A theory of legal presumptions

Journal of Law, Economics, and Organization

Volumn 16, Issue 1, 2000, Pages 1-49

  Bernardo, Antonio E ^a   Talley, Eric ^b   Welch, Ivo ^a,c  

^a UNIVERSITY OF CALIFORNIA   (United States)

^b UNIVERSITY OF SOUTHERN CALIFORNIA   (United States)

^c YALE UNIVERSITY   (United States)

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[No Author keywords available]

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EID: 0034418361     PISSN: 87566222     EISSN: None     Source Type: Journal    
DOI: 10.1093/jleo/16.1.1     Document Type: Article

References (114)

1. Black's Law Dictionary defines a presumption as, "A legal device which operates in the absence of other proof to require that certain inferences be drawn from the available evidence . . . . A presumption is either conclusive or rebuttable." The Dictionary of Modern Legal Usage (2nd ed) defines it as, "A judicially applied prediction of factual or legal probability."
2. Black's Law Dictionary defines a presumption as, "A legal device which operates in the absence of other proof to require that certain inferences be drawn from the available evidence . . . . A presumption is either conclusive or rebuttable." The Dictionary of Modern Legal Usage (2nd ed) defines it as, "A judicially applied prediction of factual or legal probability."
3. Of importance, the BJR does not protect corporate fiduciaries who are accused of self-dealing. [Klein and Ramseyer (1997)].
4. Our focus on commercial and corporate presumptions should not be read to preclude possible future extensions to other doctrines. In fact, a number of prominent noncommercial legal rules amount (in large part) to some form of presumption. In accident law, for instance, the doctrine of res ipsa loquitur shifts the presumption against the defendant if a plaintiffs injury is of a type that ordinarily happens because of negligence [Prosser (1984)]. In employment discrimination litigation under Title VII of the 1964 Civil Rights Act, the burden of evidentiary production (and thus the applicable presumption) can shift to the defendant if the plaintiff was a qualified (but rejected) applicant and a member of an historically oppressed group [McDonell-Douglas v. Green, 411 U.S. 792 (1973)]. Even in constitutional law, the equal protection doctrine implicitly operates as a presumption, requiring a court to determine a "level of scrutiny" to apply to a challenged statutory or regulatory classification [Gunther and Sullivan (1998)]. Each of these doctrines might fruitfully be analyzed with appropriate modifications of our framework.
5. For the moment, our analysis assumes that litigation costs are a simple deadweight loss. If, however, courts and legislators value the production of social policy within a legal system, then they might favor policies that encourage the expenditure of resources on litigation. We comment briefly on this possibility infra at Section 4.
6. Formally, of course, presumptions are distinct from evidentiary burdens of proof. As noted above, presumptions refer to an initial probabilistic estimation by the court - in the absence of evidence - of some fact. Burdens of proof, in contrast, refer to whether or how the parties can dislodge the court's estimation through the presentation of evidence. In fact, the burden of proof is often further subdivided into two subparts: (1) the "burden of production," focusing on which litigant has a duty to come forward with evidence in court (or risk losing); and (2) the "burden of persuasion," referring to the applicable criterion a court uses to update its initial presumption on the production of evidence (e.g., preponderance, clear-and-convincing, beyond a reasonable doubt, etc.). As will become apparent below, our analysis collapses all of these concepts into a single parameter. We offer some justifications for this modeling decision when we present the framework in Section 2.
7. It is worth noting as well that other legal and nonlegal mechanisms (such as substantive law and express contractual mechanisms) can provide important incentives. Our analysis, however, holds many of those other possibilities constant in order to focus on the role played by presumptions.
8. More traditional influence-cost accounts focus on out-of-court venues, such as the boardroom or factory floor. See, for example, Milgrom and Roberts (1990), Becker (1983), Hirshleifer (1995), Welch (1997).
