Inflation and Family Law

I was looking through my oldest daughter’s baby book last night and found that we had noted the price of gas at $0.70 per litre; I had noted at the time that this was “really high”! This got me thinking about inflation.

My daughter is 10 years old now, and gasoline has been hovering at between $1.00 and $1.10 in recent weeks here in Toronto. Some of the increase is due to volatile commodity prices, but a large portion of it is due to inflation.

We tend not to think about inflation these days; it is an unspoken part of our everyday lives. A friend of mine recently commented to me that inflation is a modern phenomenon and that in pre-modern societies people simply didn’t have to put up with it. I pointed out to him that a) he’s wrong, there have been four Great Waves since the 13^th century, (to borrow from the title of David Hackett Fischer’s excellent book on the topic), and that b) in modern times there have been periods of significant deflation (most recently during the Great Depression). Here is a graph showing the annual rate of change in the Consumer Price Index in Canada since 1919:

Anyway, as I said, we tend not to think much about inflation. Often, this is a good thing; many people feel good when they receive a 2% raise, and do not like to be reminded that they are just treading water. Deflation, meanwhile, can be crippling for debtors; over 100 years ago, the Democratic presidential candidate, William Jennings Bryan*, famously said that American farmers were being crucified on a “cross of gold” due to a refusal of the government to depreciate its currency.

*It still blows my mind that the Democrats gave Bryan three consecutive kicks at the can as their presidential candidate. Not until Mike Milbury took over the New York Islanders would an organization show such patience with an unsuccessful leader.

Inflation is something that we are comfortable with, so long as it is predictable. It is over 20 years since the Bank of Canada committed itself to fighting inflation, and we tend to assume that things will simply chug along. Yet inflation can cause tremendous distortions in the economy. It can lead to large losses on seemingly safe investments, such as government bonds, as anyone who purchased such bonds in the 1970s will know (or may not know). Payments on bonds are in nominal dollars; when the anticipated real (i.e. inflation-adjusted) value of a dollar declines, bond prices drop as well. If the annual yield on the bond you buy is less than the average rate of inflation over the term of the bond, you will lose money. Here is a look at the average real rate of return for holders of long term Government of Canada Bonds:

You can see that depending on where in the inflationary wave you purchased your bond, you could either make a lot of money, or none at all. (In general, bond yields tended to price in the recent history of inflation; they were lousy at predicting inflation. So, for example, if you bought a bond in 1982 – on the heels of the “stagflation” experienced in the late 1970s – the anticipated inflation built into your bond yield allowed you to make a killing).

Inflation and the Law

So much for the brief economics lesson. How is this relevant to lawyers?

Some areas of law consider inflation. One example is the Income Tax Act. One of the reasons that only 50% of capital gains are included in taxable income (for now) is because for assets that are held over a long period of time, there will have been an inflationary increase in the nominal asset value, which does not really represent incremental income to the asset owner. Tax brackets are also changed every year for this reason. Prejudgment interest is designed to compensate plaintiffs for inflation between the time of injury and trial.

One area of law that does not take inflation into account is family law (at least in Ontario). Consider the following case:

• A couple enters a marriage in the year 2000 with no assets or liabilities, other than a piece of land owned by the wife worth $100,000 (in 2000 dollars).
• Assume that the couple accumulates no additional assets or debts during the course of their marriage – they spend everything they earn, no more and no less. The land just sits there, but it has risen in value due to inflation. Assume that this occurs in a region of the province where inflation in land prices is equal to CPI (i.e. not Toronto). In 2010, assume the land is worth $120,000 (in 2010 dollars).
• In such a case, would there be any equalization payment to reflect the gain in the wife’s net family property? Or would the law recognize that, in real terms, the wife’s property has not appreciated at all?

I presented this scenario to a leading family law practitioner and asked whether it made any sense that an equalization payment would need to be made. He replied that under Ontario’s Family Law Act, any increase in the nominal value of family property, even if due to inflation only, is considered to be an increase and to be part of "net family property". Section 4 of the Act defines "net family property as:

the value of all the property, except property described in subsection (2), that a spouse owns on the valuation date, after deducting,

(a) the spouse’s debts and other liabilities, and

(b) the value of property, other than a matrimonial home, that the spouse owned on the date of the marriage, after deducting the spouse’s debts and other liabilities, other than debts or liabilities related directly to the acquisition or significant improvement of a matrimonial home, calculated as of the date of the marriage;

This issue arises in business valuations as well. As a result of inflation, a business will increase its selling prices (hopefully), its costs will increase, the replacement costs of its assets will increase, and a business that undergoes no fundamental change can find itself worth much more in nominal terms than it was at the date of marriage.

