Tuesday, March 11, 2014

Game Theory in Contract Drafting

I participate in a Mac user group for attorneys.  One of the participants asked about the use of game theory in the practice of law.  Here are my posts and follow up answers:

I use game theory, of sorts, by using "baseball arbitration" when I use an arbitration clauses.  With baseball arbitration, each party (lets call them "Buyer" and "Seller") appoints an appraiser to come up with a value, and a third "independent" appraiser is also retained.  The "final" price for the property is either the Buyer's appraised value or the Seller's appraised value depending upon which one is closer to the third party appraiser's value.  In this way, each party have an incentive to be realistic if not conservative in its valuation (a Buyer won't go too low and a Seller won't go too high).  If they do, the other party's value will be chosen as the final price.  For instance, let's say the Buyer's appraised value is $1 mil. and the Seller's appraised value is $2 mil.  If the appraiser comes in at $1.7 mil, the Seller's $2 mil. becomes the price.  In the face of this, the Buyer has an incentive to come up with a higher value, and the Seller has an incentive to come up with a lower value since they don't know what the third party appraiser will do.  I find this beneficial because if the parties are close enough after their first two appraisals come in, they might just elect to forego the third appraiser and agree on a value.  In any event, it tends to reduce the chances of wild discrepancies.  I also try to correctly analyze incentives in creating contracts and attempt to incentivize the desired outcomes.  As for a particular book that influenced me, depending upon how you look at it, it is the entire field of economics, or law and economics, but the concepts are well written in many books on negotiation, business and other disciplines.  Posner is a good one to read if you can wade through it:

Someone from the group emailed me and asked for some sample language of the baseball arbitration, and I posted:

"If the BUYER has elected to have the then-current fair market value of the SELLER Parcel determined by appraisal, the value will be determined by three appraisers, one appointed by SELLER, one appointed by BUYER, and the third selected by the other two appraisers (hereinafter respectively “SELLER Appraiser,” “BUYER Appraiser,” “Third Appraiser,” and collectively the “Appraisers”).  Each of the Appraisers must be an MAI appraiser who is certified by the State of California, with at least 10 year’s experience in appraising businesses.  Within five (5) days of BUYER’s notice of its election to have the then-current fair market value of the SELLER Parcel determined by appraisal, BUYER and SELLER shall exchange the names of its respective appraiser, and those two appraisers shall select the Third Appraiser within ten (10) days thereafter.  If the SELLER Appraiser and the BUYER Appraiser cannot agree upon the Third Appraiser, then either party may apply to the Southern California Chapter of the Appraisal Institute for appointment of the Third Appraiser (or if no procedure then exists for such application, to the then-presiding Judge of the Superior Court of the State of California, in and for the County of San Bernardino, Central Branch).  Within thirty (30) days of the appointment of the Third Appraiser, each of the Appraisers shall complete an appraisal of SELLER’s Parcel to designate each of the Appraisers’ opinion of the fair market value, as of the date of the Exercise Notice, of the SELLER Parcel, as fully improved, using the Uniform Standards of Professional Appraisal Practice of the Appraisal Institute.  None of the three Appraisers shall share their opinion of value with any of the others, and the Appraisers shall confirm by telephone that they will deliver (by overnight delivery with proof of receipt) their respective appraisal on each other, SELLER and BUYER on a particular day not later than thirty-five (35) days after the appointment of the Third Appraiser.  The final price of the SELLER Parcel shall be either the appraised value of the SELLER Appraiser or the BUYER Appraiser, depending upon which of those appraisals is closest in value to that of the Third Appraiser.  In the event that the Third Appraiser’s opinion of value is: a) exactly between the other two; or b) greater than that of the SELLER Appraiser; or c) less than that of the BUYER Appraiser, then the Third Appraiser’s valuation shall be the final price of the SELLER Parcel, subject to the following minimum valuation.  In no event shall the fair market value of the SELLER Parcel be less than SELLER’s undepreciated cost basis in that property, including all acquisition, construction, development, permit, professional, costs, fees and expenses."

This is a bit different from the clause I described above and would need to be modified to allow for the possibility for the parties to come to agreement before the third party appraiser is chosen.  Also, this version increases  risk from being the odd appraiser out in that the floor and the caps are removed.  For example, with this clause, if the third party appraiser is higher than the Seller's price, the third party appraiser's value becomes the price.  Anything that increases the risk of having your appraisal NOT chosen creates an incentive to be very conservative in your valuation.  Another difference is that this provides for a floor price which the Seller cannot be required to sell below.  If I were drafting this today, I think that I would make the changes to make the clause look more like what I described yesterday, but each case is different.  You have to look at the transaction, the desired results, undesirable results and the incentives created by the agreements and the circumstances.  It is also good to draft it, walk away, look at it again, and look at it with the different markets you might face when the clause is exercised.  For example, does the clause work in an increasing market, a decreasing market, when the capital markets are flowing and loans are available, when not, etc.?  You can also consider particular clients.  For example, if you have a client that is so well financed that they could always cash out an obligation, that is treated differently than a client that finds it hard to pay their line of credit down to zero every year to meet the financial covenants of that loan.

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