LOSS OF PROFIT AND LOSS OF PROFITABILITY: A LEGAL ANALYSIS

ALISHAHZ LEGAL LLP

Adv. Lazim Vengattil, Associate, Alishahz Legal LLP

INTRODUCTION

In the realm of commercial law, “loss of profit” and “loss of profitability” are often important concepts in litigation and contractual disputes. While they might sound similar, they refer to distinct types of financial setbacks. This article aims to clarify these terms, their legal implications, and how they are typically addressed in legal contexts.

LOSS OF PROFIT

Loss of profit refers to the actual income that a business would have earned but was unable to due to a specific event or breach of contract. This is usually calculated based on historical financial data and projected earnings. In legal disputes, claiming loss of profit requires the claimant to demonstrate that:

  • A Breach Occurred: There was a breach of contract or wrongful act that caused the loss.
  • Causation: The breach directly caused the loss of profit.
  • Quantifiable Loss: The lost profits can be quantified with reasonable certainty, often supported by financial records and expert testimony.

For example, If a supplier fails to deliver materials on time, causing a manufacturer to miss a lucrative sales contract, the manufacturer might claim the profits they would have made had the materials been delivered as agreed.

While the requirement to prove actual loss is stringent for loss of profitability claims, it is not as rigid for claims of loss of profit due to contract termination. In M/s A.T Brij Paul Singh and others v. State of Gujarat, the Supreme Court ruled that a contractor is entitled to damages for expected profits from the work if the respondent is found guilty of contract breach. This principle was reaffirmed in Dwarka Das v. State of M.P. & Anr.

Furthermore, in MSK Projects India (JV) Limited v. State of Rajasthan & Another, the Supreme Court  stated that claims for expected profits are valid upon proving the breach of contract. Since a reasonable expectation of profit is inherent in a works contract, losses due to breaches must be compensated without needing further proof of specific loss.

However, confusion between loss of profits and loss of profitability has led to differing judicial interpretations regarding the necessity of proof of loss. In Ajay Singh v. Suneel Darshan, the Bombay High Court, referencing Maharashtra State Electricity Board v. Sterlite Industries (India) Ltd., ruled that without evidence of actual loss, a claim for loss of profit cannot be awarded, even if a breach occurred. The court stressed that damages should not result in a windfall.

This approach contradicts fundamental contract law principles, which aim to restore the injured party to the position they would have been in without the breach. Once a contractor establishes a breach, they should not need to prove specific losses incurred from the breach, as a reasonable profit expectation is implicit. However, compensation must be reasonable, avoiding excessive claims based on mere breach allegations. Courts generally conduct broad evaluations to estimate damages without delving into minute specifics, as reinforced by established legal precedents.

LOSS OF PROFITABILITY

Loss of profitability, on the other hand, refers to a decline in the business’s overall profit margins or financial health over a period, rather than specific lost transactions. This is often more complex to prove and quantify, as it involves broader financial metrics. To establish a claim for loss of profitability, the claimant must demonstrate:

  • Impact on Business Operations: The event or breach had a long-term negative impact on the overall profitability of the business.
  • Financial Analysis: A detailed analysis showing a decline in profit margins or overall financial performance, typically over several reporting  

In legal disputes, compensation claims for loss of profitability necessitate robust evidence. Claimants must not only prove that the delay was solely due to the employer but also substantiate the actual losses incurred, supported by documentation and evidence. The Delhi High Court, in NHAI vs. HCC, clarified that claims for loss of earning capacity and profit are essentially about ‘opportunity cost’—what the contractor could have earned if they had allocated their resources elsewhere. Such claims must meet two critical criteria: proximity and measure. Specifically, the claimant must demonstrate they had the opportunity to deploy their resources in another venture, and that this venture would have been profitable.

The Supreme Court, in Bharat Coking Coal Ltd. v. L.K. Ahuja, upheld an arbitrator’s decision rejecting a claim for loss of profit due to reduced turnover caused by delayed project completion. The court emphasized that claimants must prove that, had they received timely payments under the contract, they could have invested the funds in another profit-generating business. Without such proof, claims for loss of profits are not viable. Notably, even though the Supreme Court used the term ‘loss of profits,’ the essence of the claim was ‘loss of profitability.’ Therefore, the requirement to prove actual loss applies strictly to delays and should not be conflated with claims for unexecuted works.

For calculating loss of profitability, contractors commonly use the Hudson, Emden, and Eichleay formulas. The Supreme Court, in McDermott International Ltd v. Burn Standard Co. Ltd., detailed these formulas’ applications, reaffirming that the appropriate formula depends on the case’s specific circumstances. Determining damages using these formulas is within the arbitrator’s purview. However, as emphasized earlier, any claimed loss must be substantiated with proper documentation and evidence.

CONCLUSION

Understanding the distinction between loss of profit and loss of profitability is important for businesses involved in legal disputes. While both involve financial setbacks, loss of profit is about specific lost earnings, whereas loss of profitability concerns a broader decline in financial health. Proving either requires detailed evidence and expert analysis to establish causation and quantify the loss accurately. Being well-prepared with robust financial documentation and a clear legal strategy is essential for successfully navigating these complex claims.