Date12 Mar 2021
CategoryForensic Accounting, Expert Witness, Fraud Investigation
With at least parts of the UK economy managing to adapt and survive in the ‘new normal’ in the wake of the ongoing Covid-19 pandemic and businesses taking stock of their financial situation, unsurprisingly, contract disputes are expected to be on the increase in the coming months and years. Reasons for such disputes will be wide ranging, from companies who have suffered significant inabilities to trade owing to complete collapses in their supply chains, to those looking to tighten their purse strings by terminating, for example, expensive IT contracts for minor contract infringements that would normally be ignored.
As accounting experts, we (mostly) leave it to the legal advisors to prove the sometimes complex issues surrounding whether a breach of contract has resulted in a loss to a claimant, by either a direct or proximate action, only getting involved where financial expertise is needed. This gets particularly difficult for legal advisors, when there are potentially numerous causes contributing to a company’s loss in addition to a contract breach, and when you throw the complexity of the impact of the Covid-19 pandemic into the mix, this becomes a causation mine-field. The intricacies of whether a respondent can rely on a force majeure contract clause, excusing them from their contracted obligations due to non-mitigatable circumstances beyond their control, will no doubt prove to be another hard fought legal battleground. Good luck to the lawyers.
Forensic accounting instructions in contract disputes typically involve quantifying the “but for” scenario. This is an assessment of the financial compensation that would need to be paid to the claimant, to put them back in the position they would have been in, but for the breach of contract by the respondent. In its simplest form this is sometimes formulated as:
Loss of profits = lost revenue – costs that were avoided
It is worth noting, particularly given the struggles of some businesses during the Covid-19 pandemic, that a company does not have to be profitable in order to make a loss of profits claim under a contract dispute. A contract breach may have resulted in a company making a greater loss than it otherwise would have during the period of the breach, with the resulting claim under these circumstances being the reduced loss under the “but for” scenario. There may also be the potential to reclaim additional costs incurred as a result of the breach, but care must be taken to ensure no double counting of claimed amounts occurs.
In quantifying a loss of profits claim, we usually review a combination of the following information sources in order to estimate how a company would have performed, and what additional profits it would have achieved, but for the breach:
The challenge lies in estimating the financial impact of something that did not and now will not happen, often taking into account numerous interlinked factors, with seemingly small changes in assumptions, potentially having significant impacts on the overall quantum of loss assessed. The complexity drives the need for specialist advice.
By way of example, imagine you are CEO of Luxurious Polyester Ltd., a polyester manufacturer. You are subject to two separate contract disputes with two different customers, for failing to fulfil the minimum volumes of polyester required under the respective supply contracts, at the height of the Covid-19 pandemic. The supply contracts are identical in every respect, force majeure clauses do not apply, and a wrongful act by you has been proven and linked to the losses incurred by the customers. Despite the similarities, each claim’s potential financial impact can be very different, purely as a result of how the Covid-19 pandemic has impacted each of the customers.
The first customer is PPE Pandemic Ltd., a wholesaler of personal protective equipment, recently formed right at the start of the Covid-19 pandemic. The company has no trading history and is yet to experience a significant trading period that has not been impacted by the breach of contract. As forensic accountants seeking to quantify loss, a comparison of pre and post breach financial performance is not instructive. Comparing to similar companies in the sector is a possibility, but the likelihood of having access to published financial records for such companies for the relevant period soon is unlikely. Further, the complete lack of track record for PPE Pandemic Ltd. means it is difficult to assess which other companies they would be comparable too, even if they had produced contemporaneous financial forecasts prior to the breach.
Whilst it seems likely that PPE Pandemic Ltd. Would have been able to make strong sales during the Covid-19 pandemic, given the heightened demand for their products, any quantum of loss calculation under these circumstances would be a delicately balanced ‘tower of assumptions’. PPE Pandemic Ltd.’s claim may face significant challenge on the basis that it is not possible to calculate a likely level of sales and associated costs avoided with any reasonable certainty.
The second customer is Super Static Shirts Ltd., a worldwide high-street clothing chain, with its roots dating back to Saville Row in the 1850’s. The company has a long trading history, and although it is yet to experience ‘lockdown’ trading that has not been impacted by the breach, comparing performance before the breach and contemporaneous forecasts as benchmarks can be used as a starting point in a calculation of loss. It would need to be recognised that trading has been difficult for high street clothing shops during the Covid-19 pandemic. Formulating the quantum of loss for Super Static Shirts Ltd., based purely upon the historical and pre Covid-19 forecasted financial performance, would be wrong. The financial performance of comparable companies (Super Static Shirts Ltd.’s well-known competitor Teflon Ties Ltd. springs to mind) would be relevant information in this respect. However, it may be some time before Teflon Ties Ltd.’s financial information for the relevant period becomes available, and there is often a question as to whether the comparable companies identified are indeed comparable (e.g. one might have a much better online presence than the other).
So, for you as CEO of Luxurious Polyester Ltd, there may be cause for optimism.
It is likely to be challenging for PPE Pandemic Ltd and its advisors to formulate a justifiable and evidenced opinion on its quantum of loss. The claim by Super Static Shirts Ltd. also faces challenges, if it struggles to show how it would have been able to trade during the Covid-19 pandemic, but for he breach. It may be some time before a forensic accountant is able to formulate an evidenced opinion, as this will likely be heavily reliant on the financial performance of competitors during the relevant period, the financial results for whom are unlikely to be available yet.
Covid-19 is likely to make the already complex issue of contract disputes even more complex. Our hypothetical example only considers claims one step down the supply chain. The catastrophic impact of Covid-19 on some industries could result in a domino effect, with ripples of contract disputes along complex supply chains. As forensic accountants, we are experienced in dealing with complexity and presenting financial evidence in a clear and compelling way. We look forward to supporting our clients and our lawyer connections in the months ahead.