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directors in the dock is business facing a liability crisis?


About this research Directors in the Dock: Is Business Facing a Liability Crisis? was written in-cooperation with the Economist Intelligence Unit, which carried out an extensive programme of research activity to shed light on this important topic. The Economist Intelligence Unit conducted a global survey of 183 board-level executives that explored corporate perspectives on liability risk management. Of these, 52% of respondents are CEOs, presidents or managing directors. The survey drew opinions from a broad spectrum of industries, with particularly strong representation from financial services, professional services, construction and real estate, and IT and technology. A cross-section of large and small organisations was included to provide a broad business perspective on the issue. To supplement the results, the Economist Intelligence Unit carried out a number of in-depth interviews with senior executives and advisers with expertise in this topic. We would like to thank the survey respondents and interviewees for their valuable time and insights.

Front cover image: A general view of the Scales of Justice on top of the Old Bailey in London


directors in the dock is business facing a liability crisis?

3

Foreword

4

Executive summary

7

The liability environment and its impact

18

Financial markets instability

25

Managing tomorrow’s emerging risks

35

Conclusions


 Directors in the dock Is business facing a liability crisis?




FOREWoRD

from the chairman of lloyd’s

Product recall notices now seem like a weekly occurrence, with their total number in Europe alone growing by 50% last year, doubtless driven in part by fears of consumers keen to exercise their rights. At the same time, groups of angry investors calling for management heads are becoming commonplace and shareholder activism is forecast to rise again this year, fuelled by continuing stock market uncertainty. Add to this our ever more complex operating environment: high-profile losses of customer data are being reported at the same time as we learn that bank details are changing hands on the internet for £5, while directors are trying to get to grips with new legislation such as the UK’s Corporate Manslaughter Act. These are just a few of the reasons why boards everywhere feel increasingly challenged by a liability environment which is taking up more of their time. Eight years after the start of the dotcom crash, what’s happening in the world’s financial markets is reminding boards everywhere of the interconnected nature of our business environment. Simultaneously, there is concern about the economic impact of a compensation culture which may now be spreading far beyond the traditional confines of the United States. In our latest annual survey of Lloyd’s underwriters, the majority said they believe that compensation culture is out of control. While they acknowledge that insurance buyers are giving liability risk greater consideration now than previously, most agree that boards still need to do more to prepare for its impact on their business. As this report highlights, dealing with liability risk consumes some 13% of board time and a level of company resources which many business leaders now find problematic. It is also increasingly clear that the accompanying costs must ultimately be passed on to the consumer. In this context, it is important for boards to understand whether they have in place the right culture and structure to manage liability risk as effectively and efficiently as possible.

Our research shows that the perception of an increased chance of liability is stifling risk taking and innovation, as it impacts on company strategy. In particular, many businesses are adopting a more cautious and bureaucratic approach and – rightly or wrongly – may be avoiding opportunities in new products and markets which they would have embraced otherwise. Looking to the future, it is critical that boards give greater attention to anticipating and responding to liability risks which may emerge later down the line. Advancing technology, environmental issues and corporate governance are the three areas boards are most concerned about in our study. As our findings indicate, however, there is too often a tendency to give most attention to risks that have already been the subject of a great deal of regulatory activity. Yet, with the right culture and processes in place, companies will be much more likely to identify and address issues before they become the subject of litigation. At Lloyd’s, we know that taking risks is part and parcel of doing business. But this report suggests that there may be wide-ranging benefits for boards in thinking differently about the liabilities their companies face. We do not pretend to have all the answers, but we hope that this report will encourage this process of innovative thinking and we are most grateful for the Economist Intelligence Unit’s work in raising some of the key issues for further discussion. For our part, Lloyd’s remains equipped and ready to help companies to take on and manage the changing risks they face.

Lord Levene Chairman of Lloyd’s May 2008


 Directors in the dock Is business facing a liability crisis?

Executive Summary The modern liability environment brings with it a number of stereotypes, from individuals who treat a perceived tort by a major corporation as a lucky lottery win, to ambulance-chasing lawyers who help self-styled victims seek their fortunes. But beyond the stereotypes, liability is a serious issue for companies and one that cannot be ignored. To manage the risks involved effectively, businesses first need accurate information – on both current issues and likely emerging trends. But just as importantly, they need to put in place robust policies and processes to anticipate and mitigate what is becoming a more prevalent and costly problem.

1

 ompensation culture is spreading within Europe and Asia. c Directors feel increasingly exposed, while fast-growing companies may be most at risk

There is widespread agreement among business leaders that a US-style compensation culture is spreading, especially within Europe. Globally, most firms have experienced a lawsuit within the past three years, with actions brought by employees and customers being the most frequent. While suits brought against individual directors and officers are less widespread, half of directors feel more exposed then three years ago. Large companies are most likely to be targets for lawsuits, but smaller and fast-growing companies may be more exposed if they lack the infrastructure and experience to respond effectively.

2

 Boards are allocating increasing resources to litigation issues, which is pushing up the price of products and services and leading many companies to adopt a more cautious business strategy

On average, boards now spend 13% of their time discussing litigation and expect this to increase further over the next three years. There is strong agreement that valuable resources are being spent on legal issues that could be deployed elsewhere. With 58% of respondents using lawyers more frequently and 47% reporting a rise in the cost of directors’ & officers’ insurance, one third of companies are passing the cost on to customers through higher prices, and even more expect to do so in future. Most significantly of all, about one third of businesses have become more risk averse and less likely to invest in new business opportunities as a direct result of concerns about litigation.

3

business leaders are divided about the long-term economic impact of current financial market instability, but are concerned about the potential liabilities that could emerge for their business and its directors. Financial services leaders are the most pessimistic Business leaders are divided on the potential impact of financial market instability: around one-third expect it to have a highly adverse effect on short-term business confidence, while 13% expect a similar impact over the long term. Among financial services companies, however, these figures are considerably higher. There is more widespread concern among business leaders overall about the potential for liability issues to emerge. Just over half of those surveyed think it is likely that individual company directors will become targets for professional liability claims, and just under half think that the scale of claims arising from the sub-prime crisis will exceed those resulting from the dotcom crash.




4

Business leaders are concerned about future liability issues emerging from three key sources: advances in technology, environmental damage and corporate governance Asked about the potential for emerging liability issues, three categories of risk are uppermost in executives’ minds. Of greatest concern overall are the risks associated with technology - such as data and system security and nanotechnology - where the understanding of risks may not keep pace with the speed of innovation. Business leaders are also concerned about emerging environmental liabilities, in the context of growing scrutiny of corporate environmental performance and fears about the impact of climate change and industrial pollution. The liabilities arising from poor corporate governance and the legislation that surrounds it are also of widespread concern. After a decade of high-profile company failures and the sub-prime crisis currently in the news headlines, boards are not yet convinced that business has fully got to grips with issues around transparency and disclosure.

5

Too many boards remain reactive rather than proactive in managing liability risk, and companies need to anticipate and forecast emerging risks more effectively Boards already think that they spend too much time on liability and litigation issues, but this could be spent more wisely and even reduced if they switched their focus to emerging risks rather than concentrating on issues which are already subject to legal and regulatory activity. Many executives interviewed for this report admit that there has not yet been board-level discussion on a range of emerging threats, even though they recognise the need to tackle the issue. Almost four in ten say that they should discuss work-related stress, but have not yet raised this issue formally, while 29% believe that they should discuss technology security but have not done so.

