A Discussion of Wasteful Plaintiff-side Litigation and Proposal for Reform
The United States is an extremely litigious society. Apart from the U.S. Chamber of Commerce’s Institute for Legal Reform, there’s sadly actually not that much empirical research on just how much this screws up the economy. But the Swiss insurance firm Swiss Re, which doesn’t have as much of a clear bias, describes this as follows:
Litigation costs are rising and are now the key driver of liability claims…we observe continuous increases in aggressive litigation practices…Increased claims costs not only create a riskier and more costly environment for businesses but are also a concern for insurers. Over the past five years, US commercial casualty insurance losses grew at an average annual rate of 11% to USD 143 billion in 2023 [my note: many times more than the rate of GDP growth]
An insurer’s objective is merely to arrive at a correct actuarial understanding of firms’ litigation risks, not to publicly advocate for reducing them. We can therefore take this account somewhat seriously as an accurate summation of just how unusually expensive it is for American businesses to face such massive liability claims.
Swiss Re believes–and I think this is simple common sense–that there are unique elements of the American legal system that explain why this is happening:
It is driven by a range of socioeconomic, legislative and litigation trends such as an increased tendency to settle compensation claims in court and is most pronounced in the US, where tort law is based on precedent and court cases are adjudicated by juries. In addition, third-party litigation funding (TPLF) – the process by which litigants and law firms can fund their litigation with the help of a third-party investor – facilitates access to trial, and the legal system allows for the payment of large sums of compensation, particularly for bodily injury claims. In 2023 alone, there were 27 court cases awarding compensation of more than USD 100 million each.
What Swiss Re is alluding to here is the rise and increased scale of a well-funded plaintiff-side litigation industry. Superstar plaintiff’s lawyers frequently earn 10-figure payouts upon successful jury verdicts in their trials. Some plaintiff’s attorneys even earn billions from mere settlements. One can assume that the litigation finance firms that invest in this space also earn large returns from these outcomes.
These large payouts are caused by a fee arrangement known as contingency. When a lawyer accepts a case “on contingency,” the clients are charged nothing, but if the case results in a settlement or damages verdict, then the lawyer receives a portion of the payout. Since many law firms which represent plaintiffs are financed primarily or exclusively by contingency deals, they often enter into arrangements with litigation financiers who fund the firm’s operations in exchange for a portion of their contigency winnings.
On first inspection, one might think there is nothing pernicious about contigency arrangements. Investors–whether attorneys (who are effectively acting as investors when they choose to accept fees this way) or litigation finance firms–seem incentivized to accept good cases and reject bad ones because their compensation depends on the success of the cases they undertake. Contingency also has the attractive property of aligning the economics of the client and the lawyer (our law and econ friends would refer to this reducing agency costs) so that the lawyer is incentivized to win through direct financial exposure to the benefits of victory rather than mere reputational benefits.
An Illustration from Corporate Law
Contingency resembles the concept of equity investment. Equity investors in a firm receive a share of the upside if the firm performs well and lose their investment if the firm fails. We can think of this as holding a [call option] (https://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/opt.html) on the firm’s cashflows. Below a certain level of return, the investor has a capped downside equal to the cost of their investment; above that level, the investor’s upside is uncapped. Since this call-option structure of equity investment constitutes a fundamental and extremely common way that firms raise capital, what could be wrong with legal contingency investors doing the same?
Though equity investor-ownership is ubiquitous in the American economy, there is actually a big problem with this return structure. Notice the portion of the x axis before the strike price–the point at which the investor’s return begins to slope upwards. Continuing with the analogy of equity as a call option, this represents the set of cashflow levels at which the firm earns some income but not enough for the residual claimants to enjoy any.
This possibility exists because when firms are financed by a combination of equity and debt, as most are. In plain English, this means that firms fund themselves in part by offering stock and in part by borrowing money which requires them to pay back fixed amounts. Since bankruptcy law requires that debt is always (ok, almost always) repaid before equity investors receive anything, it is possible for the firm to earn positive cashflows without having stockholders receive a cent. That would be because there is only enough cash to pay or partially pay the firm’s debt obligations.
If a firm is earning enough to pay its creditors but does not have enough left over to give its equity owners any return, then the fact that equity owners typically manage the firm becomes a problem. In the Delaware Chancery case of Credit Lyonnais Bank Nederland v. Pathe Comm , the famous Chancellor Allen remarks in a footnote:
The possibility of insolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior and creating complexities for directors…[correct results] will not be reached by a director who thinks he owes duties directly to shareholders only.
