Foreign Exchange Issues in Damage Quantification: Part II - Applying the Concepts

In the previous post, we presented a basic framework for analyzing the impact of foreign exchange fluctuations on quantifying financial remedies. We argued that the treatment of foreign exchange should be consistent with the principal underlying the financial remedy being awarded; we referred to this as a "matching principle".

In this post, we extend that basic logic to consider other scenarios.

 

1.     What if we are not sure how to match?

Consider Mr. Canuck, an executive working for a Canadian subsidiary of a US-based public company is wrongfully terminated. As a result, the stock options to which he would have been entitled as of July 2009 did not vest. He sues for wrongful dismissal, and is successful. His damages are assessed as the difference between the exercise price ($1 USD per share) of the options and the market value of the stock on July 2009 ($10 USD per share). The trial occurs in 2011, and an award for damages is granted shortly thereafter.

Arguably, the appropriate exchange rate will depend on particular findings of fact:

 ·         Assume that the court determines damages based on the profit that could have been earned by exercising the options on the date they vested, and immediately selling the shares thus acquired and converting the proceeds into Canadian dollars (to buy a new sportscar). Under this set of assumptions, the relevant exchange rate is the rate in effect on the vesting date, since that is the date Mr. Canuck would have converted his $USD-denominated assets into $CDN. Converting his award based on the current exchange rate will not provide Mr. Canuck with sufficient funds to buy his sportscar![1]

 

·         Conversely, supposing that Mr. Canuck held a large $USD-denominated stock portfolio at the time he would have exercised his options. In that case, it may be more appropriate to assume that he would have simply rolled his company stock into another US investment, which he would have continued to hold. If so, then his damages award should be based on the exchange rate in effect at the award date; Mr. Canuck can take his award, convert it into USD and purchase the same portfolio of stock that he would have purchased following the exercise of his options.

2.     Future Losses

Let us now turn to the example of a personal injury claimant, Ms. Nascar. She is a US resident, and is injured in a motor vehicle accident in Canada, and will never be able to work again. What sort of foreign exchange rate should be applied to her prospective losses?

But for her injuries, Ms. Nascar would have continued to work in the US, earning USD. Her lump sum damages award will be calculated in USD; she will then need to be given a CDN amount such that she will be able to use it to purchase a USD stream of income (e.g. a portfolio of US government bonds) sufficient to replace her lost income. This will be accomplished by looking to the current exchange rate on the award date.

(Some may argue that if the exchange rate on the award date is unusually high or low, it may be fairer to apply some sort of long term forecast exchange rate. I would argue that generally speaking, actual exchange rates are the best reflection of anticipated future rates; to the extent that they are not, the defendant can always enter into a hedging arrangement.

Suppose the liability insurer of the defendant feels that the exchange rate of $1 USD = $1.25 CDN is abnormally high, and that a “fairer” exchange rate to use would be $1 USD = $1.10 CDN. The insurance company could simply borrow USD now, exchange the USD for CDN at the “favourable” exchange rate, and then pay back the USD when the exchange rate “normalizes” to $1 USD = $1.10 CD.)

3.     Damages and Profits

Consider the case of Maple Leaf Technologies Inc. (“MLT”), a Canadian firm who infringes a patent by manufacturing goods in Canada and selling them in the United States. Most of the MLT's operations are in Canada.

 

Under Canadian law, the patent owner – a US based firm, Stripes and Stars Inc. (“SSI”) - may sue for either damages on its lost sales, or an accounting of the defendant’s profits from the infringing sales. I would argue that the appropriate exchange rate to use may depend on the type of financial remedy that is being pursued. 

In an award for damages, the goal is to return the plaintiff to the position it would have been in had the wrongdoing not occurred. The analysis centres on the plaintiff. In the case of the SSI, whose patent was infringed, arguably the treatment of the damages award should depend on what it would have done with its USD sales. Since SSI’s operations are all US-based, the damages award needs to be such that SSI can take the award (based on the exchange rate in effect on the award date) and convert it into USD.[2]

The analysis in an accounting of profits case is different. The focus is on the profit taken by the infringer, which in this case is a Canadian company, MLT. MLT is in the practice of converting the proceeds of its USD sales into CDN, since virtually all of its operations are carried out in the Canada. In order to eliminate the benefit received by MLT from its wrongful sales, it would be more appropriate to quantify the profits to be disgorged based on the actual historic rate at which Maple Leaf Technologies had converted its USD sales into CDN, and not on the rate in effect on the award date.

