Glass half full? The legal case for mutual optimism and risk preferences

• When do two parties end up in court? Keith Hylton, Professor at the Boston University School of Law in the USA, has proposed a litigation model driven by the level of risk the parties are willing to take.
• His model draws upon Prospect Theory, which suggests that people are more likely to take risks when they stand to lose and less likely to take risks when they stand to gain.
• Under Hylton’s mutual optimism model, parties go to trial because the minimum financial award the plaintiff demands is greater than the maximum amount the defendant is willing to pay, and this is mostly due to risk preferences.

Why do two parties end up in court? Could it be due to the differences in the information each party holds, or could it be based more in psychology, such as hostility from one party towards the other?

If parties end up in court for psychological reasons rather than those relating to the information they hold, both parties come from an optimistic standpoint regarding the dispute, argues Keith Hylton, professor of law at the Boston University School of Law, USA.

Optimistic prospects

In his 2023 paper, ‘Mutual Optimism and Risk Preferences in Litigation’, Hylton explores the psychology of litigation and why some legal disputes fail to settle. His model incorporates psychological research, citing Kahneman and Tversky (1979), Rachlinski (1996), and others in making the case that Prospect Theory allows for the successful prediction of the level of risk individuals are likely to take.

Prospect Theory predicts that people display risk aversion when weighing up a gamble that could lead to a significant win.

Prospect Theory predicts that people display risk aversion when weighing up a gamble that could lead to a significant win. Conversely, it predicts risk-seeking behaviour when weighing up a gamble that could lead to a significant loss.

It follows that defendants are more likely to display risk-seeking behaviour while plaintiffs are more likely to display risk-averse or risk-neutral behaviour.

Likelihood of litigation and settlement

If legal disputes are driven by risk preferences, how does this affect trials and settlements? Hylton looks at the situation where both parties have access to the same information and are not indifferent to risk. In this case, parties always settle unless one of them is risk-seeking.

In a few cases, the defendant may be risk-neutral or risk-averse and the plaintiff risk-seeking. Alternatively, the plaintiff may be risk-averse while the defendant is risk-seeking. In both scenarios, there is a higher likelihood that the case will go to court. Obviously, the greatest likelihood of litigation is observed when both parties are risk-seeking. However, if parties have asymmetric information as to the level of risk-aversion of their opponent, both sides being risk-averse will not necessarily result in settlement.

Glass half full

Under the old ‘mutual optimism’ model, the plaintiff assumes he has a greater likelihood of winning than the defendant. To consider a specific example, the plaintiff might assume he has a 75% chance of winning while the defendant thinks the plaintiff’s chance of winning is only 25%. Therefore, we can say that both the plaintiff and the defendant are optimistic.

Generally, the parties go to trial when the minimum financial award the plaintiff expects to receive from trial, which becomes the plaintiff’s minimum settlement demand, is greater than the maximum amount the defendant expects to pay in a judgment, which becomes the defendant’s maximum settlement offer. This inequality holds in the context of mutual optimism.

However, if both parties have access to the same information, we should never observe mutual optimism unless there are psychological aspects or motivations driving the parties to litigate. In the absence of such psychological motivations, and where both parties have access to the same information, their predictions of the plaintiff’s likelihood of winning should be the same.

Based on these considerations, Hylton argues that mutual optimism, especially in a setting where both parties are equally informed, must be grounded in psychology. Psychological factors, moreover, can explain either risk-averse or risk-seeking preferences among litigants.

Hylton’s model shows how the level of risk that parties in a legal dispute are willing to take affects the likelihood of going to court or settling out of court.

For instance, if a party in a legal dispute is risk-averse, they are more likely to opt for a certain payout from settling out of court than taking the gamble of going all the way to judgement. Unlike cases where both parties are optimistic, risk aversion is more likely to result in cases of mutual pessimism. When considering how likely the would-be plaintiff is to file suit against a would-be defendant, we can consider as a reference point a payoff of zero for the plaintiff should he choose to do nothing. If the payoff becomes higher or lower than zero, the level of risk he is prepared to take could possibly change.

Hylton also explores the risk-neutralising probability measure, which effectively linearises the relationship between willingness to pay (or to accept) and the utility functions of litigants. The plaintiff seeks to maximise his benefits from the effort of going to court. Conversely, the defendant aims to minimise his losses in paying out as a result of going to court.

What’s the incentive?

At least one of the parties in a dispute must be risk-seeking for the case to go to court. If both parties are risk-averse, the case will go to settlement. Assuming that both parties demonstrate risk-neutral behaviour, the benefits of going to court have to outweigh the costs for a case to go all the way to judgment.

However, as soon as the plaintiff files suit against him, the defendant faces losses. If he loses the case, he must pay what the judge orders on top of his own legal costs. If he wins the court case, he must still pay his legal costs. Alternatively, he may settle, which will also require him to pay out. The plaintiff does not simply win, either. If he loses, he is still responsible for his own legal costs. If he wins, he receives his judgment with the deduction of the legal costs. Because of this distribution of wins and losses, defendants are likely to be risk seekers and plaintiffs might be either risk seekers or risk averters, according to Prospect Theory.

What are the chances?

Hylton discusses Priest-Klein theory, which predicts a win rate of 50%. How does this tally with Hylton’s model? As the amount of the damages payout increases, so does the proportion of parties willing to go to court rather than settling out of court. However, in some cases, parties will still choose to litigate rather than settle, despite a small damages payout, if they are risk-seeking enough.

Hylton’s model, in its most basic version, suggests that the actual trial win rate for plaintiffs varies almost directly with the objective likelihood of a win in the courtroom. However, when the plaintiff is the more risk-seeking of the two parties, the likelihood of a win is low. But, when the defendant is the more risk-seeking, there is a moderate likelihood of the plaintiff winning. Hylton finds that when the variance of the litigation payout dominates incentives, which is especially the case when the litigants have exponential utility functions, the plaintiff has exactly a 50% likelihood of winning.

More generally, Hylton’s model shows how the level of risk that parties in a legal dispute are willing to take affects the likelihood of going to court or settling out of court. The model is capable of explaining patterns observed in the data on trial win rates and settlement patterns.

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