The Investment Theory of Class Actions

AuthorGuy Halfteck
Pages89-136
89
THE INVESTMENT THEORY OF CLASS
AC TI ON S
Guy Halfteck*
A. INTRODUCTION
This article builds on insights developed in the economic theory of
investment under conditions of uncertainty to advance a novel theory
of class action law enforcement. The theory conceptualizes class action
law enforcement as a financial call option, namely, as a complex form
of investment opportunity that consists of multiple, sequential options
to invest under conditions of uncertainty. This novel theory is both
conceptually inclusive and analytically rigorous, thereby building solid
intellectual foundations necessary for adopting welfare-enhancing social
policy and designing proper regulation of class action law enforcement.
Class actions, as is well recognized, provide an overwhelmingly pow-
erful law enforcement mechanism that is capable of imposing, unlike any
other civil law enforcement mechanism, a threat of liability exposure on
business entities for the social consequences of systematic wrongdoing.1
* Lecturer, Faculty of Law, Tel-Aviv University; LL.B., Hebrew University of
Jerusalem (1998); LL.M., Columbia University (2000); S.J.D., Harvard (2003).
For helpful comments, I thank David Rosenberg, Steven Shavell, and partici-
pants at the John M. Olin Seminar on Law & Economics at Harvard; partici-
pants at the Litigating Conspiracy symposium at Western Law; and participants
at the Israeli Law & Economics Association Annual Conference. Financial sup-
port from the John M. Olin Center at Harvard is greatly appreciated.
1 An economic analysis of the functional capacity of class action law enforcement
to impose a threat of liability and deter systematic, risk-producing activities is
found in Guy Halfteck, The Class Action Enterprise: A General Economic Theory
of Mass-produced Law Enforcement, Parts II–III (2003) (unpublished, archived
at Harvard Law School Library). The analysis shows that this capacity squarely
derives from integrating two economic properties in the design of the class
action mechanism, namely, (i) law enforcement entrepreneurship, which is
necessary to bypass collective action problems; and (ii) formal aggregation and
collectivization of numerous, similarly-situated victims into a single, cohesive
pool, thereby creating an opportunity to exploit economies of scale of effort in
class action law enforcement. For a detailed discussion of litigation scale econ-
90 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
Monetary remedies, including billions of aggregate liability dollars that
corporations internalize under the aegis of class action litigation and
settlement, evidence the intrinsic capacity of the class action mechanism
to enforce the law and serve the social objectives of deterrence and com-
pensation.2 Similarly, non-monetary remedies, including injunctions that
prevent repetition of systematic, harm-inflicting conduct and corporate
governance reforms of public companies, are also prevalent in the land-
scape of class action civil justice.3
Remedies obtained in class action law enforcement enhance social
welfare inasmuch as they deter wrongdoing and induce corporations to
closely align their conduct with the social interest in minimizing risk of
harm or injury to consumers, investors, employees, residents, and other
classes of similarly-situated individuals.4 On a more general level, the
magnitude and far-reaching effects of such monetary and non-monetary
remedies demonstrate the intrinsic capacity of the class action mecha-
nism to deter wrongful corporate conduct and practices and, ultimately,
bring about desirable, welfare-enhancing social change.5 The prevalent
use of class actions does not remain free of criticism, however.6
omies, see David Rosenberg, “Mass Tort Class Actions: What Defendants Have
and Plaintiffs Don’t” (2000) 37 Harv. J. on Legis. 393, and, more recently, David
Rosenberg, “Mandatory-Litigation Class Action: The Only Option for Mass Tort
Cases” (2002) 115 Harv. L. Rev. 831.
2 See generally Kenneth W. Dam, “Class Actions: Efficiency, Compensation,
Deterrence, and Conflict of Interest” (1975) 4 J. Legal Stud. 47. See, for
example, “$149M Bridgestone-Firestone Class Action Settlement Approved”
Associated Press (15 March 2004), describing the $149M class action settlement
reached on behalf of Bridgestone-Firestone tire owners in connection with the
tires’ tread-separation problems and the resulting safety concerns.
3 Class-wide settlements of securities fraud class actions often involve non-mon-
etary remedies. These include corporate governance measures that not only
reduce the likelihood of future violations by the defendant company and its
directors and officers, but also increase financial transparency, increase corpo-
rate accountability, and, ultimately, strengthen the legal protection afforded to
investors.
4 See generally David Rosenberg, “The Regulatory Advantage of Class Action” in
W. Kip Viscusi, ed., Regulation through Litigation (Washington, D.C.: American
Enterprise Institute Press, 2002) at 244.
5 See Greg Burns & Michael J. Berens, “Special Report: The Class Action Game”
Chicago Tribune (7 March 2004) C1, writing that “class actions have reshaped
the nation’s economic and social landscape … [an] analysis of more than 300
state and federal class-action settlements over the past three years shows that
nearly one-third prompted reforms of improper practices — from forced over-
time to the use of inferior auto parts in repairs.”
6 Inevitably, the prevalent use of class actions to enforce the law across many
THE INVESTMENT THEORY OF CLASS ACTIONS 91
That being said, and the scholarly literature notwithstanding,7 the
existing knowledge of how class actions function and how the use of
sectors of the economy and society and, especially, the far-reaching economic
effects of liability on corporate America, are the target of harsh criticism.
The latter is repeatedly voiced by advocates of “tort reform” who, in addition
to sponsoring various studies, also invest resources in promoting legislative
measures to curb allegedly abusive class action practices. The basic tenets of
the Republican “tort reform” manifesto are contained in Ed Gillespie & Bob
Schellhas, eds., Contract with America: The Bold Plan by Rep. Newt Gingrich,
Rep. Dick Armey, and the House Republicans to Change the Nation (New York:
Times Books, 1994). Recent studies include, among others, “Excessive Legal
Fees: Protecting Unsophisticated Consumers, Class Action Members, and
Taxpayers,” online: Manhattan Institute Center for Legal Policy
tan-institute.org/html/mics3a.htm>. For further discussion, see Walter Olson,
The Litigation Explosion: What Happened When America Unleashed the Lawsuit
(New York: Truman Talley Books, 1991) and, more recently, Thomas F. Burke,
Lawyers, Lawsuits, and Legal Rights: The Battle over Litigation in American
Society (Berkeley: University of California Press, 2002). In the past decade, the
efforts of “tort reform” advocates to constrain the class action bar have been
most influential in the context of securities class action litigation. See gener-
ally David J. Bershad et al., eds., Securities Class Actions: Abuses and Remedies
(Washington: National Legal Center for the Public Interest, 1994). Their effort
led to the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 77u-4
Stat. 2641 (1996), codified as amended at 42 U.S.C. § 1988(b). More recently,
however, the contentious political debate over the proper role of class actions,
the alleged abuses by plaintiffs’ lawyers, and “tort reform” more generally
underlie the recently-proposed Class Action Fairness Act of 2004, a legislative
measure that seeks to impose severe limitations on consumers’ access to justice
in state courts as well as significant constraints on the ability to use the class
action device to obtain redress for injured victims and deter systematic corpo-
rate wrongdoing. See Class Action Fairness Act of 2004, S. 2062, 108th Cong.
