Fall_2007_sample_term_paper___Every_Man_for_Himself_v_Loser_Pays_All.f07

Fall_2007_sample_term_paper___Every_Man_for_Himself_v_Loser_Pays_All.f07

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Unformatted text preview: Evegy Man for Himself versus Loser Pays All 17719 American and English Rules for Allocating Legal Costs and their effects on. the Decision to Litigare or Settle Introduction: The Litigation Process The litigation process is triggered by some event, such as an accident or breach of contract, in which one person allegedly harms another. The Victim then has to decide Whether to assert a legal claim. Assuming the victim is rational, if the benefits of a favourable judgment or settlement outweigh the legal costs, the Victim will file a legal claim against the inj‘urer (Cooter and Rubinfeld, p. 1069). The parties to the dispute then begin to prepare for the trial. They reply to complaints, attend preliminary hearings, engage in pretrial discovery and set trial dates. During this lengthy third stage of the litigation process, the plaintiff (the Victim) and the defendant (the injurer) try to negotiate a settlement, in the hope of avoiding a trial and the associated legal costsi. A settlement is possible when there exists some settlement amount that both the plaintiff and the defendant would be better off accepting out of court than they would be going to trial. it follows that a settlement is only possible when the expected benefit of the trial to the plaintiff is lower than the expected costs of the trial to the defendant. If negotiations fail, the parties enter into the forth and final stage of the litigation process: the trial (Cooter and Ruhinfeld, p. 1070). Under the American rule, each party is responsible for his or her own legal costs. Under the alternative English rule, which is the norm in most of the world, the losing party is responsible for both parties” legal costs. The cost~benef1t analysis each party performs in order to decide whether to settle or litigate is different under the American rule than it is under the English rule. This paper investigates the economic theory behind the decision to litigate or settle 1 Settlement negotiations can continue into the forth stage, right up-until the court’s judgment is rendered. However, for the simplicity’s sake, i assume that settlement negotiations end when the trial begins. This assumption should not effect the economic analysis of the settlement—vs.~litigate decision. under both the American and English rules for legal fee allocation In Part I, I describe Poser and Shavell’s simple mathematical model representing the plaintiffs and the defendant’s decision to litigate or settle. This model predicts that litigation will be more likely under the English rule than it will be under the American rule (Shavell, p. 65). in Part II, I illustrate H'ause’s alternate model for the settle—vs—litigate decision. Unlike the Posner and Shavell model, Hause assumes that the likelihood of prevailing in trial increases as legal fees increase. Hause concludes from this model that litigation is less likely under the English rule than it is under the American rule (Hause, p. 158). I briefly discuss the implications of risk aversion for the Posner-Shavell and Hause Models in Part III. Risk aversion should increase the likelihood of settlement, more so under the English rule than the American rule (Shavell, p. 68). In Part 1V, 1 evaluate the hypotheses generated by-=the"Posner-Shavell and Hause Models using data collected in Florida by Hughes and Snyder. Florida experimented with the English rule for medical malpractice suits from 1980-1985 (Snyder and Hughes, p. 355). The evidence suggests that the Hause Model better reflects the legal world, although neither the Posner—Shavell nor the Hause Model accurately captures the risk averse behavior of plaintiffs and defendants. To conclude, I evaluate the efficiency of the English and American rules. The primary purpose of litigation, according to Posner, is to make sure that violators of the law are confronted with the costs of their violation (FPosner, p. 586). Based on the available evidence, I contend that the American rule better fulfills this purpose. Part 1: The Posner~Shavell Model In deciding whether to settle cut of court, both the plaintiff and the defendant must calculate the expected cost or benefit of going to trial. This estimate depends on three factors: the probability of a plaintiff’s success in trial, the size of the judgment if the plaintiff wins and the litigation costs of each party (Donohue III, p. 1096). Let “Pp” be the plaintiff 3 estimate of his probability of prevailing at trial and “Pd” be the defendant’s estimate of the plaintiff s probability of prevailing at trial. Let “I” be the size of the judgment should the plaintiff be successful. Lastly, let “Cp” and “Cd” be the legal costs