Choosing the Appropriate Approach for Loss Assessments

Crosby MacDonald, Nikola Stambolic, Pascale Leymin and Adrian Girach | BRG

This article is an extract from Lexology In-Depth: Investment Treaty Arbitration – Edition 10. Click here for the full guide.

Introduction

Economic losses caused by a wrongful action can take many forms. As the first step towards claiming compensation for a loss, a claimant will normally define that loss in the context of the specific circumstances of its claim.

For example, a claimant could say that it suffered a loss of profits or a diminution in the value of its shares in a business as a result of the respondent’s actions. In investment treaty arbitration, for example, claims often arise due to complete or partial loss of an asset as a result of an expropriation.

Once counsel have identified the claims to be made, they can instruct a quantum expert to quantify the loss suffered. After consultation with counsel (with respect to the basis of the claim, the appropriate measure of loss and other matters of instruction that provide the framework for the quantum assessment), and after consideration of the factual matrix of the case, the expert will determine the appropriate approach (one or more) that may be used to quantify the loss.

In this chapter, our aim is to set out the typical heads of loss that may be claimed in investment arbitration (but are also relevant to commercial arbitration), and discuss the considerations a quantum expert will have when determining which approach should be used to assess the loss.

Typical heads of loss

Claims in investment treaty arbitration are typically raised under the following potential heads of loss:

  1. loss of, or diminution in, the value of an investment – this type of a loss is commonly claimed in expropriation cases;
  2. loss of profits – such a loss may, for example, arise in the event of temporary interference by the state, or in cases where an investment remains but will experience worse financial performance as a result of government action;
  3. loss of opportunity – this can account for the loss of an opportunity or chance to generate profits;
  4. loss of capital spent on an investment (investment expenditure or sunk investment) – this can be an independent head of claim in some non-expropriatory treaty cases;2 and
  5. expenses incurred as a consequence of the wrongful conduct of the host state (incidental expenses) – this can be a head of claim in circumstances where the claimant incurred, or will have to incur, additional expenses as a result of the alleged wrongful acts.3

These heads of loss are not mutually exclusive. For example, a claimant may incur incidental expenses in addition to suffering a loss in the value of its investment. As another example, to the extent that an investor claims for the value of its expropriated investment at the date of award, it may also need to claim for the historical profits lost between the date of expropriation and the date of the award.

Quantum experts can and do get involved in the assessment of investment expenditure or incidental expenses as separate heads of loss. Such assessments present their own set of challenges and may require forensic accounting analysis to help identify relevant expenses and evaluate their eligibility for inclusion in the claims.

For the purposes of this chapter, however, we focus on the first three heads of economic loss listed above, as the selection of an appropriate approach for these can be more complex.

While the choice of approach by a quantum expert should be driven by economic principles, it is prudent for both counsel and experts to be aware of the decisions of tribunals in investment treaty arbitrations with respect to loss assessment approaches. We therefore note some such decisions below.

Value of an investment

The appropriate measure of compensation in an expropriation, or ‘taking’, may be defined in international law, or in the investment treaty under which the claim is being made.4

Generally, a government taking will lead to a claim by the investor for ‘full compensation’, being the entirety of the value of the investment if the taking is complete. In these circumstances, the most common task for a quantum expert is to calculate the market value of the investment that has been lost, at a certain point in time.5

In other cases, an expert may be required to calculate the diminution in the value of an investment by comparing: (1) the value of the investment after the alleged wrongful act (the actual value); with (2) the value of the investment absent the alleged wrongful act (the counterfactual value).

Broadly, an expert will determine the appropriateness and feasibility of potential valuation approaches based on:

  1. the information available;
  2. the nature of the asset being valued;
  3. the basis/standard of value to apply (such as fair market value); and
  4. the factual and legal circumstances of the case.

While different valuation guidelines and principles may adopt different terminology, most who participate in investment treaty claims will be familiar with the three widely accepted approaches that can be used to determine the value of an asset:6

  1. the income approach, in which the value of an asset is determined based on the future income (or rather cash flows) it is expected to provide its owners;
  2. the market approach, in which the value of an asset is determined by reference to the observed values of similar assets; and
  3. the cost approach (also known as the asset approach), in which value is determined based on the sum of the value of individual assets.

