics and regulatory constraints appropriate to each scenario. Depending on the facts and circ*mstances of the case, these factors may be distinct in the counterfactual scenario compared with the actual scenario. Moreover, economic market conditions can change over time, and may be substantial, which would affect sales quantities and prices. Economic evidence of the claimant’s ability to reasonably expect to maintain its competitive position in the marketplace over time would support the claim. Also, the expert must consider the extent to which any potential new entrants could economically displace some of the claimant’s business.

The expert must consider regulatory constraints over time in both the actual and counterfactual scenarios. Industries with a complete or partial regulatory overlay require careful consideration of the regulatory framework and the ongoing changes in regulation occurring and expected to occur over time.

Costs: consider reinvestment as technology constantly changes

The expert must also develop cost projections for a valuation and lost profit analysis for the actual and counterfactual world. Costs in the counterfactual world reflect the incremental costs that the claimant would have incurred from manufacturing, mining or procuring and selling an additional quantity absent the alleged wrongdoing. Costs in the actual world (historical as well as forecast) represent the overall costs the claimant incurred in producing or providing the quantity of goods or services sold despite the alleged wrongdoing.

Legal instructions and the responsibility of the damages expert

Although it is common for damages experts to rely on legal instructions, the instructions should not entail economic conclusions that replace critical parts of a proper damages assessment. For instance, instructing the damages expert that the claimant would have become a successful competitor in the counterfactual world might be inappropriate because it is not legal guidance but an economic conclusion about commercial success. Similarly, legal instructions to assume the claimant would not have borne any company-specific risk requires an economic analysis.

Damages model: transparent, understandable and well documented

It is the responsibility of the damages expert to understand all facets of the damages model used and to be able to explain it to the tribunal. A damages analysis should be accompanied by a complete description of the model, an explanation of the model inputs and the related underlying documents. The goal is to provide the tribunal with a transparent, understandable and well-documented damages model. Conversely, a black-box damages model that does not permit the replication of results or the ability to audit the analysis is not acceptable. A disorganised damages model that suffers from an inefficient architecture with untraceable assumptions and unreliable calculations is not trustworthy. As an example, an expert presented a damages model that consisted of dozens of Excel files containing hundreds of different sheets, several programs, hundreds of data files and other supporting files; yet this expert’s report provided no insight into the model’s structure or the derivation of the model’s inputs. This does not meet transparency requirements and it is not helpful to the tribunal.

Source of information: responsibilities of experts regarding internal data

Although the degree of discovery and company information available for arbitration is beyond the expert’s control, the expert should exercise professional scepticism and ask questions about potential data anomalies. Although damages experts typically do not audit the parties’ data, they must ensure the data used in the damages analyses are economically sound and not contradicted by other evidence in the case.

Discount rate: reflecting the risk of underlying investments

When assessing the FMV of an investment of lost profits, future free cash flows require conversion to present value. This is done by discounting future free cash flows at a rate that reflects the anticipated rate of return of the monetary flows. One of the customary methods to compute the discount rate is based on the capital asset pricing model (CAPM), according to which the expected return associated with a given asset (and therefore the discount rate) is a combination of a return for ‘waiting’ (i.e., the time value of money) plus a return to compensate for the risk.[17] According to the CAPM, a certain type of risk is accounted for in the discount rate, called the undiversifiable risk (i.e., systematic risk or market risk, meaning any risk affecting a large number of assets, each to a different extent), as opposed to the diversifiable risk (i.e., firm-specific or asset-specific risk, meaning any risk that specifically affects a single asset or a small group of assets).[18] This is because a rational investor is expected to put into place the necessary measures to mitigate risks that can be diversified. The market will not compensate for risks the investor could have mitigated through diversification.[19]

The discount rate usually reflects systematic risk through a metric known as the beta (β), which measures the volatility of a specific investment in relation to the overall market.[20] The expert usually assesses the beta using stock market data.[21] When assessing damages, the beta used to estimate the discount rate must accurately reflect the systematic risk of the asset, the project or the company being valued. The discount rate would consider all relevant factors that are specific to the facts and circ*mstances of the case.

On the other hand, diversifiable risks (i.e., unsystematic risks) are often accounted for in the expected cash flows under the income approach. In this respect, double counting of risk should be avoided, and it is appropriate to include diversifiable risk in the expected cash flows instead of in the discount rate.

Prejudgment interest: choosing the correct rate

Prejudgment interest converts historical dollars to current dollars at the time of the damages award. It compensates the claimant for the temporal loss of the funds that are subject to the damages amount. The appropriate prejudgment interest rate may be specified by contract or by a statutory legal requirement. If no rate is specified, the economic literature supports that a prejudgment interest rate equals the opportunity cost of capital. The economic circ*mstances of the case will guide the economically appropriate interest approach. For instance, to the extent that the claimant did not incur any risks on the deprived cash flows, the risk-free interest rate might form the basis of the prejudgment interest rate. Of course, the definition of risk-free interest needs careful investigation, especially in periods during which monetary policies are overly restrictive or extremely loose. If the claimant incurred debt to finance the subject investment or had to forego other productive uses of its investment, then a rate based on the opportunity cost of capital could be the applicable prejudgment interest rate used to convert historical dollars to present-day value dollars at the time of the award. Of course, care needs to be exercised that these costs are not already included in the damages analysis. Other potential candidates for the prejudgment interest rate include the claimant’s borrowing rate and the prime rate. The evaluation of the specific economic circ*mstances in the case should guide the determination of the appropriate prejudgment interest rate.

