How to get the other side to pay costs you have not yet incurred
A party might settle early to avoid the risk of paying your costs of going to trial. They will pay something now to avoid that risk. In other words, they are paying you now for legal costs you have not yet incurred. It seems rather obvious once you run the numbers, but I think many people don't think of settlement negotiations in this way.
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Let’s say you are claiming £1m. Each side expects to incur £250k in legal costs to go to trial.
Claimant's best case outcome at trial looks like this:
Pay your costs: -£250k
Get all costs back on an indemnity basis: +£250k
Net outcome: +£1m
Let’s say the claimant estimates they have a 75% chance of winning, so the expected value of this outcome is £750k (75% of £1m). To keep the arithmetic easier to follow, I’m just going to ignore the downside risk for the claimant. In real life, the claimant absolutely should factor in the 25% of losing, and paying the other side's costs and so on. But it makes it harder to follow the numbers, so I’m just going to ignore that side of the equation to keep things simple.
From the defendant's point of view, their worst case outcome looks like this:
Pay £1m claim: -£1m
Pay own costs: -£250k
Pay other side’s costs on an indemnity basis: -£250k
Net outcome: -£1.5m
Let's say that defendant is not confident of winning, they put their chances at 50:50. So the expected value of their worst case outcome is £750k (50% x £1.5m)
This case should then settle at £750k. C should rationally accept £750k and D should rationally offer to pay £750k.
But why? Why are the two offers the same when C puts their chances of success much higher than D does? C rates their chance of winning at 75%. D puts it at only 50%. How can they end up with the same settlement figure? Because D is factoring in the risk of paying C’s costs which C has not yet incurred. C effectively gets the benefit, in D’s calculation, of costs that C has not yet incurred.
To make this clearer, let’s exclude legal costs. C values their claim at 75% * £1m = £750k still (because their best case assumes they get all their costs, so costs are already neutral for them in their best case scenario). But, without the risk of paying C's costs, D would only be willing to pay 50% x £1m = £500k. The reason why D is actually willing to pay £750k, not £500k, is because D is factoring in the risk of paying C’s future costs.
Another way to illustrate this point is to consider the picture just before trial, when both sides have already incurred most of their legal costs. Let’s say each side has spent £200k, and has another £50k to get through trial.
Now, D’s worst case is that they spend another £50k, lose at trial and pay the £1m claim and the other sides costs of £250k, total £1.3m. If they still assess their chances at 50:50, then the expected value of this outcome is £650k.
So they’d be willing to offer £650k to settle at this point, down from £750k they were offering at the outset.
For C to continue to trial costs them another £50k. In their best case scenario, they’ll collect £1m + £250k costs order, less their final £50k outlay, so net upside of £1.2m. If they still reckon their chances at 75%, that’s an expected value of 75% x £1.2m = £900k.
Without changing either side’s probabilities, the zone of possible agreement has been completely lost now. C should rationally accept £900k. D should rationally offer £650k. There is a huge gap.
In some sense, this is not surprising: as parties get deeper into a costs hole, it becomes harder to settle. So settle earlier. The insight here, though, is that settling earlier doesn’t simply avoid getting into a costs hole. It means you can actually get paid for costs you have not yet incurred, because your opponent has to factor in the risk of paying those costs in future. That makes it possible to find a settlement even when each side has a very different view about how likely they are to win.
For completeness, let me just run the numbers taking into account C's downside risk which we skipped over. You'll see the effect is even larger when you factor this in:
Best case: £1m x 75% = +£750k
Worst case: -£500k (both sides's costs) x 25% = -£125k
Net expected value = +£750k - £125k = £625k
So, C should rationally accept £625k to settle at the outset.
D's best case is net £0 (they get all their costs paid on an indemnity basis), so including their "upside" doesn't change their expected value which will still be the -£750k we calculated at the beginning (being 50% probability of their £1.5m worst case outcome). So D is actually going to offer C much more than C's settlement figure: £750k vs £625k. Happy days.
D can even be quite bearish about C's chances, and still find that they can offer C an acceptable settlement. Let's say D reckons C has a 40% chance of winning. 40% of D's worst case outcome of £1,500 is £600k, which is close enough to C's figure of £625k.
So even though C puts their own chances of winning at 75%, and D puts them only at 40%, their rational settlement offers still overlap (nearly), because D's offer has to factor in the risk of paying C's future costs and this pushes up the offer, even though C has not even incurred those costs yet.
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