The income approach is most commonly applied as a discounted cash flow (DCF) analysis, in which the expected future cash flows generated by the asset are forecast and then discounted back to the valuation date. A DCF analysis is based on the fundamental principle that value arises from the cash flows an asset is expected to provide for its owner.7

The key considerations for a DCF valuation are: (1) whether a sufficiently reliable cash flow forecast can be produced; and (2) whether the discount rate is appropriate. Those topics could each merit their own chapter, and the discount rate in particular is often a matter of significant debate between experts.8

Tribunals have correctly noted that the reliability of a DCF analysis is dependent on the reliability of its inputs, and that DCF results can be highly sensitive to small changes in certain parameters.9 In some cases in which the company does not have a track record of profitability, or has not sufficiently established its prospective earnings forecasts, tribunals have been reluctant to award damages on the basis of a DCF calculation.10

The market approach is most commonly applied by identifying assets with observable market prices that are sufficiently similar to the subject asset. The share prices of similar publicly traded companies and the reported values at which similar companies have been acquired can be converted into valuation metrics relative to parameters such as earnings, revenue or industry-specific measures (such as reported reserves for mining or oil and gas companies, for example). Those valuation metrics can then be applied to the subject asset. In some cases, transactions in the disputed asset itself can provide the basis for applying a market approach, provided they are sufficiently contemporaneous and appropriately represent the value of the asset prior to the alleged wrongful actions.11

The key considerations for a market approach valuation generally relate to the degree of similarity between the subject asset and the comparable companies chosen, taking into account the circumstances of the case. No comparable assets or transactions are perfect, and in some cases, tribunals have found that this renders the method unreliable.12

The asset approach can be distinguished from the first two approaches, as it is generally only appropriate in circumstances in which the asset or assets to be valued are expected to be liquidated, rather than to operate as an ongoing business. For this reason, valuation practitioners generally consider it inappropriate for businesses or investments that expect to operate as a going concern. For a business for which its value (driven by expected future cash flows) is ‘more than the sum of its parts’, an asset-based valuation is not generally considered appropriate. As the International Valuation Standards note: ‘The cost approach is rarely applicable in the valuation of businesses and business interests’, with certain exceptions.13

Asset or cost-based approaches are commonly applied when claimants are seeking restitution of wasted costs. Such analyses reflect different claims and bases of value than typically underlie a claim for compensation for the value of an investment. However, they are often presented as a backstop by claimants, and have, in some cases, been the basis of an award for the fair market value of an investment.14

Given the intricacies of both legal claims and the valuation exercise in investment treaty cases, which often involve large and complex assets, there is no set rule as to when certain approaches should be applied. In some cases, industry norms and guidelines will inform the expert’s decision. Mining valuations, for example, are informed by various valuations standards and guidelines that have been developed by industry groups, and, in some cases, valuations must adhere to specified standards. In other cases, equity analysts and industry participants have adopted common approaches to valuation that might be taken into account.

In general, valuation guidelines encourage, but do not require, the use of multiple valuation methods.15 When multiple valuation approaches can be applied reliably in the circumstances, experts will commonly do so. In some cases, experts will rely on one ‘primary’ approach and use a secondary approach as a ‘cross-check’, while others will ‘triangulate’ their view on quantum based on the results of different valuation approaches.16

We prefer to consider and explain the differences in valuation results quantitatively, rather than by broad-brush approaches that often obscure the underlying strengths and weaknesses of each approach. We would generally recommend detailed examination of both the income approach and the market approach in nearly all cases,17 even if one approach is ultimately preferred over another. Working through the available information and considering the analysis required to apply each approach often provides insight into the key determinants of value, and in doing so ensures that issues relating to quantum are bottomed out.

Counsel will want to understand their experts’ approach to determining the appropriate valuation methods to be applied. In many cases, quantum may be sensitive to key factual or legal assumptions that are in dispute between the parties, and are not for the experts to resolve. Counsel will want to understand how different assumptions of fact may influence value, and to instruct their experts accordingly.

Of note for both experts and counsel is the recent work of the UNCITRAL International Trade Law Working Group III on Investor-State Dispute Settlement (ISDS) Reform, which has been considering the issue of damages and compensation in ISDS since 2017. At its most recent session, it debated a set of draft guidelines to assist tribunals in deciding on damages and compensation. The draft guidelines suggest that given the potential for differences between the results from different valuation approaches, it is ‘good practice for experts to be instructed to use multiple valuation methods when determining damages’.18 As experts, we would consider such an instruction unnecessary, but we note the motivation for the proposal, given the often wide divergence between valuations.

Loss of profits

Lost profits are financial gains a claimant would have earned, but for a wrongful act taking place. International tribunals have awarded lost profits in cases involving breaches of international law as well as breaches of contract.

It is important to highlight that even when a claim is for lost profits, what the claimant will have actually lost, and what quantum experts will assess, are cash flows. Cash flows are a better measure of economic loss than profits, since profits, as an accounting category, are impacted by non-cash accounting entries (for example, depreciation and accruals), and are subject to differing accounting standards, the company’s own accounting policies and, ultimately, an accountant’s judgment.

While there are some similarities between lost profits and the market value of an asset as measures of loss, lost profits is a different measure.

