The Challenge of Valuating Lost Profits and Business Losses from Armed Aggression

The valuation of lost profits and business losses arising from military actions is a complex and multifaceted issue that poses significant challenges for governments, businesses, and international organisations. The consequences of armed conflicts can have far-reaching economic implications, including disruptions to trade, investment, and economic stability. This article delves into the intricate problem of evaluating business losses from military actions, examining international practices and the complexities involved.

International Practice of Estimates Compensatory Losses

Compensatory losses, as the name implies, are intended to compensate the plaintiff for the losses incurred as a result of the (wrongful) behaviour of the other party. These damages may be tangible (e.g., excess costs, lost profits, related expenses) or intangible (e.g., non-pecuniary damages due to pain and suffering, loss of reputation).

International practice for evaluating compensatory losses resulting from military actions is primarily guided by principles established in various international agreements, conventions, and customary international law. These principles provide a framework for assessing the economic consequences of armed conflicts, aiding affected parties in seeking compensation or redress.

Defining Armed Aggression

Before delving into the methods and practices for evaluating economic losses, it is essential to clarify what constitutes armed aggression in international law. The United Nations Charter (Article 2(4)) prohibits the use of force against the territorial integrity or political independence of any state, save for instances where the United Nations Security Council authorises it or acts in self-defence under Article 51. Armed aggression encompasses acts of aggression that violate these principles, including armed conflicts, invasions, and military interventions.

Customary international law recognises the principle of reparation for harm caused by wrongful acts. States must provide restitution, compensation, or satisfaction for injuries they cause to other states or individuals under international law. When military actions lead to economic losses, customary international law is foundational for pursuing claims for lost profits.

Several treaties and agreements also address the issue of compensation for economic losses resulting from military actions. For instance, the Hague Convention 1907 established rules regarding treating private property during armed conflicts. Article 46 of the Convention explicitly requires compensation for losses sustained by individuals due to the hostilities.

Similarly, the Convention on the Protection of Cultural Property in the Event of Armed Conflict (1954) and its two protocols recognise the need to compensate for losses of cultural property, including lost profits that may arise from damage to cultural heritage sites.

Compensation mechanism

The United Nations Compensation Commission (UNCC), established in the aftermath of the Gulf War, represents a notable example of an international mechanism that addresses economic losses caused by military actions. The UNCC's mission is to assess and settle claims arising from Iraq's invasion of Kuwait in 1990-1991. This mechanism has provided a structured approach to evaluating lost profits and other economic losses, relying on expert panels and a well-defined claims process.

The International Law Commission's "Principles on the Reparation for Injuries Suffered in the Service of the United Nations" (2001) provides a comprehensive framework for evaluating economic losses arising from armed aggression. While primarily designed to address injuries suffered by United Nations personnel, these principles offer valuable guidance on assessing and quantifying economic losses in a broader context.

Bilateral and multilateral agreements between states often outline procedures for evaluating and compensating economic losses resulting from armed aggression. These agreements may establish claims commissions or arbitration mechanisms to adjudicate disputes and determine compensation amounts.

On 14 November 2022, the United Nations General Assembly adopted a resolution (document A/ES-11/L.6) entitled "Provision of remedies and reparations for the aggression against Ukraine". This resolution clearly recognised the need to establish "an international mechanism for reparation for damage, loss or injury resulting from the internationally wrongful acts of the Russian Federation".

On 17 February 2023, the Dutch government approved establishing an international organisation in The Hague - the Register of Damage Caused to Ukraine by Russian Aggression. The Register is to become the first component of a comprehensive reparations mechanism designed to ensure that the Russian Federation pays total financial compensation for the damage caused by the war.

The issue of filling the compensation fund seems to be the most problematic at the moment: on the one hand, there is a basic consensus on the transfer of assets of the Russian central bank, sanctioned state-owned enterprises and oligarchs, but on the other hand, the adoption of the relevant legislation is moving slowly - the partners of Ukraine are wary of violating international law or private property rights. Implementation may take many years before the mechanism becomes fully operational.

The only effective and accessible mechanism for recovering damages from Russian Federation today is International arbitration with the:

Absence of a statute of limitations,
Experience in awarding substantial compensation,
Recognition of its awards in almost all countries of the world,
Tools for enforcement of decisions.

Another disadvantage of arbitration is that it is not a cheap process, so the amount of claims against Russia must be adequate to the costs.

