Dispute Rates and Contingency Fees: An Analysis from the Signaling Model

1. IntroductionContingency fee contracts, under which the plaintiff pays her lawyer a percentage of the judgment if she wins at trial and nothing if she loses, are very common in the United States but are banned or severely restricted in many other countries.1 Their use in the United States generates great controversy, and while their use is restricted in some states, further calls for restrictions on contingency fee contracts are often heard.2 Although contingency fee contracts are quite simple, their effects on the litigation process are complex and wide ranging. Previous studies have considered the effect of contingency fees on the frequency of litigation (Danzon 1983; Miceli and Segerson 1991) and nuisance suits (Miceli 1993, 1994) and on various aspects of the lawyer-client relationship (Miller 1987; Dana and Spier 1993; Rubinfeld and Scotchmer 1993; Watts 1994; Hay 1996, 1997). In this article, we focus on the effects of contingency fees on the selection of disputes for trial and the overall dispute rate in the signaling model of Reinganum and Wilde (1986).3 Along with Bebchuk (1984), this is one of the two canonical models of pretrial settlement. In addition, since the solution to a model with two-sided informational asymmetries has a strong signaling element (Daughety and Reinganum 1994), it is particularly important to understand how contingency fees affect dispute rates in the signaling model.As in the standard literature on pretrial settlement (e.g., Bebchuk 1984; Reinganum and Wilde 1986), we assume that the plaintiff controls all aspects of the case.4 In the Reinganum and Wilde model, an informed plaintiff makes a take-it-or-leave-it offer to an uninformed defendant who rejects these offers with some probability in equilibrium. In order to conduct a complete analysis of the contingency fee in a signaling model, we also consider the case in which an informed defendant makes a single offer to the uninformed plaintiff.Reinganum and Wilde first develop a signaling model in which the plaintiff's lawyer is paid via a fixed fee and then go on to present (pp. 562-3) a very general solution to the model in the presence of a contingency contract. We use the general framework of Reinganum and Wilde to focus on specific forms for the contingent fee contracts. Our contribution lies not in the derivations of the model solutions, as these follow from the Reinganum and Wilde framework rather closely. Instead, our contribution lies in the analysis of how these specific contingency fee contracts affect pretrial settlement patterns. We analyze the effects both on overall dispute rates and on the selection of disputes for litigation. In section 2, we will further note the relationship between our work and the earlier analysis provided by Reinganum and Wilde.We examine two types of contracts in this article, a bifurcated contingency fee and a unitary contingency fee. Under a unitary contract, the same contingency payment is made by the client to her lawyer regardless of whether there is an out-of-court settlement or a victory at trial.5 Under a bifurcated fee, the contingency percentage at trial is generally higher than the percentage for cases that settle.6 While unitary fees appear to be more common, a significant use of bifurcated fees has been noted in the literature.7 In a model with attorney moral hazard, Hay (1997) notes that bifurcated fees are generally optimal from the perspective of the plaintiff. On the other hand, Bebchuk and Guzman (1996) argue that a unitary fee can lead to a larger net settlement for the plaintiff. Since both types of contracts appear to be relevant empirically, we examine both in this article.One robust finding from our article is that unitary fees lead to an unambiguous increase in the incidence of trial relative to both the fixed fee contract and the bifurcated contingency fee contract. …