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2020-07-doc4 Making sense of business failure

During the last decade, in Dutch Law Schools, in the field of private law (including corporate and insolvency law), gradually an emphasis has been placed on empirical legal studies. Traditionally, the nature of the study of law is rather descriptive (what is the law?) and normative (what should it be?). Empirical legal science mainly concerns the consequences of the application of a particular rule of law. Personally (may I say, a veteran in traditional legal research) I have no objection to empirical research into law. It is only far from me to understand what the methods of social or other empirical sciences are and how to apply them. So welcome to studies that introduce such topics!

Elements to build a solid relation between law and psychology have been developed by Niek Strohmaier with his dissertation defended at the University of Leiden in July 2020, with the title Making Sense of Business failure. It is, as the subtitle indicates, a social psychological perspective on financial and legal judgments in the context of insolvency.

His starting point has been the observation that (i) financiers and legal professionals need to make several important judgments when faced with an insolvent business and (ii) that humans in general are notoriously susceptible to cognitive biases when faced with complex problems under certainty and time restrains. To what extent do these professionals succumb to the effects of cognitive biases when making sense of business failure? To answer these two questions, several studies were conducted including among legal professionals and financial professionals. Several of his studies concentrate on ‘similarity bias’, the judgment that when evaluating another person more favourably or behaving in a more positive manner towards another person is the result of a (perceived) shared identity or other shared characteristics.

Among a sample of bankers the study demonstrates that sense-making processes regarding the cause of a company’s financial distress can be affected by similarity bias to the extent that more external causal attributions are made in the case of high degrees of perceived similarity between bankers and entrepreneurs. The same bias was found to affect bankers’ trust in the entrepreneur, however,  no significant relationship was found between perceived similarity and the likelihood of extending credit. Strohmaiers’ conclusion is that bankers in the specific context of credit decisions involving distressed assets might overall be less affected by similarity bias than other financiers such as venture capitalists.

Among a sample of legal professionals, it was found that they can be biased in their assessments of business valuations and business valuators. Specifically, the study showed that the outcome of a deal, the similarity with a valuator as well as the gender of a valuator, can all affect legally relevant judgments and evaluations pertaining to valuators and their valuations. Rather noteworthy, Strohmaier has found that these biases in the context of business valuation risk obscuring the efficient settlement of valuation disputes as well as unfounded trust or distrust in a particular valuation, which can then lead to suboptimal decisions to insolvent companies. This is quite a shocking finding for those who must on such judgments, especially a judge who wants to be informed objectively and thoroughly.

A large part of his study includes hindsight bias in judging director’s liability and irrelevant information pertaining to a director’s moral character influences mental state attributions, perceptions of a company’s outlook, as well as blame and punishment attributions. His overall conclusion is that the results found provide ample support for the idea that legal and financial professionals can be affected by cognitive biases when making sense of business failure.

The author believes that motivated reasoning processes play an important role in legal and financial judgments. It implies that people’s initial moral intuitions guide their subsequent sense-making processes in such a way that people are unconsciously motivated to arrive at a conclusion that is coherent with their initial reaction/intuition. At this juncture the bridge ibeng laid to the field of legal scholarship. Despite its importance, knowledge of cognitive biases in general and of motivated moral reasoning in particular is largely absent among financiers and legal professionals. Strohmaier argues that much work still needs to be done in as much as three fields: (i) to raise awareness of these key psychological insights among practitioners, (ii) to substantially improve insolvency investigations as well as judicial investigations to limit the effects biases can have, and (iii) to further develop his hypothesis pertaining to a change in mindset regarding business failure. He submits that normalizing business failure might help overcome some of the biases in sense-making processes stemming from moral intuitions.

Strohmaier is to be congratulated with his study. Interesting views, written in a clear way, making the lawyer-reader curious to learn more. I understand the author is preparing for a larger publication, aimed at lawyers, which will certainly be welcomed. We will certainly be hearing more from him, if only as a result of his Proposition 12 to his PhD: ‘A crash course in psychology should be mandatory in any law school’s curriculum’.