  1. First, lost profits are centred around a specific claimant’s lost financial gain from utilising an asset (be it a physical asset, a right or a contract). The value of an asset in a hypothetical transaction, as may be required in a valuation, is related, but not necessarily the same as the financial gains to the asset’s owner.
  2. Second, the method of assessment of lost profits is different, in that to assess lost profits, an expert must compare two streams of cash flows, the actual (or as-is) cash flows, and the counterfactual cash flows (but for the wrongful act). The loss is the difference between the two. A valuation-based damages assessment may take into account different sets of cash flows, but will also take into account different aspects of value that may depend in part on the valuation standard adopted.
  3. Third, a valuation can be performed by the income, market or asset methods described above. Lost profits can only be assessed by reference to cash flows.
  4. Fourth, lost profits are always assessed as at the date of the award.19 Lost profits can, therefore, be entirely in the past, entirely in the future, or both. A valuation looks only at future cash flows, albeit from the perspective of the present or some point in the past.
  5. Fifth, an important implication of lost profits being assessed as at the date of the award is the requirement to reflect ex-post information in arriving at the historical loss. A market standard-based valuation will only reflect ex-ante information (i.e., what was known or knowable at some date in the past or at the present date).
  6. Sixth, historical lost cash flows are not to be discounted.20 The purpose of discounting in a valuation is to address the time value of money and to reflect in the valuation the risks that cannot and should not be reflected in the forecasted cash flows.21 With historical lost cash flows, estimated on the basis of ex-post information, the passage of time will have crystallised any such risks while the time value of money is addressed by a pre-award interest rate. The future lost cash flows will, however, need to be discounted to the date of the award for the same reasons they are discounted in a valuation.

When performing a valuation, an expert should employ as many approaches as reasonably possible and appropriate. The purpose of this triangulation is to provide comfort to the expert and the tribunal that the expert’s conclusions are consistent and logical (which does not mean that all approaches need to or can show the same or similar results). When assessing lost profits, however, these sense checks may not be immediately available.

In order to assist the tribunal, however, an expert might be able to isolate parts of their assessment of lost cash flows and contrast these with market information. For example, an expert could derive market multiples for similar businesses and use these to compare against the multiple implied in their assessment of the present value of counterfactual future cash flows of the business in question. This is possible to do because the assessment of counterfactual future cash flows is akin to a valuation at the present date. While the implied multiple may or may not be consistent with the market multiples, the expert should be able to explain, in this market context, why their conclusions are logical.

Loss of opportunity

A loss of opportunity may be characterised as a loss of profits, whether standalone or as a component of value,22 where the available data may not allow the loss to be evidenced with a high degree of certainty.

This situation may arise, for example, when a claimant loses a business opportunity or a chance to earn profits because of the state’s alleged wrongful conduct. It may have been an opportunity to enter into a transaction or to complete a project. In the absence of sufficient certainty regarding the occurrence of certain events or the assessed lost profits, a probability factor may be applied to the estimated loss.

Given the range of circumstances that can give rise to a loss of opportunity claim, a range of assessment approaches may be applicable. In practice, quantum experts assess the lost profits, or the future prospects impacting the value of the relevant business, using the same approaches and considerations as those described in the previous sections. The probability to apply to the result would be a matter for the tribunal to decide on. Tribunals may exercise discretion in awarding compensation under this head of claim, potentially in the form of lump sums.

While expert assessments may be reduced by the application of a probability or discretionary reduction, this does not diminish the need for a rigorous and diligent analysis. The evidence must be thoroughly analysed, the inputs carefully considered and the assumptions clearly set out. In some cases, expert evidence on comparable projects and commercial practice may assist the tribunal in determining the appropriate probability.

When applying an approach based on expected income, the same criteria used in lost profits claims (or forward-looking value assessments) must be considered. These include past financial performance, investor’s experience, availability of financing and progress of the investment. The reliability of forecasts and the plausibility of counterfactual scenarios are also critical, given their inherent uncertainty. Whether a given opportunity existed is primarily a legal and factual question. Where certain inputs or events are particularly uncertain, but a loss remains likely, the claim may be treated as a loss of opportunity, with the tribunal assigning a probability based on its assessment of the assumptions and causation. Investment tribunals have applied the concept of loss of opportunity to recognise damages beyond amounts invested, even in uncertain contexts.23 In contrast, some tribunals have found that the loss of opportunity falls below the amounts invested.24 In other cases, tribunals may find that claimants did not provide enough evidence to award a loss of opportunity claim.25

Conclusion

The appropriate approach to loss assessment depends on the specific circumstances of each case. First and foremost, it is essential for quantum experts to have a clear understanding of the specific heads of loss being claimed and the basis for each. The nature of the business or asset involved, as well as the availability and reliability of relevant information, will also significantly influence the choice of methodology.

Perhaps unsurprisingly, the approaches put forward by parties can differ.26 This may result from differing legal instructions or divergent views regarding the business’s future prospects. Multiple approaches may be valid to assess a given loss. It is part of the expert’s role to explain why a particular approach was chosen, while also acknowledging possible alternative methodologies and conducting cross-checks where possible. All key assumptions should be clearly set out and supported by evidence.

Different methodologies may also be applied across various heads of loss within the same case. This is entirely appropriate, provided that any potential issues of double-counting are identified and addressed.

When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.

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