At the same time, the length of the compensation process is not a reason to postpone it - plaintiffs who succeed in obtaining a decision in their favour, which will be recognised not only in Ukraine but also in most developed countries, will have a better chance of receiving compensation when access to Russian Federation assets becomes available.

Understanding Lost Profits and Business Losses

Before delving into the valuation methodologies, it is essential to understand the nature of lost profits and business losses resulting from armed aggression. These losses encompass a wide range of economic harm, including:

Direct Business Disruption: Armed aggression can result in physical damage to property, equipment, and infrastructure, disrupting normal business operations.
Market and Customer Disruption: Market dynamics often change during armed conflicts, leading to losing customers, market share, and competitive advantage.
Supply Chain Interruptions: Businesses may face difficulties procuring essential supplies, impacting production and distribution.
Labour and Workforce Challenges: Employee safety, displacement, and disruptions to the labour force can hinder business continuity.
Economic Environment Impact: Wider economic instability, inflation, currency devaluation, and government policies can affect profitability.

Thus, we can conclude that the basic rule of compensation is that the plaintiff is entitled to "that sum of money which will put the party who has suffered or been injured in the same position as he would have been in had he not suffered the crime for which he is now receiving compensation or redress".

Best Practices in Valuating Lost Profits and Business Losses

To effectively evaluate lost profits and business losses resulting from armed aggression should adhere to the following best practices:

Engage Experienced Professionals: Seek lawyers, expert business valuation, and international law to ensure a comprehensive and accurate valuation.
Thoroughly document losses: record losses and collect evidence correctly, keep detailed records of financial statements, contracts and correspondence before and during the armed aggression. Comprehensive documentation is essential to substantiate claims.
Estimate direct damages and loss of future revenues: determine the full cost of restoring the damaged physical asset (the cost of returning the asset to its usefulness and "if only" value), analyse the impact of armed aggression on future revenues, taking into account both short-term and long-term consequences. This includes analysing market conditions, demand and growth prospects.
Use Standard Valuation Methods: Apply recognised valuation methodologies such as the discounted cash flow (DCF) analysis, market approach, or income approach to calculate the value of lost profits and business losses.
Consider Industry-Specific Factors: Recognise that different industries may experience varying degrees of impact during armed aggression. Tailor valuation methods to industry-specific nuances.
Assess Mitigation Efforts: Evaluate whether the business took reasonable steps to mitigate losses, such as relocating operations, diversifying product lines, or seeking new markets.
Quantify Non-Financial Losses: Recognise that not all losses are purely financial. Non-financial losses, such as reputational damage or loss of goodwill, should be quantified and included in the valuation.
Pay attention to the date of filing the claim and the date of receiving compensation (these dates may be much later than the beginning of the military aggression), and therefore, the plaintiff should be compensated for the fact that he or she was unable to access funds during the period from the date of the violation to the date of filing the case with the court and, accordingly, actually receiving them.
Develop a clear overall litigation strategy.
Development of a financial strategy: what mechanism will be used to obtain compensation.

In addition to best practices, international valuation standards offer valuable guidelines for evaluating lost profits and business losses consistently and credibly. The International Valuation Standards 2022 (IVS 2022) issued by the International Valuation Standards Council (IVSC) provide a globally recognised framework for valuation professionals. Adherence to the Valuation Standards set out in IVS 2022 will ensure that the financial value supporting compensation claims is reasonably valid and that it is consistent and transparent. Fundamental principles within the IVS 2022 that are relevant to the valuation of lost profits and business losses include:

Transparency and Objectivity: Valuations should be conducted with transparency and objectivity, ensuring that all relevant information is considered and assumptions are clearly documented.
Market-Based Data: The IVS 2022 emphasises the importance of using market-based data when applicable. Comparable transactions and market multiples can provide valuable insights into valuing lost profits and business losses.
Risk Assessment: Valuers should assess the specific risks associated with armed aggression, considering factors like geopolitical stability, legal uncertainties, and market volatility.
Documentation and Reporting: Comprehensive documentation of the valuation process and clear, concise reporting are fundamental to meeting international standards.

