DE GRUYTER Journal of Business Valuation and Economic Loss Analysis.

2017; 20160019

Shruti Rajagopalan1

Adversarial versus Inquisitorial Systems: Error

and Valuation
1
Department of Economics, Purchase College, State University of New York, Social Sciences Building, 735 Anderson Hill Road,
Purchase, NY 10577, USA, E-mail: shruti.rajagopalan@purchase.edu

Abstract:
This paper discusses valuation within the judicial processes by comparing the adversarial and inquisitorial
systems of litigation. It evaluates adversarial and inquisitorial litigation on the legal systems’ ability to aid pro-
cesses that lead to discovery of knowledge. It argues that much of the information required for accurate valua-
tion must be discovered. While the adversarial method of litigation is essentially a competitive model of evidence
production; the inquisitorial system comprises only the expert/principle searcher, and lacks a competitive dis-
covery process. Therefore, as a system, adversarial litigation may be more conducive for error minimization
in enforcing rules than inquisitorial litigation. On the question of business valuation of firms under Chapter
11, both the adversarial and inquisitorial systems are problematic, given that market competition leading to
discovery of prices and valuation is impossible within the judicial system of valuation.
DOI: 10.1515/jbvela-2016-0019

1 Introduction
This paper compares adversarial and inquisitorial litigation on the legal systems’ ability to aid processes that
lead to discovery of knowledge. Instead of focusing on the method of valuation, the paper focuses on the system
within which such valuation takes place. I argue that much of the information required for accurate valuation
must be discovered. This paper compares the discovery of the relevant information within the legal system.
Scholars in law and in economics have distinguished between the legal system followed in Europe and the
legal system followed in the United Kingdom and the United States. The former (i. e. European) is usually
dubbed the inquisitorial system and the latter (i. e. in the UK and the United States) the adversarial system. A
key general distinction is about the functions performed by judges and lawyers within the two systems. Another
important distinction is the method of evidence production.
There is a large legal literature on the relative merits of adversarial versus inquisitorial systems. Legal schol-
ars have debated the merits of the adversarial (Gross 1987) and the inquisitorial system (Langbein 1985). Schol-
ars have argued in support of the adversarial system (Fuller 1978 and Landsman 1984) as well as critical of the
adversarial system (Pound 1936 and Frank 1973).
There is an extensive literature in economics comparing the two systems (Tullock 1975; 1980; 2005a; 2005b;
2005c; Milgrom and Roberts 1986; Froeb and Kobayashi 2001; Parisi 2002; Zywicki 2008; Posner 2014). This
literature largely focuses on incentives within each system of litigation for the various stakeholders and on the
costs and efficiency of the two systems. This debate has not focused much on the specific question of judicial
valuation of businesses within an adversarial or inquisitorial system.
I argue that the adversarial method of litigation is essentially a competitive model of evidence production.
On the other hand, the inquisitorial system primarily comprises only the judge as the principle searcher, and
lacks the competitive discovery process. Therefore, as a system, adversarial litigation may be more conducive
for robust rule-making and for error minimization in rule enforcement.
On the issue of business valuation for a firm, especially for a bankruptcy reorganization under Chapter 11,
both the adversarial and the inquisitorial systems are plagued by incentive and knowledge problems. The main
reason for this is that the valuation takes place outside of the market process and the judges in either system
do not have access the relevant knowledge. Therefore, judicial valuation cannot be accurate where the relevant
standard is market valuation.
Section 2 of this paper describes the two different systems of litigation. Section 3 discusses the role of com-
petition within the legal system. Section 4 distinguishes the search for facts undertaken within the two systems
and shows the adversarial system created incentives to minimize both Type I and Type II errors. Section 5 ana-
lyzes the problems of business valuation within the two systems. In Section 6, I conclude.
Shruti Rajagopalan is the corresponding author.
© 2017 Walter de Gruyter GmbH, Berlin/Boston.