If this analysis is correct, then fluctuations in foreign exchange rates may be a relevant factor for SSI in deciding which remedy to pursue. Assuming that SSI's lost profits and MLT's incremental profits from the infringing sales are very similar (i.e. that any sales MLT made would have been made by SSI, and the two companies have similar cost structures), and the value of the Canadian dollar has depreciated relative to USD by 20%, then SSI will be better off electing damages.

4.     Hedging

Finally, consider a Canadian firm, Stick and Puck Ltd. ("SPL"), which was unable to make sales to the US as a result of its contractor’s negligence. SPL does a steady volume of business in the US, and in order to reduce its exposure to fluctuations in foreign exchange rates, it typically enters into forward contracts to sell USD and purchase CDN. How does one treat the hedging arrangements that Stick and Puck had entered into? Do they matter?

There are many types of such arrangements, but two common ones which we will consider here are:

·    Forward contracts: These contacts obligate the Canadian firm to exchange a certain amount of USD at a certain date at a certain price.

·    Option contracts: These contracts give the Canadian firm the right (but not the obligation) to exchange a certain amount of USD at a certain date at a certain price.

Let us suppose that SPL lost $1M (USD) in sales as a result of the incident. At the time, the spot exchange rate was $1USD = $1.2CDN, but SPL had entered into a forward contract a number of months prior to that, according to which it agreed to trade $1M USD to its counterparty in exchange for $1.15M CDN.

At first glance, one might think that the relevant exchange rate to apply would be the forward contract rate of $1USD = $1.15CDN, on the grounds that, but for the incident, SPL would have taken its $1M (USD) and exchanged it for $1.15M CDN.

This is not correct, however. A forward contract has an intrinsic value of its own, regardless of whether it is being used to hedge against exchange rate risk or for purely speculative purposes. A contract that requires me to sell $1M (USD) for $1.15M (CDN) when the spot exchange rate is in fact 1 (USD):1.2 (CDN) has a value of negative $0.05M to me, and that needs to be considered. In reality, one should really think of there as being two separate transactions that would have occurred:

 1.     Receive sales proceeds of $1M (USD), convert to $1.2M (CDN) at spot rate.

2.     Take $1.2M (CDN), convert it to $1M (USD), and give the $1M (USD) to the counterparty in exchange for $1.15M (CDN).

Had SPL been able to complete both transactions, its net result would have been to have $1.15M (CDN) in its pocket. However, because it was not able to make the sale for $1M (USD) (Transaction #1), it is left with a loss of $0.05M as a result of the forward contract (Transaction #2). Combining the sales proceeds of $1.15M (CDN) that SPL would have had with the negative $0.05M that they now are stuck with, the aggregate loss is $1.2M.

In short, even if a company enters into forward contracts, the relevant exchange rate will be the spot rate at the time the lost sales would have occurred, not the forward contract rate.

What if SPL had the right, but not the obligation, to sell $1M (USD) in exchange for $1.15M (CDN)? In our example, such an option would have a negative intrinsic value (since the spot rate is $1USD=$1.2CDN); SPL would not have exercised the option, but would have simply exchanged its $1M (USD) received from the sale of its goods based on the spot rate. Again, it is the spot rate that is relevant, not the contracted rate.

Conclusion

Foreign exchange rates can add complexity to financial loss calculations. My central argument in this post has been that the choice of exchange rate should never be a mechanical exercise; rather, it should be a function of how best to achieve the underlying goal of the financial remedy in question. Carrying this line of thinking through to its logical conclusion can yield interesting results.

