Encyclopedia of Law & Economics - 7300 INDEMNITY OF LEGAL FEES

7300

INDEMNITY OF LEGAL FEES

Avery Wiener Katz

Georgetown University

© Copyright 1998 Avery Wiener Katz

Contents

Abstract
1. Introduction
2. The Practical Extent of Legal Fee Shifting
3. The Effect of Fee Shifting on Trial and Pretrial Expenditures
4. Effects of Fee Shifting on The Decisions to File and ContestLawsuits
5. Effects of Fee Shifting on the Settlement of Litigation
6. Effects of Fee Shifting on Substantive Behavior
7. Variations on Simple Fee Shifting
8. Empirical Evidence on the Effects of Fee Shifting
9. Conclusion
Bibliography on Indemnity of Legal Fees (7300)
Other References
Cases


Abstract

This article surveys the effects of legal fee shifting on a variety of decisionsarising before and during the litigation process. Section 2 provides a briefsurvey of the practical situations in which legal fee shifting does and doesnot arise. Section 3 analyzes the effects of indemnification on the incentivesto expend resources in litigated cases. Section 4 examines howindemnification influences the decisions to bring and to defend against suit,and Section 5 assesses its effects on the choice between settlement and trial.Section 6 addresses the interaction between the allocation of legal fees andthe parties' incentives for efficient primary behavior. Section 7 considers twoimportant variants on simple indemnification: rules that shift costs based onthe parties' settlement negotiations (such as U.S. Federal Rule 68 and theEnglish practice of payment into court), and rules that shift costs based onthe margin of victory (such as U.S. Federal Rule 11 and the common law tortof malicious prosecution). Section 8 reviews the brief but instructive empiricalliterature on legal cost shifting, and section 9 summariwes the discussion andoffers conclusions.

JEL classification: K40, K41

Keywords: Litigation, Legal Costs, Legal Fees, Legal Fee Shifting

1. Introduction

In most Western legal systems, a party who prevails in litigation is generallyentitled to indemnification from the losing party for at least part of his or hereconomic costs of prosecuting the lawsuit. The amount of litigationexpenditures that can be recovered, however, varies substantially bothamong and within individual regimes. In the United States, the predominantrule awards a prevailing litigant what are officially termed "costs" -- typicallydefined by statute to include filing fees, court reporter charges, printing,copying, and witness fees, and the like -- but does not entitle him or her torecover expenditures on attorneys' fees, which are of far greater magnitude inthe usual case. Consequently, U.S. litigants can bear significant expense evenwhen they are ultimately vindicated on the merits. In the other common-lawcountries, in contrast, and indeed in most of the rest of the Western world,winning litigants are entitled to recover attorneys' fees as well as otherout-of-pocket costs of litigation. As a result, they come closer to being madewhole than do winning litigants in the U.S.

The substantial increase in expenditures on litigation and disputeresolution in the United States in recent years has led both policymakers andscholars to advocate a variety of substantive and procedural reforms in thelegal system. The rules for allocating attorneys' fees in civil litigation havedrawn particular attention in this regard, with a number of influentialcommentators recommending a move in the direction of fuller indemnification-- or what in the U.S. is usually called, for historical reasons, the "English" or"British" rule. Such recommendations have begun to have influence on bothpublic and private lawmakers; indeed, one of the more prominent and widelysupported provisions in the Republican Party's 1994 "Contract with America"platform would have adopted a modified form of the English rule for federalcases brought under the diversity jurisdiction. But the political debate overlitigation costs in the U.S does not seem to have assimilated the main lessonof the economic literature on the topic -- that the effects of cost shifting onthe amount and intensity of litigation are substantially more complicated thana superficial consideration of the matter might suggest. Indeed, the currentstate of economic knowledge does not enable us reliably to predict whether amove to fuller indemnification would raise or lower the total costs oflitigation, let alone whether it would better align those costs with any socialbenefits they might generate.

The reason for this agnostic conclusion is straightforward. Legal costsinfluence all aspects of the litigation process, from the decision to file suit tothe choice between settlement and trial to the question whether to takeprecautions against a dispute in the first place (for a survey of such effects,see Cooter and Rubinfeld, 1989). Furthermore, as Shavell (1982b) has shown,an individual litigant's incentives to bring suit in a costly legal system do notgenerally conform to the social optimum; and the divergence between privateand social incentives to sue are complex. A plaintiff's decision to sue imposesan obvious cost on the defendant and on the taxpayers who foot the bill forpublic legal institutions. Less obviously, it affects litigants in other cases bycrowding the courts, by delaying the resolution of other disputes in thesystem, and, through informational externalities, by altering the expectedcosts of settlement. It also affects future litigants by increasing the stock oflegal precedent, and potential litigants (as well as those who never intend toresort to the courts at all) by influencing the perceived likelihood of sanctionsfor violating substantive legal duties. Similarly, the decisions to pursue alawsuit to trial rather than settling, and to litigate more rather than lessintensively, generate analogous external costs and benefits. The combinationof all these external effects are too complicated to be remedied by a simplerule of "loser pays." Instead, indemnity of legal fees remedies someexternalities while failing to address and even exacerbating others.

This article, accordingly, surveys the effects of legal fee shifting on avariety of decisions arising before and during the litigation process. Section 2provides a brief survey of the practical situations in which legal fee shiftingdoes and does not arise. Section 3 analyzes the effects of indemnification onthe incentives to expend resources in litigated cases. Section 4 examines howindemnification influences the decisions to bring and to defend against suit,and Section 5 assesses its effects on the choice between settlement and trial.Section 6 addresses the interaction between the allocation of legal fees andthe parties' incentives for efficient primary behavior. Section 7 considers twoimportant variants on simple indemnification: rules that shift costs based onthe parties' settlement negotiations (such as U.S. Federal Rule 68 and theEnglish practice of payment into court), and rules that shift costs based onthe margin of victory (such as U.S. Federal Rule 11 and the common-law tortof malicious prosecution). Section 8 reviews the brief but instructive empiricalliterature on legal cost shifting, and section 9 summarizes the discussion andoffers conclusions.

[N.B.: The scholarly literature on fee shifting has flourished in recentyears, to the point where it is no longer feasible to discuss every pertinentcontribution. For recent surveys of work in the area, see Cooter and Rubinfeld(1989), Anderson (1996), and the symposia appearing in Law andContemporary Problems (1984) and Chicago-Kent Law Review (1996)respectively.]


2. The Practical Extent of Legal Fee Shifting

This article does not attempt to survey the law governing fee shifting, eitherin the U.S. or elsewhere. For such surveys, see Pfennigstorf (1984), Note(1984), or Tomkins and Willging (1986). It should be recognized, however,that there are significant areas of U.S. legal practice that do not follow thetraditional American rule. Most important among these are the various federaland state statutes that entitle a successful plaintiff, though not a successfuldefendant, to court-awarded attorneys' fees as part of a recovery. Similar"one-way" fee shifting policies have also been established in both federaland state courts through a combination of statutory interpretation andcommon law development, though the scope for such interpretations at thefederal level was substantially limited by the Supreme Court in AlyeskaPipeline Service Co. v. Wilderness Society. Such provisions and policies,which make up a central part of litigation practice in such fields as civil rights,consumer, and antitrust law, have only some of the effects of the traditionaltwo-way English rule. Second, both federal and state courts have authority toaward indemnification to parties who are victimized by abuse of process,though such authority is typically exercised only in response to egregiousbehavior. Examples include the provisions in Fed. R. Civ. Proc. 11 dealingwith frivolous or improper pleadings, and those in Fed. R. Civ. Proc. 37.relating to discovery abuse. U.S. practice also provides litigants with an"offer-of-judgment" procedure under which a defendant can make asettlement offer to the plaintiff which, if rejected and filed with the court,creates a trigger for partial indemnification. Both of these specialized types ofprovisions -- sanctions for abuse and offers of judgment -- are discussedseparately in section 7 below.

