I'm very happy to welcome our friend Alex Tabarrok back to Point of Law this week to talk with me a bit about his and Eric Helland's empirical research on contingency fees. Our readers may remember Alex's interesting discussion last year with David Rottman of the National Center on State Courts on judicial selection and election mechanisms.

Alex and Eric's work in that area, along with invaluable work looking at juries, is summarized nicely in a new book, Judge and Jury: American Tort Law on Trial. I highly recommend this book for all our readers. It’s accessible to a lay audience without extensive legal training or a deep econometric background, and it covers some of the best recent empirical work done in the area of tort law. In a field where good data are sparse and empirical evidence is sometimes lacking (though it's far more plentiful than the plaintiffs' bar likes to pretend), Alex and Eric have led a new batch of empirical scholars who creatively use what data is out there to reach some very interesting conclusions.

While Alex and I largely agree on the need for tort reform—-both think that litigation in America is significantly more costly and more inefficient than it could be—-we part ways in our enthusiasm for the contingent fee. Based on their empirical findings as well as their preference for permitting private contracts, Alex and Eric give "two cheers" for contingency fees in the final chapter of their book. (Readers who have yet to buy the full book and want an accessible version of their paper should look at the AEI Liability Project's publication here.)

Why Contingency Fees?

At the outset, let me stipulate that I do not support wholesale elimination of the contingency fee. As Alex and Eric ably argue, there are some valid reasons for permitting plaintiffs to contractually shift the financing and risk of their case to their attorneys. Eliminating the contingency fee entirely would either lead to the evolution of less efficient financing alternatives or reduced access to courts for less sophisticated and financially well-off claimants, neither of which is a very defensible option.

Why do contingency fees make sense? Alex and Eric give the pro-contingency rationale in more detail, but in a nutshell, contingency fees are a mechanism for reducing information asymmetries and liquidity constraints. Taking the latter, simpler point first, a lot of individuals in the society are unable to afford to pay lawyers' high fees by the hour, but they may well have valid legal claims. Having legal costs assumed by the plaintiffs' attorneys in exchange for a piece of the ultimate verdict or settlement is one way in which such individuals can fund their prospective litigation.

The other major problem for most plaintiffs—-at least individuals without legal training and resources—-is that they lack the ability to value their potential case as well as the ability to monitor their lawyers' pursuit of the case. The hourly fee arrangement places the burden for such unsophisticated plaintiffs on the ethical scruples of their attorneys. An unethical lawyer might agree to take a case without merit, rack up legal fees, and later drop the case, profiting from the unknowing plaintiff's lack of sophistication. Or, the lawyer might encourage the plaintiff to go on litigating in the face of a perfectly good settlement offer, because the lawyer keeps getting paid regardless of whether it's worth the additional expense from the plaintiffs' perspective.

Big companies or sophisticated parties can more effectively monitor their lawyers, but the threat of lawyers bilking their run-of-the-mill clients is very real. This hypothesis—-that with contingency fee limitations, you see lawyers taking on more bad cases and taking longer to settle them, on hourly fee arrangements—-underlies Alex and Eric's interpretation of their findings, which I'll leave to Alex to explain in more detail. I'll get into my specific objections to that interpretation tomorrow, but for now I want to lay out the basic economic case for limiting contingency fees.

Why Limit Contingency Fees?

In essence, the contingency fee restrictions Alex and Eric examine are of the following sort: the state mandates a fee percentage above which attorneys cannot charge. Some states have outright limitations on fees for all cases, some for only certain types of cases (e.g., medical malpractice), and some have fee limits that kick in, or shrink, as payouts get larger. I think that there's a strong case that such contingency fee limits do make some theoretical sense.

Using the simplifying assumption that all cases go to trial (of course, only a fraction do, but settled cases are going to be a function of expected trial outcomes), the plaintiffs' lawyer on a contingency fee approaches the case with the following expected return:

EV = F*Pr*D – C

Where

EV = expected value of case to plaintiffs’ attorney,
F = contingency fee ratio,
Pr = probability of success at trial,
D = expected damages at trial, and
C = cost of pursuing and trying case.

Under these assumptions, then, the lawyer takes any case in which his expected return is positive, i.e.,

F*Pr*D > C

What becomes immediately apparent is that under a contingency fee arrangement, plaintiffs' lawyers accept not only cases that are likely to succeed but long-shot cases with high potential damage payouts. A risk-neutral plaintiffs' lawyer with a diversified portfolio of cases is just as happy to take a case with a 1 percent chance of paying out $20 million as a case with an 80 percent chance of paying out $250,000.

But as a society, do we really want to be flooded with high-dollar, low-probability claims? The contingency fee creates a very real incentive to play the "lawsuit lottery"—a lottery with positive expected returns for the plaintiff and client, but substantial social costs. At a very basic level, the contingency cap, while a crude mechanism, ameliorates this problem. If a lawyer's take in a case goes down—-especially for high-dollar cases-—the incentive to take shoot-the-moon cases falls proportionately.

In chapter 2 of The Litigation Explosion, my colleague Walter Olson compares the contingency fee to analogous arrangements we find odious: traffic cops having an incentive to give more tickets (through, e.g., monthly "quotas"), IRS agents being given financial incentives to find more problematic tax returns, and soldiers in conquering armies getting to keep some of the "spoils" of the conquered peoples. What's crucial to recognize in each of these examples is that they involve using the heavy hand of government force to redistribute wealth—-which is no less true of tort lawyers and their clients. They may reach private arrangements, but make no mistake that plaintiffs and their lawyers are using the government's monopoly over legitimate force to take money from unwilling parties.

In some instances, is this redistribution through tort law warranted? Of course, just as in some instances traffic tickets, IRS audits and prosecutions, and military actions are warranted. But those of us committed to limited government should be ever watchful for keeping the scope of such government interventions appropriate.

I have lots more to say. Specifically, my simplifying equation for how a plaintiffs' lawyer approaches a case ignores two very basic points: (1) that the probability of success, and likely damages, are a range rather than a fixed level for any case; and (2) that the such ranges—-as well as legal costs-—are not constant across the entire time litigation is pursued. Relaxing those core assumptions forms the heart of my critique of the conclusions you and Eric draw from your results. I'll get to that tomorrow.

Until then,
Jim