(2004) and Class Action Fairness Act of 2003, H.R. 1115, 108th Cong. (2003).
7 Insightful studies include, among others, John C. Coffee, Jr., “Understanding
the Plaintiff’s Attorney: The Implications of Economic Theory for Private
Enforcement of Law Through Class and Derivative Actions” (1986) 86 Colum.
L. Rev. 669; John C. Coffee, Jr., “The Regulation of Entrepreneurial Litigation:
Balancing Fairness and Efficiency in the Large Class Action” (1987) 54 U.
Chicago L. Rev. 877; Samuel Issacharoff, “Class Action Conflicts” (1997) 30
U.C. Davis L. Rev. 805; Jonathan R. Macey & Geoffrey P. Miller, “The Plaintiffs’
Attorney’s Role in Class Action and Derivative Litigation: Economic Analysis
and Recommendations for Reform” (1991) 58 U. Chicago L. Rev. 1; David
Rosenberg, “The Causal Connection in Mass Exposure Cases: A ‘Public Law’
Vision of the Tort System” (1984) 97 Harv. L. Rev. 849; David Rosenberg,
“Individual Justice and Collectivizing Risk-Based Claims in Mass-Exposure
Cases” (1996) 71 N.Y.U.L. Rev. 210; and David Rosenberg, “Mandatory-
Litigation Class Action: The Only Option for Mass Tort Cases” (2002) 115
Harv. L. Rev. 831.
92 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
that mechanism in the general scheme of law enforcement promotes
deterrence of wrongdoing and compensation of harm — namely, two
objectives that bear directly on the measure of individual well-being and
social welfare — falls short of providing an adequately coherent theoreti-
cal account on either descriptive or normative grounds.8 Further, that the
class action mechanism has occupied an increasingly dominant role in
the landscape of civil justice ever since its introduction in 1966 makes
such insights — and, correspondingly, the existing theoretical shortcom-
ing — all the more consequential to enhancing social welfare.9
This intellectual shortcoming is a cause for concern because it effec-
tively — and, indeed, inevitably — undermines society’s ability to make
informed, welfare-enhancing policy decisions and choices. The ubiqui-
tous lack of thorough understanding among state social planners and
federal policy-makers of the role of class actions in designing the system
of public and private law enforcement and, more particularly, the role
of (often derided) competent plaintiffs’ lawyers in protecting the inter-
ests of consumers, investors, employees, residents, and other classes of
similarly-situated individuals against wrongful corporations increases the
likelihood that ineffective legislative and regulatory measures are adopted
and, in turn, make everyone in society — defendants, plaintiffs, victims
of potential wrongs, and taxpayers — worse-off.10
8 For a brief review of the economic literature on class actions, see Peter
Newman, ed., The New Palgrave Dictionary of Economics and the Law (Albany,
N.Z.: Macmillan Reference, 1998) vol. 1, s.v. “class actions.”
9 Rule 23 of the Federal Rules of Civil Procedure introduced, in 1966, the mod-
ern form of the class action mechanism, which was predicated on its 1938
predecessor. See Harry Kalven, Jr. & Maurice Rosenfield, “The Contemporary
Function of the Class Suit” (1941) 8 U. Chicago L. Rev. 684. Tracing its origins
to seventeenth-century England, the history of the class action is reviewed
in Deborah R. Hensler et al., Class Action Dilemmas: Pursuing Public Goals
for Private Gain (Santa Monica, Cal.: RAND Institute for Civil Justice, 2000)
at 10–15. See also Zechariah Chafee, “Bills of Peace with Multiple Parties”
in Zechariah Chafee, Jr., Some Problems of Equity (Ann Arbour: University of
Michigan Law School, 1950) at 149, tracing the class action mechanism to the
ancient, equitable “Bill of Peace,” a procedure that enabled multiple plaintiffs
or defendants — referred to as the “multitude” — to resolve common issues of
law and fact in a single action brought before the Court of Chancery. For fur-
ther discussion of the evolution of the class action procedure, see Stephen C.
Yeazell, From Medieval Group Litigation to the Modern Class Action (Washington:
Beard Books, 1987).
10 Analytically, sound theoretical understanding of class action law enforcement
is necessary for designing effective social policy for two reasons. First, in order
to be socially desirable, policy prescriptions must identify the relevant welfare-
THE INVESTMENT THEORY OF CLASS ACTIONS 93
Against this intellectual backdrop and policy concerns, this article
advances a novel theory of class action law enforcement — the option the-
ory of class actions — providing, in turn, the most conceptually-inclusive
and analytically-accurate model of class action law enforcement and its
underlying incentive structure. As demonstrated below, the option theory
carries far-reaching implications for designing and implementing welfare-
enhancing social policy on legislative, rule-making, and judicial levels.
The focal interest of the theoretical inquiry is in gaining insight into
how the class action mechanism shapes the incentives of private agents
— namely, competing plaintiffs’ lawyers and, subsequently, the court-
appointed class counsel — and how the latter’s incentives affect the mag-
nitude of liability exposure and, in turn, the deterrence and compensa-
tion effects of class action law enforcement. Stated more generally, the
theoretical inquiry unravels the intricate effects of plaintiffs’ lawyers’ and
court-appointed class counsel’s investment in class action law enforce-
ment on the measure of individual well-being and aggregate social welfare
in mass society.
The theoretical inquiry is predicated on two inter-related supposi-
tions, both of which are strongly reinforced by real-world observations.
First, class action law enforcement is a resource-intensive undertaking,
requiring investment by plaintiffs’ lawyers of both intellectual capital
and financial wherewithal over a long period of time. Second, broadly
defined, the multi-stage sequence of investment in class action law
enforcement begins with initial investment in detecting legally-action-
able systematic, wrongful conduct, and in identifying injured individuals
or entities.11 Further, the investment sequence encompasses investment
enhancing determinants: compare Louis Kaplow & Steven Shavell, “Any Non-
Welfarist Method of Policy Assessment Violates the Pareto Principle” (2001)
109 J. Pol. Econ. 281. Second, in order to be effective, legal reforms and regula-
tory measures must target — and possess a functional capacity to affect — the
respective incentives that bear on the attainment of the social objectives of law
enforcement.
