New Frontiers in Expert Testimony: Quantifying Risk in Commercial Litigation

1.0 Introduction

The paper will examine failed bank litigation and litigation arising from the oil spill in the Gulf of Mexico. Both of these high profile case studies involve man-made catastrophes that are alleged to have been caused by irresponsible risk taking on the part of individuals and imprudent risk management practices on behalf of their organizations.

The paper will rely on pending Complaints to demonstrate the importance of the social science, behavioral economics, and a branch of study known as “decision making under risk and uncertainty” in quantifying human factor risk. The author will explain how behavioral economics is currently being applied in expert testimony within the context of current gulf oil spill litigation and demonstrate why it is vital in other types of negligence and mismanagement litigation, using failed banks as an example. The following Complaints will be used as support:

• Gallo, et al v. BP, PLC - Oil Spill Litigation (Appendix A):

Corliss Gallo; Tight Lines Fishing Charters, LLC; Red Hot Fishing Charters, LLC; Ernest J. Browne, Jr.; Gulf Coast Assets, LLC d/b/a Breath’s Boats & Motors; Judy and Lawrence Simpson; Retreat, Inc.; Dave Phelps; and all others similarly situated (Plaintiff) v. BP, P.L.C.; BP America, Inc.; BP Corporation North America, Inc.; BP Exploration & Production, Inc.; BP Products North America, Inc.; Transocean, Ltd; Transocean, Inc.; Transocean Offshore Deepwater Drilling, Inc.; Transocean Deepwater, Inc.; Halliburton Energy Services, Inc.; and Cameron International Corporation f/k/a Cooper Cameron Corporation (Defendants)

In this class action punitive damages Complaint filed in United States District Court For the Eastern District of Louisiana on August 20, 2010 (hereinafter referred to as Gallo, et al v. BP, PLC), BP and others are being sued for negligence in the gulf oil spill.

• FDIC v. Van Dellen et al - Failed Bank Litigation (Appendix B)

Federal Deposit Insurance Corporation, as receiver for Indymac Bank, F.S.B. (Plaintiff) v. Scott Van Dellen, Richard Koon, Kenneth Shellem, and William Rothman (Defendants)

In this Complaint filed in United States District Court, Central District of California on July 2, 2010 (hereinafter referred to as FDIC v. Van Dellen et al) the Federal Deposit Insurance Corporation has filed suit against officers and directors of IndyMac – a failed back with headquarters in California. According to the Complaint, the estimated loss to the FDIC stemming from IndyMac’s failure currently stands at $12.75 billion.

1.1 Disclosures

In a statement of full disclosure, the author wishes to acknowledge his role as consultant to the Gulf Oil Spill Litigation Group (GOSLG). He recently completed a report on behalf of the GOSLG that has, in large part, been incorporated into the aforementioned Complaint, Gallo et al v. BP, PLC. Furthermore, in addition to his role as consultant to the Gulf Oil Spill Litigation Group, the author is also Founder & CEO of Upside Risk – a risk management consultancy that helps organizations monitor, manage and mitigate risk taking.

The author therefore has a vested interest in risk litigation and has different incentives than most in advocating risk mitigation. None the less, the author has made every effort to substantiate comments with evidence and refrain from injecting personal opinion into the paper. The economic case for risk mitigation is that it is ultimately cheaper than risk litigation. The ethical reasons speak for themselves.

2.0 A Breakdown in the System

A familiar axiom in business school education is that the purpose of business is to make money. This is a hallmark of the capitalist system and it has traditionally worked very well. As a result, America has risen to become a great power and the country as a whole has generally prospered.

Every American citizen has a stake in the system and we support it through our tax dollars. To sustain the system we depend on our business and government leaders to make good decisions. The primary objective of any business leader is to maximize shareholder value. This is particularly true for public companies. The role of the board of directors is to establish the business strategy. The job of the management team is to deliver it.

The global economic crisis and the Gulf oil spill have exposed a breakdown in this system. In the blind pursuit of greater profit, prudent risk management practices have been fully and wantonly disregarded. Many of the nation’s financial institutions have either gone bust or been purchased by competitors at severally distressed prices. In the case of the oil spill, billions of dollars have been wiped off the balance sheets of the companies involved. In most cases, shareholders are being forced to shoulder the brunt of the losses.

2.1 Risk Management Failures

According to The Center for Chemical Process Safety’s ‘Guidelines for Investigating Chemical Process Incidents’; “almost all serious accidents are typically foreshadowed by earlier warning signs such as near misses and similar events”. In the oil spill litigation, the defendants are accused of risk management deficiencies that failed to rectify past safety failures and previous catastrophes. The plaintiff claims that had the defendants are negligent in the catastrophe because they did not take adequate steps to mitigate the risks. Had they done so, the catastrophe could have been prevented.