6

Boards recognise the need to manage liability risk more effectively, but face many other competing priorities. Approaching liability issues as part of an overall enterprise risk management framework could help better align risk management with other business goals Most boards surveyed are taking positive steps to manage corporate risk more effectively but 43% have not yet adopted formal policies and procedures to manage liability risk. With competing business priorities seen as the number one obstacle to effective management of liability risk, many companies would benefit from integrating this activity within a clear overall enterprise risk management framework. This not only has the potential to deliver a more efficient risk management strategy for the business, but also to align risk management more closely with other business goals.


 Directors in the dock Is business facing a liability crisis?

It is becoming more expensive to deal with litigation now than in the past


7

Part 1

The liability environment and its impact

Litigation is a fact of life for modern business and is becoming increasingly commonplace. Among the companies surveyed for this report, almost seven in ten have faced lawsuits in the past three years, with employees and customers the most likely source, and one in five has experienced lawsuits targeted at individual directors or officers, including non-executive directors. The fact that 15% of companies have seen lawsuits brought by regulatory authorities is perhaps indicative of change, both in the law in countries such as the United States and the United Kingdom, and in the strategies of various enforcement authorities who are increasingly willing to initiate criminal actions against companies and their directors. Of course, all of these numbers would be higher if threatened actions are included and it is clear that dealing with lawsuits, and the threat of lawsuits, has now become part and parcel of business for a substantial majority of companies. Lawsuits: During the past three years has your company experienced the following? (respondents were asked to tick all that apply) % Percentage of respondants

Lawsuit brought by customer

Frankland, CEO Europe and Chairman of International Board at Guy Carpenter, a risk consultancy. “But in many cases, those further down the pyramid are considerably less sophisticated.” Averages do not tell the whole story, however. For small firms in particular, litigation may not happen or may be infrequent, but if its frequency is unexpectedly high, there can be a substantial and sudden increase in the resources required to deal with the issue. The biggest danger of all may be for those companies that are growing quickly, which are less familiar with the scale of exposure that larger companies experience. “Companies sitting in the middle, which are becoming larger businesses, need to address these issues early in their development plans,” explains Mr Frankland. The fact that company size makes a difference is probably an indication of the greater number of business relationships that large businesses must maintain, which in turn attracts a greater likelihood of disputes arising. There is also the monetary element to consider. As Joanna Page, Head of Contentious Insurance at the global law firm Allen & Overy points out: “Those launching claims go for the deeper pockets, and the deeper pockets can handle it.”

38

Lawsuit brought by employee

36

Lawsuit brought by contractual partner Lawsuit brought by government or regulator Lawsuit brought by special interest or lobby group

21 15 10

Lawsuit brought by investor

8

Class action lawsuit

2 0

10

20

30

40

50

60

70

80

90

100

Size matters It seems that size matters – in a number of ways. First, litigation is most common for larger companies. Among the biggest companies surveyed (those with annual revenues exceeding $1bn) almost nine in ten have faced litigation and three in ten have experienced lawsuits aimed at directors or officers. Of those big companies that face litigation, almost two thirds have been sued by an employee in the past three years and over half by a customer. In both cases, these proportions are nearly double the figure for their smaller peers.

Slow growth, but a heavy burden In the past three years, 38% of companies have seen some increase in the number of cases brought against them, and 34% have experienced growth in the size of claims, while just over 50% have seen no change at all. Similarly, when asked about whether the scale and extent of litigation activity is changing in specific parts of the world, more respondents saw it worsen rather than improve, with Europe recording the biggest deterioration.

In the past three years, what change has there been to the number of lawsuits and the size of claims brought against your company?

%

Number

10

28

Size of claims

12

22

0

Moreover, the effectiveness of companies at identifying and dealing with litigation risk depends on their size. “The very largest companies are incredibly efficient,” says Nick

10

20

55

4

58 30

40

50

60

2 70

Significant increase

Slight decrease

Slight increase

Significant decrease

No change

80

3 6

90

100


 Directors in the dock Is business facing a liability crisis?

Among the companies surveyed for this report, almost seven in ten have faced lawsuits in the past three years




William Powers, Enron Board of Directors Special Investigative Committee Chairman, testifies 4 February 2002 during a hearing about the collapse of Enron Corporation before the House Financial Services Committee on Capitol Hill in Washington, DC.


10 Directors in the dock Is business facing a liability crisis?

However, the frequency of corporate litigation may be less of a problem than the cost of handling cases. The evidence suggests that for many organisations, this burden is now reaching a level that is seen as unacceptable. Almost seven in ten companies believe that managing litigation risk consumes resources that could be more valuably employed elsewhere, including both financial and human resources. First, the amount of time spent discussing litigation issues is becoming problematic, with the majority of boards now devoting more hours to this activity than they did three years ago. On average, 13% of board meeting time is taken over with the discussion of corporate litigation issues, a significant and surprisingly high amount. These trends highlight a clear perception of greater risk.

Over the past three years, what change has there been at your company?

%

Difficulty recruiting non-executive directors Difficulty protecting intellectual property

27 40

Use of lawyers Size of legal department

One particular area where expertise is increasingly needed is intellectual property law. Some 40% of respondents believe that the difficulty of protecting intellectual property has increased over the past three years, as the legal and regulatory environments have become more challenging. In the US, for example, two 2006 Supreme Court decisions, eBay Inc. v. MercExchange LLC and KSR International Co. v. Teleflex Inc., have made it harder to get injunctions to stop potential violations, and raised the bar for the creativity required in order to obtain and defend a patent. The process can become even more difficult elsewhere. The general counsel of a US pharmaceutical company interviewed for this study notes: “Most of our legal focus is on patents – obtaining them, as well as disputes and enforcement. This doubles where Europe is concerned due to the continuing lack of harmonisation with the US.” Dealing with issues related to intellectual property is clearly becoming one of the most costly aspects of many companies’ legal work – and a growing source of litigation activity.

3 37

4

69

27

3

67 47

D&O insurance policy limits

Increase

57

28

Difficulty in finding insurance coverage for liability risks Cost of directors’ and officers’ insurance (D&O)

Levels of deductabilities/ excesses on D&O policies Frequency of claims on D&O insurance policies

5

58

6 51

2

22

76

2

22

75

3

10 0%

Another resource issue is the increased need for legal expertise. In the past three years, 58% of respondents have increased their use of lawyers to manage litigation-related risks, while 28% have increased the size of their own legal departments. Numbers here were lowest among respondents from North America at 16%, suggesting that other regions may be experiencing an increase in required resources, while the need in North America has peaked.