11 Helping to reduce plaintiffs’ lawyers’ initial investment in detection and investi-
gation, information concerning legally-actionable wrongful systematic conduct
may become publicly available following public investigation into the alleged
wrongful conduct (including, for example, Congressional hearings, enforce-
ment proceedings taken by state and federal agencies, and grand jury proceed-
ings) or following voluntary disclosure and possible admission by the alleged
wrongdoer. Compare Howard M. Erichson, “Coattail Class Actions: Reflections
on Microsoft, Tobacco, and the Mixing of Public and Private Lawyering in
Mass Litigation” (2000) 34 U.C. Davis L. Rev. 1, discussing the Security and
Exchange Commission’s Law Enforcement Division investigation of fraudulent
94 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
in the ensuing case investigation, investment in developing alternative
case theories to maximize the wrongdoer’s liability exposure and prepara-
tion and filing of a class action complaint, and investment in obtaining
the sought-after court-appointment as class counsel. The investment
sequence subsequently entails investment in defeating pre-trial motions;12
undertaking costly class- and merit-related discovery;13 securing certifica-
tion of the action as a class action; publication of notice to class members,
informing them of the pending action, their right to appear before the
court and, where relevant, their right to opt out; and preparation of a trial
plan and negotiation of a class-wide settlement. The lengthy, multi-stage
investment sequence comes to its end with class counsel’s investment
in obtaining the court’s approval of a proposed class-wide settlement,
often over possible objections of third parties, the award or approval of
already-negotiated lawyer’s fees,14 and, finally, the administration and
implementation of the class settlement, often including distribution of
funds to class members.
Intertwining these conceptual observations into a cohesive model
of class actions, the option theory conceptualizes the class action law
enforcement enterprise as a financial call option. More concretely, build-
ing on insights developed in the standard economic theory of investment
under conditions of uncertainty, the key theoretical proposition is that
class action law enforcement is a complex form of investment, consisting
of sequential, multi-stage options to invest under conditions of multi-
dimensional uncertainty.
The analysis reduces this theoretical proposition into an explicit and
analytically accurate model of class action law enforcement. To that end,
it identifies the specific properties of investment in class actions across
a broad range areas of law where class actions are used to enforce the
securities schemes and the Department of Justice Antitrust Division’s investiga-
tion of Microsoft’s antitrust violations.
12 Pre-trial motions often include a motion to dismiss the class action complaint
as well as a motion for summary judgment.
13 Class-related discovery covers issues that bear on plaintiffs’ motion to certify
or maintain their action as a class action pursuant to Rule 23(a)–(b) of the
Federal Rules of Civil Procedure (or any parallel state rule); merit-related dis-
covery covers issues that bear on the merits of the plaintiffs’ claims.
14 Obtaining a court’s approval of a proposed class-wide settlement may entail
additional costly discovery — namely, confirmatory discovery — espe-
cially when an action is settled at a relatively early stage of the litigation.
Confirmatory discovery operates as a form of “due diligence” and is designed
to confirm that the terms of the settlements are adequate in light of the defen-
dant’s wrongdoing.
THE INVESTMENT THEORY OF CLASS ACTIONS 95
law including, among others, antitrust, consumer protection and prod-
uct liability, mass torts, securities and financial fraud, labour relations,
and environmental protection. These properties include (i) investment
expenditures shouldered by plaintiffs’ lawyers; (ii) future rewards on
investment, including lawyer’s fee awards and reputation and learning
benefits; (iii) the multi-dimensional investment uncertainty, including
cost-uncertainty and reward-uncertainty; (iv) the irreversibility of invest-
ment expenditures, namely, the problem of sunk costs and the inability
to disinvest if expected expenditures or expected rewards change so as to
render further investment inefficient and thus unwarranted; and (v) the
sequential, multi-stage nature of investment opportunities and invest-
ment decisions.
The final building block of the model concerns the judicial screen-
ing of competing plaintiffs’ lawyers followed by judicial selection and
appointment of class counsel at a relatively early stage of the sequence.
The selection of class counsel is conceptualized, under the model, as
judicial assignment of a monopoly over options to invest in class action
law enforcement to the appointed class counsel. The appointment of
class counsel thus demarcates a clear temporal watershed, differentiating
between the competitive phase (and investments decisions made in that
phase) and the monopolistic phase (and investments made in that phase)
of the class action investment sequence.
Thus structured, the option theory offers novel descriptive insights
that significantly enhance the existing understanding of class action law
enforcement. These insights, as I show below, are germane to design-
ing welfare-enhancing social policy and making sound policy choices.
First, having conceptualized the class action law enforcement enter-
prise as a multi-stage sequence of options to invest under conditions of
multi-dimensional uncertainty, it becomes readily apparent that decisions
made by plaintiffs’ lawyers and, subsequently, by the court-appointed
class counsel are nothing but — and, indeed, boil down to — sequential
investment decisions under uncertainty.
Second, at any given stage of the investment sequence (but for the
last one), plaintiffs’ lawyers and, later, the court-appointed class counsel
face a financial call option, namely, an option to invest and “buy,” with
some probability, the option to invest that follows in the sequence. Put
another way, the immediate payoff from investment at any given stage of
the sequence is obtaining the option to invest in the stage that follows in
the sequence. These sequential payoffs lead, with some probability, to the
ultimate payoff in the form of lawyer’s fee awards.
96 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
Third, plaintiffs’ lawyers and, subsequently, the court-appointed class
counsel must complete the multi-stage investment sequence in order
to obtain monetary rewards on their investment. In other words, they
must invest in each investment opportunity — namely, exercise sequen-
tial financial call options throughout the completion of the sequence
— before the material rewards on investment are realized in the form of
often lucrative lawyer’s fee awards.15
Fourth, the magnitude of incentives to invest and the investment
decisions plaintiffs’ lawyers and, later, the court-appointed class coun-
sel, make throughout the investment sequence are the most important
determinant of the magnitude of liability exposure and, in turn, of the
magnitude of deterrence effects and compensation results of class action
law enforcement.
Combined, these insights unravel the investment structure of class
action law enforcement and invite — and, indeed, facilitate — the
application of well-established decision-making methods developed by
investment theorists. Applying these methods to options to invest and
the corresponding investment decisions in class actions is enlightening
primarily because investment decisions made by plaintiffs’ lawyers and,
subsequently, by the court-appointed class counsel become, for the first
time, predictable and amenable to rigorous positive and normative analy-
ses.16
Viewed from a normative vantage point, the option theory and the
methods developed by investment theorists provide the tools and req-
15 Lawyer’s fee awards do not encapsulate the entire payoff from investment in
class action law enforcement because, in addition to the monetary payoff,
investment in class actions may entail significant learning and reputation ben-
efits. Unlike lawyer’s fee awards, benefits from learning are forward-looking
because learning builds expertise and therefore enables plaintiffs’ lawyers to
perform similar tasks in the future at a lower average cost (that is, at a lower
level of intellectual or financial investment). Benefits from reputation are also
forward-looking because, in the context of class action litigation, a good repu-
tation may increase the likelihood of obtaining the sought-after court appoint-
ment as class counsel and may also lead the court to award higher lawyer’s fees.
