Financing the class: strengthening the class action through third-party investment.

• Author: Hill, Tyler W.

INTRODUCTION I. THE VIRTUES OF THE PRIVATE BAR A. Plaintiffs' Lawyers Provide a Valuable Service B. The Profit Motive Does Not Debase the Class Action II. THE DEFECTIVE ECONOMICS OF THE CLASS ACTION LAWSUIT A. Background: Fees and Financing 1. Ex Post Fee Awards 2. Financing Restrictions B. Valid Claims Suffocate Due to Lack of Financing C. Incentives Favor Claims with Less Social Utility D. Fees Are Inflated Due to Lack of Competition III. THE SOLUTION: AUCTIONING EQUITY IN THE CLASS ACTION TO FINANCIAL INVESTORS A. The Equity Auction Proposal 1. The Equity Sale Procedure a. Step One: Preoffer Preparation b. Step Two: Solicitation of Bids and Due Diligence c. Step Three: The Auction 2. Extensions of the Equity Sale Procedure a. Extension One: Sale of Plaintiffs' Equity b. Extension Two: Settlement Bonding c. Extension Three: Syndication 3. What Happens When Investors' Cost Predictions Are Wrong? B. Rule 23 and the Role of the Judge C. Required Changes in the Law D. Distinguishing the Equity Auction 1. The Lead Counsel Auction 2. Macey and Miller's Auction IV. ASSESSING THE RESTRICTIONS ON OUTSIDE FINANCING A. Agency Costs Arguments B. Lawsuit Abuse Arguments 1. The Theoretical Possibility of Negative Value Suits 2. Litigation Finance Solves Its Own Problem CONCLUSION INTRODUCTION

The class action lawsuit, a mechanism of civil procedure that facilitates collective action where individual action would be financially or administratively infeasible, is a critical component of the American regulatory state. It provides at least two services to society. First, the class action enhances the ability of plaintiffs with legally cognizable harms to secure the remedy due to them under the law. Second, it promotes the rule of law, complementing the government's enforcement powers by enabling private parties to deter deep-pocketed defendants from malfeasance. But the system we have does not do as well as it could. The viability of class action lawsuits depends on an industry of fee-seeking attorneys to discover, orchestrate, and finance lawsuits. Deficiencies in how these suits are financed and attorneys are paid distort the economics of this industry, undermining its ability to deliver on its potential.

The first deficiency involves financing class action lawsuits. Class actions are often expensive to litigate. Antiquated laws and rules prohibit nonlawyers from taking financial interests in lawsuits, so funding typically comes from the plaintiffs' lawyers themselves. Class action attorneys agree to front litigation costs through contingency fee arrangements in which they receive a portion of the funds awarded to the plaintiffs. This makes the financial viability of the lawsuit entirely dependent on the financial means and risk appetite of the plaintiffs' lawyers. It also raises the cost of capital--the financial return on their investment that the lawyers must achieve in order for the enterprise to be profitable.

The second deficiency is the method courts use to set attorney fees. When they front the litigation costs, the lawyers take on the risk that the lawsuit will not prevail--a risk they can only properly appraise before the case commences. However, the fee, which partially compensates the lawyers for taking on this risk, is only set by the judge at the end of the case. Moreover, while the price of risk-taking and the price of providing legal services are dictated by markets, class action attorney fees--set by judges--are generally not tested by any competitive market. As a result, even independent of the restrictions on outside financing, attorney fees often do not reflect the going market rate of legal services or the price of the risk of an individual lawsuit.

This financing and fee regime undermines the class action's effectiveness. A failure to adequately differentiate lawsuits with differing levels of risk distorts the set of commercially viable lawsuits. It potentially suffocates some meritorious suits, and it privileges less socially beneficial suits that ride the coattails of government regulatory action over more beneficial suits based on novel claims. Moreover, the current system can raise the overall level of fees awarded to class counsel at the expense of plaintiffs. Finally, it can encourage--or even force--the plaintiffs' attorneys to settle for less than a claim is worth because the lawyers cannot or will not bear the responsibility of financing additional litigation, even where the risk-adjusted marginal benefit to the plaintiffs would exceed the marginal costs. As a result, plaintiffs with sound claims go without compensation and wrongdoers are not held accountable.

