Guest Post: Second Response to Proposal on Litigation Financing
Eli’s note: This is a further response to the blog’s previous exchange on my litigation financing proposal.
Having pondered the exchange of views between my esteemed, illustrious, and I am sure (although I have never met them in the flesh) handsome colleagues, I have reached the conclusion that Mr. Lee’s proposed reform is desirable, but not for the reasons he gives. The agency cost framing is a distraction, because the legal system does not directly create value. Rather, it transfers resources between persons in such a way as to give clear guidance on how laws will be enforced and to encourage compliance with them. The proper question is whether the proposed reform would allow the legal system to do this job better.
Rather than agency costs, we should begin with the observation that legal process is expensive, and yet for all that expense it sometimes errs. Sometimes, whether due to a confused judge or a mistaken jury, a plaintiff can recover on a claim that should not have resulted in recovery. As a result, although the reality of course is a spectrum, we can as a stylized fact say that there two different types of claim with more than de minimis value, but with value low enough that the expense of legal process might deter: meritorious claims not worth very much, and meritless claims potentially yielding a great deal.
From a societal perspective, recovery on a meritorious claim (no matter how small-stakes) creates value, though one can argue if the value created was worth the cost. Whereas recovery on a meritless claim (no matter how large-number) destroys value, in every case. The value created or destroyed is not the transfer from defendant to plaintiff, which is just that, a transfer. Rather, the value created or destroyed is more abstract: justice, the predictability that enables long-term planning, etc. Still, if we need to put a number on it, it would perhaps be fair to say that society values each person getting their due the same amount as does that person. So recovery on a meritless claim destroys value equal to the amount recovered, while recovery on a meritorious claim generates value equal to the amount recovered (up to the proper amount of recovery, at which point any further recovery becomes unmeritorious).
The costs of litigation, from a societal perspective, include plaintiff-counsel costs (“PC”), defendant-counsel costs (“DC”), and adjudicator costs (“AC”). These costs are the costs of having a functional justice system. Reducing these costs might seem an unalloyed good, serving to increase access to justice. But in fact reducing the costs of litigation is a double-edged sword. Or, to pick a more precise metaphor, it is like dumping lubricant over a complex machine. The point of lubricant is to allow a movement that ought to occur to occur more easily, with less loss of energy in the form of heat. But apply lubricant to a knot, and it might come undone; apply lubricant to the floor, and someone might fall down. Reducing the costs of litigation across the board is not necessarily a good idea, because it invites in the courthouse door both low-value meritorious claims and high-value meritless claims.
Rather, the best way to encourage small claims while discouraging longshot claims is fee-shifting. Fee-shifting encourages any claim with a high probability of success, while discouraging any claim with a low probability of success, regardless of claim value. This is fairly easy to show. Let \(R\) be the expected amount of recovery and \(E\) the probability of recovery. Then there are four possible regimes, with the following payoffs:
- No fee-shifting: plaintiff expects \(E(R)-1(PC)\), defendant expects \(E(-R)-1(DC)\)
- Total fee-shifting: plaintiff expects \(E(R)-(1-E)(PC+DC)\), defendant expects \(E(-R-PC-DC)\)
- Fee-shifting only for plaintiff: plaintiff expects \(E(R)-(1-E)(PC)\), defendant expects \(E(-R-PC)-1(DC)\)
- Fee-shifting only for defendant: plaintiff expects \(E(R)-(1-E)(DC)-1(PC\)), defendant expects \(E(-R-DC)\)
On the plaintiff’s side, the more is wrapped up in an \(E\) coefficient, the more incentive there is to bring a meritorious suit, and the more is wrapped up in a \((1-E)\) coefficient, the more disincentive there is to bring a meritless suit. Vice versa for the defendant’s side, where the question is whether to resist the suit or settle. The no-shifting rule encourages meritorious suits, but does not disincentivize meritless suits at all. The total fee-shifting rule strongly disincentivizes meritorious suits, while doing more than the no-shifting rule to encourage meritorious ones. In effect, it prevents a claim from being brought unless the expected value of the claim exceeds the likelihood that the claim is meritless times the costs of litigation (excluding adjudicator costs, which society bears).
Unsurprisingly, fee-shifting is the preferred rule between sophisticated parties, and commercial contracts tend to include fee-shifting clauses. So why isn’t fee-shifting the default rule in American courts? The general rule is no fee shifting. In civil rights suits, the rule is fee-shifting only in favor of plaintiffs. Fee-shifting only in favor of defendants is used for certain claims perceived to exert a chilling effect on civil rights, like copyright suits and defamation suits. Total fee-shifting is relatively rare as a legal rule, though, again, parties often opt into it. If you ask Claude this question, it will give you various answers, such as that a lack of fee-shifting encourages settlement, while fee-shifting discourages settlement–perhaps a desirable outcome when civil rights are on the line. But even for run of the mill cases, it’s hard to see how the beneficial effect of encouraging more settlement could outweigh the detrimental effect of encouraging more longshot claims.
I suspect that the true answer is that phrase–“sophisticated parties.” The American system is a default rule for the benefit of unsophisticated parties. That default rule makes sense, I think, not just because it makes it more likely that all parties will have an opportunity to choose, but also because it gives unsophisticated parties a rule closer to what’s good for them. After all, if fee-shifting properly incentives small claims while disincentivizing meritless claims for relatively risk-neutral parties, it might go too far in discouraging both types of claims when the plaintiff is far from risk-neutral. In layman’s terms: For sophisticated parties, a lawsuit is a gamble, and it’s important for the risk and the reward to be properly calibrated–otherwise the sophisticated party might become a claims-monger. But for the common man, who is more risk-averse, bringing a lawsuit is hard enough without the added risk of having to shoulder the defendant’s legal bills just because some unforeseen issue meant that your claim was not recoverable.
The harm of claims-mongering was one of the primary motivators for the traditional rules limiting alienability of choses in action. I express no view on whether the abandonment of those rules in favor of contingency fee agreements and litigation funding agreements is itself desirable. But the above considerations strongly suggest that contingency fees and litigation funding agreements destroy at least one of the primary justifications for the American rule. The problem with plaintiffs firms and litigation funding firms is not that what they are doing is bad for their clients, the way an agency-costs framing would suggest. Rather, the problem is that they are sophisticated, relatively risk-neutral parties whose incentives must be properly aligned, or else they will engage in litigation that is beneficial for their clients, but damaging to the legal system as a whole. Fee-shifting is the most natural way to accomplish that goal.
And, once again, litigation does not create value. What creates value is having a legal order where people respect one another’s legal entitlements.To the extent that such an order is not maintained through perfectly accurate adjudication, the cost of legal process is not a bug. It’s a feature, serving to deter abuse of the adjudicatory system’s inaccuracies.