9. The intuition behind this prediction is, in an abstract sense, analogous to the idea within optimal deterrence theory that reducing the fines levied against tortfeasers will cause them to commit harm with greater frequency. Our approach diverges from the standard approach, however, by focusing on evidentiary rules rather than substantive fines, on contractual allocations rather than torts, and on game-theoretic rather than decision-theoretic environments.
10. Some legal scholars have made the opposite claim [see, e.g., Gaskins (1993)]. Others [e.g., E. Posner (1999)] have posited that litigation before extremely error-prone courts may provide a beneficial punishment device for parties that interact repeatedly over time, so long as they care about reputations, and opportunism is observable to both sides. Our principal argument, in contrast, assumes neither repeat interaction nor the observability of shirking.
11. A notable exception is Sanchirico (1998a, b), discussed below.
12. Similarly, Hirshleifer and Osborne (1996) conceive of litigation as a conflict game in which the degree of a party's "fault" is an exogenous parameter in the model.
13. In a companion piece, Sanchirico (1998a) uses the same framework to demonstrate how litigation stage concerns may induce an optimal second-best legal rule to overdeter a potential defendant relative to first-best.
14. The only critical aspect of the probability structure in Equation (1) is that effort must increase the likelihood of the high-payoff state.
15. We also assume that the agent's effort is not verifiable (at least directly) in court. Nonetheless, as we demonstrate below, the underlying evidentiary rule may act as an indirect means of verifying the agent's effort.
16. There is a growing literature on the costs of express contracting, costs that emanate from problems of (among other things) bounded rationality, multitasking concerns, complexity, and intraorganizational political concerns [see, e.g., MacLeod (1999)].
17. A number of statutes make certain types of contracts invalid [see, e.g., Cal. Civ. Code § 1668 (1999) (voiding as unlawful all contracts that exempt anyone from responsibility for fraud, willful injury of another, or violation of law)]. This trend appears to be continuing [see, e.g., California Assembly Bill 858, 1999 CA A.B. 858 (voiding, as against public policy, all contracts in which consumers or employees consent to binding arbitration, waive their right to rescind a contract during a statutory cooling-off period, or waive their rights to a jury trial)]. In this article, however, we do not attempt to provide a reason for immutable rules, other than to recognize that they exist in many circumstances.
18. Our analysis excludes the possibility of suit in the high-payoff state, assuming implicitly that it would be impossible to prove damages in such a suit. We briefly revisit this possibility in Section 4, where we discuss optimal presumptions.
19. We treat D as exogenous in what follows, assuming only that it is "large" enough to have a potential deterrent effect on the agent. See Section 3.4, infra. In principle, it is possible to generalize the model to allow for alternative substantive liability rules as well; however, so doing would simply obscure the intuitions we attempt to expose below.
20. It is easy to demonstrate that the principal will always file a complaint if F = 0. Thus we limit our attention to the (more realistic) case of F > 0. 20. For now, we assume that no presuit bargaining occurs in this model. We conjecture how settlement might affect our results in Section 7.
21. As a formal matter, of course, the rules of evidence prescribe sequential rather than simultaneous performances, with the plaintiff moving first. See, for example, Fuller (1967). Nevertheless, we motivate our assumption of simultaneity on three grounds. First, the equilibria of the simultaneous game are simpler to describe yet qualitatively similar to those of the sequential game, which we have solved in a technical companion piece [Bernardo and Talley (1999)]. Second, as a practical matter, litigation is frequently not sequential, at least in the sense described above. Discovery, interrogatories, depositions, cross examination, rebuttal witnesses, and the like all tend to blur the discrete divide between the plaintiffs and defendant's evidentiary performances. In the limit, such an iterative process is likely to be captured better by an assumption of simultaneity. Finally, the simultaneous-move equilibrium tends to emerge even from a sequential structure if the first mover's action can only be observed with some noise [Bagwell (1995)].
