22 June, 2016
Jamie Gardiner writes on New insights into commercial litigation risk
Ampersand’s Jamie Gardiner writes:
How a software tool can apply modern risk analysis techniques to deliver projections on the prospects of settling an action at a given figure that commercial clients will understand
Why risk analysis matters
Risk is a central part of litigation. Lawyers are adept at assessing the likelihood of success of a particular argument, or even a conclusion. But where we struggle is putting all these different assessments together into a total value for the case. There are simply too many moving parts. So we rely on instinct, and offer necessarily vague assessments: there is “a reasonable prospect of success”, say, or “an arguable case”.
These instinct-based prognoses put some clients off litigating. First, they mean that businesses cannot analyse litigation in the same way that they do for other investment decisions. A CEO may be faced with the choice between, say, a marketing investment with a risk-adjusted return of 300% over three years, and a litigation investment which is said to have a “reasonable prospect of success”. It is not difficult to see the challenge in persuading CEOs to free up scant resources for litigation.
Secondly, we may miss opportunities to advise clients on how to manage risk proactively. All sorts of options now exist to match risk to risk appetite, from litigation funding to after-the-event insurance. But risk cannot be managed until it is known how much is actually faced.
Thirdly, when lay clients do not understand the entire range of possible outcomes they are susceptible to bad surprises. A client might be assured that they have a good prospect of recovering £1,000,000. On the face of it, this is attractive. But there may also be small possibility that losing the case will seriously damage the client financially or even render them insolvent. This creates a perception sometimes felt by clients that litigation is akin to Russian roulette.
The biggest problem with analysing complex risk, whether commercial or litigation risk, is that any single set of assumptions about the future is bound to be wrong. In business, for example, analysts simply do not know whether oil prices will rise or fall or whether there will be another war in the Middle East.
As a result of these unknowable uncertainties, modern risk analysis looks at multiple different scenarios. For investments the gold-standard methodology is the “Monte Carlo” technique (so called because it incorporates randomness). Instead of assuming a single, fixed value for uncertainties, parameters are set for them. For example, we might say that a conclusion is worth between £1,000,000 and £2,000,000, or that it has a 70% chance of success. The simulation then automatically generates hundreds or millions of scenarios, and in each scenario the uncertainties are recalculated within the parameters given. Then a financial outcome for the scenario is calculated. Running through scenarios runs through more and more permutations.
A simulation therefore produces as many sets of results as there are scenarios. This in turn reveals the probabilities of different outcomes. If 90% of scenarios produce a positive outcome for the pursuer after expenses, then we can say that there is a 90% probability that the outcome will be positive. Having visibility over the whole range of potential outcomes reveals the best and worst possibilities too.
Worked example: the facts
Here follows a worked example based on a hypothetical action. In the example we act for the pursuer, a small oil trading company called David Ltd. It brings an action against an international bank, Goliath Ltd. First, David avers that Goliath mis-sold it oil hedging products shortly before the price of oil collapsed. Secondly, David avers that Goliath promised it credit for a warehouse investment. In reliance on this promise, a plot of land was purchased. But the credit never came, and the land had to be sold at a discount. In its defences, Goliath avers that the oil hedging action has prescribed, and counterclaims that in the aftermath of these disputes David has withheld fees for unrelated transactions.
David’s legal team have done a thorough case analysis, and have arrived at the following assessment:
- For the oil hedge conclusion, David has a 35% chance of success and would recover £200-300,000.
- There is a 10% chance that Goliath will succeed in establishing that the oil hedge conclusion has prescribed, which would mean zero recovery on the conclusion but which would reduce overall expenses by 20%.
- For the loan promise, David has a 70% chance of success and would recover £560-840,000.
- For the fees counterclaim, Goliath has 30% chance of success and would recover £160-240,000.
- Each side will incur £150-250,000 in expenses, 60% incurred prior to proof.
- 50% of expenses are recoverable by the winner (i.e. the side which emerges with a positive financial outcome).
Based on these assumptions, the reader is asked to consider and write down what the net value of the action to David is? This estimate can then be compared with the results overleaf. The reader may find that, even in an action with only a handful of issues, quantifying the total value is challenging.
Worked example: the results
The analysis below uses an Excel spreadsheet prototype tool, which I developed to illustrate how risk analysis can be applied to litigation. The above case assumptions were entered into the tool, and it was set to automatically generate and run 1,000 scenarios based on them. Click here to see Figures 1, 2 & 3.
Figure 1 – Valuation snapshot
This report tells a litigant how much the action is worth to them, and how risky it is.
A Key statistics, quantifying the value of the action more precisely. The headline is that the average net value of the action to David is £366,000 after expenses (based on the average financial outcome from all the scenarios). That represents a healthy 183% return on David’s initial litigation investment.
B Opponent analysis, letting us see things from the other side’s perspective. Goliath can expect to have to pay out £758,000 after expenses. This helps us to understand how confident they will be feeling, and suggests that we are in a strong position.
C Probability distribution, telling us how likely different outcomes are. The figures along the bottom of the chart represent different “buckets” of expected net financial outcomes. The red columns indicate the probability of an outcome in a given bucket. Looking at these results gives us a more nuanced understanding of the action’s riskiness as a whole. For example, the most likely bucket is £462-675,000 (36% probability). But the average expected award is lower. The reason for this is that the terrible outcomes at the far left of the chart pull down the average.
