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Settlements v. Judgements: A Prospect
Theory Analysis
Acuerdos versus sentencias: Un análisis
de la teoría prospectiva
Juan Martín Morando
Universidad Argentina de la Empresa
City:
Buenos Aires
Country:
Argentina
Original Article (research note)
RFJ, No. 13, 2023, pp. 73 - 88, ISSN 2588-0837
ABSTRACT:
When the Rational Choice model reveals itself
insufficient to explain why parties in judicialized Labor
disputes in the Provincia de Buenos Aires prefer to settle over
waiting for a final decision, the Prospect Theory provides a
sound explanation: as Labor Law and Procedural Rules become
applicable, they produce a visible cost-shift to the employer,
so parties expect judges to decide in favor of the workers.
In this scenario, the employer’s perception of what is to be
considered a cost and a benefit become altered, incentivizing
her risk-aversion and leading her to bargain settlements that
she wouldn’t even consider otherwise.
KEYWORDS:
Labor Law; Labor Procedure; Settlements and
Decisions; Prospect Theory; Cost-Benefit Analysis.
RESUMEN:
Cuando el modelo de Decisión Racional resulta
insuficiente para explicar por qué las partes de un conflicto
laboral judicializado en la Provincia de Buenos Aires prefieren
acordar antes que esperar una decisión judicial, la Prospect
Theory nos brinda una buena explicación: cuando las leyes
DOI 10.26807/rfj.vi.465
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laborales y las normas procesales laborales resultan aplicables,
se produce una traslación de costos hacia el empleador, por lo
cual las partes esperan que los jueces resuelvan favoreciendo a
los trabajadores. En este escenario, la percepción del empleador
acerca de qué debe considerar como costo y como beneficio se
ve alterada, incentivando su aversión al riesgo y llevándolo a
negociar acuerdos que, de otro modo, no hubiera considerado.
PALABRAS CLAVE:
Derecho del Trabajo; Derecho Procesal
del Trabajo; Acuerdos y Sentencias; Prospect Theory; Análisis
Costo-Beneficio.
JEL CODE:
J23, J81.
INTRODUCTION
In 2014, the Suprema Corte de Justicia de la
Provincia de Buenos Aires’ decided to propose a change in
Labor Procedural Rules. Their decision was based solely on the
Justices´ perception of a problem: parties decide to settle their
disputes 80% of the time. As they expressed, their concern was
that a decision such as that could only have the explanation that
Labor judges are lazy.
The Justices assumed that those who go to Court
to end their conflict do so because they couldn’t settle it
before. For this reason, it troubled them that, once the courts
intervened, both parties preferred a settlement, which seemed
irrational in their view. For this, it was self-evident that the
courts
´
intervention was the cause for this sudden change in
parties’ revealed preferences before filing the lawsuit. For this
reason, Suprema Corte’s argument seemed irrefutable: the
intervention of the Judiciary caused the preferences’ change.
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First, we compared the most laborious courts’
statistical data - in this case, those that issue more judgments
than others - with the average. Not shockingly, the
workaholic
courts kept a very similar proportion of a 75% preference for a
settlement. If the Supreme Court hypothesis was any helpful at
all, it could only explain some odd marginal cases but not the
sheer preference. There was another explanation.
Both parties of the employment relationship know,
at least superficially, their fundamental rights, duties, and
obligations arising from its celebration, its execution, and its
termination. Although that knowledge may be imperfect, both
employer and employee are somehow aware of what they can
expect from labor legislation. Thus, with well-defined property
rights and low transaction costs, both parties can bargain a
solution that would lead to the most efficient resource allocation
1
when a conflict strikes. But when bargaining is impossible or
unproductive, the Labor courts’ intervention introduces two
new variables: litigation costs’ particular distributive scheme,
and a fair deal of uncertainty about how the judges will decide.
As we will show, this distributive pattern transfers
litigation costs to the employer, leading to a societal perception
that workers always win, and employers always lose in Labor
courts. This belief shows that the initial uncertainty about what
the judges will do is not that strong after all.
Considering all these elements, the classical rational
decision model proved insufficient to explain the cause of these
changing preferences. Aware of the classical model’s limitations
when analyzing flesh and blood human beings’ behavior and
1
I’m referring to informal agreements since judicial or administrative
intervention curtails the parties’ bargaining power because it requires
courts to analyze if the settlement is a fair deal.
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accounting for empirical evidence, we considered a different
variable: the likelihood that this scheme not only affects costs
but also creates a framing effect on both parties, which alters
their perception of what they consider as a gain and a loss.