I suppose one could suggest a reading of the Act to the effect that the calculation should be based on real (and not nominal) values; but in my experience in dealing with family law matters, this is typically not argued.

Conclusion

One might ask, is this fair? There has been no real increase in the value of the property, why should the husband get anything? This was my first instinct In thinking about the issue. But I think now that perhaps that question - "is it fair?" - is not the right one to be asking.

Life is not fair. In some marriages, both spouses contribute equally (either to the business or to home life). This is not always the case, however. Rather than trying to assign points, the Family Law Act says simply: we will split the net increase down the middle.  It may not be “fair”, but it is impossible to legislate fairness with anything more than very broad strokes.

Statutory financial remedies will never be perfect. They cannot address all possible cases. The advantage of such relatively cut-and-dried remedies is that they provide a relatively simple system of efficiently adjudicating disputes and allocating money between the parties.

Of course, it does not always work out that way J

 

 

 

 

Dunkin' Donuts c. Bertico inc., Part II: Lost Profit and Loss of Business Value

Towards the end of its decision in Dunkin’ Brands Canada Ltd. c. Bertico inc.2015 QCCA 624, the Quebec Court of Appeal discussed the issue of whether an award for both a) lost profits up to 2005 and b) loss of business value as at 2005 represented a form of double-counting [219-222]. It rejected the defendant’s arguments on this front, noting that the defendant failed to substantiate the argument on appeal, while its evidence at trial on this point was “confused” [220]. The issue of the interaction between lost profits versus loss of business value is one of the more controversial (and confusing) issues currently at play in my field, and I have discussed it elsewhere (see here).  In this post, I examine the issue of lost profits, business value and the overlap between them in the specific context of the Dunkin’ Donuts case and the objections raised by the defendants both at trial and on appeal.

The Arguments

At trial, the plaintiffs argued that in addition to their lost profits up to a particular date in 2005, they had also suffered a loss in the value of their respective businesses.  The plaintiffs introduced non-expert evidence that as a “rule of thumb”, Dunkin’ Donuts franchises typically sold for an amount equal to 50% of the prior year’s revenue. They argued that as a result of the actions of the defendant, the value of their stores had declined to essentially $nil. The trial judge accepted these arguments, and awarded each store an amount equal to 50% of the projected sales at that store but for the actions of the defendant.

The defendants offered a number of arguments against the plaintiff’s approach. They argued that:

• The loss of business value should be limited to the “value of the net equity of the shareholders…and not their gross investment in fixed assets” [87]. That is, they argued that the loss to the plaintiffs was equal to the amount of equity capital that had been invested in the business (computed as assets less liabilities as reported on the year-end financial statements), and not the value of the assets of the business on a pre-debt basis. 
• The term of each franchise was finite (unlike most businesses, which are assumed to exist into perpetuity), after which substantial renovations and renewal fees would have been payable. These were not taken into account by the plaintiffs.
• The residual value of any assets held by the plaintiffs upon actual sale or closure of their businesses was not deducted.

The Theory

Before commenting on this particular case, it is important to introduce a few key concepts:

• The value of  a business (or any income generating asset, really) is a function of a) the magnitude, and b) the risk inherent in, its anticipated future profits (or, more precisely, after-tax cash flows). This is true whether the business is assumed to exist into perpetuity, or whether it is defined by a finite contract period (such as a franchise restaurant).
• Business assets are typically financed by a mix of equity (i.e. shareholders’ money) and debt (i.e. other people’s money). On an accounting balance sheet, Assets = Liabilities (i.e. Debt) + Equity.  The market value of a company’s assets will likely differ from the book value. When the profitability of a business is impaired, the value of the assets declines, but the value of debt generally stays the same (unless there is a default).

 By way of illustration of the above two points, assume that:

• Two different Dunkin’ Donuts franchises each carry assets (i.e. equipment and leaseholds) with book value of $400,000, which are financed by $200,000 of bank debt and $200,000 of owner’s equity.
• The market value of the assets of a Dunkin’ Donuts location can be estimated at 50% of sales. Better stores may sell for more, less efficient stores may sell for less, but on average if the store is a going concern and earning some level of profit, its assets will sell for 50% of sales.
• But for the defendant’s wrongdoing, sales for Location A would have been $1M in 2005; as a result of the wrongdoing, they declined to only $700,000. Sales for Location B, which was not as profitable, suffered a decline in sales from $600,000 to $400,000. Location A is still moderately profitable, while Location B will likely suffer operating losses on a go-forward basis (assume that $500,000 in annual sales represents a “breakeven point” for a restaurant of this type).