Valuation Methodologies

While the choice of valuation method depends on the circumstances of each case, several methodologies are commonly employed to determine the value of lost profits and business losses:

Income Approach (Discounted Cash Flow (DCF) Analysis): This approach estimates the present value of future cash flows that the business would have generated without armed aggression and the impact of armed aggression. It considers revenue projections, operating expenses, and discount rates reflecting risk and opportunity costs.
Market Approach: The market approach uses comparable transactions or market multiples to estimate the value of the business before the armed aggression and assess the impact of the conflict on its market value.
Cost Approach: The cost approach calculates the value of lost profits and business losses based on the cost of replacing assets and infrastructure damaged or lost due to armed aggression. This approach is particularly relevant for asset-intensive industries.

Case Study: The Valuation of Lost Profits from Armed Aggression

Consider the hypothetical case of ABC Electronics, a multinational corporation that suffered business losses due to the armed aggression of the Russian Federation. At the same time, the physical assets of ABC Electronics were not damaged, and the corporation's management claims compensation for lost profits due to the unlawful actions of the Russian Federation. To estimate its lost revenues, ABC Electronics follows best practices and international valuation standards:

Engaging Experts: ABC Electronics assembles a team of lawyers, forensic accountants, valuation specialists, and international law experts to conduct the valuation. Introduction of the current The Guide to Damages in International Arbitration. Global Arbitration Review. Fourth Edition. Editor John A Trenor. Published in the United Kingdom by Law Business Research Ltd, London, 2021. Р. 537, to the team.
Thorough Documentation: The company maintains comprehensive records of financial statements, contracts, correspondence, and market research, both before and during the armed aggression. The legal essence is to prove that the losses directly result from armed aggression.
Evaluation of future revenues: the team estimates the impact of armed aggression on ABC Electronics' future revenues, considering market disruption, supply chain disruption and potential long-term impact on consumer behaviour. The team also estimates hypothetical cash flows based on the "what if" principle: what would have happened "but for" the loss event (in this case, Russia's armed aggression) and what actually happened. The team uses various forecasting methods, including analysis of expected or signed contracts, company forecasts before and after the armed conflict, extrapolation of retrospective data to future periods, and comparison with the performance of similar companies that have not suffered losses, if available. At the same time, the team understands that estimating what might happen or predicting the future is not an exact science, and the goal is to calculate the most likely outcome.
Standard Valuation Methods: The team employs the DCF analysis using an appropriate discount rate. They also consider market-based data and comparable transactions when available. Additionally, a sensitivity analysis is used to show how different sources of uncertainty in a mathematical model contribute to the overall uncertainty of the calculation model.
Industry-Specific Factors: Given the nature of the electronics industry, the team recognises that the impact of armed aggression on supply chains and consumer demand is significant. The valuation methodology is tailored to account for these specific industry dynamics.
Mitigation Efforts: ABC Electronics can demonstrate that it took reasonable steps to mitigate losses, including diversifying suppliers, relocating certain operations, and exploring new markets.
Quantifying Non-Financial Losses: Besides calculating directly lost revenues, the team assesses non-financial losses, such as possible loss of business reputation in international markets.
Date of claim and probable date of compensation: the team estimates the time impact on the amount of compensation.
Preparation of the Valuation Report in accordance with international valuation standards.
Developing a general litigation strategy, including the arbitration to which the case will be referred after receiving the Ukrainian court decision.
Developing a mechanism for transferring claims to international financial institutions: the team is launching the development of a financial instrument (Litigation Funding, assignment/sale of claims).

Conclusion

Valuating lost profits and business losses resulting from armed aggression is a complex and vital task that requires adherence to best practices and international valuation standards. Businesses and valuation professionals must consider the multifaceted nature of these losses, encompassing direct disruptions, market dynamics, and long-term consequences.

Transparency, objectivity, and adherence to recognised valuation methodologies are essential to ensure that valuations of lost profits and business losses are credible and reliable. International standards offer valuable guidance in maintaining consistency and professionalism in the valuation process.

In an increasingly interconnected global economy, accurately evaluating lost profits and business losses from armed aggression is paramount. By following best practices, international standards, and sound valuation methodologies, businesses and valuation professionals can contribute to fair and equitable compensation for those affected by armed conflicts and aggression, fostering economic recovery and stability in affected regions.

Yaroslav Nagul MRICS, REV

Partner Nexia DK

RICS Chartered Valuation Surveyor (Member #1296450)

Recognised European Valuer by TEGoVA (REV-UA/UABVS/2024/4)