Covid-19 – the economic fallout and the effect on damages claims

In summary

This article looks at the pandemic’s economic and financial consequences. It then considers their implications on the quantification of damages in disputes arising out of the pandemic.

Discussion points

• Financial and economic effects of covid-19.
• Implications of covid-19 for assessing lost profits.
• Complications introduced to the assessment of discount rates.

Referenced in this article

• CAPM – capital asset pricing model.
• CDS – credit default swap.
• Covid-19.
• CRP – country risk premium.
• Damages.
• DCF – discounted cash flow.
• International Monetary Fund.
• Lost profits.

Following the first reports of acute respiratory syndrome in China at the end of 2019, the Chinese authorities identified a novel coronavirus as the main causative agent. Since then, countries around the world have imposed containment measures and social distancing policies in an attempt to slow the spread of the virus. Despite these measures, the outbreak has evolved into a global threat and on 11 March 2020 the World Health Organisation declared covid-19 – the disease caused by the novel coronavirus – a global pandemic.^[1]

The spread of covid-19 presents major challenges to global businesses and has delivered a deep and sharp economic shock to many sectors and industries. Mounting concerns and precautionary measures taken by affected countries have brought global economic activity to a near standstill.^[2]

This chapter summarises the pandemic’s economic and financial consequences, and considers their implications on the quantification of damages in disputes arising out of the pandemic.^[3]

Impact on global economy

The lockdown of cities in China after the Chinese New Year holidays prevented workers from returning to work across China and South East Asia. As a result, manufacturers struggled to maintain their production lines, disrupting supply chains on a global scale. The official Chinese purchasing managers index fell to 35.7 in February 2020 from 50 in January 2020, indicating a deep contraction in manufacturing and related activity in China.

The virus’ spread to Europe and the United States was followed by a wave of tightening restrictions on movement across the continent. By mid-March 2020 more than 100 million people in Europe were under effective lockdown. Since 11 March 2020, the United States also restricted all travel from Europe for 30 days and closed its borders with Canada shortly thereafter. These moves severed supply and distribution chains across the global economy.

To compound these supply side issues, most industries have also seen a change in consumer spending patterns as consumers reduce their discretionary spending. In China, the China Association of Automobile Manufacturers reported that sales at dealerships fell by 79 per cent in February 2020 compared to the same period in 2019. Despite hopes that the prominence of e-commerce would help sustain consumption as consumers avoided shopping malls and restaurants, e-commerce platforms in China and the United States have stated that the impact on their businesses in the first quarter of 2020 will be negative due to higher proportion of sales coming from low-priced household staples and a shortage of workers to cope with demand.

Airlines have suffered perhaps the greatest fall in demand, as stringent restrictions on national and international travel have resulted in mass cancellations of business and leisure travel. International flight bookings to Europe were down almost 80 per cent year-on-year in the final week of February 2020, while airlines across Europe, North America and Asia have cut up to 90 per cent of their international and long-haul capacity. Governments globally are offering aid to the aviation industry to help cope with the slump in demand. The US Senate has set aside US$50 billion in direct grants and loan guarantees to support its aviation sector, with similar packages announced in Australia, Italy, Taiwan, Sweden and Denmark.

Unsurprisingly, the crisis has resulted in significant stock market volatility, as investors weighed the virus’ excepted medium and long-term economic consequences against the effects of interventions from governments and central banks. On Monday 9 March 2020, the Dow Jones Industries Index declined by more than 7 per cent due to mounting fears over the coronavirus and an unexpected price war between oil producers Saudi Arabia and Russia. The following day it rebounded by almost 5 per cent in anticipation of a stimulus package from the US government. However, on 12 March 2020 investor confidence in the US government and the European Central Bank waned, leading to the largest falls in the US markets since 1987.

This volatility has driven investors into comparatively less risky assets, such as government bonds. At the same time, central banks around the world have responded to the crisis by cutting interest rates to zero. As a result, the yields on the bonds issued by several major economies have fallen close to, or below, zero. On 25 March 2020, yields on one-month and three-month US Treasury bills fell below zero for only the second time ever.

The scale and depth of the dislocation across markets has affected companies’ abilities to meet their contractual obligations across a wide range of industries and sectors and is likely to trigger many arbitrations and litigations. Law firms and management consultants have written extensively and insightfully about the contractual provisions and risk management strategies that companies can use to manage and minimise these potential disputes. This chapter considers issues that could arise when quantifying the damages in disputes related to covid-19.

