Counting The Real Cost Of Disputes

How many businesses would invest in an expensive new piece of plant or tender for a significant contract without evaluating their options through a proper analysis of the likely costs and returns? Despite the existence of many uncertainties as to what might occur, commercial decision makers will regularly use established tools and techniques for evaluating the cost/benefit equation with reasonable sophistication and accuracy.

Why then should the same decision makers be asked to view a legal dispute any differently? Unfortunately, businesses are frequently faced with legal advisors who are unprepared to give a clear view of what is likely to happen in the dispute, how it might most effectively be settled, what it might cost to get to settlement and the impact that the dispute will have on the business. Businesses then hand control of disputes over to their advisors on an open-ended basis and commit to a course of action over which they, the client, have no real influence.

It is no real surprise that purchasers of legal services are becoming increasingly unprepared to invest the considerable sums of money that litigation often demands without understanding in advance what the costs will be, what their options are or without having a clear picture of what the likely returns, if any, might be. Of course, the more enlightened law firms are responding to the challenge.

The tools being applied are borrowed from the fields of science, engineering and commerce. One such example is the use of decision trees, which may be familiar to some, and provide a balanced picture by which the risks and rewards associated with different options and their likely outcomes can be laid out, analysed and assessed.

By way of illustration, the following decision tree shows the various available options and outcomes for a contracting business faced with the decision whether, and at what price, to tender for a contract to supply emergency generators for a new build hospital.

The contractor's marketing staff expect the lower bid of £1.25m to have a 75% chance of success. However, the contractor's manufacturing manager is concerned that he may be unable to control the costs involved in fulfilling the contract. The manufacturing manager considers that, in the best case, the costs should amount to no more than £750,000. His view is that there is a 20% chance of this occurring. In the worst case (30% chance) he believes the costs may escalate to £1,250,000 and that it is most likely (50% chance) that he will be able to constrain costs to around £1,000,000. In each case these costs exclude the design and tender costs estimated at £250,000.

The contractor can calculate, therefore, that if the bid is won at £1,250,000 there is a 30% chance that the contract will lose money (£250,000). Similarly there are 50% and 20% chances that the contract will either break-even or will make a profit of £250,000 respectively.

If the bid is made at £1.5m the contractor's marketing staff consider the expected likelihood of winning would drop to 40%. However, if won, the contract should, at this level of bid, never become unprofitable. Indeed it has a 30% chance of achieving breakeven, a 50% chance of making a profit of £250,000 and a 20% chance of making a profit of £500,000.

In seeking to compare options the contractor may then choose to calculate the weighted average of the possible returns from each bid in order to calculate the expected value of the net profit it might generate. If the contract is won at £1.25m the expected value of the net profit calculates to £225,000¹. However, the effect of losing the tender should also be considered. In the event of losing the tender, the costs incurred in bidding and design would be lost. These are estimated at £250,000. The weighted average of the win-lose position equates to an expected value of the option. In the case of a bid at £1.25m this amounts to -£60,000². (i.e. a net loss of £60,000).

If the bid is made at £1,500,000, the expected value of a successful bid is - £25,000³. However, if the effect of losing the bid is taken into account the expected value of a bid at £1.5m can be shown to be -£81,250⁴.

On this basis, the contractor might consider that bidding is folly. Whilst he has a chance to make a profit regardless of what he bids the odds tell him he ought, on average, to expect to make a loss, the lower of which is -£60,000⁵. If, however, he chooses not to bid the contractor is giving up the opportunity to make a profit. Indeed, if he could find a guaranteed way of reducing costs by say £125,000, the expected value of the net profit for the £1.25m bid becomes positive to the tune of £12,500 and may therefore be seen as attractive. Alternatively, the contractor may decide (for other reasons) to ignore the odds relating to financial return and instead take the risk he loses the bid (at a cost of £250,000) by bidding at £1.5m in the hope (and not expectation) that he can at least break even if successful.

