The importance of reputation in the auditing of companies: A game theory analysis

Numerous, mainly empirical, studies of auditing behaviour have recently looked at the “reputation” of the auditor and the size of fees it attracts. Our model of the auditing market advances the study of the fundamental principles involved in determining behaviour in relation to the rewards and penalties using an extensive-form game of the auditing process. We set up a two-player fraud detection game with bribes, bonuses and fines faced by an auditor. Our model yields that the auditor’s reputation, reflected in the size of bonuses, is critical to establishing a non-fraudulent behaviour by the client. Hence the model confirms expected behaviour. We further find the new insight, that while the existence of penalties deters fraud by the client, their size is not critical. This is a new understanding of what determines auditor behaviour. It is the perception of a possible penalty that moves the auditor in the direction of executing a thorough investigation using his acquired expertise

Split-Award Tort Reform, Firm's Level of Care and Litigation Outcomes

In an attempt to reduce the liability insurance costs of firms, several US states have implemented many different kinds of tort reform. Some reforms take the form of caps or limits on punitive damage awards while others have mandated that a proportion of the award be allocated to the plaintiff with the remainder going to the state. These latter reforms, called “split-awards†have recently been implemented in Georgia, Illinois, Indiana, Iowa, Missouri, Oregon, and Utah. It is important to note that reforms that reduce the firm's expected litigation loss also affect the firm's expenditures on accident prevention (firm’s level of care), and therefore, the probability of accidents. Our paper presents a theoretical model that explores the effect of the split award on a wide range of economic and social outcomes – the level of care that firms choose in an effort to prevent accidents and lawsuits, the probability of an accident, the probability that a lawsuit proceeds to the award stage of a trial, and the social costs of accidents. Our model builds upon Pngâ's (1987) theoretical framework on liability and litigation and extends it in a number of ways. First, we incorporate the split-award statute into the framework. Second, we establish sufficient conditions for a unique litigation stage equilibrium that survives the universal divinity refinement (Banks and Sobel, 1987). Third, we find a sufficient condition for the positive relationship between the plaintiff's share of the punitive award and the probability of trial. Fourth, we study the effects of this statute on social cost of accidents and establish necessary and sufficient conditions for a reduction in social costs of accidents under the split-award regime. Previous studies of the split-award tort reform (Daughety and Reinganum, 2003; Kahan and Tuckman, 1995) are also extended by incorporating into the analysis the effects of this statute on the firm’s level of care and social costs of accidents. Consistent with Daughety and Reinganum (2003), we predict that, holding filing constant, a decrease in the plaintiff's share of the award decreases the conditional and unconditional probabilities of trial. Given that the split-award statute applies only when the case is settled in court, the parties have an incentive to settle out of court in order to cut out the state. In addition, we find that a reduction in the plaintiff's share of the award increases the probability of accidents. This effect arises because a decrease in the plaintiff's share reduces expected litigation costs. The firm reacts to these lower expected costs by reducing expenditures on safety. Conditions under which this reform reduces the social cost of accidents are derived.Settlement; Bargaining; Litigation; Asymmetric Information

Private Antitrust Enforcement in the Presence of Pre-Trial Bargaining

We study the effect of encouraging private actions for breaches of competition law. We develop a model in which a plaintiff, who may have private information about whether a breach of law has been committed, decides whether to open a case against a defendant. If opened, the case may be settled out of court or may proceed to full trial. The authorities can facilitate private actions by lowering the costs of opening a case or of proceeding to a full trial, or by raising the damages to be expected in the event of success. We show that facilitating private action increases the number of cases opened and sometimes but not always makes plaintiffs more aggressive in pre-trial bargaining. The latter, if it occurs, tends to make defendants who have committed anti-trust violations more likely to settle than innocent defendants. We also show that for screening to work requires the Court to be committed to rely only on submitted evidence in the case, and not on other possibly relevant background material. We finally study how to design the rules so as to enhance the role of private litigation on antitrust enforcement and prove that it is better to increase damages that to reduce costs of initiating a suit. In particular we find large benefits from introducing a system of compensation for Defendants found non-liable, paid by unsuccessful plaintiffs.

The role of private litigation in antitrust enforcement

In this article, we study the effects of encouraging private actions for breaches of competition law. We also analyze how to design a private litigation system which deters anticompetitive actions without deterring legitimate pro-competitive actions.Private Antitrust Litigation

Missing Contracts: On the Rationality of not Signing a Prenuptial Agreement

Many couples do not sign prenuptial agreements, even though this often leads to costly and inefficient litigation in case of divorce. In this paper we show that strategic reasons may prevent agents from signing prenuptial agreements. Partners who value more the benefit of the marriage wish to signal their type by running the risk of a costly divorce. Hence this contract incompleteness arises as a screening device. Moreover, the threat of costly divorce is credible since the lack of an ex-ante agreement leads to a moral hazard problem within the couple, which induces partners to reject any ex-post amicable agreement.symmetric information, incomplete contracts, prenuptial agreement.