What Chancellor Allen is getting at here is that in the situation described before the quote, equity owner-managers do not have the proper incentives for managing the firm. Insofar as they are self-interested, they are incentivized to either do nothing or take excessive risk because they receive no benefits from the firm increasing its cashflows as long as they remain below the level of the firm’s total debt obligations. They don’t care about what happens to creditors because they are not going to get paid anyways, so they have no reason to exert efforts to maximize the firm’s earnings.
The bankruptcy code explicitly addresses this problem by creating new duties for the managers of a corporation when the corporation is in a state of insolvency. That means that when the firm is not earning enough to fully repay its debt, the bankruptcy code creates a legal requirement for managers to consider the best interests of the creditors in addition to themselves. Outside of insolvency, equity owners do not need such requirements because they are already motivated by their return structure to act in the best interests of creditors. But once they lose this incentive, the law sees the need to explicitly demand their consideration of fixed claimants.
The Lesson for Plaintiff’s Litigation
As we saw in the above discussion of insolvency, equity owners can have bad incentives (agency costs) that require affirmative correction by law. These agency costs arise from the call-option structure of equity returns in which the investors are infinitely sensitive to cashflows above the firm’s debt burden (uncapped upside) but indifferent to nonzero cashflow levels below that line (capped downside).
I hope the reader can already see that contingency arrangements have the exact same call-option return structure. The point I hope to make is that this return structure creates analogous bad incentives for lawyers taking cases on contingency or litigation finance firms taking stakes in these deals.
The problem is simple: contigency causes lawyer-investors to ignore the costs of litigating claims when the payout of those claims is below the threshold at which they get paid, just as ordinary equity investors are incentivized to ignore managing a firm when its cashflows are nonzero but below the firm’s debt burden.
There is an obvious difficulty in this comparison: in most contigency deals, lawyers receive a pro rata share of every positive settlement, so there does not appear to be any situation in which there is not enough prospective return for the contingent claimant to receive anything. But there is in fact just such a situation when one considers the total costs of the litigation, not just the costs to the financiers of plaintiffs’ claims.
The two big costs that fall into this category are the legal fees paid by the defendent and the burden placed on the court system when parties engage in extensive litigation. We can think of the total benefits of plaintiff-side litigation as: payouts distributed to deserving plaintiffs minus contigency share distributed to plaintiffs’ lawyers minus the previously mentioned two cost categories associated with the litigation process.
These costs behave like the debt portion of a firm’s capital structure. They represent another party’s funding for an enterprise that–if successful–will create enough payout to both recoup the expenditure (by creating benefits for the deserving plaintiff in excess of the litigation costs1) and generate excess cashflows to pay the contigent claimants (plaintiff’s lawyers and investors in the claim).
If you buy this as a basic model for thinking about plaintiffs’ claims (I go into more detail here), then we can see how there are situations in which contigency investors face bad incentives. If a case has a slightly positive expected value for contingency investors but creates much larger costs for courts and defendants, then the contigency investors are incentivized to pursue a claim that has a negative total value.2 In the same way that ordinary equity investors are indifferent to nonzero cashflows under the firm’s debt obligations, legal contingency investors are indifferent to avoiding litigation with an expected value lower than their cost of capital.
This isn’t just a hypothetical and unrealistic possibility. A great example would be securities derivative claims. There is an entire industry of securities plaintiffs’ lawyers who have a lot of experience bringing claims and can very quickly and easily file one. If they believe there is even a small chance of one of these claims being succesful and getting a big payout, then they won’t mind inexpensively spamming claims. Even if these claims create total costs far in excess of their expected payout, the contingency investor doesn’t care because they are not financially exposed to these costs, just as equity investors are not exposed to earning differences below the firm’s debt burden.
Professional ethics counterargument to my story
There is a big problem someone could have with the story I’ve just told: the adversarial role of the American lawyer. Who cares if plaintiff’s lawyers aren’t incentivized to care about the total costs of their claims? Isn’t their role just to zealously represent the interests of their client, with the legal system taking care of deciding who is right or wrong?
The response to this is that it’s absolutely right that lawyers need only care about the interests of their clients. But the problem with contigency is that conflates the role of lawyer and investor. The fundamental justification for employing profit-seeking investment is that it is an efficient way of allocating resources. But for this to be true requires that investors are motivated to puruse value-creative activities because they share in the upsides and downsides of the investment.