For the purposes of this discussion, we have assumed that a respondent has been found liable for breach of contract and that liquidated damages, or other contractual measures of loss, do not apply. In such circumstances, losses are typically assessed as either lost profits (expectation losses) or wasted costs (reliance losses).^[4]

The issues surrounding covid-19 are likely to complicate assessments of both lost profits and wasted costs. However, the complications are likely to be greatest in claims for lost profits, which are the focus of this chapter.

Assessing lost profits

Lost profits are measured as the difference between:

• the cash flows that the injured party expects to earn as a consequence of the alleged breaches – the ‘actual scenario’;^[5] and
• the cash flows that the injured party would have earned ‘but for’ the alleged breaches – the ‘but-for scenario’.

These scenarios can be assessed using a discounted cash flow (DCF) analysis. In a DCF analysis, the claimant’s estimated cash flows in the actual and but-for scenarios are projected over a discrete period from the date of breach to the estimated end of the loss period. The cash flows in each year are then discounted back to the assessment date using a discount rate that reflects the riskiness of these cash flows. A DCF analysis, therefore, relies on credible projections of the claimant’s cash flows in the actual and but-for scenarios and a reliable estimate of the discount rate applicable to those cash flows.

Even in a conventional breach of contract dispute, both of these elements can be subject to considerable debate between the parties. Due to the extent of the disruption caused by covid-19, parties are likely to face additional challenges assessing cash flows and discount rates in disputes arising from the current crisis.

Cash-flow complications

On the cash flow side, the outbreak complicates the projection of cash flows in the but-for scenario. For example, consider a hypothetical dispute between a smartphone manufacturer (claimant) and a member of its supply chain (respondent) over an alleged failure to supply smartphone displays, that resulted in the termination of a supply agreement.^[6]

Under normal circumstances, it might be reasonably assumed that had the contract been performed, the claimant would have taken possession of the displays and used them to manufacture smartphones, which it would then have sold to customers. When considering the but-for scenario the valuer could reasonably use the claimant’s historical price and cost data to estimate the incremental profit that the claimant would have earned on these sales.

However, given the extent of the disruption caused by the outbreak, it is unlikely that a shortage of displays was the only factor affecting the claimant’s business at this time. To construct a plausible but-for scenario, a valuer may need to consider whether the outbreak has affected the claimant’s business more widely.

For example, the outbreak may also have caused a shortfall in other inputs used in the manufacturing process, such as other raw materials and labour, or closures of the claimant’s factories. In these circumstances a valuer would have to consider whether the claimant would have been able to manufacture the smartphones, even if the displays had been available, and at what cost. The claimant’s historical manufacturing costs may be an unreliable guide to the manufacturing costs it would have incurred during the outbreak.

The valuer would need to work with counsel to develop the appropriate but-for scenario. In constructing this but-for scenario it may be necessary to consider how to treat a situation in which the manufacturer has suffered multiple breaches of its supply agreements, each of which in isolation would have caused the manufacturer to suffer some loss but that have cumulatively resulted in far greater losses. In such a situation, the judge or tribunal will need to balance the risk that the claimant will not fully recover its losses (if each loss is treated individually) against the risk that the respondent is held liable for damages not attributable to its breach (if losses are treated collectively). To assist the judge or tribunal, valuers and counsel will need to clearly set out how they have treated multiple breaches and the damages implication of that treatment.

Equally, the outbreak may have affected demand for the claimant’s products, and the claimant’s ability to meet that demand. Preliminary data published in Q1 2020 indicated that smartphone sales in China fell by more than 50 per cent in February 2020, compared to February 2019.

Historical demand and price data may not be a reliable guide to demand for the claimant’s products during the outbreak. The valuer may need to perform economic analysis to estimate demand and compare it to the claimant’s estimated inventory levels. This analysis is complicated by the speed with which the pandemic developed and governments restricted travel and introduced lockdowns, meaning that forecasts of demand may change significantly from day to day.

When forecasting a product’s sales and revenues, a valuer will often seek to rely on credible third-party estimates of future market growth and demand. However, particularly early on in the outbreak, credible sources formed very different views as to its likely medium and long-term economic consequences. For example, on 5 February 2020 the European Central Bank stated that the effects of the outbreak may be short term and temporary, limiting the need for policy action. However, around the same time, credit rating agency Moody’s discussed the consequences of a coronavirus pandemic, which it saw as a bigger risk than the global financial crisis and Great Recession of 2008–2009. Thus, in forming its own forecasts, a valuer may need to carefully consider and incorporate information from conflicting sources.

