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Reconsidering "Loser Pays"
By Marie Gyphon

Although the American justice system is derided as expensive, capricious, and prone to abuse, Americans go to court more often—and more expensively—than any other people in the world. The purpose of this paper is to explore an old idea that has recently been missing from legal reform debates in the United States: the possibility of adopting a loser-pays rule in order both to reduce abusive (i.e. very low-merit) litigation and to better compensate deserving claimants. Part I of this paper summarizes the best theoretical research into what kinds of effects we could expect loser pays to have on litigation. Part II examines an important but flawed experiment with loser pays for medical malpractice cases in Florida. Part III offers guidelines for the implementation of a loser-pays rule.

Part I: What to Expect from Loser Pays

While researchers differ on what some of the effects of a loser-pays rule might be—and certainly differ on the overall advisability of adopting one—there is broad consensus that a loser-pays rule would reduce the number of abusive suits. A reduction would occur because defendants would be unwilling to pay as much to settle them as they currently do.

A simple example will illustrate why a defendant would insist on paying less to settle a nuisance suit under loser pays. Suppose a plaintiff has suffered a loss of $10,000 (an amount that is not in controversy in this example), but his suit has very little legal merit because the defendant probably did not cause his injury, giving the plaintiff only a 20 percent chance of winning at trial. Suppose that the plaintiff's lawyer (who is working under a contingent-fee agreement for 33 percent of any recovery) and the defendant would each have to invest $5,000 worth of legal services in order to try the case. The plaintiff's lawyer could expect a fee of only $667, since 20 percent of $10,000 is $2,000, and 33 percent of $2,000 is $667, for $5,000 worth of work if the case goes to trial.

The plaintiff's lawyer, therefore, plans to settle the case. Under the American rule, he may extract between $2,000 and $7,000 from the defendant in settlement, because the defendant knows that it will have to spend $5,000 on unrecoverable legal costs if it fails to settle and because the case has an additional expected value of $2,000 for the plaintiff.

Under loser pays, however, defendants would either refuse to settle or would offer far less in settlement. In our example, the defendant has an expected cost of going to trial of only $3,667 under a loser-pays rule, reflecting its 20 percent chance of losing the case and paying damages and both parties' legal fees. Therefore, the defendant would never pay more than $3,667 to settle this case—just over half of the maximum of $7,000 that a plaintiff could extract from the same suit under the current system. Because loser pays would make nuisance suits less valuable, the effective hourly rates of nuisance lawyers would decline. In the face of reduced earnings, some nuisance lawyers would surely choose to file different kinds of cases (such as meritorious small claims), or they would migrate to other specialties or careers.

More Meritorious Small Claims

In addition to reducing the number of nuisance suits, a loser-pays rule should increase the viability of small, highly meritorious lawsuits that cannot be profitably tried in the current system, a point on which most researchers agree. The increased viability of small, meritorious claims would have costs as well as benefits. On the one hand, a person with a modest but meritorious claim should be compensated. Critics of loser pays who worry that the rule would limit access to the courts often fail to acknowledge that the American rule essentially eliminates court access for small but strong claims of injury, unless the claims can be grouped into a class action. On the other hand, a significant influx of small, meritorious claims under loser pays could keep the overall amount of litigation from going down, and thus the overall cost of administering the legal system.

There is reason to think that the reduction in nuisance suits following the adoption of loser pays would be greater than the increase in small, highly meritorious claims. While it is true that many such claims are too small to be worth taking to trial under the current system, many nuisance claims are small as well. Yet nuisance claims of this kind are filed, anyway, for their settlement value—just as are, undoubtedly, substantial numbers of meritorious claims that are not too insignificant to be worth pursuing. Also, many small claims are currently litigated as class actions.

Responses from Kritzer's survey of contingent-fee lawyers in Wisconsin suggest that the number of nuisance filings deterred under a loser-pays rule would be larger than any increase in the number of small, meritorious cases filed. Figure 1 shows how prevalent are the various reasons that contingent-fee lawyers give when they decline a case. It shows that in 46 percent of the cases declined by the surveyed lawyers, there was, in their view, a low probability of a finding of liability. Only 19 percent were declined because the expected size of the recovery was too low.

