Is Silence Golden? Confidentiality and Correlated Culpability

Abstract

We consider the formation and legal protection of secret agreements by analyzing a negotiated settlement between a harmed plaintiff and a culpable defendant that seeks to disenfranchise a second harmed plaintiff by keeping the existence (and details) of the instant settlement secret. This is done so as to reduce the likelihood of the second plaintiff suing the defendant for damages or, failing that, to reduce the losses incurred by the defendant in the second suit. Such agreements happen every day and are generally legal, but are they socially optimal? Formally, we consider a sequence of incomplete information bargaining games wherein uninformed plaintiffs make demands of the informed defendant, with the defendant and the first plaintiff recognizing that their actions in the first case may convey information about the defendant's culpability to the second plaintiff. We then use the results of the analysis to provide insight as to when the law should prohibit or permit confidential agreements. We find that, even though early plaintiffs prefer permitting confidentiality and later plaintiffs prefer prohibiting it, the average plaintiff prefers prohibition. We also show that defendants always prefer that confidentiality be permitted. When role-interim decisions (that is, decisions made when agents know whether they are likely to be plaintiffs or defendants) have no (or small) adverse welfare consequences, society would (ex ante) prefer permitting confidential settlements. However, if agents know their roles, then this conflict of preferences can mean reduced consumer demand due to perceived incentives for firms to reduce care and due to the expectation of undercompensation for harms suffered. This can lead to further reduced care and provide reduced incentives to innovate. Furthermore, confidentiality potentially biases perceived reputations of firms, potentially leading consumers to avoid trade due to concern for adverse selection and moral hazard. We also show how this analysis can systematically inform the exercise of judicial discretion with regard to such agreements.