Conversely, even in jurisdictions following the majority or "English" rule,indemnification for legal costs is substantially less than complete.Court-awarded attorneys' fees obviously do not compensate for thenonmonetary and psychic costs of litigation. Even the monetary amountsawarded, furthermore, are limited by the judge's view of what expenditures arereasonable and, in some jurisdictions (e.g., British Columbia), by statutoryschedule. Such judicial and statutory caps can and often do hold fee awardsbelow the going market rate for legal representation, forcing winning litigantsto pay the difference out of anticipated recoveries or their own pockets(indeed, Leubsdorf (1984) presents evidence that such court-imposed priceceilings were responsible for the historical development of the American rulein the first place.) Accordingly, the pure "English"and "American" rulesdiscussed below should be understood as ideal polar cases, and thedifferences among actual jurisdictional practices as ones of degree along aspectrum ranging from lesser to greater indemnification .

Additionally, Donohue (1991b) points out that the American rule is adefault rule rather than a mandatory one, in that parties are generally free toprovide for indemnification through private contract -- either at the time theybegin their litigation or, for those disputes arising out of an consensualrelationship, in their original agreement. He presents anecdotal evidence thatsuch ex ante indemnification terms are widespread, though the provisions hecites seem primarily to be drawn from standardized form contracts and tend tooperate asymmetrically in favor of the drafting party: for instance, apartmentleases that indemnify landlords but not tenants for attorneys' fees in theevent of a dispute over unpaid rent. The scope for fee shifting in the U.S,.therefore, may be significantly greater than is ordinarily supposed.Conversely, there is no apparent bar in England or in the other jurisdictionsfollowing the English rule to a partial settlement or stipulation in which thelitigants agree in advance to give up their rights to indemnification ex post.Donohue's further conjectures that such contractual terms are likely to beefficiency-enhancing and that the pattern of such terms will help revealwhether the English or American rule is more efficient, however, are moreproblematic. To the extent that indemnification is provided by a one-sidedstandardized term, there is no guarantee that it promotes the joint interests ofthe parties. The nondrafting party may fail to notice the indemnificationprovision at all; and if he does notice it, he may avoid raising it as an issue forfear of revealing himself as someone who anticipates a dispute. Even whensuch agreements arise out of arms-length bargaining, furthermore, this doesnot imply that they are efficient. As Bernstein (1993) and Shavell (1995) haveobserved in their respective analyses of alternative dispute resolution,because of the divergence of private and social incentives in litigation, thefact that a particular agreement is in the litigants' ex post interest does notnecessarily mean that it is socially efficient. The fact that the parties havecome to litigation in the first place, moreover, casts doubt on the presumptionthat they are bargaining in a Coasian fashion.


3. The Effect of Fee Shifting on Trial and Pretrial Expenditures

The standard economic theory of litigation, as developed by Landes (1971),Posner (1973), and Gould (1973), models litigating parties as rational actorswho seek to maximize their returns from the litigation process. From thisperspective, amounts spent on trial preparation can be seen as a type ofprivate investment. An additional hour of legal research or argumentation isprofitable, on this view, only if the marginal return, measured by the changein the expected outcome of trial or settlement, outweighs the cost of theattorney's time. Plaintiffs, accordingly, will choose to spend legal resourcesup to the point where their expected recoveries, net of expenses, aremaximized; defendants will act so as to minimize total payouts. The preciseoutcome of this contest depends on how the parties react and adjust to eachothers' decisions. One simple and natural assumption is that the litigantsreach a Nash equilibrium in expenditure; that is, that each takes the other'sexpenditure as given when choosing his own. Whatever the nature of theparties' strategic interaction, however, the parties' expenditures aredetermined in equilibrium by a host of economic and technological factorsincluding the stakes of the case, the marginal cost of legal resources, and thesensitivity of trial outcomes to the parties' individual efforts. In high-stakescases in which the outcome is heavily dependent on the parties' workproduct, expenditures will be high; in petty cases where the outcome islargely predetermined by legal precedent, expenditures will be low.

As Braeutigam, Owen and Panzar (1984) first proved and Katz (1987)subsequently explained, it follows from the standard model that fee shiftingencourages greater expenditure in litigated cases. The reasons are twofold.First, fee shifting increases the stakes of the case by making legalexpenditures part of the potential damages. Second, it lowers the expectedmarginal cost of legal expenditure. Each party, when deciding whether topurchase an additional unit of legal services, will discount its cost by theprobability with which she expects to win and to be reimbursed by heropponent. More formally: if we let p denote the probability of liability, A theamount awarded if the plaintiff wins, and x and y the amounts spent by theplaintiff and defendant respectively, then under the American rule a plaintiffwill expect to recover p(x, y) A(x, y) - x. Assuming risk-neutrality for the sakeof simplicity, it follows she will choose x to satisfy the first-order-condition,px A + pA x = 1. The defendant, conversely, expects to pay out pA + y, and willselect y to satisfy his first-order-condition, py A + pA y = -1. Under the Englishrule, in contrast, the plaintiff's expected recovery is pA - (1-p)(x+y); so herfirst-order-condition is px(A+x+y) + pA x = 1-p. Similarly, the defendant'sexpected payout is p(A+x+y), and his first-order-condition is py(A+x+y) +pAy = -p. In all of these equations, the left-hand side represents the marginalprivate benefit of expenditure, and the right-hand side its marginal cost.Inspection of the equations reveals that the marginal private cost of legalexpenditure is lower for both parties under the English rule. If the parties'expenditure affects the probability of liability (that is, if px and py arepositive), the marginal private benefit is also higher; if expenditure affects theamount awarded rather than the probability of liability, marginal benefit isunchanged. Other things being equal, therefore, the English rule makesexpenditure more attractive.

It should be noted that the marginal-cost effect depends not on the actualprobability of liability, but on its perceived probability. It follows that theincrease in expenditure under the English rule will be greater the moreoptimistic are the litigants. In the extreme, parties who regard themselves asvery likely to win will perceive litigation as virtually costless and will increasetheir expenditures accordingly. To the extent that such efforts increase theprobability of prevailing, therefore, such optimism will be partiallyself-fulfilling. Similarly, in other than even cases, the marginal-cost effect willbe stronger for the party with the stronger probability of prevailing ex ante.For instance, if both parties regard the initial probability of liability as 90%,the plaintiff will discount the expected marginal cost of legal services to 10¢on the dollar while the defendant discounts it only to 90¢. The stimulus to theplaintiff's expenditure will accordingly be ten times greater than the stimulusto the defendant's. Fee shifting, accordingly, reinforces the advantages of theparty who is initially favored in litigation.

Because of the interaction between the parties' expenditure decisions, it isnot possible to prove that both sides will increase their expenditures underthe English rule. The reason for this ambiguity is that a marginal increase inone side's expenditure has an ambiguous effect on the other's; it could eitherprovoke the opponent to respond in kind, or intimidate him into reducing hisown efforts. Braeutigam, Owen and Panzar, however, showed that in Nashequilibrium the sum of the parties' expenditures must increase. The extent ofthe increase depends on how sensitive p and A are to litigation expenditure,as Plott (1987) has demonstrated. Using a Nash equilibrium model and makingsome simplifying technical assumptions regarding functional form, he foundthat if the case outcome depends entirely on factors out of the litigants'control, the English rule has no effect on expenditure. If case outcome isdetermined solely by their efforts, conversely, the English rule will causeexpenditure to increase without limit.

Such effects are mitigated in regimes that limit the amount of fees that canbe shifted. For example, under both English and U.S. practice, indemnificationis limited to reasonable expenditures. Similarly, some recent U.S proposalsprovide that a losing party need not pay any indemnification in excess of hisor her own litigation costs. Both of these variations reduce the privatebenefits of legal expenditure relative to the pure English rule; and as Hughesand Woglom (1996) show, the latter actually operates as a tax on the weakerparty's expenditure, since increases in his spending raise the cap on theindemnification potentially payable to his opponent.

