Harvard Law School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR) and European Corporate Governance Institute (ECGI)
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Interdisciplinary Center (IDC) Herzliyah – Radzyner School of Law
PROCEDURAL LAW AND ECONOMICS, Chris Sanchirico, ed., 2011
Harvard Law School John M. Olin Center Discussion Paper No. 656
We review the literature on negative-expected-value suits (NEV suits) – suits in which the plaintiff would obtain a negative expected return from pursuing the suit all the way to judgment. We discuss alternative theories as to why, and when, plaintiffs with NEV suits can extract a positive settlement amount. In particular, we explain how such a plaintiff can extract a positive settlement due (i) asymmetry of information between the parties, (ii) divisibility of the plaintiff’s litigation costs, (iii) upfront costs that the defendant must incur before the plaintiff incurs any costs; (iv) expectation that the arrival of information during the course of the litigation may turn the suit into a positive-expected-value one, (5) reputation that enables the plaintiff to bind itself to going to trial if the defendant refuses to settle; or (6) the plaintiff’s having a contingency fee or retainer arrangement with its lawyer.
Negative-Expected-Value Suits – Introduction
This essay reviews the state of knowledge about why (and when) plaintiffs with negative-expected-value suits can extract a positive settlement amount from the defendant. The literature on the subject has continued to grow since the publication of the earlier review of Bebchuk (2000), and we attempt to reflect in this paper all the advances made since that time.
DEFINITION OF NEV SUITS. A negative-expected-value (NEV) suit is one in which the plaintiff would obtain a negative expected return from pursuing the suit all the way to judgment — that is, one in which the plaintiff’s expected total litigation costs would exceed the expected judgment. Thus, denoting by Cp and Cd the total litigation costs of the plaintiff and the defendant respectively and by W the expected judgment, a suit is an NEV suit if Cp > W.
It should be emphasized that an NEV suit need not be a frivolous suit — that is, a suit in which the plaintiff is unlikely to win. The expected judgment is a product of the likelihood of a plaintiff’s victory and the amount at stake. Therefore, a meritorious suit — one in which the likelihood of a plaintiff victory is quite high — might be NEV if the litigation costs involved are sufficiently large relative to the amount at stake.
THE PUZZLE OF NEV SUITS. It is generally believed that cases with NEV suits are abundant, and that plaintiffs with negative-expected-value suits are frequently able to extract a positive amount from the defendant to settle the case. But why would a rational defendant agree to pay any settlement amount to a plaintiff with an NEV suit? This is the question that the literature has sought to answer.
The early literature on litigation has largely abstracted from the question of negative-expected-value suits (see Gould (1973), Landes (1971), and Posner (1973)). And the first papers on litigation decisions under asymmetric information (see, Bebchuk (1984), P’ng (1983) and Reinganum and Wilde (1986)) have explicitly limited their analysis to cases in which the plaintiff’s suit is known to have a positive expected value (a PEV suit). But work done since the mid-80’s has put forward a number of explanations for the potential success of plaintiffs with NEV suits to extract a settlement. This literature has shown that a plaintiff with an NEV suit will not be able to extract a settlement offer only if the following assumptions are satisfied:
(1) There is no asymmetry of information between the parties;
(2) The plaintiff’s litigation costs are not divisible;
(3) The defendant does not have to incur some upfront costs before the plaintiff incurs any costs;
(4) The expected value of the judgment is expected to remain below total litigation costs throughout the litigation;
(5) The plaintiff does not have a reputation that enables it to bind itself to going to trial if the defendant refuses to settle; and
(6) The plaintiff does not employ some special contractual arrangements with the plaintiff’s lawyer.
The following discussion demonstrates how relaxing each of these assumptions allows the negative-expected-value plaintiff to extract a settlement.
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