Litigators, Money, Wall Street

Forget Holding Them Or Folding Them - Start By Not Leaving Money On The Table!

Many attorneys leave money on the table by overlooking hedonic damages.

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poker cards money on tableDetermining damages is fundamental to many parts of the business of law. For both business disputes and personal injuries, damage calculation is a key aspect of getting a reasonable outcome for a client, whichever side you represent. Yet many attorneys leave out an important aspect of legal damages, which in turn leaves money on the table: hedonic damages.

According to Black’s Law Dictionary, damages are defined as “money claimed by, or ordered to be paid to, a person as compensation for loss or injury.” Damages calculations involving individuals often relate to personal injury, wrongful death, medical malpractice, or employment disputes. Businesses can also claim what amount to damages if they are harmed by unfair trade practices, tortious interference, etc.

For attorneys arguing in court, economic damages calculations can be difficult to convey effectively to a judge or jury. It is critical that attorneys understand the calculations well themselves in order to help them make a more lucid argument to other parties in the case.

Damage calculations generally entail three types of claims:

  • Special damages
  • Punitive/exemplary damages
  • Hedonic damages

Hedonic damages compensate a plaintiff for experiencing a loss of enjoyment of life due to pain and suffering caused by a damaging event. Accounting experts typically don’t calculate these damages – the calculations are more complex and require economic analysis, something that is usually outside the purview of accounting experts.

Yet, ignoring hedonic damages is leaving money on the table!

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Hedonic damages can be calculated based on two different methods:

  • Hedonic damages using Compensating variation
  • Hedonic damages using Equivalent variation

Each method will produce a different value. Attorneys need to make sure they are using the right one to maximize success for a client.

Hedonic damages have the potential to add significantly to overall damages, but are more “debatable” due to their intangible nature. The measurement of hedonic damages is based on some 40 years of extensive, well-accepted, peer-reviewed economic research. Daubert v. Merrell Dow Pharmaceuticals, Inc. helped establish hedonic damages, and set the stage for their acceptance in many (but not) all jurisdictions. Generally, economic expert witness testimony needs to be used when seeking hedonic damages.

As I said, hedonic damages are intangible and debatable. Hedonic damages are often based on the concepts of the Value of a Statistical life (VSL) and the Willingness-to-Pay model (WTP). The WTP approach is based on measuring what people pay for safety that results in small reductions in their risk of death.

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For instance, if the average person will pay $40 for a fire alarm that stands a 1-in-100,000 chance of saving their life, the WTP says that purchasers value their life at $4 million ($40 times 100,000). Economists generally agree that the typical VSL is in the $4 million to $5 million range. This value is an average of many published results based on economic research using WTP experiments – results may vary considerably, though, so it is important to determine how WTP may apply to a particular client.

Hedonic damages can also apply in cases involving claims like wrongful imprisonment or business disruption cases. When used in business loss cases, hedonic damages represent a form of opportunity cost. Opportunity cost is the cost that was incurred by giving up an alternative outcome.

A simple example of opportunity cost is the cost of going to law school. A law degree has two costs: direct tuition PLUS the lost income one would have earned while working. Similarly, the cost of a business disruption is both direct damages PLUS the profits and business growth that would have occurred if disruption had not taken place.

The opportunity cost can actually be bigger than the direct cost in many instances. I’ve buried the lead a bit, but both hedonic damages and opportunity costs center on hypotheticals – what would have happened had a particular event not occurred. There are two methods for calculating these damages, and these techniques are well-accepted in economics.

First, there’s compensating variation or CV, which is defined as the amount of compensation gain an agent (person or business) would need to reach its initial utility after an action that affects economic well-being of the agent. Under the new post-event regime, CV is what level of compensation it would take for the agent to allow the change to occur.

For example, if a business is hurt by an unfair trade practice, how much money does it take to bring the owner back to being “equal”? CV is the answer.

The second method for calculating damages is equivalent variation or EV. EV measures the amount of money a consumer would pay to avoid an event, before it happens. For instance, how much money would a person pay to avoid being injured in a car accident before the accident happened? The answer is EV.

EV and CV can be equal in some circumstances, but often they are not, because they are NOT the same thing. In essence, CV defines how much money it takes to make someone equally well-off given that an event has occurred. EV defines how much money someone would give up to avoid the event occurring in the first place. In research studies, economists have found, EV is often more than CV – it’s about property rights, and an element of human psychology. Attorneys would be wise to consider which metric is right for them in a particular case and how it can enhance their damage awards.

Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

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