With the last statement in mind, we inquired if the
belief that judges favor workers and disfavor employers
may be one of the reasons why the parties prefer to settle
80% of the time. Our focus addresses wrongful termination
disputes since the motivations to settle may differ
2
in worker’s
compensation conflicts.
We start by briefly explaining the classical rational
choice model’s limitations in this regard. Then, we show how
the substantive and adjective rules alter the procedural costs’
distribution scheme, which creates the belief that the judges
favor workers and disfavor employers. Finally, applying
Behavioral Economics’ add-ons, we explain the conclusion.
1. RATIONAL CHOICE MODEL
It is still surprising how the Law, so closely linked to
behavior, lacks models to analyze how legal norms influence it.
If we were to determine from the Legal Science what leads the
inhabitants of any State to comply or not as the norms provide,
we would soon realize that we don’t have suitable tools for this
essential kind of work. On the other hand, Economic Science
has models that predict and explain how changes in the relative
prices of products produce changes in suppliers’ and buyers’
behavior. Based on their assumed rationality, which leads them
2 In the case of legal and judicially assessed obligations, there are no rational
reasons to deviate from the legal formula once the parties have the
necessary parameters to calculate the benefits - salary, degree of disability,
and age of the worker at the time of the claim or the first disabling
manifestation -.
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to try to obtain the best result or benefit from their actions, one
of those models is the ancient Homo Economicus, today known
as the Rational Choice model.
If we simplify any legal system, we can argue that it ties
punishments and rewards to certain behaviors. Furthermore,
we can consider these punishments as prices and these
rewards as benefits. For this reason, if we assume that laws
produce changes in human action´s relative prices and benefits
associated with them, we will find how logical it is to apply
economic reasoning to legal questions. This is what Ronald
Coase and Guido Calabresi had in mind while elaborating the
seminal works of the Economic Analysis of Law.
Many academics addressed the question of why people
sue or settle using Economics tools. As a matter of fact, and
despite being almost 40 years old, any scholar – including me
– addressing questions like the one presented here appeals
to the model that Steve Shavell (1982) developed in “
Suit,
Settlement, and Trial: A theoretical Analysis under alternative
Methods for the Allocation of Legal Costs”
. In his work,
Shavell
used a basic sequential game, according to which, when faced
with a conflict, the parties make the following decisions: a) the
plaintiff to
sue
, or
not to sue
(case in which the conflict ends);
b) the defendant to
settle
(actually, proposes an agreement
because the model assumes that the plaintiff will accept it), or
not to settle
(in which case the procedure continues until the
court issues a final judgment).
The Rational Choice model uses a simple Cost-Benefit
Analysis to predict both decisions: a) when expected costs
of litigation outstand its expected benefits, the plaintiff does
not judicialize the conflict; otherwise, the plaintiff sues; b)
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when expected costs of a trial outstand the expected costs of a
settlement, the defendant proposes a settlement; otherwise, the
defendant waits for a final decision.
As Shavell (2004, p. 401) explained, a conflict is settled
when both parties formed the same beliefs about what the trial
outcome could be, which looks somehow self-explaining. But,
taking this argument from the Rational Choice perspective, if
both expected the same outcome, why would they go to trial
in the first place? Why did not the parties settle the conflict
before when it was cheaper? Pushing this argument, a little
further, if both parties decided to judicialize their conflict, is
because, at least initially, they did not have the same belief
about the outcome. Then, their belief changed as soon as they
got to court, and in this regard, the Rational Choice Model
proves useless to answer why.
But we know that as soon as they judicialize the conflict
Labor Law and Labor Procedure rules come into play.
2. DESIGNING A REGULATORY REGIME
When designing a regulatory regime, lawmakers must
choose between a default set of rules or an imperative set of
rules. Argentinian lawmakers considered that imperative rules
were the most suitable design to regulate labor relations. They
assumed that the employer’s market power would influence
the bargain, harming the worker
´s
rights. For this reason,
Argentinian Labor laws are imperative, exhaustive, and
noticeably worker protective.
Due to the protectionist tinge imposed by article 14
bis of the Constitution, Argentine labor legislation considers
the worker very differently from the employer, up to the point
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that the Federal Supreme Court of Justice has defined him as a
subject of preferential constitutional protection
.
