Incentive Structures for Class Action Lawyers

Abstract

Unlike ordinary litigation where courts rarely interfere with litigants' contractual relations with their lawyers or intervene in settlement decisions, in class actions courts are required to do both. We focus on one explanation for the court's presumed inability to secure just and fair treatment for class members, namely, the court's inferior information vis-a-vis the class attorney concerning the case's merit or probability of success. Using a mechanism design approach, we identify the maximum expected payoff that a class may obtain when the court cannot observe the case's merit. We demonstrate that when the court can observe the lawyer's effort (the number of hours she spent on the case), the optimal payoff can be realized using the lodestar method - a contingent hourly fee arrangement that is currently practiced in many class actions. When the court cannot observe the lawyer's effort, it can still guarantee the same (optimal) expected payment to the class with a menu of percentage fee contracts each consisting of a percentage and a threshold amount below which the lawyer earns no fee, with the threshold increasing with the chosen percentage.