Optimal Design Settlement Devices for Cases of Disputed Liability: Fee-Shifting Rules and Pleadings Mechanisms

We study the effect of alternative fee shifting rules on the probability of settlement when the defendant's liability is under dispute. Using a mechanism design approach we demonstrate that the probability of settlement is maximized by a particular Pleadings mechanism: Both parties are given the choice to opt into the mechanism; if they choose to do so, the defendant is asked to plead liable or not. Based on the defendant's pleading the plaintiff is offered a settlement amount which if accepted would be binding to both parties. If the plaintiff refuses the offer, then the case goes to trial and the allocation of litigation costs between the parties is set according to the outcome of the trial and the defendant's pleading of liability. When the background rule for allocation of litigation costs is given by the American rule, we show that the probability of settlement is maximized by requiring the plaintiff to bear both litigants' costs when the defendant has admitted liability irrespective of the outcome of the trial, and by applying the Pro-Plaintiff rule in the event that the defendent has denied liability. Extensions that allow for court inaccuracy, different background rules, variable shares of costs shifted, and detterence are considered.