Lexsee 5 s cal interdis L

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LEXSEE 5 s. cal. interdis. l.j. 375
Copyright (c) 1997 Southern California Interdisciplinary Law Journal

Southern California Interdisciplinary Law Journal

Summer, 1997
5 S. Cal. Interdis. L.J. 375
LENGTH: 33921 words
Donald C. Langevoort * and Robert K. Rasmussen **
* Lee S. & Charles A. Speir Professor, Vanderbilt Law School.

** Professor of Law, Vanderbilt Law School. The authors wish to thank Richard Painter, Jim Cox, and Geoff Miller for comments on earlier drafts.


  ... While this popular portrayal is clearly misleading, it rests on an intuition that we propose to take seriously: that the overstatement of legal risk may be a natural by-product of professional self-interest and self-definition. ... Why would a lawyer knowingly overstate a legal risk to a client? Obviously, answering this question is the linchpin of our analysis. ... Finding a legal risk thus signals to the client that the attorney has indeed expended effort on the client's behalf. ... She also has no control over the client's belief as to the likelihood that the transaction will run into legal risk if the advice given is inaccurate. ... A second constraint on the overstatement of legal risk is that the client can observe actions taken by its competitors. ... This being the case, the client may find it prudent to follow the advice given, even if it suspects that the legal risk may be overstated. ... Perhaps the greatest ex post constraint which the client can impose on the lawyer's incentive to overstate legal risk is to have in-house counsel review the lawyer's bills and her output. ... Once a lawyer discovers that a legal risk exists, the lawyer can reduce her potential exposure by playing up the risk to the client. ...  



Business lawyers are often caricatured as worry-warts and nay-sayers, obsessing on risk, burdening their clients' dealings. While this popular portrayal is clearly misleading, n1 it rests on an intuition that we propose to take seriously: that the overstatement of legal risk may be a natural by-product of professional self-interest and self-definition.

The possibility that lawyers are often tempted to act in a manner that is self-serving, rather than in their clients' best interests, is well recognized. Many of the bar's rules of professional responsibility are designed to discourage breach of the duty of loyalty, and the scholarly literature abounds with studies of the temptations to cheat their clients that lawyers face in such settings as the conduct of litigation, n2 the settlement process, n3 fees and billing, n4 and the like. Curiously, however, little if any serious attention has been given to the possibility that self-serving behavior will occur consciously or unconsciously in one of the most basic of the lawyer's roles, that of giving legal advice to a client. The counselling function has received increasing attention [*376] recently, particularly in the law and economics literature. But the question most scholars have chosen to explore is whether the extensive provision of legal advice is socially optimal - how advice is allocated or whether society might not be better off with less of it. n5 The tension posed is between client interest and public interest. The same duality can be found in studies dealing with ethics and professional responsibility. n6 The implicit assumption throughout this literature is that the advice provided to clients, on average, is objective, unbiased and accurate. n7

In this article, we explore the contrary possibility. The question of whether lawyers systematically tend to overstate legal risks is an empirical one, of course, and we do not offer any data one way or the other. Instead, we will approach the problem theoretically (and thus tentatively), with a view toward generating some testable hypotheses about the behavior of lawyers. We will see whether a plausible claim can be made that the popular intuition, however overstated, is based on at least some grains of truth.

If so, the implications would be profound. To the extent that lawyers, on average, do tend to overstate legal risk, then the legal profession should presumably recognize it as a problem of fiduciary irresponsibility and try to discourage it. Much more fundamental, however, are some fascinating questions about the diffusion of legal knowledge in society. If overstatement of risk is endemic, then the information economic actors act upon may well be different from the law as objectively understood, and the efficiency of the "received" law thereby called into question. Excessive caution may be the norm. [*377] The idea that there is an "acoustic separation" between the law as generated and as received by the general population has been advanced. n8 What has not been considered is that such a separation may be in part the product of a filtration bias.

This Article looks at the possibility of such a filtration bias in business law settings. We will concentrate on the sort of advice sizable law firms are asked to provide to their clients. We have chosen this context partly because it is the setting with which we are most familiar. More importantly, it is probably the setting in which elite lawyers are most widely employed in an advisory capacity, and where legal advice seems to be taken quite seriously. Whether our conclusions can be generalized to other contexts - a family law practice, for instance, or a legal services setting - is something we will leave to others.

