Springboard Profits/Damages in Canadian Intellectual Property Litigation

A few weeks ago, I co-presented at the Intellectual Property Institute of Canada’s annual conference in Vancouver on the topic of financial remedies in patent litigation. My portion of the talk focused on springboard profits as part of the accounting of profits remedy. In this post, I’ll share some of my thoughts from the presentation, as well as some other ideas that were suggested to me by my co-panelists and audience members.

The Concept

The concept behind springboard profits is that, by virtue of having infringed a patent, the infringer has achieved a financial advantage that continues beyond the expiry of the patent. This can occur for several reasons:

• A valid patent prohibits not only the sale, but also the manufacture and offering for sale of an invention covered by the patent. This means that had the infringer not infringed during the life of the patent, it would have taken some time to develop its product, to build up inventory, to market the product and build distribution channels. In short, it would have taken months, if not years, to build up their sales to a steady plateau. By infringing, the infringer is able to “hit the ground running” following the expiry of the patent.
• If the patented product is a durable good, then the benefits to the infringer in selling that good may include not only the initial sale, but also the sale of replacement parts, maintenance services, or other associated revenue streams. While the initial sale of the good may have taken place during the life of the patent, there will be additional benefits accruing to the infringer well beyond the life of the patent.
• In some instances, there may be an even longer-lasting benefit to the infringer. The existence of multiple firms already selling the patented product by the time of the patent’s expiry may dissuade additional firms from joining the market following the patent’s expiry, firms who may otherwise have entered the market if there had been only a single incumbent with whom to compete. In situations like this, the infringer’s benefit will continue into the indefinite future.

Are such post expiry springboard profits recoverable in an accounting of profits? In Dow Chemical Company v. Nova Chemicals Corporation, 2017 FC 350 (CanLII), Justice Fothergill found that they were. He was persuaded by Dow’s argument that if the incremental profits earned by the infringer following the expiry of the patent are not also disgorged, then the infringer will be left in a better financial position than if it had not infringed, a result that is antithetical to the very concept of the accounting of profits remedy.

Nova’s Argument

While they were ultimately rejected, the arguments raised by Nova also deserve some comment. Nova advanced several arguments. Conceptually, the most interesting arguments was the following:

• An infringer who disgorges its profits from infringement is implicitly acting as the agent of the patentee, and such payments implicitly serve to effectively condone the infringing activities themselves.
• The difficulty with this argument is that the profits remedy is not necessarily equal to the amount that, in the real world, the plaintiff would have agreed to in exchange for use of its patented technology. In many cases (such as the Dow case) the plaintiff would clearly never have agreed to license the technology under those terms, as its Minimum Willingness to Accept would be based on the damages it would suffer by reason of losing its monopoly over the invention in question.

The same argument would hold if the remedy awarded was lost profits (i.e. damages). The damages award compensates the patentee for its losses during the patent period only; any losses beyond that period would also need to be considered insofar as they are causally connected to the infringement.

Could Nova’s argument work in a damages context?

Is there a situation in which Nova’s argument would have carried more weight? Perhaps.

Suppose a plaintiff elects a damages remedy, which it measures based on a reasonable royalty since it is unable to prove it suffered any loss of sales as a result of the infringement.  In that scenario, the plaintiff’s MWTA is less than the defendant’s MWTP; that is, the benefit to the defendant from licensing is greater than the value to the plaintiff of its monopoly. This arises most commonly where the plaintiff is a smaller firm, while the defendant is much larger and able to scale to market.

In that case, a hypothetical royalty rate (and a fortiori an empirically based royalty rate, measured based on comparable transactions) should incorporate the fact that the defendant will thereby gain a springboard advantage. If so, then there should be no award of springboard damages.

This conclusion is implicit in the words of Justice Fothergill at paragraph 123 of the Dow decision:

[123]      Dow is entitled to awards under both ss 55(1) and 55(2) of the Patent Act. Even if the royalty rates calculated by Dr. Heeb and Dr. Leonard can be said to include the period following the expiration of the ’705 Patent, the royalty compensates Dow only for Nova’s infringement during the period December 9, 2004 to August 21, 2006. The accounting of profits extends over a much longer period.

Dow Chemical v Nova - Differential Profits and "Indirect NIA"s

Last year’s award of over $644M in Dow Chemical Company v. Nova Chemicals Corporation, 2017 FC 350 [1] is one of the largest awards for intellectual property infringement in Canadian history. The decision of Justice Fothergill contains many novel points of interest, but perhaps none so significant as his treatment of the issue of non-infringing alternatives and the deduction of fixed and capital costs in determining Nova’s profits to be disgorged to Dow.