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2 Adversarial and Inquisitorial Systems

Dispute resolution can be adversarial or inquisitorial. Adversarial systems rely on the parties to a dispute to
gather and present evidence and legal arguments, whereas inquisitorial systems grant the judge wide latitude
in defining the scope of a dispute and the evidence relevant to resolving it.
Black’s Law Dictionary defines the adversarial system as a procedural system involving active and unhin-
dered parties contesting with each other to put forth a case before an independent decision-maker. This is in
contrast to the inquisitorial system, a procedural system used in civil law, where the judge conducts the trial,
determines what questions to ask, and defines the scope and the extent of the inquiry. The main differences are
in procedures followed by the litigants and judges, method of evidence gathering, and the role of lawyers and
judges.
In a typical inquisitorial proceeding, the judge determines the type of evidence sought, the order in which
evidence is gathered, and evaluates the content of the gathered evidence. The judge has extensive functions and
powers, through which he/she will ascertain facts, identify the relevant evidence, and evaluate the evidence
presented by the parties. Further, judges may conduct their own investigation, and examine witnesses, etc. This
direct involvement of the judge in the gathering of evidence often avoids the problem of reconciling completely
contrary positions resulting from independent partisan searches. The judges are not bound by many formal
rules in the evaluation of the facts, but are to decide on the basis of their conviction.
By contrast, in a typical adversarial system, the case develops based on evidence gathered by the individual
parties to the dispute. The process develops in the presence of a passive judge who reaches a decision on
the sole basis of the evidence and arguments presented by the litigants. An adversarial process leads to two
clashing positions. The judge within this setting is supposed to be neutral and needs to enforce procedural rules
constraining litigants, where the judge is also bound by related procedural rules.
In an adversarial system, the judge must rely on the reports of interested parties, rather than gather evidence
for on his/her own initiative. Much of this is done individually by the parties, and not by the judge. In any
adversarial system, the plaintiffs must determine whether or not to file suit. Once the suit is filed, the plaintiff
and defendant must decide whether they want to settle out of court, or proceed with a trial. The plaintiff will
sue only if the expected cost of the suit is less than the expected benefit, which may include settling out of
court or the damages won from the trial. Adversarial trials rely on lawyers to gather, select, present their own
evidence as well as probe and scrutinize the evidence of the adversary. The inquisitorial system, in contrast, is
more akin to a fact-finding mission, where the search ends if the judge is satisfied with the evidence.

3 Competition as a Discovery Procedure for Rules

A critical issue in the adversarial versus inquisitorial debate is whether the “truth” or the “correct valuation”
can be reached independent of the system within which the answer is sought.
On this question, Hayek’s insights are extremely useful. Hayek extended his analysis of spontaneous or-
ders in the market to legal orders and especially to the common law system (which is mainly an adversarial
system). Hayek wrote that the critical problem that any economic system must solve is to mobilize and use
knowledge that “never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete
and frequently contradictory knowledge which all the separate individuals possess” (Hayek 1945, p. 519). In
this context, it is important to understand Hayek’s view of competition as a “discovery process” (Hayek 1968).
Hayek wrote, “it is on the ground that we do not know in advance the facts that determine the actions of
competitors. In sports or in examinations, no less than in the award of government contracts or for prizes for
poetry, it would clearly be pointless to arrange for competition if we were certain beforehand who would do
best” (Hayek 1967, 179).
Within any dispute resolution in a legal system, there are mainly two types of information or knowledge
that need to be discovered. The first is the discovery of rules and the second is the discovery of facts. This is
merely an analytical distinction, because within the common law system, depending on the facts of any case,
judges are automatically discovering existing rules as well as applying them to new situations.
On the first question of discovery of rules, Hayek argued that law has never been “invented” but need to
be discovered (Hayek 1973). He went on to state that rules emerge from the judicial process; i. e. that rules are
“discovered either in the sense that they merely articulate already observed practices or in the sense that they
are found to be required complements to the already established rules if the order which rests on them is to
operate smoothly and efficiently. They would never have been discovered if the existence of a spontaneous order
of actions had not set the judges their particular task, and they are therefore rightly considered as something

