Category: Economic Analysis of Law


Markets for Markets

Rob Rogers and I recently completed an article on the development of information markets. Our motivating question was to ask why information markets have covered certain subject areas, sometimes of minor importance (like the Michael Jackson trial), while neglecting other subject areas of greater social or monetary significance. We trace part of the answer to the choice of business model that information market entrepreneurs have chosen to employ, but part of it remains unexplained and is, we propose, a product of the random walk. The article is here.


Update on Plea Bargains and Prediction Markets

In Let Markets Help Criminal Defendants, I wrote that “If I were running a public defender service, I’d consider setting up an online prediction market for the conviction of my clients.” I still think this is a good idea, but someone suggested a serious problem that would have to be remedied for the scheme to be possible.

Right now, prediction markets bets on judicial events, like the conviction of Lewis Libby (whose graph is to the right), pay off at 100 for conviction, and 0 for any other ending of this set of charges, including a plea. This creates noise which renders them useless for criminal defendants looking to see if they ought to plea. That is, as I didn’t fully appreciate before, traders must be estimating the probability of conviction, tempered by the likelihood of a plea – prices are lower than the actual market estimate of a guilty verdict independent of a plea. That is, if the current price of Libby’s “stock” is .40, that means that incarceration is not 40% likely. It means that traders think it is 60% likely that Libby will win at trial, receive a mistrial, obtain a dismissal, be granted a pardon, or plea. I imagine that the likelihood of a plea accounts for a large percentage of this figure.

If traders thought that conviction prices affected defendant behavior, then presumably they’d seek to put in sell orders at prices above those where rational defendants would plea. This would put downward pressure on price and make the entire system useless from defense counsel’s perspective.

For my system to work, you’d have to exclude the possibility of a plea (i.e., nullify all bets if there is a plea). Of course, this still would create some dynamic tension, as bettors presumably would become eager to invest time and trade only as pleas become less likely – near trial, or in jurisdictions, like Philadelphia, where the District Attorney has a no-plea policy. But the resulting prices would be more informative than those offered by the current system.


Let Markets Help Criminal Defendants

ballandchain.jpgDan’s interesting post on plea bargaining made explicit the informational inequalities faced by criminal defendants and their lawyers. Indeed, one of the advantages public defenders have over private defense counsel is that they can more easily share information internally about the informal norms that “really” govern the system (judge sentencing practices; which cops tell what stories; which labs are sloppy; etc.) But even so, the instruments of law and order almost always will know more about the facts and the law than the defense, at least until the eve of trial and probably throughout the process.

That there are exceptions (Enron; OJ) proves the rule that informational asymmetry is a significant part of the prosecutor’s arsenal – indeed, this asymmetry justifies constitutional attempts to remedy the problem through mandatory discovery procedures. But I’m skeptical that legal rules alone are a panacea to structural problems. Why not try markets?

To be more concrete, the major decision that criminal defendants face is whether or not to plead guilty. The decision depends on a prediction about what will happen at trial. Assuming that defendants are risk averse, they will take pleas when rational actors would not, but generally will go to trial when the expected time served post-trial is less (by some margin) than the actual time proposed in the plea agreement. The problem is that (1) defendants are unsophisticated; (2) defendants’ lawyers are incented to push pleas; and (3) neither defendants nor their lawyers have as much information as prosecutors about likely verdicts.

If I were running a public defender service, I’d consider setting up an online prediction market for the conviction of my clients. Prediction markets did a fantastic job in the Enron trial. At the beginning of the trial, the odds of conviction were about 50% for each defendant; by the end, the odds were significantly higher. Now, I can understand why neither defendant would have pled facing a coin-flip’s chance at conviction. As I argued at the beginning of the trial:

I’d guess that the reason Skilling and Lay have not pled and Fastow has is demographics. Fastow is a young(ish) man, who can serve significant time and still emerge with earning power. Lay and Skilling don’t have the years left to do the time that the government (apparently) would find appropriate.

But for most criminal defendants, 50% odds would translate into a pretty hefty expected sentence that might make a plea more attractive. And, assuming that such markets would be sufficiently liquid, the predictions generated by traders ought to be both more accurate and less prone to bias than defense counsel’s odds. I imagine that the result would be a net decrease in pleas, and in the long term, as prosecutors reacted, less net jail time. That is, the current system is biased by risk aversion and agency problems – as others have observed – toward more jail. This effect may serve the forces of law and order, but it doesn’t necessarily serve the search for truth. Why not try something different?