Furthermore, while most of the economic literature on litigationexpenditure has assumed a Nash equilibrium, a few authors [e.g., Hersch(1990)] have argued that it is not reasonable to expect litigants to ignore theeffect on the other side's expenditure when choosing their own. The Nashspecification is most appealing when expenditure is simultaneous, when eachside must choose how much to spend before learning the opponent'sdecision, or when the expenditure decision is largely determined by one'sinitial choice of an attorney; it is least appealing when one side can commit toa given level of expenditure and communicate that commitment to theopponent in advance. One can analyze the latter situation using the moregeneral model of conjectural variations -- so called because it allows a party'sdecision to depend upon his conjectures regarding how the opponent'sdecision varies with his own. Formally, let vx denote the rate at which theplaintiff expects the defendant to respond to her expenditures. This rate couldbe positive (in which case expenditure would be provocative), negative (inwhich case expenditure would be intimidating), or zero (as in the Nash model).The plaintiff's first-order-condition then becomes (px + vx py)A + p (A x+ vx A y)= 1 under the American rule, and (px + vx py)(A + x + y) + p (A x+ vx A y) =(1-p)(1+vx) under the English rule. (The analysis for the defendant issymmetric and is omitted for the sake of brevity.) Comparing the first term ofeach equations, one can see that the stakes effect is still present. Thedirection of the marginal-cost effect, however, is now ambiguous. Under theEnglish rule, an additional dollar spent on legal services will cost the plaintiffonly 1-p, after she discounts for the probability of prevailing. But if theplaintiff loses, she will also have to pay the defendant's costs, and theadditional dollar induces him to change his expenditures by vx. If theplaintiff's expenditure is intimidating, this will lower her marginal cost evenfurther. If her expenditure is sufficiently provocative, however, her marginalcost of legal resources will rise; if it is provocative enough to outweigh thestakes effect, her equilibrium expenditure will fall.

It is difficult to judge the empirical importance of theconjectural-variations model. Katz (1988) has shown that in the typical caseone party is in a provocative position and the other in an intimidating one. Inparticular situations, however, expenditure may be very provocative. Onesuch context may be civil discovery, the process through which U.S. litigantsare permitted to request information from their adversaries before trial.Expenditures on discovery have risen substantially in recent decades, and ithas been widely alleged that much of this increase is an abuse of the system,encouraging both frivolous suits and unfair settlements. The underlyingproblem, however, may simply be one of incentives. As Cooter and Rubinfeld(1994, 1995) and Cooper (1994) explain, a party seeking discovery can undercurrent American practice impose significant costs on her adversary atrelatively low cost to herself -- for instance, by issuing a formulaic thoughburdensome list of interrogatories and document requests, or by resistingrequests that could be complied with cheaply. For such types of expenditure,the conjectural variation vx is very large; fee shifting, accordingly, maysubstantially deter "abusive" behavior of this sort.

The analysis in this section has focused on the amount of resourcesexpended in litigated cases. Total expenditures on litigation, however, are theproduct of two factors: expenditures per litigated case, and the number ofcases that are actually litigated. Fee shifting can influence the number oflitigated cases in two ways: by influencing the decision to bring the disputeto court in the first place, and by influencing the parties' incentive to settlecases before trial. The next section of this article discusses the former effect,and section 5 discusses the latter.

4. Effects of Fee Shifting on The Decisions to File and Contest Lawsuits

Consider the case of a consumer who has purchased a defective ballpoint penand who is in theory entitled to a refund. Because the value of the pen isexceeded by even the most streamlined judicial proceeding, the consumer'sthreat to litigate is not credible; and absent procedural devices such as aclass action that can allow aggregation of her claim with others, she will beforced to rely on nonlegal incentives such as the seller's interest in itsreputation for goodwill. If the consumer can recover legal fees along with thevalue of her refund, however, her threat to sue becomes credible. Shavell(1982a), extending work of Landes (1971) and Gould (1973) on the incentivesto sue, generalized this argument to show that the English rule, andindemnification in general, works to encourage lawsuits by plaintiffs withrelatively small claims but relatively high ex ante probabilities of victory. TheAmerican rule, conversely, encourages plaintiffs with relatively large claimsbut lower probabilities of victory.

The formal logic of the argument is as follows: let p represent theprobability of a plaintiff victory, A the expected award if the plaintiff wins, andc the cost of litigation for each litigant. (To simplify the argument, supposethat this cost is the same for both sides; this will affect the specific point atwhich the incentives switch, but not the basic intuition of the argument.)Under the American rule, litigation is profitable if (and only if) pA > c; thus, aplaintiff will bring suit if she views her chances at better than the thresholdprobability pUS c/A. Under the English rule, however, the plaintiff's expectedlitigation cost is not c but (1-p)2c, since she pays no costs if she wins but 2cif she loses. She will accordingly wish to litigate if pA >(1-p)2c, orequivalently, if she views her chances at better than pENG 2c/(A+2c).Algebraic manipulation reveals that c>A/2 implies pUS > pENG > ½, and c<A/2implies pUS < pENG < ½. Thus, when costs are high or stakes low, the Englishrule encourages some better-than-average suits that would be deterred underthe American rule; when costs are low or stakes high, the Englishdiscourages some worse-than-average suits that would be brought under theAmerican rule.

An identical line of argument shows the effect of indemnification on theincentives to defend against a lawsuit once it has been brought. If it costs thedefendant c to put up a defense that will succeed with probability p, it isworthwhile to defend (rather than suffer a default) only if the expectedsavings pA exceed the expected costs of litigation. Under the American rulethese expected costs are c, and under the English rule they are (1-p)2c. Thelogic is as before; the American rule encourages long-shot defenses inhigh-stakes and low-cost cases, while the English rule encourageshigh-probability defenses in high-cost and low-stakes cases.

Such arguments lend support to the frequently expressed view that theEnglish rule is superior on grounds of corrective justice, since the claims anddefenses that it promotes are relatively meritorious ones -- at least whenviewed from an ex ante perspective. Similarly, as Rosenberg and Shavell(1985) have shown, indemnification can help discourage certain frivolous or"strike" suits, by emboldening defendants to put forward costly defensesagainst them (assuming that the frivolous nature of the suit is commonknowledge; as Katz (1990) argues, the English rule may do little to discouragestrike suits that cannot be identified as such without a trial.)

But there is a cost to this ostensible increase in justice. The claim anddefenses encouraged by the English rule are low-stakes and high-cost -- thatis, expensive to try relative to their importance. The claims and defensesencouraged by the American rule may be relative longshots on the merits, butthey are relatively cheap to resolve. Moreover, some suits, including thosebrought to test or clarify the law or to settle matters of principle, may besocially desirable notwithstanding a low ex ante probability of success.Accordingly, legal policy in this area may present a tradeoff between justiceand more narrow conceptions of efficiency.

Any conclusions regarding the effect of litigation fee shifting onincentives to sue must also take account of the litigants' expected response torisk. As has been widely recognized, the English rule magnifies the privaterisk arising from litigation by increasing both the returns from success andthe losses from defeat. Thus, it tends to discourage risk-averse parties frombringing or defending lawsuits, regardless of the merits of their positions -- afactor that has been stressed by partisans of the American rule. What hasbeen less well recognized, however, is that this same increase in variance canencourage more litigation by the risk-neutral. The reason is that most lawsuitsare divided into a series of procedural stages, at each of which it is possibleto decide whether to continue depending on how the case is going. Becauseof this flexibility, as Cornell (1990) has shown, the decision to litigate can beinterpreted as the purchase of an option. Just as financial options can sell fora positive price even if the probability of exercising them is low, the optionvalue of litigation can make it profitable to put forward claims with negativeexpected value. Because the value of an option increases with its variance,the English rule, by increasing both the upside and the downside of litigation,intensifies this incentive. Indeed, if parties can drop arguments before trialwithout penalty, such enhanced option value could increase litigation evenby the risk-averse.

Additionally, as the previous section indicated, the English rule indirectlyalters incentives to sue through its effects on the expected cost of theindividual case. Because indemnification encourages parties to litigate theirdisputes more intensively, it increases the expected cost of bringing anddefending suits ex ante. This will deter parties on the margin of litigation frompursuing their cases, whether they are on the margin because of low stakes,high cost, or low probability. This effect is essentially analogous to a tax onlitigation; as both Bowles (1987) and Hause (1989) have observed, to theextent it is empirically significant it could outweigh the effects describedabove. Unless such increased expenditures improve the quality of judicialdecisionmaking, however, they must be counted as a disadvantage of theEnglish rule. Even if it is deemed desirable to deter litigation by raising itsprivate cost, it is plainly more efficient to do so with a excise tax, which merelytransfers wealth from litigants to the public fisc, than by wasting realresources. The same objection applies to any policy of deterring litigationthrough increased risk, which constitutes a real loss for those on whom it isimposed.


