A few years back, when Google acquired YouTube, I was heard to remark that the deal seemed kind of…imprudent. Given YouTube’s potential as a lawsuit generator, the best owners might not be the guys with some of the world’s deepest pockets.
A colleague points out that it seems equally odd for a company with pockets the depth of BP’s to be engaged in as risky an activity as deep water oil drilling. Why wasn’t this project sold off to someone with a lot less to lose?
Maybe BP expected to be protected by laws limiting its liability, but surely it was foreseeable that those laws might be circumvented, as it appears they’re about to be. So if that’s part of the answer, it’s only a small part.
I’m not saying it would be a good thing for more of these risky ventures to end up in the hands of relatively judgment-proof firms. I’m just saying I don’t understand why we don’t see more of that. What am I missing?
Well, I’m not a deep sea drilling expert, but it seems to me that the deeper the pockets of the company financing the drilling, the more exhaustive the risk management and disaster management should be/ is. Mainly because they do have a lot more to lose. Not seen here, though.
Conversely, what might put off other (smaller) companies would be the considerable technical risk involved, the uncertainty regarding presence of oil and when its found etc. Call it a company’s risk appetite. In case BP farms out the risk to a sub contractor etc, it is open to any amount of risk due to business/ operational practices followed by the latter. Supervision and legal enforcement costs may well be the same as if BP executes the project in house.
Also, any legal protection insulating BP from ecological disasters due to negligence on part of the sub c would probably be thrown out of any court in the US.
IS this close to what you’re looking for?
The large size of the initial financial capital probably eliminates the possibility of “judgement-proof” firms entering these particular ventures. A company that has $1.5 billion to spend on YouTube is likely to be one that also has the deep pockets to be liable to pay lawsuits.
I’ve been wondering the same thing regards BP. Can it be that they simply did not see it as that risky? And that there’s learning by doing that created a cost advantage for BP for deep sea drilling.
A friend of mine is in a business that’s subject to letters making frivolous patent claims. He says that Google absolutely refuses to settle such claims. They have enough money to fight a suit to the death. The claimers have lots of money too, but their business model can’t handle lots of legal costs — they need capitulation — so they tend to leave Google alone.
Perhaps that’s part of the answer. Having deeper pockets than your opponent hurts you in damage awards actually paid, and hurts you in your attractiveness to claimants — but maybe it helps you in terms of ability to fight off, and especially deter, claims with less merit.
Why don’t firms become as small as possible in order to maximise the benefits they get from limited liability? Presumably because there are other advantages of firm size (e.g. lower transactions cost as Coase showed) that outweigh it.
Also, in some instances, there might be some backward induction. If I’m thinking of hiring your firm, I might not without the option to sue you if you wrong me. Not sure how this applies to YouTube though, where most of the lawsuits will come from non-customers.
Actually my guess is that BP probably _did_ have a legal subsidiary (for which BP’s liability could in theory
be limited to its investment. However, I’m guessing (but could be totally wrong..i’m not a lawyer) the
subsidiary is also probably considered an independent contractor for BP due to the type of relationship that was likely necessary between the two entities in this complex enterprise.
I was just explaining to someone this weekend that I’m glad it was BP and not a small firm that caused the spill, essentially for the reason Dr. Landsburg is giving. I never thought to consider why disaster-prone businesses aren’t smaller…you’d rather have your $1 million start-up be wiped out by a disastrous liability than your mulit-billion dollar oil company.
I can definitely think of two things that make firms bigger than they need to be. One is regulation, which imposes high fixed costs on firms, and whose cost scales with firm size in a way that benefits large firms. (BP definitely felt regulatory costs; it most likely had teams of people whose entire job was to comply with the regulatory regime.) I regulatory costs are something like $8000per employee per year for a small company and $5000 per year for a larger company…it simply pays to be big. Another less obvious thing that makes firm grow large is the corporate tax. A tiny start-up that drills for oil may or may not hit any; if it gets no oil and it turns no profit, it owes nothing in taxes but still runs at a loss. If it does strike oil and turns a profit, it incurs a large tax liability. The result can be a negative expected value of future profit. If you have a lot of drilling operations, your profits look more stable. There is a benefit to packaging a lot of risky operations together under one firm. (Suppose you run a single risky operation with a 50% chance of losing $10 and a 50% chance of earning $12 profit. In a tax-free world you might want to do it, but at a 40% tax rate on corporate profits it has a negative expected value. You’ll want to either avoid this operation or package it with many similar projects.)