Why would a lawyer knowingly overstate a legal risk to a client? Obviously, answering this question is the linchpin of our analysis. We posit two main reasons. First, it is often wealth-maximizing. In general, the more legal risk there is, the more necessary and valuable legal services are. True, if a lawyer is asked whether a proposed course of action is lawful and says no, the risks are too high, then the lawyer gains nothing but the fee from rendering the advice. (The same is true, of course, when the answer is yes, there is no risk at all). In the middle ground, however, the lawyer can make the claim that the course of action - or something like it - is possible but only with the careful management of legal risk. In other words, "You can do it, but you'll need my help." The more credible the risk, the more resources that are justified in terms of both legal research and transactional assistance. Now, the wealth-maximizing incentive is palpable.

The second explanation is quite different, but often reinforcing. The nature of the attorney-client relationship is such that clients typically have a hard time measuring how well their lawyers have served them in rendering advice. n9 Clients lack the information and expertise to make such judgments (presumably, that is why they retained a lawyer in the first place). Consequently, if a transaction is foregone [*378] because of the lawyer's warnings, there is usually no way of discovering whether the lawyer was excessively cautious or not. The same is true if the transaction goes forward, layered with excessive and costly precaution, and encounters no trouble or is upheld. The lawyers appear to have done a good job. But one situation where the client will be able to make a rough assessment of the quality of the advice is when the lawyer has given the go ahead (i.e., sufficiently minimized the risk) but the transaction is later deemed unlawful. Here, we suspect, the lawyer can reasonably fear that he or she will pay a substantial reputational (and perhaps financial) penalty - with the immediate client, and probably potential ones as well. n10 And rarely will there be any counterbalancing reward for more accurate calibration. In other words, there is an asymmetry in the observability of good and bad advice that leads naturally to an incentive to err on the side of caution. n11

Part I of this Article employs conventional economic analysis, treating the lawyer-client interaction in the counselling setting as a straightforward principal-agent problem. To this end, we consider whether common contractual or market-based mechanisms are likely to dampen the incentive to overstate risk. As we shall see, the standard method for compensating business lawyers - the hourly fee - actually accentuates the bias. Nor is there reason to believe that law firm structure, competitive influences or client monitoring (i.e., the increased use of in-house legal staffs) will offer a complete check.

Part II proceeds differently. Many lawyers deny that they have observed any significant incidence of consciously biased legal advice. Perhaps the ethos of professional responsibility sufficiently counters the incentive to cheat. But we draw from a variety of the social sciences to create a montage of reasons why lawyers might systematically [*379] overstate legal risk while at the same time believing that they are acting loyally. One sociological explanation is that lawyers' norms somehow operate to legitimate excessive caution, declaring it to be standard or in the clients' or society's best interests. From work in psychology we can see ways that undue attention to risk-positive information can unconsciously be motivated by ego, concern about accountability - even status-seeking. Finally, we argue that the way the legal profession organizes and transmits its knowledge may itself introduce a bias toward risk-positive information, causing a cascade of reactive conformity even by otherwise unbiased legal advisors. Whereas findings from psychology and sociology are often invoked to question the emphasis on rational behavior found in economic analysis, n12 here they tell stories that are supportive and reinforcing.

In sum, we predict that systematic overstatement of risk is a robust, if not universal, phenomenon in the legal profession. Surely there will be situations where the accountability structure overcomes it (as when the advice is open to scrutiny by other lawyers who are in a position to try to take business away from the one who is too cautious) or clients diffuse it (as when a risk-seeking client makes clear to the lawyer that he or she is expected to come as close to the line as possible). Still, large segments of legal advice seem to meet the criteria we identify as likely to give rise to bias. n13

Before beginning our analysis, we should make clear what we mean by the "overstatement" of legal risk. We harbor no illusions that the law is particularly determinate or certain. n14 Quite apart from any of the biases we identify, lawyers will frequently differ in their analysis of a hard legal problem. n15 A rational lawyer will often be [*380] cautious in giving advice, hedging it with qualifiers and assumptions n16 - especially if she senses that the client does not want to risk a lawsuit, even if one might be won. By itself, this is not necessarily overstatement. But by definition, there is some advice that goes beyond simple prudence, where risks are magnified beyond the measure the average reasonable lawyer would attach to them absent the incentives we describe. This is not a very rigorous definition, which admittedly creates a challenge for the design of experimental tests of our hypotheses. n17 But hopefully it suffices for our limited purpose here, which is simply to establish the plausibility of the tendency to overstate legal risk.


