Lawyers, to their chagrin, acknowledge that their banking clients have commoditized – turned into a package which can be priced accurately – virtually every area of legal practice, except litigation. Bankers are used to having bond issues and syndicated loans negotiated and documented by lawyers on a fixed-fee basis. But litigation remains largely subject to the “piece of string rule” as in Q: How much will it cost? A: How long is a piece of string?
This is not simply a matter of lawyers’ intransigence. Litigation is by definition risky: if the outcome of a dispute were clear-cut, the losing party would capitulate immediately and not incur the costs of fighting it. Since the outcome is not clear-cut, lawyers are unable to price the cost. It depends on how long the dispute takes to be resolved (in or out of court) and the intensity with which it is fought.
Contingency fees, where the party only pays if the lawyer wins the action, are common in the US. But if the lawyer does win, he or she routinely keeps 30% to 40% of the proceeds. “In effect, the lawyers have insured the plaintiffs’ downside by writing an expensive premium on their potential upside,” say Andrew Freeman and Ron Dembo, the authors of Seeing Tomorrow: Rewriting the Rules of Risk, published this month by Wiley.
Freeman (a respected financial journalist who trained at Euromoney) and Dembo (founder of Algorithmics Inc) have developed a formula based on portfolio theory using the notions of upside, regret and lamda as improvements on traditional measures of risk. Upside is equivalent to a call option on future outperformance. Regret is insurance or a put option. Lamda represents a risk-aversion constant or premium against the risk of the upside failing to materialize. The larger the value of lamda, the more risk-averse the decision-maker is because he or she is paying a higher price to self-insure the risk.
In one of many illustrations the authors apply their concept to the litigation between Bankers Trust and Procter & Gamble over derivatives sold by the bank to the company in the early 1990s.
The deals were based on the single-scenario forecast that interest rates would not rise. By 1994 they had and P&G was nursing $195 million in losses. The consumer-goods company refused to pay, alleging that Bankers Trust had misled it into buying inappropriate instruments. The bank reacted firmly. It could show that P&G had entered willingly into the deals, had done similar deals with other banks, was a sophisticated counterparty and had spurned the bank’s advice to close out its exposures while they were still small.
P&G, for its part, had to explain its conduct to its shareholders. Senior management had little idea of the extent of the risks the treasurer – subsequently sacked – was taking: an embarrassing situation in a supposedly well-run company. Both sides had strong reasons for fighting. But in May 1996, a week before the case was due to come to trial, it was settled out of court. Why?
The short answer is that the possible upside to both parties had diminished considerably. By 1996 Bankers Trust had suffered costly damage. The P&G action had increased that damage through the constant publicity. This in turn had sapped morale at the bank, which is why Bankers Trust had been quick to settle other cases where it felt it had been at fault.
The potential upside remained limited to $195 million (hardly enough to restore the bank to its glory days), and was offset by the increasing reputational damage it was suffering, and a precedent that would have placed the onus on the bank’s counterparties to understand the risks they assumed when dealing with the bank – a two- edged sword.
Meanwhile, the downside – its possible regret – had increased. The bank would lose the $195 million it was owed and could suffer much worse (P&G was seeking punitive damages which could triple any award against the bank). The trial was to be held on P&G’s home turf, so exposing the bank to the risk of a jury sympathetic to the company. Losing the case would be the final straw for some of the bank’s investors. If they sold, its share price would tumble.
Then, during pre-trial proceedings, tapes were leaked indicating that some sales staff had enjoyed misleading customers. The bank therefore had an overwhelming desire to settle.
For P&G the case had significant upside: it would be walking away from $195 million and the possibility of millions in damages. But in the weeks before the trial, Bankers Trust won some key pre-trial rulings. The judge appeared to limit the bank’s downside. He suggested that P&G had wilfully carried on with the disastrous trades even after receiving warnings from the bank. He also wondered why the company should be entitled to triple damages when it had not paid up a cent on its losses. The judge effectively capped P&G’s upside and had potentially increased its regret by making the company responsible for some of its losses. The risk-adjusted calculation for both sides was quite clear: there was too much downside for insufficient upside. They settled.
This use of risk-management analysis is echoed in work carried out by the Centre for Advanced Litigation at Nottingham Law School in the UK, using criticality matrices, decision trees, statistics in settlement and legal risk audit. The purpose of these techniques is to help litigators ask better questions, generate clearer answers and provide clients with more information with which to manage the process. Although the answers produced will necessarily be incomplete, they narrow the area of uncertainty and identify the gap where legal judgment, expertise and experience needs to be exercised. Clients are given appropriately packaged and defined information on which to make critical decisions, so offering them considerable opportunity-cost savings, while the lawyer has day-to-day control, mastery of the facts and, in most cases, greater technical competence.
This approach is summed up in what professor Peter Jones, the dean of Nottingham Law School and a former practising litigator, calls the theory of the matter. Instead of analysing a case in terms of the legal basis, available evidence and possible liability, the lawyer analyzes the client’s preferred outcome in the light of available and obtainable information, commercial and legal risk, project management and budgetary control.
Lawyers who do this will find they are beginning to use their banking clients’ language – something clients the world over are coming to expect.