16 Option pricing, a method developed in the academic literature on investment,
is a rigorous analytic tool that is used to determine (i) whether exercising an
option to invest is desirable; (ii) what is the efficient level of investment; (iii)
when it is best to exercise the option and invest; (iv) what is the minimum
expected reward on investment that is sufficient to trigger the exercising of an
option and investment throughout the multi-stage sequence; (v) how the cost
of investment affects investment decisions; and (vi) how uncertainty and the
length of the investment sequence affects investment decisions.
THE INVESTMENT THEORY OF CLASS ACTIONS 97
uisite intellectual underpinnings to design sound investment-oriented
regulatory measures (including legislative and rule-based measures as
well as judicial rule-making) that focus on the nature of investment in
class action law enforcement and shape incentives to invest and invest-
ment decisions in socially desirable ways. For example, it is desirable
for the social planner to design regulations to encourage investment in
meritorious claims and, at the same time, to discourage any investment
in the prosecution of frivolous claims.17 Policy-makers and courts ought
to be mindful of the fact that (i) any decision made by plaintiffs’ lawyers
and, later, by the court-appointed class counsel is solely an investment
decision; and (ii) the magnitude of incentives to invest and investment
decisions ultimately made are the most important determinants of the
magnitude of liability exposure and, in turn, the magnitude of deterrence
and compensation effects of class action law enforcement.
The normative appeal of the option theory arises from (in addition
to its conceptual inclusiveness and analytic accuracy) its capacity to
prescribe welfare-enhancing legal reforms and regulatory measures that
focus on any of the various properties of investment in class actions.
Ultimately, regulatory measures that utilize the insights outlined above
can affect the magnitude of deterrence and compensation results of class
action law enforcement and, consequently, significantly impact individual
well-being and social welfare.
On the whole, the option theory can accomplish a threefold objec-
tive. First, the theory rectifies the critical shortcoming of the academic
17 Stated more generally, regulatory intervention in class action law enforce-
ment ought to bridge, or at least seek to minimize, the divergence of private
incentives to invest (namely, the incentives of plaintiffs’ lawyers) from the
social optimum. Private incentives to invest in class actions are bound to be
excessive (supra-optimal) or insufficient (sub-optimal) compared with the
social optimum. See generally Steven Shavell, “The Fundamental Divergence
between the Private and Social Motive to Use the Legal System” (1997) 26 J.
Legal Stud. 575, discussing the private-social divergence of incentives under-
lying the decision to bring an action, invest in litigation, and settle; Steven
Shavell, “The Social versus the Private Incentive to Bring Suit in a Costly Legal
System” (1982) 11 J. Legal Stud. 333. The private-social incentive divergence
is a broadly-observed phenomenon, cutting across all contexts of social activity,
including litigation, manufacturing, the use of motor vehicles, and like activi-
ties. This intrinsic divergence results from the general problem that decisions
made by private actors do not take account of the positive or negative effects
of their decisions (in other words, positive and negative externalities) on the
well-being of others and the welfare of society more generally. The analysis of
this problem and its implication for social policy are presented in Arthur Cecil
Pigou, The Economics of Welfare, 5th ed. (London: MacMillan and Sons, 1952).
98 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
literature on class actions including, among others, economic-oriented
analyses. Notwithstanding its voluminous nature, scholarly studies
have failed to provide any comprehensive theory of the structure or
functioning of class actions as a law enforcement mechanism. Second,
the theory advances a rigorous, conceptually-inclusive analytic frame-
work and offers novel insights that, taken together, provide the requisite
intellectual underpinnings for social policy analyses of class action law
enforcement.18 The option theory provides a framework that is capable of
disentangling the myriad and diverse aspects of class action law enforce-
ment and reducing them to investment problems under conditions of
uncertainty. Virtually any aspect relating to the performance and conduct
of plaintiffs’ lawyers and, later, class counsel in the course of class action
law enforcement becomes amenable to uniform analysis as an investment
problem. Third, the theory sets guidelines for designing effective regula-
tory measures across the diverse areas of law where class actions are used
to enforce the law.
Finally, the option theory developed in this article bears on the direc-
tion of the future study of class action law enforcement. The theory shows
that further inquiry into the determinants of the magnitude of incentives
to invest and, correspondingly, the possibility of different forms of regula-
tory intervention to induce socially desirable incentives to invest in law
enforcement is not only warranted, but is essential to crafting desirable,
welfare-enhancing social policies.
The analysis is organized in the following order: Section B presents
a short primer on the standard economic theory of investment under
uncertainty. In addition to considering the definitions of investment,
investment expenditures, future rewards on investment, and invest-
ment uncertainty, close attention is paid to the “option approach” to
investment decision-making and to sequential investment opportunities.
Building on the concepts of investment theory, Section C develops the
18 On a more general level, however, the option theory of class action law enforce-
ment provides a comprehensive conceptual framework, necessary to identify-
ing and analyzing a variety of problems arising in the context of class actions.
Specifically, owing to its general nature, this conceptual framework is capable
of capturing the numerous investment decisions that are made throughout the
process of class action law enforcement, ranging from the initial investigation
to bringing a lawsuit and undertaking discovery to settlement negotiations. As
such, the theory is germane to undertaking descriptive analyses of the effects
of legal regulation on the magnitude of liability and deterrence results and to
prescribing efficient, normative regulatory measures that may be necessary to
enhance the social welfare effects of class action law enforcement.
THE INVESTMENT THEORY OF CLASS ACTIONS 99
investment option theory of class action law enforcement. The discussion
pays explicit attention to the analytic properties of investment in class
actions. Section D focuses on the judicial appointment of class counsel at
an earlier stage of the overall sequence and models this appointment as a
judicially-granted monopoly over the options to invest in the class action.
Section E derives normative implications and sets forth policy guidelines
for designing investment-oriented legal reform and welfare-enhancing
regulatory intervention. Lastly, the conclusion outlines directions for
future study of class action law enforcement.
B. THEORETICAL FOUNDATIONS OF
INVESTMENT UNDER UNCERTAINTY
This section presents the foundations of the standard economic theory
of investment under conditions of uncertainty. Geared toward develop-
ing the option theory of class action law enforcement, which I gradu-
ally develop below,19 I deliberately pay specific attention to the “option
approach” to investment decision-making and consider the case of
sequential investment opportunities.20 Gaining understanding of these
issues is significant, as the premises and insights developed by invest-
ment theorists underlie the general investment theory of class action law
enforcement that I advance below.
19 The conceptual foundations and analytic dimensions of the option theory are
developed throughout the discussion in Sections C and D, below.