Substantive labor legislation is built on this tutelary
ideal, translated into a protective principle, which constitutes
its conceptual framework. This principle turns operational
through a set of tools, consisting of rules of interpretation
in cases of controversy that can arise during the bargaining,
execution, and termination of the employment contract, as well
as during a judicial procedure. Within this set of tools, the rule
of the most beneficial condition, the regime of irrevocability
of labor rights
3
, the rule of doubt - in its two meanings -, and
the procedural benefit of poverty
4
arise. For this reason, the
protective imprint of the substantive legislation inevitably
extends to judicial processes.
From this set of rules, it turns out that, ultimately, the
cost of Buenos Aire’s labor judicial process is transferred, in the
first instance, to the employer and, in the second instance, to
the society.
Accordingly, the worker can obtain all the benefits of
litigation and impose all its costs on third parties. As so, he has
every incentive to prosecute any claim, even the ones with a
negative expected value, as an
ex-ante
, he is indifferent about
the outcome.
3 Related to the former, the irrevocability of rights and substitution of
contractual clauses limits the parties’ freedom of bargaining to agreements
that exceed the minimum rights provided by legislation or collective
agreements. If parties break the floor, those clauses are automatically
replaced by the former.
4 To guarantee the exercise of the worker’s rights, federal Labor legislation
grants the worker and its heirs a benefit of gratuity in judicial and
administrative processes. In turn, the Provincia de Buenos Aires procedural
rules grant a broader benefit, generally called - to distinguish it from that -
of poverty. In the case the worker loses, the employer must pay all experts´
and his own lawyers´ fees.
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As can be seen, the main characteristic of the legislation
applicable to the Labor judicial procedures reduces the cost
for the worker of proving the controversial facts, assigning
probative value to some manifestations or omissions, and forces
judges to provide a favorable interpretation of the claims made
by the employees. But this reduction in the cost of proving is
only possible because, on the contrary, that same legislation
increases the probative cost of the employer.
The worker files a lawsuit with a substantial advantage
over his employer: his day in court is guaranteed even when he
does not have the economic means to bear the cost, and he can
enforce legal contractual clauses for his benefit even when they
were different from those agreed upon and will have a favorable
interpretation of his claim even in the existence of reasonable
doubt, and the employer would not be able to defend himself
presenting agreements or waivers of rights as evidence. No
doubt he feels like a “winner.”
For this reason, the ones that must pay feel that, at least
in his case, Justice has failed: even in the case of acquittal, the
sense of injustice overwhelms the employer, because he will also
have to pay the fees of the experts and lawyers who represented
him in the unjustified process. These situations help build that
belief, which has become a quasi-certainty, that employers lose
in all lawsuits, regardless of the fairness or unfairness of the
worker’s claim.
But that’s not all.
3. RATIONAL CHOICE MODEL FAILURE
We pointed out before that, although generally useful
to predict and explain behavior, the Rational Choice model
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fails to predict and explain it in this situation. I must say now
that human rationality is quite distant from the unmistakable
logic of the Vulcan Mr. Spock, whom the model seems to
replicate. We, humans, act many times in ways that the model
will consider
irrational
. But many of these
irrational
behaviors
are reproduced in most of us, and as such, they cannot be
attributed to mere failures in the logic of a given John or a
Mabel. Hundreds of studies have shown regular people like you,
and we act with our rationality, will, and self-interest limited
by heuristics and biases that affect our decisions. Through the
heuristic procedure, our mind develops solutions to questions
using mental shortcuts, consciously or unconsciously based on
the information it has, answers that may or may not be correct.
The latter constitute cognitive biases.
Then, heuristics and biases affect rationality and,
therefore, the behavior that the Homo Economicus model
associates with it. In this way, we humans decide in ways that
the Rational Choice model cannot explain. Hence the need to
use a different one that considers its impact on human behavior.
This is the realm of Behavioral Economics.
Insofar as it applies to legal issues, Behavioral
Economics departs from the hypothetical behavior of the ideal
model and looks up to one of real human behavior.
One of these models called the Prospect Theory
5
, is
helpful to explain the parties´ irrational change of perception
about the outcome of their dispute.
One scenario plagued with inconsistencies between
natural man´s behavior and the ideal model´s predictions is one
of the decisions under uncertainty or risk. This is related to the
5 Developed by Daniel Kahneman and Amos Tversky.
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ability to make decisions that maximize utility, according to the
Swiss mathematician Daniel Bernoulli´s expected utility model.
Kahneman and Tversky published 1979 a study in the
Econometric Magazine
called “
Prospect Theory: An Analysis
of Decision Under Risk
.” They proposed a low-risk decision-
making model, an alternative to Bernoulli´s.
