In prior posts, I’ve written about risk. See “To The SEC, ‘Risk’ Is A Four Letter Word“. In my view, risk should be understood as the product of the probabilities of a range of outcomes and the consequences of those outcomes. In assessing risk, both positive and negative outcomes should be considered. Yesterday, I wrote about surprising legal holdings in Douglas E. Barnhart, Inc. v. CMC Fabricators, Inc., 2012 Cal. App. LEXIS 1202 (Nov. 20, 2012). The case presents an interesting risk analysis scenario.

The plaintiff sued for only about $66,000 and the defendant paid its lawyers $150,000 to defend this claim. Let’s assume that the plaintiff paid a lesser amount in legal fees to prosecute its claim – $100,000. If we assume that the court could have awarded anything between $0 and $66,000, then the plaintiff’s risk would have been the probability of each award multiplied by the amount. To keep things simple, let’s assume the plaintiff believes that only three positive outcomes are possible:

If we assume that the probability of the plaintiff being awarded its attorneys’ fees is equal to the overall risk of prevailing on the contract (i.e., the plaintiff will receive 100% of its attorneys’ fees if it obtains any of the three possible awards), then we should add another $60,000 (.6*$100,000). The plaintiff’s overall positive risk is $89,900. But we must also account for the possible negative outcomes. By the plaintiff’s own reckoning, it has a 40% chance of not receiving any award (i.e., losing on the contract). If it loses, it will pay 100% of its attorneys’ fees ($100,000) and there is a risk that the court will award the defendant its attorney’s as well, as happened in the actual case. The expected loss is $100,000 ((.4 *$100,000) + (.4*$150,000)). The plaintiff’s expected return under these assumptions is -$10,100. Although the plaintiff’s expected return is a loss, pursuing the litigation would result in a smaller expected loss than doing nothing.

If we assume that the defendant shares the same conclusions about the probable outcomes, the expected damage award will be $29,900. If the defendant loses, it will also have to pay the plaintiff’s and its own attorneys. The probability of this occurring is $150,000 ((.6*$100,000) + (.6*$150,000)). Thus, the expected return for the defendant is -$179,900.

This example is, of course, based on arbitrary assumptions that I’ve made for the sake of illustration. It also greatly simplifies the problem. Nonetheless, I present it as an illustration of how to think about risk.