Understanding Litigation Risk: Definitions
Risk is “exposure to the possibility of loss” or a “situation involving such a possibility.” Oxford English Dictionary. Litigation risk is the exposure to the possibility of loss as a result of a lawsuit or set of lawsuits. It includes the probability that a suit is brought at all, the probable scope of that suit, and the probable outcome.
Risk vs. Uncertainty
In economics, risk refers to situations where, while we do not know the outcome, we are able to calculate the probability of an event occuring. Uncertainty, by contrast, describes situation where we do not have the information that will allow us to calculate the odds. This may be because the information does not exist or it may be because the information is inaccessible. If the former, there is nothing that can be done systematically to address the problem, but if the latter, there are systemic ways to force information. It is important, therefore, to distinguish elements of litigation which may be subject to measurement and prediction (risk), and those that are not subject to such measurement (uncertainty). This uncertainty is sometimes referred to as Knightian Uncertainty, after Frank Knight, author of the book Risk, Uncertainty and Profit (1921).
Loss
The losses that might be considered in evaluating litigation risk include:
losses incurred as a result of an adverse judgment or settlement (“judgment exposure”)
losses incurred in litigating the case (“litigation costs”)
reputational loss, including the reputational loss from publicity attendant to the filing of a lawsuit as well as the reputational costs of settling and/or an adverse judgment
costs associated with regulatory and compliance changes resulting from litigation
human costs
The first two of these are the traditional losses associated with litigation, but firms know that the three remaining categories are also extremely important. I will discuss each of these in turn.
Judgment Exposure
Judgment exposure consists of the predicted losses directly resulting from a judgment in a case or series of cases. In other words, the judgment exposure is what the judge or jury is likely to order the defendant to pay if the firm loses the lawsuit. To determine judgment exposure, it is important to know both the likelihood that the defendant will lose and the likely amount they will pay if they lose.
In complex litigation, however, more variables will need to be taken into account, such as “proliferation risk.” For example, suppose that there is a potential for 100 lawsuits to be brought. If the firm prevails in the first ten suits, the 90 remaining plaintiffs are less likely to bring a suit. But if the firm loses the first suit or settles it, all 100 are likely to file. The proliferation risk increases the judgment exposure of a firm.
Litigation Costs
Litigation costs consist of all the costs to the firm of maintaining a suit, and should be measured in stages of the litigation. Choices at different stages of the litigation will affect these costs. Such costs include spending on outside counsel, experts, collection of information and internal investigations, document production, diverted time and energy of in-house counsel and management, and so-called “soft” costs such as the psychological effect of maintenance of the suit.
Reputational Costs
Reputational costs may include the cost to the brand value from being sued at all because of the attendant publicity, as well as the potential reduction in brand value due to negative information obtained and released in connection with litigation. That is, just being sued may in some circumstances put a defendant in a bad light. In other circumstances, there is little cost to being sued because the fact of the suit is not salient to customers, but the cost begins to play a role once negative information is released in the course of litigation. In other cases, reputational cost may play a role only once an adverse judgment is reached.
Reputational costs may have the longest half-life of all the costs associated with litigation.
Regulatory and Compliance Costs
Another cost that can result from litigation involves changes to the regulation and accompanying compliance requirements that are spurred by adverse outcomes or by the revelation of information in litigation. At bottom these changes are caused by the primary conduct, not the litigation itself, but they can be considered part of litigation costs because but for the existence of the litigation the firm may not be subject to additional regulatory controls.
Human Costs
Finally, there is the toll of stress imposed by litigation. The experience of being sued, especially in high-stakes cases, may create a bias towards settlement. It may change the way that managers make decisions, which in some ways is the point of the deterrence value of litigation, but may also work to the detriment of the firm if management becomes so risk averse in its thinking that it passes up valuable opportunities. The analogy here would be to defensive medicine in the wake of malpractice suits. It is possible that some defensive medicine is good for patients if doctors are more careful, but it is also possible that defensive medicine both increases costs and exposes patients to unnecessary risks from intervention.