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existing independently of a particular human will; while the rules of organization aiming at particular results
will be free inventions of designing mind of the organizer” (Hayek 1973, 123).
The discovery of rules within the common law system took place, initially, in a system of competitive courts,
without rules such as stare decisis (see Zywicki 2002). Further, unlike the inquisitorial system, which had a “rule
book” or a centralized law making, adversarial systems engaged in decentralized law making. Judges adapted
existing rules, or marginally changed the application of existing rules, to apply to a specific legal dispute. The
rules cannot be discovered outside of the common law system at large – like writing and new and interesting
rules for fictitious situation. Hayek describes a judge articulating or discovering pre-existing rules in society in
much the same way that he describes market participants discovering knowledge about the economy (1973).
Using this Hayekian insight, Zywicki and Sanders (2007) and Stringham and Zywicki (2011) have compared
a common law judge discovering rules to an entrepreneur discovering prices. “Viewed in isolation, it may
appear that when the gas station owner posts the price for a gallon of gas, he is “making” or “creating” the
price of gas. But in reality, of course, neither the gas station owner nor any other person creates the price of
gas. Instead, the price of gas at a particular gas station at a given time reflects the decentralized interactions of
billions of people around the world. …. Although it appears that a judge “makes” the law, Hayek argued that
in reality the common law judge is simply doing what the gas station owner does: articulating or announcing
the outcomes of an underlying spontaneous order process, not actually “making” the law.” (Stringham and
Zywicki 2011, p. 294).
In contrast, in an inquisitorial system, the rule making is centralized. While the judges have extensive powers
on procedural issues like evidence gathering, etc., they have little ability to “discover” or make law. Their role
is mainly one of applying the law that has been handed down as a set of codified instructions by legislators to
the circumstances of a case.
However, there is an additional type of discovery in legal disputes, which is regarding fact finding. The next
section is compares the adversarial and inquisitorial system with respect to their ability to accurately find facts.

4 Competition as a Discovery Procedure for Facts

Economists have spent much time analyzing the incentives created by the two systems. This literature extends
to the merits of the adversarial and inquisitorial system on grounds of efficiency. This analysis is about specific
procedural rules regarding evidence (Froeb and Kobayashi 2001; Posner 2014; Tullock 2005a) and also about
the effect of these rules and systems on economic growth (LaPorta et al. 1996). In this section, I mainly focus
the discovery of facts and error minimization within the two systems.
While describing its tendency to be efficient, the adversarial process has been compared to the competitive
process of the marketplace (Posner 2014). Posner argues that in an adversarial system all the stakeholders –
litigants, lawyers, and judges – face appropriate incentives. In contrast, the inquisitorial system takes away a
lot of the control of the process from litigants and lawyers, and dilutes the incentives of various stakeholders.
The most well-known critique of the adversarial system is by Tullock (2005b), where he argues that the com-
mon law system, characterized by the adversarial system, is sub-optimal. He models the behavior of competing
litigants in the adversary system as rent seeking parties seeking a favorable allocation of rents from the deci-
sion of the judge. There is little reason to believe, he argues, that this clash of self-interested parties under these
institutional constraints will be likely to result in socially beneficial results, as opposed to rent dissipation with
random results. Tullock argues that the adversarial system is both less accurate and more expensive than the
inquisitorial model.
The two systems set up different sets of incentives for the parties, lawyers and judges. Posner (2014) argues
that the adversarial system is preferable because it allows the parties who bear the costs and benefits of the
litigation to shape the litigation. The victim of the unlawful conduct (through his lawyer), investigates the cir-
cumstances, organizes the information obtained by the investigation, determines whether he should use the
legal system for appropriate allocation, feeds the information gathered in the appropriate form to the legal
system, checks the accuracy of the information provided by the defendant, attempts to change the rules if nec-
essary, and ensures the collection of the final judgment. For all these actions, the budget for evidence gathering
is endogenous to the case and is established by the parties. In short, the party internalizes the costs and ben-
efits of each action. In addition to the benefits of investing resources proportional to the size – and hopefully,
importance – of a dispute, placing these costs on the parties minimizes costs to the judiciary. As a result, the
costs of discovery (or investigation) are neither fully determined nor borne by the state.
Alternatively, the inquisitorial method shifts power to judges, and thus promotes an expansion of the public
sector as well. Posner predicts that police, public prosecutors and attorneys, and other bureaucrats operating the
legal system “would be less highly motivated than a private plaintiff, since their economic self interest would

