Litigation Risk Not So Risky For Smart Investors

Jun.11.12 | About: BP p.l.c. (BP)

One way to kill interest in a stock for many if not most potential investors is to list "litigation risk" somewhere in the analysis. Even more damning is if the litigation risk is a risk well known to the average investor, as in the case of the BP (NYSE:BP) oil spill or if the risk is based on some generally accepted truism, i.e. smoking causes cancer and its corresponding effects on Altria (MO) and other tobacco stocks. Overall there seems to be a general depressing effect on such equities, although in fact many "litigation risks" either never materialize or they simply go away through adverse verdicts or the more likely path of a global settlement.

Exxon Valdez

On March 24, 1989 the Exxon (NYSE:XOM) Valdez tanker struck ground off the coast of Alaska on its way to deliver oil to Long Beach, California. Although the exact amount of the oil spill is unknown, it is estimated that between 260,000 and 750,000 barrels of crude spilled into the Prince William Sound. As expected Exxon stock went down but only at a gradual rate and 30 days after the disaster sat at only a 5% decline.

In the case of Baker v. Exxon, an Anchorage jury awarded $287 million for actual damages and $5 billion for punitive damages. To protect itself in case the judgment was affirmed, Exxon obtained a $4.8 billion credit line from J.P. Morgan & Co. (NYSE:JPM) created one of the first modern credit default swaps in 1994, so that Morgan would not have to hold as much money in reserve (8% of the loan under Basel I) against the risk of Exxon's default.

As expected, Exxon appealed the ruling, and the trial court was ordered to reduce the damages to $4 billion, which the judge concluded was justified by the facts of the case and was not grossly excessive. Exxon appealed a second time and the court increased the punitive damages to $4.5 billion, plus interest.

A third appeal heard on January 27, 2006, resulted in the damages award being cut to $2.5 billion. Exxon appealed a 4th time and the 9th Circuit Court of Appeals let stand the court's 2.5 billion dollar ruling. After three appeals and with the original damage award cut in half one might expect Exxon to accept this as a final judgment. But Exxon wasn't finished yet.

An appeal to the U.S. Supreme Court was noted and they agreed to hear the case. On February 27, 2008, the Supreme Court heard oral arguments. Justice Samuel Alito who at the time, owned in excess of $100,000 in Exxon stock, recused himself from the case. In a decision issued June 25, 2008, Justice David Souter issued the judgment of the court, vacating the $2.5 billion award and remanding the case back to a lower court, finding that the damages were excessive. Ultimately the trial court ordered a final award in the amount of 507 million.

So what is the lesson from the Exxon Valdez?

First is that the large corporations who are facing billion dollar exposure have the capacity and the incentive to "lawyer up" and defend themselves. Multiple appeals, at least 4 in this case, that lasted almost 10 years can put a damper on any bearish outlook.

Second, appeals certainly can only improve the verdict against the corporate defendant. While there is no doubt the attorneys defending Exxon billed in the 7 figures once all was said and done, the result being that the 5 billion dollar punitive award was reduced by 90% to 507 million.

BP and its "Litigation Risk"

As mentioned, 30 days after the Exxon Valdez spill the stock of that company had declined a mere 5 %. The BP oil disaster, which occurred on April 20, 2010 resulted in BP stock declining roughly 35% some 30 days later. By mid summer of 2010, BP had dropped approximately 50% from a price of 60 to 30. In the last 2 years it has fought back to a high of 48 but more recently it is back down below 40. Is the depressed price still caused by the ominous litigation risk? While certainly there are other factors: China's slowdown, declines in the price of oil in general to name a few, traditional valuations show a P/E of less than 5 and a dividend in excess of 5%.

Litigation risk is exaggerated and wise investors will recognize that those that get sued have lawyers too - often the best money can buy - to defend themselves and their considerable assets. So when a company is involved in a mass disaster with widespread media attention, look for the inevitable drop in stock price and consider establishing a position at a price overly penalized by the risk and exposure of litigation.

Disclosure: I established a long position in BP shortly after the oil spill and continue to hold it today.