These responses (combined with statistical principles) imply that of all the cases that lawyers are asked to pursue—on either side of their accept/reject threshold—a greater number have little legal merit than have merit but promise only modest recoveries. If that is so, loser pays should discourage more low-merit cases than the number of high-merit small claims it would encourage.

High-merit, low-damages injuries are also unlikely to be litigated to trial under loser pays because defendants would have no financial incentive to resist compensating those they have genuinely harmed in small ways. Loser pays may therefore be more likely to promote immediate, and appropriate, handling of small injuries than to trigger a tide of small suits. Under the American rule, defendants are more likely to treat many small, high-merit claims as no different from nuisance claims and under-compensate genuinely injured victims, since they know that it is unprofitable for plaintiffs' lawyers to litigate such cases to trial.

Settlement Rates

Research is deeply split on the issue of whether a loser-pays rule would increase or decrease the rate at which lawsuits are settled rather than tried. Loser pays, by increasing the amount of money in dispute in any given case (that is, by "raising the stakes" of litigation), may reduce settlement rates by magnifying differences of opinion between the parties about what each is likely to gain by going to trial. On the other hand, higher stakes could induce risk-averse parties to settle. Experiments designed to predict the effect that a loser-pays rule would have on settlement rates have yielded mixed results. Economists Kevin McCabe and Laura Inglis found that loser pays would lower rates of settlement, while two older experiments suggest that settlement rates would increase.

The question of the effect of loser pays on settlement rates, however, may not be as consequential as the extent of academic interest in the subject implies. Only about 79 percent of lawsuits filed go to trial. The rest are resolved by settlement, by dismissal or summary judgment, or by the plaintiff's decision to drop the suit.

In part because so few cases proceed to trial, most resources devoted to litigation are spent at its earlier stages, including settlement negotiations. Figure 2 is a breakdown of the time that litigation attorneys report spending on various activities related to the resolution of lawsuits. Because attorneys' fees are by far the largest cost of litigation, these figures are a reasonable proxy for overall legal costs. Importantly, litigation attorneys report that they spend only 9 percent of their time on hearings and trials. Most of their time is devoted to activities that may precede serious settlement discussions: client interviews, case investigation, pretrial motions, and settlement negotiations. While an early settlement would avoid many of these expenses, a settlement on the eve of trial would avoid very few of them.

All else being equal, therefore, legal reforms that reduce filings are likely to reduce costs more than legal reforms that increase settlement rates, which are already high. Nonetheless, a loser-pays rule should be carefully designed not only to discourage low-merit filings but also to promote settlement.

Litigation Costs per Case

Critics of loser pays warn that even if the rule should reduce the number of lawsuits filed, the cost of litigation per case may increase because each party no longer necessarily and exclusively bears its own costs. Under a loser-pays rule, each dollar of additional spending by either party is discounted by the probability that the other side would assume those costs upon losing the case. Whereas $1,000 in additional spending under an American rule would be borne wholly by the party making the decision to spend, a party under a loser-pays regime that estimated its chance of winning at 50 percent would only bear $500 of the additional $1,000 spent. Assuming that increased spending on legal services enhances a party's chances of prevailing, parties will spend more on legal services under loser pays, loser-pays critics argue, than they would under a system employing the American rule.

While this "cost-internalization" critique of loser pays is not without merit, the charge that loser pays would generally increase costs per case is less than convincing, closer analysis reveals. A party's decision to increase spending on litigation under loser pays reflects not merely its expectation that such spending will improve its odds of success at trial. It reflects as well what it understands to be the odds that such spending will encourage additional spending by the other side, and it reflects a view as to how different amounts of additional spending by both sides are likely to affect either side's chances of winning or losing at trial.

All studies that predict higher per-case expenditures under loser pays than under the American rule assume that a party that spends more on litigation increases its chance of prevailing, especially if the opposing party does not match those expenditures. But, in reality, a loser-pays rule would not necessarily motivate either party to spend more.

Rather than increasing a party's chance of success at trial, much legal spending may be what economist Avery Katz calls "provocative expenditure," spending that merely induces the opposing party to respond with additional spending of its own. While Katz argues that loser pays would increase trial expenditures, his argument assumes that legal spending is not provocative. If it were, his doubts about loser pays would, he concedes, be misguided.