67

89 10%

20%

30%

40%

50%

1 60%

70%

80%

90%

100%

Decrease

No change

The search for cost-effectiveness Many companies are bringing the legal function in-house or experimenting with other cost structures in order to rationalise the expense on litigation issues. For Alexandre Lamoure, former general counsel at travel operator Thomas Cook, any typical legal function is under the same commercial pressures as other departments to reduce headcount and focus on costs. This often means striking a balance between the use of internal resources and external counsel. “You may be able to do better with outside counsel, but if you don’t have enough in-house staff, it can be incredibly expensive,” he says. “Hiring in-house is far less expensive than using an outside counsel. You either have a strong in-house legal department with limited use of outside counsel or you employ an experienced general counsel who can source and manage outside experts.” Even attempts to make litigation more cost-effective sometimes has the opposite effect. Preparatory work carried out before the launch of an action can reduce the number of cases going to trial but can still increase the overall expense of the exercise. There is also considerable activity – and therefore money spent – dealing with complaints and settling claims before they reach the legal system. It is nevertheless perceived to be less costly than the alternative of going to court, a process that is becoming more complex. “The cost in defending yourself seems to be increasing exponentially,” says Mr Frankland. “Unless you


11

are seeking to set an incredibly strong precedent, you will do your utmost to avoid getting to court.” John Smart, Head of Forensic Investigation and Dispute Services at the consultancy Ernst & Young, notes that the sheer volume of data that needs to be reviewed as part of the litigation process is pushing up costs. He adds that cost-consciousness is even leading to procurement functions seeking a more structured selection of legal services that incorporates the use of outsourcing and offshoring. “In some cases, the document review process is starting to be outsourced to places like India,” he says. “That is a trend that will accelerate over the next few years.” Whichever model a company chooses, the key to managing litigation risk effectively is to act quickly and assertively – only by doing so can companies address the problem before it becomes insoluble. The cost of insurance is rising too. There is also a significant appetite for directors’ and officers’ (D&O) insurance – 36% of respondents say that they purchase or review such policies on a regular basis. But more than four in ten respondents report an increase in their overall cost of insurance and higher rates for D&O cover – driven by the fact that 10% of businesses overall are claiming more frequently on these policies due to an increase in criminal actions against directors due to changes in US and British law, and the strategies of various enforcement authorities. Liability risk management - which of the following steps do you carry out on a regular basis?

63 60

Specific employee training and consultation Adoption of formal policies and procedures to manage litigation risk

57 54

Review and implementation of accounting policy Review and implementation of health and safety policy

46

Review of investment policy

46

“There is a general impact on consumers and others,” says Henry Udow, Chief Legal Officer of Cadbury Schweppes, the confectionery and beverages company. “The cost is built into products and services. It is a hidden cost for the consumer, a real inefficiency.” The General Counsel of one US-based biopharmaceutical company interviewed for this report, is also clear that the cost of litigation has a significant impact on drug costs. “People wonder why drugs are so expensive and why the cost of healthcare spirals. You don’t have to look too far to find one of your answers,” he explains. “It’s the result of a legal system that won’t place limits.” Is the risk of litigation strangling innovation? Even more striking for many companies are the broader repercussions that increased litigation risk is having on their wider business strategy and operations. Put simply, fear of future litigation appears to put constraints on the ambitions and growth prospects of many businesses around the world – something that, in aggregate, can have a devastating economic impact. Success in business requires companies to innovate and to ensure that they have the agility and rapid decision-making required to seize opportunities as soon as they arise. The looming threat of litigation, however, can drastically constrain the ability of companies to develop these capabilities. For example, one-third of respondents report that litigation has made them more risk averse in the past three years and a similar proportion report adopting a more bureaucratic approach, which further stifles innovation in their business.

%

Use of technology to improve records management and data collection

A cost passed on to consumers One logical outcome of all these rising costs is an increase in prices charged by a significant minority of companies for their products and services: 34% say that they have had to increase the prices they charge to cover additional spending, and even more – 39% – expect to have to do so in the next three years.

36

Purchase/review of directors’ and officers’ insurance

32

Purchase/review of errors and emissions insurance Review and implementation of employment or diversity policy

30

Review and implementation of environmental policy

30 27

Specific supplier/partner training and consultation

26

Assessment by independent risk consultant Lobbying for legislation to better protect business against fraudulent or excessive compensation claims

16 0

10

20

30

40

50

60

70

80

90

100

Litigation risk also serves as a barrier to investing in certain markets, and to launching new products and services. Around one third of respondents say that they are more cautious about making these kinds of investments as a result of litigation risk – whether real or perceived. In other words, the threat of litigation creates a pervasive atmosphere of excessive caution, which means that companies end up foregoing a whole range of business development opportunities.


12 Directors in the dock Is business facing a liability crisis?

In what ways has increased risk of litigation affected your business over the past three years?

There is widespread agreement that a US-style compensation culture is developing in other regions

%

%

We have reviewed or implemented several corporate policies to reduce liability risk

Compensation culture is a major disincentive to overseas companies wishing to do business in or with the US

53

Our company devotes greater attention to risk management

49

We devote greater resources to communication and disclosure

43

Our board has become more involved in litigation risk issues

38

Levels of internal bureaucracy have increased We conduct more stringent due diligence of suppliers and partners

37

The cost of our products and services has increased

34 33

We have become more risk averse We have become more cautious about investing in new products or services

31

We have become more cautious about investing in certain markets or regions

29 0

10

20

30

40

50

60

70

80

90

100

What change do you expect over the next three years? %

Our company devotes greater attention to risk management

61

We devote greater resources to communication and disclosure

50

We conduct more stringent due diligence of suppliers and partners

47

We have reviewed or implemented several corporate policies to reduce liability risk

46

The cost of our insurance has increased

10

20

15 21

40 0

40

22 55

Class and group actions are becoming more frequent outside the US

44

The cost of our insurance has increased

42

A US-style “compensation culture” is developing in other regions

26 30

40

Agree

Disagree

Neither agree nor disagree

Don’t know

50

5

6 60

21

70

19 26 80

90

100

In fact, US litigation norms are spreading in two ways. Almost everyone interviewed for this study believes that businesses outside the US are growing increasingly ready to litigate. Just as important, however, has been the greater willingness of US courts to rule on cases that might once have been considered extraterritorial. For example, drinks giant Diageo was sued by the Colombian government over money laundering allegations and the illegal import of spirits. But the action, started in 2004, took place in a US court rather than a Colombian one. “Jurisdiction used to be a fairly technical point over which lawyers would argue,” says Phil Haberman, a partner at Ernst & Young specialising in litigation. “Now, it seems to have become a big issue. Everyone is concerned that US courts have been willing to take jurisdiction over something happening anywhere. We have even seen examples of competitive jurisdiction-seeking.”

45

Our board has become more involved in litigation risk

Brad Gans, General Counsel, Markets and Banking, Europe, Middle East and Africa at Citi, expects that this trend towards forum shopping will intensify. “I think some of European litigation is attracted to the US,” he says. “There is no culture of ‘loser pays’. Litigants get a jury instead of a judge. In addition, the US awards much larger punitive damages.”

42

The cost of our products and services has increased

39

We have become more cautious about investing in certain markets or regions

39 39

We have become more risk averse We have become more cautious about investing in new products or services

37

Levels of internal bureaucracy have increased

31 0

10

20

30

40

50

60

70

80

90

100

Europe and Asia are alert One key debate currently centres around the reach of the US legal system and spread of the so-called compensation culture. In recent years, there have been growing concerns that this aspect of the US legal culture is spreading to other regions. According to survey respondents, 55% believe that a “US-style ‘compensation culture’” is developing elsewhere in the world, while just 5% disagree.