As the global economic crisis has clearly shown, financial institutions are not immune from risk management failures either. In the vast majority of bank failures, shareholders have ultimately shouldered the brunt of the losses. To add insult to injury, the American public has been forced to bail banks out under the auspices of the U.S. government’s Troubled Asset Relief Program (TARP). To date, 843 of the nation’s banks have received a total of $545,122,508,408 of tax payer money. Of that amount, a total of $6,428,000,000 has been dispersed to 26 Georgia banks – the largest recipient being SunTrust at $5,000,000,000. These numbers may well increase as several banks have lined up to ask for more.

Nationwide, 829 are on the FDIC’s “Problem Bank List” – nearly double the number from a year ago (see chart below). The State of Georgia has the unfortunate distinction of leading the nation in the number of banks failures. Since the financial crisis began in 2008, Georgia have thus far accounted for 41 bank failures.

The subprime housing crisis is largely to blame for causing the global financial meltdown. Rating agencies played a significant role in the crisis. Their job is to rate financial products like collateral debt obligations (CDO) so that investors can have better assurances of the level of risks of the products they are buying. The eating agencies rubber stamped AAA ratings on just about any collateral debt obligations (CDO) that crossed their desks. Given that financial institutions pay the agencies to rate their financial instruments, there is little wonder why.

The conflicts of interests between the rating agencies and their financial institution clients are astounding, yet regulators failed to act and mitigate the risks. Government regulatory agencies, such as the U.S. Securities and Exchange Commission (SEC), are supposed to serve as watchdogs to sustain the system–but they likewise failed to do their job. Recent legislation, the ‘Restoring American Financial Stability Act of 2010’ is designed to repair the breakdown of the system. However, the bill does little to address one of the most fundamental causes of the crisis: human factor risks.

The judicial system will serve as the ultimate backstop to settle the resulting fallout of these catastrophes. As the number of bank failures increases, the number of corresponding lawsuits will undoubtedly rise too. As the number of risk management lawsuits rise, the testimony of human factor risk experts will become an ever more important part of the process.

2.2 Human Factor Risk Mitigation

In light of recent catastrophes there is an obvious need for organizations that operate in high risk sectors, such as oil exploration and banking, to improve their risk management practices. The common denominator in the global economics crisis and the oil spill is that these catastrophes were caused by the acts of man, not nature. And in both instances, the catastrophic events are alleged to have resulted from negligent decision making and irresponsible risk taking. Without question, the failure to adequately account for these human factor risks has come at a very high cost to society, the economy and the environment.

The current risk management practices employed across these sectors is structurally deficient. The proof to support that is evidenced by the catastrophes themselves. If the human factor risks were properly mitigated then the catastrophes could have been potentially averted in the first place. In this instance, there would be no need for the current litigation. As oil well management expert Dr. Nansen points out in the Gulf oil spill complaint, “the Deepwater Horizon disaster was ‘entirely preventable’… The reason this happened was a series of bad decisions about the well that are human-based and that completely disregarded the risks.”

The comments of the former Fed Chairman, Alan Greenspan, help explain how failures in existing risk management practices contributed to the subprime crisis which is largely to blame for bank failures (critics will note that Mr. Greenspan’s own economic policy decisions are likewise to blame). In an interview following the subprime meltdown, the former Fed Chairman wrote:

“I do not say that the current systems of risk management or econometric forecasting are not in large measure soundly rooted in the real world… But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modeling—the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve”.

“This, to me, is the large missing ‘explanatory variable’ in both risk-management and macroeconometric models. Current practice is to introduce notions of ‘animal spirits’, as John Maynard Keynes put it, through ‘add factors’. That is, we arbitrarily change the outcome of our model’s equations. Add-factoring, however, is an implicit recognition that models, as we currently employ them, are structurally deficient; it does not sufficiently address the problem of the missing variable… Forecasters’ concerns should be not whether human response is rational or irrational, only that it is observable and systematic”.

As Mr. Greenspan point out in these comments, the “missing variable” in risk management is the failure to adequately account for human factor risks. Identifying the problem is a good start. Finding a solution to the problem it is made easier thanks to behavioral economics. The social science, behavioral economics, helps to differentiate between “rational” and “irrational” decisions. Furthermore, behavioral economics research provides irrefutable evidence that irrational behavior is both “observable” and “systematic”.