of the plaintiff and the defendant respectively. A risk neutral. agent evaluates an uncertain prospect according to it’s expected value, discounting each filture event by the probability that it won’t occur. For example, say a plaintiff believes that the likelihood of obtaining a judgment of $10,000 is 25%. The potential $10,000 judgment is discounted by $7,500 because there is a 75% chance that the plaintiff will get nothing. The expected value of the judgment is therefore only $2,500 (Shavell, p. 57). Similarly, the defendant must also discount the cost of a judgment in the plaintiff‘s favour by the probability that it won’t occur. Therefore, when calculating the costs and benefits to each party under both the American and British rules, the expected benefit of a judgment for the plaintiff will be Pp x3 and the expected cost of the judgment to the defendant will be Pd x} . The American Rule Under the American rule, each party is responsible for his or her own legal fees. The expected benefit to the plaintiff and the cost to the defendant of going to trial are given by: (i) as, = Pp xrwcp (2) ECP = Pd xJ +Cd (DonohueIILp.1096) There will be a settlement only if the expected cost to the defendant of going to trial is greater than the expected benefit to the plaintiff (Shavell, p. 63), in other words, EB, < ECd. To see why this is true consider an example where the opposite is true, EB!) > ECd. Say the expected La) cost of going to trial for the defendant is $1,000 while the expected benefit for the plaintiff is $2,000. The plaintiff would demand a settlement of at least $2,000, while the defendant would only be willing to offer a settlement of $1,000 at most. There is no settlement amount that would leave both the plaintiff and the defendant better off than. they would be going to trial. Negotiations would fail and a trial would be inevitable. Therefore, under the American rule, a settlement is possible when: (3) Pp ><J~CP < Pd xl- Cd; or equivalently, (4) J(Pp - Pd) < (Cp + Cd) @onohue Ill, 13.1097) The British Rule The requirement that the losing party pay both parties” legal costs will alter the expected value of going to trial for both. the plaintiff and the defendant. The legal costs of the losing party will be Cp + C6. This total cost must be discounted by the probability that the party will win and. avoid all legal costs. It follows that the expected legal cost to the plaintiff is (l - 131,)(Cp t Cd) and to the defendant is Pd(Cp + Cd) (Donohue III, p. 1097). Therefore, the expected benefit of going to trial for the plaintiff and the expected cost for the defendant are given by: (5) EB? mPp ><J’—(1—PP)(Cp +Cd) (6) ECd = Pti xJ +Pd(Cp + Cd) (Donohue lll,p.1097) As mentioned previously, a settlement is only possible when EBp < ECd. The condition for settlement is therefore: (7) Pp x J—(l ~Pp)(Cp +Cd) < Pd x J+Pd(Cp + Cd); or equivalently, (8) J (Pp — Pd) < (1 — Pp + 121 )(C p + Cd) (Donohue In, P. 1097) Likelihood of Settlement under the American and English Rules When the plaintiff and the defendant agree on the plaintiff’s probability of prevailing at trial, inequalities (4) and (8) are identical: the left hand side is 0 and the right hand side is the total. legal costs divided by the judgment. Since the right hand side is always positive, both inequalities are always satisfied (Donohue Ill, p. 1097). This means that, when the plaintiff and the defendant agree on the probability of the plaintiff getting a favourable verdict, a settlement is always possible and the settlement gaps under the American and English rules are identical. On the other hand, when the plaintiff and the defendant disagree on the plaintiff’s probability of prevailing at trial, the settlement gaps under the American and English rules are different sizes. More importantly, sometimes the English rule forces the parties to go to trial while the American rule allows for a settlement (Donohue ill, p. 1098). To compare the likelihood of settlement under the American and English rules for fee shifting, consider two examples where the plaintiff and the defendant agree about the size of the potential judgment but disagree about the probability of the plaintiff prevailing at trial. The plaintiff believes that there is a 60% chance that he will receive a $10,000 judgment, while the defendant believes that there is Only a 50% chance. The plaintiff spends $1,000 on legal costs, the defendant $1,250. Under the American ruie, the expected benefit to the plaintiff is $5,000 and the expected cost to the defendant is $6,250. Under the English rule, the expected benefit to the plaintiff is $5,100 and the expected cost to the defendant is $6,125. Therefore, settlement gap under the American rule is $225 wider than the gap under the English rule. Now, consider another example where the plaintiff believes he has a 70% chance of prevailing. Under the