If your company suffers significant losses due to a fraud incident, you may decide to pursue the perpetrator in court, possibly to obtain compensatory damages. Assuming you win your case, you should know that estimating fraud damages is challenging. It generally requires the assistance of a financial expert, who will consider the facts of the case and the harm suffered by your business. Let’s take a look at calculation methods.

Benefit-of-the-bargain vs. out-of-pocket

Damages experts typically use either the benefit-of-the-bargain or out-of-pocket approach to make estimates. The appropriate method depends to some degree on the location and nature of the fraud. But in most cases, the benefit-of-the-bargain method results in greater restitution for victims.

Take, for example, a real estate developer who buys a parcel of land that the seller says is worth $2 million but is being offered at $1.5 million. In reality, the seller is lying about the parcel’s value and has falsified the valuation report. The land is actually worth about $800,000. Putting aside the developer’s failure to perform proper due diligence, how might fraud damages be assessed?

Using the out-of-pocket rule, the buyer would be awarded $700,000 in damages, or the difference between the land’s real value and the amount paid for it. Using the benefit-of-the-bargain rule, however, damages would be calculated at $1.2 million — the difference between the seller’s misrepresented value and the parcel’s actual worth.

Other calculation approaches

Plaintiffs typically prefer the benefit-of-the-bargain method, for obvious reasons. But there are other methods experts might use to calculate lost profits — for example, the benchmark (or yardstick) method. Here, the expert compares a fraud victim’s corporate profits to those of another, similar company that wasn’t defrauded. This method is particularly appropriate for new businesses or franchises.

The hypothetical (or model) method is also generally appropriate for businesses with little history. It requires the expert to gather marketing evidence that demonstrates potential lost sales. After calculating the total, the costs that would have been associated with the lost sales are subtracted to arrive at lost profits.

For longer-established businesses, the before-and-after method typically is preferred. Experts look at the company’s profits before and after the fraud compared to profits during the time the fraud was being committed. The difference is the business’s lost profits.

Boost the odds

To boost your chances of receiving adequate restitution in court, you or your attorney should engage an experienced damages expert early in the litigation process.

(This is Blog Post #1563)