Essay on Funding Irrationality

Adam S. Zimmerman - New York University School of Law

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My article Funding Irrationality addresses a relatively unexamined issue in the literature of class action settlements and public settlement funds: should the people who oversee a large settlement fund account for claimants’ irrational settlement decisions?

Much of the literature related to large settlements seeks to improve how judges and private actors serve the large groups of people impacted by a massive settlement.1  Settlement funds have reformed, in turn, by giving people more choices, such as more filing opportunities, different settlement outcomes, and extended deadlines. More opportunities to opt out of a large settlement theoretically assure that the fund’s administrators represent the interests of those who do not opt out. More choices of settlement awards means that more claimants can elect awards that fit their individual needs and circumstances. And more time to decide helps claimants to arrive at decisions that reflect their divergent interests. Few commentators have considered, however, how claimants to a large settlement fund make those choices.2 Modern reform efforts, rather, assume that claimants make rational decisions about their options based on their own stable values and preferences.3

But is that correct? Studies have long shown that because of cognitive bias, people may buy things they do not want, save too little for retirement, or make risky choices about their health—based on their point of reference, the timing of the decision, and the presence of seemingly irrelevant choices.4 Behavioral economists have examined these ostensibly irrational decisions in many other legal contexts, but few commentators have explored these effects in the context of a large group settlement. Because claimants to large settlements are generally unassisted laypersons, large settlement funds may be particularly compelling settings to examine the adverse impact of cognitive bias.

To that end, I make three claims in this Essay. First, people may make irrational decisions about their settlement options in a large settlement fund because of cognitive bias. Second, cognitive bias may undermine some of the stated purposes of public and private settlement funds—to provide claimants with more access, efficiency, and fairness than in traditional litigation. Third, “fund designers”—judges, lawmakers, and agencies—should identify and, in some cases, capitalize on claimants’ cognitive bias by altering the context, timing, and sequence of settlement options. Fund designers, however, should avoid reforms that unduly eliminate settlement options or impose excessive administrative costs. Rather, the benefits of any reform—preventing avoidable harm to irrational claimants—must outweigh the potential costs, including the value of client autonomy, the chance of error, and the burden on the courts and public administrators.

I examine these three claims by describing how three cognitive biases are likely to affect claimants in large settlement funds. These biases are: (1) status quo bias, (2) contrast bias, and (3) time-inconsistency bias.


Status Quo Bias

Status quo bias refers to a person’s tendency to stick to the status quo even when other options would increase well-being. In principle, a completely rational person will choose between alternatives based on his or her preferences and the potential costs of making an informed decision. In practice, however, simply characterizing an option as the status quo significantly increases the chances that a person will choose that option. Some speculate that this preference for the status quo derives from a general aversion to risks caused by one’s own actions, even when there are greater risks associated with inaction.5

For example, alternative investment and saving options are significantly more popular among college professors when designated as the status quo or the default choice.6 Because of the status quo effect, some commentators like Cass Sunstein and Richard Thaler have advocated “libertarian paternalistic” ways to encourage saving.7 They advocate changing the default rules to promote particular outcomes—like an employee’s decision to enroll in a 401(k) retirement plan—without limiting the employee’s opportunity to opt out of the plan at a later time.

Of course, switching costs also might explain adherence to default rules. A decisionmaker may rationally determine that it is not worth the time, money, or potential opportunity cost to deviate from the status quo. Moreover, people may be rationally indifferent to certain choices. Such explanations, however, do not fully account for how people make decisions. Although the subject of some criticism, many studies show that people irrationally overvalue either the default option or the costs associated with departing from the default option.8

In class action settlements and public settlement funds, status quo bias may be unavoidable. After all, there must be a default rule that asks people either to affirmatively join or affirmatively withdraw from a large settlement fund. But status quo effects complicate the long-held belief that opt-out rights (1) ensure fairer settlements and (2) provide an adequate opportunity to claim or reject awards through the fund. When few people affirmatively opt out or object to a settlement, courts and administrators have assumed that the fund successfully represents what claimants rationally want and therefore ensures a “fair, reasonable, and adequate” settlement.9 Status quo bias, however, provides a reason to be skeptical of these assumptions and the policies based on them, even when very large payouts are involved. Many people will join a large fund not because the overall settlement reflects their values and interests but simply because the default rule requires parties to affirmatively opt out of the fund.

The status quo bias also contributes to the phenomenon of underclaiming, in which parties refuse to opt out of a settlement but never claim an award. Many public and private settlements require parties to complete a new form to claim an award, to choose among substantive settlement options, or to select a settlement process. Commentators studying claim rates in class action settlements have found that the fraction of funds actually disbursed was very modest in these so-called claims-made settlements.10 This includes cases in which claimants were otherwise entitled to substantial awards.