American rule, expected benefit to the plaintiff would be $6,000 and the defendant’s expected cost is $6,250. Under the English rule, expected benefit to the plaintiff would be $6,325 and the defendant’s expected cost is $6,125. Therefore, a settlement would still be possible under the American rule but not the English rule. As mentioned previously, when Pp : Pd, the settlement gaps under the American and English rules are identical. Under the American rule, when the plaintiff becomes more optimistic, only the expected value of the judgment (Pp XJ) increases w his legal costs stay the same. However, under the English rule, when the plaintiff becomes more optimistic, the expected value of the judgment increases and the expected legal costs decrease ((1— Pp )(Cp + Cd ) ). Therefore, when the piaintiff gets more optimistic, the next increase in his expected benefit is larger under the English rule than it is under the American rule. Conversely, when the defendant gets more optimistic, the decrease in his totai expected cost is larger under the English mic than it is under the American rule. An increase in the optimism of either party results in the gap between EBp and ECd shrinking mere under the English rule than the American mic. Since a settlement is only possible when EBp < ECd, litigation is more likely under the English than the American rule (Shaveii, p.66). Part Ii: The Hause Model Hause’s alternative economic model for the settiemvs.»litigate decision relies on the plausible assumption that the probability of a plaintiff prevailing in trial (a) increases (at a decreasing rate) as the plaintiff spends more on legal fees, and conversely, (‘0) decreases (at a decreasing rate) as the defendant spends more on legal fees (Hause, p. 165). Mathematically speaking: 2 (a) asp/an > 0 and BZPp/BCP < 0 (b) an/acé < 0 and aria/ecli2 > 0 (Hause,p.165) Given the above assumption, under both the American and English rules, the incentive to incur higher legal costs is the same: increased chances of Winning in court. However, the disincentive to incur higher legal costs is higher under the American rule than it is under the English rule. Under the American rule, each party knows they will be responsible for his or her own legal costs, Win or lose. Under the English rule, the more each party spends on legal fees, the less likely it is that he or she will have to pay for those legal fees. In other words, each party spends more money on legal fees in the hope that the other party will be forced to pick up his bill. Therefore, both the plaintiff and the defendant will spend more on legal fees under the English rule than they would have under the American rule (Hause, p. 166)? As described previously, the condition for settling under the American and English tales are: (4) KPP 41,) < (cm, item) (American)3 (8) J (P, —Pd) < (1—1), +P,)(c + (3,3,) (English) 13(6) Litigation will he more likely under the rule Who’s inequality is harder to satisfy. The left hand side of (4) is equal to the left hand side of (8). The inequality that is easier to satisfy will be the one with the larger right hand side. It has already been determined that parties will spend more on legal fees under the English rule than they will under the American rule, so (Cm) + C (M) is less than (CW) + Cam). Presumably the parties get reasonable advice from their lawyers, so it is unlikely that the plaintist estimate of his likelihood of success at trial is much different than the defendant’s estimate. (1— Pp + 3,) will be something close to l. Hause hypothesizes that (CW)? CM) will 2 in his paper demonstrating this model, Hause arrives at this conclusion using calculus. He finds that the partial derivative of PD with-respect to C], under the American rule must be larger than the same partial derivative under the English rule. The same holds true for the partial derivative of Pd with respect to Cd. This means that the English rule induces both parties to adjust their legal costs to a point where the marginal productivity of C, and Cd in changing Pp or Pi is lower than it would be under the American rule. Given the assumption of the diminishing marginal productivity of Cl, and Cd, both parties must spend more under the English rule (Hause, p. 166). 