 Hello, this is Waylon Chow and welcome to Introduction to Law and Legal Risk Management Module 1, Part A. In this part, we will look at the process of legal risk management. In particular, we'll become familiar with the various risks that a business operates in within its environment, and then examine the three legal steps of managing legal risks and the different types of legal risk management strategies. And then we'll look at the case of the Ford Pinto. Any business operates in a complex environment which subjects it to many different types of risks. Let's look at a bank, for example, and the specific risk that a bank is typically subjected to. Whenever a bank makes a loan to a customer, it is subject to credit risk. What credit risk is the risk of that customer not paying back the loan, or in other words, defaulting on the loan? Market risk also affects a bank. For example, if the value of the collateral that a bank has taken to secure a loan has changed. So let's say that collateral is a piece of real estate and the market value of that real estate has gone down, that increase the risk of that loan for the bank. Political risk is also something a bank has to consider. Banking is generally very highly regulated by the federal government. Not too long ago, for example, the federal government decided to tighten the requirements for making home mortgage loans, and that obviously has an effect on the business of a bank. IT risk, or information technology risk, is always present for any business that is dependent on information technology systems. For example, we have heard cases in the past where a bank's ATM machine network crashes and customers are unable to withdraw money or to make payments at the ATM machines. Another type of risk is operational risk, because these are risks arising from the physical operations of the bank. A simple example would be if you go up to a bank teller at a branch and you make a deposit of $100, but the teller, by mistake, inputs that deposit as a $1,000 deposit, that's an operational risk. The risk that we care most about in this course is obviously legal risk. Legal risk is essentially the potential liabilities or legal liabilities that the bank may be subjected to arising from legal issues. For example, in the past, customers of banks have sued in class actions for improper interest charges or service charges that they allege that the bank has charged them. Another risk that we are very interested in is reputational risk. So where we look at the effect of something on the reputation of the bank in the eyes of the general public or in particular their customers, we're also specifically interested in the link between legal risk and reputational risk. So you might have a legal risk and it has an attendant effect on reputational risk. For example, in that arising from that class action for improper interest charges, that class action would also or could also translate into a reputational risk if that class action is reported in the media and thus has a negative effect on the image of the bank. Let's look now at the risk environment of a manufacturing business like an automaker like Ford, Chrysler or GM. In terms of credit risk, an example of that for an automaker is where a dealership has defaulted on inventory financing. So what typically happens is that the automaker delivers cars to a dealer on credit and the dealer owes money to the automaker for those cars. A market risk that an automaker could be subjected to, an example of that would be changes or fluctuations in the prices of the raw materials that the automaker uses in manufacturing cars and most notably if the price of steel goes up. Steel is a big component or a large raw material that's used in making a car so that would drive up the cost of making the car. A political risk, governments in both Canada and the U.S. have been imposing higher fuel economy requirements so that affects automakers, they have to design, they're forced to design more fuel efficient vehicles. An IT risk for an automaker could be for example the computer systems on its assembly lines all of a sudden crashing or failing and their assembly lines come to a grinding halt and they lose a day or a few days worth of production. An operational risk, the typical automaker in making cars, they rely on parts arriving at the assembly plant around the same time where they actually need to use those parts. So this is called just-in-time inventory system. So when those parts don't arrive on time, it could stop the whole assembly line process. A legal risk, and we'll look at an example involving Ford a little later. A legal risk for a manufacturer could also involve a class action where customers are suing for injuries caused by defective vehicles. And the related reputational risk from that class action would be the class action affecting the company's reputation in the public. The responsibility of business managers, especially those at higher levels, often includes managing the various legal risks that may affect their business. The legal risk management process can be simply described in three steps. The first step is identification. So identification of the legal risks. What legal risks out there that can affect our business? Our question that we can also ask is can we be held liable for doing something wrong? The second step is evaluating or assessing those legal risks that were identified in step number one. Specifically, the business asks itself, what are the chances of something going wrong? How much can we be held liable for? So after we've identified our legal risks and evaluated them, the third and final step is formulating a response. What should the business do in responding to these legal risks? What are we going to do about it? The response can be described in various types of risk management strategies, which we will discuss in the next slide. But also one thing to keep in mind, in formulating that response, in formulating the risk management strategy, it's important to consider the reputational risk. As we've discussed before, reputational risk is inherently linked to legal risks. We can't look at just legal risk alone. We always have to look at reputational risk when we're formulating an appropriate business response to legal risks. Let's now look at a