3.0 Behavioral Economics

The study of behavioral economics combines the scientific disciplines of psychology and economics, and encompasses over half a century of empirical evidence. For several decades, behavioral economists have been researching the human decision making process and have uncovered a number of underlying biases that cause people to make errors in judgment (hereinafter referred to a “judgment biases”). Researchers have discovered that all people are susceptible to judgment biases to varying degrees. Furthermore, behavioral economists know that judgment biases adversely influence decision making under a variety of different circumstances.

Behavioral economics was first introduced by Carnegie Mellon University professor Herbert Simon in the 1950’s. In 1978, Dr. Simon received a Nobel Prize in Economics for his life-long work that introduced the notion of “bounded rationality”–the fact that people are not preconditioned to always make perfectly rational economic decisions. Bounded rationality was a departure from traditional economic thinking. Economists had traditionally assumed that people always behave rationally and that they consistently make optimal economic decisions that derive maximum value.

The groundbreaking research of Daniel Kahneman and Amos Tversky expanded the work of Herbert Simon. Kahneman and Tversky lifted behavioral economics to greater heights and helped the study gain widespread acceptance throughout the scientific community. In 2002, Kahneman earned a Nobel Prize in Economics for his work in behavioral economics and a branch of study known as ‘decision making under risk and uncertainty’ (unfortunately Tversky passed away beforehand). Many other behavioral economists have since risen to prominence including, but certainly not limited to, Richard Thaler, Paul Slovic and Robert Shiller. Behavioral economics has now reached the mainstream. Several books on the subject made the New York Times Best Business Book Sellers List in 2009 (e.g. Nudge, Sway, Predictably Irrational, Freakonomics).

“Framing effects” is a good example of a well-known judgment bias. Research shows that people are more inclined to undergo a risky medical procedure if a doctor frames the risks to the patient as "90% of people survive the operation". Contrarily, people will be less inclined to undergo the same procedure if the doctor frames it as "10% of people die as a result of the operation”. The odds are the same. The choices that people on the other hand are quite different. Choosing the wrong option as a result of this judgment bias is certainly not making the best use of the available information and it is an example of how judgment biases lead us to the wrong decisions. Unfortunately, there are several more judgment biases that people need to be concerned about as well.

3.1 Quantifying Risky Decisions

Poor business decisions are often derived from the same judgment biases that have been uncovered in behavioral economics research. For instance, judgment biases cause people to resist change, if when it is in their own best interest to do so (think American auto industry). They cause people to focus on the short-term without considering the long-term consequences of their actions (think subprime mortgage lenders). Judgment biases are also responsible for making people misjudge risk, ignore warning signs and take risks that they would have been better off avoiding (think… too many to mention). These catastrophic examples show that business leaders are not immune to judgment biases.

By their very nature, judgment biases can lead to negligent behaviors. When others are harmed as a result of negligent acts people often rely on the judicial system for remedy of the wrong and compensation for loss. This is certainly the case in the oil spill and failed bank litigation, and in commercial litigation of this nature, behavioral economics expert testimony is critical because it helps to quantify “bad” or “negligent” economic decisions. The next section of the paper will explain how by highlighting examples found in the aforementioned Complaints.

3.1.1 Time Discounting

The judgment bias known in behavioral economics as ‘time discounting’ is the tendency for people to discount the long-term for short-term gain. It can lead to negligent behavior when people focus exclusively on the short-term benefits and fail to account for the possible long-tem consequences of a decision. Below are examples of how it applies to accusations of neglect in the oil spill and failed bank Complaints.

• Gallo, et al v. BP, PLC

46. For the behind-schedule and over-budget Macondo well, BP chose a risky well design with relatively few barriers against gas blowouts because the safer option–which had been part of BP’s original well design and was recommended by its contractors – would have taken longer to complete and would have cost up to an additional $10 million.

52. Halliburton, despite having run the models that made it clear proceeding with only six centralizers would lead to “failure of the cement job,” did not insist that BP use additional centralizers, but recklessly and wantonly moved forward with the cement job it knew was destined to fail.

92. In a confidential worker survey conducted on the Deepwater Horizon in the weeks before the disaster, workers voiced concerns about poor equipment reliability... Transocean’s policy of running equipment into the ground before making just the bare minimum of repairs: “[r]un it, break it, fix it. … That’s how they work.”

105. ...A special probe into that disaster by the Chemical Safety and Hazard Investigation Board found that “[c]ost cutting, failure to invest, and production pressures from BP Group executive managers impaired process safety performance” at the refinery…

• FDIC v. Van Dellen et al

49. HBD’s policies placed importance on the strength of the borrower and its guarantors as well as on market conditions and the project. In particular, full recourse guarantees were generally required for all transactions. Full recourse included personal guarantees from controlling parties of the borrowing entity. Exceptions were considered on a case-by-case basis. Personal guarantees from the borrower’s principals, like requirements of cash equity, required the borrower to have some downside risk, giving HBD a better assurance of repayment. The guarantees policy was frequently waived, however, even in the face of weak market conditions and even for marginal projects.