22. Although we assume constant marginal costs, most of the core arguments presented below carry over to the case in which the marginal cost of evidence production increases in litigation effort (so long as the low-effort agent's cost schedule is uniformly higher than that of the high-effort agent).
23. Similar assumptions to this also appear in Rubinfeld and Sappington (1987), Daughety and Reinganum (1998), and Sanchirico (1998a, b).
24. j function collapses presumptions, burdens of production, and burdens of proof into a single parameter. Our reasons for doing so are twofold. First, the concepts are clearly related. For example, knowing that a defendant enjoys the benefit of an initial presumption in his favor also conveys information about the applicable burden of production and persuasion (i.e., the plaintiff must carry both, and in stronger proportions as the initial prodefendant presumption increases). For a similar point, see R. Posner (1999). Second, although it is possible to enrich the posited judicial heuristic so that it accounts separately for presumptions and burdens of production/persuasion, we conjecture that such an adaptation would have little effect on our qualitative results.
25. There are other possible evidentiary interpretations of the b parameter. For example, a judicial bias toward a litigant may manifest itself in the relative frequency with which the court deems one party's evidentiary offerings inadmissible. A proplaintiff court may tend to admit virtually all of a plaintiffs offers of proof, while admitting the defendant's only 70% of the time.
26. In addition to those listed in the text, Skaperdas (1996) shows that this functional form also has some desirable axiomatic properties in other contexts, such as a monotonic improvement in outcome when more resources are expended. The only other known conflict parameterization that satisfies such properties (exponential) leads to corner solutions.
27. In particular, the set of equilibria described below is also the set of perfect Bayesian equilibria (PBE), an equilibrium concept that does not require consistency in beliefs. There is no distinction between PBE and sequential equilibrium in much of what follows because all relevant information sets are reached with positive probability.
28. Though α is exogenous at this stage, sequential rationality requires its value to be related to the agent's equilibrium effort choice β via Bayes' rule. This constraint is taken up at length infra in Section 3.4.
29. p.
30. L). Once suit is filed, the high-effort agent finds it relatively cheap to mount a defense, and therefore presents more evidence (and wins more often) than does the low-effort agent.
31. A full description of the equilibria, absent parametric restrictions, is available from the authors.
32. Note also that both assumptions must be satisfied when the damage amount (D) grows large. More generally, a sufficiently large value of D is necessary for our problem to be an interesting one. For example, consider the extreme case where F > D, so that damages cannot even cover the fixed costs of filing. Here, Region III (infra) is the only viable region, and the unique equilibrium involves shirking by the agent and abstention by the principal. The legal presumption is irrelevant. Alternatively, consider the case where φ > (2p - 1) · D, so that damages are so small as to have no deterrent effect on the agent (even for the most potent proprincipal rule). Once again, in such a situation the agent will always choose to shirk regardless of the evidentiary presumption b. (Our Assumptions 1 and 2 are slightly more restrictive than those implied from above for expositional reasons, as they ensure that corner solutions of the litigation game occur only for relatively "extreme" proplaintiff presumptions).
33. Note also that if a court were free to choose damages as well, it could effect the same outcome by specifying small or zero damages (and thus Region III would span all of b-space). Equivalently this proposition does not depend on either Assumption 1 or Assumption 2.
34. A(γ*) = 0, embodying indifference expressions of the principal's and agent's best-response functions.
35. It is important to note, of course, that this result is a local one. If b increases so much, say, as to move it out of Region II and into Region III, the probability of litigation would fall discontinuously from γ* to 0.
36. L*). Note that this value does not include the (1 - γ*) fraction of shirking defendants who are never sued, which is also decreasing in b. 37. It should be noted, of course, that simply comparing the probabilities of Type I and Type II errors is often insufficient unless one also has an idea about the costs associated with each. Although it is sometimes possible simply to assume that such costs are exogenous [Rubinfeld and Sappington (1987)], such an approach is clearly inadequate for our purposes. For example, consider the lower portion of Region II, just above b. Here the agent's equilibrium strategy is to expend effort nearly all of the time, and thus most defendants are likely to have worked hard. Consequently the practical cost of false positives is much larger than that of false negatives. The opposite tends to hold true in the upper portion of Region II.
