This paper analyzes the effects of “offer of settlement” rules on the terms of settlement. The analysis shows that such rules can systematically shift the terms of settlement, and we derive surprisingly sharp results regarding the direction and magnitude of these shifts. The analysis also shows how we can design such rules to neutralize the advantage that parties with lower litigation costs would otherwise enjoy.
Under an offer-of-settlement rule, a party to a lawsuit may make a special offer to settle with the other party, such that if the other party rejects this offer, then this offer (unlike an ordinary offer) becomes part of the record in the case and may affect the allocation of litigation costs. Specifically, if the parties litigate to judgment, then the allocation of litigation costs may depend on how the judgment compares with the special offer. The court may shift costs to the party that fails to improve on the special offer at trial. Offer-of-settlement rules can vary with respect to several features: If only one party may make a special offer, which party may do so? For each party that may make a special offer, is such an offer mandatory or optional? If both the plaintiff and the defendant may make special offers, does the rule regulate the sequence in which they make these offers? If so, what order does the rule specify? For each special offer, if the offeree rejects the offer, then what are the implications for the allocation of litigation costs? For example, under onesided cost-shifting, such an offer can trigger cost-shifting only in favor of the party making the offer: if an offeree who rejected the offer fails to improve upon that offer at trial, then the court may require the offeree to pay the costs incurred by the other party since making the special offer. If the rule triggers two-sided cost-shifting instead, then party making the rejected offer similarly may be required to pay the corresponding costs of the offeree if the judgment at trial is less favorable to the offeror than the special offer. Thus, there is a large family of possible offer-of-settlement rules.