In fact, most decisions to spend money on litigation are provocative because they trigger a litigation event, such as a motion, discovery request, or pretrial conference, which requires the opposing party to undertake a costly activity in response. Serious analysts of the legal system, even those who typically defend the status quo, admit as much. For instance, Kritzer notes that lawyers' efforts in litigation are "largely determine[d]" by "the actions of the opposing party." He adds: "Each decision to invest additional effort will then influence the defense side, which in turn may make investments that require further investment by the plaintiff's side."

Empirical analysis supports what theory would predict. Data from the Wisconsin Civil Litigation Research Project confirm that in litigation conducted under the American rule, case complexity and associated litigation "events," not the sums at stake, are the main drivers of litigation spending—a result that is at odds with the simplistic hypothesis embraced by critics of loser pays that parties under such a regime will keep spending more in order to improve their chances of prevailing.

Practically speaking, there is reason to believe that it has been the American rule that more often provokes increased legal spending per case, due to the provocative nature of legal expenditures, particularly at the pretrial stage. Plaintiffs' attorneys in the United States bury defendants in onerous discovery requests, knowing that their clients bear none of the costs of document production; the cost of discovery itself increases cases' settlement value. Similarly, defendants flood plaintiffs with motions; regardless of the motions' probability of success, the expected settlement value of the case falls, given the costs that plaintiffs must incur in responding and that they might seek sooner rather than later to avoid. Because motions and particularly discovery requests are far cheaper to draft than the responses they trigger, the American rule promotes provocative legal spending. A loser-pays rule would discourage it.

Thus, there is reason to believe that a loser-pays rule would not generally increase litigation expenditures per case very much and may, indeed, have the opposite effect. Nevertheless, under at least some conditions, the critics' concern that loser-pays rules would encourage higher spending is well-founded. For instance, a party that estimates its probability of success to be very high might refuse reasonable settlement offers and run up costs, confident that the other side will end up bearing those costs. While judicial fee reviews are the means by which other countries' loser-pays systems deter such tactics, an American loser-pays reform could best deal with such tactics by relying on offer-of-settlement rules already in place in most states. Such rules encourage settlement by reducing recovery if the ultimate judgment does not exceed an earlier, rejected offer by a substantial margin.

Part II: Lessons From Florida

In 1980, Florida embarked on an important experiment. In response to escalating medical-malpractice insurance rates, the state legislature adopted a loser-pays rule exclusively for medical-malpractice lawsuits. The Florida Medical Association and the insurance industry lobbied for the provision, which they hoped would reduce the rate of abusive litigation and thus the insurance premiums paid by doctors and hospitals. However, both groups quickly discovered a problem with the new system—the frequent inability of victorious defendants actually to collect their attorneys' fees from insolvent plaintiffs —and they were taken aback by the multimillion-dollar plaintiff's attorneys' fee that a Florida doctor who had lost the case against him was ordered to pay. With every interest group lobbying for its repeal, Florida's loser-pays law was wiped from the books in 1985.

The first rigorous analysis of the Florida law's effects was published five years later, and its findings suggest that the loser-pays experiment was given short shrift by policymakers and its erstwhile advocates. Economists Edward A. Snyder and James W. Hughes found that 54 percent of medical-malpractice plaintiffs voluntarily dropped their lawsuits under Florida's loser-pays rule, while only 44 percent of plaintiffs dropped their suits when the American rule was in force both before and after the loser-pays rule was in effect. Loser pays also almost halved the share of medical-malpractice lawsuits that went to trial—from 11 percent to 6 percent (see Figure 3).

Supporting the hypothesis that more plaintiffs with weak suits dropped them under Florida's loser-pays rule, cases governed by loser pays were settled for higher amounts ($94,489), on average, than were cases governed by the American rule ($73,786). Most notably, settlements of less than $10,000 dropped from 49 percent of all settled cases under the American rule to less than 37 percent under loser pays, suggesting that some low-value settlements under the American rule were paid to the sort of nuisance complainant who did not actually file suit or the sort of plaintiff who dropped his lawsuit during the period when loser pays was in force.