The appropriate decision will depend greatly upon the contractor's view of risk and return. However, in either example the formal process of analysing the outcomes of the options in the decision tree will have clarified the degree of risk that might be taken.

Experience shows that in essence the process of resolving disputes may be viewed in a similar manner. Modern dispute resolution comprises the management of a series of incremental decisions about what actions or activities the disputant (or his lawyers) should take next. Having undertaken the selected actions or activities the disputant arrives in the position of either making further decisions or at a point where an outcome is achieved. When viewed prospectively these outcomes are usually uncertain and may therefore be viewed as a continuum with the expectation of the most likely outcome falling somewhere between a most favourable likely outcome and a least favourable likely outcome.

By using decision making tools borrowed from other disciplines the client can be put back in the driving seat of the dispute resolution process by having a clear view of options and outcomes.

For example, it may be that, following the successful tender discussed above, a dispute arises when the prime contractor for the hospital cancels the contract. Having tried unsuccessfully to resolve the dispute through negotiation the contractor has now been advised by its solicitors that in order to progress the claim it will need to bring legal proceedings. Looking beyond that point the solicitors have further advised that, after issuing proceedings but before pressing on to trial, the contractor may choose to seek to resolve the matter through mediation. The contractor now seeks to make a decision as to whether litigation is in his financial interests. The lawyers draw up the following decision tree to assist the contractor to make a decision.

The important drivers of the decision will be a proper assessment of the prospects of success, the likely quantum of damages and of the costs likely to be incurred. Using effective cost estimating and proper project management tools the solicitors should be able to produce a step by step analysis of what will need to be invested in the form of legal costs and at what stage and for what purpose this investment is required. In addition, a proper legal analysis focusing only upon what is important in the case based upon the facts, evidence and experience of similar disputes will allow an unambiguous assessment of the likelihood of success of achieving a given objective. A proper evaluation of the likely outturns again based upon the facts and evidence provides clarity of the returns the contractor may expect from his investment in costs. Where information is not available it may be necessary to make reasonable assumptions based upon experience. It should also be a simple matter to identify what these assumptions are and to re-perform the analysis on a differing basis to assess how sensitive the outcome is to changes in assumptions.

Thereafter the issue is about clarity of presentation to facilitate the contractor's decision making process. The upper branches of the decision tree illustrate the likely costs and outcomes which may be expected at trial. For illustration the example assumes a similar analysis of outcomes and expected values to the decision tree illustrating the original tender analysis shown above. Of course, in practice, this might look very different.

The middle branches deal with the situation where the case is mediated. It illustrates the outcomes and expected value⁶ if the mediation is successful as well as what the consequences would be of abandoning the case if the mediation is unsuccessful. In practice the case might then progress to trial with the expected outcomes at trial being reduced by the additional wasted costs of mediation (£50,000). The expected value of mediation overall is calculated at £11,000>sup>7.

The decision tree provides the contractor with a rational basis upon which to make his decision in the context of the objectives of the business and the solicitor has provided real value in identifying the issues which drive the risk/investment/reward assessment. If the options are compared the contractor might assume, based upon the information currently available, that he should expect to be £11,000 better off by issuing proceedings and then mediating. In practice the analysis may be re-run after proceedings have been issued to assess whether, in light of information gathered by that stage, the view had changed or whether other (more attractive) options had then become apparent.

The true cost of disputes may be counted in terms of wasted investment in cases with little prospect of success and where the investment is disproportionate to the likely returns. Informed decision making by a fully informed client helps avoid this. Decision trees provide an effective tool to assist this by:

• clearly laying out the problem so that all options can be assessed and evaluated;
• allowing disputants and advisors to analyse fully the possible consequences of a decision;
• providing a framework to quantify the values of outcomes and the probabilities of achieving them; and
• helping disputants to make the best decisions on the basis of existing information and best reasonable assumptions.

However, as with all such methods, decision tree analysis should be used in conjunction with common sense!