37. Such an inquiry presupposes, of course, that courts have the ability to commit the jury (when present) to such a presumption. Some mechanisms for doing so (such as exclusion of evidence) are likely to be extremely effective, while others (such as admission of evidence for limited purposes) are probably less so. To this end, jury commitment problems constitute a constraint of our normative inquiry.
38. In the analysis that follows we ignore the effects of external costs and benefits of litigation. For instance, if the parties' use of the court system is partially subsidized by the public, the welfare analysis below would tend to understate the social costs of litigation. If, on the other hand, the precedents that emanate from litigation represent a valuable public good for future litigants [e.g., Fiss (1984)], then the analysis would tend to overstate the social costs of litigation. Adding these various costs and benefits to the analysis below is possible, but its effects are largely quantitative rather than qualitative.
39. The parameter values used for our comparative statics illustrations below may sometimes violate Assumptions 1 and/or 2. In such cases, there may exist multiple equilibria in Regions I and II. However, when more than one equilibrium exists we consider only the equilibrium that minimizes social waste.
40. L) ≤ φ), then the optimal - in fact the first-best - legal presumption is any b > b̄). But even in situations where the agent's effort is socially desirable viewed alone, an effective immunity rule may still be optimal when the costs of filing suit (F) are large.
41. L) - φ. Once again, we reiterate that our analysis excludes the possibility of suit in the high-payoff state. Were it possible for the principal to sue and recover the same damages in the high-payoff state, then extremely proplaintiff presumptions would never be optimal, because the principal would always file suit (and win) and thus the agent would never expend effort. Such an outcome would be dominated by an extremely prodefendant rule, as it would obviate filing costs with no effect on effort.
42. For very small fixed costs F, of course, it is optimal to set b = 0 because litigation costs will only involve filing fees and the agent will give effort with probability one. For higher values of F (as in Figure 4C), however, it may be optimal to choose intermediate values of b in order to induce probabilistic litigation and economize on fixed costs. While this also increases marginal litigation costs, it also increases deterrence and economizes on the fixed costs of filing suit.
43. As should be clear from Figure 4C, the optimum presumption in Region II sometimes occurs at the boundary of the region. The reason for this effect is simple. Although increasing b always increases effort waste, it can either increase or decrease litigation waste on the margin; in particular, the variable costs of litigation (once invoked) depend on whether the increased b moves the relative litigation strengths of the parties toward equality or further tips the balance in favor of the agent.
44. Private Securities Litigation Reform Act, Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified in scattered sections of 15 U.S.C.).
45. The act imposes a "safe harbor" for any forward-looking projection that also conveys meaningful cautionary language about the potential lack of accuracy of such projections. This safe harbor applies regardless of whether the private action is brought by the Securities Act of 1933 or the Securities Exchange Act of 1934 (see 1933 Act § 27A; 1934 Act § 21E). As to cases not involving forward-looking statements, the exact quantum of scienter required has become an item of disagreement among the Circuit Courts. The Second and Third Circuits require that a plaintiff plead recklessness, but deem the test to be satisfied circumstantially if the plaintiff can allege with specificity that the defendant had a clear motive and opportunity to commit securities fraud [Donald Press, et al. v. Chemical Investment Services Corp., et al., 166 F.3d 529 (2nd. Cir. 1999); In Re: Advanta Corp. Securities Litigation, 180 F.3d 525 (3rd Cir. 1999)]. This test was considered to be the most restrictive in the country before PSLRA, but now may be the weakest. The Sixth Circuit has adopted a more stringent test, requiring direct proof sufficient to create "a strong inference of reckless behavior" and disallowing circumstantial proof. (In Re: Comshare, Incorporated Securities Litigation, 1999 WL 460917, Fed.Sec.L.Rep. 90,513.) Finally, the Ninth Circuit has adopted the harshest test of all, also disallowing circumstantial proof and requiring that the plaintiff establish "deliberate or conscious recklessness." [In Re: Silicon Graphics Inc. Securities Litigation, 1999 WL 595194, Fed.Sec.L.Rep. P90,512, 99 Cal. Daily Op. Serv. 6339 (9th Cir. 1999).]