5. Effects of Fee Shifting on the Settlement of Litigation

Because the great majority of civil cases are settled rather than tried, andbecause trial substantially increases the cost of disputes, effects onsettlement are a critical factor in any comparison of the English and Americanrules. As a result, the economic literature on fee shifting has focused on thisissue more than any other. The conventional wisdom among practicingattorneys appears to be that a shift toward fuller indemnification wouldencourage settlement. The conclusions of the scholarly literature, however,cannot be said to offer strong support for this proposition; at best the effectsare ambiguous.

As a first approximation, fee shifting magnifies the effect of litigants'optimism, making them less likely to settle. As Landes (1971) and Gould (1973)observed, since litigation is a negative-sum game ex post, parties whoaccurately assess their chances of victory have a strong collective incentiveto avoid the costs of trial. Indeed, in a world of purely Coasian bargaining,there would be no trials at all, since full sharing of information wouldeliminate any differences of opinion. Because of random variations ininformation, judgment, and temperament, however, some fraction of litigantswill inevitably overassess their chances; and it is these optimistic litigantswho have an incentive to go to trial. Pessimistic or unbiased parties, incontrast, would prefer to settle. But the degree of optimism necessary for atrial to result depends on how litigation costs are allocated, as the followingargument [suggested by Mause (1969) and formally demonstrated by Shavell(1982a)] shows: Under the American rule, a plaintiff who perceives theprobability of liability as pP, her stakes as AP, and her costs as cP will insist onreceiving a settlement of no less than SP pP AP - cP. Similarly, a defendant whoperceives the probability of liability as pD, his stakes as AD, and his costs ascD will be willing to pay no more than SD pD AD + cD. Settlement is thuspossible if (and only if) SP < SD, or equivalently, if the total litigation costs, cP+ cD, exceed the difference between the parties' reservation settlement values,pPAP - pDAD. Parties whose litigation costs are below this cutoff level,conversely, will prefer to go to trial. Under the English rule, however, theplaintiff's reservation settlement value becomes SP pP AP - (1-pP)(cP + cD), andthe defendant's becomes SD pD (AD + cP + cD). Now settlement is possible onlyif cP + cD > (pP AP - pD AD)/(1-pP+pD). If the plaintiff's probability estimate pPexceeds the defendant's probability estimate pD, the parties' reservation priceswill diverge, making settlements less likely.

The economic intuition underlying this result is that indemnificationinternalizes one externality while creating another. Under the English rule, alitigant is forced to take into account the other side's litigation costs to theextent that she risks losing the case, making her more willing to settle. Butconversely, she is freed of her own litigation costs to the extent that shehopes to win, making her less likely to settle. Since litigants aredisproportionately drawn from the population of optimists (else they wouldsettle however costs are allocated), the latter effect tends to outweigh theformer. Indeed, in the limiting case when both parties are fully confident ofwinning, neither expects to pay any costs at all and settlement is impossible.This line of argument, however, suggests an important exception to the basicresult: in some cases, parties might choose to litigate due to a difference ofopinion not over liability but over stakes. A plaintiff who regarded the stakesas sufficiently higher than did the defendant -- for example, because shehoped to establish a favorable precedent that could be drawn on in latercases -- might refuse all settlements even if the parties agreed on theprobability of liability or were both relatively pessimistic. If the parties'relative optimism about the stakes were enough to outweigh their relativepessimism about probability, fee shifting would encourage settlement anddiscourage trial.

The Landes-Gould model of settlement bargaining (often called the"optimism model" in subsequent literature) is open to the criticism that it isnot rigorously grounded in the modern theory of imperfect informationgames. In particular, it does not explain how the parties can maintain theirinconsistent perceptions of the case in the face of negotiation; and itsconclusion that nonoptimistic parties will always settle ignores the possibilityof strategic behavior and depends on the assumption of collective rather thanindividual rationality. Accordingly, subsequent writers have often preferredto base their analyses on an alternative bargaining model based on Bayesianinference and on the assumption of rational expectations. In this model, dueto Harsanyi and Selten (1972) and introduced into the law-and-economicsliterature by Cooter, Marks, and Mnookin (1982), trials are caused not byoptimism but by uncertainty over the opponent's reservation settlementvalue. The logic is that parties uncertain of their opponents' bottom line willfind it individually rational to balance the probability of settlement against itsterms -- making offers that more combative opponents will reject, in order toimprove the return from settlements with those who are more conciliatory,Whether cases settle, therefore, depends on a number of factors, includingthe stakes, the cost of litigation, and, most importantly, the extent ofuncertainty between the parties. A high variance of reservation settlementvalues means that taking a marginally tougher position sacrifices fewerbargains -- lowering the opportunity cost of hard bargaining. Moreuncertainty thus means less settlement.

Despite their differences from the optimism model, however, Bayesianmodels of settlement [see, e.g., Bebchuk (1984), Reinganum and Wilde (1986),Talley (1996)] tend to confirm its conclusion that the English rule tends todiscourage settlement in disputes revolving around liability, though not indisputes revolving around stakes. The reason is that indemnificationmagnifies uncertainty in the former set of cases but not in the latter. Moreprecisely, uncertainty about opponents' reservation values can stem fromnumerous sources: variations in the private cost and stakes of litigation, inattitudes toward risk and delay, and in private information relevant to the trialoutcome. Differences in risk aversion, time preference, and stakes are notaffected by fee shifting, but differences in private cost and in informationrelevant to liability are. Fee shifting thus increases the difference between thereservation values of parties with favorable private information and highlitigation costs on one hand, and parties with unfavorable information andlow litigation costs on the other. This increase in uncertainty leads all typesof parties to toughen their overall bargaining positions, lowering theprobability of settlement. Ironically, as Polinsky and Rubinfeld (forthcoming1997) point out, this implies that the English rule actually lowers the averagequality of tried cases, since the marginal parties it sends to trial haverelatively less favorable private information than those who would litigateabsent the prospect of indemnification.

The foregoing discussion of both optimism and Bayesian models,however, has assumed risk neutrality and has taken the cost of litigation asgiven. As the previous sections have observed, indemnification bothincreases the risks of litigation and raises litigation costs generally. Botheffects tend to encourage settlement, thus mitigating and perhapscounteracting the effects of optimism and asymmetric information. Whetherindemnification increases or decreases settlement on balance, accordingly,depends on the relative magnitude of competing factors, and cannot besettled theoretically.

Even if fee shifting does not alter the probability of settlement, however, itcan still influence its amount. As Cooter and Rubinfeld (1994) have argued inthe context of legal discovery and Bebchuk and Chang (1996) have argued inthe context of offers of judgment, fee shifting can, by equalizing thebargaining power of parties with asymmetric litigation costs, help to move thesettlement amount closer to the expected trial outcome. To the extent that trialoutcomes are deemed to be just, fee shifting thus may help promote equity;to the extent that trial outcomes reflect substantive legal norms, fee shiftinghelps promote incentives for proper primary behavior -- a subject more fullyexplored in the following section.


6. Effects of Fee Shifting on Substantive Behavior

The discussion thus far is in a fundamental sense incomplete, since it hasfocused largely on the procedural costs of litigation. If such costs were one'sonly concern, of course, they could be eliminated entirely by abolishing thelegal system and all publicly enforceable rights to relief. A central purpose ofhaving a public system of courts, however, is to redress wrongs and toencourage compliance with primary substantive norms such as takingprecautions against accidents and keeping one's promises. Indemnity of legalfees, accordingly, must ultimately be judged on these latter criteria -- or moreaccurately, on whether it increases the social value of substantiveenforcement net of process costs.

