The Impact of Information Exchange on Settlements in Legal Disputes, Study notes of Economics and Law

Download The Impact of Information Exchange on Settlements in Legal Disputes and more Study notes Economics and Law in PDF only on Docsity! - 1 - Econ 522 – Lecture 20 (Nov 20 2009) • Over the last two months or so, we’ve developed theories of property and nuisance law, contract law, and tort law • We’ve looked at how rules of legal liability create incentives, and how these rules can be chosen to achieve efficient, or close to efficient, results. • With damages in nuisance law, with expectation damages in contract law, and with compensatory damages in tort law, we assumed it was possible to make one party’s liability for damages exactly match the harm he caused to the other party, so that he would internalize this harm and therefore make efficient decisions • Implicitly, we were making two big assumptions: o the legal system works flawlessly o the legal system is costless • The first assumption we made explicitly – by assuming we could set damages precisely in relationship to actual harm • And, in tort law, we even examined the effect on incentives when it is violated • The second assumption we made implicitly – by ignoring the costs of the legal system in figuring efficiency, and also by ignoring the private costs of litigation when considering the parties’ incentives. • The next two lectures, we will relax these assumptions, and explicitly consider the details of the legal system and the incentives it creates. Docsity.com - 2 - • We begin with an example from the Polinsky book. I hit you with my car and did $10,000 worth of damage. (Sorry.) • You and I both know that I was negligent • But we also both know that courts aren’t perfect – if we go to trial, there’s an 80% chance I’ll be held liable, and a 20% chance I won’t • If I am held liable, damages will be correctly set at $10,000 • So if we go to trial, you expect to recover (on average) 80% X $10,000 = $8,000. • However, if we go to trial, we’ll both have to hire lawyers, and lawyers are expensive. Suppose going to trial will cost each of us $3,000. • So now your expected net gain from going to trial is $8,000 – $3,000 = $5,000. • Similarly, my expected cost if we go to trial is $8,000 + $3,000 = $11,000. • Of course, since a trial will (in expectation) cost me $11,000 and earn you $5,000, it’s possible we can agree to settle without going to court. • Any settlement between $5,000 and $11,000 makes both of us better off. • So perhaps this will happen. • However, it’s also possible we disagree about the likely outcome of a trial • You probably have some private information about the degree of your injuries • I probably have some private information about how recklessly I was driving • First, suppose I’m more pessimistic about my chances at trial than you • That is, you think I’m 80% likely to be found liable, but I think it’s more like 90% • So you perceive your expected gain from trial to be $5,000; but I perceive my expected cost to be 90% X $10,000 + $3,000 = $12,000 • This makes the range of possible settlements we’d both agree to even wider, and makes settling more likely. • On the other hand, suppose I’m optimistic about my chances • You still think I’m 80% likely to be held liable, but I think it’s more like 10% • Your expected gain from trial is still $5,000 • But now my expected cost, given my beliefs, is 10% x $10,000 + $3,000 = $4,000 • So now we’re very unlikely to settle. • Finally, even if our beliefs are compatible, that is, even if there is a range of settlements which would make us both better off than going to trial, the private information we both have might lead to a failure to settle. • Recall from before, that if each of our threat points are private information, we might fail to reach an agreement because one of us tries to hold out for too big a share. • So even if we both had the same beliefs about the likely outcome of a trial, private information could lead us to fail to settle. Docsity.com - 5 - • An error in, say, computing damages after the fact affects distribution but not efficiency • However, anticipated errors also affect the costs that each side perceives as stemming from their actions, and therefore changes incentives and may lead to actions which are not efficient. • Error costs are the costs of any distortions in actions (precaution, activity levels, etc.) due to imperfect incentives caused by flaws in the legal system. Theoretically, then, we can see the goal of a legal process as minimizing the sum of these two costs • the direct costs of administering a legal process • plus the economic effects of errors due to that process. The next several sections of Cooter and Ulen consider in depth each of the different stages we already mentioned: • the decision to pursue a legal claim or not • the decision to settle immediately or exchange information • the decision to settle then or go to trial • the trial itself • the appeals process We begin with the question of whether or not to sue. In a rational world, this comes down to calculating the amount you expect to gain from suing, and comparing it to the cost. Looking at the problem from the victim’s point of view, we can turn all the questions above into a decision tree, assign values and probabilities to the different outcomes, and calculate the overall expected value of a legal claim. Docsity.com - 6 - • (In the U.S., before going to trial, the two sides in a lawsuit go through “pre-trial discovery” – basically, the two sides exchange information they have that is relevant to the case. • This could be doctor’s reports about the extent of injury, police reports about the accident, lists of witnesses each side intends to call, and so on • In many European countries, there is no pre-trial discovery, and instead, the first part of the trial itself involves a “giving of proofs,” in which the two sides offer evidence to support the basic facts of their claim.) • To keep the arithmetic simple, Cooter and Ulen make the numbers unrealistically small – you can think of these as hundreds of dollars. • They assume that the damage done was $100. • Starting at the