We can show three financial statements for each of the two plaintiffs. Both have assets with book value of $400,000, as shown in the left-most column in the table below. Location A’s assets have declined in value from $500,000 (50% x $1M) to only $350,000 (50% x $700,000). Location B, meanwhile, has ceased to be profitable and no longer has any market value, aside from minor residual value for its used restaurant equipment.

 

 

Application of the Theory

In Dunkin’ Donuts, the trial judge assessed the past loss of profit as the difference between the profits that would have been earned but for the breaches by the franchisor and the actual profits earned up to 2005. The question is, what are the losses from 2005 onwards? Conceptually, the losses were equal to the difference between:

1. The present value of the future cash flows the businesses would have generated from 2005 onwards (i.e. the businesses' value “but for” the incident); and
2. The cash flows the businesses actually did experience from 2005 onwards.

The “But for” Value

With respect to the “but for” value, the trial judge ruled that but for the wrongdoing, each plaintiff’s business would have been worth an amount equal to 50% of the business’s sales in 2005. Note that this is an asset value; it is the value of the plaintiff’s business assets, before any deduction of debts. The level of debt does not change based on the decline in sales.

While the defendant argued that applying a “rule of thumb” was inappropriate, and that it was necessary to consider the individual aspects of each business in order to determine the decline in value, in many ways the Dunkin’ Donuts case – in which losses for a large, disparate group of franchises were being quantified, and individual characteristics of each store could reasonably be assumed to cancel each other out – was the perfect venue for a “rule of thumb” valuation. Moreover, the 50% "rule of thumb" (assuming it accurately represented the average multiple at which franchises changed hands) would take into account such issues as renovations and renewals.

 The Actual Value

In theory, the judge should have compared this “but for” asset value with the actual value of each franchise in 2005 in light of the precipitous decline in sales.  This is particularly so in the case of Location A, which continues to operate at a profit. Even location B may have some residual asset value. This is essentially the objection of the defendant. The defendant argued that Location A's loss was only $500,000 - $350,000 = $150,000, and not $500,000 - $0 = $500,000.

This objection would have been valid if the plaintiffs all sold their businesses immediately in 2005. But this is not (apparently) what actually happened.

Let us assume that Locations A and B continued to operate for several more years. Assume – perhaps optimistically – that  Location A continues to earn sales of $700,000 per year and suffers no further reduction in value. The loss to the owner of Location A will be the difference between her original asset value of $500,000 and the residual value of $350,000 (refer to the table above).

For Location B, things are much different. Recall that the loss in business value to Location B as at 2005 was $300,000, that being the difference between the “but for” value of $300,000 and the actual value of $0. One might ask why we assigned a value of $0 to Location B’s assets, if Location B now projects to run at an annual deficit. The reason is that an asset can never be worth less than $nil; an economically rational owner is assumed to simply walk away from the asset. But suppose that Location B tried to make a “go of it” and suffered operating losses for several years, trying to turn things around.  These operating losses will need to be added to Location B’s losses. In all likelihood, Location B lost more than the $300,000 that its assets would have been worth if not for the breaches of Dunkin' Donuts.

(The one caveat to what I have written in the last paragraph would be if Location B financed its continued losses with bank debt and then managed to negotiate a settlement of that debt for less than its face value).

Conclusion

So, was the trial judge’s decision fair? It is difficult to say with any certainty based solely on the written decision.

If most franchises were like Location A and continued to operate and earn profits from 2005 onwards (albeit at a reduced level), then the loss measured by the trial judge may very well have been overstated.

If, on the other hand, a significant number of businesses decided to labour on after 2005, suffering operating losses in the process, then the actual losses suffered by the plaintiffs may have been higher than the damages award.

Lessons:

• Loss of business value and lost profits can both be claimed as heads of damage without overlapping, so long as they relate to separate time periods.
• A loss of business value is properly measured as the decrease in a business's operating asset values.
• It is possible, in some instances, for a business to suffer a loss of business value greater than the original value of the assets.

My articles

These publications deal with a variety of damages-related topics. I have sorted them by broad area of topic.

As with everything I write (including this blog), these represent my personal views and not those of my firm as a whole or my partners and colleagues.