The problem is not simply one of litigation between businesses – in fact, most prefer some form of arbitration and frequently build this concept into contracts – but one between companies and customers or shareholders. “You cannot control this form of litigation,” says Mr Haberman. “That is where the real fear lies.” Action by special interest groups represents only a small proportion of corporate litigation – in the past three years only 10% of companies in our survey have experienced such cases


13

the actual number of cases that reach court is just the tip of an expanding iceberg


14 Directors in the dock Is business facing a liability crisis?

– but it is on the rise in the US. These groups consider the US courts to be an increasingly popular destination for lawsuits, even if the supposed incident happens in another country. With American courts being asked more frequently to consider behaviour worldwide, this kind of forum shopping could have global implications. Mr Udow explains that until now there has been a cultural difference between the US and Europe towards litigation. “In the US, filing a lawsuit is almost second nature for a lot of people. In the UK, you are subject to being assessed on a portion of the costs. It’s a very significant disincentive and can reduce the number of less meritorious claims. In the US, there is little consequence for those making claims that are near frivolous. European countries are worried about the influx of such an attitude.” Mr Udow adds that there is fear that the high level of compensation routinely awarded by juries in the US will become a growing trend in Europe. Mr Lamoure agrees: “As lawyers in Europe, we have seen that trend coming from the US, but it is in Europe now,” says Mr Lamoure. “We have to face that. There has been a change and we have to handle it.” The problem is most acute for those countries that experience a paradigm shift towards a more aggressive litigation culture, which may also involve retrospective accountability.

decades of historical behaviour and for their part, insurers would face substantial new risks with unknown costs. Percentage of companies expecting the following changes as a result of corporate litigation in the next three years by region

%

Says Mr Tippin, “What really hurts is when the litigation culture unexpectedly moves on to another plane in another country. If a large economy went from being non-litigious to having many cases, you could be ten to twenty times wrong in your calculation of cost and impact.” Without the familiarity that comes with decades of dealing with these issues, and without the required structures and systems in place, countries eyeing the spread of US legal culture into their own territory face genuine uncertainty. Not only would this throw out current business assumptions, but companies in a changing society might suddenly face litigation related to several

39 36 25

More cautious about investing in certain markets/regions

39 45 37

More stringent due dilligence of suppliers/partners

45 61 53

Greater attention to risk management

57 73 35

Increased board involvement in litigation

39 52 65

Increased time spent on litigation related issues

60 66 0

North America

While concern may be greatest in Europe, it is also increasingly apparent in the Asia-Pacific region. “US companies are more used to and more comfortable with the litigation culture,” says Mr Haberman. “The real fears lie with companies elsewhere in the world, which realise that it is possible to be captured by US litigation.”

33

More cautious about investing in new products

10

20

30

40

50

60

70

80

90

100

Europe

Asia-Pacific

One way of assessing the potential impact of a more litigious culture is to examine its economic impact on the US, which has become used to such an environment. According to a US Tort Liability Index, published in 2006 by the Pacific Research Institute, the high cost of the US system has made products more expensive and showed that states with high tort costs experience lower standards of living and slower economic growth. An annual survey by Tillinghast, an insurance consultancy, on US Tort costs and trends revealed that the US Tort system cost $247bn in 2006. This was a decrease of 5.5% compared with the previous year, but still translates into $825 per US citizen. Our survey certainly suggests that the current US culture now has considerable consequences for companies that want to do business there. Indeed, 42% of respondents consider the US compensation culture a “major disincentive” for wanting to do business in and with the country.


15

Case study

Cadbury Schweppes: Corporate litigation in a global landscape Most people are aware that litigation arising out of social issues, such as obesity, is now much more likely to spread from the US to other countries. People are less aware, however, of a host of other changes stemming from globalisation, such as closer co-operation among regulatory authorities. This means that litigation and investigations mounted in one country can often spread to other jurisdictions, even if they are perceived as being primarily local issues. In late 2007, Canadian regulators began an antitrust investigation of several leading chocolate makers, including Cadbury Schweppes. The company is co-operating with the authorities, and in the past this is the level at which things might have stayed. “Fifteen years ago there was sporadic, and not particularly effective, co-ordination between the EU, the US, Canada, and Australia on these issues,” says Henry Udow, Chief Legal Officer at Cadbury Schweppes. “Now, if you have an antitrust issue arising in one jurisdiction, the others are quickly alerted.” While Mr Udow notes that the issue in question was “a localised Canadian one”, parallel investigations have begun in the other jurisdictions mentioned, and in several EU member states as well.

While globalisation has its downside in some respects of managing litigation, there are also benefits to be gained. For example, a global legal market offers companies increased flexibility when it comes to addressing costs. Cadbury Schweppes has tried a variety of strategies. One has been to seek out lawyers based within a jurisdiction but not in the highest cost centres. For example, in a recent UK litigation case, the company used a Birmingham-based firm rather than a London one, providing the company with the same quality of service but at a lower price. The next, natural step is to look beyond specific country expertise. While Mr Udow says that Cadbury Schweppes has not, as yet, offshored many of its legal activities, it is a process that the company is looking at very carefully. The company’s first foray in to this has been to retain several firms in India to do some intellectual property work. The situation was ideal for the experiment: the work involved was not particularly related to a specific jurisdiction, the level of intellectual property law expertise in India is reasonable, and the company was familiar with the capabilities of the contracted firms. “We have had a great experience with it,” says Mr Udow. “We are certainly going to extend our off shore legal work.”

“Now, if you have an antitrust issue arising in one jurisdiction, the others are quickly alerted.”


16 Directors in the dock Is business facing a liability crisis?

A US flag flies outside the US Supreme Court in Washington, DC.


17

42% of respondents considered the US compensation culture a “major disincentive� for firms wishing to conduct business there


18 Directors in the dock Is business facing a liability crisis?

PART 2

Financial markets instability

Companies in our survey (which took place in January, prior to events involving troubled investment bank, Bear Stearns) largely view the impact of current financial market instability with realism. A significant majority of respondents expect a somewhat negative influence on short-term business confidence, and 60% on long-term business confidence. But concerns go much deeper within the financial services sector. Here, 45% expect the effect on business confidence in the short term to be highly adverse, and more than one quarter believe this will persist over the long term. Just over half of business leaders overall think that demand for their products and services will fall as a result of the situation, and that market instability will have a real effect on their ability to execute business strategy. The credit crunch: where liabilities might emerge Access to capital is perhaps the most tangible issue: 85% of respondents foresee the cost of borrowing rising and 68% see the availability of bank credit falling, which could cause difficulty for any company with high levels of debt, and not just those within the financial services sector. This is also likely to have a significant knock-on effect in terms of companies’ ability to carry out new strategic initiatives. Acquisitions, large-scale capital expenditure and geographic or market expansion could all be affected as companies prepare to weather the storm. Among our respondents, 19% expect to delay or even cancel the launch of a product or service over the next year, while 38% say that they will cancel, reduce or postpone capital spending. Over the next year, which of the following steps do you expect to take in response to the current credit/liquidity crisis?