Obvious objections: (1) the idea is “”utterly repugnant to a civilized society“; (2) thin markets are prone to manipulation; (3) incentives would increase to violate the attorney-client privilege; (4) it would look like public defenders are selling out their clients. Of these objections, I’d be most worried about #3.

Incidentally, if you are interested in thinking more about criminal law and the Enron trial, the Conglomerate is hosting what promises to be a great forum on the topic for the next two days. Check it out!


Six Flags Syndrome: Price Discrimination In Plea Bargaining

Six Flags.jpg Price discrimination occurs when any seller charges two different buyers a different price for the same product. Coupons are one obvious method of price discrimination. Airline advance purchase requirements are another. The term sounds ugly, but it’s basic marketing. One major area of price discrimination occurs between sophisticated and unsophisticated consumers. Uninformed car buyers often pay more for their autos than those who arrive with the newest pricing data from Edmunds. And while many web buyers routinely pay full price, others of us consult Coupon Cabin, Mom’s View, or XP Bargains before ordering online. We don’t do anything special for the discount; we just know enough to check for coupons.

In a blunt admission of price discrimination based on consumer sophistication, Six Flags’ VP for ticketing, Steve Brown, stated) “any guest paying full pirce at our parks is probably not doing their homework.”

Perhaps all is fair in love and sales, but what about plea bargaining? Would we feel OK if US Attorney Patrick Fitzgerald announced that “anyone pleading to ten years on a marijuana charge probably didn’t do his homework”? As a public defender, I often discovered that a DA’s “best” offer wasn’t on the table initially. I had to request it. Sometimes I provided good reasons for a better deal – I cast the client in a new light, for example, or discussed an extenuating circumstance. But often I simply scrunched up my face and said “come on, you can do better than that”…and he or she would serve up a better offer. I understood the game; as a public defender, I played it every single day.

But it turns out that clients – and more importantly lawyers – are often surprisingly unsophisticated in the negotiation process and will not demand the best posible offer. I’m reminded of a friend who was handling his first serious felony. His client faced a mandatory 6 year bid for the gunpoint robbery, but the DA was offering 10 years. My friend planned to ask for seven years. After we talked, I explained that in my jurisdiction (we were in different states), a first time offender facing these charges would usually receive the mandatory minimum. I encouraged him to ask for six years. And that’s exactly what his client got. But if he’d asked for seven years – his initial plan – the client would have served an extra year.

So should prosecutors “take advantage” of unsophisticated opponents by jacking up offers?

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This Post Will Be Barely Illuminating

Thanks to a reader of my recent paper on puffery, I recently came across the work of Andrew Ward and Lyle Brenner, Accentuate the negative: The positive effects of negative acknowledgment (forthcoming 2006; presentation link here). It is a neat paper, that examines the extent to which we credit messages that contain obvious warnings of their fallibility, and like messengers who introduce themselves with self-deprecation. Obviously, the study of deflation is less developed that that of optimism – and puffery – but it is an odd finding nonetheless that we seem to want any sales message except the unvarnished truth. I wonder if how the law can best take into account this psychological part of consumption. If we feel less cheated by, say, the purchase of stock which has been exposed as partly susceptible to a downturn through strategic pessimism, should the anti-fraud regimes of the ’33 and ’34 Acts account for this feeling?

More generally, it strikes me on first glance that the negative attribution effect may help to explain otherwise strange corporate events like the success of the self-deflating google IPO. (For Vic F’s branding theory, see this post; Ribstein’s comments here.)

It also helps to explain the odd persistence of the “shameless self-promotion” tag to law article announcement posts, even when the promotion benefits friends. Bill S., at TOTM, recently lamented this phrase, and said that “I don’t feel at all ashamed of doing this nor do I feel it is unseemly. Hence, I propose we drop the custom of including a “shameless self-promotion” reference when engaging in self-promotion.” I think Bill is leaving some money on the table here. Deflation, like puffery, moves flawed products.