As the outbreak develops, it has become increasingly clear that its effects will be significant and long lasting. This has led to many third-party sources issuing frequent updates to their estimates and outlooks. On 9 January 2020 the International Monetary Fund (IMF) projected that in 2020 the global economy would grow by 3.3 per cent. It revised this estimate down to 3.2 per cent on 16 February, and on 5 March, estimated that growth in 2020 would fall below previous year’s level of 2.9 per cent. On 23 March 2020, the IMF said that the outlook for global growth was negative and expected ‘a recession at least as bad as during the global financial crisis or worse’.

When forecasting a product’s sales and revenues at a point in time, a valuer will typically use only information that was known or knowable at that time. In such a rapidly changing situation, the chosen date of assessment will likely have a significant effect on the third-party forecasts and estimates available to the valuer. A forecast of smartphone sales formed before Apple closed its stores outside of China may look very different to one formed after the announcement.

Moreover, determining whether information was known or knowable at the assessment date is not straightforward and does not necessarily rule out information that was published after the date of assessment. A valuer may rely on information published after the date of assessment if it evidences conditions as of the date of assessment. For example, there is a delay between the date of a company’s financial year end and the completion of its audited financial statements for that year. However, a valuer may consider it reasonable to rely on audited financial statements published after the date of assessment, if they relate to a financial period that ended close to or before the date of assessment, on the basis that the information contained in the financial statements would have been available to management, and therefore known or knowable, at the date of assessment. Determining whether a document published after the assessment date evidences information that was known or knowable at the assessment date often requires judgement and even during more stable conditions, reasonable people may reach different conclusions. The speed with which the covid-19 crisis has developed further complicates these judgements, increasing the scope for reasonable disagreement.

In cases of a continuing breach, or where the date of breach is otherwise unclear, a valuer will need to work with counsel to identify the appropriate date of assessment. It may also be necessary to allow the tribunal to choose between losses assessed at several alternative dates. If this is the case, the valuer should take care to explain the inputs and assumptions underlying each assessment and to identify the main causes of difference between the assessments.

Finally, many jurisdictions require a claimant to take reasonable steps to mitigate its losses. When projecting a claimant’s profits in the actual scenario, a valuer may need to consider whether and how the outbreak has affected the claimant’s ability to mitigate its losses over the intended life of the contract.

Discount rate complications

The wider financial consequences of the outbreak also complicate assessments of the discount rate applicable to projections of a claimant’s cash flows in both the actual and but-for scenarios. Valuations are often highly sensitive to changes in the discount rate: a one percentage point increase in the discount rate, from 9 per cent to 10 per cent, may reduce value by over 10 per cent.

Valuers typically estimate the discount rate using the capital asset pricing model (CAPM). The inputs to this model are often estimated using financial market data such as government bond yields and stock market returns. Projecting cash flows is a forward-looking exercise and, in principle, the inputs selected to assess the discount rate should reflect expected conditions over the forecast period. However, the outbreak has contributed to significant volatility in financial markets and current conditions may not reflect expected conditions over the entire forecast period.

For example, the first stage in applying the CAPM is to identify the appropriate risk-free rate (ie, the rate of interest earned on a bond that is free of default risk, reinvestment risk, inflation risk and liquidity risk). In practice, the risk-free rate is often based on the yield to maturity of long-term sovereign bonds of the United States or a small number of West European countries.

Historically, the yield on 10-year US Treasury bonds has fluctuated between 2 per cent and 5 per cent, with a long-term average of approximately 3 per cent.^[7] However, during crises the yields on high-quality sovereign bonds may fall much lower as a result of central bank monetary intervention and a ‘flight to quality’ (ie, a shift in capital away from risky assets such as equities and into safer ones such as government bonds).

On 15 March 20202, the US Federal Reserve Bank announced that it would further cut its benchmark rate to a target range of between 0 per cent to 0.25 per cent and would launch a US$700 billion quantitative easing programme to support the economy amid the rapidly escalating pandemic. As a result, the yield on 10-year US Treasury bonds fell to 0.73 per cent on 16 March 2020.

In such circumstances, some valuers argue that the risk-free rate should no longer be based on the spot rates prevailing on the date of assessment, but should instead be normalised. Normalised risk-free rates are typically based on long-run averages of historical yields to high-quality sovereign bonds and are intended to reflect the risk-free rate that, in the valuers’ opinion, is most likely to prevail over the life of the forecast period.