Franchise rescission:

• "Section 6(6) Damages under the Wishart Act" ABA Franchise Law Journal (this piece, which I wrote with Jonathan Mesiano-Crookston) received the 2014 Markus Cohen Q.C. Memorial Award from the Ontario Bar Association's Franchise Law section).
• "Clarifying financial remedies under the Arthur Wishart Act (Lawyers Weekly, May 13, 2011) 

Personal injury:

• “Calculating Sports Star Damages” (with Matt Mulholland), (Lawyers Weekly, December 18, 2015)
• "Remarriage and the Wrongful Death Equation" (with Rehana Moosa) (Lawyers Weekly, September 12, 2014)
• "Capital asset approach to personal injury damages" (Lawyers Weekly, May 2, 2014)
• "Personal Injury and the Self Employed - A Business Valuation Perspective on Labour, Capital and Everything in Between, Journal of Business Valuation (2013)
• "Real Injuries, False Returns (Lawyers Weekly, September 7, 2012)

Intellectual Property

• "Financial Remedies in Intellectual Property Disputes: Requests for Information and Discovery Questions", in Paul V. Lomic, Intellectual Property Litigation - Forms and Precedents, LexisNexis (2016)
• “Damages under Section 8 of the Patented Medicine (Notice of Compliance) Regulations: The Financial Consequences of a Statutory Injunction”, (co-authored with Jonathan Mesiano-Crookston) Canadian Intellectual Property Review 31:1 (2015)
• “Federal court examines impact of available alternative technologies” (with Mark Gain), (Lawyers Weekly, September 18, 2015)
• "Calculated Risk: A $75M Award Adds Urgency to Pre-Judgment Interest Considerations" (Lawyers Weekly, May 29, 2015)
• "Court Breaks with Apportionment (Lawyers Weekly, March 14, 2014)
• "A New Take on the Accounting of Profits Remedy (Lawyers Weekly, November 22, 2013) (The article actually discusses infringement damages, not the accounting of profits remedy. I don't write the titles)

 Commercial Litigation (general) 

• "Adding up the damage - Lost profits vs. Business Value (Lawyers Weekly, January 30, 2015)
• "Aggregate Damages - Doing the Math: Ontario case offers rare guidance on class action damage awards", (co-authored with Shane Murphy of Sotos LLP) (Lawyers Weekly, December 5, 2014)
• "Calculating the Cost of Time and Labour (Lawyers Weekly, August 30, 2013)

Fraud/Investigative Accounting

• "Who's Responsible for that Bounced Cheque" (Lawyers Weekly, July 18, 2014)

Restricted Stock Valuation  

• "Valuing Restricted Shares and Restricted Share Units", Journal of Business Valuation (2014) (this contains all four of the pieces that appears in the Money and Family Law newsletter - see below:
• Stulberg_Restricted StockII
• Stulberg_Restricted StocK III 
• Stulberg_Restricted StockIV

Dunkin’ Donuts c. Berticoinc, Part I: the Benchmark Approach to Lost Profits

Two weeks ago, the Quebec Court of Appeal released its decision in Dunkin’ Brands Canada Ltd. c. Bertico inc. 2015 QCCA 624. The Court of Appeal upheld the trial judge’s ruling (Bertico inc. c. Dunkin' Brands Canada Ltd., 2012 QCCS 2809) that Dunkin’ Donuts did not make appropriate efforts to stave off the impact of the rapid expansion of the rival Tim Horton’s chain into Quebec, and agreed that Dunkin’ Donuts was liable for having breached its contractual duties, as well as its duty of good faith to its Quebec franchisees. Where the Court of Appeal did find take issue was with  some elements of the trial judge’s damages award, reducing it from $16.4M to $10.9M. In the next two posts, I will comment on some of the interesting damages of the aspects of the appeal. This first post deals with the issue of the proper application of the “benchmark” approach to lost profits calculations.

Introduction

Dunkin’ Donuts had historically had a strong brand in the province of Quebec. Beginning in the mid-1990s, Tim Horton’s made a strong play to expand into the Quebec market, at the expense of Dunkin’ Donuts. In spite of repeated pleas from franchisees for assistance from the franchisor, Dunkin’ Donuts share of the Quebec market declined precipitously, from 12.5% in 1995 to only 4.6% in 2003, and many of its franchisees were forced to cease operating altogether due to unprofitability. A group of 21 plaintiff franchisees were ultimately awarded damages for both a) lost profits and b) loss of investment/business value.

The Damages Award

At trial, the parties put forth competing models to project the sales at the plaintiff franchise locations “but for” the failure of Dunkin’ Donuts to properly support the system. One model proposed by the plaintiff’s expert accountant was to assume that the plaintiff stores would have grown their sales at a rate of growth equal to that achieved by Tim Horton’s during the damages period. This methodology is generally referred to as the "benchmark" approach (it is referred to the "comparable" approach by the trial judge [103]). Under this methodology, one projects a plaintiff’s sales during a loss-affected period, but for the alleged wrongdoing, based on the actual results of a similar yet unaffected firm during the same period.