46. In addition to these reforms, the PSLRA also mandated proportional (rather than joint and several) liability for all but knowing violations of law, and mandated that courts conduct a "Rule 11" inquiry as a matter of course at the end of an action.
47. See, for example, H.R. Rep. 104-50, 104th Cong., 1st Sess. 16 (1995) ("H. Rep."); Statement of Managers, "Private Securities Litigation Reform Act of 1995," H.R. Rep. 104-369, 104th Cong. 1st Sess. at 31). Of particular importance to members of Congress was the degree to which securities litigation involved meritless claims. 141 Cong. Rec. H13699 (daily ed. Nov. 28, 1995) ("Statement of Managers").
48. The litigation rates for securities class actions (i.e., number of companies sued as a fraction of total public corporations) has once again regained its preact prominence. From 1993 to 1999, the annual litigation rates are as follows: table presented *Estimated. Source: Securities Class Action Alert, at 50 (June 1999).
49. Foster et al. (1999) estimate that the market-corrected litigation rate has increased by more than half since 1995.
50. This assumes, of course, that both the pre- and postreform presumption is within the "intermediate" Region II. Clearly, an extremely large reform that increased the prodefendant presumption by an arbitrarily large amount would foreclose any litigation whatsoever. This has obviously not occurred.
51. It is important to note that Figure 7 tracks filing rates rather than win rates to measure the equilibrium effects of legal change. As Priest and Klein (1984) have aptly demonstrated, the selection biases created by settlement activity significantly conflate the task of measuring legal change by examining equilibrium win rates. On the other hand, filing rates are more closely associated with the expected value of a legal action (regardless of whether the action is eventually resolved through settlement or litigation).
52. An obvious objection to this argument is that one might expect rational defendants to anticipate the lag effect and alter their primary behavior sometime before the effective date of the statute. While possible, this objection is somewhat unlikely on at least two grounds. First, the lag between fraudulent activity and realization of harm may not be known with certainty, and thus issuers might have been reluctant to alter their strategies until the act was in effect. And second, the PSLRA was enacted over a presidential veto, and the willingness (if not the ability) of Congress to override the veto remained unclear until December 22, 1995.
53. Securities Litigation Uniform Standards Act of 1998 ("Uniform Standards Act") (codified in scattered sections of 15 U.S.C.).
54. For example. Dodge v. Ford Motor Co., 170 NW 688 (Mich 1919). Fiduciary duties are present not only in corporations, but also in partnerships, limited partnerships, limited liability companies, and other statutory forms of business organization. For a review, see Talley (1999).
55. See Clark (1986). In a typical duty-of-care case, a shareholder might argue that an officer or director spent inadequate time becoming informed about the substantive terms of a merger agreement. For example, Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
56. In a typical duty-of-loyalty complaint, a shareholder might allege that a fiduciary unfairly engaged in interested transactions with the firm on lopsided terms, or appropriated new business opportunities for her own account without giving the firm a right of first refusal. For example, Broz v. Cellular Information Systems, 673 A.2d 148 (Del. 1996). For a general review, see Talley (1998).
57. The Revised Model Business Corporation Act's Section 8.30, for example, attempts to spell out general duties for corporate directors, but it does not articulate the standards by which their comportment is judged. RMBCA § 8.30 (off'l cmt.) ("In light of . . . continuing judicial development, section 8.30 does not try to codify the business judgment rule . . . . That is a task left to the courts and possibly to later revisions of this Act . . . .").
