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Private Contracts and Market Failures

April 11, 2006 2:37 PM


Your comments are typically thoughtful and lucid. I have so much to say, so I'm going to start with a very basic reaction to your post. I'll then post later today with more detailed thoughts about the empirical evidence you and Eric put together on this issue.

First, again, I'd like to emphasize where we do agree: that fee regulation is not inappropriate for class actions. That concession is actually a major step in the right direction. Class actions are a particular problem in that low probability claims very regularly have fairly high expected returns for the plaintiffs' attorneys working on a contingency fee merely due to the size of the class. As you note, in no way can we say that class members are actually able to negotiate at arms' length for fee contracts, since they're automatically in the class unless they choose to opt out. The lawyers drive the process. Securities class action lawyer Bill Lerach has noted that his legal practice is "the best" since it has "no clients."

I wonder if you'd also extend that position to mass tort claims? There, plaintiffs aren't automatically in the class, so you could say there's (in theory) some fee negotiation. But plaintiffs' attorneys advertise aggressively to pull together thousands of claims. Often, such claims wind up being manufactured. Courts are flooded. Again, the contingent fee is the primary driver in these cases because the aggregate nature of the claims makes speculative cases much more valuable. Television, internet, and radio advertisements trolling for clients wouldn't be nearly so effective if the clients weren't told "you pay nothing unless you win."

Taking television advertising as an entry point, let's look at why I don't buy your argument that contingency fees "have been around for well over a hundred years -- thus they cannot be responsible for problems in the tort system that have developed over the past several decades." Yes, contingent fees -- like the "American rule," like civil juries, like elected judges, like so many other features of American law -- are deeply rooted. But it simply does not follow that such entrenched features of our legal system are not related to the litigation explosion merely because they've been around a long time; it only follows that such features are not solely responsible. 100 years ago, there were no aggregate claims like today's class actions and mass torts; tort claims were much more restricted by substance and procedure (indeed, there wasn't any products liability law to speak of -- see Richard Epstein's discussion of the evolution of products liability law here); federal courts weren't bound to apply state law under Erie v. Tompkins; transportation costs were much higher (making forum shopping much more difficult); there was no television, radio, and internet; and attorneys were not permitted to advertise.

The real question is whether any of these changes, interacting with deeply rooted features of American law (like the contingency fee, no fee-shifting, elected judges, civil juries, federalism, etc.), have contributed to the increase in litigation costs. My claim is yes. And it's not because the changes are necessarily all bad; rather, we may need to look at the long-standing rules as well. For instance, a free speech purist like myself agrees with the Supreme Court that attorneys have the right to advertise commercially. But there's no question that such a right changes attorney behavior. When attorneys can aggregate mass tort claims on a contingent fee, the payoffs are huge. Folks who may or may not be sick are happy to sign up when there are "no fees unless we win."

Private Contracts and Contingent Fees

I, like you, am generally a big fan of private contracting. But "spider-sense" isn't infallible, at least in those of us who can't climb walls. So, here too, I want to take issue with a couple of points.

I think it's important to remember that contingency plaintiffs, in general, are not only liquidity constrained but relatively unsophisticated. Yes, that's one reason contingency fees can be useful: when lawyers are only paid if they win, it pays them to be careful about the cases they take and to be cautious about rejecting settlement and proceeding to trial. But the "screening function" in which the lawyer evaluates the merits of the case cuts both ways. Because an unsophisticated plaintiff is unable to evaluate the merits of his case, he has no idea if, for instance, it's a "slam dunk" that the insurance company is certain to settle for the policy limit. The lawyer does typically know that and is happy to take the case, on a standard contingency fee of 33 percent, to score a windfall at the plaintiff's expense. This potential for abuse is at the root of the contingency fee reforms that are focused on plaintiff protection -- admittedly different from the "blunt instrument" caps we're discussing. (Yes, I agree with you that percentile fee caps are a crude reform measure, as I said before. So are damage caps. But that doesn't mean they can't be effective.)

What we have when it comes to contingency fees is a market failure. Unsophisticated plaintiffs can't value their cases and therefore can't bargain with their attorneys over price. They can't shop on price -- they're too unsophisticated to know a good attorney from a bad one, and might indeed be suspicious that a "cheaper" attorney isn't as good, whether that's the case or not. Thus, as Lester Brickman has shown, there isn't really any price competition over contingency fees. Now I disagree with Lester's claim that the lack of price competition is likely due to collusion; as those of us with training in economics are well aware, collusive arrangements are very difficult to maintain and would be virtually impossible to maintain for a group as broad and varied as contingency fee lawyers. It's the very fact that plaintiffs in contingency fee cases have too little information and understanding to shop and negotiate on price that leads contingency fees to be set at a standard level.

So, there are ethical reasons to question the contingency fee, from the plaintiff's perspective. Unlike Professor Brickman, I tend to approach most of these questions from a law and economics rather than an ethical perspective, but the above-normal windfall from noncompetitively priced contingency fees almost certainly helps drive excess litigation.

Why is that? Well, let's start with Lester's seminal study concluding that contingency fee lawyers, on average, make above normal profits relative to their hourly brethren, even after adjusting for risk. I view that paper similarly to yours and Eric's on contingency fees: very useful work, but the wrong analysis. (I know I haven't yet laid out in detail why I think that is for your paper, but I will in my next post, as I said at the outset. I just want to get the main theoretical debate on the table first.) I find it hard to believe that contingency fee plaintiffs' lawyers, on average, make a risk-adjusted return higher than hourly attorneys, because if that were the case, hourly attorneys would switch to contingency work.

And that, I think, is just what has happened. Lester's study, importantly, looks at the top quartile of contingency fee lawyers. Some of those lawyers are indeed getting paid handsomely for risk, luck, or performance. Others are exploiting the information imbalance between plaintiffs and lawyers to get extra cash based on the absence of price competition over fees. But among the lawyers not in the top quartile, a lot are doing worse than hourly lawyers. They're often less skilled, in courtroom work, in preparation, in case screening, or even in advertising strategy. Still, they stick around chasing the big payoffs, at least as long as they can. The absence of price competition over contingency fees leads directly to more contingency fee lawyers -- and more lawsuits and cost to society.

Of course, the mere fact that there's a market failure need not imply a regulatory response. Far too often, those with too little respect for limited government ignore the cautions of public choice theory and the law of unintended consequences and rush to "correct" market imperfections with cures that are worse than the disease.

But so too is it the case that merely because we generally respect the law of contracts -- and indeed think that the substitution of the law of tort for that of contracts over time is a major underpinning of overlitigation -- we need accept every contractual arrangement. You admit as much in saying "we don't enforce contracts against the public interest." My argument is that contingent fee contracts, at least in some cases, can be just that, as I'll explain further in my next post.




Rafael Mangual
Project Manager,
Legal Policy

Manhattan Institute

Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.