Reasonableness tests: independent validation of damages amount

Additional supporting analysis demonstrating the reasonableness of the damages amount is useful to the tribunal. Various reasonableness tests are available; for example, contemporaneous evidence from contemporaneous business documents and real-world performance (including the performance of comparable businesses or assets) may help to corroborate a damages assessment.

Presentation of findings: how to structure reports

If not written and structured clearly, an expert report will fail to achieve its intended purpose. The following list illustrates some of the main elements commonly expected in an expert report:

• Scope: The report should be transparent about the scope and the questions that the expert is expected to answer.
• Data and information used: All data and information relied on by the expert must come from reliable, identified sources. The expert should include the data and information in appendices, exhibits or Excel workbooks.
• Economic and financial models used: The expert must clearly explain the underlying methodology step by step so that non-experts can understand the process.
• Assumptions: The expert must support all assumptions with external and internal references and, if necessary, ground them in sound economic or finance theory.
• Replicability: The report should be self-contained so that readers can reproduce the analysis. As such, it should contain all references, sources, data and analysis.
• Summary: The report should include a summary of key facts, such as alleged harm, valuation period and valuation date.

Conclusion

We have summarised the key economic considerations for a proper damages assessment in the form of a checklist. It is hoped this will ease the burden on arbitrators when they are evaluating whether the damages estimates presented are a reasonable and accurate reflection of the economic harm suffered. Our aim in this chapter has been to empower arbitrators by rendering damages awards rooted in solid economic theory and that are, hence, presumably enforceable, ultimately leading to a favourable environment for investments.

Endnotes

[1] Julie Carey and Christian Dippon are senior managing directors and Ralph Meghames is a director at NERA. The authors thank Kristopher Boushie for his valuable comments and discussions and Patricia Cunkelman for her research and editorial review.

[2] In the remainder of this chapter, the term ‘asset’ is used in a broad sense and refers not only to fixed assets but also to any income-producing business.

[3] See Julie M Carey, Christian Dippon and Will Taylor, ‘Measuring Economic Damages with Maximum Certainty’, Global Arbitration Review, 26 March 2019.

[5] See Elizabeth A Evans and Roman L Weil, ‘Ex Ante Versus Ex Post Damages Calculations’, Chapter 5 in Litigation Services Handbook: The Role of the Financial Expert (6th edition, Roman L Weil, Daniel G Lentz and Elizabeth A Evans (editors), John Wiley & Sons, Hoboken, NJ, 2017).

[6] Another often referenced example addressing ex ante versus ex post is discussed in Franklin M Fisher and R Craig Romaine, ‘Janis Joplin’s Yearbook and the Theory of Damages’, Journal of Accounting Auditing & Finance 5, No. 1/2 (Winter/Spring 1990).

[7] See Yukos Universal Limited (Isle of Man) v. The Russian Federation, UNCITRAL, PCA Case No. 2005-04/AA227.

[8] See Michael K Dunbar, Elizabeth A Evans and Roman L Weil, ‘Ex Ante Versus Ex Post Damages Calculations’ in Litigation Services Handbook: The Role of the Financial Expert (5th edition, Roman L Weil, Daniel G Lenz and David P Hoffman (editors), Wiley Online Library, 2012) (https://doi.org/10.1002/9781119204794.ch5).

[9] S P Pratt, Valuing a business: The analysis and appraisal of closely held companies (McGraw Hill, New York, 2022), Chapters 9, 10 and 13 to 16.

[10] id., Chapters 9 and 10.

[11] id., Chapters 13 and 14.

[12] See J E Fishman, S P Pratt and W J Morrison, Standards of value: Theory and applications (Hoboken, NJ: Wiley, 2007), 25; and Richard Hern, Zuzana Janeckova and Yue Yin, ‘Market or Comparables Approach’, Chapter 17 in Damages in International Arbitration Guide (5th edition, John A Trenor (editor), Global Arbitration Review, December 2022), p. 318.

[13] Charles Jonscher, ‘Determining the Weighted Average Cost of Capital’, Chapter 15 in Damages in International Arbitration Guide, op. cit. note 12. To be more comprehensive, an asset-based approach would also have to capture non-balance sheet items, such as internally developed intellectual property, to the extent relevant to the fact pattern of the case.

[14] Pratt, op. cit. note 9, Chapters 13 and 14.

[16] Mark Allen, Robert Hall and Victoria Lazear, ‘Reference Guide on Estimation of Economic Damages’ in Reference Manual on Scientific Evidence (Third Edition, National Research Council, National Academies Press, Washington, DC, 2011), p. 432 (emphasis in original) (https://nap.nationalacademies.org/read/13163/chapter/10#427).

[17] The capital asset pricing model is discussed at length in modern finance textbooks; for example, Richard Brealey, Stewart Myers and Franklin Allen, Principles of Corporate Finance (9th edition, McGraw-Hill, 2008); Thomas Copeland, Fred Weston and Kuldeep Shastri, Financial Theory and Corporate Policy (Addison-Wesley, 2005).

[18] See Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd edition, 2012), Chapter 4: ‘The Basics of Risk’.

[19] In general, the means of avoiding diversifiable risk is to diversify by holding a broad portfolio of different assets. Once an investor is sufficiently diversified, at a point at which the investor holds a portfolio comprised of every asset in the same proportions as the market, the investor cannot diversify further and is only exposed to the market risk – or the undiversifiable risk, as measured by the beta.

[20] See Damodaran, op. cit. note 18.

[21] Tim Koller, Marc Goedhart and David Wessels, Valuation: Measuring and Managing the Value of Companies (Fifth edition, John Wiley & Sons, 2010), Chapter 11: Estimating the Cost of Capital.