On appeal, Dunkin’ Donuts noted that Tim Horton’s primary competitor in the period in question was, in fact, Dunkin’ Donuts. Using Tim Horton’s actual growth rate during the loss period was not an appropriate measure, since Tim Horton’s actual rate of sales growth in Quebec had been positively affected  by the failure of Dunkin’ Donuts to support its brand. In projecting store sales in the hypothetical “but for” world, in which Dunkin’ Donuts is assumed to have acted properly, Tim Horton’s sales would have been lower, and it is this lower growth rate that ought to have been applied. The Court of Appeal accepted this argument, and decided that it would be more appropriate to use 75% of Tim Horton’s growth rate to project the plaintiffs’ sales.

Problems with the Benchmark Approach in Franchise Litigation

The (mis)application of the benchmark approach in the Dunkin' Donuts case illustrates both the attractiveness of the benchmark approach, as well as one of its drawbacks.

The benchmark approach to projecting sales can, at first glance, be very appealing, and especially so in franchise litigation involving an individual franchise, where there would appear to be many businesses that are very similar to the plaintiff, whose results can be used as a sort of “control group”.

The danger is that one might select a control group that is so similar to the plaintiff business that the damage caused to the plaintiff actually affects the control group as well. To illustrate, consider the following example.

A number of years ago, I had to quantify lost profits at a particular location for one of the largest franchise restaurant systems in Canada. The location (the “Loss Location”) had experienced flood damage caused by one of its contractors, and had to close for approximately 8 months (the “Loss Period”). I considered two potential approaches to projecting lost sales :

• Based on the rate of year-over-year growth experienced in the 12 months prior to the incident.
• Based on the actual rate of sales growth of nearby, unaffected stores during the Loss Period.

Both of these approaches proved problematic. Year-over-year growth at the Loss Location had been spectacularly high; upon inquiring, I was informed that nearby locations of that chain had undergone renovations the prior year, causing a diversion of customers to the Loss Location. Such a spike in sales would not have persisted following the completion of renovations to the nearby stores.

And of course, results at nearby stores during the loss period were skewed by two factors: the diversion of customers who normally would have dined at the Loss Location to other, nearby locations; and the natural increase in sales at the nearby locations following the completion of their renovations.

The correct approach in that case (or at least, the one I adopted) was to:

• Use a pre-incident base period that eliminated the effect of the one-time increase in sales at the Loss Location due to renovations at nearby stores; and,
• Use a broader benchmark group, consisting of all stores outside of a particular radius of the Loss Location. These stores would not have received much in the way of diverted customers, and the sample group was large enough that the effect of location-specific events such as renovations (which were being carried out on a staggered basis within the system) would be only minimal.

Reconstructing the “But For” World

The issue dealt with the Quebec  Court of Appeal also suggests a broader frame of analysis.

It is tempting to assume that the effect of a wrongdoing has been limited to the plaintiff, and that otherwise results in the actual world were unaffected and can be used to recreate the “but for” world. But, perhaps more often than we care to believe, a wrongdoing involving a single company can have a sort of “butterfly effect” on things such as market size price. This can be the case even when the injured party is only a small part of its market. I will provide other examples of this in future posts, but for now I conclude with the following lesson:

Lesson: If using an outside benchmark to project the results of the plaintiff but for the wrongdoing, be sure to fully consider the possible effect of the wrongdoing on that external benchmark

Welcome to Canadian Damages Blog

Who am I?

I am a chartered accountant and chartered business valuator living in Toronto, Ontario, Canada. I am a senior manager with Matson, Driscoll & Damico.

My practice is focused on three main areas:

·         Economic Loss Quantification
·         Business Valuation
·         Investigative Accounting

What can I do for you?

Typically, my engagements involve the preparation of some form of expert report setting out my findings, generally in the context of litigation. The report is used by the parties to arrive at a financial settlement, or in court if things proceed that far.

Goal of the Blog

This main purpose of this blog is to provide comment on the damages aspects of Canadian case law (both recent and otherwise). Damages decisions are often very fact-specific; I will try to extract the general damages principles implicit in the cases.

In addition to commentary on specific cases, I will also post general commentary on various aspects of economic loss quantification and business valuation.

Frequency of Posts

Blogs are like diets (only you don’t have to give up potato chips, which would have been a deal breaker for me). They begin with the best of intentions, but can quickly peter out. I’m committing to posting every day, other day – well, perhaps it’s better if I make no commitments at this point. It’s not like you’re paying me for this.