Unsurprisingly, a significant proportion of businesses everywhere expect to reduce debt and spend less. The specifics depend on business size, with the squeeze affecting small companies far more than large ones – perhaps because they do not have the strength of balance sheet or access to capital markets on which their larger competitors are able to draw. Smaller businesses are twice as likely to reduce their levels of debt (54% of small organisations plan to do so, compared with 26% of larger companies), while the favoured strategy among bigger businesses is simply to refinance, and to allocate greater resources towards improved communications with stakeholders and customers. As a result of all this, three-quarters expect relations with financing banks to become strained as they scrutinise companies’ books more carefully or withhold credit. 61% expect tension with shareholders to emerge as they become frustrated by the lack of growth resulting from these capital constraints and the impact on share prices. Indeed, 54% of those surveyed expect an adverse impact on their share prices as a result of the credit crunch. How adverse do you expect the impact of the credit/liquidity crisis to be on your business? %

Share price

20

Cost of borrowing 23

Availability of capital markets debt

23

49

Renew efforts to improve customer and stakeholder communications Cancel, scale back or postpone capital expenditure plans

16

Demand for products and services

16

13

Ability to execute strategy

15 0

Highly adverse impact Slightly adverse impact

36

Refinance debt or bank credit Cancel or postpone acquisition plans

30

Cancel or postpone launch of new product or service Cancel, scale back or postpone debt issuance plans Cancel, scale back or postpone equity issuance plans Cancel or postpone sale or divestiture plans

19 15 15 10 0

10

20

30

40

50

60

70

80

90

100

36

40

44

42

42

40

44

32

Long-term business confidence

15 32

42

Capital expenditure plans

43 38

52 45

16

Short-term business confidence

Reduce levels of debt

46

33

Availability of bank credit

Value of assets

%

34

47

21

48

40

41 10

20

30

44 40

50

60

No adverse impact

70

80

90

100


19

61% expect tension with shareholders to emerge as they become frustrated by the lack of growth


20 Directors in the dock Is business facing a liability crisis?

House Financial Services Committee Chairman, Barney Frank delivers an opening statement 6 December 2007 in Washington, DC in connection with the sub-prime mortgage crisis.


21

two in three business leaders believe that the scale of liability claims from the credit crunch will exceed those arising from the dotcom crash


22 Directors in the dock Is business facing a liability crisis?

How adverse do you expect the impact of the credit/liquidity crisis to be on your business? (financial services respondents only)

RiskMetrics, a consulting firm, federal class-action lawsuits were filed between August and October 2007 at an annualised rate of about 270, which is more than twice the total that were filed the year before. Some commentators are also reporting a rise in the number of shareholders bringing actions against companies in Europe, including class actions.

%

Share price

45

Cost of borrowing

45

Availability of bank credit

Demand for products and services

24

52

17

28

38

10

45

62

Short-term business confidence

28

45

Long-term business confidence

48

28

Ability to execute strategy 10

7

55 34

0

20

17

34 30

The full impact of the current instability will clearly take time to play out. At the time of publication, there have been few bankruptcies of large institutions, although the near collapse in March of investment bank Bear Stearns may mark the tipping point. On March 18, US law firm Coughlin Stoia filed a shareholder claim against Bear Stearns and its outgoing management, while in the UK, Northern Rock investors have embarked on a similar process against the government.

24

52

21

Capital expenditure plans

17

45

24

Value of assets

31 38

31

Availability of capital markets debt

Highly adverse impact

24

40

50

31 60

70

80

90

100

No adverse impact

Slightly adverse impact

The outlook so far Given that many business leaders expect an adverse impact on share price and shareholder relations, it is likely that corporate litigation will increase. Indeed, two in three business leaders believe that the scale of liability claims from the credit crunch will exceed those arising from the dotcom crash, while four in five think that it will increase the chances that individual company directors will become targets of lawsuits. Within the financial services industry, these ratios are at their highest. At 64% of financial companies, directors feel more exposed to liability issues than they did three years ago, compared with the survey average of 49%. Miriam Smolen, associate general counsel at US financial company Fannie Mae, which offers banks and other mortgage lenders financing, says that, among general lenders, there is a lot of discussion over what sorts of actions borrowers might take against banks to prevent foreclosures: “There might be allegations of predatory lending or of overcharges for fees and services,” she says. “With pressure from consumers, real increases in these sorts of actions are looking very likely.” The situation also has to be viewed in the context of a wider trend of increased shareholder activism more generally. According to

Securities class actions could also prove to be a significant issue for major financial institutions. “These have been happening and will continue to be around for two reasons: the markets are not performing well and legitimate securities class action cases often result in very large settlement amounts” adds Ms Smolen. Mr Gans of Citi points to a trend among hedge funds to finance litigation activity, which he expects to increase in the wake of the credit crisis. “Hedge funds will buy securities that have claims attached, for which there is a substantial litigation premium, and are then content to fund a lawsuit in the expectation of a payout.” However, the ultimate impact of the current crisis on the wider economy remains uncertain, as long as the scale of the losses is unclear. “The trouble is to define what comes under the credit crunch,” says Mr Tippin. “There is a sense of hyperbole about this: it is hard to know what the underlying losses are and to what extent people are going to be able to claim.” Businesses can, however, go some way towards assessing the extent of these risks, by monitoring existing lawsuits, ensuring their lawyers are aware of the latest trends and regulatory issues, and by improving stakeholder communications. In times of economic uncertainty, investor and customer relations become especially important not only to reduce the risk of litigation but also to deter stakeholders from taking their investment and custom elsewhere.


23

Case study:

Suntrust banks: getting to grips with legal issues US-based financial services provider SunTrust Banks provides deposit, credit, trust and investment services to a broad range of retail, business and institutional clients. It says it has seen levels of corporate litigation rise, largely in the employment area, and has 50 internal lawyers divided by subject matter, including a dedicated litigation manager. “Employment law in the US has become so much more intensive from a legal point of view,” says Ray Fortin, general counsel at the company. “It used to be that a high-quality HR professional could handle just about any tough employment situation. But now we’re at a point where you need a specialised lawyer because things are so much more complicated and technical.” He adds that the increasing complexity of products in the financial services sector is also contributing to growth in corporate litigation. And while the sub-prime crisis has not yet had an impact on SunTrust’s business, this could be a possibility in the future. “We’re involved in the old-fashioned world where people aren’t paying their loans and we have to foreclose,” says Mr Fortin. “But we are not a sub-prime lender, so we’re not currently subject to some of the more problematic issues that part of the industry is experiencing.” The biggest challenge facing SunTrust from a corporate liability risk point of view is the tension created by the need to keep expenses down at the same time as handling the growing complexity and legal demands being placed on the business.

“You try to do more with less,” says Mr Fortin. “It’s about how you make your decisions and how you deploy your resources. We work hard to make sure that the lawyers we hire have an idea of how to work efficiently.” The rising costs of dealing with litigation are an issue, according to Mr Fortin. “Outside counsel expenses continue to go up, and often we’re caught in the middle,” he says. “Obviously we’re not a revenue source, we’re an expense. And the outside law firms are trying to raise their fees too.” Ultimately, he says, businesses need to define their decisionmaking process to avoid unnecessary work. But this is easier said than done and appears to be a delicate balancing act. “There is that situation in litigation where sometimes you pursue things that seem to make a lot of business sense but aren’t that rational from an economic point of view,” he explains. “For example, there may be someone who owes us $100,000, but we can’t efficiently get it from him. Sometimes, you have to know when enough is enough.” Firms ultimately need to establish a good relationship with their legal teams to ensure that any litigation process is managed as efficiently as possible. Companies must also adopt a flexible approach towards their legal strategy and be prepared to review their processes time and again.