bottom of the tree, suppose that if you lose at trial, an appeal will cost $20, and will be successful 10% of the time. • That is, 10% of the time you’ll win the appeal and get a judgment of $100; the rest of the time, you’ll get nothing. But either way, you pay the costs of $20 • So an appeal has an expected value of 10% X $100 + 90% X 0 – $20 = –$10 so the victim expects not to appeal if he loses at trial. SUE? Don’t File File SETTLE IMMEDIATELY OR EXCHANGE INFO? Settle “Discovery” SETTLE OR GO TO TRIAL? Settle Trial WIN OR LOSE AT TRIAL? Win Lose APPEAL? Win Lose Docsity.com - 7 - • Now go back a step. • Suppose going to trial costs $20, and you’ll win with probability ½. • So with probability ½, you’ll win a judgment of $100, and with probability ½, you’ll win nothing. • So the expected value of going to trial, knowing that you don’t plan appeal if you lose, is ½ (100) + ½ (0) – 20 = $30 • Now go back another stage, and consider bargaining for a settlement. • Suppose that it’s out of your hands whether bargaining will be successful or not; 70% of the time, you’ll reach a settlement, for an average of $50, and incur costs of $1. The other 30% of the time, talks will break down, and you’ll go to trial. • So now the expected value of reaching this stage is 70% * ($50 - $1) + 30% * ($30) = $43.30 So this is the expected benefit of reaching the stage where you’ve already initiated a suit, failed to settle initially, and already gone through discovery. • Now go back another stage, to the initial decision to settle immediately or go through discovery. • Again, Cooter and Ulen assume this is not a decision but a random chance – with 70% probability, you’ll reach a settlement (averaging $50, and costing $1 in legal costs), and with 30% probability, negotiations will fail. • They assume the discovery process costs $3.30 • So the expected value of getting to this stage is 70% X ($50 – 1) + 30% * ($43.30 – 3.30) = $46.30 • Finally, they assume it costs $10 to file a lawsuit; in this case, the expected gain, $46.30 (with all the later costs built in), outweighs the filing cost, $10, so you would expect the victim to file. Docsity.com - 10 - • (Recall with contract law, we discussed the difference between “productive information” and “redistributive information”. The distinction here in the same – the question is whether errors just affect who has how much of the pie, not how big the pie is, or whether the errors lead to a shrinking of the pie as well.) • In some situations, failing to provide a remedy for a harm will impact distribution, but will not change anyone’s behavior • This might be the case with lawsuits involving hunting accidents: my reasons for not wanting to shoot my friend probably have very little to do with how worried I am about paying his widow if I kill him. • So failing to “punish” the marginal hunting accident might be bad for widows and good for hunters, but it won’t have any impact on the number of accidents, so the social cost of these errors is very small. • On the other hand, consider a contract setting where I paid up front for you to provide a valuable service • Whether or not you want to live up to your end of the deal might depend very much on whether you think I’ll bother to sue you if you walk away • So failing to “punish” the marginal breach might have a substantial impact on production – whether you actually perform the service, or even whether I agree to the contract in the first place. • So we conclude that when errors have large incentive effects, filing fees should be kept low; when errors have small incentive effects, efficiency requires higher filing fees. • The textbook goes on to make some obvious, and uninteresting, points about the effect of the number of lawyers on the supply of legal services, and therefore on price. Feel free to read about it if you like. Docsity.com - 11 - • As long as there are filing fees or other litigation costs, there will be some situations where the harm done to each victim is below the threshold to justify a complaint • One solution when the harm is small to each individual but large overall is one we talked about Tuesday: a class action lawsuit • This is where one or more plaintiffs bring a lawsuit on behalf of a large group of people harmed in a similar way • The book gives the example of a California man who sued his bank over a $6 fee for bouncing a check • $6 obviously exceeds the costs of pursuing the claim, so he sued on behalf of all the bank’s customers who were charged the same fee. • In order for a class-action suit to proceed, the court must decide to “certify” the class • This has to be done thoughtfully, since participation in a class-action suit extinguishes each victim’s right to sue later • (Some class action suits do allow individuals to choose whether to participate or opt out, preserving their right to sue on their own.) • If a class-action suit succeeds – if it leads to either a settlement or a judgment at trial – the court must then approve the plaintiff’s proposal for distributing the award to the other members of the class. • Economics suggests class-action suits are appropriate where individual harms are very small but aggregate harms are large, since these cases might otherwise go unpunished – and especially appropriate especially if the avoidance of liability will have strong effects on incentives. • However, there’s also a view that class-action suits come with a danger: that when a class is large enough, losing at trial would be so catastrophic for the defendant that even when the claim is very dubious, the defendant can’t take the risk at trial and is basically forced to settle. • (These have been referred to as “blackmail settlements.”) • (And as I mentioned Tuesday, there’s also a view that some class-action suits are motivated more by lawyers looking for a plaintiff rather than the other way around.) Docsity.com - 12 - • This last point brings us to the next one: the agency problem between lawyer and client • Ideally, the client wants the lawyer to work on the case until the marginal cost of more work (the opportunity cost of the lawyer’s time) equals the marginal benefit (in increased expected