But-for Scenarios and Calculations

Contract breaches and treaty violations put the parties in a different position than they would have been if the contract or treaty obligations had been fully honored. The but-for, or counterfactual, premise is typically required in order to analyze, frame, and prove a damages claim for contract or treaty breaches.

A “but-for” analysis asks what would have happened if the breach had not occurred. Similar to a discounted cash flow valuation of an income producing asset, the but-for method requires building a model for the company or asset being valued based on projected cash flows and applying a probabilistic analysis of growth and return estimates. The model is then applied to project the expected income flows for the company or asset during the damages period absent the breach and compares it to what actually occurred and, for breaches that are expected to continue into the future, what is expected to occur going forward. Damages are the difference between the value of the asset or business based on the actual and the counterfactual scenarios.

Applying the but-for approach to a damages claim therefore requires:

• Determining the actual income flows based on the facts after the breach;
• Projecting the income flows from the “but-for” or “counterfactual” case based on reasonable expectations and probabilities of what would have happened absent the breach;
• Calculating the difference between the factual and counterfactual scenarios; and
• Determining the difference between the present value of the scenarios at appropriate discount rates.

The degree of difficulty in determining the factual and counterfactual scenarios depends on the facts, the nature of the breach, and the legal standard. The starting point factual scenario is not always easy to establish, and adjustments may be required to exclude effects that are unrelated to the breach and those that could have been avoided if the harmed party had taken reasonable efforts to mitigate.

The counterfactual scenario should reflect a realistic estimate of what would have happened absent the breach and therefore requires an assessment of risk. The difficulty of establishing the counterfactual will be determined by the factual and legal complexity of the damages case. For instance, in the case of non-delivery under a contract, the counterfactual may simply refer to a pre-agreed volume of goods and services over a pre-specified time period at a pre-specified price without allowing any deviation, in which case the counterfactual will be relatively straightforward. However, establishing the counterfactual may be more complex when these underlying elements are not fixed. For instance, how would high market uncertainty impact the volume and timing of deliveries? How would changes in market conditions, exchange rates, inflation, taxes, etc., have impacted performance and affected the value of the contract under the counterfactual scenario? How would the non-breaching party have responded to those variables? Furthermore, many counterfactuals will not be as straightforward as a simple breach of contract (for example, joint ventures, licensing transactions, long-term development projects, treaty violations, etc.), and developing the counterfactual requires considerations of alternative scenarios based on various possible outcomes and probabilities.

Another consideration that may need to be taken into account in the counterfactual in investment arbitration cases is how the risk of future illegal acts should be reflected. See Valuation > Overarching Issues > Country Risk. Excluding the specific illegal act at issue does not uniquely determine what should be assumed about future conduct: the market value will be different depending on alternative views about whether future unlawful acts would be fully compensated absent the specific treaty breach. In such cases, the reference to actual or hypothetical market transactions immediately prior to an expropriation requires an accompanying view of the counterfactual risk to which the assets are assumed to be exposed.

In undertaking a but-for damages valuation, the analysis therefore reflects assumptions (sometimes based on instructions from counsel) related to the matters that gave rise to liability, whether it be the breach of a contract or a treaty violation. These assumptions should be described clearly in the analysis, and a clear distinction made between assumptions that are based on the expertise of the analyst and those that are given by instruction or depend on legal issues. For example, experts may make assumptions about market changes in the absence of the disputed conduct, which should be outlined in the report. Furthermore, if any assumption or instruction is inconsistent with other aspects of the analysis, this should be addressed explicitly in the expert report.