61. HBD’s compensation of its account officers rewarded risk taking and encouraged production without regard for loan quality. Taken together with HBD’s other underwriting practices, HBD’s compensation of its account officers further worsened its situation. In essence, HBD encouraged “adverse selection” through underwriting and loan pricing practices and compensation of its account officers that rewarded account officers who brought the riskiest loans to HBD, and made it possible for those loans to be approved as long as customers were willing to pay a higher price. Of course, only customers rejected by other banks were willing to pay HBD’s prices.

63. Account officers’ commission plans also were administered in a way that encouraged them to take additional risks. For example, account officers received an additional 1% of the net income after tax for loans that produced ROEs of 24% or more. Higher ROEs were typically available on riskier loans with lower credit scores.

3.1.2 Confirmation Bias

‘Confirmation bias’ is when people seek out information that supports or re-affirms their existing beliefs and avoid information that may contradict it. This judgment bias causes people to align themselves with like-minded individuals or “yes men” and to shun those who may question the conventional wisdom of the group. Confirmation bias is prominent in oil spill and failed bank litigation because the defendants are accused of ignoring warning signs, disregarding dissenting advice and failing to conduct due diligence. Below are examples that can be found in the Complaints:

• Gallo, et al v. BP, PLC

43. At the time of the explosion, drilling at Macondo was already weeks behind schedule and costing BP over $1 million per day in rig lease and contractor fees. In spite of the difficult and dangerous nature of the Macondo well, BP made multiple decisions about the drilling plan for economic reasons, even though those decisions increased the risk of the catastrophic failure of the “nightmare” well. BP repeatedly chose to violate industry guidelines and government regulations, and ignore warnings from its own employees and contractors on board the rig to reduce costs and save time on the behind-schedule Macondo well…

45. Halliburton, hired for its expertise in cementing wells, was fully aware that BP’s cementing plan was unsafe. Indeed, on April 1, 2010, Halliburton employee Marvin Volek warned in an email that the cementing plan BP had given to Halliburton “was against our best practices.” Despite this knowledge, Halliburton elected to implement BP’s plan without insisting on changes.

48. …Documents show that BP had originally planned to use the safer double pipe design, but rewrote the drill plan weeks before the disaster – against the advice of its own employees and those of its contractors – because the project was behind schedule and over budget. Internal BP emails from late March acknowledged the risks of the single pipe design but chose it as the primary option because it “saves a lot of time…at least 3 days,” “saves a good deal of time/money,” and is the “[b]est economic case.”

50. BP also cut corners – again despite multiple warnings from its contractors – with the number of centralizers within the wellbore…

54. …BP chose to save time and money at the expense of safety by circulating only a small fraction of the drilling mud before beginning cementing. This too put the cement job further at risk.

109. Many of BP’s workers at various facilities have voiced complaints about their employer’s actions and policies, sometimes in the face of harsh retaliation from supervisors…

110. Testimony at Congressional hearings has shown that BP actively discourages workers from reporting safety and environmental problems. Reports from multiple investigations of the Texas City and Alaska disasters all indicate a pattern of intimidating – and sometimes firing – workers who raise safety or environmental concerns…

• FDIC v. Van Dellen et al

30. The 2006 reorganization of HBD also resulted in the removal of Shellem as a Junior Loan Committee member. Van Dellen replaced Shellem on the Junior Loan Committee with a credit administrator, Todd Camp (“Camp”), who reported directly to Rothman. Van Dellen proposed that Shellem remain as CCO for HBD without voting authority on the Junior Loan Committee and without credit officers reporting to him. Shellem refused and ultimately left HBD.

31. Prior to the reorganization of HBD in 2006, Shellem had the power to object to a loan being approved by the Junior Loan Committee. … Van Dellen also directed credit officers to report to a single head credit administrator, Camp, who in turn was reporting to the CLO and lead Production officer, Rothman. This reorganization of HBD created the very blurring between credit and production functions that existed when Van Dellen first arrived at HBD in 2002, and about which regulatory agencies had previously complained. Both Koon and Shellem described Van Dellen’s reorganization as having created a serious conflict of interest.

55. Hasty loan committee meetings left committee members little time to properly discuss complicated multi-million dollar transactions or thoroughly question account officers and credit officers about the details of the transactions.