Accordingly, settlement funds could automatically process claims, not unlike automatic 401(k) plan enrollment. Under such a system, a settlement fund would automatically distribute presumed awards to claimants who join the fund. Such a policy, however, would come at a cost. Among other things, funds would bear the administrative cost of precisely identifying eligible claimants in advance of payment.

In light of potential costs, automatic processing would be more justified in certain funds. In large-value cases, for example, automatically processing claims would not be worth the administrative cost, the burden on the courts, and the potential for error or fraud. Thus, automatic processing may be warranted in welfare benefit settlements or shareholder class action funds, in which fund designers typically have a great deal of information about claimants, the awards are modest, and claimants generally do not choose among multiple settlement options.11 Such policies would be more problematic in large mass tort settlements, in which settlement trusts or public settlement funds have less information about potential claimants, the awards are large, and claimants may be offered various procedural and substantive options in the settlement.


Contrast Bias

Contrast bias is the irrational tendency to weigh an option more or less favorably depending on the presence of other options. Theoretically, a rational decisionmaker should not rank options differently simply because the options are described in a particular way. Moreover, the introduction of an additional choice should not alter a decisionmaker’s relative valuation of the original options. But this is not always the case.

Take, for example, the uncanny effects of decoy options—options that no one ever chooses but that make another alternative more appealing—on physical attraction. In a survey of six hundred students, a behavioral economist asked subjects to rate the looks of two men.12 When asked to choose between the photographs of two equally attractive candidates—call one “George Clooney” and the other “Brad Pitt”—subjects were equally divided. When another group of subjects was asked to choose between the two initial candidates and a third candidate, a photoshopped and deformed version of George Clooney, however, 75 percent chose the unspoiled version of George Clooney and 25 percent chose Brad Pitt. Although no one selected the third option, the seemingly irrelevant introduction of an ugly version of George Clooney led 50 percent more students to believe that the original George Clooney was better looking than Brad Pitt.

Psychologists and behavioral economists have found that contrast effects directly impact a wide array of decisions, including consumer purchases, employment decisions, elective medical procedures, and even presidential elections.13 There are many explanations for contrast bias. Some suggest that it is simply easier to compare similar options among a set of choices than to give an absolute or innate value to any particular option. 14

The presence of contrast bias may be relevant to laws designed to improve the oversight of large settlements. Many settlement funds ask claimants to choose from an array of options after joining a settlement, in part to maximize the benefit to claimants with different interests in settlement. But the interrelationship of various settlement options may unwittingly impact a choice between cash and nonpecuniary awards, like coupons and warranties. In my own classes, I distribute an altered Apple iPod Settlement Notice as an illustration. After litigation over reported battery problems in old Apple iPods models, Apple settled and offered customers a choice of a $50 store credit or $25 in cash. Half of my students receive the original version of the iPod settlement notice. The other half receives a modified notice that contains the same two options—a $50 store credit and $25 in cash—and a decoy option, a $35 store credit. The results show the addition of a seemingly irrelevant coupon dramatically affects the students’ willingness to take the coupon settlement. The original group chooses cash more than 61 percent of the time; the decoy group chooses the cash only 40 percent of the time.

Contrast bias has implications for laws like the Class Action Fairness Act (“CAFA”), which expressly requires courts to conduct “fairness hearings” in coupon-only settlements and to postpone decisions about the amount of attorneys’ fees until after the coupons have been redeemed.15 CAFA’s purpose is to ensure that the attorneys’ fees are closely connected to the actual value of the settlement to the class. But CAFA does not impose a similar requirement for settlements involving both coupons and other options. Rather, courts may award attorneys’ fees upfront, based on an estimate of the cash value of the settlement apart from the portion of the settlement involving coupons. Due to contrast bias, courts may also have reason to wait for claimants to redeem these kinds of settlement awards: the coupon may encourage claimants to accept another settlement option that, by comparison, seems to offer a better value or greater liquidity. Such delay imposes costs. Class action litigation is risky business, and delaying even a portion of attorneys’ fees may dampen some attorneys’ willingness to file in the first place. But delay may be justified if it ensures that the attorneys’ fees better reflect the actual value that class members derive from the settlement.


Time-Inconsistency Bias

Rational models of choice assume that people have time-consistent preferences. That is, a person’s relative preference for gratification will be the same no matter when he or she is asked. Substantial evidence, however, demonstrates that people have time-inconsistent or present-biased preferences. Ask whether a person prefers to rent Schindler’s List or So I Married an Axe Murderer, and the answer should not depend upon whether the decisionmaker plans to watch the movie today or later next week. But the proportion of people who elect to watch Schlindler’s List in the near future may be thirteen times higher than those willing to watch it on the same day they are asked.16 Present-biased preferences explain the systematic tendency to seek out more immediately gratifying benefits today than the long term benefits called for by earlier plans.17 More often than not, people choose a bird in the hand—be it dessert, a little extra cash, or a silly movie18—over three or four in the bush.