However, normalising the risk-free rate is controversial within the valuation community, as a normalised risk-free rate is an artificial rate of return that was not available to investors at the assessment date. Since the CAPM is intended to reflect the opportunity cost of investing in the company in question, rather than in other available investments, some valuers argue that it should be based on inputs that were actually available to investors at the assessment date.

Regardless of the approach that the valuer adopts, it is important to ensure that the inputs to the CAPM are internally consistent. For example, the equity market risk premium tends to move in the opposite direction to the risk-free rate, offsetting some of the effect of changes in the risk-free rate. Therefore, it would not be appropriate to use a normalised risk-free rate together with an equity market risk premium based on spot market conditions, and vice versa.

Another consideration in determining the discount rate applicable to a claimant’s projected cash flows is whether an adjustment to the CAPM is required to account for country risk (ie, the incremental risk associated with investing in less economically developed countries that lack one or more of the sophisticated financial, legal and constitutional systems seen in developed countries). Broadly, these risks can be divided into:

• political and legal risks, such as corruption, weak protection of property rights, armed conflict, civil strife, unstable political leadership and terrorism; and
• economic and financial risks, such as currency volatility, volatility in gross domestic product growth rates, unexpected changes in inflation or interest rates and exchange controls.

To incorporate these risks into their valuations, valuers often add a premium to the discount rate that they use to value assets located in relatively risky jurisdictions: the country risk premium (CRP). Valuation practitioners have proposed several different approaches to measuring the CRP, a full discussion of which is outside the scope of this chapter.

The most commonly used approaches rely on measures of sovereign default risk (ie, the risk that the government of the country in question will default on its debts). The intuition behind this approach is that riskier countries are more likely to default on their debts than less risky countries. Therefore, by comparing two countries’ levels of sovereign default risk, its relative riskiness to an investor can be assessed.

Under this approach, sovereign default risk is typically estimated using either:

• the yield on a country’s US-dollar-denominated government
  bonds;
• credit ratings assigned by the various credit rating agencies to the country’s sovereign bonds; or
• spreads for credit default swaps on the sovereign bonds.

These measures are widely recognised to be imperfect proxies for country risk, as the factors influencing sovereign default risk are not necessarily the same as the factors that influence country risk for a private investor. For example, pervasive corruption and weak enforcement of contracts may significantly affect the perception of risk by investors but may have a relatively small effect on sovereign default spreads.

The consequences of covid-19 are likely to exacerbate this issue. As of 18 March 2020, the spread between Italy’s 10-year government bond yields and those of Germany had increased to 2.63 percentage points, 1.26 percentage points higher than the spread a month previously. A valuer will need to consider carefully whether the relative riskiness of long-run investment in Italy also doubled compared to Germany during the month.

Comment

As covid-19 continues to disrupt businesses and supply chains across the globe, many companies will find themselves unable to fulfil their contractual obligations and potentially in dispute with their counterparties.

The damages issues in these disputes are likely to be conceptually similar to those that dispute professionals see routinely, which can be addressed using standard techniques. However, the level of disruption caused by the outbreak introduces new complexities to the implementation of those standard techniques. It is important that parties and valuation experts engage with these complexities when presenting damages assessments to courts and tribunals. Failure to do so may undermine the parties’ chances of securing a fair outcome in their disputes.

Notes

^[1] This chapter represents the author’s views from early April 2020. The pandemic is a fast-moving situation and its effects on the economy and on the quantification of damages are also evolving rapidly.

^[2] This chapter focuses on the economic and financial consequences of the pandemic and its implications for damages quantifications. This is not intended to dismiss or diminish the pandemic’s enormous human and social costs.

^[3] The views expressed in this chapter are those of the author and not necessarily the views of FTI Consulting, its management, subsidiaries, affiliates or its other professionals.

^[4] Other measures of loss, such as Wrotham Park damages, are outside the scope of this chapter.

^[5] Although disputes professionals typically refer to lost profits, valuers typically assess loses based on cash flows. Profit is the difference between revenue and expenses, measured according to accounting standards. Cash flow is the cash flowing in to and out of the business.

^[6] It is also possible that dispute will arise from a manufacturer’s refusal to accept delivery of goods, if it is unable to store these goods or use them in its manufacturing processes due to factory closures or shortages of other materials.

^[7] Source: Board of Governors of the Federal Reserve.