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be affected only indirectly by the outcomes of particular cases.” Public officials do not internalize both the costs
and benefits arising from a suit. The budget for evidence gathering is set exogenously and somewhat arbitrarily
by the taxpayers, in terms of money, time, and support staff available for investigation. This divergence between
private and social costs may lead judges in an inquisitorial system to exert suboptimal levels of effort (Posner
2014, pp. 708–712).
An important distinction between the adversarial and inquisitorial systems is with respect to the search for
evidence. A decision in favor of one party over another is based on evidence in the adversarial system, and
therefore, within an adversarial system, each party has an incentive to undertake extensive search. Because the
incentives are so strongly in favor of searching under an adversarial system, search costs are optimal for each
private party, but may not be optimal socially (Tullock 2005b). This is because there are two or more searches
undertaken, often to extract the same information, therefore spending valuable resources. However, under the
inquisitorial system, the judge only undertakes a single search for evidence. This avoids duplication that is
present in the adversarial system, and also avoids adding misleading information that is used to throw off the
judge. Instead, in the inquisitorial system, resources are spent towards pursuing truth or accurate information,
instead of obfuscation and concealment. Under this system, unlike the litigants in the adversarial system, the
judge has no reason to pursue lines of argument that conceal or obfuscate or mislead. As a result, the judge in
an inquisitorial system will converge on the correct set of facts, or the truth, more easily, and at lower cost than
the participants under the adversarial system.
There is a crucial insight in Hayek’s argument that can be used to compare the adversarial and inquisitorial
systems. Hayek argues that competition is “a procedure for discovering facts which, if the procedure did not
exist, would remain unknown or at least would not be used” (Hayek 1968, p. 9). Without the procedure or the
system within which the dispute resolution takes place, the result, in this case the accuracy of the litigation
outcomes, may not exist.
The advantage of the adversarial system is not just that more extensive searches are conducted, but that
such extensive searches in an adversarial system lend themselves to error minimization (Zywicki 2008). There
are two types of errors that can affect the accuracy of a given dispute-resolution system; Type I error or false
positives, and Type II errors or false negatives. Total error cost is the sum of all false positives and false negatives
produced by the system. Applied to adjudication, a false positive occurs when the judge erroneously imposes
liability; a false negative occurs when the judge erroneously fails to impose liability.
Applied to error minimization, the defendant’s lawyers have a greater incentive to discover faults in the
evidence of the plaintiff’s lawyers to reduce their liability, and in the process minimize Type I errors, or a false
positive which occur when liability is erroneously imposed by the judge. Similarly, the lawyers of the plaintiff have
a greater incentive to provide more evidence of the harm, and in the process minimize Type II errors, or false
negatives, which occur when the judge erroneously fails to impose liability. Through this competitive system of
evidence gathering and presentation, both Type I and Type II errors are minimized.
The competitive character of adversarial litigation gives the individuals searching for evidence (essentially
the lawyers representing the parties) a greater incentive to search hard for relevant information. Additionally,
the adversarial system also gives a greater incentive to lawyers on each side to find faults in the evidence of
the other side. Therefore, the incentives are much greater to find good evidence under an adversarial litigation
system than under a system where the search is led by a single judge or bureaucrat (Dewatripoint and Tirole
1999).
The inquisitorial judge faces the incentives of the bureaucrat while the lawyers working for fees act like
entrepreneurs. Lawyers often provide services based on success fees, where lawyers receive a payment only in
the case of a successful verdict (usually in the form of a percentage of the damages awarded/saved). This results
in the incentives of the lawyers and plaintiffs being aligned. Even if lawyers are not working for contingent fees,
their reputation is tied to the outcome of the dispute i. e. even if they do not receive a direct financial benefit in
the current case, their future benefits are tied to it. This is not the case for judges.
Compared to the incentives within the market, there is no signal of profit and loss in the world of a bureau-
crat, and his criterion of success and failure is the ability to follow the rules and regulations that have been set
by his superiors. A bureaucrat’s reward is based on his ability to follow arbitrary procedures and not profits
and losses. On the other hand, an entrepreneur is bound by profits and losses determined by the demand for
his services. This has a very important bearing on error within the system.
Inquisitorial judges/bureaucrats will tend to stop searching for evidence once they believe that they have all of
the information that they need to decide the case. The adversarial system is particularly effective at uncovering
private information or information that is difficult to discover, relative to the inquisitorial system. Experimental
research confirms that lawyers in an adversarial system may work harder and will produce more information
than judges in an inquisitorial system (Lind, Thibaut, and Walker 1973).