If a lawyer wants to merely represent clients, then they need not incur any duty (beyond professional ethics) to care about whether their representation creates or substracts value from society. But if a lawyer wants to also be an investor, then that role only makes sense if their incentives are properly aligned with value creation. That means it becomes a problem if they are not properly incentivized to create economic value. The rewards of investorship only make sense if those incentives are in place.
Constructive Policy Solutions
I don’t want to just complain about this problem, so I’m going to propose a policy solution that can remedy this misalignment of incentives. The idea is to expose contingency investors to the full spectrum of the upsides and downsides of their investment, just as a regular investor would be in a 100% equity-financed firm without insolvent-shareholder agency costs.
The way to create this exposure would be to replicate the contingency investor’s upside exposure in the downside case. The mechanism is: whatever share of the winnings a plaintiff’s lawyer stands to win if the case is victorious, they should have to pay the equivalent share of the defendant’s cost if the claim loses. This way the contingency investor is, as all investors should ideally be, exposed to all changes in the payout levels of the investment they undertake.
The American legal system is generally against arrangements in which the loser of a case is responsible for legal fees. Whatever justifications for this policy exist, they are much weaker in a scenario where a lawyer is acting as an investor as well as a mere advocate. If a lawyer gets to enjoy the economic privileges of being an investor, they must also face the risks. It’s precisely this lack of exposure to risk that creates the excess of litigation that can be surmised from the massive factor by which plaintiffs’ awards are growing faster than GDP.
Another fear someone may have is that defendents will report exorbitant legal bills to artificially impose costs on unsuccesful claims against them. The answer to this is to simply allow courts to review defendents’ reported costs in victories in the same way they currently review contingency fees for reasonability.
One might then say to all this: big corporations are very powerful and the kinds of individual consumers who file claims against them are relatively helpless in comparison. So why care if big corporations are paying a bit more costs than is in theory optimal–aren’t they going to be fine anyways?
The answer to this is that unless one assumes absurd degrees of elasticity in the markets with respect to which litigation is taking place, then at least some of the improper costs imposed by litigation will be passed onto consumers. Consumers as a whole ought not to subsidize the private jets and vacation homes of plaintiffs’ lawyers filing silly cases and causing needless litigation. And since the courts are funded by taxpayers, the improperiety of plaintiff-side lawyers’ inventives is even more obvious there. But the best argument is simply that it seems much better for the poor to lower prices for everybody than it is to give a few lucky plaintiffs lottery-size winnings.
There is also the fear that increasing the expected costs of financing plaintiff-side litigation will deter plaintiffs from pursuing meritorious claims. One can first answer these fears by noting that my policy proposal does not in any way impose loser-pays compensation burdens on the plaintiff, only on any party that chooses to engage in a contingency financing arrangement with plaintiffs. These parties are almost always rich and powerful law firms and litigation finance funds who should have no problem going up against well-capitalized corporations.
While it is true that the total number of liability lawsuits would probably fall under my proposal, that is a necessary correction if one thinks there is something obviously wrong with litigation awards growing 3-4x faster than GDP. What we should want to do is disincentivize financing for bad lawsuits while promoting it for good ones. Subjecting legal contingency investors to the full spectrum of economic possibilites associated with their investment does precisely that. It is also simply fair.
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The idea that a payout from a defendent to a plaintiff should be thought of as a total benefit rather than a mere redistribution may sound odd. The main reason this is true is that a system that systematically forces defendents to pay for wrongs done to plaintiffs incentivizes better behavior from the general class to which defendents belong. Another reason is that we might think there is some good associated with justice being done. ↩
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Ignoring settlement for a moment, the expected contingency payout is P(success)payout of claim - cost of capital. When P(success) is low but the claim payout is high, we can get high expected values that exceed the contigency investor’s cost of capital but do not exceed said investor’s cost of capital *plus defendent’s defense costs. Returning to the call option analogy, this basically sets the strike price of the contigency investor’s payout structure at their cost of capital (funding the lawsuit). Below that strike price, they are not incentivized to behave in a way that maximizes the value of that enterprise, which is the problem I hope to remedy. It may be helpful here for the reader to review Chancellor Allen’s footnote 55 in Credit Lyonnaisse. He arrives at his point by considering a hypothetical insolvent corporation whose only asset is their ownership of a legal claim (!). The relationship that the shareholders of that corporation have to the legal claim is identical to the relationship that contingency investors have to claims that they pursue, with the role of creditors being occupied by defendants. That footnote thus provides a rigorous demonstration of how the contigency investor’s incentives can go awry. I also expand more on that idea here. ↩