An economic analysis of the lawyer/client relationship shows that the lawyer has an incentive to overstate the relevant legal risks to her client, and that the client does not have sufficient means to ensure that such overstatements do not occur. The lawyer's incentive stems from the fact that she maximizes her income by portraying the risks inherent in a proposed transaction in such a way as to require additional legal services. Such a portrayal, on average, leads to an overstatement of the risks which the client faces. To be sure, constraints on such opportunistic behavior exist. The biggest of these constraints is the market for legal services. Yet, given information asymmetries in this market, competition for such services will not drive out those attorneys who overstate legal risks. While a client may employ devices designed to reduce the opportunity for strategic behavior on the part of lawyers, such as reviewing attorney bills and employing in-house counsel, these devices cannot eliminate the ability of lawyers to increase their payoffs above those which clients would be willing to pay in a perfectly informed and competitive market. Specifically, lawyers can maximize their income by adopting a strategy which overstates legal risks. [*381]

This overstatement of legal risks stems from the fact that the incentives of lawyers diverge from those of their clients. Lawyers seek to maximize their income while clients seek to obtain accurate, cost-justified information. Placed in the language of economics, there is an agency problem inherent in the lawyer/client relationship. Economists have produced a rich literature on the generic problems that arise in a principal/agent relationship. n18 We do not purport to add to this technical, complex body of research. Rather, we seek to apply the general learning in this area to the particular problems facing a client and its lawyer.

We proceed as follows. We first set forth the conflicting incentives of a lawyer and her client. We then look at how these incentives would affect the lawyer's performance where the lawyer is paid on a per-hour basis. We show that even where there is a well-established market for lawyers, which thus prevents the lawyer from charging monopoly rents for her services, the existence of asymmetric information allows the lawyer to charge more than she would in a market with complete information. While the market for legal services and client monitoring both limit the amount which the lawyer can charge, they nevertheless cannot eliminate the potential for opportunistic behavior. Indeed, the market for legal services, which requires lawyers to maintain a reputation for quality work, increases the incentive for the lawyer to overstate the risks inherent in a proposed transaction. Thus, we conclude that in the case of commercial transactions, lawyers who are compensated on a per-hour basis will overstate legal risks.

This conclusion raises the following question: Can clients obtain better information at a lower cost by altering the way in which they compensate their attorneys? Much of the economic literature focuses on the incentives of an agent under differing compensation schemes. n19 Indeed, in other contexts, lawyers depart from a per-hour fee arrangement. In some settings lawyers charge their clients on a contingency [*382] basis, while at other times they work for a flat fee. We show that in the case of business transactions, these alternative arrangements entail substantial agency costs. We tentatively suggest that the durability of the per-hour compensation system implies that the agency costs associated with this arrangement are lower than those attendant with these other compensation schemes.

A. The Basic Transaction Between Attorneys and Clients
We start with the basic transaction between a lawyer and a client. In short, a client purchases service from a lawyer. The nature of this service depends on the matter at hand. A client faced with a products liability suit wants a different service than a client who seeks help in facilitating a merger. Defending a client in a litigation setting is different than attempting to ensure that the transaction which the client wants to enter into does not run into legal difficulties. n20 Indeed, different clients may seek different services when faced with the same legal problem; for example, one client may wish to have a hard-nosed litigator when faced with a lawsuit while another client may seek a less combative advocate. n21 Lawyers simply do not sell a single homogeneous product called "legal services." Thus, any analysis of the incentives of the lawyer and the client must specify the services that are being purchased.

As we stated at the outset, our focus here is on those situations where clients seek advice regarding commercial transactions which they want to enter into. For this reason, we are basically concerned with the incentives of lawyers in firms. Few solo practitioners handle major commercial transactions. n22 When we talk about the incentives of lawyers, we are basically talking about the incentive of the firm as a whole. Where it is necessary to examine how the firm translates its [*383] general incentive to the individual attorneys, we explicitly draw the distinction between the larger entity and those who are its members. With these points in mind, we can now look at the conflicting incentives which arise when a client seeks legal advice on a business transaction.

We posit that the client seeks what we term "optimal information" regarding the legal risks that the transaction may face. By "optimal" information we mean more than "accurate" information. To be sure, clients want all the information that they receive to be accurate. A strategy of basing business decisions on inaccurate information has little to commend it. But clients do not necessarily want to receive all possible information concerning a proposed transaction, regardless of how accurate it is. At some point, the cost of gathering the information exceeds the benefits which the information will bring. For example, clients don't want lawyers spending 100 hours researching the problem of where a financing statement should be filed. If there is any doubt on the matter, it is cheaper to file in all offices which might be the right one. The basic observation is that for every transaction there comes a point where the client wants the attorney to cease her investigation. To put the point another way, the client wants the attorney to act as a perfect agent; it wants the lawyer to act as if she were handling her own affairs. n23 If the attorney would not spend her own money tracking down a tangential point, the client does not want to pay the lawyer to make such an undertaking.