Viewed from this perspective, the English rule initially appears attractive,since it tends to encourage high probability suits and discourage lowprobability ones. Assuming that the probability of liability is correlated withthe actual violation of substantive norms, therefore, indemnification increasesthe net expected punishment for such violations and thus helps promotesubstantive compliance. This is easily seen in the case where courts' liabilitydeterminations are error-free, as Rose-Ackerman and Geistfeld (1987) andPolinsky and Rubinfeld (1988) have shown. Consider a potential tortfeasorwho can take precautions against an accident that will cause an uncertainamount of damage. Suppose that the possible damage ranges from zero to A,and that the cost of establishing liability following an accident is c. Under theAmerican rule, it follows that the tortfeasor will have inadequate incentivesfor precaution. In the event that damages turn out to be less than c, the victimwill not sue, so the tortfeasor will escape responsibility for a portion of thedamages caused. Under the English rule, however, the victim will always havethe incentive to sue, so that all accident costs will be fully internalized. Undera rule of negligence as opposed to strict liability, indeed, complete costinternalization can be achieved without incurring any litigation costs at all:defendants will be induced to take optimal care by the threat of litigation, soplaintiffs will never actually have to sue. Conversely, under the Americanrule, defendants may rationally decide to take excess care -- or to abstain fromrisky though optimal activities -- in order to avoid the greater expense ofhaving to defend their behavior in court. Indemnification protects them fromsuch expenses, thus preventing overdeterrence.

This happy outcome, however, depends on the assumption thatdeserving plaintiffs and defendants always win their cases. In the presence oflegal error, as P'ng (1987) and Polinsky and Shavell (1989) have shown,neither the American nor the English rule provides incentives that arefirst-best optimal. Optimal incentives, rather, require at least two separatepolicy instruments -- one to motivate efficient substantive behavior, andanother to promote an efficient amount of litigation. Polinsky and Che (1991)demonstrate that, in general, this means decoupling the amounts paid bylosing defendants from those received by victorious plaintiffs. (Indeed, asPolinsky and Rubinfeld (1996) show, decoupling is generally necessary evento achieve the lesser goal of minimizing the litigation costs associated withachieving a given level of deterrence). Devices combining fines, punitivedamages and taxes (positive or negative) on litigation accomplish suchdecoupling, but the English rule, which merely re-allocates costs between theparties in zero-sum fashion, does not. Furthermore, it is not even the case thatthe English rule is second-best efficient within the category of zero-sumpolicy instruments. Kaplow (1993) shows that damage multipliers, such as thetreble damage provisions of U.S. antitrust law, provide a cheaper method ofachieving any given amount of deterrence. The reason is that damagemultipliers provide incentives for private law enforcement to be undertakenby those plaintiffs whose litigation costs are lowest; fee shifting, in contrast,encourages plaintiffs to bring lawsuits without regard to their costs oflitigation.

One might still ask whether the English rule does better than the Americanin promoting efficient substantive behavior, notwithstanding the potentialavailability of alternatives that are superior to both. The answer to thisquestion, however, is ambiguous, as Gravelle (1993), Hylton (1993a, 1993b),and Beckner and Katz (1995) demonstrate in independent formal models. It ispossible to draw generalizations regarding when the English rule improvesmatters, but they depend on the subtle interaction of a number of factors,including whether substantive precaution affects the magnitude of injury orjust its probability, the extent to which precaution affects the probability ofliability, whether damage awards are sufficient to compensate plaintiffs fortheir losses, and whether defendants have the opportunity to act strategicallyby taking just enough care to foreclose litigation. Hylton, for instance,concludes that a one-way fee shifting rule operating in favor of plaintiffswould be best, but this conclusion depends upon several features of hismodel (including, perhaps most importantly, the assumption that plaintiff'scare does not affect the expected cost of accidents). Applying suchgeneralizations to individual cases or categories of cases is probably beyondthe capacity of either courts or legislatures. As Gravelle concludes, "[i]tseems more promising to pursue other, more direct means of correcting theinefficient incentives for care provided by a costly and imperfect legalsystem."

7. Variations on Simple Fee Shifting

The foregoing discussion has been premised on the assumption that "costsfollow the event" -- that is, that any fee shifting that takes place is basedsolely on who wins the case. Much recent discussion in policy and scholarlycircles, however, has focused on two more complicated forms ofindemnification.

7.1. Fee Shifting Conditioned on Offers Made in Settlement

Both England and a number of American jurisdictions provide a mechanismthrough which a defendant who would otherwise be obliged to pay for legalexpenses can partially avoid the obligation by making a suitable offer ofsettlement. In England this procedure is called "payment into court" andrequires the defendant actually to deposit funds with a court officer; while inthe United States, Federal Rule of Civil Procedure 68 and similar court rulesmerely require the formal filing of what is labeled an "offer of judgment."Under either provision, a defendant who makes such a formal offer isconsidered the prevailing party for purposes of cost allocation if the plaintiffrejects the offer and then is subsequently awarded a lesser amount at trial. Insuch event, the defendant avoids having to pay any costs incurred by theplaintiff subsequent to the offer, and is entitled to indemnification for his ownsubsequent costs as well. By all accounts, defendants avail themselves ofthis procedure much more frequently in England than in the U.S. -- probablybecause the prospect of shifting liability for "costs" is likelier under thebroader English definition of the term to outweigh the disadvantages ofmaking a settlement offer. Similarly, within the U.S., Rule 68 appears to beused more widely in disputes covered by one-way pro-plaintiff fee shiftingstatutes such as Title VII, since the Supreme Court held in Marek v. Chesny,that attorney's fees shifted under such statutes are to be considered "costs"under Rule 68.

Because of the relatively infrequent use of Rule 68 in U.S. courts, anumber of American critics have in recent years supported its expansion --either by extending its coverage to attorneys' fees generally, or by making theprocedure available to plaintiffs as well as defendants. [It should be noted,however, that providing the procedure to plaintiffs is meaningless to theextent that they are already entitled to collect costs when they prevail; insuch circumstances, the opportunity to make an offer of judgment can onlyadvantage defendants.] The recent GOP "Contract with America," forexample, would have established just such a generalized offer-of-judgmentrule in federal diversity cases. Such proposals have commonly beensupported by the claim that they will reduce expenditures on litigation byencouraging parties to make more reasonable settlement offers and to acceptsuch offers when they are made. Their proponents have also argued that it isfairer to charge the costs of trial to the party who, by refusing a reasonablesettlement, causes those costs to be incurred.

In general, the economic literature on offers of judgment is substantiallyless developed than that on pure indemnification; and many interestingquestions remain to be fully investigated, including the effect of theprocedure on strategic behavior in negotiations. The place to begin anyanalysis of the offer of judgment, however, is with the observation that it isessentially an option to convert disputes over damages into disputes overliability. To see this, compare two cases: one in which it is clear that thedefendant has acted negligently but unclear whether the plaintiff's injuries are1000 or 3000 (with the two possibilities being equally likely), and a second inwhich it is clear that damages are 4000, but an even gamble whether thedefendant is liable at all. In both cases, expected damages are 2000, butabsent an offer-of-judgment procedure the plaintiff's position is stronger inthe former. She is certain to prevail at trial and to recover some fraction of hercosts, even if it is only court fees. In the latter case, she runs the risk ofpaying both her costs and a portion of the defendant's. Under Rule 68 or asimilar procedure, however, the defendant can convert the former dispute intoa partial settlement of 1000 combined with a dispute over whether thedefendant is liable for an additional 2000. In this converted dispute, thedefendant stands an even chance of avoiding liability for the plaintiff's costsand of recovering his own. This improves his expected position to what itwould be in the case of pure liability, at the plaintiff's expense.

The example illustrates two lessons. First, a rule authorizing defendantsbut not plaintiffs to make offers of judgment redistributes wealth fromplaintiffs to defendants in disputes that are entirely or partly over damages,as both Priest (1982) and Miller (1986) have suggested. Second, such offershave no effect in disputes that are purely over liability. If the only possibletrial outcomes are verdicts of zero or 4000, for instance, there is no advantageto the defendant in making a Rule 68 offer of less than the full 4000. If heoffers a lesser amount, he will be liable for costs in the event of a plaintiff'sverdict and certain to receive costs in the event of a defendant's verdict -- justas he would if he made no offer at all. Similarly, a less-than-full offer does notaffect the possible payoffs for the plaintiff. The defendant could of courseoffer to settle for the full 4000, but the plaintiff should be happy to acceptsuch an offer whether or not Rule 68 is in force. The offer-of-judgmentprocedure, accordingly, cannot affect whether an offer is made or accepted insuch cases.

With these points taken as caveats, the effects of offer-of-judgment rulesare roughly analogous to those of indemnification in general. The possibilitythat costs will be shifted following a settlement offer both raises the stakes ofthe case and lowers the perceived marginal cost of legal expenditure, thusincreasing incentives to expend resources at trial. The effect is less thanunder the pure English rule, however, since only post-offer expenditures areliable to be shifted. Similarly, the opportunity to make an offer of judgmentincreases expected payoffs for plaintiffs who expect to win large awards attrial, and lowers expected payouts of defendants who expect awards to below, emboldening such parties to pursue litigation.