“the increasing complexity of products in the financial services sector is also contributing to growth in corporate litigation”


24 Directors in the dock Is business facing a liability crisis?

In times of economic uncertainty, investor and customer relations become especially important


25

PART 3

Managing tomorrow’s Emerging Risks

A central pillar of effective risk management is to scan the external environment and attempt to anticipate what shape future threats might take. In the context of liability risk, this means identifying potential risks at an early stage – well before they have reached courts and forced companies into responding to the threat rather than preventing it. Among our survey respondents, there is only a certain level of consensus about what the key future liability risks might be. While it may be unrealistic to achieve unanimity on such complex questions, this also suggests that corporate risk management strategy is not well enough focused on forecasting the future. However, based on our survey, it is possible to group some of tomorrow’s most pressing threats into three broad categories: technology, the environment and corporate governance. 1) Technology Technological development and innovation is now occurring at such a rapid pace that companies can find it very difficult to keep up with the legal implications. Innovation in the online world can have unintended consequences from a liability perspective, while health scares involving new technologies have come to the fore: in 2006, a domestic cleaning product in Germany called Magic Nano was recalled following the hospitalisation of a number of customers, prompting a number of pressure groups to call for greater scrutiny of nanotechnology products. In addition, there are more prosaic reasons to fear litigation arising from technology: data can be accidentally lost or stolen, and issues around a loss of privacy can easily arise. Business leaders are conscious that problems associated with data security have been much in the news, as evidenced by the loss by the UK Inland Revenue’s of personal data relating to millions of Child Benefit claimants.

WorldCom, Parmalat and others. These events brought a wave of stringent new legislation, such as the 2002 Sarbanes-Oxley Act in the US. But although this regulatory environment has been in place for a number of years, many boards report that they are still struggling with increasingly demanding compliance obligations. Failure to meet these exacting standards – and the potential for individual directors to be in the firing line – has become a potential source of liability. At the same time, boards are mindful of the complexity and lack of transparency that helped give rise to the sub-prime crisis and fear that the economy has not yet fully got to grips with corporate governance issues. As a result some 50% of business leaders expect their companies to devote greater resources to communication and disclosure over the next three years. Looking ahead five years, which of the following could give rise to a major new wave of liability claims? %

Inadequate technology security (e.g. exposure of confidential data)

45

Environmental damage (e.g. pollution)

40

Lack of transparency or disclosure in reporting

38 34

Work-related stress

32

Product liability issues (e.g. lead paint) Climate change

27

Inadequate security (e.g. against terrorist attack)

20

Electromagnetic fields (e.g. Wi-fi, mobile phones)

20 13

Obesity 7

Inadequate protection against pandemic Nanotechnologies

6

Silica

2) Environment Concerns about climate change and the impact of business on the environment have the potential to create a new source of future litigation. Many non-governmental organisations have pushed business into the firing line of environmental litigation, while tightening legislation makes it much more likely that companies will transgress established boundaries. Meanwhile, an increasing focus on the ‘polluter pays principle’ is shifting responsibility back onto the originator of the problem. It may take time for companies to become used to this new model and unfamiliarity could, in the meantime, drive litigation. 3) Corporate governance Issues associated with corporate governance and transparency have been high on the agenda since major scandals at Enron,

1 0

10

20

30

40

50

60

70

80

90

100

Look ahead to forecast better What perhaps emerges above all is that a surprisingly high proportion of companies have not yet given board consideration to a number of potential future liability issues, despite acknowledging that they are risks that need to be discussed. Within the organisation, some 52% have already discussed the threat from inadequate technology security, seen as the most likely factor to give rise to a new wave of liability claims. However, 29% have not given it consideration at board level – despite admitting that they should, and 14% acknowledge that there is little prospect of this happening in the near future.


26 Directors in the dock Is business facing a liability crisis?

a surprisingly high proportion of companies have not yet given board consideration to a number of potential future liability issues


27

The overriding conclusion is that too many companies tend to examine what they have done in the past when assessing future liabilities and remain reactive rather than proactive. “The emerging risk management process is less developed than some of the other risk management capabilities,” says Keith Bevan, an Enterprise Risk Management Analyst at Standard & Poor’s. “This is partly because a lot of companies find it difficult to understand or think about the unknown, and to look forward to what new risks could come up.”

Where do you currently seek information and advice on emerging liability issues? %

70

Lawyers 51

Insurance companies The media

36

Risk consultants

34

Regulators

Has your company discussed the potential risks at board level?

32 28

Government bodies 23

Management consultants Special interest/lobby groups

%

16

Other, please specify

Climate change

33

17

22

4

28 0

Nanotechnologies

12

Inadequate security (e.g. against terrorist attack) Inadequate protection against pandemic

14 32

11

Electromagnetic fields (e.g. Wi-fi, mobile phones) Inadequate technology security (e.g. exposure of confidential data)

28

25

21

38

25 29

37 4

20

19

22

18

54 20

26

22 30

6

49 22

37

10

5

19

34 36

0

14

38

12

40

30

40

50

60

70

80

90

100

42

52

Environmental damage (e.g. pollution) Product liability issues (e.g. lead paint) Lack of transparency or disclosure in reporting

20

from surveying the wider horizon. “The first stage of any risk assessment is environmental scanning,” explains Mr Bevan.

29

33

17

Work-related Stress

21

30

14

10

45

19

17

Obesity

Silica

28

50

60

16 70

80

8 90

Yes we have discussed

No, and little likelihood of discussion

No, but we should discuss

Not applicable

100

So, how can companies begin to understand and monitor tomorrow’s liability issues – and with the current economic uncertainty, can this be done at all? While there are no easy answers, there are a number of guidelines that business leaders can follow. Monitor and assess the risk environment in a more structured way Faced with an uncertain future, where do business leaders turn to for advice that can help them plan for and monitor future risks? There are a range of resources that companies can call on, but it seems that the understanding of what is available and the take-up of these resources is patchy. Currently, seven in ten consult lawyers and half seek advice from insurance companies. Both are sensible steps, but many companies could benefit

The media can be a valuable source of information on emerging threats – today’s isolated news story can easily become tomorrow’s major litigation trend. It therefore makes sense for companies to monitor the media in a structured way, which is something that only 36% of respondents currently do. “Companies that do this successfully have a formalised process in place,” says Mr Bevan. “For example, they look at publications such as medical journals, or might have software scanning the internet looking for peaks in discussion of certain topics.” Companies should also monitor legal activity elsewhere (especially in the US, where many legislation waves originate), they should consider sectors other than the one in which they operate, as this can often be an indication of future drivers of activity for other industries. The proportion of companies that turn to regulators and government bodies is lower still. However, with 35% of business leaders citing the complexity and rapid pace of legislative change as an obstacle to successful liability risk management, these sources can be particularly valuable. Many government bodies encourage companies to contact them with queries. For example, the Health and Safety Executive in the UK offers a free advice service for businesses to help increase their awareness of potential risks. In addition, a relatively low proportion of companies take advantage of the increasing range of services available from