This Note proposes a novel financing and fee-setting mechanism for a wide range of common fund class action lawsuits that would couple third-party funding with competitive price setting. (1) Under this proposal, the plaintiffs' attorney auctions off an interest in his potential fee award to financiers, other attorneys, or even the plaintiffs themselves to fund all or part of the litigation. The auction would draw capital, allowing the lawsuit to proceed independently of the lawyer's ability or appetite to finance it. The auction would also set the plaintiffs' attorney's fee at a level determined by a competitive bidding process, driving down the price and maximizing the plaintiffs' share of the compensation for their injuries.

Three other mechanisms for giving attorneys and plaintiffs financial flexibility could complement this "equity auction" procedure. First, courts could allow financial investors to purchase the claims of individual plaintiffs at the price set by the initial financing auction, giving plaintiffs the opportunity to sell their claims--in other words, to cash out, rather than opt out. This would allow plaintiffs to divest themselves of the risk of an adverse judgment and to benefit from cash payment before the completion of the lawsuit. Second, the equity auction could be accompanied by settlement bonding--an arrangement whereby a third party foils a defendant's settlement offer by indemnifying the plaintiffs and attorneys against the risks of rejecting the settlement and financing continued litigation. (2) This could reduce the impact of the plaintiffs' attorneys' incentive to settle prematurely. Finally, the winning bidder in the initial auction could syndicate her financial interest in the suit, bringing a wider panel of financiers to the table to share the risk. This could enhance many of the benefits of opening lawsuit financing to wider financial markets.

Deficiencies in how class action plaintiffs' attorneys are compensated have long been a topic of academic and political debate. While this Note is not the first attempt at a solution, it offers a fresh approach. The analysis provides an account of the economic distortions inherent in the current class action financing and fee system, drawing on well-developed critiques of agency costs, (3) asymmetry in the plaintiffs' and defendants' stakes, (4) and the futility of setting fees by judicial fiat after the lawsuit is complete. (5) The proposal draws on recent literature about the benefits of third-party litigation financing. (6) While the equity auction builds on and incorporates features of several attempted and proposed auction procedures, it is the first to incorporate improvements based on fee-setting procedures and external financing for a broad range of suits for damages and in a way that allows plaintiffs to retain ownership of their claims.

Part I of this Note defends the normative foundation of this project, arguing that compensating plaintiffs and enforcing the law are worthwhile goals of the class action. Part I also addresses objections that converting the role of the plaintiffs' lawyer into a commercial enterprise is inappropriate. It replies that commodification of the class action is a natural result of reliance on the private bar to finance aggregate litigation and an essential corollary of our regime of public regulation through private rights of action. Part II demonstrates that the class action has fallen short of its potential due to restrictions on outside financing and irrational procedures for setting attorney fees. Part III provides an overview of the equity auction procedure, and elaborates on its advantages over the current system and other alternatives. Finally, Part IV responds to counterarguments that allowing third-party financing would increase agency costs and further enable socially undesirable negative-value lawsuits. Rather than making these problems worse, an open market in lawsuit financing could reduce agency costs and make it more difficult for unscrupulous lawyers to use the class action to extort unjustified damages from defendants.

1. THE VIRTUES OF THE PRIVATE BAR

   This Note proposes a novel way to improve the contingency fee class action, but it must begin by laying the normative antecedent that the privately prosecuted, contingency-fee class action is something worth keeping and improving. We should encourage private, fee-seeking attorneys to prosecute class action lawsuits to enforce the law on behalf of society and compensate plaintiffs for harm they have sustained. Moreover, we should reject normative counterarguments premised on squeamishness at commercializing the lawsuit. Such arguments deny the critical role that money already plays in American civil justice.

   1. Plaintiffs' Lawyers Provide a Valuable Service

      For the rule of law to obtain, the law must be enforced. (7) Enforcement is not free; the resources required to prosecute a claim must come from somewhere. Who should provide this service? We often turn to the government to enforce the law for us, with resources drawn from the public fisc. But there is an alternative: we can empower private citizens to enforce the law on behalf of themselves, others, and society at large. The American system of civil law enforcement is a mixture of both public and...