The case involved Dow’s patent (the “705 patent”) for the production of a certain type of metallocene linear low density polyethylene (mLLDPE), a type of plastic. The patent was used by Dow to produce its ELITE mLLDPE, and the same technology was used by Nova in its SURPASS product. A previous trial had found that Nova had infringed on the 705 patent from 2002 until it expired on April 19, 2014, and as its financial remedy Dow elected (and was granted) an accounting of Nova’s profits from the sale of SURPASS.

Differential Profits

Over the past decade, Canadian courts have generally adopted what has come to be known as the “differential profits” approach. This approach, as described by the Supreme Court in Monsanto Canada Inc. v. Schmeiser, [2004] 1 SCR 902, 2004 SCC 34, says that in accounting for the defendant’s profits from infringement, one makes “a comparison … between the defendant’s profit attributable to the invention and his profit had he used the best non-infringing option”.

The notion behind this treatment is that the defendant should only be required to disgorge the incremental benefit it received as a result of the infringement of the patent. If, instead of infringing, the defendant would have devoted its efforts to some other enterprise, then the true benefit of the infringement is only the difference between the profit actually earned and the profit that would have earned from the alternative.

In much of the case law since Schmeiser, the application of the concept of “differential profits” has generally been limited to cases where it has been possible to identify a non-infringing alternative product (or technology) that would have been sold to the same customers that purchased the infringing units.

The effect of this focus on non-infringing alternative products has been that, when the infringing product embodies proprietary technologies that are key drivers of sales, such that it is not plausible the same customers would have purchased an alternative, non-infringing product from the defendant, the differential profits approach has generally been ignored, until Nova.

“Indirect NIA”

In Nova, it was acknowledged that there was no real non-infringing product that could have been sold to the purchasers of SURPASS; while Nova produces many other types of LDPE, none of these contained the unique features of ELITE or SURPASS that made those products so appealing to their customers.

However, Nova argued that but for its infringing activities, it would have deployed the production capacity used to manufacture SURPASS to make other types of plastic, which would have been sold to different customers. Nova referred to this as an “indirect non-infringing alternative” (para. 146).

The court accepted this argument, and allowed Nova to deduct a proportionate share of its fixed costs and capital expenditures related to the plant that had been used to manufacture the infringing product. The court noted that:

The “best non-infringing option” has generally been interpreted to mean a “true substitute” or “real alternative”. But appellate courts have frequently sought to reduce over-generous awards, including those that neglected to take into account alternative profits. The Federal Court of Appeal recently emphasized that “at bottom is the need to ensure that a patentee only receives that portion of the infringer’s profit that is causally attributable to the invention” (para 164, citations omitted).

Did the Court Apply a True “But for” Analysis?

Nova had argued that but for the infringement, it would have manufactured other products; if so, then it might have been appropriate for the court to analyze what the profits from those other products would have been. The court could have looked to the average profit per pound of other product during the relevant period and deducted this amount against the actual profits.

Why did the court instead simply allow for a pro-rata deduction of fixed and capital costs? First, it is not clear from the written decision whether Nova in fact attempted to claim as an offset, the profits it would have made from these alternate products. In addition, there is precedent for the court’s approach from other Commonwealth jurisdictions.

As a “shorthand” approach, the court’s approach has much to recommend it; rather than undertake a full analysis of the profits earned on other products, one can likely assume that in most cases, at the very least, those profits would have covered the fixed operating costs of the plant. But by deducting only a pro-rata portion of fixed and capital costs, rather than projecting the profit Nova would have made from alternate use of its fixed capacity, the court may have overstated Nova’s true benefit from its infringing activity.

What this means

This ruling would seem to augur the adoption of a broader, more holistic approach to the accounting of profits. The profits to be disgorged should be equal to a) the actual profits achieved as a result of the infringement in the real world, less b) the level of profit that would have been achieved in the “but for” world in which the defendant does not infringe.

This article originally appeared in The Lawyer's Daily (a LexisNexis Publication) on September 14, 2017

---

[1] In that decision, Justice Fothergill set out the framework for the calculation of damages. In 2017 FC 637, he addressed certain outstanding issues and issued the award.

Reasonable Royalties in Patent Litigation

Introduction

Until recently, there had been few reported Canadian patent infringement decisions dealing with reasonable royalties. This has changed in the past several years. This article looks at some of the key developments in this area of patent infringement financial remedies.