I think it’s really funny that we have anti-trust laws, but then our regulatory and tax regimes creates economies of scale that make firm sizes much larger than they ought to be.
This is a very good riddle. Regardless of why it goes this way with BP, for ventures with the possibility of large costs to 3rd parties, economic efficiency is only obtained if firms have the financial depth to pay for the potential externalities. If bankruptcy is probable in the event of a accident, then firms will have a financial incentive to drill in places where the expected value of profit less the expected value of externality payments is negative. With a deep pocketed outfit like BP taking on the project, we can be certain that they felt (ex ante) that the risk was justified by the profit potential. The bankruptcy option in business ventures that do not involve large externality potential are not a problem with economic efficiency, because the potential losers enter into contracts knowing that bankruptcy could happen, whereas the shrimping firm in the Gulf did not sign off on the risk.
Like the banks, they thought they’d never fail.
Might there be a captial gains tax penalty if a small company makes a huge find?
Is there a subsidy that a smaller company could not fully exploit?
An entirely uneducated guess:
Never get into an arms race with someone who already has nukes.
There presumably exists at any moment a shaky, not-well-defined detente between the state and any corporation capable of and likely to produce externalities that the state may have to clean up. Gambits like spinning your riskiest assets/projects into separate corporations to keep them off the mothership’s books get used all the time on a small scale, and everybody is happy with the arrangement: it’s a wink and a nod, but the state gets tax revenues from a thriving private sector, and investors get to tell themselves (sometimes even accurately) that they are managing their risk appropriately. Like many wink-and-nod arrangements, the trick to keeping it running is to not be seen abusing the privilege in public: do something stupid like, for instance, destroy the entire gulf coast fishing industry (just for a start), and the state might very reasonably decide that yesterday’s “prudent risk management” is in fact “conspiracy to evade justice” and void all of your clever contracts at gunpoint.
Perhaps more succinctly: in case of disaster, provably having some skin in the game is a helpful token of good faith.
Doctor Memory: Yes, I think you’ve nailed exactly the reason why BP does not spin off projects like into “separate” corporations that are not really entirely separate. But it fails, I think, to explain why BP would want to take on a project like this in the first place—or at least why they’d want it *more* than some other more judgment-proof firm.
More precisely: If it’s worth BP’s while to spend $X billion getting this project going (with its own funds), then i’d expect it to be worth $(X+1) billion to No-Name Inc. to take on the same project (with borrowed funds). So why does BP end up with the project?
Hm, I’d tend to assume, as many of the other commentors above have suggested, that “judgment-proof” and “capitalized sufficient to build and maintain a deep-sea oil drilling platform” are pretty close to mutually exclusive categories.
Which of course only leads to the question of why any company wants into the business. (And who knows, maybe none of them are going to henceforth?) I’d guess that it’s not a little bit of human perversity at work here: oilmen want to dig for oil, otherwise all of their lifelong investment in the skills of oil drilling is for naught. The ocean floor is a potentially new and large untapped source of oil, so Q.E.D.
I think profit is the answer. As Russ Roberts says, “Profits encourage risk-taking, losses encourage prudence.” But, that doesn’t mean it’s perfect.
Also: who knows? Perhaps BP was the most judgement-proof of all of the possible companies that could have done this job?
(Also also: for some reason your blog keeps insisting that I fill out my name/mail/url each time despite it having apparently successfully saved them the first time.)
Dr Memory might have it there. We know undser the law BP has limitied exposure. Would that be true of a new entity created for the purpose of drilling? That is does the cap apply to new companies, or only to existing ones.
In the case of YouTube, the bandwidth economics favor a large company like Google. A large part of the purchase price went into an escrow fund to cover the lawsuits.
If you want another riddle, why did BP not have direct insurance against this event? Last I heard, they were trying to get coverage under the umbrella of the rig operator’s insurance.