Similarly, while a smaller percentage of medical-malpractice suits went to trial in the years that the loser-pays rule was in effect, the average trial award came close to tripling, from $25,190 to $69,390 in constant dollars, and plaintiffs more often prevailed at trial. Hughes and Snyder concluded that the higher average was the direct result of the loser-pays rule's elimination of many weak cases: "Having found that plaintiff prospects improve under the English rule, we are able to establish that these effects necessarily reflect an improved selection of claims reaching the settle-versus-litigate stage."

Florida cases did experience an increase in litigation expenses, both those that settled and those that proceeded to trial during the loser-pays experiment. However, costs relative to the size of the verdict changed very little, and it would be worth exploring whether the explanation is that defendants were simply spending more on individual cases because the pool of cases was smaller but stronger (i.e., the stakes were higher, and therefore the extra effort put into defending them was well worth making).

While the evidence from Florida's ambitious experiment is ambiguous and complex, it confirms to a striking degree predictions made in the theoretical literature: litigants with weak cases should be far more likely to abandon their claims under loser pays, which allows lawyers to focus on more meritorious suits. The increased size of the average settlement and judgment under Florida's temporary loser-pays regime also tends to support this view. Attorneys' fees per case did rise during this period, although it remains possible that expenditures for cases of similar size and merit were unchanged.

Did Florida's version of loser pays work better or worse there than the American rule? The large increase in dropped claims and the lower rate of trials suggest that Florida's loser-pays law was a promising experiment that lawmakers abandoned too quickly. Doctors referred to anecdotal evidence that the rule favored losing plaintiffs with few assets, who couldn't afford to pay the winning defendants' attorneys' fees. But, Hughes and Snyder surmise, loser pays actually encouraged plaintiffs with assets to settle or drop weak cases early in order to avoid having to pay a fee award. Be that as it may, at least some percentage of plaintiffs proved judgment-proof, preventing winning defendants from collecting their fees and blunting the incentive effects of the law. In view of Florida's experience, those advocating loser-pays rules should take into account the problem of judgment-proof plaintiffs and consider insurance or other devices to ensure that plaintiffs without assets did not stop the rule from functioning.

Part III: Implementation Guidelines

The theoretical literature on loser pays as well as the Florida experiment with loser pays in the medical malpractice context suggests that future loser-pays reforms should be designed to guard against the possible negative side effects of increased per-case costs and uncollectable fee awards, and also to promote settlement.

First, loser pays works best if defendants can recover their fees in cases involving plaintiffs with few personal assets. In many nations with loser-pays rules, litigation insurance is available to plaintiffs at a reasonable price, as I have extensively discussed in my prior published work. The United States should require plaintiffs to purchase insurance, and it should permit their lawyers to advance the premium, as they do other litigation costs, in order to preserve access to the courts.

Also, loser-pays reforms should be designed to minimize any increases in costs per case and any negative effect on the prospects of settlement. In order to accomplish this, loser pays should be accompanied by a modified offer-of-judgment rule (similar to those already present in many state systems and in federal courts) that applies to both plaintiffs and defendants. Offer-of-judgment rules impose court costs on plaintiffs who pass up a settlement offer in favor of obtaining a judgment that turns out to be no more generous. If such rules are extended to include attorneys' fees, they should encourage timely settlement of claims.

The Manhattan Institute has offered a concrete reform proposal that meets these criteria by combining loser pays with a modified offer-of-judgment device that 1) limits the size of fee awards against unsuccessful litigants who make reasonable settlement offers, and 2) requires litigants to demonstrate that they have assets available to pay any fee award, that they have obtained litigation insurance, or that the lawyers representing them have agreed to assume responsibility for any fee award. This or any other proposal that is designed with these features in mind will compensate winning litigants more fully and reduce the number of abusive lawsuits filed. It should also limit any increases in litigation expenditures and encourage the parties to make reasonable settlement offers so as to limit their potential liability for attorneys' fees.

Marie Gryphon is a Senior Fellow at the Center for Legal Policy at the Manhattan Institute and a PhD candidate in public policy at Harvard University. Ms. Gryphon holds a JD from the University of Washington School of Law and a BA in political science from the University of Washington.


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