In patent litigation, the concept of a “reasonable royalty” is employed in two ways. First, a plaintiff is entitled to a reasonable royalty for infringement during the period between when the patent is “laid open” to inspection and when it is issued. Second, during the period following the issuance of the patent, a plaintiff who elects an award of damages and who is not able to demonstrate a direct loss of sales as a result of the infringement may claim a reasonable royalty on each infringing act.

Previous Approaches

In AlliedSignal Inc. v. Du Pont Canada Inc., 1998 CanLII 7464 (FC), the court ruled that a reasonable royalty would generally pay the patentee 25% to 33% of the incremental profit earned by the defendant from the use of the technology. The court noted various factors that would tend to move the rate within that range of percentages. For example, if the patentee was a competitor of the infringer, selling its products to a similar group of customers, this would tend to increase the royalty rate.

In Jay-Lor International Inc. v. Penta Farm Systems Ltd., 2007 FC 358, the court considered both the Allied Signal approach as well as two other approaches: the “analytical approach” and the “anticipated profits approach”.

The infringer’s use of the invention will often lead to a) higher selling prices for its goods, and/or b) lower manufacturing costs, depending on the nature of the invention.  Under the analytical approach as described in Jaylor, one measures the royalty rate based on the increase in the infringer’s gross margin percentage as a result of the infringement. For example, if the gross margin on non-infringing product sales is 30%, and the gross margin on infringing product sales is 50%, then the royalty on infringing sales should be somewhere between 0% and 20% of infringing sales.

Under the anticipated profits approach, one estimates the increase in the overall profit of the infringer as a result of the infringement, some portion of which is then allocated as a royalty to the patentee. The advantage of this approach is that it considers not only changes in gross margin percentage, but other changes in the business that result from the infringement, including (potentially) higher sales volumes and higher administrative costs. This was the approach adopted by the court in Jaylor; it determined that for every sale of infringing products, 20% of the selling price made its way to the bottom line. It then decided to award 35% of these profits to the patentee based on its analysis of the Allied Signal factors.

More recent cases

Some recent cases have continued with the sort of approach used in Allied Signal and Jaylor. In Frac Shack Inc. and Frac Shack International Inc. v AFD Petroleum Ltd. 2017 FC 104, for example, the court accepted the evidence that a royalty rate, across all technologies, would typically fall between 25% and 33% of the defendant’s profits. It adopted a mid-point of 29%.

However, most recent Canadian cases have tended to move away from these sorts of “rules of thumb”, mirroring a similar development in the United States (e.g. Uniloc USA Inc et al v Microsoft Corporation, 632 F (3d) 1292 (2011)). Instead, they have adopted a bargaining framework that considers two main elements of a hypothetical negotiation:

• The patentee’s minimum willingness to accept (MWA); and,



• The infringer’s maximum willingness to pay (MWP).

The reasonable royalty will fall somewhere in between the MWA and the MWP. For example, if the patentee’s MWA is 5% and the infringer’s MWP is 10%, the reasonably royalty will be somewhere between 5% and 10%.

The idea behind these concepts is that an economic actor will gauge what it is willing to pay or accept for a piece of technology based on the economic benefit or harm that this will cause to that actor.

Thus, in deciding to license its technology to an infringer, a patentee will consider:

• Whether this will result in a loss of market share due to granting a competitor access to a key technology.
• Whether this will result in a loss of sales dollars to the patentee, as a result of its loss of its previous monopoly position in the marketplace.

For the infringer, the analysis is the same, but from the opposite perspective, namely: will use of the invention allow the infringer to sell more units, and/or sell its existing products for a higher price?

In some instances, the patentee’s MWA may be quite low; this will be the case where the patentee does not produce or sell any products embodying its invention, such that any volumes sold by the infringer will not displace amounts that would otherwise have been sold by the patentee.

In other instances, the MWA will higher than the MWP, and there will be no effective bargaining range. Consider a case where the patentee and the infringer are the only two competitors in a given market. If the patentee keeps a monopoly on its invention, it will be able to sell to 100% of the potential market at monopolistic prices. If it licenses its invention to its competitor, every sale its competitor makes will represent a lost sale to the patentee; moreover, the presence of competitor in the marketplace will lead to a decrease in prices and an increase in certain expenses such as advertising. In this type of a scenario, no rational patentee would choose to license its technology.

The first mention of the MWP/MWA approach in Canadian jurisprudence appears to be Merck & Co., Inc. v. Apotex Inc., 2013 FC 751. Notwithstanding that Justice Snider ruled that she was not required to rule on a reasonable royalty rate, she accepted the basic MWP/MWA framework as conceptually sound. She also accepted that in a case where there is no effective bargaining range, the royalty should be set at the plaintiff’s MWA. In such a case the reasonable royalty will be very similar to an award for lost profits.

