The Endowment Effect’s Adverse Impact on Case Valuation and Settlement and What to Do About It

One of several powerful cognitive bias phenomena identified by behavioral economics is the Endowment Effect, a cognitive bias that causes individuals to overvalue what they already possess simply because they own it. In litigation, the “possession” is often a legal claim or entitlement, or the value and likelihood of success of their defenses. The Endowment Effect skews judgment, inflates expectations, and obstructs settlement. This article addresses techniques mediators and litigators can utilize to mitigate the Endowment Effect and help mediation participants and clients make rational, objective, and wise decisions.

In theory, legal settlement negotiation is a logical process where parties weigh risks, consider the future costs, and rationally calculate the likelihood of various outcomes to arrive at mutually tolerable compromises based on objective criteria. However, experienced mediators and litigators will confirm this is typically not true. Many matters that objectively should be settled fail to do so, often because the client decision-makers are unable to objectively value their claims and defenses.

Clients (even highly sophisticated businesspeople) often do not have the skill sets or temperament to objectively value their case, even with sound guidance from their counsel. In some cases, clients have agendas other than making smart, objective decisions – think of the nightmare family law matters we all have witnessed or heard about. Other cognitive bias factors, such as the Sunk Cost Fallacy - that time and money previously invested in the case inform its current value - impede client and lawyer objectivity.[1]

What is the Endowment Effect

First formally named by economist Richard Thaler in the 1980s (although conceptually referenced by Aristotle), the Endowment Effect teaches that people typically assign greater value to things they own than to equivalent items they do not own. Simply put, if they own something, it must therefore be “special” and necessarily above average.

In the legal world, litigants “own” their claims and defenses. This psychological ownership triggers the Endowment Effect. This causes parties to view their positions as more valuable, more correct, and more likely to prevail than any objective analysis would support. Indeed, they value such claims or positions more highly than they would value such claims or positions if others owned them.

The Endowment Effect’s Adverse Impact on Lawsuit Negotiations

When litigants assess their claims through the Endowment Effect’s distorting lens of ownership, several things happen:

• Overvaluation of Claims. Plaintiffs value their claims irrationally high and reject reasonable offers because their claim is “special.” It is more valuable than those merely “ordinary,” remarkably similar claims owned by others. They overrate the strength of their evidence, legal arguments, their experts, or how compelling and convincing they and their story will be to a jury or appellate court.
• Loss Aversion. A settlement feels like a loss. They fear they are giving up a near “sure win” of big dollars in their incredibly special, one-of-a-kind case by settling “too cheap.”
• Fear of Making a Mistake. They are afraid they are making a mistake and that in the future they will regret the decision to settle. They believe by “doing nothing” (e.g., not settling), they at least are not actively making a bad decision,  not appreciating that a decision not to settle (even one that occurs because they are “decision averse” or a “deer in the headlights”) is every bit as much of a decision as an affirmative decision to settle.
• Inefficient Outcomes. The Endowment Effect leads to prolonged litigation, suboptimal results for all involved, and almost always a much worse result than could have been achieved with an earlier settlement based on objective criteria and sound analysis. It is virtually certain that at least one side (and often all sides) will do less well by continuing or initiating litigation than the settlement they could have achieved at mediation.

How Can Lawyers and Mediators Mitigate the Impact of the Endowment Effect

Lawyers and mediators can use several approaches and strategies to help clients make sound decisions even in the face of the Endowment Effect’s powerful influence.

1. Use Objective Benchmarks. Utilize precedent, expert opinions, and risk analysis tools to shift the focus from subjective belief to empirical, objective criteria. Recent jury verdicts or appellate court decisions can offer a reality check on how the judicial system values these types of claims. Clients (and their lawyers) are more likely to rethink their expectations when presented with objective guideposts and real-world data.
2. Reframe The Narrative. Instead of presenting settlement as “giving up” a claim, frame it as “gaining certainty,” “saving time, money, stress, and opportunity costs,” “investing in closure,” “eliminating risk,” and “being in control of the outcome.”
3. Involve Neutral Voices. Mediators, retired judges, other lawyers (perhaps with some gray hair), focus groups, or even a mock trial can provide objective assessments of how others who are not emotionally involved view the case and may well carry weight with the client.
4. Discuss Cognitive Bias. Many clients and lawyers have never heard of the Endowment Effect. Educating them can help separate their emotions from the necessary objective decision-making required to make a sound assessment of the case.
5. Ask How Much the Client Would Pay for the Claims If They Did Not Own Them. Logically, one should “sell” their lawsuit claims for any dollar amount above what they would pay to acquire the claims if they did not already own them. Put another way, every time you do not “sell” the claims for a certain dollar amount, it is the economic equivalent of “buying” the claims for that amount of money offered. Both choices are simply deciding whether one would rather have the claims or the money, and rationally, the valuation and the result should be the same in both choices. Ask the client how much they would pay to acquire these same claims and pursue (and pay for) litigation if someone else owned them.
6. Will They Regret Not Settling? Ask the client how they will feel if they do less well in the litigation than the settlement opportunity available now, especially after taking into account their future attorney fees, expert fees, out-of-pocket costs, internal costs, and the ongoing stress of litigation.
7. Let Time Work. When emotions or lack of objectivity run high, a short cooling-off period can allow for more rational thinking and allow some of the objective criteria to “ripen” and “sink in.”
8. Lawyer Self-Awareness. Lawyers (especially when on a contingency arrangement) are not immune to the distorting impact of the Endowment Effect and other cognitive biases. Lawyer, heal yourself. Much like being on an airplane, put on your own oxygen mask before you help your companion passenger with theirs.
9. Put It in Writing. Put your case evaluation and the objective criteria that support it in writing to the client. Lay out in detail the factual, legal, procedural, evidentiary, appellate, and practical economic challenges with the case, as well as the many positive factors of the case, in a balanced and objective manner – together with your recommendations about settlement. A written analysis and valuation of the case, including candid discussions and analysis of liability issues, realistic damage models that will withstand appeal, collectability issues, future litigation costs, and the like, requires counsel’s thoughtful and granular analysis so they can properly advise the client. It is a more focused exercise and brings critical rigor typically absent from more casual client conversations. A formal writing also underscores the careful deliberation counsel has given to the matter and how serious your concern is about the client’s misevaluation of the case. A side benefit to such a writing is protection against a client’s future “different recollection” of the real-time advice you gave.

Settlement negotiations are not purely a debate about factual and legal arguments – they are a negotiation between human beings, whose rational decision-making is easily impacted and disfigured by powerful psychological forces. One of the most powerful cognitive biases is the Endowment Effect, which subtly and unconsciously causes the client’s view of their case to be untethered from reality. Rather than ignore this dynamic and allow them to “drink their own Kool-Aid” unchallenged, your role as a mediator or counsel is to help the client properly value their claims, defenses, and arguments and to make decisions primarily on objective criteria and not psychological and behavioral biases of which they may not even be aware.