value of a settlement or judgment) • However, this is very hard to achieve via a contract. o A lawyer being paid by the hour has an incentive to do too much work o A lawyer paid for each individual service has an incentive to do them quickly and sloppily o A lawyer working on contingency – for example, a lawyer who receives 30% of the eventual judgment or settlement – internalizes some but not all of the benefit of working, but all of the cost, and so has an incentive to work too little. • One solution to this problem would be for lawyers to work on 100% commission • That is, they pay the client some up-front amount, and then get to keep whatever settlement or judgment they get – functionally, the client sells their legal claim to the lawyer • The lawyer would then internalize the full cost and full benefit of additional effort, so they would work the optimal amount • Of course, this creates a different problem – the client, who is probably a key witness, now has no incentive to testify or assist in the case • Also, as it happens, this kind of arrangement is illegal, pretty much everywhere • Since the lawyer tends to know more about the law than the client, the client can’t always tell when he’s getting good advice, or whether more (or less) effort would be optimal • In addition, there is some randomness to the legal process, so a lawyer’s effort level can’t always be judged by the outcome of the case. • Given these problems, people often choose lawyers based on reputation and long- run relationships • Established firms have an incentive to maintain their reputation by hiring good lawyers and getting them to do good work • Given that, clients are willing to pay a premium to hire a firm with an established reputation. Docsity.com - 15 - Cooter and Ulen explain these results in the following way: Trials occur when the parties are relatively optimistic about their outcome, so that each side prefers a trial rather than settlement on terms acceptable to the other side. When the parties are relatively optimistic, at least one of them is uninformed. Pooling of information before trial that reduces relative optimism promotes settlement. Furthermore, by revealing private information to correct the other side’s false optimism, the party making the disclosure increases the probability of settling on more favorable terms. The same intuition holds in reverse for information which corrects false pessimism – revealing the information is bad for the discloser, and discourages settlement. So voluntary disclosure will tend to share information that corrects false optimist but not false pessimism, promoting settlement. So that’s voluntary disclosure. What about involuntary (forced) disclosure? • Involuntary disclosure will tend to reveal the information that the parties initially chose to withhold – that is, information that corrects relative pessimism • In this way, it may make settlement less likely. • On the other hand, involuntary disclosure reduces uncertainty, and makes the two sides’ threat points more clear • In this way, it may make reaching a settlement easier • So the overall effect is unclear. • (One other thing, of course, is that the existence of a disclosure rule may some make parties less willing to settle before disclosure, since they know they won’t be forced to disclose any harmful information, and want to see what the other side is forced to reveal. So involuntary disclosure may delay settlement until after disclosure occurs.) Docsity.com - 16 - • The disclosure rule in the U.S. is very extensive • well before trial, both parties reveal the basic arguments it will make, the evidence that supports them, the names of witness, and the nature of each witness’s testimony • Witnesses or evidence that are not disclosed ahead of time may not be allowed at trial • Each side can inspect the other side’s evidence and question its witnesses. • Most European countries have little or no pre-trial discovery • Part of this difference may stem from the constitutional right in the U.S. to request a trial by jury • Jury trials are costly – the jurors are taken away from their jobs – so there is more value in having the trial itself proceed quickly and without interruption. • Pre-trial discovery makes this more likely. • In Europe, juries are rarely used in civil cases • So delays and interruptions are less costly, and much more common • In addition, in European civil law, judges take a more active role in developing arguments and exploring evidence • In the U.S., the judge plays a more passive role, serving as a referee between the two opposing sides. Finally, we can look at the effects of voluntary and involuntary disclosure on the two types of costs we considered earlier – administrative costs and error costs. • Voluntary disclosure, we said, encourages settlements, and therefore decreases the number of trials • In addition, having more information out in the open ahead of time should ideally simplify and quicken the trial itself • So we expect voluntary disclosure to reduce administrative costs. • In addition, as information is shared, the parties get closer to agreeing on the likely outcome of a trial, so the terms of a settlement likely get closer to the result of a trial • If we believe that the judgment at trial would likely be correct, this reduces the size of errors in outcomes, and therefore reduces error costs. • So voluntary disclosure should reduce both administrative and error costs, reducing the overall social costs of the legal process. Docsity.com - 17 - • Involuntary disclosure, we said, does not predictably encourage or discourage settlement – it’s ambiguous whether it will lead to more or fewer trials • Pre-trial discovery is expected to lead to simpler, shorter trials • However, discovery is also a costly process • It’s unclear whether the overall effect on administrative costs is positive or negative. • Even more than voluntary disclosure, though, involuntary disclosure pools much of the information that would come out at trial; so when settlements occur, we expect them to deviate less from the likely outcome at trial • So we expect involuntary disclosure to reduce error costs Docsity.com