20 As is explained in great detail below, the “option approach” to investment deci-
sion-making is preferable to the ordinary net present value (NPV) rule in the
context of class action law enforcement. This is because it has long been recog-
nized that the simple NPV rule for deciding whether to invest in an investment
opportunity can provide unambiguously correct answers only under certain
conditions. When these conditions are not met, namely, (i) where the invest-
ment decision can be delayed; (ii) where the investment is not fully revers-
ible; and (iii) where the investment uncertainty is likely to be resolved and
affect the value of the investment opportunity, then relying on the NPV rule to
determine whether and how much to invest may not be optimal even where
the NPV is positive. A general discussion of the implications of investment
irreversibility and the effects of the resolution of uncertainty on investment
decision-making is contained in Robert S. Pindyck, “Irreversibility, Uncertainty
and Investment” (1991) 29 J. Econ. Lit. 1110. See also Lenos Trigeorgis, Real
Options: Managerial Flexibility and Strategy in Resource Allocation (Cambridge,
Mass.: Massachusetts Institute of Technology, 1996).
100 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
1) The Essence of Investment
Investment is defined as the act of incurring immediate cost in expecta-
tion of future rewards.21 Investment decisions are ubiquitous and are by
no means limited to investment in financial markets. The decision to
obtain a college education, for example, clearly falls within the defini-
tion of investment. The cost of tuition, related expenses, and opportunity
costs may be presently incurred in expectation of future benefits in the
form of a well-paid occupation. Firms’ expenditures on research and
development in an attempt to develop a new, profitable product or oth-
erwise gain a competitive advantage in the market similarly qualify as a
form of investment.22
In the discussion that follows below I explain the foundations of the
economic theory of investment.23
2) Investment Expenditures, Future Rewards, and
Investment Uncertainty
The cost incurred in an investment may entail different types of resources,
including financial, intellectual, and human capital. It is important to
note that, by and large, investment decisions are completely or partially
irreversible. That is, the initial cost incurred by the investor is sunk, at
least to some extent, such that the investor cannot recover it in whole or
in part (in other words, disinvest) should he later change his mind and
decide to withdraw from the investment project.
A further characteristic commonly shared by investment opportuni-
ties is uncertainty over the magnitude of investment expenditures or of
future rewards from the investment. This means that, at best, the investor
may be able to assign probabilities to alternative future outcomes, which
may entail greater or smaller expenditures or rewards.24 Further, future
21 See Joel G. Siegel & Jae K. Shim, Dictionary of Accounting Terms, 3rd ed.
(Hauppauge, N.Y.: Barron’s Educational Series, 2000), s.v. “investment,” which
is defined as “expenditure to acquire property, equipment, and other capital
assets that produce revenue.”
22 Additional examples include the decision of firms to enter (or exit) an indus-
try, the determination of an initial scale of production, the construction of a
production plant (or temporary shutdown), the decision to hire (or lay off)
employees, and the purchase of insurance.
23 The foundations of investment theory explained in this section are based pri-
marily on Avinash K. Dixit & Robert S. Pindyck, Investment Under Uncertainty
(Princeton: Princeton University Press, 1994) at 3–25.
24 Not all investment decisions are made under conditions of uncertainty. For
THE INVESTMENT THEORY OF CLASS ACTIONS 101
rewards may depend on many different issues, each of which can be
uncertain. In the case of a firm’s investment in research and development,
for example, future rewards are contingent on (i) the prospects of devel-
oping a new product; (ii) the volatility of demand for the product and the
price ultimately obtained; and (iii) the possibility that similar products
will also be developed by competing firms. Obviously, there may be some
level of uncertainty about each of these discrete conditions.
In light of such uncertainty, the investor may decide to postpone its
investment decision until further information is obtained and the level
of uncertainty is accordingly reduced.25 Having done so — and assum-
ing that the investment opportunity is still available — the investor will
be better situated to evaluate the investment opportunity and make its
investment decision appropriately.
3) The “Option Approach” to Investment Decision-
Making
Combined together, these investment characteristics, namely, (i) the irre-
versibility of investment; (ii) uncertainty over future outcomes; and (iii)
the choice of timing of the investment decision, interact to determine
investment decisions made by investors.26 But how, specifically, are invest-
some investments, the availability of future rewards is a matter of certainty,
such that their scope and magnitude are ex ante known to investors. These con-
ditions are satisfied, for example, in the case of bonds, where the rate of return
on investment is specified ex ante.
25 Clearly, there may be a cost to delaying investment decisions, in terms of losing
the opportunity to make the investment in the future, and the consequent lost
profits. The opportunity to invest may not be available because, for example,
the time for investing has lapsed or because a competing investor has taken the
opportunity. Hence, there may be occasions in which strategic considerations
would induce firms to invest earlier than they would have done otherwise; for
example, when they wish to forestall investment by potential or actual com-
petitors.
26 Neoclassical investment theory applies a simple decisional rule, focusing on the
net present value (NPV) of the investment project, to solve investment deci-
sion-making problems. Specifically, the present value of the expected future
stream of profits from investment is calculated first. Next, the present value
of the expenditures incurred in this investment is calculated. Finally, the two
values are compared, such that if the difference is positive — that is, there is
NPV — the investment is efficient. In other words, the NPV rule means that
incremental (or marginal) investment should be made until the marginal return
on investment equals its marginal cost. The NPV approach to investment deci-
sion-making underlies the q-theory of investment, which compares the capital-
ized value of marginal investment to its purchase cost. This ratio, called Tobin’s
102 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
ment decisions made? In order to answer this key question, we first need
to consider the economic structure of investment opportunities more
closely.27
An investment opportunity provides an investor with an “option,”
analogous to a financial call option. That is, the investor has the right
but not the obligation to purchase an asset — the investment opportu-
nity — within some period of time, at a given price.28 When the investor
decides to purchase the asset — that is, to make irreversible investment
expenditures and obtain in return an investment project — she exercises
the option to purchase it and thereby gives up the possibility of delay-
ing her decision until further information is obtained. The option to
wait is valuable, however, precisely because the future value of the asset
purchased may be uncertain. By postponing an investment decision, the
investor can obtain further information; if it shows that the asset rises
in value then the net payoff from investment rises and, conversely, if the
asset decreases in value, the investor need not exercise the option.
Because the future value of an investment project may be uncertain
at any given time — and given that investment expenditures are largely
or completely irreversible, such that once expended they are largely or
completely sunk29 — the availability of further information could affect
the desirability and timing of investment expenditure and, ultimately, the
decision to invest. For this reason, the option to postpone an investment
q, governs the investment decision: investment is efficient if q exceeds one, and
is inefficient when q is less than one.
27 The NPV approach to investment decision-making is insufficient because
it ignores significant investment characteristics. In particular, the NPV rule
implicitly assumes that either the investment is reversible, or, if it is irre-
versible, that investors have no choice over the timing of investment (it is a
now-or-never opportunity). These characteristics of investment opportunities,
however, can significantly affect the decision to invest. By contrast, the theory
of irreversible investment under uncertainty, developed by Dixit and Pindyck,
takes explicit account of these investment characteristics and therefore provides
a more inclusive conceptual and analytical framework to analyze investment
problems. See Dixit & Pindyck, above note 23 at 6 et seq. The discussion below
demonstrates that such a framework is indeed germane to the analysis of class
action law enforcement.