The effect of offers of judgment on the settlement decision depends, likethe effect of indemnification generally, on the parties' attitudes toward riskand on the model of settlement that one thinks appropriate. Under theLandes-Posner-Gould optimism model, offers of judgment tends to lower thechances of settlement between risk-neutral parties, since, as Priest (1982)suggests and Miller (1986) and Chung (1996) confirm, such offers lower thereservation values of optimistic defendants more than they do those ofoptimistic plaintiffs, thus reducing the potential settlement range. Offers ofjudgment also increase the risk of litigation, though not as much as pureindemnification does; this encourages risk-averse parties to settle, butrisk-preferring parties to litigate. Anderson (1994), who extends the optimismmodel to include the possibility of bargaining stalemate, reaches similarresults. Within Bayesian models of settlement, the outcome appears morecomplicated. Cooter, Marks and Mnookin (1982) conjecture that anoffer-of-judgment rule, by effectively taxing hard offers and subsidizing softones, should encourage settlement. Spier (1994), however, in a model inwhich defendants make offers to plaintiffs with private information, finds thatthe procedure leads to more settlement than the pure American rule in caseswhere the plaintiff's private information relates solely to the size of the award,less settlement than the American rule in cases where the plaintiff's privateinformation relates solely to the probability of liability, and an ambiguouseffect in other cases. She also demonstrates a similar result using amechanism-design model that, instead of specifying any particular bargainingprocess, assumes that the parties use a Pareto-efficient trading mechanism inthe style of Myerson and Satterthwaite (1983). As with pure indemnification,accordingly, the effect of offers of judgment on settlement probabilitiesappears to depend on the sources of the underlying dispute.

7.2. Fee Shifting Conditioned on the Margin of Victory

In the United States, a variety of statutory and judicially created rules allowcourts to award partial or full indemnification in lawsuits in which the losingparty's case is deemed after the fact to be of sufficiently low merit. Such rulesinclude the common-law torts of barratry, abuse of process, and maliciousprosecution, the traditional authority of courts of equity to exercise theirdiscretion in the interests of justice, the sanctions for discovery abuseprovided by Federal Rule of Civil Procedure 37, and the (just amended)provisions of the Internal Revenue Code requiring the government to pay ataxpayer's reasonable litigation costs upon a court finding that thegovernment's position in a tax dispute was substantially unjustified. Similarly,as Pfennigstorf (1984) reports, indemnification awards in most other Westernlegal systems are likely to be more generous in cases where the loser's legal orfactual position appears weak.

The possibility of tying indemnification to the merits of the losing casehas attracted increased attention in recent years, in part as a response to thegrowth of litigation practice under U.S. Federal Rule of Civil Procedure 11.This rule requires persons filing court papers to warrant that their filings arewell grounded, and authorizes courts to impose monetary sanctions onparties whose filings are found to be frivolous, harassing, or made forpurposes of delay. Limiting fee shifting to cases of particularly low merit hasseemed to many commentators an attractive compromise between the Englishand American rules, since it protects clearly deserving litigants withoutimposing unnecessary risk on those who bring colorable claims in good faith.

As Bebchuk and Chang (1996) have pointed out, the effect of policiessuch as Rule 11 is to condition fee shifting on the winner's margin of victory;those who win in a rout receive indemnification, while those who winnarrowly do not. They confirm the conventional wisdom in a formal model,showing that such policies, if designed properly, can do a better job thaneither the English or the American rule at encouraging meritorious suits (andby analogy, defenses) and discouraging frivolous ones. The reason is thatsuch policies make use of the parties' private ex ante information regardingthe merits of the case. A party who loses by a large margin is less likely tohave believed ex ante that her case had merit; conversely, one who wins by alarge margin is less likely to have believed that her case lacked merit. Whilethe optimal fee shifting rule depends on the distribution of judicial andlitigant error, it is possible by altering the threshold for fee shifting to regulatethe proportion of potential claims and defenses that are actually brought intothe system. Because its effects are zero-sum, however, margin-based feeshifting is still less efficient than policies that decouple one side's paymentsfrom the other side's recovery (see generally Polinsky and Rubinfeld, 1993).Policies that tax or subsidize individual parties based on the ex post quality oftheir case may be best of all; they may also, of course, be the most difficult toadminister.

While other incentive effects of margin-based fee shifting have not beenformally explored, it appears likely that it has analogous consequences toindemnification generally, though in lesser degree. These consequencesrecapitulate the discussion in earlier sections of this article and can besurveyed in brief. First, to the extent that such policies succeed inencouraging meritorious claims and defenses and discouraging frivolousones, they will tend to improve incentives for primary substantive behavior.The complications described in section 6, supra, however, remain to beanalyzed. It is possible, for instance, that the prospect of shifting litigationcosts to the other side following a commanding victory will induce excessivecaretaking ex ante, though the benefits of doing so are less than under thepure English rule.

Second, margin-based fee shifting will both raise the stakes of litigationand decrease its expected marginal cost, inducing the parties to intensify theirefforts at trial. Schmalbeck and Myers (1986) argue that this effect will berelatively minor, since in a truly frivolous case there is little that the partiescan do to change the outcome. Their argument is open to question, however,as the substantial amount of litigation effort under Rule 11 illustrates (see,e.g., Kobyashi and Parker, 1993, who discuss the incentive effects of recentamendments intended to reduce such "satellite" litigation.) Whilemargin-based indemnification has little effect on cases that are clearlycontestable or clearly frivolous, in many disputes the colorability of thelosing case is less obvious. Parties in such intermediate cases, thus, will havean incentive to increase their expenditures in order to influence the size of themargin of victory.

Third, margin-based fee shifting will decrease the likelihood of settlementto the extent that the parties have a difference of opinion regarding thechances of indemnification. Optimistic parties will exaggerate the likelihoodthat they will win by a large margin and underestimate the likelihood that theywill lose by a large margin. The prospect of indemnification will cause suchparties to toughen their settlement demands, reducing the range forsettlement. Since pessimistic and unbiased parties will have an incentive tosettle in any event, the net consequence will be an increase in trials. Similarly,given private information regarding the probability of a one-sided outcome,margin-based fee shifting will increase the variance of the parties' reservationsettlement values, encouraging tougher bargaining and hence fewersettlements. The increased risk of trial, however, works to counteract sucheffects for risk-averse litigants.

In sum, however, the case for at least some margin-based fee shiftingappears stronger than the case for indemnification generally, on grounds ofboth fairness and efficiency. Parties who lose lawsuits decisively areprobably more deserving of sanction than those who lose barely. The socialvalue of litigation is probably higher in close cases, whether measured by thepublic benefits of legal precedent or by more libertarian considerations. Andmargin-based fee shifting seems to do a better job at providing improvedincentives for primary behavior, and has lower costs in terms of incentives forincreased expenditure at trial. In light of the relatively limited theoretical andempirical work on this particular topic, however, these conclusions must beregarded as tentative.


8. Empirical Evidence on the Effects of Fee Shifting

Given the complexity and ambiguity of the aforementioned considerations, itwould plainly be desirable to have some hard empirical evidence to bring tothe policy debate. Unfortunately, such evidence is sparse. Critics of theAmerican rule commonly point to the larger numbers of disputes and higherexpenditures on litigation in the U.S. to support their case for reform. Butsuch a crude comparison does not seem especially fruitful in light of themany other significant features that distinguish the American legal systemfrom its counterparts in other Western countries, including economic anddemographic factors, differences in substantive rights, procedural practice,the structure of courts and the legal profession, the availability of otherfinancing arrangements such as the contingent fee and prepaid legal services,a high degree of rights-consciousness among individual citizens, and theabsence of a comprehensive program of social insurance that would help tochannel demands for compensatory relief away from the private legal system.