Figure 2 – Settlement snapshot
This report analyses the potential for settlement, looking at the action from the sides both of the pursuer and the defender.
D Key statistics, assessing whether a mutually advantageous settlement is possible. Here we can see that there is potential for a settlement. Settlement at £562,000 could leave both sides £196,000 better off than if the case went to proof, because of the potential to avoid expenses.
E Here we see the Best Alternative to a Negotiated Agreement (“BATNA”) for each side. This is what they expect the outcome to be at proof, so it is likely to be their bottom line in negotiations. The gap between the BATNAs is the settlement “premium” which arises from saved expenses. Obviously each side will try to claim as large a share of this premium as it can. Something which the analysis highlights is that there is less potential for settlement at the door of the courtroom than there is at the start of litigation. By the time the final stage is reached, so much expenditure has already been sunk that the incremental costs of going to proof are lower than they were at the outset.
Figure 3 – Tender analysis
So far the analysis has been from the perspective of David, the pursuer. But the action can also be seen from Goliath’s perspective. Running the simulation as the defender generates analysis, assisting tendering. The tendering analysis is based on the following assumptions:
(1) Goliath estimates the minimum tender that David would accept is somewhere between £150,000 and £450,000; (2) acceptance of a tender reduces the overall expenses of the action by 80%; and (3) Goliath tenders £200,000.
F Key statistics, showing whether a tender improves or worsens the expected financial value of the action. Goliath’s tender of £200,000 has a 10% probability of being accepted, and increases the value of the action to Goliath by £47,000 (in other words, they expect their payout cost to be £47,000 less than it would be without the tender).
G Post-tender probability distribution, enabling comparison of the pre-tender distribution of probabilities (in red) with the post-tender distribution (in blue). It also incorporates the effect of the tender adjustment, described below. The reduced blue columns at either edge of the chart show that the tender reduces the probability of either an extremely good or an extremely bad outcome.
H Tender adjuster, allowing optimisation of the tender level. By sliding this bar, we adjust the tender and see whether it improves or worsens the financial outcome. Here, when Goliath increases the tender by £40,000 (to £240,000) their expected payout cost falls by £46,000. So an increase in tender saves them money. This is because increasing the tender raises the likelihood of it being accepted.
On these facts, it is cheaper for Goliath to settle the action through tender than to take it to proof – so raising the tender (thereby making it more attractive) is financially advantageous.
The clients’ language
Treating litigation decisions more like investment decisions enables better financing, settlement and tendering strategy. But it also helps lawyers to deliver advice in a language that commercial clients understand. The change is in part a question of mindset: we should look for ways to deliver more meaningful analysis than simply that a case has a “reasonable prospect of success”. But we should also be prepared to use technology to assist us when a case calls for it. This article is intended to highlight a challenge and an opportunity for lawyers. The challenge is that we have fallen behind commercial clients in the sophistication of our risk analysis. But there is a real opportunity to apply the best of business thinking in this area. That can only make Scotland a more attractive jurisdiction in which to bring commercial litigation.Views from the front line
What do practitioners experienced in dispute resolution make of the concept? Three of them offer an initial assessment:
“While the litigation process has become more efficient and aligned with the commercial client’s expectations, it remains the case that the lawyer’s assessment of risk and the likely value of the claim comes down to no more than general statements about there being ‘reasonable prospects of success’ or ‘an arguable case’.
“Adopting a scientifically based methodology in calculating the likely value of a claim represents a huge step forward in the litigation process for those involved, whether it be the lawyers or the parties. At long last, those involved or indeed considering the prospect of litigation can now rely on a risk analysis much more in line with the type of analysis they adopt in their own business. In one stroke, this method propels the analysis of litigation risk into the 21st century.”David Armstrong, partner, Brodies “Assessment of risk is critical in all negotiation. In mediation, much of what we do as mediators is to help clients and their advisers, who are in negotiations, analyse and assess risk as well as they can, in order to be able to make well informed choices. That could be about whether, when and how to make offers or proposals – and whether or not to accept them – and when and how to maximise settlement opportunities. In my experience, many clients and advisers are not well trained in risk analysis and assessment. We tend to rely on experience, hunch, informal signals, assumptions, perceptions and other influences which are often not sufficiently objectively based. The quality of decision-making may thus be less than optimal, possibly denying clients the best available outcome.
“This tool has real potential in my view to enhance risk assessment in mediation and therefore to promote better outcomes.”John Sturrock QC, chief executive and senior mediator of business mediation service Core Solutions
“Our team were all immediately impressed with this tool and could see how invaluable it could very quickly become for litigators, mediators, and anyone working in the field of conflict resolution. It’s a brilliant device: it neatly takes the guesswork out of assessing risk and has the clear potential to become vital when it comes to advising clients on the way forward. I can see this type of program rapidly becoming a ‘must have’ for all litigators.”Cat Maclean, partner and head of dispute resolution, MBM Commercial
Jamie has a talk prepared on this topic. If you are interested in arranging to hear the talk, please contact him directly at: email@example.com or contact the Ampersand Practice Management team.
This article has has been published in the Scots Law Times entitled “New insights into commercial litigation risk”, which can be found at S.L.T. 2016, 16, 79-81 and on the Journal Online on 20th June 2016 here