28 A call option is defined as the right to buy (or call) an asset at a specified price
within a specified period of time: see Siegel & Shim, above note 21 at 60 and
313.
29 That the expenditure is a sunk cost stems from the fact that the investor cannot
disinvest should relevant conditions change and render the project unprofit-
able.
THE INVESTMENT THEORY OF CLASS ACTIONS 103
decision until additional information becomes available is valuable to the
investor.
The value of the option to delay an investment decision is lost once
an investment decision is made. Having made the investment, the inves-
tor is not able to disinvest or alter the timing of investment, even if fur-
ther, crucial information should later become available. The lost option
value is therefore a type of opportunity cost, arising from forfeiting the
opportunity to postpone the investment decision, and hence must be
included in the total cost of investment at any given point in time when
an investment decision is being made.30
Investment decision-making, then, ought to take account of three
different variables: (i) investment expenditures (the present value of the
stream of future costs); (ii) expected future rewards (the present value
of the future stream of profits); and (iii) the lost value of the option to
invest (the opportunity cost of investment at any given point in time).
The investment decision rule implies that investing in an investment
opportunity is efficient if the rewards on investment are as large or exceed
the total sum of investment expenditures and the lost option value. Put
differently, in order for investment to be efficient, profits obtained must
exceed the cost of investment expenditures by an amount equal to or
larger than the value of keeping the option to invest alive.
4) Sequential Investments
In this section, I consider the case of sequential investment opportunities.
Some investment projects may comprise several investment stages, all of
which must be completed in a particular sequence before future profits
are realized.31 The number of investment stages in a given sequence may
vary across different investment projects.32 As these projects entail several
30 The magnitude of these opportunity costs is sensitive to uncertainty over future
profits from the investment, such that the more uncertain profits are, the more
valuable the option to postpone the investment until further information is
available to reduce uncertainty and, hence, the higher the opportunity costs of
making present, irreversible investment expenditures.
31 This is in contrast to discrete, single-stage investments, which involve a single
investment decision. The purchase of securities in the stock market is one such
example. Yet even projects that appear to involve a single investment decision
may turn out to involve sequential investment. This may be the case in projects
that span a long period of time before they are complete, such that at any point
in time the firm can decide to stop midway, abandon the project altogether, or
continue.
32 Investment by a pharmaceutical company in developing a new drug is surely
104 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
stages, investors face a sequence of discrete investment decisions.33 At
each stage of the sequence, the investor can decide to (i) move on and
invest in the next stage of the sequence; (ii) halt further investment tem-
porarily; or (iii) terminate its investment altogether and withdraw from
the project.
While sequential investment decision-making is somewhat more
complex than the investment rule I discussed earlier, it nevertheless
relies on the same principles. In essence, we approach this investment
problem by dividing the multi-stage investment sequence into discrete
investment stages and treating each stage as a single investment problem.
Given the existence of an investment sequence, the investor’s investment
in stage one “buys” (or “produces”) an option to invest in stage two of
the sequence, and so forth until the project (the investment sequence) is
completed. Thus, the payoff on investment at stage one (and, similarly,
the payoff on investment at any discrete stage of the sequence thereafter)
is the value of the option to invest in stage two (or at any subsequent
stage of the sequence). The investment decision at stage one (and,
similarly, at any subsequent, discrete stage) boils down to a cost-benefit
analysis, where the cost variable consists of (i) the sum of investment
expenditures remaining to be made throughout the sequence34 and (ii)
a multi-stage investment project. The sequence of investment stages begins
with research aimed at discovering a new compound; it continues with testing
until Food and Drug Administration approval is obtained; it requires building
a production facility; and it necessitates investment in marketing. See Dixit &
Pindyck, above note 23 at 319–20.
33 Sequential investments may involve uncertainty over several variables, includ-
ing uncertainty over future rewards on investment (in other words, uncertainty
over the value of the completed project) in addition to uncertainty over the
cost of future investment stages.
34 Intuitively, the sum of the expenditures that remain to be made throughout the
investment sequence must be taken into account at each discrete investment
decision throughout the sequence, because the efficiency of discrete invest-
ment decisions depends on the aggregate project. See Dixit & Pindyck, above
note 23 at 325. To exemplify this point, imagine the three-stage investment in
becoming a practising lawyer. The first stage includes investment in obtain-
ing a college degree, the second stage includes investment in obtaining legal
education, and the third stage requires investment in sitting the bar exams.
Assume that these investments are sunk, in the sense that their costs cannot be
recovered in any way other than practising law (in other words, that a college
or law school degree cannot produce profits in any other way). Assume also
that the rewards on this investment stem exclusively from the income obtained;
no non-economic benefits, such as prestige, are taken into account. Given this
set of assumptions, it would be inefficient to invest at stage one if the expected
THE INVESTMENT THEORY OF CLASS ACTIONS 105
the value lost in exercising the option to invest in the first stage, while
the benefit variable comprises the value of the option to invest in stage
two of the sequence.35
Based on this discussion, the following observations are readily made.
First, as the investor gradually moves forward in the investment sequence
and fewer stages are left before the full completion of the investment
project, (i) the sum of expenditures that remains to be made becomes
smaller36 and (ii) the value of the option to invest becomes greater.
Second, it follows that as more investment stages have been completed
in the sequence, smaller expected future rewards would be sufficient to
render investment in the following stage an efficient investment (and vice
versa).37 Third, in a longer investment sequence, higher expected future
rewards are necessary to compensate for discount rates and thus induce
the investor to invest.38 Fourth, the higher the level of uncertainty over
the magnitude of future rewards on investment, the lower the value of
the completed project and the lower the value of the option to invest.
Similarly, the higher the level of uncertainty over the magnitude of future
rewards on investment (and hence the lower the value of the completed
project), the higher the opportunity costs of investment at any given stage
of the sequence.39 Fifth, at any stage of the sequence the investor can stop
investing if the value of the completed project decreases or if the expected
aggregate cost of completing it increases.
In the discussion that follows, I build on the insights that were devel-
oped in the theory of investment under uncertainty and on the obser va-
tions I have made above to advance a general investment theory of class
action law enforcement.
profits are lower than the aggregate cost of investment.
35 The value of the option to invest is derived from the value of the completed
project (the ultimate profits on investment).
36 If, however, there is uncertainty over the magnitude of future investment
expenditures, then the absolute (rather than the fractional) magnitude of this
sum may rise.
37 Put differently, the higher the sunk cost required to obtain a risky payoff, the
higher the critical value of this payoff to induce efficient investment.
38 Indeed, some investment projects — such as investment in developing a new
drug — may span a long period of time. The discount rate applied, however,
depends on firm-specific characteristics.
