Wednesday, May 19, 2010

The Rising Tide of Moral Hazard



Transocean, the owner of the drilling rig Deepwater Horizon that was lost in the explosion and fire that killed 11 workers and led to the BP gusher that will plague the Gulf of Mexico and the Gulf coast for years to come, has a plan to come out of the disaster in pretty good shape.

Citing the vintage 1851 Limitation of Liability Act, attorneys for Transocean are seeking to cap the company's liability in the disaster to the value of the drilling rig. The law was intended to protect shippers and their cargo. Transocean is using the act claiming that the value of the rig (which burned and sank) is $26.7 million. That, they say, is the limit of the company's liability in the still unfolding disaster that began on April 20 off the coast of Louisiana.

BP, the company that holds the drilling rights and that leased the rig from Transocean, has said that it will pay all legitimate damages resulting from the spill. This despite the fact that the company could seek to cap its liability at $75 million under the provisions of the Oil Pollution Act of 1990. That law and that liability cap came in the wake of the 1989 Exxon Valdez oil spill in Alaska.

Twenty years later with a still-uncontrolled gusher in the Gulf sending thousands of barrels of oil into the Gulf everyday, $75 million ain't what it used to be. The liability cap seems quaint in today's economic environment where BP declared profits in excess of $6 billion for the first 90 days of this year. Friends of the energy industry have thus far blocked the U.S. Senate from raising the liability limit in the law.

BP has paid hundreds of millions of dollars if fines in recent years resulting from the way it has conducted operations at its refineries and pipelines. Some of the fines have resulted from investigations into incidents, like the 2005 explosion at its Texas City, Texas, refinery that killed 15 workers and injured 180.

Despite the fines and penalties, BP has not fundamentally changed its behavior. BP is so big and so profitable that hundreds of millions of dollars in fines have not induced the company to change its behavior for the better.

When Regulators Refuse to Regulate

There has been a concerted effort in recent years to reduce the regulatory burden on companies. No where was this better exemplified than the Department of the Interior during the eight years of George W. Bush's presidency.

When Dick Cheney moved from Halliburton to Vice President, he brought with him a commitment to unshackle the industry from what he and his industry cohorts believed were burdensome environmental and safety regulations.

The Department of the Interior, which is supposed to act as the steward of the nation's natural resources, became a fully captured arm of the energy industry. No office was more compromised than the Mineral Management Service (MMS), which ran the offshore oil and gas leasing operation as well as set safety rules for drilling and production.

A 2008 Inspector General's report found that MMS staff members were not just cozy with the industry but — in some cases — they had intimate relations with the people they were supposed to regulate. MMS officials withheld information about billions of dollars in royalty revenue that the companies were not paying the federal government. The regulators had sided with those they were supposed to regulate in direct opposition to the interests of the people on whose behalf they were supposed to be acting.

During the early days of the 2008 financial crisis, conservative columnist David Brooks, writing in the New York Times said:
Our economic system is based on the idea that people take responsibility for their own decisions. It would be ruinous if people felt free to take horrendous risks knowing that the government would bail them out if those decisions didn’t pan out.
What we evidence in the Gulf of Mexico and across the corporate world of just the kind of behavior Brooks was describing as ruinous. Goldman Sachs was packaging 'deals' for some of its clients while betting against those same deals with other clients.

In a business climate where short-term results were all that matter, where any cost that impacts the bottom line is to be avoided, safety and regulatory compliance were things to be avoided or escaped. When supposed regulators colluded with those to be regulated (as was the case at MMS), then a moral hazard is created.

Meet Moral Hazard

One definition of moral hazard says:
Moral hazard occurs when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk.
Liability caps that shield companies like Transocean, BP and others from bearing the full cost of their actions creates a form of moral hazard. That hazard grows as the effective value of the cap falls due to inflation, as has been the case with the Oil Pollution Act.

For decades, business and industry has been engaged in a war against those who sue them. "Tort reform" is the name that this war goes by, but at its heart it is about reducing the costs to companies of their actions and behaviors that harm others.

The U.S. Chamber of Commerce has been at the forefront of this effort to reduce the liability exposure of companies by limiting the amount of punitive damages that victims can be awarded in law suits against corporations. The Chamber has gone so far as to dress up its moral hazard inducement project into an institute, calling it the Institute for Legal Reform. One of the functions of this organization is to produce annual rankings of the business climates of the 50 states based in large measure on the ways that those states limit the ability of citizens to win punitive damages against corporations in the courts there.

The ILR ranks Louisiana as having the 49th most hostile business environment in the nation in its most recent index. The ILR develops this ranking based on "the opinions of 1,482 general counsels and senior attorneys or executives in companies with annual revenues of at least $100 million."

