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The Effect of Risk on Legal Valuation

Robert J. Rhee, University of Maryland School of Law

Abstract

From a financial economic perspective, the governing condition of a meritorious civil action is the uncertainty of outcome. Expectation and outcome deviate, and the spread is the measure of uncertainty (or variance). During litigation each party has an option to settle or select trial. The decision standard can be seen as an option strike price and a finding of liability as an “in-the-money” call option. This apparent optionality suggests the application of an option pricing model to legal valuation, and a small but growing body of scholarship endorses this concept. However, option theory is not the only concept. Under an asset pricing model, the value of an asset is the sum of its expected cashflow discounted by its risk. Uncertainty is the key variable in the values of an option and an asset, but risk has a bipolar effect on value. Greater risk increases option value, but decreases asset value. At issue is the essential nature of a disputed right: is a lawsuit conceptually an option or an asset? This article argues that the essential nature of a lawsuit is best viewed as an asset. Uncertainty diminishes lawsuit value consistent with the prediction of asset pricing principles. This article shows that expected value, which has been a durable concept in law and economic literature, does not equal true economic value. The assumption of risk neutrality assumes away the most difficult aspect of the valuational analysis and fails to account for a risk-adjusted discount reflecting the quality of the forecast. Thus, two cases with the same expected value are not valuational equivalents if the variance of returns is perceived differently, and this article analyzes how parties account for different perceptions of risk in valuation.

Suggested Citation

78 University of Colorado Law Review 193 (2007).