The approach was used again in Airbus Helicopters S.A.S. v. Bell Helicopter Texteron Canada Limitée, 2017 FC 170.  In that case, much of the analysis centred on the MWP, rather than the MWA; the facts of the case were somewhat unique, in that the infringing products were never actually sold by the defendant, and the financial impact of the infringement on the patentee was very difficult to measure. Most recently, the MWP/MWA approach was adopted by both experts in Dow Chemical Company v. Nova Chemicals Corporation, 2017 FC 350; once again, in that case the court found that there was no effective bargaining range and awarded a royalty based on Dow’s MWA.

Conclusion

Over the past several years, Canadian courts have adopted a more rigorous approach to quantifying reasonable royalties that considers the economic impact of the use of the technology in question on both the patentee and infringer. Similar to claims for lost profits or an accounting of the defendant’s profits, litigants in reasonable royalty cases will now need to address this fundamental point: what is the technology really worth to their business?


(This article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.)

 

The Patented Medicine (Notice of Compliance) Regulations and The Statute of Monopolies

Do generic drug companies have access to alternative remedies after having been held off the market as a result of a Prohibition Order under section 6 of the Patented Medicine (Notice of Compliance) Regulations? Or is their compensation restricted to the damages scheme outlined in section 8 of the Regulations? In this post, we look at a novel[1] effort on the part of Apotex (Apotex Inc. v Eli Lilly and Company et al, 2015 ONSC 5396) to use an antiquated piece of legislation to do precisely this.

Facts

In 2001, Lilly obtained a patent for the use of a drug called atomoxetine in the treatment of ADHD. Apotex developed its own version of the drug, and would have received its Notice of Compliance to begin selling the drug in late 2008. Lilly filed for, and received, an automatic Prohibition Order under s. 6 of the Regulations that prevented Apotex from selling its atomoxetine until late 2010, when Lilly’s patent was declared invalid.

Apotex pleaded a series of overlapping, alternative claims. It made a claim for damages under section 8 of the Regulations. It also made a claim for unjust enrichment, seeking to disgorge Lilly’s profits while it held its market monopoly. Interestingly, it also brought a claim for treble damages and double costs under the British Statute of Monopolies of 1624 (as well as its more recent Ontario counterpart of 1897). The decision in question concerns the disposition of Lilly’s motion to strike this last part of Apotex’s pleadings.

In rejecting Lilly’s motion, Justice Dunphy noted that Lilly’s “complete code” argument - that the Regulations are a complete code that precludes other sources of financial remedy to the plaintiff generic following the removal of the statutory stay - has not been conclusively determined to apply to the Regulations by any appellate court.  For this reason, he ruled that the arcane statutory cause of action put forth by the plaintiff ought not to be dismissed on a preliminary motion, but instead allowed to proceed to trial where they can be determined on a full factual record. 

It should be noted, of course, that causes of action will only be struck on preliminary motion where it is “plain and obvious” that the cause of action stands no chance of success; therefore, little more can be said at this point about the ultimate merits of the case on these statutes. It may well prove that Apotex’s antiquarian claim receives little more traction than attempts by litigants to obtain a “trial by combat”.

Analysis

Why is it that Apotex has put forth such a creative pleading? It would appear to be a function of Apotex’s continuing efforts to – from its perspective – level the playing field when it comes to the automatic injunctive relief provided by the Regulations.

Under the section 8 damages regime of the Regulations – it has been argued - there is a built-in incentive for the “first persons” or brands to take advantage of the automatic statutory stay provisions of the Regulations, regardless of the merits of the particular patents that it has listed on the patent register. Why is this? Consider that a sale that a generic company was precluded from making during the Relevant Period – i.e. a lost sale for which the brand will pay damages - is a sale that was, in the “real world”, made by the branded drug company. The sole differences are that:

●   In the real world, the brand will have made that sale at its brand price, which is set in a monopolistic world.  In the notional “but for” world, the generic drug company (Apotex in this case) is assumed to make many of those same sales, but for only a fraction of the price. For example, during the relevant period for the atomoxetine case (i.e. 2008 to 2010), generic prices in Ontario were equal to roughly 50% of brand prices.

●    The level of rebates or customer acquisition costs for branded drugs in a monopolistic world will be negligible. By contrast, the assumed cost of customer acquisition in the “but for” world is quite high, particular when multiple generic entrants are assumed.