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There is a secondary issue concerning the type of information that needs to be discovered, the degree of in-
formation asymmetry between the parties, and the degree to which one party has some sense of the information
possessed by the other party.
If the interested parties’ interests are sufficiently opposed, then competition can reduce or even eliminate
the judge’s need for prior knowledge about the relevant variables or the strategic sophistication in the judge’s
knowledge of a particular issue (Milgrom and Roberts 1986). The main point is if the two adversaries have some
information on the content of the information of the other party, even in the case of asymmetric information,
adversarial systems may perform better. This is true even in the event that the judge does not have specialized
knowledge. Experimental literature shows that when the information held by the wrongful party is private
and difficult to uncover, the inquisitorial system performs better. However, on the other hand when the rightful
party has a clue to the content of the discrediting information by the wrongful party, then the adversarial system
performs better (Block et al. 2000). Rajagopalan (2014) argues that in cases of mass tort, where the wrongful
party is easily identifiable, but the victims and their extent of damage needs to be discerned, the inquisitorial
system fares poorly.
Therefore, for fact finding, or discovering the information that each side possesses, the double-search sys-
tem, coupled with the incentives of the lawyers in the adversarial system, is more likely to reduce error.

5 Valuation in Adversarial and Inquisitorial Systems

Tullock models the dispute resolution system as follows. Every case has two parties – “Right Party” and “Wrong
Party” and in an ideal system, “Right Party” should win. Therefore, the choice is binary. This is an accurate
portrayal of most criminal dispute resolution, where there is a party that is “Right Party” and another that
is “Wrong Party” and the appropriate system will punish the “Wrong Party.” The criminal codes and estab-
lished practices provide a clear system of penalties for the “Wrong Party” and the judge mainly ensures that
procedures are followed, but has little discretion over the final decision or the penalty imposed.
However, often, questions before the court are not only to determine the “Right” and the “Wrong”. Further,
the choice may not be binary. Often, in civil suits, the “Right” And “Wrong” parties may present the question
of liability quite easily, but the primary difficulty is one of valuation of the relief that must be provided – which
is no easy task.
Valuation litigation is complicated and the results seem arbitrary; and it has been compared to lotteries
(Bowers 1996). Further, there is no consistent legal theory or method of valuation (Bonbright 1927, 1937) and
the only pattern in legal valuation is that it is extremely inconsistent, and largely driven by the whims of the
court in question. Many courts attempt to use “market value” as the goal or standard for valuation. However,
there is no market value outside of the market, thereby making it an impossible task.
In several cases that involve valuation of damages; typically only a part of a firm or a business transaction
needs to be valued through the courts. This makes the valuation by courts less problematic. For instance, if
due to the defendant’s negligence, the defendant’s tree fell on the plaintiff’s car and damaged it, the court will
determine that the defendant owes plaintiff damages. In this case, the court may simply require the plaintiff
to produce evidence of the extent of the damage. The plaintiff, in these circumstances, can provide multiple
“quotes” provided by car repair vendors, or provide a receipt for the amount already paid to get the car restored.
Both these types of evidence are easily acquired in the market place, with prices or valuations resulting from a
market process.
In these cases, the judge must simply determine if the evidence of the extent of damage is valid. And as dis-
cussed in the previous section, the judge is aided in the adversarial process by competition in evidence produc-
tion. The judge need not enquire into the business of car repair and restoration, and determine the appropriate
valuation for a damaged roof etc. In other words, the judge has partial access to the information/knowledge
generated in the market. Even in this case, the judicial system is not the same as the market system. But the
judicial system can rely on information that can be, and is, generated through the market process.
This type of judicial reliance on market prices for determining valuation is problematic in two situations.
The first is cases where there is no market for the good/service being valued. And the second is cases where
entire businesses are valued only within the judicial system, thereby completely eliminating the market process.
For the first type of situation, an appropriate example to consider is cases involving patent infringement.
When a suit for injunction is brought against a party for patent infringement, there are two types of information
that need to be discovered. The first is the question of “Right” and “Wrong” party. For this the judge must
determine if: (1) the party claiming the patent in fact holds the said patent; (2) the scope of the patent; and (3)
whether the other party has in fact infringed on this patent. Once this is determined, there is a question of the
type of relief that is provided by the court. Relief may include damages or injunctive relief. If the court provides

