Exploding the class action agency costs myth: the social utility of entrepreneurial lawyers.

• Author: Gilles, Myriam

INTRODUCTION

John Coffee observed twenty years ago that "[h]igh agency costs" inherent in class action litigation "permit opportunistic behavior by attorneys" and, "[a] s a result, it is more accurate to describe the plaintiffs attorney as an independent entrepreneur than as an agent of the client." (1) Jonathan Macey and Geoffrey Miller picked up on this theme in a highly influential 1991 article, recognizing that "the single most salient characteristic of class and derivative litigation is the existence of 'entrepreneurial' plaintiffs' attorneys [who, because they] are not subject to monitoring by their putative clients ... operate largely according to their own self-interest...." (2)

Today, these insights have become canonical. No one doubts that class action plaintiffs' attorneys operate, in reality, as independent entrepreneurs guided by self-interest. (3) The conventional wisdom further posits that there is tremendous social disutility in the fact that class actions are "characterized by high agency costs: that is, a significant possibility that litigation decisions will be made in accordance with the lawyer's economic interests rather than those of the class." (4)

The conventional wisdom is half right. Class action plaintiffs' lawyers are indeed independent entrepreneurs driven by the desire to maximize their gain, even at the expense of class members' compensation. Where the conventional wisdom has gone wrong, however, is in condemning this as a bad thing and proposing reforms for class action practice designed to correct this conflict by increasing the compensation of absent class members.

In fact, as we will show, the so-called "agency cost" problem is mostly a mirage. So far as the vast majority of small-claims class actions go, (5) concerns with the undercompensation of absent class members are totally misplaced. In reality, there is generally no legitimate utilitarian reason to care whether class members with small claims get compensated at all. Nor is there any economic reason to fret that entrepreneurial plaintiffs' lawyers are being overcompensated.

There is but one true objective here--one valid normative measure by which to gauge any class action procedure or practice, or any proposed reform. All that matters is whether the practice causes the defendant-wrongdoer to internalize the social costs of its actions. (6) Once this normative polestar is accepted, much of the recent literature on class actions comes up for reexamination.

The orthodox school of scholarly criticism in the class action area begins its inquiry by focusing on current rules or practices--for example, the rules for awarding attorneys' fees or approving coupon-based settlements--and then asking whether current practice optimally aligns incentives to serve the ends of compensating absent class members. (7) This is the wrong question. Once the appropriate lens of deterrence is applied and the objective of internalization understood, the scholarly view of many of these rules and practices will change dramatically.

The most critical and controversial feature of this argument is that compensation is not really an important goal in small-claims class actions. As discussed in detail below, (8) we think this conclusion follows from several truths and postulates, including (1) many consumer class actions concern a trifling per-plaintiff sum, which most class members do not care very much about recouping; (2) if the amount at issue is worth chasing, the plaintiff may opt out of the class; (3) the right to be represented as a passive class member in a Rule 23(b) (3) class action for damages is not one to which parties attach any meaningful value at the time of contracting; and (4) compensating individual small-claims class members is simply not what opt-out class actions do well.

It is not enough to do the hard (or at least counterintuitive) work of showing that class member compensation is irrelevant to the formulation of sound class action policy. We must also do the easy (or at least intuitive) work of showing that the deterrence of corporate wrongdoing is what we can and should expect from class actions. But does anyone seriously doubt that there is immense deterrent power in the contemporary class action? Executives tempted to lie about earnings are more concerned about Bill Lerach and Melvyn Weiss than they are about the Securities and Exchange Commission (SEC). (9) Companies tempted to skirt fair credit reporting requirements are more concerned with ruinous liability at the hands of the class action bar than they are with the corrective measures and fines that might be meted out following a none-too-likely Federal Trade Commission (FTC) investigation. (10)

A distinct question is whether current rules and practices fail to provide optimal deterrence, either by forcing corporations to internalize costs that go beyond those inflicted upon society, or by allowing them to escape the full costs of their wrongdoing. (11) These are the right questions, and we should be asking them at every turn as we examine particular rules, practices, and reform proposals in the class action arena. As we will show, this deterrence-centric approach can be expected to yield significantly different results than the standard inquiry in key areas of class action practice, including the rules governing attorneys' fees and the standards to be employed in approving settlements.