28 Directors in the dock Is business facing a liability crisis?

risk and management consultants, while special interest and lobbyist groups can sometimes be a useful source of information, which is often free. Put the right culture in place With 42% of business leaders stating that a lack of awareness among employees is an obstacle to effective liability risk management, it seems fair to conclude that many businesses could do more to embed a stronger liability risk culture throughout the organisation. Staff education is key to ensure a higher level of awareness about liability risks and a clear understanding of the actions expected of them to mitigate and measure these issues. A strong culture and awareness of liability issues will discourage employees from carrying out activities that could lead to future litigation because there will be a higher expectation of compliance, and because there will be a better understanding of the consequences of such behaviour. In turn, this would lessen the potential for litigation risk and improve the business’s overall performance and reputation. Peter Fisher-Jones, Head of Litigation for Markets and Banking, Europe, Middle East and Africa at Citi, emphasises the importance of an approach to risk that pervades the organisation. “Risk sensitivity is embedded in the culture of our organisation. And that manifests itself in a variety of ways and in a variety of places. For example, we have a substantial and sophisticated compliance function. Among other things, it explains issues to employees and maintains awareness. We have extensive training around our policies and working practices. And because we are a financial institution, there is a tradition of being very careful with our own and other peoples assets. There’s an enforcement culture too. If there are transgressions, they are usually picked up in a timely way and there are consequences.” Boards cannot expect any of this to take place of its own accord. Rather, companies should ensure that there is someone within the organisation with specific responsibility for putting in place a process that enables relevant information to be passed up the chain of command to the board. They should review and adapt this process regularly to make sure it encourages employees to raise any concerns or share information. After all, they are the individuals who are closest to the action. In addition, companies could consider making aspects of liability risk management a part of job descriptions for relevant employees, and looking at ways of reflecting this focus in compensation and incentive packages.

Another practical way in which this culture can be strengthened is to integrate legal teams within the business more closely. “Sometimes,” says Mr Lamoure, “lawyers are too far removed from companies’ practical matters.” Where this happens, it will ensure that there is easy access to legal expertise and that all parties concerned are aiming towards a common goal. Put in place an effective infrastucture to take pressure off the board Our survey suggests that liability risk management has the attention of top executives. At 75% of companies, chief executives are ultimately responsible for managing litigation risk, and at 93% of companies, a senior executive is in charge – usually the chief financial officer or chief legal officer, if not the chief executive. It is encouraging that boards consider liability issues to be important, but clearly there is a limit to the amount of time they can spend discussing them. These issues already take up a disproportionate amount of board time – 13% on average – and 42% expect the board to become even more involved in the next three years. Unsurprisingly, respondents say that the biggest obstacle to managing liability risk effectively is competition with other business priorities and 70% agree that dealing with these issues “consumes valuable resources that could be better allocated elsewhere”. It is therefore essential for boards to put in place mechanisms that give them confidence that the issues are being identified, monitored and addressed without consuming unmanageable amounts of their time. First, they should ensure that they have a strong in-house legal team in place, consisting of individuals who have the necessary qualifications, experience and understanding of the business to manage liability issues effectively. Putting in place the right team can be expensive, but companies should not be reluctant to spend on such an important capability. “It is essential to have high-quality internal litigators,” says Mr Gans. “That costs money but it is a vital investment because there are significant amounts of money hanging in the balance.” In addition to having a trusted team that can be relied upon to manage existing and emerging issues, companies also need to ensure that there are clear lines of responsibility and accountability so that the legal team can escalate issues should the need arise. This means that the executive board can become involved when necessary but ensures that there is a filter in place to shield them from matters that do not require their attention. Companies should also put in place a systematic process


29

the biggest obstacle to managing liability risk effectively is competition with other business priorities


30 Directors in the dock Is business facing a liability crisis?

A general view of the Royal Courts of Justice on 11 February 2008 in London, England


31

is it possible to group some of tomorrow’s most pressing threats into three broad categories: technology, the environment and corporate governance


32 Directors in the dock Is business facing a liability crisis?

for identifying and assessing risks. “They should look at risk categories, ask whether the company is particularly exposed to them and try to understand what would happen if things go wrong,” says Mr Bevan. “Quite often there is a risk management committee with people from different areas of business doing this. It is not just an academic exercise. The whole process is formalised and systematic. That is the big difference between companies that are and aren’t doing well. The latter have no process to think more widely about what might occur.” Focus on prevention, rather than reaction On average, companies spend around 50% more time preventing litigation risk than responding to it. However, 61% of business leaders recognise the benefits of a greater focus on precaution, rather than ‘fire-fighting’ problems. This approach may increase resources in the short-term, but will pay dividends in terms of reducing the time and money spent dealing with unforeseen problems further down the line. A balance therefore needs to be struck between the management of existing risks and those that have yet to emerge. By attempting to anticipate problems before they become serious, companies also have a much better understanding of their overall potential exposure. This can give them a competitive advantage by allowing them to allocate resources away from potentially risky activities or by modifying products, services and processes to reduce the potential for future litigation. For Mr Fisher-Jones of Citi, striking the balance between managing existing risks and anticipating future ones is a question of governance. “Embedded within our governance structure are various early-warning systems,” he says. “For example there’s accountability across businesses to present themselves to the Regional Governance Committee to explain past events or anticipate future events. We ensure that there is open and detailed discussion around the issues that are escalated into that forum.” Emerging risks may even be best tackled by a team in the organisation that is separate to the main risk management process. This can help to ensure that the issues are given the attention they need, and can then be referred to the board as required. “The reality of emerging risk management is that, because it is about unknown things, it doesn’t fit into other risk management processes,” says Mr Bevan. “Quite often, it is a separate part of the risk framework and a separate group from across the business that considers these risks.”

Once a risk has been identified, it is essential that it is then folded into risk management as a whole. “It is quite difficult to quantify emerging risks to a large extent,” says Mr Bevan. “If you have exposure, you should know about it and reflect it in your pricing.” What are the main obstacles to achieving successful management of liability risk within your business?