 

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[1] This was essentially the approach adopted by the trial judge in Bailey v. Cintas Corporation, 2008 CanLII 12704 (ON SC),

[2] This was the approach adopted by the trial judge in Alliedsignal Inc. v. du Pont Canada Inc., 1998 CanLII 7464 (FC),; upheld on appeal (Alliedsignal Inc. v. Dupont Canada Inc., 1999 CanLII 7409 (FCA),)

Foreign Exchange Issues in Damage Quantification: Part I - Basic Concepts

International trade is an increasingly important part of the Canadian economy, as this picture clearly shows:
 

 

As a result, it is not uncommon for litigation to involve the quantification of financial remedies across multiple political and monetary boundaries. How does one take foreign exchange rates – and more specifically, fluctuations in foreign exchange rates between the date of initial wrongdoing and the trial date – into account? In the next two posts, I will consider the following five examples, through which I hope to illustrate some basic concepts:

1.   A US-based company, Manifest Destiny Inc. (“MDI”) has a contract to sell $1M (USD) of specialized goods to a Canadian firm. The Canadian firm breaches the contract, and MDI is unable to make the sale (or to mitigate its loss). The exchange rate at the time of breach was $1 USD = $1.25 CDN; it is now $1 USD = $1 CDN.

2.   Gordon C. Canuck (“Mr. Canuck”), an executive working for a Canadian subsidiary of a US-based public company is wrongfully terminated. As a result, the stock options to which he would have been entitled as of July 2009 did not vest. He sues for wrongful dismissal, and is successful. His damages are assessed as the difference between the exercise price ($1 USD per share) of the options and the market value of the stock on July 2009 ($10 USD per share). The trial occurs in 2011, and an award for damages is granted shortly thereafter.

3.   Nancy Nascar, (“Ms. Nascar”) a US resident, is injured in a motor vehicle accident in Canada, and will never be able to work again. She sues the motorist who collided with her, and seeks to recover her future loss of income.

4.   Maple Leaf Technologies Inc. (“MLT”) infringes a patent by manufacturing goods in Canada and selling them in the United States. Most of the firm’s operations are in Canada. Under Canadian law, the patent owner – a US based firm, Stripes and Stars Inc. (“SSI”) - may sue for either damages on its lost sales, or an accounting of the defendant’s profits from the infringing sales.

5.   Stick and Puck Ltd. (“SPL”) a Canadian firm that manufactures products in Canada and sells them in the United States, suffers a fire in its factory. It sues the electrical contractor to recover its lost profits. SPL does a steady volume of business in the US, and in order to reduce its exposure to fluctuations in foreign exchange rates, it typically enters into forward contracts to sell USD and purchase CDN.

 The Law

You may be asking at this point, why not simply quantify whatever the financial remedy is in the foreign currency? If only it were that simple!The Currency Act, R.S.C., 1985, c. C-52, s. 12, requires that any money referenced in a legal proceeding in Canada must be stated in Canadian currency.  It is on this basis that Canadian courts have generally felt compelled to convert awards for financial loss into Canadian dollars, even if the losses relate to a foreign currency.

There was, for many years, an established rule that the exchange rate be set based on the date of breach or wrongdoing. As summarized by the Manitoba Court of Appeal:

 

89                    At present, the Canadian “breach date rule” is based on a series of Canadian cases which adopted a now obsolete British rule.

90                        In 1945, the Supreme Court of Canada, in Gatineau Power Co. v. Crown Life Insurance Co., 1945 CanLII 33 (SCC), [1945] S.C.R. 655, applied a date of conversion at breach date in an action to recover a debt.  They did so in brief reasons, referring to the cases of The Custodian v. Blucher, 1927 CanLII 69 (SCC), [1927] S.C.R. 420 (a case dealing with unpaid dividends), and S.S. Celia v. S.S. Volturno, [1921] 2 A.C. 544 (H.L.).

91                        Those two cases, in turn, relied upon principles enunciated by previous English House of Lords cases.  That principle was that in all cases involving sums payable in a foreign currency, the applicable rate of exchange was the rate in existence on the date of breach.  See, for example, Re United Railways of the Havana and Regla Warehouses, Ltd., [1960] 2 All E.R. 332 (H.L.).[1]

The MBCA went on to describe how some Canadian jurisdictions have moved away from this principle, writing into their statutes specific rules to the contrary. For example, in Ontario, section 121 of the Courts of Justice Act stipulates that a damages award calculated in a foreign currency must be converted to Canadian dollars based on the exchange rate in effect at the judgment date; section 121(3) of that Act provides the court with discretion to use an alternate exchange rate when warranted. Other jurisdictions, even without explicit statutory adjustments, have also departed from this "rule" (as indeed did the MBCA in the case in question).