On the Milberg Indictment

MW.gifI’ve been mulling over the Milberg indictment. Since I waited a weekend to post, I have the advantage of having read lots of other folks’ views. Quick summaries follow:

  • Michael Dorf: Kickback payments slaved the named plaintiffs to MW, bloating agency costs.
  • Steve Bainbridge:Kickbacks encourage “nuisance claims.” We may need criminal sanctions to crank the Hand formula to optimal levels, but only against individual lawyers.
  • Walter Olson:”[MW was] taking no chances on the watchdogs staying pacified: It threw regular chunks of raw liver into their cages.”
  • Larry Ribstein: Who cares? Lawyers are fungible.
  • Ed Morrissey: Bad for Democrats and ambulance chasers.
  • Christine Hurt: It’s high noon, and MW can’t blink.
  • And let’s not forget MW itself: It was just a referral! And the theory is overreaching! And our interests remained aligned!

Wow. Lots of words. So here is what I think.

First, I still don’t particularly understand the economics of outrage here. I’ve seen two arguments about why kickbacks are bad (apart from their being unlawful, which we’ll put aside briefly). First, I’ve heard the argument that they “capture” the lead plaintiff, making that person less able to monitor the lawyer’s work. As Dorf points out, however, plaintiffs in securities class actions are sort of like shareholders stockholders: they have deputized oversight and management to lawyers, in return for fiduciary duties. Some folks seem to have in mind a more active role for lead plaintiffs – something like a controlling stockholder(?) – but given the relatively low bonuses awarded in settlements for lead plaintiffs, why would anyone want to play that role? That is, you can’t have distributed, small-stakes, high-impact, governance by private actions and have plaintiff management at the same time. The capture argument is another way of saying that these types of claims are not in the public interest. But we don’t criminalize inefficient lawyering. Not usually.

The second argument I’ve seen is related to the first – it is Bainbridge’s – and it suggests that kickbacks encourage securities actions that are (on the merits) weaker. Yup, that sounds right. But that isn’t an argument against kickbacks, it is an argument that judges aren’t doing enough to raise hurdles to weak actions at early stages, as the PSLRA was designed to accomplish. To the contrary, I have found that judges are quite hostile to securities claims.

The argument that I haven’t seen on the blogs, but which is larded through the indictment, suggests that MW was, in effect, selling out the rest of the class to benefit the folks at the head of the line. And in a way, this is (for me) the strongest argument against the practice. If MW really did countenance paying referrals-as-kickbacks to named class members out of their portion of the settlement, then we know that dollars were being taken out of the mouths of the rest of the class pretty directly. On the other hand, one might argue that MW had to pay off the named plaintiffs to bring the cases in the first place – that it is a an expense like overhead.

Two additional aspects of the case trouble me. Obviously, indicting the entire firm feels excessive. I don’t agree with Larry R. that reputational effects won’t follow MW’s innocent lawyers. I know lots of counsel at MW – I litigated against them – and I thought they were incredibly hard working, tough, honest, passionate adversaries. One of my worst days as a lawyer came across a deposition table from an experienced Milberg partner: he taught me a great lesson on how to get one’s opponent to hang himself on the record. And I’d be shocked if more than a handful of lawyers at the firm had any knowledge of the activities charged. If the USAO is really indicting out of pique for failure to roll over as most corporations would do in response to a patently unreasonable discovery demand, well, many folks who think of themselves as white knights are going to be tarnished unfairly.

Second, I have some problems with the continued federalization of state practice ethical rules. Although the indictment doesn’t come out and say this, some of the illegality is premised on state fiduciary duty and referral laws. (Some, granted, is based on Rule 23.) Shouldn’t this type of prosecution be the job of Elliot Spitzer and his imitators? Which raises a question: why didn’t Spitzer get here first?


Empirical Studies at ALEA

Bill Henderson (at the ELS Blog) has a very useful round-up of empirical papers presented at the recent ALEA conference. Blog-traveller Kate Litvak comes in for special praise:

Kate Litvak [presented] “The Effect of the Sarbanes-Oxley Act on Non-US Companies Listed in the U.S.,” which was an extremely well-done event study that used a natural experiment approach to capture the market reaction to SOX (it was generally negative). In the last couple of years, Kate, who does not have a PhD, has spent a lot of time learning sophisticated econometric techniques. It really showed. Very impressive (and easy to follow) presentation.

To be frank, I’ve been quite skeptical of studies showing a negative relationship between SOX and equity prices, on several grounds: (1) my practice experience managing the creation of event studies that dealt with changing legal regimes suggested that results are rarely as robust as one might hope; (2)) the passage and eventual implementation of SOX were so attenuated that event studies would seem hard to perform; and (3) the debate is quite politicized, with folks already disposed to dislike federalization of corporate law leading the charge on the empirical front as well. But, having read Kate’s paper, I’m inclined to rethink my position. It is well-worth a read.