Missing Contracts: On the Rationality of not Signing a Prenuptial Agreement

Many couples do not sign prenuptial agreements, even though this often leads to costly and inefficient litigation in case of divorce. In this paper we show that strategic reasons may prevent agents from signing a prenuptial agreement. Partners which have high productivity in marital activities wish to signal their type by running the risk of a costly divorce. Hence this contract incompleteness arises as a screening device. Moreover, the threat of costly divorce is credible since the lack of an ex-ante agreement leads to a moral hazard problem within the couple, which induces partners to reject any ex-post amicable agreement, under specific circumstances. We also investigate conditions that make this contract incompleteness an optimal form of contracting and we briefly discuss the effects of enforceable and/or mandatory premarital agreements on the rate of divorce and on the social welfare. Finally, our model suggests that there is no major objection in making prenuptial agreements enforceable, but also that there are not good reasons to make them mandatory.asymmetric information, incomplete contracts, prenuptial agreement.

Rules of Proof, Courts, and Incentives

We analyze the design of legal principles and procedures for court decision-making in civil litigation. The objective is the provision of appropriate incentives for potential tort-feasors to exert care, when evidence about care is imperfect and may be distorted by the parties. Efficiency is shown to be consistent with courts adjudicating on the basis of the preponderance of evidence standard of proof together with common law exclusionary rules. Inefficient equilibria may nevertheless also arise under these rules. Directing courts as to the assignment of the burden of proof is then useful as a coordination device. Alternatively, burden of proof guidelines are unnecessary if courts are allowed a more active or inquisitorial role, by contrast with that of passive adjudicator.evidentiary rules, standard of proof, burden of proof, inquisitorial, adversarial, discovery, deterrence

Disclosure of Information in Regulatory Proceedings

This paper examines how different rules for presentation of evidence affect verdicts in regulatory hearings and the welfare and efficiency properties these procedures exhibit. The hearing is modeled as a game of imperfect information in which the respondent is privately informed about validity of his case. The respondent may present evidence to support his case. The commission observes whether the respondent presents evidence, and the nature of the evidence presented to update its beliefs about the validity of the case. Based on these beliefs and the standard of proof for conviction, the commission decides whether the respondent's application should be accepted or rejected. The sequential equilibria of this game are examined for their implications regarding (i) the desirability of making disclosure of evidence mandatory rather than voluntary, (ii) the burden of proof undertaken by the respondent to prove his case, and (iii) the impact of information accuracy and disclosure costs on the outcome of the hearing and the welfare of the respondents. Ce papier étudie comment différentes règles pour la production de preuves peuvent influencer la prise de décision d'une agence de réglementation ainsi que les propriétés de bien-être de ces règles. Une firme réglementée possède une information privée quant à la validité de sa requête et peut produire des éléments de preuve pour la soutenir. Une agence de réglementation observe la preuve présentée par la firme et se forme alors une opinion sur la validité de la requête. Les équilibres de ce jeu sont caractérisés et les points suivants sont étudiés : (i) la production de certains éléments doit-elle être obligatoire ou volontaire ? (ii) quelles sont les conséquences du fardeau de la preuve que la firme doit supporter ? (iii) quel est l'impact de la précision de la preuve et des coûts associés à sa produciton sur la décision de l'agence et le bien-être de la firme ?Regulation; Imperfect information; Disclosure of evidence, Réglementation ; Information imparfaite ; Production de preuves

Rules of Proof, Courts, and Incentives

We analyze the design of legal principles and procedures for court decision-making in civil litigation. The objective is the provision of appropriate incentives for potential tort-feasors to exert care, when evidence about care is imperfect and may be distorted by the parties. Efficiency is shown to be consistent with courts adjudicating on the basis of the preponderance of evidence standard of proof together with common law exclusionary rules. Inefficient equilibria may nevertheless also arise under these rules. Directing courts as to the assignment of the burden of proof is then useful as a coordination device. Alternatively, burden of proof guidelines are unnecessary if courts are allowed a more active or inquisitorial role, by contrast with that of passive adjudicator.Evidentiary rules, standard of proof, burden of proof, inquisitorial, adversarial, discovery, deterrence

Trial and settlement negotiations between asymmetrically skilled parties

Parties engaged in a litigation generally enter the discovery process with different informations regarding their case and/or an unequal endowment in terms of skill and ability to produce evidence and predict the outcome of a trial. Hence, they have to bear different legal costs to assess the (equilibrium) plaintiff's win rate. The paper analyses pretrial negotiations and revisits the selection hypothesis in the case where these legal expenditures are private information. This assumption is consistent with empirical evidence (Osborne, 1999). Two alternative situations are investigated, depending on whether there exists a unilateral or a bilateral informational asymmetry.\ Our general result is that efficient pretrial negotiations select cases with the smallest legal expenditures as those going to trial, while cases with largest costs prefer to settle. Under the one-sided asymmetric information assumption, we find that the American rule yields more trials and higher aggregate legal expenditures than the French and British rules. The two-sided case leads to a higher rate of trials, but in contrast provides less clear-cut predictions regarding the influence of fee-shifting.litigation, unilateral and bilateral asymmetric information, legal expenditures