few quick quiz questions to make sure that we have a good understanding of each of the three different steps of legal risk management. At any point in time, please feel free to pause the video so that you can consider these questions. The first question, if a business says our product might cause harm to 5% of our customers, is it identification, evaluation, or response to legal risk? This is an evaluation of a legal risk. The business is determining the potential scope or amount of the legal liability from the product causing harm to its customers. A business says our customers may sue us with a class action for injuries caused by our defective product. Is that identification, evaluation, or response to legal risk? It's identification of a legal risk. The business has identified the potential legal risk of customers suing them with a class action. Let's recall the defective products. Identification, evaluation, or response. It is the response. The identification was the part where we identified that there is a potential of customers suing us. The evaluation was assessing what the amount of that legal liability is. And now the response of the decision that this company is taking in response to the legal risk is to recall the defective products. So that is the response. In step three of the legal risk management process, a business would need to determine what their legal risk management strategy is. There are four different ways of describing a legal risk management strategy. Let's go over each of them with an example of that type of strategy. The first type of strategy is called risk avoidance, where the business is making a conscious decision to avoid a particular legal risk altogether. In an example where a bank is considering making a loan to a customer that is a high credit risk, risk avoidance would be deciding not to make a loan to that client at all. The second strategy is called risk reduction. With risk reduction, the business is deciding to take certain steps to reduce the legal risk that has been identified. In our example, the bank would decide to make a loan to that risky client, but would reduce their risk by obtaining mortgage security on the client's real estate. So what would happen here is that if the client did default on this loan, the bank would be able to seize that real estate and use it to help pay down that loan. The third type of legal risk management strategy is called risk shifting, where the risk is shifted to another person or another company altogether. Here the example is that mortgage insurance would be purchased. So how that would work is that the borrower would pay to purchase mortgage insurance from a mortgage insurance company, and if the loan went into default, the bank could ask the mortgage insurance company to pay the amount that's outstanding under the loan. The fourth type of legal risk management strategy is risk acceptance, where the business has identified the legal risk and has decided to just go ahead and accept that risk. In our example, the bank would go ahead and make the loan without any security, but they could ask for a high rate of interest as compensation for taking on that high risk. The thing to keep in mind when formulating any of these legal risk management strategies is that reputational risk should always be considered, and we'll talk more about that later. To illustrate this legal risk management process and also to show how it can go terribly wrong, let's look at the case of the Ford Pinto. The Pinto was a subcompact car produced by the Ford Motor Company starting in 1971. The purpose of this car was to compete against other small imported cars from companies such as Toyota and Datsun. Datsun we know today as Nissan. The problem with the Ford Pinto was that it had this nasty tendency to explode when it was hit from behind. So what happened specifically was that the gas tank would rupture and the whole car would burst into flames. You can see a video of a Ford Pinto being hit from behind and bursting into flames on YouTube and the link for that video is provided in the learning modules. The management of Ford was fully aware of this defect in the Pinto. However, they were comforted by the fact that the car met all of the minimum government safety standards in the U.S. that existed at that time in the early 1970s. So back at that time safety standards were quite low. The managers at Ford in deciding about how to deal with this defect, the first thing they did is they went out and estimated how much it would cost them in terms of legal liability by not fixing this defect. So they did a very specific and precise analysis. They estimated that each year there would be 180 people who would die in these exploding Ford Pintos and that each of them would need to be paid about $200,000. So $200,000 per death. They also estimated there would be about 180 serious burn injuries from these exploding vehicles and that these burn victims would be compensated about $67,000 per injury. And also there would be about 2,100 burned out vehicles and the compensation for that would be about $700 per vehicle. So the total estimated annual cost of legal settlements that they would have to pay out arising from the defect in this Pinto would cost about $49.5 million. And they also ascertained to compare to that figure how much it would cost to fix that defect in the manufacture of the car and the estimate was $137 million which translates into about $11 per vehicle. It would add $11 to the cost of each Pinto that was manufactured. Based on this quantitative analysis, the management at Ford decided to go ahead and sell the Pinto without fixing this defect. So what happened is that the car went to market with this defect and many people bought the car and many people got killed or seriously injured when these cars burst into flames and there were a number of significant lawsuits against Ford because of those exploding cars. Now what I would like you to do is to work through the three steps of the legal risk management process, the steps of identifying the legal risk, evaluating those risks and then determining the response to those risks. Apply those three steps to what you think the managers at Ford did in this case and then ask yourself what went wrong in that legal risk management process.