June 02, 2010
The Financial Crisis and the BP Oil Spill: Risk, Externalities and Criminal Investigations
Posted by Christine Hurt

No corporate law professor (or follower of business generally) should be surprised that the Obama administration announced today that criminal charges may be brought against BP for the spill in the Gulf of Mexico and ensuing failure to remedy the situation.  This case can be analogized to many of the corporate law scandals in the past decade, specifically the financial meltdown of 2008 ncaused by the collapse of the subprime mortgage-backed securities market.

So, for years mortgage-backed securities were packaged and sold by various issuers to investors of all kinds.  Recently, much of the growth in this market has been in the subprime mortgage area, with even riskier mortgages being "sliced and diced" and packaged into investments supposedly safe for the investing public.  Perhaps most investors did not know how risky some of these investments were.  Perhaps they were misled by ratings given them by ratings agencies, information provided by the issuers, or just an overconfidence in the real estate market.  Or perhaps they just weren't paying attention because these investments have historically been quite profitable and safe.  To reduce exposure to risk, institutions and other investors hedged risk by buying insurance products, credit default swaps, that would pay if the mortgaged-backed securities failed.  And the number of firms that sold these swaps were few, and one large insurer, AIG, got stuck being obligated on many, many of these swaps.  And when the music stopped, a lot of financial institutions owned these declining securities, swaps sold by defunct insurers, and loser swaps they themselves had sold.  And so the credit markets dried up very quickly.  And the administration tried to make credit flow, but it was very difficult.  The administration created bailouts for individual institutions and the financial industry, but they were slow to work to clean up the mess made by a number of participants engaging in risky ventures that paralleled one another.  It's fine to take on risk for yourself or your shareholders, but these risks increased systemic risk, creating the externality of severly damaging the credit market, the real estate market, and the U.S. economy as a whole.  So, what do we do?  We see if any AIG executives maybe could be criminally liable; we investigation Goldman, Sachs for criminal activity, we pass new regulation trying to avoid such problems in the future of such large-scale risk taking.

So here's BP.  They explore, extract, produce, refine and sell a very popular product.  Oil allows us all to light and heat our homes and businesses, get to work every day, travel, distract ourselves with numerous electronic gadgets, cook and store our food, and fight and defend wars.  But oil exploration and extraction is risky.  At best, it's risky to the oil producer and its workers -- the costs of unsuccessful exploration, injuries to workers, costs of equipment and technology, etc.  However, at its worst, the externalities are huge, particularly with riskier types of exploration made feasible by high demand.  As we've seen with the Deepwater Horizon explosion, the economic and environmental impact of off-shore drilling can be immeasurable.  (As well as the loss of 11 lives, a fact which tends to be forgotten.) So, BP could have been negligent in two ways.  First, its well-capping procedure could have been a suboptimal choice -- choosing a less expensive procedure with foreseeably higher risks of failure.  Second, the company may be negligent in not having a great plan in place for remedying such failure.  And just as we all stood and watched the stock market decine in value in October 2007 and beyond, we all just stand and watch the oil spread without consensus or a clear idea of how to stop it.

Of course, there will be lawsuits against BP.  People are up in arms that recent curtailments of punitive damages will let BP go scot-free, but let's be realistic.  The compensatory damages, if BP is found to be negligent, will be astronomical.  If BP has any money after compensatory damages, even the smallest ratio of punitives-to-compensatories will inflict whatever punishment necessary.  BP has already spent $1 billion on unsuccessful cleanup and the meter is still on.  I would think that other oil companies are experiencing an deterrence value just by turning on the TV or picking up a newspaper right now. 

But that's not going to get the Obama administration off the hook as the frustrated look to the government to do something, anything.  Regulatory reform in the area of safety for future drilling seems pretty light-handed.  Civil fines and penalties may seem like a cost of doing business.  So, there will be a criminal investigation.

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