The New Business Rule and Compensation for Lost Profits

Not so long ago, most American jurisdictions followed the “new business rule.” If a business did not have a history of profitable operations, it would have been denied recovery for lost profits. That has changed. The prevailing wisdom nowadays replaced a per se rule with a rule of evidence—damages must be proven with reasonable certainty, regardless of whether the claimant was a new business.

However, the prevailing wisdom is wrong. The damages for a new business ought not be viewed as merely a matter of whether the evidence is sufficient to surmount the “reasonable certainty” hurdle. The new business rule conflated a number of different problems. By stuffing inherently different types of problems into a single box, courts and commentators undermined the rationale for the rule, even for cases in which application of the rule was appropriate. Unpacking the concept results in a more nuanced approach to measuring damages.

There is a class of cases in which the appropriate new business award should be zero, but the courts have drawn the line in the wrong place. The crucial issue is not the lack of a track record or whether damages can be proved with “reasonable certainty.” Rather the focus should be on the expected return on a new investment (whether by a new or existing business). These cases can be characterized by Terry Malloy’s plaintive cry: “I could’ve been a contender.” Following a breach, the plaintiff, who has done nothing in reliance, claims that, but for the breach, I would have done X, and I would have made a lot of money by doing so.

The relevant question should not be whether the project would make money but whether it would make more money than the next best alternative. The investment might have turned out to be wildly successful or a dismal failure, but there is no a priori reason to believe that the expected rate of return would exceed the going market rate. After the breach the promisee still has the money that it would otherwise have invested in the project and it would be free to do anything it wants with those funds. The expected value of the specific project would be the same as the market rate, so the promisee’s loss would be zero.

For an example of how courts have misunderstood this, consider a claim by an aspiring franchisee. Courts have typically awarded damages using the earnings of comparable franchisees to demonstrate lost profits with reasonable certainty. But the relevant question should not be whether the franchisee would do as well in this location as anywhere else. Rather it should be whether there is reason to believe that it would do better, and the answer to that should be negative. Indeed, the very notion of basing the compensation on the earnings of comparable franchises presumes that the plaintiff would not do better.

In cases involving a claim for the future stream of profits on a stillborn project, the presumption should be that there were no lost profits. Any recovery should be based on whether the plaintiff had assets—either preexisting ones or those acquired in reliance on the contract—the value of which was contingent on the performance of the project.

For other cases that have been analyzed under the new business rubric, such as those involving nonpayment of a royalty stream, delay, or defects, claimants have suffered a real loss. Whether those claimants should recover damages should not depend on the newness of the business or the certainty of proof.

If the owner of some intellectual property licenses it to a party that fails to exploit it, and part of the licensor’s compensation was in the form of a royalty on the licensee’s sales, the damages would be positive. Unlike in the first case, the licensor has already made its investment. Unless the contract has a liquidated damages clause or some other restriction on recovery (and contracts often do) the damages should be recoverable.

If the breach resulted in delay—perhaps a construction project came on line a few months late, or a delivery arrived late— the performance eventually does take place. This category puts us squarely in the Hadley v. Baxendale world. The losses are real, but their recoverability depends on factors like foreseeability and remoteness, not on the newness of the business.

In MindGames, Inc. v. Western Pub. Co., Inc. 218 F.3d 652 C.A.7 (Wis.),2000, Judge Posner rejected the use of the new business rule, asking: “What, for example, is a ‘new’ business? What, for that matter, is a ‘business’? And are royalties what the rule means by ‘profits’?” Courts have fiddled with all these questions to determine whether or not a particular claimant should be allowed to recover. Sometimes they will uphold the per se rule but then decide that the business is not new. Sometimes they will find that there is no per se rule, but they will decline to award lost profits for various reasons, often invoking certainty. In other cases, courts will claim that certainty is needed only to show the existence of lost profits and that there is a lower standard to show the magnitude of the loss. Some courts have judged the lost profits measure by an even lower standard: Does the size of the verdict so shock the sense of justice as to compel the conclusion that the trier of fact was influenced by partiality, prejudice, mistake or corruption? The one question that courts have failed to ask is whether there was reason to believe that the claimant’s expected earnings in this project would be greater than with its next best alternative.

This post comes to us from Victor P. Goldberg, the Jerome L. Greene Professor of Transactional Studies Emeritus at Columbia University Law School. It is based on his paper, “The New Business Rule and Compensation for Lost Profits,” available here.