39 In other words, the higher the level of uncertainty, the more valuable the abil-
ity to postpone investment decisions until further information is obtained.
See Carliss Y. Baldwin, “Optimal Sequential Investment when Capital is Not
Readily Reversible” (1982) 37 J. Finance 763, showing that there is economic
value to waiting.
106 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
C. THE INVESTMENT THEORY OF CLASS
ACTION LAW ENFORCEMENT
The foregoing discussion has advanced the proposition that the class
action mechanism is uniquely designed to rectify impediments to optimal
law enforcement40 that arise from the fundamental divergence between
private and social law enforcement incentives.41 While the class action
mechanism provides the capacity to address the problem of sub-optimal
law enforcement, its functional capacity is a necessary, though an insuffi-
cient, condition to obtaining optimal deterrence through class action law
enforcement.42 Here it is necessary to distinguish between the functional
aspect of class action law enforcement, on the one hand, and the incen-
tive structure, which involves private agents’ incentives to use the class
action mechanism, on the other.43
In view of the class action’s functional capacity to address impedi-
ments to optimal law enforcement, the key question is, therefore, how do
the incentives of private agents in class action law enforcement affect the
magnitude of liability and deterrence obtained through class actions?
In general, the magnitude of liability and deterrence from class action
law enforcement — and the consequent social welfare effects — depend
not only on the functional capacity of the class action mechanism to
address impediments to optimal law enforcement but, equally, on the
incentives of private agents, in whose hands class action law enforce-
ment is entrusted as a matter of institutional design. Identifying these
incentives and gaining insights into how they bear on the level of class
action law enforcement is therefore of prime theoretical concern. The
theoretical inquiry that follows deals precisely with this aspect of class
action law enforcement. Based on the descriptive insights gained, it will
40 The design of the class action mechanism, comprising (i) an opportunity to
exploit economies of scale benefits and (ii) economic entrepreneurship, is ana-
lyzed in Halfteck, above note 1 at Part III(A)–(C).
41 That the divergence between private and social law enforcement incentives
results in a sub-optimal level of law enforcement is discussed in Halfteck, ibid.
at Part II(C)(1)–(3).
42 Simply put, the fact that private law enforcement agents may make use of the
class action’s functional capacity for law enforcement purposes by no means
suggest that those agents will actually be optimally motivated to utilize the
class action.
43 As the discussion shows, agents’ incentives to use the class action mechanism
are affected by several factors, including the structural design of the class
action mechanism, the economic environment in which the agents are situated,
and the like.
THE INVESTMENT THEORY OF CLASS ACTIONS 107
later become possible to consider the desirability of regulatory interven-
tion, which may be necessary to align the incentives of private agents
with the social interest.
1) Class Action Litigation: An Investment Opportunity
under Conditions of Uncertainty
The basic theoretical proposition that class action law enforcement
comprises, in essence, an investment opportunity under conditions of
uncertainty appears to be rather straightforward.44 The class action device
provides plaintiffs’ lawyers — and plaintiffs’ law firms more generally
— with an opportunity to undertake class action law enforcement and to
invest financial and intellectual resources in the prosecution of claims on
behalf of a pool of similarly-situated dispersed victims in exchange for
the prospect of collecting often-lucrative returns on their investment.45
To better understand the general validity of this proposition, however,
it is necessary to identify the investment features that are embedded in
class action law enforcement. These include (i) investment expenditures;
(ii) the prospect of future rewards on investment; (iii) multi-dimensional
investment uncertainty over the cost and benefit variables of the invest-
44 A class action in which the plaintiff’s lawyer invests his resources is all but a
capital asset, which carries the prospects of generating revenues and neatly falls
within the economic definition of investment. While the class action device
creates a quadripartite structure — including the plaintiff class, the plaintiff
lawyer, the defendant, and the court — the theory focuses primarily on plaintiff
lawyers, not on the plaintiffs themselves or any other party, due to intrinsic
features of the class action device itself. Specifically, class action law enforce-
ment is paradigmatically designed to provide a solution to a collective action
problem running afoul of the otherwise best interests of numerous, similarly-
situated victims. For this reason, the class action device entrusts the initiative
into the hands of plaintiff lawyers. Acknowledging their decisive role in class
action law enforcement, the theory developed in this article focuses on plain-
tiff lawyers’ law enforcement incentives as they are formed by the class action
mechanism.
45 In that respect, the plaintiff lawyer could well be portrayed as an entrepreneur,
committing her resources to using the class action device as a mere business
venture. See Mike France, “The Litigation Machine” Business Week (29 January
2001), describing lawyer-driven tort litigation in the United States as becoming
an all-but-automated process, made possible, in large part, by the availability of
litigation-support institutions serving the plaintiff bar which provide litigation-
related information and finance. It goes without saying, however, that portray-
ing plaintiff lawyers as mere profit-seeking entrepreneurs runs afoul of notions
of public interest litigation that plaintiff lawyers sometimes ascribe to the type
of work they do, often characterized as public- or civic-minded litigation.
108 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
ment opportunity (cost- and price-uncertainty, respectively); and (iv) the
irreversibility of investment expenditures.46 The sequential, multi-stage
nature of investment in class action law enforcement is subsequently
analyzed in the second part of this section.
a) Investment Expenditures: The Private Cost of Class Action
Law Enforcement
From the perspective of plaintiffs’ lawyers, class action law enforce-
ment entails two distinct types of investment expenditure.47 They are (i)
investment of legal services, in terms of human and intellectual capital;48
and (ii) investment of financial wherewithal, being the costs incurred
throughout the law enforcement process.49 While investment of legal
services is intrinsic to the legal expertise proffered by plaintiffs’ lawyers,
investment of financial wherewithal is definitely not. Rather, the role of
plaintiffs’ lawyers in advancing and investing capital that is necessary to
undertake class action law enforcement inheres in the design of the class
action mechanism itself as a corrective social policy in response to insuf-
ficient private incentives to employ the liability system. Thus, the fact
that plaintiffs’ lawyers assume an entrepreneurial, venture-capitalist role
stems precisely from the institutional choice made in the design of the
class action mechanism.50
The magnitude of both types of investment expenditures may vary
across different cases. Depending on case-specific characteristics, class
action law enforcement may require extensive investment of legal services,
in particular where the prosecution of claims involves novel legal theories
or where the case calls for the application of unsettled legal doctrines.
Similarly, where the case entails vast and intricate factual issues,51 such as
46 The definition and components of investment opportunities are expounded in
Section B, above.
47 The plaintiff lawyer may fine-tune his level of investment by making incremen-
tal adjustments to the investment of legal services and financial wherewithal.
48 The investment of legal services, through human and intellectual capital, com-
prises the lawyer’s opportunity cost of deciding to invest in class action law
enforcement.