The proper question to ask, therefore, is what effect fee shifting has onlitigation expenditures and primary behavior, holding constant other featuresof the legal environment. But again, answers to this question are hard tocome by. Although the U.S. legal system contains a number of pockets ofindemnification, these examples have for the most part escaped systematicquantitative inquiry. The evidence on fee shifting, rather, falls into threecategories: laboratory research on bargaining behavior by experimentalsubjects, numerical simulations of litigation behavior based on empiricallyobtained parameters, and econometric evidence primarily drawn from a singlepolicy experiment: Florida's experience with the English rule in medicalmalpractice cases from 1980 through 1985.

8.1. Laboratory Experiments

Coursey and Stanley (1988) tested the effects of fee shifting within anexperimental setting they designed to simulate the process of bargainingunder threat of trial. They divided their subjects (students at the University ofWyoming) into pairs and instructed them to attempt to divide betweenthemselves a number of tokens that were subsequently convertible into cash.If time expired before the subjects reached agreement, the tokens weredivided through a random drawing, intended to represent an uncertain courtaward. To simulate rational expectations, the subjects were presented with theprobability distribution of awards arising from the random drawing, and tosimulate the costs of trial, the subjects were collectively fined an amountequaling 40% of the total value of the tokens in the event the drawing had totake place.

The experimenters conducted negotiations using three different costallocation rules. Under the simplest procedure, the fine was divided betweenthe two parties equally, in an intended simulation of the American rule. Asecond group of subjects negotiated under a rule whereby the fine was paidentirely by the party who received the smaller portion of the token in arandom drawing; this was intended to simulate the English rule. Yet a thirdgroup negotiated under an offer-of-judgment rule intended to simulate Rule68: the plaintiff paid the entire fine if the draw awarded her an amount lessthan or equal to the defendant's last proposal; and the fine was otherwisesplit equally.

The result of this experiment were that subjects settled more frequentlyunder the English than under the American rule. Under Rule 68 settlementwas likeliest of all; and in addition the plaintiff was much more likely to be theaccepting party. The authors also found that settlements were more favorableto the defendant under Rule 68 than under the English rule, consistent withthe theoretical predictions outlined in the previous section. The Americanrule was most favorable of all for the defendant, though the authors ascribedthis result to the behavior of one especially risk-averse individual. Thesefindings are consistent with theoretical models that predict increasedsettlement on the basis of simple risk aversion. Because the experimentaldesign ruled out the possibility of optimism or private information, however,its results cannot be extrapolated to situations in which such phenomena,which could cause the English rule to reduce settlement, are present.

In a separate series of survey experiments, Rowe and various co-authorsstudied the effects of cost allocation rules on lawyers' and law students'responses to a variety of bargaining situations presented by hypothetical tortand civil rights cases. While this experimental design suffered from theweakness that the subjects were not provided with any direct financialincentives, the more realistic nature of the problems and the subjects'professional status and experience provided at least some motivation tobargain seriously. The results of the experiments, however, were mixed. Roweand Vidmar (1988) found that there was little difference between the Americanrule and an modified Rule 68 (enhanced to cover attorneys' fees and to allowplaintiffs as well as defendants to make offers) on law students' willingness toaccept offers of settlement, although they did find an effect on the size ofcounteroffers as well as a difference in plaintiff acceptance rates betweenmodified Rule 68 and a one-way pro-plaintiff rule. Anderson and Rowe (1996)replicated this experiment with practicing lawyers, also examining thesubjects' behavior under an alternative fee shifting rule in which the maker ofa rejected offer had to pay the rejecting party's subsequent reasonableattorneys' fees. They found that while modified Rule 68 did not appreciablyaffect plaintiffs' minimum asks relative to the American rule, it did raise themaximum amounts that defendants were willing to offer. Finally, Rowe andAnderson (1996) considered the effects of a modified rule 68 on hypotheticalbargaining in civil rights cases otherwise governed by a pro-plaintiff rule.They found that replacing this one-way rule with an enhanced Rule 68significantly lowered plaintiffs' minimum asks, as well as the gap betweenplaintiff asks and defendant offers. In all, these results suggest that feeshifting has its strongest effect when it is one-sided and when the favoredside is risk averse or liquidity constrained.

8.2. Simulations

A number of authors have attempted to estimate the quantitative effects offee shifting by numerically simulating the behavior of theoretical models.Katz's (1987) approach is illustrative. He developed algebraic formulas, basedon a linear approximation to the standard model of litigation expenditure, thatrelate the difference in expenditure per case between the English andAmerican rules to two empirical parameters: the ratio of total expenditure tothe stakes of the case, and the elasticity with which parties increase theirexpenditures in response to higher stakes. Using empirical estimates of theseparameters taken from the University of Wisconsin's Civil Litigation ResearchProject (Trubek et al. 1983), he calculated the likely effects of switching fromthe American to the English rule, concluding that such a switch wouldincrease expenditures per case in the neighborhood of 125%.

Such a large increase in cost per case, however, could be expected to leadto a reduction in the number of cases or to increased settlement. In an attemptto measure this anticipated reduction, Hause (1989) extended theLandes-Gould optimism model to allow for variable expenditure, andcalculated its numerical behavior for a range of possible parameter values. Heconcluded that the increased costs per case under the English rule weresufficient to outweigh any effects of optimism, resulting on balance in anincreased frequency of settlement. Hersch (1990) recalculated Hause'ssimulations under the assumption that trial expenditure is determined in aconjectural-variations rather than a Nash equilibrium. He found that bothsettlement and costs per case rose, though by a lesser amount than Hausehad estimated. The parameter values Hause and Hersch used, however, werenot based on any empirical data. Donohue (1991a) recalculated Hause'ssimulations using what he argued were more plausible parameter estimates,and concluded that the English rule would increase trials on balance.

Finally, Hylton (1993a, 1993b) used numerical simulation to estimate theeffects of fee shifting on primary behavior. He concludes that while litigationis more frequent under the English than the American rule, levels ofsubstantive compliance under the two rules would be similar. Best of all,according to his calculations, is one-way pro-plaintiff fee shifting, whichleads to the highest level of compliance and least amount of litigation. Theseconclusions, however, depend both on the functional form used in hissimulations, and on the specific assumptions of his theoretical model.

8.3. Econometric Evidence of Actual Disputes

The statistical and econometric evidence on fee shifting, as well as onlitigation and settlement more generally, has unfortunately been ratherlimited. Schwab and Eisenberg (1988) report on a 1976 statute that establishedone-way pro-plaintiff fee shifting in federal constitutional tort cases (i.e.,cases in which where the federal government is sued for violating theplaintiff's constitutional rights.) They find some evidence that the statute wasfollowed by a decline in plaintiff success rates at trial and by an increase intrials relative to other federal civil actions, but little evidence of any increasein the number of lawsuits filed. These results suggest that the statute had itsprimary effect in encouraging plaintiffs to bargain more aggressively insettlement negotiations, consistent with Rowe et al.'s survey experiments aswell as with the theoretical predictions of the optimism and Bayesiansettlement models discussed in section 5 above. Because of the relatively lowmagnitude of their quantitative estimates, however, and because theirobservations were muddied by the fact that some courts shifted fees on adiscretionary basis before the statute was passed, the authors present theirfindings as tentative.

Fournier and Zuehlke (1989) develop an econometric model of settlementbehavior in which the plaintiff's settlement demand and the probability ofsettlement are jointly determined. Using nonlinear methods that correct fordata censoring (i.e., the fact that the amount of the demand is only observedwhen settlement takes place), they estimate their model using data from anationwide survey of civil federal filings between 1979 and 1981. The dataclassifies disputes according to the type of legal claim at issue (e.g., tort,copyright, antitrust) and includes information regarding the alleged damagesand the number of litigants in each case, the mean and variance of trial awardsin litigated cases within each subject-matter classification, and separatelyprepared estimates of government litigation costs in each case classification,which the authors argue serve as a reasonable proxy for private litigationcosts. The coefficients of the resulting equations suggest, not surprisingly,that settlement demands are positively correlated with mean trial awards andalleged damages, and negatively correlated with litigation costs. Moreinterestingly, they also suggest that settlement is more likely in cases andcategories with high alleged damages, high mean and variance of trial awards,multiple parties, and low (!) litigation costs. These latter results are at oddswith the theoretical predictions of most models of settlement, although thenegative relationship between settlement and potential trial awards isconsistent with a hypothesis of risk aversion.