58. In perhaps the most famous duty-of-care case of the last generation, Smith v. Van-Gorkom, 488 A.2d 858 (Del. 1985), the Delaware Supreme Court described the BJR as follows: Under Delaware law, the business judgment rule is the offspring of the fundamental principle, codified in 8 Del.C. § 141(a), that the business affairs of a Delaware corporation are managed by or under its board of directors . . . . The rule itself is a presumption that in making a business decision, the directors of a corporation acted on an informed bases, in good faith, and in the honest belief that the action taken was in the best interests of the company' Id. at 872 (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)) (emphasis added).
59. See, for example, Ind. Code Ann. § 23-1-35(1)(e)(2) (1998) (requiring either "willful misconduct or recklessness"). In addition, in most jurisdictions the shareholder-plaintiff must demonstrate the fiduciary's recklessness in investigating the decision (shielding the fiduciary's exercise of judgment once the investigation is complete).
60. Revlon Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986); Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 1994) (expanding Revlon's "imminent break-up" test to any transaction that moved control from a fluid aggregation of unaffiliated stockholders into unified hands, and generalizing the "duty to auction" into a duty to implement measures reasonably calculated to maximize short-term shareholder value).
61. AL). If so, then intermediate presumptions (Region II) are no longer very attractive or feasible. In such situations, courts may opt for a protective presumption anticipating that extra-legal mechanisms for providing incentives - such as express contracts, reputational labor markets, and internal governance structures - are more effective mechanisms.
62. Indeed, the extra-legal mechanisms noted above may also be equipped to respond to the aggregated effects of piecemeal shirking by managers over time.
63. In Paramount v. QVC, for instance, the ultimate control premium paid by Viacom was in excess of 50% of the precontest share price of Paramount.
64. In addition, creditors sometimes have a limited right under the law of fraudulent conveyance to void certain transactions by the firm.
65. The duty of good faith and fair dealing has been notoriously unhelpful to creditors attempting to enforce rights that are not explicitly provided in express debt covenants, and fraudulent conveyance law requires a plaintiff (or bankruptcy trustee) to show either an actual intent to defraud or a transaction on grossly disproportionate terms. The limited assistance of both areas of law to creditors is perhaps most clear in the LBO context. See Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (SDNY 1989).
66. Note, however, that the first application of our model - interpreting the surprising effects of the 1995 PSLRA - did not turn on any posited goal for the courts.
67. See, for example, Dworkin (1986). Note, however, that even from an efficiency perspective, one reason to value "truth" is that doctrine creates a public good for future litigants to look at. Such concerns are outside our model. See also Hirshleifer and Osborne (1996).
68. The overlapping moral dimension easily obscures any conscious or subconscious motives: after all, finding the truth may not only be somewhat more likely when there is a lot of argument, it may also just happen to shift resources from the productive economy toward the legal system. Consciously or subconsciously, the legal system can thus reinforce its own importance and needs.
69. Courts can do a number of things to increase the stakes from litigation, such as increasing damages or adopting the European convention of forcing the losing party in court to compensate the winning party for some of its legal expenses.
70. Similarly, if judges care only about maximizing the market for legal services, they would favor rules that "equalize" the strength of plaintiff and defendant (in light of the parties' respective marginal costs of producing evidence). Such concerns might not only affect the presumption adopted by such courts, but also other controllable parameters of the model. For example, courts might reduce filing costs to equalize the strength of defendants and plaintiffs, such as by granting plaintiffs a permission to roll up small claims into a single class action or derivative suit. In many such cases, individual plaintiffs receive only trivial sums and most of the redistributive activity is from the defendant to the parties' attorneys.
71. See, for example, Cal. Evidence Code 646(b) (stating, "The judicial doctrine of res ipsa loquitur is a presumption affecting the burden of producing evidence").
72. H). Here, however, the Wigmorian court would choose an intermediate presumption that systematically encourages litigation (in Region II), so as to exploit these signaling benefits.
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