One might be tempted to argue that this desire for optimal information is an artifact of the predominant type fee arrangement between the client and the lawyer, the per-hour billing system. After all, the per-hour fee arrangement ensures that the client both pays for the lawyer's marginal effort and receives the marginal benefit. The client thus wants the attorney to cease her efforts when the additional cost exceeds the additional benefit. We leave for later a full discussion of the ways in which various types of fee arrangements affect the incentives of lawyers in performing their tasks. Indeed, much of the economic literature on agency is concerned with how compensation schemes affect the incentives of the agent. For now, we simply want to [*384] make the limited point that the client's desire for optimal information exists regardless of which compensation scheme is in place. n24

It is readily apparent that clients want to limit the amount of information that they receive to that which is cost-justified when the attorney is being paid on an hourly rate. In such a situation the client directly receives both the marginal cost and the marginal benefit of the attorney's efforts. Yet such an incentive exists regardless of the type of fee arrangement between the parties. Consider first the client's incentives where the client hires the attorney on a flat fee arrangement. Once the lawyer and the client negotiate a fee, the client will want as much information as it could use. Here the attorney bears the marginal cost of her efforts while the client receives the marginal benefits. Looking at the client's motivations only after the fee has been negotiated, however, fails to take into account the client's concern with cost. The amount of a flat fee is not the product of divine mandate. Rather, the flat fee represents an implicit estimate of the amount of effort that the lawyer will spend on the matter. The more hours that the attorney generally spends on a given type of transaction, the greater the fee will be. To the extent that a lawyer spends additional effort where the benefit of such effort is less than its cost, the client will end up paying for this inefficient action. Thus, clients only want cost-justified information even in a flat fee arrangement.

A similar analysis holds for contingent fee arrangements. In such arrangements, the lawyer is promised a certain percentage of the proceeds of a transaction if that transaction is successful. n25 In a competitive market for legal services, this percentage is fixed so that the lawyer's expected compensation is equal to her expected effort. n26 To the extent that lawyers gather information which is not optimal, this is an added cost which will be passed on to the client in the form of a [*385] higher percentage rate. The more effort that a lawyer expects to put into an average case taken on a contingency fee basis, the higher the contingency rate will be. While clients are willing to pay a higher rate to obtain accurate information which is cost-justified, they do not want to pay a higher rate to procure information which does not meet this criterion. Thus, from an ex ante perspective clients seek optimal information even under a contingent fee arrangement.

Indeed, once we assume that there is a competitive market for legal services, it necessarily follows that clients want optimal information when they first select a lawyer. As we noted above, clients want unbiased information. To the extent that the client receives information from the attorney, the client must pay for this information. Regardless of how the particular compensation deal is structured, the attorney will expect to be compensated for her efforts. There is little reason to believe that attorneys will routinely accept fee arrangement under which they will not recover, on an expected basis, the value of their services. Such a price mechanism is an inherent feature of a market system. To the extent that lawyers provide information which is not cost-justified, the clients will pay the cost for this excess. We therefore are quite comfortable with the assumption that clients seek optimal information.

Lawyers do not share the incentives of their clients. We assume that lawyers seek to maximize their fees. Like most other people, attorneys want to have as high an income as possible. People generally receive a higher utility from more rather than less money. Of course, this desire to maximize income is constrained by other desires, such as the desire for leisure and the desire to maintain a pleasant work environment. People usually derive utility both from activities other than work and from the conditions under which they work. Thus, lawyers seek higher wages subject to the constraints that they also want to spend time away from work and that they wish to work under conditions that they enjoy. For the purposes of this paper, we assume that the lawyer has determined the amount of effort she wishes to devote to client matters. We thus treat her as needing to procure enough business to allow her to expend this effort.

The state of affairs just described creates an agency problem. Left unchecked, the agent (in this case the lawyer) would take action which runs contrary to the interest of the principal (the client). Specifically, lawyers would spend as many hours as possible on a given matter. Indeed, if clients had no way in which to monitor the hours [*386] spent by the attorney, the attorney would have an incentive to deliberately inflate the bill. n27 In the extreme case, the attorney would submit a bill based on her view of the maximum number of hours the client would be willing to pay for. While such intentional deception no doubt occurs in some cases, we do not believe that it is the standard practice in the profession. The reason that fraudulent billing is not the norm is that there are substantial constraints on the lawyer's ability to systematically overstate her efforts on behalf of her clients. We therefore set out a fuller account of the relationship between the attorney and the client. In particular, we make the following assumptions regarding the attorney/client setting that we are investigating. We view these assumptions as being a realistic approximation of the attorney/client setting.

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