Nominally Empirical Evidence of Unraveling in the Law Review Market

book21a.jpgIn a previous post, I observed that “the time for submitting law review articles is creeping backwards.” I then hypothesized that “we are experiencing what Alvin Roth called the ‘unraveling’ of a sorting market.” This is bad news:

Authors may not be able to get any sense at all of the “market value” of their article (loosely reflected, the myth goes, by multiple offers at a variety of journals). Conversely, journals feeling pressure to move quickly will increasingly resort to proxies for quality like letterhead, prior publication, and the eminences listed in the article’s first footnote (which tell you who an author’s friends and professional contacts are).

At the end of that post, I promised to “explore empirical evidence that this is in fact an unraveling market problem (as opposed to anecdote, to the extent possible).” As it turns out, this was a hard promise to deliver on. There simply isn’t data out there – at least that I’ve been able to find, that collects historical information about the submission processes to law reviews. This is somewhat surprising. Law professors are insular, interested in navel gazing, and well-motivated to do anything other than grading. Moreover, the process of submission is an economically consequential activity. But only recently, in two works-in-progress, has there have been any attempt made to systematically get at this problem. See here, and here.

I thought I’d make a modest contribution to the field by contributing some data from Temple in this recent submission season, and ask our readers to contribute with their experience as well. The sample size is tiny; the respondents self-selecting. This is, therefore, Co-Op’s second “very non-scientific survey” this week. It’s a trend! The data is not meant to suggest any definite conclusions, but rather help researchers with hypothesis formation. But I’ll offer some grand thoughts at the end of this post anyway.

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Listen to Some Hot Air On Gas Gouging

I did an interview on public radio that appeared over the weekend on WAMC‘s “The Weekly Rundown.” No, I’m not at Tulane, as Mary Darcy (the host) suggests. But the Co-Op got a shout-out, so I really ought not complain. Welcome, readers from upper New York State! Go ahead and give it a listen (I start about two minutes in. I’m the guy who pronounces “gas” as “gaaz,” as all true Philadelphians do.).


Memento Mori, and Constraining of Executive Power

362319_caesar.jpgClifford Ando’s book on Imperial Ideology and Provincial Loyalty in the Roman Empire is being passed around the family lending library. It, together with a recent conference invitation, has gotten me to thinking some about the different ways that the American legal system works to constrain executive power. This may all be old hat to some, but, hey, this is just a blog entry!

The legal system offers two major methods of constraining executives: incentives and structural checks. Both approaches are formal, and to a large extent, treat subject executives as rational, wealth-maximizing, actors. Incentive-based constraints follow a fairly traditional carrots-and-sticks approach.

Corporate law relies mostly on carrots. Punishments in corporate law are rarely felt by individual Directors and officers due to the BJR and D&O Insurance. SOX is a notable, and contested, exception. By contrast, control of public sector executives (like agency heads, police, and military officers) is largely based on sticks: court marshals; public shaming, etc.

Control of the government’s chief executive is largely left to institutional constraints. President Bush, not so long ago, reminded Americans that a second-term President has a wide latitude to act in ways that might seem unpopular: “We had our accountability moment, and that’s called the 2004 elections.” That is, elections provide limited incentives; impeachment an impractical stick. Congressional control of subpoena power is the real hammer.

The Romans had a somewhat different model. They had exceptionally few state administrators – a few thousand folks in total at the empire’s height. Those administrators were governed and constrained in a variety of ways. The preeminent, according to Ando, seems to have been socialized norms. Thus, famously, Roman generals on their victory parade were accompanied by a slave whispering in their ear: “Memento Mori.” Remember, you are mortal.

Are there interesting ways to pay-off this analogy? Perhaps we might achieve more efficient corporate and federal executive control through socializing norms of humbleness, loyalty, and self-control. Maybe this humbling function could be served by independent directors, in a reinvigorated real devil’s advocate way. Or, if we wanted to really re-engineer the system, perhaps SOX should be amended to rely less on punishment and more, as in the sexual harassment context, on a system of presumptions that encourages training and socialization of pro-social norms. In the federal government arena, perhaps we need to hire someone who will remind Presidents of the limits of their power, and the fact of their morality. Hmm. Actually, maybe those positions are filled already.