3 In the subscripts of CI, and. Cd, I have added a “(a)” to designate costs under the American rule and a “(e)” to designate costs under the English rule. When discussing the Posner-Shavell Model, I assumed that each party‘s costs under the American rule were equal to their costs under the English rule. That assumption is rejected by Hause. he greater than (C + C ma,) by a significant percentage (Hausa, p. 167')“. Assuming Hause is 9(a) COITBCll (9) (cm) + cm) < (1 — Pp + Pt, )(CW) e cam) (Hause,p.167) It follows from (9) that the range of settlements possible under (4) must be smaller than the range of settlements under (8). The smaller the range of settlements, the more likely litigation. becomes. Therefore, comm Posner and Shavell, Hause concludes that litigation is more likely under the American rule than it is under the English rule. Part lll: Risk Aversion Both the Posner-Shavell and Hause Model take for granted that the parties to the dispute are risk neutral. A risk neutral plaintiff would he indifferent between receiving a settlement for $2,500 and going to trial where the likelihood of obtaining a $10,000 judgment is 25%. A risk adverse plaintiff, by definition, would accept the settlement. A risk averse agent is one for whom uncertainly itself is undesirable (Shavell, p. 58). Risk aversion would make settlement more likely under both rules for allocating legal fees, although this effect would be more pronounced under the English rule than it would be under the American rule. The English rule makes litigation more risky because the range of outcomes, good and bad, for both parties is greater than it would he under the American rule. Under the English rule, a Victorious plaintiff can costlessly claim his reward, but a defeated plaintiff has to pay for both his own and the defendant’s legal fees. Under the American rule, a victorious plaintiff can claim his reward but must pay his legal fees, and a defeated plaintiff need only pay his own legal fees. Similarly, under the English rule, a victorious defendant can walk 4 In Part IV, I summarize Hughes and Snyder’s empirical. evidence supporting Hause’s suspicions. away unscathed, but a defeated defendant must pay the judgment as well as both parties’ legal costs. Under the American rule, a Victorious defendant is burdened by his own legal fees, but a defeated defendant can escape paying the plaintiff’s legal fees. “Under the American rule the need to pay (only) one’s own legal fees dampens the joy of Victory but moderates the agony of defeat” (Donohue ill, p. 1107). Risk adverse parties would have greater incentive to settle under the riskier English system than under the American system. According to the Hause Model, the plaintiff and defendant will spend more on legal fees under the English rule than the American rule. The more the parties spend on legal fees, the higher the stakes, the greater the risk. Therefore, if risk aversion was factored into both economic models of the decision to settle or litigate, the Hause model would predict settlement to occur more often than the Posner—Shavell model would. Part IV: Empirical Analysis The Posner—Shavell and Hause Models generate a number of testable hypotheses, not all of them contradictory. Florida’s temporary adoption, from June ESQ-September 1985, of the English rule for medical malpractice suits provides a near perfect testing ground for these hypotheses. The five-year time frame is long enough for substantial data collection, yet short enough to reasonably hope that background factors influencing litigation stayed constant (Snyder and Hughes, p. 355). Snyder and Hughes collected data on 16,674 medical malpractice claims, 57% of which were governed by the English rule (Hughes and Snyders). (a) Plaintififs win more often under the English rule (Both models) Proponents of the English rule argue that it allows all plaintiffs with meritorious claims to 5 There are no page numbers in my citations of “Litigation and Settlement under the English and American Rules: Theory and Evidence” by Hughes and Snyder, as I accessed this article through LexisNexis. file suit. Assuming that both parties can predict the court’s verdict with certainty, both the American and English rules will discourage all frivolous suits. Under both regimes, Plaintiffs with frivolous suits can’t hope to win in court and will only end up with legal fees; there is no incentive to file suit. Turning to meritorious claims, the English rule allows for all meritorious claims to be filed while the American rule does not. Under the American rule, some plaintiffs with meritorious but small claims will not file suit because the legal costs outweigh the benefits of a favourable judgment. Under the English rule, plaintiffs with meritorious claims know that the defendant will be responsible for their legal fees, and so will not be discouraged from filing suit (Bebchuck and Chang). However, neither the Posner—Shavell nor the Hause Model assumes that the parties can predict the court’s verdict with certainty. Both the plaintiff and the defendant estimate the probability of the plaintiff prevailing; Pp and Pd do not have to be I or G (a certain win or a certain loss). Allowing for uncertainty, neither the American nor the English rules will discourage all frivolous suits, since some plaintiffs might bank on the slim possibility that they will win. The plaintiffs expected value of a favourable judgment might outweigh his legal costs, if they are small enough. By similar