Because a fraction of the sampled filings were subject to the English rule,Fournier and Zuehlke were able to estimate its effects as well. They find thatfee shifting is negatively correlated with both the probability of settlementand the size of the settlement demand, although the latter effect is notstatistically significant. This finding lends some support to the predictions ofboth the optimism and Bayesian models. The filings in their sample governedby the English rule, however, were few in number and concentrated in a fewspecialized areas, so this evidence cannot be regarded as especially strong. Itis possible that this correlation reflects differences in the types of disputescovered by the rule, rather than effects of indemnification. The authors'unusual findings regarding the other determinants of settlement also call thisresult into question.

More instructive is Hughes' and Snyder's research on Florida's experimentwith the English rule in medical malpractice cases. The Florida statute, passedin 1980 with the support of the state medical association, also provided anoffer-of-judgment procedure and exempted insolvent parties from theobligation to pay indemnification; it was repealed in 1985 with the support ofits original proponents following a series of expensive and well-publicizedplaintiff verdicts. In Snyder and Hughes (1990), the authors use a bivariateprobit procedure to analyze insurance company data on closed claims filedbefore, during, and after the period in which the rule was in effect, andestimate the effects of indemnification on plaintiffs' decisions to drop claims,settlement, and defendants' expenditure on lawyers. Their findings lendsupport to several of the theoretical predictions outlined in previous sectionsof this article. Specifically, they find that in cases governed by the Englishrule, (1) a significantly higher percentage of claims were dropped at an earlystage of the litigation, consistent with the proposition that fee shiftingencourages risk-averse and low probability plaintiffs to exit the system; (2)defendants spent significantly more per case, in amounts consistent withKatz's simulations, in both settled and in litigated cases; (3) holding othercase characteristics constant, the likelihood of litigation increased, consistentwith the optimism model. Because dropped cases tended disproportionatelyto have characteristics that would have made them likelier to go to trial hadthey remained in the system, however, the authors conclude that the Englishrule decreased the frequency of litigation on balance. Because of greaterexpenditure per case, however, total expenditures on litigation still increased.

In a subsequent article analyzing the same data set [Hughes and Snyder(1995)], the authors find that the English rule was associated with anincreased frequency of plaintiff success rates at trial, increased jury awards,and larger out-of-court settlements. These increases were significant not juststatistically but in absolute terms; for instance, the average judgment inlitigated cases increased from $25,190 in cases governed by the American ruleto $69,390 in cases governed by the English rule. These results appear to bedriven by the case selection effects detailed in the first article. The authorssuggest that their results vindicate the proposition that indemnificationimproves the quality of claims brought, although they admit the possibility ofan alternative explanation that low-damage cases are merely being drivenaway by the higher costs of litigation. They conclude that fee shifting,contrary to the assertions of some legal practitioners, is not necessarily anantiplaintiff policy. Rather, it benefits plaintiffs with high-quality orhigh-damage claims at the expense of those with low-quality or low-damageclaims, and possibly at the expense of defendants. These conclusions, ifvalid, would explain why the financial advantages expected by the Floridastatute's original proponents did not appear to materialize; they would alsosuggest that the statute improved the deterrent effect of civil liability.Whether such an improvement would be worth the increased litigationexpenditures it occasioned, however, and whether it would be replicated inother areas of law with different substantive and procedural characteristicsfrom medical malpractice, remain open questions.

9. Conclusion

It is worth mentioning two relatively underinvestigated aspects of feeshifting, the first of which is its interaction with attorney/client fee contracts.U.S. practice is unusual not only in its allocation of costs between plaintiffand defendant, but also in its tolerance of a variety of cost-sharingarrangements between attorney and client, including the contingent fee,which is widely used by tort plaintiffs. While an analysis of the contingentfee is beyond the scope of this article, it is apparent that many of theincentive effects of fee shifting would be altered in its presence. To give justone obvious example, any deterrent effect of indemnification on risk-averselitigants may be substantially lessened in the presence of contingent fees,since it may be possible to shift some of the increased risk fromindemnification to the attorney through adjustments in the contingencyarrangement. For another example, the effect of indemnification on trialexpenditures may be different under contingent than under hourly fees, sinceunder the former arrangement the attorney's incentives to devote time to thecase are dependent on the trial outcome, while under the latter they areindependent. Halpern and Turnbull (1983) discuss some of the incentives ofcontingent fee contracts under both the English and American rules, andDewees, Prichard and Trebilcock (1981) analyze some of the additionalcomplications that can arise in class actions, but neither article explicitlyfocuses on the effects of indemnification. Donohue (1991b) discusses thecombined effect of the English rule and contingent fees, but his analysis islimited to effects on the settlement range within the optimism model ofsettlement, and he presents only numerical examples based on a fewparameter values. A systematic analysis of the effects of fee shifting undercontingent fee contracts, accordingly, remains to be undertaken.

Second, it would be useful to know more about the effects of the Englishrule on incentives for investigation prior to the onset of litigation. Onecommonly cited advantage of fee shifting is that, by increasing the penaltyfor losing at trial, it encourages potential litigants to spend more resourcesinvestigating the merits of their claims before officially entering the legalsystem. This claim is plausible, but the developing economic literature onpre-trial investigation has not yet formally addressed it. While it is possiblethat this effect could help to make the English rule more efficient than theAmerican, such a conclusion turns on a number of unknown propositions,including whether litigants' investigative incentives are currently adequate,and whether, given the availability of civil discovery, it is cheaper forinvestigation to take place before rather than after a lawsuit has been filed.

All in all, despite the substantial scholarly and popular attention that thequestion of indemnity for legal fees has attracted, the number of robustconclusions that can be drawn regarding its consequences are few. Feeshifting does appear to increase legal expenditures per case, in some casessignificantly. It also encourages parties with poorly grounded legal claims tosettle or to avoid litigating them in the first place, and has a similar effect onlitigants who are averse to risk, regardless of the merits of their cases. Asidefrom these generalizations, most of the other propositions commonly assertedabout fee shifting can neither be verified nor rejected. It is unclear whether feeshifting increases the likelihood of settlement, whether it decreases totalexpenditures on litigation or total payouts by defendants, or whether it onbalance improves incentives for primary behavior. It is even unclear whetherfee shifting makes it easier for parties with small meritorious claims to obtaincompensation, in light of the increased costs per case that it induces. In thisregard, the relative lack of systematic empirical investigation of thesequestions is particularly lamentable.

In light of this state of affairs, and in light of the numerous theoreticaldemonstrations that fee shifting is a less effective way to promote optimalbehavior than other available procedural devices such as decoupling ordamage multipliers, one is tempted to conclude that the amount of scholarlyattention directed to this topic exceeds its actual social importance. Thecontinued popular and political interest in fee shifting rules, however, makesthis conclusion problematic. While some support for fee shifting arises fromits relative simplicity and its status as the international majority rule, much ofits continued appeal undoubtedly stems from its association with deeply heldnotions of corrective justice -- and specifically, from the idea that a party whois determined ex post to be in the right should be made financially whole.Counterarguments based on economic efficiency, or indeed on any ex anteperspective, can never entirely rebut this simple yet powerful intuition.

Whether the English rule is more just than the American rule, or whetherits greater fairness justifies its incentive properties, cannot be settled bylawyers or economists alone. The citizenry as a whole must decide whetherthe principle of full compensation for victorious litigants outweighs theprocedural values of providing citizens with an open forum for grievancesand an opportunity to be heard, the uncertainty imposed on those whocannot predict the outcome of court decisions, and the political implicationsof regulating legal fees through a system of bureaucratic oversight ratherthan through private contract between attorney and client. Moreover, asPrichard (1988) and Hylton (1996) have observed, rules of cost allocation feedback through the selection of cases to influence the development of otherareas of substantive and procedural law. Rules that encourage parties to raiserelatively innovative claims and defenses help to break down precedent,while rules that penalize risk-taking and novel arguments help to preservetraditional formal categories. Given the pervasive influence of ostensiblyprocedural rules on substantive outcomes, it may not be possible to separatethe policy of fee shifting from deeper questions of what the law should be.

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Cases

Alyeska Pipeline Service Co. v. Wilderness Society, 421 U.S. 240

Marek v. Chesny, 105 S.Ct. 3012 (1985)

© Copyright 1998 Avery Wiener Katz