Time-inconsistency is compounded by nonintegrated decisionmaking. Nonintegrated decisions are rational decisions about costs and benefits in irrationally short periods of time. If a person had to choose whether to spend the next five minutes writing a paper or watching a YouTube video, she would rationally choose YouTube, the more pleasurable activity. After five minutes, she would rationally make the same decision again. But when the decision is viewed under a more integrated time horizon—four hours of paper writing versus four hours watching YouTube—she would rationally choose to write her paper. Because people are susceptible to nonintegrated decisionmaking, even small tastes for immediate gratification, or small costs associated with a task, may cause a naïve person to continuously postpone making decisions.

The converse of nonintegrated decisionmaking is that procrastinators will be highly sensitive to very small short-term incentives or penalties. Policies that make the cost of a short delay loom larger thus make procrastination less likely.19

Time-inconsistency bias may prove costly to claimants filing with a fund and to the administrative operation of the fund. Although some settlement funds fix relatively short deadlines, requiring filing within three to six months of settlement, other more complicated mass tort funds may allow one to two years to file. In many cases, there is no overt penalty for failing to file at an earlier time. There is a very powerful hidden penalty, however, to claimants—the time value of money and potential lost interest. For example, as illustrated in the graph below, more than half of the families affected by the September 11 attacks waited two years to file with the September 11 Victim Compensation Fund; as a result, each gave up, on average, over $100,000 in lost interest per year.

September 11 Victim Compensation Fund Claims Filed20

Note the large spike in claims that appears just before the filing deadline on December 22, 2003. Rational considerations certainly explain some of the late filings. Claimants may choose to gather more information before filing with a large settlement fund. Or, particularly in large funds involving personal injuries, parties may need additional psychological distance from the event that gave rise to the claim. These explanations, however, are insufficient to account for the concentration of claims that appear just at the filing deadline of many large settlement funds. It is more likely that many claim filings represent present-biased preferences.

One solution is that large settlements could adopt rolling deadlines to encourage earlier filings. Parties could be required to file in the first week of each month until the final deadline. Human resource departments often use such rolling window systems to encourage employees to enroll in benefit programs, but these systems have never been applied in large public or private settlement funds. Cognitive science, however, suggests that such short-term incentives will encourage claimants to file more often over the duration of the fund, saving both opportunity costs to claimants and administrative costs to the fund.

Any such solution must take costs into account. Undoubtedly, rolling deadlines impose a cost on individual actors, who would suffer the inconvenience of filing at the beginning of the month, as well as on the fund, which would have to expend additional resources making such a filing system easy and transparent. But it would impose comparably small costs to claimants’ autonomy. A party unable to file at the beginning of the first month would always retain the ability to file the following month. A party that wants to wait for other strategic, information-driven, or psychological reasons would still retain that right.

Because of such costs, rolling deadlines may be more justified in funds that award high-value claims, like mass torts and some antitrust settlements, but not necessarily low-value claims, like consumer class actions. For high-value claims, the additional savings to the individual and the fund justify taking measures to encourage parties who might otherwise suboptimally delay filing.21


By “funding irrationality,” I do not challenge efforts to increase choices and opportunities for claimants to large funds. I only question whether such efforts, by themselves, are enough to accomplish their objectives of greater fairness, efficiency, and equity. Although such measures help rational participants to monitor, object, and exclude themselves from such funds, few measures exist to protect claimants who will make decisions based upon cognitive error. As this Essay demonstrates, there will be cases in which, on balance, many subjects will make poor decisions—both for themselves and for the fund as a whole—when available settlement options are not adjusted to account for cognitive biases. This is, in part, because in many large funds parties lack individual access to third-party expertise, like lawyers. Given the tremendous economic, social, and institutional resources devoted to operating large funds, it is worth asking: Are there better ways to design large funds? Can their design accommodate both rational and irrational decisionmaking?

I answer both questions with a qualified “yes” by recommending policies that benefit those prone to make cognitive errors but impose minimal costs on those who otherwise choose rationally. In so doing, I recommend accounting for and sometimes exploiting the timing, structure, and combination of options in large settlements to increase the welfare of all potential participants.

But such solutions raise fundamental questions of fairness and efficiency themselves: Will fund designers suffer from their own biases? Will procedures that fund irrationality unfairly limit claimants’ rights to control their own litigation? Will funding irrationality risk replacing one set of claimant biases with new biases that lead to even less desirable outcomes? These are all valid concerns. The compensatory goals of large funds require, however, that fund designers understand how claimants make choices and, when possible, adjust rules so that funds better serve them.