In their theory, the authors explain that the certainty
effect influences subjects’ decisions in situations that offer
them a high probability of obtaining profits - exploiting their
aversion to risk - And, on the contrary, the reflection effect
influences the ones of those who face situations of a high
probability of suffering losses - exploiting their attraction or
love for risk -. This theory assumes that the discomfort that
results from a loss is more significant than the well-being
obtained from a gain, contradicting the traditional idea about
the equivalence of values of profits and losses. On the other
hand, there is a framing effect, which occurs individually and
sets a different reference point or status quo from which every
person evaluates their alternatives.
In theory, the expected utility has a concave function in
the upper right quadrant (profit area) and a convex function in
the lower left quadrant (loss area). This characteristic is usually
represented as follows:
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Figure 1:
Prospect Theory
Own Elaboration
We stated before that from the Rational Choice
Perspective, a settlement is possible when both parties to a
conflict form the same beliefs about what the trial outcome could
be. But the mere existence of a judicial procedure - even with
Labor Law and Labor Procedure Law’s cost-shifting scheme -,
is self-evident that parties do not evaluate the outcome in the
same way.
Applying the Prospect Theory, the result seems to be
the same: being a zero-sum game whereby one of the parties is
a winner to the same extent as the other is a loser, an agreement
between them seems impossible since the defendant presumably
will prefer to assume the risk of an eventual conviction to the
certainty of a loss that settlement will produce. Are we missing
anything? The extent of Labor Law and Labor Procedure’s rules
influence the reference point.
It is logical to assume that the setting, the legal norms,
the degree of wealth, and even emotions constantly alter the
status quo. In this regard, references tend to be shifted, altering
the frame. In fact, in both collaborative and non-collaborative
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situations, it is easy to figure out that each party starts from a
different status quo.
From this perspective, the concepts of what is a loss
and what is a profit become blurry. So, we need to analyze
them relative to the new reference points the Labor legislation
created for both parties.
Returning to the hypothesis for a moment: the labor
legislation, insofar as it transfers costs towards the employer,
creates the perception that he will lose no matter what because
he will be forced to pay at least all the expenses.
This shift of costs towards the employer produces an
undoubted displacement of its reference point towards the area
of losses and creates a new framework. Thus, a sued employer
is likely to view as profit any sum that he can save from what he
expects to close in the lawsuit. Hence, since it represents less
than what he expects to pay if convicted, it feels like profit from
his new reference point. Now, his risk aversion gets a hold and
forces him to propose a settlement.
Figure 2:
Labor legislation
Own Elaboration
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But the belief affects the worker too: being in
a situation of the near certainty of success, affected by an
endowment effect, and influenced by his risk aversion, he will
most likely agree to the proposed agreement.
Figure 3:
New reference point
Own Elaboration
Later, parties are more likely to agree because, according
to the individual reference points Labor Law created for them,
and because of their increased risk aversion, they both perceive
the settlement as a gain.
CONCLUSIONS
Throughout this work, we have analyzed the reasons
that lead the parties to a judicial process to prefer to settle
rather than wait for a court decision. For this, I decided to
ignore the consideration of the Suprema Corte that judges’
laziness produces this phenomenon.
Using Prospective Theory, we found an explanation.
Although it has been handy to explain human behavior,
the classical model of rational decision has presented some
shortcomings. For this reason, without abandoning it altogether,
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sometimes it is necessary to twist it to replicate actual human
behavior.
The theory developed by Kahneman and Tversky has
proven to be a helpful tool for analyzing human behavior. But it
is common to overlook the influence that some external factors
- such as legislation - can have on the parties’ status quo.
Finding an explanation for seemingly irrational
behavior can be tricky. A hasty conclusion about its origin can
lead to wrong decisions or actions. In this case, it was proven
that the legislation and not the judges - as the Buenos Aires
Supreme Court held - cause this behavior. Then the Supreme
Court, prey to its own biases, proposed changes in the legislation
to force judges to step away from their laziness. Guess what? No
changes were made to the set of tools that cause this abnormal
situation. My prognosis is not good: if things change, they will
change for the worse.
Being impatient, not giving the situation second
thought, and looking for culprits, the Supreme Court could not
see that the only real problem was its hasty conclusion.
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Received:
14-05-2021
Approved:
12-07-2022
Juan Martín Morando:
Professor of Law and researcher at
Universidad Argentina de la Empresa.
City:
Buenos Aires
Country:
Argentina
Email:
jmorando@uade.edu.ar
ORCID:
https://orcid.org/0000-0002-5678-6079