In this post and the next, I will discuss a variety of situations in which the issue of foreign currency conversion will arise. I will suggest that a simple set of principles can be applied to cut through some of the confusion to arrive at monetary awards that are economically fair and predictable.

1.     Matching the Remedy to the Loss

The basic principle behind an award for damages is to return the injured party to the position he or she would have been in but for the wrongdoing. Let us apply this principle to the question of foreign exchange in each of the five examples listed above.

Turning to our first example listed above, consider that MDI is a US company, and its lost sales were in USD. The exchange rate at the date of breach is irrelevant to MDI; MDI was never going to take the proceeds from the sale and invest them in Canadian dollars. It would have taken the USD from the sale and used them to run its US-based business. It has lost USD.

In order to be made whole, MDI needs to receive an amount of Canadian dollars such that it can take them to the bank today and convert them into $1M USD (the amount of its loss). The relevant exchange rate is therefore the rate in effect on the award date, not on the date of breach.

(By the same logic, if there is a delay between the award date and the date of actual payment, we would argue that it is the date of actual payment that is more relevant.)[2]

Conclusion

 

Thus far, I have argued that the treatment of foreign exchange should be consistent with the principal underlying the financial remedy being awarded. In the next post, I will show how this approach can be applied to other types of cases.

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[1] Kellogg Brown & Root Inc. v. Aerotech Herman Nelson Inc. et al, 2004 MBCA 63, at para. 89. This decision contains a useful summary of the legal background to this issue.

[2] This is an issue that the MBCA grappled with in Kellogg.

 

The Dividend Double Count

In this post, I touch on a common error I encounter in dealing with a financial analysis of multiple companies owned by the same group or individual. I call this error the “dividend double count”, for reasons that will become apparent momentarily. The error arises in various areas of my practice, but most commonly in the areas of family law and personal injury.

The Issue

The error is as follows. Consider the following simple ownership structure:

Now, suppose that during the most recent calendar year, the following results were reported:

 

 

The question that arises in a family law context is: what was the pre-tax income available to Mr. Shareholder? An intuitive response might be to simply look at the “income before taxes” line on the income statements of Opco and Holdco, and take the sum of $120,000 (i.e. $80,000 + $40,000). Some may also be tempted to pick up the $15,000 in dividends paid to Mr. Shareholder.

But this would be wrong.

Opco shows dividends paid of $45,000. Holdco is the sole shareholder of Opco, so those dividends – which have not been deducted in calculating Opco’s income before taxes – are appearing as part of Holdco’s revenue (along with some miscellaneous revenue).

Had Opco paid out a $45,000 management fee to Holdco, the analysis would be much simpler; the management fee would show as an expense to Opco and as revenue to Holdco; the impact on the combined net income of the two companies would be neutral. The problem really arises because dividends are not deducted in calculating income. In order to calculate the overall pre-tax income, it is necessary to deduct the $45,000 in intercompany dividends. The actual pre-tax income of the two corporations is $120,000 - $45,000 =  $75,000.

(The same commentary would apply to the $15,000 reported by Mr. Shareholder on his personal tax return; these have been paid out of Holdco’s pre-tax income, and should not be included again at the personal level in analyzing Mr. Shareholder’s income).

Other Contexts

This issue also arises in other situations. A number of years ago I analyzed the income of a group of real estate development companies in the context of a claim for personal injury damages. The plaintiff’s expert had presented a claim based on a decline in net income between the pre-accident and post-accident periods, but had neglected to consider the distortions created by the issuance of large intercompany dividends.

Conclusion

Dividends issued from one company to another are included in the income of the recipient, but are not deducted from the income of the issuer.[1] In analysing the revenue or profitability of a group of companies, it is important to gain an understanding of how the revenue of each company is generated in order to gain a proper picture and to avoid double counting.

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[1] The Income Tax Act recognizes this; intercompany dividends amongst related companies are not subject to tax in the hands of the recipient company.