Pretrial Negotiation, Litigation, and Procedural Rules

TLDR: In this article, the authors study the effect of fee shifting on the fairness and expenditure of a civil dispute resolution process in the U.S. and find that the English rule shifts the settlement away from the interim fair and unbiased settlement in most circumstances.

Abstract: R. PRESTON MCAFEE [*] We model the civil dispute resolution process as a two-stage game with the parties bargaining to reach a settlement in the first stage and then playing a litigation expenditure game at trial in the second stage. We find that the English rule shifts the settlement away from the interim fair and unbiased settlement in most circumstances. Overall welfare changes are in favor of the party who makes the offer in the pretrial negotiation stage. Lawyers however, always benefit from the English rule, because fee shifting increases the stake of the trial and thus intensifies the use of the legal service. (JEL K40) I. INTRODUCTION Newt Gingrich, in the Contract with America [1994, 145], calls for "common sense legal reforms," including a "so-called loser-pays rule" (in which the unsuccessful party in a suit pays the attorneys' fees of the prevailing party). The "loser-pays rule" (hereafter fee-shifting or English rule), Gingrich argues, "strongly discourages the filing of weak cases as well as encourages the pursuit of strong cases, since claimants can get their court costs reimbursed if they win" [1994, 1461. A voluminous literature, discussed below, supports Gingrich's view. However, by and large, this literature neglects two important considerations in analyzing the English rule. First, the English rule increases the stake of the litigating parties. Thus, although a switch to the English rule may reduce the number of lawsuits, the lawsuits that get to court should involve higher legal expenses. Consequently, the overall effect on legal expenses is unclear. Second, the literature neglects the fairness of the outcome. Do plaintiffs obtain an award justified by the evidence? We provide some theoretical evidence that the English rule distorts outcomes away from a fair outcome. The judicial procedural systems in most nations follow the English rule, which allows for some degree of fee shifting, or the rewarding of legal fees to the winner of legal battles. [1] It is an old British doctrine of "the costs follow the event." The United States is a remarkable exception. [2] The American rule developed gradually. In the early days of the colonies, the procedural system inherited the English rule, allowing attorneys to recover fees from the losing party. Gradually, attorneys found it more lucrative to sign private contingency agreements with their clients and paid less attention to redemption from the losing party. The court in the meantime gradually relaxed enforcement of fee shifting and ceased monitoring legal costs, until the American rule became part of the statutory law. [3] We develop a model that permits us to address the question of the effects of fee shifting on fairness and expenditure at trial. Since pretrial settlement occurs in a significant portion of legal disputes, pretrial negotiation appears empirically important. In environments with symmetrically informed contestants, costly trials will be avoided by settling, because there are no deviating views as to the outcome of the trial. However many disputes do go to trial. Thus, incomplete information also appears to be empirically significant. We allow for incomplete information about the fundamental facts of the case as well as the costs of prevailing at trial. The actual likelihood of prevailing at trial is itself endogenous. We also endogenize expenditure at trial, which is obviously necessary to answer any question about the effects of fee shifting on legal expenditures. Orley Ashenfelter and David Bloom [1993] provided empirical evidence that legal expenditures have a prisoner's dilemma nature, thus appearing to be socially wasteful. Since fee shifting works like a subsidy to winning and a tax on losing, one might reasonably expect fee shifting to increase the stake of the trial and thus to encourage greater legal expenditures, than under the U.S. system. We model a trial as a dispute over a fixed amount of money. …