59. From the time that it was first implemented in CAMs, through the end of loan production at HBD in 2007, the credit risk matrix was used to assign credit scores and grades to loan applications. A resulting grade of Pass 1, 2, 3, 4 or 5 dictated benchmark ROE, which then determined the pricing of the loan. Over time, HBD continually increased its ROE targets. Koon noted that this priced HBD out of the market for lower risk borrowers. Nonetheless, HBD kept increasing its ROE targets throughout its existence despite Koon’s concerns.

3.1.3 Status Quo Bias
‘Status quo bias’ is a tendency for people to resist change–even if change is in their own best interest. Status Quo Bias is prominent in oil spill litigation because the defendant(s) is accused of failing to effectively implement organizational change, despite a history of previous catastrophes and a dismal safety record. These practices, in turn, became standard operating procedure and embedded in the respective corporate safety cultures. In the failed bank litigation, the defendants are accused of lower their underwriting standards to meet growth targets. This led to a risk culture where rubber stamping loan applications became the status quo way of doing business. In both cases, the defendants are accused of failing to enforce their own risk mitigation policies–common risk management pitfalls when an organization lets the status quo take hold. Below are examples that can be found in the Complaints:

• Gallo, et al v. BP, PLC

49. BP also made a risky choice for the pipe material itself, using metal well casings that raised concerns from its own engineers. …Moreover, using the metal casings would violate BP’s own safety policies and design standards. Nevertheless, the riskier metal casings were used after special permission was granted by BP supervisors. The internal reports do not explain why the company allowed for such a risky departure from its own safety standards.

77. At the time of the explosion, the Deepwater Horizon’s BOP was overdue for an extensive check-up – it had not undergone a thorough series of maintenance checks since 2005…

80. Transocean, which owned the Deepwater Horizon and was responsible for maintenance of its equipment, including the BOP, has a poor historical safety record with such maintenance. …The Wall Street Journal reported in June that nearly three out of four deepwater drilling incidents that triggered federal safety investigations on rigs in the Gulf of Mexico occurred on rigs owned by Transocean, despite the fact that Transocean owns fewer than half the deepwater rigs operating in the Gulf.

107. At sea, BP’s record is equally awful…

108. Despite this history of crises and near misses, BP has been chronically unable or unwilling to learn from its mistakes. The company’s dismal safety record and disregard for prudent risk management are the results of a corporate safety culture that has been called into question repeatedly by government regulators and its own internal investigations…

• FDIC v. Van Dellen et al

44. HBD disregarded many of its own internal credit policies and regulatory guidance in approving loans…

45. Policies designed to reduce the Bank’s overall risk exposure were often ignored…

47. …For larger projects, this requirement could compel a borrower to seek multiple construction loans, limiting the Bank’s exposure and requiring careful underwriting of each phase of the project. This requirement too was frequently waived.

48. HBD’s policy recognized condominium financing as exceptionally risky. …The policy further specified that condominium conversion loans must include re-margining requirements at origination if the DCR (excluding construction or rehabilitation costs) was less than 1.0. This policy also was frequently waived.

50. HBD also ignored regulatory guidance in its underwriting as much as it ignored its own internal credit policies…

3.2 Decision Making under Risk and Uncertainty

In addition to uncovering and scientifically quantifying new judgment biases, Kahneman and Tversky also pioneered a branch of behavioral economics called ‘decision-making under risk and uncertainty’. In 1979, Kahneman and Tversky introduced “Prospect Theory”–a scientific breakthrough that would later earn Daniel Kahneman a Nobel Prize in Economics 2002 (unfortunately Amos Tversky passed away beforehand, as mentioned previously).

Prospect Theory analyzes the way people behave when they are faced with economic circumstances that involve risk. It shows that people generally dislike loss twice as much as they like gains. The abhorrence of loss often leads people to take greater risks in order to avoid loss. In the face of mounting losses, people will sometimes take on significantly greater risks to get back to a “reference point”. For example, if a person starts with $1 million, and they lose $500K of it, the individual will be prepared to take on significantly greater risk to get back to $1 million they started with (e.g. double down).

This risk propensity often leads people to take risks that they would have been better off avoiding, and in such cases, lead to negligent risk taking. For instance, in the face of mounting losses people may decide to “double down” their bets (i.e. sunk costs) without fully considering the consequences of the actions, thereby increasing the magnitude of the losses (sometimes with catastrophic effect).

3.3 Quantifying Risk Appetite

Decision-making under risk and uncertainty analysis explains the roles that risk preferences and risk appetite play in deciding whether a risk is worth taking, and in determining how much people are willing to stake on it. This is very important in risk management, especially in cost and benefit analysis. The prudent risk management approach is to weigh the risks and rewards equally.

