One of the first things I Iearned about in game theory was the prisoner’s dilemma. As explained in Wikipedia, this theory was developed in 1950 by Merrill Flood and Melvin Dresher while working at the RAND corporation. It explains why two rational beings may not cooperate even though it is in their best interests to do so:

Two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of communicating with the other. The prosecutors lack sufficient evidence to convict the pair on the principal charge. They hope to get both sentenced to a year in prison on a lesser charge. Simultaneously, the prosecutors offer each prisoner a bargain. Each prisoner is given the opportunity either to: betray the other by testifying that the other committed the crime, or to cooperate with the other by remaining silent. The offer is:
• If A and B each betray the other, each of them serves 2 years in prison
• If A betrays B but B remains silent, A will be set free and B will serve 3 years in prison (and vice versa)
• If A and B both remain silent, both will only serve 1 year in prison (on the lesser charge)

This theory came to mind in a recent mediation. It was a subrogation case in which the insurance company (Let’s call it “Insurer”) paid a lot of money to its homeowner insureds (“Insureds”) to remediate their home damaged by smoke. Apparently, and quite allegedly, the Insureds had a vehicle (“Vehicle Manufacturer”) parked in their garage which caught fire due to an alleged electrical short in a part (“Parts Manufacturer”) in the engine. The garage caught fire and the smoke escaped into the home causing extensive damage not only to the possessions but also to the structure itself.

After making a pre-litigation demand on the Vehicle Manufacturer without success, the Plaintiff Insurer filed suit against the Vehicle Manufacturer only. The Vehicle Manufacturer in turn filed a cross-complaint against the Parts Manufacturer. Not being able to resolve the claim once in litigation, the parties came to mediation.

As one might surmise, the real disagreement was not between the Plaintiff Insurer and Vehicle Manufacturer but between the Vehicle Manufacturer and the Parts Manufacturer. The Parts Manufacturer was not willing to contribute as much towards the settlement as the Vehicle Manufacturer thought it should. The Plaintiff did not care, as it believed that it had a clear case of liability against the Vehicle Manufacturer and so could easily prove its case at trial. Its expert was going to testify that the fire started somewhere in the engine of the vehicle although it could not be determined precisely where. Thus, to succeed on its cross-complaint, the onus was on the Vehicle Manufacturer to show that the part in issue was, indeed, the cause of the fire.

Notably, the amount sought to settle the matter during mediation was about 50% of what the Plaintiff Insurer would be seeking at trial.

During the mediation, the Parts Manufacturer made it clear that it would contribute X amount and no more. If more was needed to reach a global settlement, it would have to come from the Vehicle Manufacturer. If the Vehicle Manufacturer was not willing to contribute the additional sums, the Parts Manufacturer would settle with Plaintiff separately. Plaintiff let it be known that it would settle with the Parts Manufacturer for the X amount.

The matter did not settle. And hence the prisoner’s dilemma. Rather than working together to resolve this matter and thus enter a global settlement that would be about half of a potential judgment after trial, the Parts Manufacturer betrayed the Vehicle Manufacturer by settling separately with Plaintiff. This leaves the Vehicle Manufacturer with a much larger “sentence”, i.e., a potentially larger judgment that it may face at trial.

But the story does not end: The Parts Manufacturer must now file a motion to have its settlement with the Plaintiff Insurer deemed to be one in “good faith” so that the Vehicle Manufacturer cannot later seek any sort of contribution or indemnity from it based on the alleged faulty part in the engine. (California Code of Civil Procedure § 877.6). Naturally, the Vehicle Manufacturer will oppose the motion, arguing the X amount constituting the settlement between the Insurer and the Parts Manufacturer is not enough given the alleged evidence that the fire was caused by this part and nothing else. Hence, the Vehicle Manufacturer will oppose the motion, arguing that the Parts Manufacturer should be paying much more than just a “minimal” amount. And, no one knows how the court will decide! (It could very well end up on appeal!)

By betraying rather than cooperating with the Vehicle Manufacturer, the Parts Manufacturer may have thought it was acting in its own best interest but if its motion for good faith settlement is denied, it will be proven wrong. In contrast, if it is willing to contribute a little more money, then a global settlement can be reached and everyone need not worry about being a prisoner in a dilemma.

In sum, it epitomizes the adage of being penny wise but pound foolish.

…. Just something to think about.

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