What’s in a name? Quantifying damages for reputational harm
From the July/August 2018 issue of BCC Advisers Litigation & Valuation Report
emember the drug tampering incident involving Tylenol products in the 1980s or allegations of accounting malpractice against Arthur Andersen following the Enron scandal? Negative events — including defamation, securities fraud, product liability, intellectual property (IP) infringement, and data breach and other cybercrime proceedings — can seriously impair a company’s reputation.
Some damages are permanent; others are only temporary. Measuring the financial impact of reputational harm can be challenging. But these calculations may be necessary to quantify damages in a litigation context or to support an insurance claim.
Reputational harm can manifest itself in several ways. Examples include lost profits, depressed stock prices, lost enterprise value, and impaired value of trademarks, tradenames and other IP assets. Whether a company may seek legal remedy from the wrongdoer for such harm depends on the nature of the case and applicable law.
Assuming damages are available, the following methods can be used to quantify losses:
Lost profits. A financial expert estimates a company’s lost sales resulting from its damaged reputation, using one of several methods. Then he or she discounts them to present value.
For example, an expert might compare a company’s postinjury sales to its preinjury sales (the “before-and-after” method) or to sales of comparable businesses or an unaffected segment of the company’s business (the “yardstick” method). Under either method, the expert should account for any unrelated factors that have an impact on the company’s sales, such as poor macroeconomic conditions or changes in technology.
Lost business value. The expert calculates damages based on impairment of a company’s value, using one or more accepted valuation methods. Generally, this approach is appropriate when a reputational injury permanently destroys the business or a discrete segment of the business. If the injury is temporary — even if it takes years to recover — lost profits are typically used.
Relief-from-royalty method. This method is commonly used to value certain IP assets. It tends to be most appropriate if injury to a company’s reputation impairs the value of a brand, trademark or tradename.
Essentially, the expert values the brand or other asset based on the royalty rate the company would have paid to license the asset if it didn’t own it. To apply this method, the expert selects a royalty rate based on available market data for licenses involving similar companies and similar IP assets. Then he or she applies that rate to the company’s projected revenues and discounts the royalty stream to present value.
Event studies. These studies are often used in securities litigation to measure the impact of an event — such as a disclosure that corrects a prior misrepresentation — on a public company’s stock price. They can also be used to measure the effects of a reputation-harming event, such as a data breach or fraud allegations. The expert uses statistical methods, such as regression analysis, to isolate the portion of price drop that’s attributable to the event from the portion that’s attributable to other factors.
In some cases, a company may launch a public relations campaign to assuage the concerns of customers and investors. Depending on relevant laws, the injured party may be able to recover the cost of the PR campaign, along with other expenditures to mitigate reputational harm.
Here today, gone tomorrow
Reputational harm is one of the most significant risks companies face today. A single event can suddenly destroy a reputation that took years or even decades for a company to build. Fortunately, with the help of experienced financial experts, there are methods available to quantify — and recover — reputational damages.