Negligence litigation often arises when the risks are mismanaged or ignored in pursuit of greater rewards. This is highly relevant in expert testimony because it enables the expert to analyze the decision-making processes of a defendant and testify as to whether a defendant exercised proper due diligence and sound judgment when deciding how to manage and mitigate risk. It is also vital in helping to quantify what is an acceptable level of risk and what is not.

In the oil spill litigation, cost and benefit analysis expert testimony is critical because the defendant(s) are accused of continually putting profit before safety, factors that ultimately led to the catastrophe. In the failed bank litigation, cost and benefit analysis expert testimony is critical because the defendants are accused of ignoring their fiduciary responsibilities in the pursuit of rapid growth, factors that ultimately led to the banks collapse. In both cases, business leaders are accused of negligently pursuing the benefits without exercising duty of care. Below are examples that are found in the Complaints:

• Gallo, et al v. BP, PLC

44. In a June 14, 2010 letter to Tony Hayward, BP’s Chief Executive Officer, Congressmen Henry Waxman and Bart Stupak identified five critical, questionable decisions made by BP in the days leading up to the explosion… The Congressmen added that the “common feature of these five decisions is that they posed a trade-off between cost and well safety.” These five decisions, combined with other willful, risky, reckless, and short-sighted cost-cutting, time-saving measures taken by Defendants certainly led to this avoidable disaster.

63. After having made risky choices on well design, casing choice, the number of centralizers, skipping the “bottoms up” circulation and using the new type of cement, all of which sharply increased the risk that the cement job would fail, and after experiencing difficulties during the cementing itself and red-flag pressure test results afterwards, BP then made the unfathomable decision to cancel the “cement bond log” test that would check the integrity of the completed cement job. …BP’s reasoning for skipping this absolutely critical and required test seems to have been a savings of $90,000 and less than 12 hours of work.

101. …This safety device would have cost BP and Transocean $500,000, an amount they considered too high to be warranted. These devices are required on rigs in other countries, and several other large oil companies voluntarily install them on risky wells even when they are not required. BP and Transocean were well aware of this but chose cost savings over safety yet again…

105. …In 2005, a huge blast at a Texas refinery killed 15 people and injured more than 170; federal investigators found the explosion was due to cost-cutting, poor facility maintenance, and “organizational and safety deficiencies at all levels of BP.” …A special probe into that disaster by the Chemical Safety and Hazard Investigation Board found that “[c]ost cutting, failure to invest, and production pressures from BP Group executive managers impaired process safety performance” at the refinery. Investigators also found that managers ignored warning signs that an accident was imminent.

106. In 2006, four years after being warned to check its pipelines, BP had to shut down part of its Prudhoe Bay oilfield in Alaska after oil leaked from a corroded pipeline. …Congressional investigators found that BP had employed “draconian” cost cutting measures in Alaska, and suggested that BP had “bet the farm” that the pipeline wouldn’t fail before Prudhoe Bay ran out of oil, saving BP the cost of replacing older pipes. BP eventually pled guilty to violations of the Clean Water Act for the 2006 spill. In November last year, BP spilled oil in Alaska again, as 46,000 gallons of oil gushed from an over-pressurized BP pipeline on the North Slope, prompting yet another criminal investigation of BP’s actions.

113. Transocean’s corporate culture is also skewed towards profits over safety, according to the results of a broad review of its North American operations made just a month before the Deepwater Horizon explosion…

• FDIC v. Van Dellen et al

33. Shortly after assuming command of HBD, Van Dellen announced a plan to grow HBD. Production goals increased for account officers every year under Van Dellen until the latter part of 2007. This was true despite a broad consensus amongst HBD production officers that production targets needed to be lowered. Account officers who did not meet their annual production targets were often terminated or encouraged to leave. Van Dellen continued to push for growth and took no steps to reduce or end production.

In November 2004, Van Dellen, Koon and Shellem, as HBD’s top management, identified residential construction lending as involving “increasing competition, current customers getting bigger and demanding lower returns…”.

34. In the fall of 2005, Van Dellen, Shellem and Koon were being warned by IndyMac’s upper management of deteriorating conditions for home builder lending. In September 2005, Perry suspended mezzanine lending and equity investments through one of Bancorp’s subsidiaries that had been used to assist HBD’s borrowers. Responding to complaints by an HBD account officer, Perry explained that “construction lending is always going to be perceived by any financial institution and its regulators as risky . . . especially in this environment . . . therefore construction lending cannot go ‘business as usual’ in all markets . . . every prudent bank has to ‘pull in the reigns’ (sic) from time to time.”