Copyright © 2010 Duke Law Journal.

Adam S. Zimmerman is an Acting Assistant Professor at the New York University School of Law.

This Legal Workshop Editorial is based on the following article: Adam S. Zimmerman, Funding Irrationality, 59 DUKE L.J. 1105 (2010)

  1. Adam S. Zimmerman, Funding Irrationality, 59 DUKE L.J. 1105, 1127–31 (2010).
  2. I cite a few exceptions in my article, but one more recent, insightful article bears mention. See Elizabeth Chamblee Burch, Litigating Groups, 61 ALA. L. REV. 1 (2009) (applying social psychology to analyze group behavior in non-class aggregated settlements).
  3. Zimmerman, supra note 1, at 1120–31.
  4. Zimmerman, supra note 1, at 1134–55.
  5. Zimmerman, supra note 1, at 1135.
  6. RICHARD H. THALER & CASS R. SUNSTEIN, NUDGE: IMPROVING DECISIONS ABOUT HEALTH, WEALTH, AND HAPPINESS 34–35 (2008); William Samuelson & Richard Zeckhauser, Status Quo Bias in Decision Making, 1 J. RISK & UNCERTAINTY 7, 7–11 (1988).
  7. See, e.g., THALER & SUNSTEIN, supra note 6, at 5, 108–11.
  8. The strength of the status quo bias, and other related effects, is the subject of some debate. See Jennifer H. Arlen & Eric L. Talley, Introduction to EXPERIMENTAL LAW AND ECONOMICS, at xli–xliv (Jennifer H. Arlen & Eric L. Talley eds., 2008) (summarizing the debate over the scope of the endowment effect); Charles R. Plott & Kathryn Zeiler, The Willingness to Pay-Willingness to Accept Gap, the “Endowment Effect,” Subject Misconceptions, and Experimental Procedures for Eliciting Valuations, 95 AM. ECON. REV. 530, 530–32 (2005) (contesting the existence of the endowment effect). Substantial evidence, however, also demonstrates that such effects may be prominent for rare decisions, when valuation is difficult. See RICHARD H. THALER, THE WINNER’S CURSE: PARADOXES AND ANOMALIES OF ECONOMIC LIFE 66 (1992); Leaf Van Boven, George Loewenstein & David Dunning, Mispredicting the Endowment Effect: Underestimation of Owners’ Selling Prices by Buyer’s Agents, 51 J. ECON. BEHAV. & ORG. 351, 362–64 (2003).
  9. FED. R. CIV. P. 23(e)(2); Zimmerman, supra note 1, at 1138–39.
  10. Zimmerman, supra note 1, at 1139.
  11. See, e.g., Leslie Kaufman, A Bounty of Food Stamps, Harvested from a Lawsuit, N.Y. TIMES, Nov. 27, 2008, at A36 (describing a settlement in which 9,500 class members illegally denied food stamps were automatically credited $12 million through the use of electronic benefit cards).
  13. Zimmerman supra note 1, at 1143–46.
  14. Id. at 1143; see also Simone Moran & Joachim Meyer, Using Context Effects to Increase a Leader’s Advantage: What Set of Alternatives Should Be Included in the Comparison Set?, 23 INT’L. J. RES. MARKETING 141, 142 (2006) (stating that a seller can offer an expensive version of a product that “is not expected to sell, but should raise the attractiveness of” the less-expensive version).
  15. 28 U.S.C. § 1712 (2006).
  16. Daniel Read, George Lowenstein & Shobana Kalyanaraman, Mixing Virtue and Vice: Combining the Immediacy Effect and the Diversification Heuristic, 12 J. BEHAV. DECISION MAKING 257, 265–67 (1999).
  17. See Shane Frederick, George Loewenstein & Ted O’Donoghue, Time Discounting and Time Preference: A Critical Review, 40 J. ECON. LITERATURE 351, 382 (2002).
  18. Dilip Soman et al., The Psychology of Intertemporal Discounting: Why Are Distant Events Valued Differently from Proximal Ones?, 16 MARKETING LETTERS 347, 348 (2005); Andrew J. Wistrich, Procrastination, Deadlines, and Statutes of Limitation, 50 WM. & MARY L. REV. 607, 627–30 (2008) (collecting studies of “intertemporal discounting” or “hyberbolic discounting”).
  19. Zimmerman, supra note 1, at 1150–53.
  21. Even in mass tort cases, however, fund designers may be leery of solutions that push claimants to accept settlements before they can know the full extent of their damages. Justin Gillis, U.S. Report Says Oil that Remains Is Scant New Risk, N.Y. TIMES, Aug. 4, 2010, at A1 (observing that it “remains to be seen whether subtle, long-lasting environmental damage from the spill will be found, as has been the case after other large oil spills”).

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