Legal departments face both Type I and Type II errors

When lawyers make judgments under uncertainty, they can make two general types of errors — false positives (Type I errors) and false negatives (Type II errors). A false positive claims to find something that isn’t there, such as deliberate manipulation of option pricing when actually only sloppiness was at fault. A false negative fails to find something that is there: no discrimination in a termination when in fact there was blatant racism.

No decision maker can simultaneously minimize both types of errors because decreasing the likelihood of one necessarily increases the likelihood of the other. Furthermore, the costs of these two types of errors are rarely symmetrical. So, in theory, law departments should build systems and train lawyers so that they are biased toward making the less costly errors. This bias might increase overall error rates, but it minimizes overall cost.

Setting aside the technical talk, this distinction suggests that inside lawyers are better off making Type I errors. It is better for one’s career to spot legal issues even if they are not genuine or serious (a Type I error) rather than let a legal blunder slip by (a Type II error). Now we can better understand the law department’s tendency toward risk aversion and conservativism.

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