35. Perry frequently forwarded news articles warning of deteriorating conditions in the home builder market and cautioning Van Dellen to “be careful.” In particular, Perry forwarded articles to Van Dellen such as the following:

a. March 3, 2006 article in The Wall Street Journal. Perry underlined portions of this article that discussed reduced sales in single-family homes and the highest level of unsold new homes in nearly a decade. Perry made a handwritten note on the article stating “Be careful, especially on our new construction projects.”

b. July 26, 2006 article in MBA NewsLink. Perry forwarded this article noting Weyerhauser’s plans to scale back its home builder unit. Perry cautioned Van Dellen to “err on the side of being ‘safe’ . . . as it is not a time to stretch for volume”…

38. As early as 2005, HBD’s management indicated repeatedly to the Bank’s board, the regulators, and outside consultants that it was taking steps to tighten underwriting, even though, as discussed following, it was not in practice doing so…

42. Despite the warnings detailed above, Van Dellen continued to push for growth, announcing his strategic initiative for 2007 in an October 20, 2006 e-mail. Van Dellen asserted that HBD needed to “grow, expand and diversify faster to keep up with the bank and leverage our very solid platform. Our competitors may be retreating or exiting. Now is the time to pounce…”…

43. Only five weeks later, on November 30, 2006 at a meeting of the Bank’s senior managers, which included Van Dellen, corporate management warned of the declining market, describing among other things, a decline of 9.7% in the median price of new homes since September 2005 and mentioning that home builder volumes and margins were “under pressure.” The presentation was entitled the “wall of worry.” Nonetheless, Van Dellen continued, as late as the first quarter of 2007, to push for HBD to “grow production at double digit rates over the next five years.”

4.0 Expert Witness

One of the major obstacles facing expert testimony in risk management litigation is the lack of a common vocabulary to define ‘risk’. The term risk is used in many different ways in many different contexts and thus the perception of risk varies greatly between individuals, organizations, industries and cultures. Indeed, the term “risk management” has different connotations. It is widely perceived to be insurance but insurance is only one type of risk management, there are many others (e.g. operational, financial, safety, reputation, etc.). Therefore, it is important to adequately define the terms commonly used in risk management and to communicate the terminology within the correct context.

Properly communicating the meaning of “risk” within the proper context alleviates any misconceptions in the minds of the judge, jury and all other parties involved in the litigation. In organizations, the lack of a common risk language often hampers effective implementation of risk management practices. The lack of a common language often makes risk management policies incoherent and thus difficult for employees to abide to and hard for managers to enforce– problems that can eventually lead to negligence litigation.

4.1 Risk versus Uncertainty

The most widely accepted definition of “risk” in risk management is:

“The probability of the occurrence of an event multiplied by the likely impact”.

"Risk" is not the same as "uncertainty". People often confuse the two. The words of former U.S. Secretary of Defense, Donald Rumsfeld (who critics will point out suffered quite a few errors of judgment of his own) are helpful in understanding the difference. In discussing the conditions on the ground in Iraq following the invasion he said, "there are the knowns, the known unknowns, and the unknown unknowns".

In this statement, the "knowns" represent certainties. The "known unknowns" represent risks because the variables are understood and thus people are better equipped to manage them. The "unknown unknowns" on the other hand are the uncertainties. People have no idea what the variables are and therefore managing them becomes a guessing game. Thus, it is easier to make a better informed decision under risk than it is under uncertainty - but only if people are capable of making the best use of the information available to them.

4.2 Risk Domains

Research has shown that human risk-taking behavior is compartmentalized and divided into five distinct domains:

• Financial (divided into sub-domains of Investing & Gambling)
• Health & Safety
• Recreational
• Ethical
• Social

Individual risk-taking behaviors vary in each of these domains. Risk-taking behavior is highly dependent on personal risk preferences within each domain. For example, a person who prefers to make high risk investments with his 401K plan may be the same person who is quite conservative in his choice of recreational activities, such as avoiding high risk sports like mountain climbing, hang gliding, etc. At the same, this same individual may take health risks by drinking excessively and smoking cigarettes. There are individuals who may share all of these same risk preferences within the same domains while still others who share only one or two domains, or none of them. This is important in risk behavior profiling and expert testimony. Each of these risk domains involves distinct scientific disciplines and therefore expertise in all of them is difficult to master.

4.3 Risk Appetite

“Risk appetite” is a good example of a term that creates misconceptions in the minds of a lot of people. Risk appetite means the level of comfort that a person has in taking risk. It is also commonly referred to as “risk tolerances” and “risk preferences” and sometimes incorrectly labeled “attitudes toward risk”. In testimony, after defining the meaning of the terms, it recommended that an expert use only one of terms, and to use it in a consistent manner as to avoid confusion.

