Your business faces a claim for damages to the amount of $10,000,000.00 and the claim has an 80% chance of success.   An economist would say that a fair settlement amount is $8,000,000.

The problem, however, is that people generally become risk seeking when faced with a certain loss (in this case the settlement amount of $8,000,000) and a chance of losing nothing (in this case a 20% chance of defeating the claim).  As a result the decision makers of the business may have a preference to litigate when, from a commercial point of view, they should settle the claim.

In another example, your business commences an action, seeking damages of $10,000,000, with low prosects of success; say 20%.  An economist would say that a fair settlement amount is $2,000,000. 

Nobel Prize winner, Daniel Kahneman explains that people overweight a small chance of a gain.  This may explain why some plaintiffs with minimal prospects of success would not settle at that price.  Studies show a 20% chance of a gain, psychologically, corresponds to a weight of 26.1%.  As a result we can speculate that the settlement amount of $2,610,000 would be considered to be a fair price from the plaintiff’s point of view.

Professor Kahneman provides a useful theory, referred to as the “fourfold theory” that attorney’s and anyone else faced with litigation should understand.  The basic takeaways are: 

  • High chance of successful claim, the person becomes risk averse and may accept an unfavourable settlement offer.
  • High chance of losing defence to a claim, the person becomes risk seeking and may reject a favourable settlement offer.
  • Low chance of successful claim, the person becomes risk seeking and may reject favourable settlement offer.
  • Low chance of losing defence to a claim, person becomes risk averse and may accept unfavourable settlement offer.

A commercial lawyer must understand the psychological factors that interplay with legal issues in order to help the client navigate the settlement process. 

Our previous article found here on the role of anchoring also demonstrates how heuristics can play a large role in deciding the outcome of a settlement process.

Daniel Kahneman (2011). Thinking Fast and Slow. New York: Farrar, Straus and Giroux. 316-317