%

Competition with other business priorities

43

Low awareness among staff of liability issues

42

Complexity and rapid pace of change with legislation

35

Lack of adequate reporting processes and controls

29

Low awareness among staff of legislation

24

Complexity of supplier/ partner relationships

23

Lack of legislative harmony between regions

21

Lack of leadership or “tone from the top”

16

Other, please specify

3 0

10

20

30

40

50

60

70

80

90

100

Integrate liability risk management into an overall enterprise risk management framework and align with other business goals Our survey shows that around half of companies now devote greater attention to risk management generally as a result of changing levels of corporate litigation. But with a constraint on board time a perennial problem, companies can perhaps achieve more if they integrate their management of liability risk within an overall enterprise risk management framework. Not only will this deliver a joined-up risk management strategy; it will also help to align it more closely with other business priorities. By examining broader business activities, such as product design or customer relationship management, through a prism of liability risk management - a company has the opportunity both to improve those processes and reduce the risk that problems will emerge at a later stage. For example, a company might think about product liability risk earlier in the design process. By conducting a thorough examination of the potential liability issues that could emerge from a product, companies have the opportunity to modify the design to prevent any flaws causing problems in future. For financial institutions, which are regulated under Basel II, liability risk should be seen as part of operational risk. The Basel II regulations require institutions to set aside capital


33

against credit risk, market risk and operational risk. Banks that are seen by the regulators to manage these risks effectively can be required to hold less capital aside than those institutions that are less sophisticated, in their approach to capturing managment information. “Regulators calculate how much operational risk is in your business and you have to hold capital for that, just like you would for credit or market risk,” explains Mr Gans. “And legal risk and legal loss fall into that operational category. So we’re now applying the same kind of statistical approach we use in credit and markets risk to our operational risk. We spend time and effort to develop more sophisticated tracking methods, statistical models and processes, so we can go to the regulators and they’ll say, ‘you’re well managed and sophisticated, so we’ll require you to hold less capital’.” In practical terms, the management of liability as part of operational risk comes down to a scientific approach based around the ongoing gathering of information and measurement. “By examining trends and aggregating data, you have the ability to make more sophisticated decisions about your capital,” says Mr Gans.

between the number of companies who consider this an effective approach, and those who actually take action, highlighting the opportunity for many boards to think about liability in a longer-term context. Liability risk management: Is there a gap between awareness and action?

%

21

Lobbying for legislation to protect business from litigation

37 16 20

Adoption of formal policies and procedures to manage the risk

77 57 14

Specific employee training and consultation

74 60 13

Use of technology to better collect and manage data and records

76 63 11 43

Errors and omissions insurance 32 0

Use the right tools to manage liability risk Companies have a range of tools at their disposal to improve their management of liability risk. Some, such as employee training and the use of technology, are internally focused, while others, such as the use of insurance contracts and lobbying, involve external stakeholders. An effective risk management strategy uses a combination of both sets of techniques, and companies should ensure that they strike the right balance between them. This sounds like an obvious point, but companies are not always consistent in choosing the tools that will provide them with the greatest benefit. A significant minority of companies, in some cases one in five, are not using the strategies and techniques that they themselves rate as most effective. For example, while 77% say that the adoption of formal policies and procedures to manage liability risk is an effective approach, only 57% indicate that they follow their own advice. Boards need to get better at examining the full range of techniques available to them and ensuring that resources are allocated to those that provide the most positive outcome, instead of simply relying on existing processes. Lobbying governments and others for legislative change is another area where there is a high discrepancy

10

% difference % who consider approach effective

20

30

40

50

60

70

% who regularly practise

80

90

100


34 Directors in the dock Is business facing a liability crisis?


35

ConclusionS Lessons in liability

There is a real perception that both the range of future liabilities and the cost and time required to deal with liability-related issues is significantly on the rise.

litigation and liability issues consuming a growing amount 1 With of corporate resources, companies will need to use these more effectively Legal teams – whether in-house, external, off shore or a combination of all three – will be an increasingly valuable but expensive resource, and the most forward-looking companies will regularly review their legal strategy and supplier relationships.

a US-style compensation culture spreads, organisations 2 As in Europe and Asia, in particular, need to implement the right infrastructure to respond to new risks European and Asian companies believe that a US-style compensation culture is already well established, and there is a real danger that boards in these regions lack the experience of dealing with such a litigious environment. Organisations operating there may need to spend substantial time and resources improving their infrastructure, skills and capability to respond to this trend.

3

Financial services companies need to put in place formal processes to track emerging risks and ensure that they assess their potential exposure It is still early days in terms of assessing the impact of current financial market instability. However, a reported rise in class action lawsuits, combined with the widely held view that the litigation impact could exceed that of the dotcom crash means that financial services companies should prepare for the potential for high-profile, high-cost actions - possibly against individual directors.

boards that build a culture and process to anticipate 4 Company emerging risks, rather than continuing to focus on existing threats, will manage liability risk most effectively Companies that are looking to diversify and expand will need to address these threats early in their development plans, if they are to successfully manage and mitigate future liability risks.

5

leadership from the board is critical in improving the understanding of liability risk throughout the whole organisation With lack of time and poor employee awareness of liability issues being the biggest obstacles to effective liability risk management, staff education is becoming essential. Boards which involve staff in developing and implementing effective risk management policies and processes can gain both a holistic view of the risks they face and a powerful early warning system to alert them to potential problems when they arise.

the most forward-looking companies, liability risk 6 Among is viewed and managed as part of a broader enterprise risk management framework Liability risk should not be seen as something that is simply left to lawyers. The best risk managers will integrate the management of liability risk within a clear overall enterprise framework. There are many effective options open to companies, from improving communication between legal teams and the rest of the business in the short-term, to lobbying for legislative change over the longer-term.


36 Directors in the dock Is business facing a liability crisis?

About the 360 risk project

Today’s risk environment is changing and evolving more rapidly than ever before. At Lloyd’s, understanding and anticipating major risk trends is what we have been doing for 300 years. Lloyd’s 360 risk project was created with one aim: to generate discussion on how to manage risk in today’s business environment. By tapping into the concentrated expertise and knowledge within the Lloyd’s market, and bringing together the views of experts from the insurance industry and the wider business, political and academic worlds, we want to stimulate practical, thought-provoking discussion about the risk issues that matter, from climate change and terrorism through to corporate liability. Lloyd’s 360 risk project will not give all the answers, but it will provide a forum for us to debate the steps we need to take to better manage risk. To find out more about the 360 risk project and download the reports described below, visit www.lloyds.com/360. To request printed versions email 360@lloyds.com adapt or bust ­— explores what climate change could mean in our lifetime in four areas of particular relevance to the insurance industry: sea level rise, melting ice caps, flood and drought.

Under attack? Global business and the threat of political violence — provides a corporate perspective on political violence and examines how geopolitical risk can impact business.

What next on climate change? — highlights the key issues raised during the 360 Live Debate on Climate Change and provides an update on how Lloyd’s is addressing the issue of climate change.

Home-grown terrorism - What does it mean for business? — identifies the practical steps which companies must undertake to mitigate and manage the home-grown risk of terrorism.

Rapid climate change — addresses the issues and impact of climate change and the steps the insurance industry might take to prepare for the increasing volatility of the climate.

Terrorism in Asia - what does it mean for business — examines the current terrorist threat in Asia, and how it impacts on business.

Disclaimer This document is not a prospectus or invitation in connection with any solicitation of capital. Nor does it constitute an offer to sell securities or insurance, a solicitation or an offer to buy securities or insurance, or a distribution of securities in the United States or to a US person, or in any other jurisdiction where it is contrary to local law. Such persons should inform themselves about and observe any applicable legal requirement. While every effort has been taken to verify the accuracy of this information, neither the Economist Intelligence Unit, Lloyd’s nor their affiliates can accept any responsibility or liability for reliance by any person on this information. Copyright Notice: © 2008 the Economist Intelligence Unit and Lloyd’s. All rights reserved.


Lloyd’s is a registered trademark of the Society of Lloyd’s.© Lloyd’s 2008.


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Directors in the Dock - Is business facing a liability crisis