Risk appetite is a personal preference and there are varying degrees of comfort and discomfort in taking risk. Some people embrace risk while others avoid it at all costs. For instance, there are people who consistently seek out risk-taking opportunities (sometimes paying a high cost in the process). This group would be considered to have a “high” risk appetite. People with high risk appetites, in combination with poor judgment often increase the magnitude of losses (e.g. staking 100K on a risky decision as opposed to the "safer" 50K).

On the other end of the spectrum there are people who people dislike risk and even fear it. People in this group try to avoid situations that entail risk taking which is generally referred to as “risk averse” behavior, or having a “low” risk appetite. Then there are those who neither avoid nor seek out risk. This group is considered “risk neutral” in their approach to risk taking. They do not mind taking risks when necessary.

Properly communicating risk appetite is a problem that extends into the risk culture of many organizations. Often communicating what is an “acceptable level of risk” becomes too vague to be meaningful. The board of directors has a fiduciary responsibly to establish and effectively communicate what an “acceptable level of risk” means, and company officers have a fiduciary responsibly to implement and enforce those clearly defined levels of risk across the workforce.

5.0 Conclusion

The oil spill in the Gulf of Mexico and bank failures are examples of human failures. We are all human and we all make mental mistakes. However, the aforementioned catastrophes were avoidable. The key to preventing a reoccurrence of similar catastrophes in the future is the ability to learn from past mistakes. Similar catastrophes have occurred in the past but unfortunately lessons were not learned.

These catastrophes should serve as a wake up call to people in positions of power who have the capacity to effectively force change. Risk management will continue to fail so long as human factor risks remain unaccounted for and until that happens, there are no assurances that an even worse catastrophes will not follow. The judicial system may well be the last vestige of hope that we have in protecting us from that likelihood.

Citations

Greenspan, Alan. “We will never have a perfect model of risk”, Financial Times, March 16, 2008.

Laibson, D. (1997). "Golden Eggs and Hyperbolic Discounting". The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 443-77.

Kahneman, D., Tversky, A. (1979) “Prospect Theory: An Analysis of Decision under Risk”, Econometrica, XLVII: 263-291.

Oswald, Margit E.; Grosjean, Stefan (2004). "Confirmation Bias", in Pohl, Rüdiger F., Cognitive Illusions: A Handbook on Fallacies and Biases in Thinking, Judgement and Memory, Hove, UK: Psychology Press.

Simon, Herbert (1957). "A Behavioral Model of Rational Choice", in Models of Man, Social and Rational: Mathematical Essays on Rational Human Behavior in a Social Setting. New York: Wiley.

Tversky, A. & Kahneman, D. (1981). “The Framing of decisions and the psychology of choice”. Science, 211, 453-458.

U.S. Chemical Safety and Hazard Investigative Board, Final Investigative Report, Refinery Explosion and Fire, 15 Killed, 180 Injured, Report No. 2005-04-I-TX, March 2007, p. 179.

Weber, E.U., Blais, A.R., Betz, N.E. (2002). “A Domain-specific risk attitude scale: Measuring Risk Perceptions and Risk Behaviors”. Journal of Behavioral Decision Making J. Behav. Dec. Making, 15: 263–290.


Websites:

http://blogs.wsj.com/deals/2010/06/16/bp-oil-spill-costs-20-billion-try-63-billion/
http://bailout.propublica.org/list/index
http://www.fdic.gov/bank/individual/failed/banklist.csv
http://money.cnn.com/2010/06/25/news/companies/BP_stock_price/index.htm
http://money.cnn.com/2010/08/31/news/companies/fdic_problem_bank_list/index.htm

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ABOUT THE AUTHOR: Tyler D. Nunnally
Tyler D. Nunnally is Founder & CEO of Upside Risk, a risk management firm that helps organizations manage and mitigate financial risk taking. He is also Principal at Nunnally International, Inc. which provides risk management consulting and expert witness testimony to the legal community. He currently consults the Gulf Oil Spill Litigation Group.

As an expert in risk-taking behavior, Tyler has led several risk behavior research studies and is regularly invited to speak on the topics of behavioral economics and decision-making under risk and uncertainty. He gained expertise in this field at Oxford University and recently guest lectured at Emory University and Georgia State University. He has also spoken on these topics to professional trade organizations such as the American Bankers Association, Virginia Bankers Association and Georgia Trial Lawyers Association in the U.S., as well as the Institute of Actuaries and the Association of Insurance and Risk Managers in London.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.