reasoning, not all meritorious claims will be filed under the English rule. It is possible that the plaintiff” 5 expected value of going to trial is negative; there is a chance his expected legal costs may be greater than his expected judgment, especially if the potential judgment is small. That said, even in the face of uncertainty, the English rule will allow for more meritorious suits and fewer frivolous suits to be filed compared to the American rule (Bebchuk and Chang). Both models predict that more meritorious and fewer frivolous suits will be filed under 6 There are no page numbers in my citations of “An Analysis of Fee Shifting based on the Margin of Victory: On Frivolous Suits, Meritorious Suits and the Role of Rule ll” by Bebcliuk and Chang, as I accessed this article through LexisNexis. lO the English rule. it follows that the quality of plaintiffs’ claims should be higher under the English rule. As a result, plaintiffs under the English rule should win more trials than their counterparts under the American rule. The evidence presented by Hughes and Snyder confirms this hypothesis; 11.4% of the plaintiffs won under the American rule, while 2l.6% of plaintiffs won under the English rule (Hughes and Snyder). (b) Higher legal costs, on average, under the English rule (Hausa Model) (0) Settlement less common under the English rule (Power-Shovel] Medel) (d) Settlement is more common under the English rule (House Model) The reasoning behind these two contradictory hypotheses is spelt out in the previous two sections. It is important to note that Hause’s prediction (d) that settlement is more likely under the English rule depends on (b) being true. The evidence from Florida bears out Hause’s hypothesis that parties Will incur higher legal costs under the English rule. For litigated claims, parties spent $7,894 on average under the American role and $13,214 under the English rule, an increase of 108%. For settled claims, parties spent $3,462 on average under the American rule and $7,632 under the English rule, an inerease of 150% (Snyder and Hughes, p. 374). The evidence also supports Hause’s hypothesis that settlement will be more likely under the English rule. The probability that a cased filed under the American rule will go to trial is 189%. This probability falls to 12.4% under the English rule (Snyder and Highes, p- 365). Using bivariate probit regression, Hughes and Snyder separate the “Posner-Shavell” effect from the “Hause effect” (my own labels). The PosnermShavell effect makes litigation more likely under the English role because the parties both hope their opponents will have to pay their legal fees. The Hause effect, on the other hand, makes litigation less likely because neither the plaintiff nor the defendant want to risk paying for both parties legal costs, which tend to be much ll higher under the English rule. According to Hughes and Snyder, if parties responded to the liause effect alone, then litigation under the English rule would fall to 2.8%. The PosnenShavell effect increases the likelihood of litigation by 9.6%. Overall the likelihood of litigation under the English rule is 12.4% (Snyder and Hughes, 13. 366). It is important to note that the Posnen Shavell model does not allow for the Hause effect, but the Hause Model allows for the Posner- Shavell effect- Hausa simply argues that the Hause effect is greater than the Posner-Shavell effect. The evidence from Florida supports his argument. (e) The size of the average judgment for the plaintifi’ will be lower under the English rule (Risk neutrality) 09 The Size of the average judgment for the plainrifi‘wifl be higher under the English rule (Risk aversion) As mentioned previously, proponents of the English rule argue there are some plaintiffs with meritorious but small claims who would not be able to bring suit under the American rule but would be able to under the English rule. If this is true, then more small claims should be litigated under the English rule than the American rule. It follows that the average judgment for the plaintiff should be Smaller under the English rule than it is under the American rule. However, if plaintiffs are risk adverse, then the opposite should hold true. The potential losses for a plaintiff are much larger under theEnglish rule than the American rule; not only does the loser have to pay both parties” legal costs, but legal costs are higher under the English rule. In order to persuade a risk averse plaintiff to hazard these larger potential. losses, two things can happen: either the size of the judgment gets larger or an the possibility that the plaintiff will prevail increases. it follows that the English rule will lead to the filing of higher-probability, higheruaward claims (Hughes and Snyder). The size of the average judgment will be larger under 12 the English rule than it is under the American