Recent ruling clarifies novel consequential damage models

A recent ruling by the Texas Supreme Court clarifies the extent to which the highest state court will tolerate novel consequential damage models. In Signature Industrial Services LLC v. International Paper Company, the Supreme Court of Texas generally barred use of diminution in an entity's market value as a measure of consequential damages. No. 20-0396, 2022 WL 128546 (Tex. Jan. 14, 2022). The Court held that loss of the plaintiff company's market value was not foreseeable at the time of contracting absent special circumstances and that the proffered evidence was insufficient to prove market decline. In doing so, the Court signaled what evidence is needed for successful recovery of market value diminution consequential damages.

International Paper and Signature Industrial Services ("Signature") entered into a construction contract for Signature to upgrade a large piece of paper-making equipment—a slacker—at International Paper's Orange, Texas mill for US$775,000, but both parties knew additional change orders would be submitted once construction was completed. In the end, Signature submitted a change order, requesting International Paper pay it another US$2.4 million. International Paper refused and Signature sued.

Unbeknownst to International Paper, Signature was simultaneously engaged in negotiations to sell itself to a third party for US$42 million. But Signature alleged that because of International Paper's failures to pay, the deal collapsed. Signature faced mounting financial difficulties and its "book value" was negative US$12.4 million.

At trial, Signature sought the US$2.4 million owed for the change order. It also presented expert testimony that it suffered US$54 million in consequential damages, made up of the US$42 million scuttled sale price and Signature's negative book value. The jury awarded Signature all of the damages that it sought. The 13th Court of Appeals reduced the consequential damages to US$12.4 million (reflecting Signature's lost "book value") but rejected Signature's asserted "market value" losses from its sale efforts. Both sides appealed.

The Texas Supreme Court rejected Signature's efforts to obtain diminished market value as foreseeable consequential damages. In doing so, the Court made numerous observations about what does—and does not—constitute "evidence" of lost market value. While not part of the Court's holding, these pronouncements nonetheless shed light on the evidence necessary to prove an entity's market value.

For example, the Court noted that "dense volumes detail the proper way to value companies," citing McKinsey & Company's valuation: Measuring and Managing the Value of Companies. The Court also acknowledged that pricing models and weighted average costs of capital are required to determine an entity's value. Finally, the Court noted that "specialized bankers and consultants" are usually hired to perform valuations. And that, when valuing a business, "confounding events may be hard to disentangle," making it difficult to "isolat[e] the impact of the breach . . . from other factors . . . ."

In effect, the Texas Supreme Court has now acknowledged the unspoken reality that valuation has become a specialized corner of disputes practices, involving competing pricing models, battles of the expert, and, routinely, in-depth Daubert/Robinson challenges regarding experts' assumptions and their ability to "disentangle" those "confounding events."