In Part I we will canvass the scholarly literature, much of which measures class action practices and reform proposals against implicit or explicit goals of maximizing class member compensation and minimizing "windfall" attorneys' fees. We will show that this state of "compensationalist" hegemony is a relatively recent phenomenon, dating from the 1980s. Before that, some scholars appear at least to have intuited that the true allocative-justice purposes of class actions are served by forcing companies to internalize the costs of their actions, and that the distribution of damages to individual claimants is entirely incidental.

In Part II, then, we will advance the argument that, in assessing the efficacy or desirability of class action practices and reform proposals, any goal of class member compensation must be utterly disregarded in favor of a separate and often competing objective: forcing companies to internalize the social costs of undesirable behavior. We will emphasize that these objectives do in fact compete--that the introduction of compensationalist norms into class action policymaking not only is gratuitous, but also undermines the efficacy of many rules and practices as deterrents. The reflexive inclination to service both objectives, we argue, is unprincipled and often counterproductive.

In Part III we draw extensively on real-world class action practice to demonstrate how the flawed compensationalist model leads to unintended consequences and suboptimal policy choices. We will focus here primarily on the rules governing attorneys' fee awards. So, for example, we will show how attorneys' fee rules that are animated by the misplaced concern of class member compensation have the unintended consequence of misaligning incentives between class and counsel. In fact, such rules ensure that lawyers will settle cases too cheaply--or at least, far more cheaply than they would under a set of fee rules designed to maximize the defendant's internalization of costs. In the process, we will also demonstrate that, under the current, misguided regime, unethical lawyer activities such as bill-padding and overstaffing actually (and perversely) serve to increase class member compensation. We will also briefly discuss two current hot-button issues in class action practice--coupon-based settlements and class action waivers (12)--in order to show that, here too, a deterrence-based perspective produces results that diverge from the traditional compensationalist view.

In Part IV we will address the critique that current legal rules and our own reform proposals might overdeter undesirable conduct, that is, the concern that the class action device may be (or become) too effective, and may force corporate defendants to internalize costs that exceed the social toll of their undesirable actions. We will also address the underdeterrence concern, focusing on "sell-out" settlement deals and reverse auctions. Concerns about suboptimal deterrence are real and important; indeed, we believe these are the principal concerns that should be addressed in the context of proposals to reform class action rules and practices.

1. COMPENSATIONALIST HEGEMONY

   Once upon a time, scholars considered deterrence of future wrongdoing the strongest justification for small-claims class action litigation. Writing in 1941, Harry Kalven and Maurice Rosenfield warned against restricting the availability of class actions lest we "impair the deterrent effect of the sanctions which underlie much contemporary law." (13) Focused as they were on the deterrent, law-enforcement function of class actions, Kalven and Rosenfield were naturally untroubled by the practices that so vex modern commentators:

   It is thus seen that the class suit is a vehicle for paying lawyers handsomely to be the champions of semi-public rights.... Because of the lawyer's incentive ... the suit which might not be brought at all because the demands on legal skill and time would be disproportionate to the original client's stake can, when turned into a class suit, be brought and handled in a manner commensurate with its magnitude. Thus, the class suit as a way of redressing group wrongs is a semi-public remedy administered by the lawyer in private practice.... (14) The Kalven-Rosenfield understanding of small-claims class actions and their core public purposes carried over and intensified during the social upheavals of the 1960s. As Judith Resnik has described in great depth:

   By the 1960s, lawyers, judges, academics and legislators began to conceive of...