As a result, the actual profits per unit made by the brand during the statutory stay period will likely greatly exceed the hypothetical profits that the generic would have made during the time it was kept off the market.  For example, if a brand company sold a drug for $1.00 per tablet in the real world and its variable costs were $0.10 per tablet (for a gross margin of $0.90), and was later found to have wrongly kept a generic off the market, it will pay as little as $0.20 per tablet in damages to the generic to compensate the generic for its losses; the net gain to the brand in such a case will be $0.70 per tablet, no matter the merits of its patent.[2]  Generic drug prices (as a percentage of brands) have continued to drop in recent years; as a result, this gap has continued to widen.

It is this discrepancy between the actual profits of the brand and the potential damages award available to the generics under section 8 that has given rise to Apotex’s (unsuccessful) attempts to recover an award for unjust enrichment (Apotex Inc. v. Eli Lilly Canada Inc., 2011 FCA 358, Apotex Inc v Abbott Laboratories Ltd, 2013 ONCA 555; Apotex Inc v Eli Lilly & Co, 2015 ONCA 305.) The claim for treble damages on the Monopolies Act is simply another attempt to break-out of the “complete code” that the Regulations have been characterized by some courts as being.

Conclusions

Is Apotex likely to recover treble damages? It is probably pointless to predict at this point. As to the broader question of whether the damages component of the Regulations, combined with the automatic right of a brand to injunctive relief, has created an uneven playing field – I am not so sure. Following the Supreme Court’s dismissal of the appeal in Sanofi-Aventis v. Apotex Inc., 2015 SCC 20, there does exist the spectre that, at least in cases involving drugs with multiple generic companies attempting to enter, brands may indeed be left with net losses as a result of multiple, overlapping damages awards or settlements.

---

[1] Novel for most litigants, anyway; Apotex has played this card several times before. E.g., see Apotex Inc. v. Warner-Lambert Company LLC, 2012 FCA 323

[2] This calculation assumes that the variable costs of producing and selling the medications are similar between the brand and the generics, which is typically the case. The calculation is based on the following assumptions:

 

$1.000 x 50% (formulary standard) x (1-40% rebate) - $0.10 (other variable costs) = $0.20

 

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.

 

---

[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),)

Tax Rates, Timing and Damages

The deadline for most individuals in Canada to file their income taxes is today, so I thought I would post on the issue of damages and taxation.

In Canada, as a general rule, damages awards are subject to the same tax treatment as the monetary amounts they are meant to replace. For example, awards for lost profits are taxed as business income.[1] Litigation can often take a long time to resolve; some lawsuits span decades. What happens when the tax system undergoes significant changes between the year the lost profits would have been earned and the year in which the damages award is paid?

In Canada, corporate tax rates have fallen significantly in recent years. The following chart shows the combined corporate tax rate for income earned in Ontario for income not subject to the small business deduction. Rates have fallen from slightly over 50% in the 1960s to under 30%. This can have a significant impact on damages calculations:

Consider the case of Eli Lilly and Company v. Apotex Inc.,2014 FC 1254. Apotex was found to have infringed Eli Lilly’s patents for the drug cefaclor; after many years, in late 2014 the court awarded Eli Lilly approximately $31M in damages resulting from the infringement over the period 1997 to 2000.

There is no discussion of income taxes in the written decision, and it is not clear if the issue was raised at trial. I refer to this case simply to illustrate the concept, and impact, of differential tax rates.

Had Eli Lilly and its Canadian subsidiary not been deprived of their lost profits in the period 1997 to 2000, they would have paid an average income tax rate of roughly 35% for sales made in Ontario; rates were similar in most other provinces. By comparison, on receiving its damages award in 2014 or 2015, Lilly will pay taxes at a rate of around 26.5%, a differential of 8.5%.

Had Lilly earned the profits in question in the period 1997 - 2000, its after-tax profit would have been $31M x (1-35%) = $20.15M. Receiving the same profit in 2014, the after-tax value is$2.64M higher. This is a factor that should have been taken into consideration in assessing, (and reducing) Lilly's losses.

Stated otherwise, had the court wished to give Lilly an award in 2014 that would equate to $20.15M in after-tax dollars (the amount of after-tax profit it would have received in 1997-2000), the award should have been $27.4M, or $3.6M less than the actual award ($27.4M x (1-26.5%) = $20.15M).

Considering that prejudgment interest of $75M was also awarded on the damages assessed - and I will return to this spectacular prejudgment interest award in future posts - the issue of declining tax rates likely represented a $10M issue in this case.

---

[1] http://www.cra-arc.gc.ca/E/pub/tp/it365r2/it365r2-e.html