rule. The evidence from Florida supports the risk averse prediction. Conditional on a verdict for the plaintiff, the average judgment under the English rule is $321,346 and under the American rule is $215,828. Moreover, the fraction of judgments under $50,000 drops from 39.5% under the American rule to 23.0% under the English rule, while the fraction of judgments over $100,000 rises from 48% under the American rule to 65.0% under the English rule (Hughes and Snyder). Hughes and Snyder’s analysis of the data from Florida strongly supports the Hausa Model of the decision to settle or litigate. That said, neither the PosnenShaveil nor Hause Model can accurately predict whether a legal dispute will end in trial or settiement because neither model accounts for the risk averse behavior of the plaintiff and defendant. Conclusion: The Efficient Ailocation of Legal Fees Assuming iaws are designed to promote economic efficiency, then the primary purpose of litigation is to make sure that law breakers are confronted with the costs of their violation (Posner, p. 586). If litigation failed to do this, then some agents would be better off breaking the law then following it, and this would iead’ to an inefficient outcome. The English and American rules for legal fee allocation should be judged according to how frequently law breakers are allowed to evade the costs of their vioiation In theory, the English rule is more efficient than. the American rule. As explained previously, some plaintiffs with small but meritorious claims might not be able to file suit under the American rule. An potential. injurer would not be deterred from violating the law if the victim 13 of the violation would incur only small costs; these injurers could rest assured that they would not be punished in court for their transgression. Presumably, the cumulative costs of these “small” violations of the law are greater than the costs of punishing these violations in court (if not, it wouldn’t be efficient to punish them). Because it does not allow these “small” law breakers to escape the costs of their violation, the English rule is more efficient than the American rule. However, theory does not match reality. Ironically, the American rule actually favors the plaintiff with the small but meritorious claim. The data from Florida strongly suggests that the English rule discourages plaintiffs with small but meritorious claims more than the American rule does. More “small” lawbreakers escape the costs of their violation under the English rule. Furthermore, legal costs are usually more than twice as much under the English rule than under the American rule. Therefore, in practice, the English rule is less efficient than the American rule for two reasons: it allows more “small” lawbreakers to go unpunished anti encourages parties to incur higher legal fees. The Hause Model hints at flaws of the English rule by assuming that the probability of the plaintiff prevailing can vary according to legal costs. However, neither the Posner—Shavell Model nor the Hause Model accurately captures the settle~vs.-litigate decision because they both assume the plaintiff and defendant are risk neutral. Risk-aversion causes many more potential plaintiffs to forgo litigation and opt for settlement than either model predicts. Word Count: 4,434 Works Cited Bebchuk, Lucian and Chang, Howard. “An Analysis of Fee Shifting Based on the Margin of Victory: Frivolous Suits, Meritorious Suits and. the Roie of Rule 11,” June 1996, 2, p. 371. Cooter, Robert and Rubinfeld, Daniel. “Economic Analysis of Legal Disputes and their Resolution,” Journal of Economic Literature, September 1989, 27(3), p. 10674097. Donohue III, John. “Opting for the British Rule, Or if Posner and Shavell Can’t Remember the Cease Theorem, Who Will?” Harvard Law Review, March 1991, 104(5), p. 1093—1119. Hause, John. “Indemnity, Settlement, and Litigation, or I’ll be Suing You,” Journal of Legal Studies, January 1989, 18(1), pp. 157—159. Hughes, James and Snyder, Edward. “Litigation and Settlement under the English and American Rules: Theory and Evidence,” Journal of Legal Studies, April 1995, 38, p. 225. Snyder, Edward and Hughes, James. “The English Rule for Allocating Legal Costs: Evidence Confronts Theory,” Journal ofLaw, Economics and Organization, Fall 1990, 6(2), p.345- 379. Posner, Richard. Economic Analysis of the Law. Sixth Ed. New York: Aspen Publishers, 2003. Shavell, Steven. “Suit, Settlement and Trial: A Theoretical Analysis Under Alternative Methods for the Allocation of Legal Costs,” Journal of Legal Studies, January 1982, 1 I (1), p. 55- 73. ...
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This note was uploaded on 12/11/2007 for the course ECON 4040 taught by Professor Hay during the Fall '07 term at Cornell University (Engineering School).

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