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injunctive relief, then it is simply assigning which party is “Right” and “Wrong” and that the wrongdoing must
cease. Should the “Wrong” party wish to continue its use of that patent; the parties have to engage in bargaining
outside of the judicial system to arrive at a mutually acceptable valuation of the patent. In the United States,
the availability of injunctive relief has somewhat decreased in the last decade since the opinion in EBay Inc.,
v. MercExchange. 1 Now, where the court assigns damages instead of injunctive relief, it must determine the
dollar value of damages for patent infringement. The requisite standard is to come close to market value of
such infringement. Given the nature of patents, where an innovation is unlike any other and without an easily
discernable market value, it is extremely difficult, if not impossible, to come up with a market value for the
infringement within the judicial process and outside of the market process.
This brings us to the even more difficult second case of valuing entire businesses. Entire businesses are
valued within courts in cases pertaining to insolvency, which takes place through Chapter 11 of the Bankruptcy
Code in the United States .
The purpose of bankruptcy reorganization in Chapter 11 valuations is to preserve the going-concern value
of a firm by keeping its assets intact, instead of liquidating the firm and redeploying those assets elsewhere in
the economy. 2
To accomplish this, the judge must decide whether a firm is merely financially distressed or whether it is
economically failed. An economically failed firm is worth more dead than alive: the opportunity cost of its
assets is higher than their current deployment, so its constituent assets would be worth more if redeployed
elsewhere in the economy. A financially distressed firm, on the other hand, is worth more alive than dead: its
constituent assets are in their highest-valued use, but it is unable to meet its financial obligations.
A bankruptcy judge faces two challenges of valuation. First, the judge needs to determine whether the firm
is only financially distressed or also economically failed—that is, whether the firm should be liquidated (also
known as Chapter 7 bankruptcies), or preserved and reorganized (Chapter 11 bankruptcies). Second, the judge
needs to value the firm in order to pay the creditors in lieu of their debt.
Bankruptcy judges can no more outperform the market than a Soviet-style central planner could outperform
markets; this is an impossible standard. Once the valuation is to be performed within the judicial system, it
is impossible to exactly calculate market value. Absent the market process where individual entrepreneurs,
guided by profit and loss, bid competitively to arrive at a market price, judicial valuation can only be an estimate
of market value, which is unknown (2016).
Given that the judge is performing the valuation task outside of the market process, in a sort of institutional
vacuum; both the adversarial and inquisitorial process are plagued with problems.
Though the parties within litigation are adversaries, or competing, they are not competing within the market
context. Typically, one party will ask for a high valuation, to its own benefit; the other for a low one, to its own
benefit; and each will offer evidence in support such a valuation. The judge can agree with either valuation, or
determine a third valuation. This is a discretionary exercise that can result in extremely inaccurate valuations,
depending on the quality of the evidence placed before the judge, and the judge’s personal preferences, beliefs,
and biases.
Lawyers have an incentive to get the maximum possible financial benefit for their clients. There are two
reasons for this. As stated in Section 4, sometimes, the lawyer-fee arrangement is on a contingent basis, where
the incentives of the lawyers and plaintiffs are aligned. Even in the absence of success fee arrangements, the
lawyers’ long term reputation and ability to charge high fees depends on their ability to gain a favorable verdict
for their client.
While the same set of incentives can minimize error while determining the rules and enforcing the rule
to determine the liable party, there are problems when it is applied to valuation. This process can quickly
degenerate into a rent seeking and extraction exercise, where each party spends resources to support a valuation
to its benefit. These resources are wasteful, because it is not spent towards creating value for the business, simply
to engage in getting a larger share of the existing value. Tullock (2005b)has analyzed this process in detail, and
it is his main critique of the adversarial system. The rent seeking specifically within Chapter 11 bankruptcy
cases has been described by Stearns and Zywicki (2009), pp. 165–67; and Rajagopalan and Zywicki (2016).
In this context, it becomes important to once again examine the incentives within the system that would en-
able the judge to arrive at the correct valuation. The judge faces two problems related to non-market incentives.
First, he is not personally vested in the success or the failure of an insolvent firm and therefore is less likely
to make decisions like an entrepreneur. The second problem is that unlike an entrepreneur, a judge does not
face the real costs and benefits. And in the case of business valuations under Chater 11, both adversarial and
inquisitorial judges will face this problem.
If we assume that the judge is equipped with the relevant knowledge required to calculate the accurate
valuation, then there is really no problem left to solve. The judge can simply arrive at the dollar amount and
enforce the decision by making the “Wrong Party” pay the “Right Party.” If this is the case, it is clear that the
inquisitorial system would be more efficient. It is important to emphasize that if the judge possesses all the