Perhaps Louisiana's poor rankings are related to the flood of litigation that resulted from disputes policy holders had with insurance companies following hurricanes Katrina and Rita in 2005. The ILR does not say. It just assumes that anything that would result in damages being awarded companies must be bad — regardless of the actions that produced the dispute.

Murphy's Laws

It is odd that Louisiana would receive such a poor ranking from the ILR because the state was a leader in aggressively moving to cap punitive damage awards in a number of areas during Governor Murphy "Mike" Foster's tenure in office. There was a full tort reform package in 1996. That same year the Legislature passed Foster's bill to ban punitive damages awards in cases involving the handling of hazardous wastes.

These laws made Foster the darling of the Louisiana Association of Business and Industry (LABI), although it was not enough to keep them friends throughout Foster's eight years in office. Foster had the temerity to raise taxes to balance the state's budget and LABI went to war with him over that.

So long as the impact on tort reform was viewed as protecting Louisiana companies from the impact of pesky plaintiffs attorneys, it was golden in Louisiana. But, in the wake of the storm and flood damage of 2005, the state was awash with contractors working to repair or replace the damage inflicted. This was also at the peak of the national housing boom that became a bubble that, when it burst, almost brought down the global economy.

There was intense competition for building materials. Some companies went outside the country to get materials so that they could get the work done on houses in Louisiana. One of the materials imported was dry wall from China.

It turned out to be tainted. It was used in between 5,000 and 7,000 houses in Louisiana. It fell apart. It damaged other parts of the house. It made people sick. The culprit (the dry wall) was identified. The homeowners wanted to sue the manufacturers.

They ran into Foster and LABI's 1996 tort reform statutes. According to the Times-Picayune, the 1996 tort reform legislation will prevent local homeowners from making a full financial recovery.

There is federal litigation underway but that will take years to complete. The Louisiana Recovery Authority (the funnel through which all storm recovery dollars flowed into the state) has put up $5 million to help the homeowners until some form of relief finds their way to them.

There is a bill in the current session (SB 595) by Republican Senator Julie Quinn that would provide some paper-thin protection to homeowners against cancellation of their homeowners insurance policies if they made a Chinese drywall claim. But, even passage of that bill is shaky given the pro-business tenor of the House and LABI's opposition to anything that might be construed as weakening the 1996 tort reform package.

So, here is LABI standing firm against middle-class Louisiana homeowners (some of whom are probably business owners and LABI members) in defense of laws that work against the interests of those citizens.

One aspect of the 1996 tort reforms that has come under attack has been the caps on damage awards in medical malpractice cases. Democratic Representative John Bel Edwards of Amite tried to get the cap raised last year, noting that $500,000 is a lot less money today than it was in 1996. Edwards' HB 224 sought to raise the cap to $750,000. The bill would have also raised the amount of liability exposure for healthcare providers from $100,000 to $150,000.

Edwards' bill never got out of the House Insurance Committee.

Falling Deterrence, Rising Hazards

Edwards' bill contains the essence of the moral hazard that has been created by this confluence of sham regulation, frozen liability caps and the continued push for tort reform. The costs to business of failure to comply or to harm or otherwise injure a customer or client through shoddy workmanship, bad product design, or sloppy handling of materials continues to fall in relative terms to their ability to absorb the cost of those damages.

This is the essence of how moral hazard arises. Louisiana with its history of pollution and environmental degradation has gone out of its way to protect polluters and those who inflict public health costs in their quest for private profit.


The Louisiana Chemical Association (LCA) does not think the scale has been tilted far enough in their direction. The organization had recruited Republican Senator Robert Adley to carry their water in trying to shut down the Tulane University Environmental Law Clinic, which has a long history of representing the interests of poor and under served communities, as well as environmental organizations, in an effort to win compliance with regulations or even (gawd forbid!) bring relief from pollution.

The LCA does not just want to shut the law clinic down, in a classic bit of overreach, it wanted to cut off all state funding to Tulane University as a means of punishing the university for daring to allow such activity in defense of ordinary citizens to take place under their watch.

In a startling display of common sense today, the Louisiana Senate Committee on Commerce, Consumer Protection and International Affairs voted to defer Adley's bill, effectively killing it for this year.

One day, when the LCA has had time to think things over, they will thank the Senate from saving the LCA from itself. As it is, they have the kind of control over the Department of Environmental Quality that oil companies have had over the MMS. Shutting down the Tulane Environmental Law Clinic would mean that the LCA and its members would be at the mercy of their own whims.

The LCA so desperately needs perspective that it was apparent even in Baton Rouge today.

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