For over fifty years, class actions in the US have been initiated and litigated by self-driven entrepreneurial lawyers. Lawyers have taken the risks and costs of pursuing class action litigation in the hope of obtaining a class-wide relief, out of which they would earn their fees. Those fees, usually calculated on a contingency percentage basis, have fueled the engines of American class actions.

However, the entrepreneurial, private attorney general model has its inherent costs. Since lawyers’ incentives are not fully aligned with class members’ interests, opportunities for rent-seeking produce agency problems that are manifested both in inadequate litigation incentives and in potentially collusive settlements. Our paper proposes a simple mechanism which resolves the class action agency problem and maximizes the expected payoff to the class. The proposed mechanism allows courts to select the best class representative, and then aligns her interests with those of the class, leaving class members with maximal net payoff. It resolves both the problem of adverse selection in choosing the optimal class representative and the problem of moral hazard in litigation management.

Our proposal is based on a theoretical insight made by Polinsky and Rubinfeld more than fifteen years ago regarding ordinary individual litigation. The proposal relied on contracting between the lawyer and a third party who compensates the lawyer for a certain fraction of her costs against an upfront payment made by the lawyer. In essence, the idea was to equalize the percentage earned by the lawyer from the litigation outcome and the percentage of the costs she has to bear. To implement this parity, the lawyer must be compensated for the complementary percentage by the third party in return for the upfront payment.

As a simple example, consider the case where the lawyer earns 25% of the litigation award. In this case, the lawyer should also bear only 25% of the costs of litigation. Assuming these costs consist mainly of the lawyer’s time investment, she should be compensated for the remaining 75% of her hourly fee, for each hour she spends on the case. If a third party is paid before the litigation the expected cost of 75% of the litigation investment, it would be willing to pay the lawyer this same percentage over each hour she spends on the case. The parity between the lawyer’s share of the expected payoff, and her share of the expected costs induces her to exert optimal effort in litigation and negotiate optimal settlements when evaluated from her client’s perspective.

We use a similar fee structure, where the third party is an After-the-Event Insurer who is paid an initial insurance premium by the lawyer. The lawyer is then paid a fixed percentage of her hourly fee, in addition to a complementary percentage of the eventual litigation or settlement common fund. Analyzing a model in which both parties – plaintiff lawyers and defendants – make litigation and settlement decisions, we show that the lawyer’s litigation and settlement incentives are aligned with the class’ benefit.

We then add a preliminary selection stage, through auction, and show how it allows the court to maximize the class’ expected payoff by choosing the best class attorney and minimizing her fee, where attorneys’ quality is unobservable by the court. The proposed auction is divided into two stages. In the first stage, lawyers bid for the highest ratio between the upfront premium they make to the Insurer and their percentage fee. The winner is guaranteed the winning bid-ratio, but the actual insurance premium and percentage fee are determined in the second stage auction. In the second stage, insurers bid for the highest percentage they are willing to pay lawyers, given that their premium would be determined by the first stage winning bid.

As we demonstrate, the winning bids in these auctions would leave the class with the highest possible net payoff. The percentage taken by the lawyer would be the lowest possible, and the winning lawyer would be the one whose expected net payoff to the class would be highest.

This entire idea is demonstrated in the following table:

 Expected litigation outcomeLawyer's litigation costsNet maximal class' payoffLawyer's shareUpfront premium
Lawyer 180020060025%150
Lawyer 2100050050050%250

Lawyer 1 produces 800, and her litigation costs equal 200. Hence the maximum net litigation value for the class is 600. For any percentage θ%, the lawyer earns that percentage out of the 800 and bears the same percentage of the 200 costs. Thus, her net payoff, before paying the upfront premium to the Insurer, must equal θ% x 600. Since this is the highest premium she is willing to pay the insurer, she would bid θ% x 600/θ% = 600. Since insurers’ expected costs are (1-θ%) x 200 and the premium they are paid equals θ% x 600, it follows that to win the auction insurers would bid 75% and the lawyer’s share would be 25%.[1] Thus, the class would be left with its maximal net payoff, 600.

Compare this to Lawyer 2, who produces 1000, and his litigation costs are 500. Following similar analysis it can be shown that the winning lawyer’s bid would be 500, and if she were to win, her percentage, set by the insurers’ auction, would be 50%. Yet, since this bid is lower than Lawyer 1’s bid, she would not win the auction. This outcome is best from the class perspective, because if Lawyer 2 were to win the auction, the class would earn 500 at most.

The idea of using auctions in class actions has been suggested by Macey and Miller in 1991. Their proposal was to auction the whole class action, but the proposal was never implemented in practice. Our main contribution is to show that the optimality results of the whole class action auction can be replicated even if the auction is restricted to the lawyer’s share only. This, however, requires that the lawyer bears the same percentage of the litigation costs and outcomes under the proposed optimal mechanism. Our analysis demonstrates why the combination of an optimal incentive scheme with the proposed auction holds promise for better outcomes.

We also demonstrate how the proposed selection and incentive scheme can be implemented if lawyers have insufficient resources to pay the insurer’s premium. A litigation funder or a class representative who can sponsor this premium and is allowed to share with the lawyer the proceeds from the class action would facilitate optimal outcomes if lawyers have liquidity constraints. Furthermore, we show how the optimal scheme may be implemented under a loser-pay English fee shifting rule. These extensions render the proposal applicable not only in the U.S., but also in other countries, most significantly in Australia, which uses a loser-pay fee shifting and in which funder-sponsored class actions have been recently on the rise.  

 

[1]  This is the percentage which solves (1-θ%) x 200 = θ% x 600.