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relevant information about individuals’ true preferences, costs, benefits, and the choice, then the judge could
potentially enforce the decision that accurately values the firm and awards the benefits to the "Right" party.
However, this information does not exist completely with the judge. And lacking such information, there is no
certainty that the valuation is correct, or efficient. The relevant information is dispersed, and without access
to such information, there is no method for the judge to calculate costs and benefits that would enable him to
fulfill the market valuation test.
In this context it is important to understand Hayek’s view of competition as a “discovery process” (Hayek
1968). Applied to judicial valuation, one cannot simply assume that a judge, any judge, will arrive at the ap-
propriate valuation. The information required to arrive at the correct judicial valuation is itself subject to the
procedure used within the judicial system. In the absence of the access to a competitive market process, the
judicial process has no method of arriving at similar results.
This leads one to believe that inquisitorial systems may be the answer to avoid the rent seeking exercise
that judicial valuation encourages within the adversarial system. However, inquisitorial judges are acting in
an institutional vacuum quite similar to the central planner. Since the system does not require the parties to
produce information, verify information of the other party, etc., the judge is left to his own devices in the search.
The situation may be even worse for an inquisitorial judge, who does not even have competing claims to assess,
and must come up with his own valuation entirely relying on a single search. Furthermore, he has no incentives
to get the valuation right. As mentioned in the previous section, a judge’s incentives are similar to a bureaucrat,
and his incentives are not linked to the accuracy of the valuation, or the success or failure of the firm.
Perhaps the best alternative to Chapter 11 reorganization, that appears to be most compatible with the in-
sights of Hayek, is the proposal by Douglas Baird to have a going concern auction in the event of bankruptcy.
This would simultaneously preserve the firm’s going-concern value while also enabling entrepreneurs (instead
of judges) to determine whether the firm should be reorganized in whole, reorganized in part, or otherwise or-
ganized (Baird 1986). If the firm failed because of bad luck instead of bad management, but the firm still has
inherent value as an on-going concern, then the bidders for the firm in the auction would recognize that. If there
are no bidders for the firm as an on-going concern, then the firm should be liquidated. This would convert the
assets of the firm to cash that could be distributed to creditors with minimal delay and administrative expense.
Moreover, a speedy auction of the firm as a going concern would reduce administrative and rent-seeking costs,
while enabling capital markets to harness the knowledge of private parties to determine the value of the com-
pany.
There are two advantages to using a market process instead of restructuring within bankruptcy courts:
information and incentives. First, through an auction, market participants have access to dispersed information
on the subjective values and tradeoffs faced by all other market participants. No individual is required to make
decisions for the entire market; he must only make decisions for himself, given market prices, which are inputs
for his subjective valuation of the resource. Second, the incentives of the creditors, debtors, and owners of the
firm are aligned. An entrepreneur is bound by the profits and losses that follow from his decisions. This is
essentially the policy implication of the inability of judges to value firms undergoing Chapter 11 bankruptcies.
Instead of valuing the firm, courts must simply ensure that procedures are followed to facilitate a going-concern
auction.
Another suggestion, which takes into account information and incentive problems of Chapter 11, is the au-
tomatic conversion of bondholders into equity holders with the decision-making powers of a residual claimant
once a firm becomes insolvent (Adler 1993). This reduces the problems of judicial valuation and long delays in
bankruptcy courts.
Hayek’s insights about the price system assimilating decentralized information cannot be applied to any
court proceeding. There is no market-type mechanism within court proceedings. And absent such a mecha-
nism, there can be no mimicking the informational advantages of the market (Rajagopalan and Zywicki 2016).
Therefore, the court must rely more on the market mechanism, instead of attempting to replicate it – such
replication is impossible.
Hayek, while supporting common law, propounded the value of competition aiding discovery within the
legal system. But he only extends the discussion to the discovery of rules. According to Hayek, the judge can “do
no more”; he also states and that the judge has “no power to do more” than to find and express already existing
rules (1973). Therefore, the types of valuation problems seen in cases pertaining to patents and to reorganization
of firms within Chapter 11, would be expressly outside the purview of Hayek’s analysis. Hayek was clear on
the limitations of the judicial system in its comparison to the market system.

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6 Conclusion
The chief perceived virtue of an adversarial system is that it is a competitive system of information gathering,
whereas an inquisitorial system is centralized in its information gathering. On the other hand, the chief merit of
the inquisitorial system is that it reduces the rent-seeking behavior witnessed in certain adversarial litigation;
where such behavior will hinder the process of gathering accurate information.
There are three different types of information that need to be discovered, relevant to the arguments in this
paper. The first is the discovery of rules. The second is the discovery of facts pertinent to a particular case, which
help determine the liable party. And the third is the discovery of valuation. All three are compared in Table 1.

Table 1: Comparison of adversarial and inquisitorial systems

Adversarial system Inquisitorial system
Rule formation Aids discovery of rules N/A
Fact finding More likely to minimize Type I and Less likely to minimize Type I and
Type II errors Type II errors
Valuation Knowledge problem Knowledge problem

There are three types of informaation to be discovered: the discovery of rules, of facts, and of valuation. The
judicial system lends itself well to the discovery or rules and the discovery of facts. In fact, the judcial system, is
perhaps the best suited for discovering rules and facts, and its systems and procedures facilitate such discovery.
Within this context, adversarial systems are better suited for discovery than inquisitorial systems.
The adversarial system is really a competitive system of discovering rules and facts. Competition among
courts and competition between adversaries within a particular court, lends itself well to the discovery of rules.
The adversarial system, because of competition between litigants, also minimizes Type I and Type II errors and
lends itself better to the discovery of facts. Therefore, it may perform better than an inquisitorial system for the
first two types of information gathering.
However, on the question of judicial valuation of businesses, both the adversarial and the inquisitorial judge
will fail at the impossible task. Both types of judges are performing the task of valuation outside of the market
process, and are likely to have the same problems as that of a central planner. The normative implication is
that courts must engage only in discovering rules, and applying rules, but must not provide relief by actively
engaging in business valuation. And instead rely on the market using mechanisms like Baird’s going-concern
auction (1986).

Acknowledgments
Author would like to thank the participants of the symposium on Austrian perspectives on business valuation
at Texas Tech University, and Alex Salter for comments and suggestions.

Notes
1
L.L.C., 547 U.S. 388 (2006).
2
The presence of a going-concern surplus rests on the assumption that the current deployment of human, physical, and financial capital
is more valuable than the opportunity cost of each in its next-best usage. But because of collective-action problems and strategic behavior
by uncoordinated individual creditors, it is deemed necessary to essentially force them to cooperate for their own good. Left to their own
devices, rational, uncoordinated creditors of an insolvent debtor would race to grab the debtor’s assets to satisfy their individual claims,
thereby destroying the potential going-concern surplus.

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