49 The structure of this investment obviously involves a social cost component as
well, because class action law enforcement imposes significant administrative
costs on the legal system itself which are not borne by plaintiff lawyers.
50 The entrepreneurial nature of class action law enforcement is discussed in
Halfteck, above note 1 at Part III(B).
51 The sheer magnitude and complexity of the “Agent Orange” litigation, brought
on behalf of Vietnam veterans and their families, saw the consortium of plain-
tiffs’ lawyers “constantly litigate discovery motions, examine and digest mil-
THE INVESTMENT THEORY OF CLASS ACTIONS 109
where an expansive discovery campaign and costly scientific studies are
necessary to establish the defendant’s liability,52 considerable investment
of legal services will likely be required.53 Lastly, onerous class action pro-
cedures may also entail a significant investment in legal services.
Likewise, the magnitude of capital investment may differ tremen-
dously from one case to another, depending on several factors. The avail-
ability of public information about the alleged wrongdoing or the harm
inflicted on individual victims is one such variable. Indeed, the informa-
tion problem is often of considerable dimensions, given that victims’
incentives to seek recovery and thereby provide relevant information (as
is the case with low-value claimants),54 or their incentives to invest in
obtaining such information (as is the case with high-value claimants),55
are largely insufficient and thus cannot be relied upon to yield sufficient
and relevant information for the purpose of law enforcement. In addition,
the problem of long latency periods — which often arise in the context
of mass toxic torts — and the strong incentives of corporate wrongdo-
ers to invest their efforts in concealing their wrongful conduct to reduce
liability exposure, suggest that plaintiffs’ lawyers will often need to invest
resources in extensive forensic investigation.
Further, the size of the pool of similarly-situated victims — and how
dispersed they are, both geographically and temporally — also affects
the magnitude of capital expenditures that may be required to aggregate
and consolidate the victims into a cohesive, unified pool in order to
bring a class action on their behalf.56 Additional variables that are likely
lions of documents in the government’s and defendants’ files throughout the
country, organize and computerize their document base, identify and interview
expert witnesses, and prepare their own witnesses for pretrial depositions.”
See Peter H. Schuck, Agent Orange on Trial: Mass Toxic Disasters in the Courts,
enlarged ed. (Cambridge, Mass.: The Belknap Press of Harvard University
Press, 1987) at 84.
52 When appropriate, expansive discovery campaigns may involve numerous
depositions, extensive interrogations, and the filing of frequent discovery
motions, all of which are necessary to establish the factual basis — and hope-
fully find the “smoking gun” — underlying the prosecution (or settlement) of
claims on behalf of the class.
53 In addition to the investment of legal services, expansive discovery campaigns
often require substantial investment of capital resources.
54 The insufficient incentives of victims with low-value claims to seek recovery
and thereby provide information that is relevant to bringing law enforcement
actions are analyzed in Halfteck, above note 1 at Part II(C)(1).
55 The insufficient incentives of victims with high-value claims to invest in
obtaining enforcement-specific information are analyzed in Halfteck, ibid.
56 This may also depend on the type of notice that the court requires, since in
110 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
to impact the magnitude of capital expenditures incurred in the course
of class action law enforcement include the period over which the litiga-
tion extends, the complexity of the factual issues on which the plaintiffs’
theory depends, and the need for expert testimony or related scientific
studies to establish the relevant etiology to hold the defendant liable.
The costs incurred by plaintiffs’ lawyers through the process of class
action law enforcement also include expenditures incurred in the course
of complying with orders issued by the trial court. Specifically, class
action procedure requires that notice be given to putative class members
in opt-out class actions,57 informing them of their right to request exclu-
sion from a certified class action,58 and advising them that unless they
opt out, they will be bound by any judgment, whether favourable to the
class or not.59 While it is for the court to order the “best notice practicable
under the circumstances, including individual notice to all members who
can be identified through reasonable effort,”60 the cost of giving such
notice is borne by plaintiffs’ lawyers and may certainly be substantial.61
some cases lesser notice is deemed sufficient and so less cost needs to be
incurred.
57 Class members are entitled to opt out of a plaintiffs’ class only in pending
actions certified as class actions under Fed. Rules Civ. Proc. R. 23(b)(3). Under
R. 23(d)(2), however, the court can exercise its general, discretionary author-
ity to order that class notice is given — “for the protection of the members of
the class or otherwise for the fair conduct of the action” — whether the class
was certified under R. 23(b)(3) or otherwise. See Barahona-Gomez v. Reno, 167
F.3d 1228 (9th Cir. 1999) at 1236, holding that the District Court may use its
authority under R. 23(d)(2) to order that class notice be given in actions under
R. 23(b)(2). See also Crawford v. Honig, 37 F.3d 485 (9th Cir. 1994) at 487, n.
2, to the same effect. However, this discretionary authority is used rather infre-
quently.
58 See Sperling v. Hoffmann-La Roche, Inc., 24 F.3d 463 (3d Cir. 1994) at 470, hold-
ing that members of a R. 23(b)(3) class action are automatically included in the
class unless they exercise their right to opt out in a timely manner.
59 See Fed. Rules Civ. Proc. §§ 23(c)(2)(A)–(B). The notice should also advise
class members that they are entitled to enter a court appearance through coun-
sel: ibid., R. 23(c)(2)(C). Although not formally included in R. 23(c)(2), it
is required that the class notice describe, in general terms, the nature of the
action: see Eisen v. Carlisle & Jacquelin, 417 U.S. 156 (1974).
60 See Fed. Rules Civ. Proc. § 23(c)(2). To ensure effective notice, courts often
require that notice is sent by mail to all class members whose identities and
addresses are known or can be ascertained in addition to publishing notices in
the media.
61 In general, the financial cost of notification is borne by plaintiffs’ lawyers: see
Oppenheimer Fund, Inc. v. Sanders, 437 U.S. 340 (1978). However, the courts
maintain the discretion to allocate the cost of notice between the opposing par-
THE INVESTMENT THEORY OF CLASS ACTIONS 111
Additional costs that plaintiffs’ lawyers may have to incur are those
imposed by courts when a dismissal or settlement of a class action is
sought62 or otherwise arising from specific class action procedures.63
Finally, costs may include monetary sanctions imposed by courts for fail-
ure to comply with procedural rules.64
ties.
62 Irrespective of the specific R. 23(b) provision under which the action is certi-
fied, class members are entitled to receive notice of the proposed settlement
or dismissal of the case: see Fed. Rules Civ. Proc. § 23(e). See also Payne v.
Travenol Laboratories, Inc., 673 F.2d 798 (5th Cir.) at 812, cert. denied, 459 U.S.
1038 (1982), concluding that a court must order that notice be given to absent
class members when settlement or dismissal of a class action is sought. Class
notice given under R. 23(e) is likely to be less costly, because notice require-
ments under R. 23(e) are less rigorous than those under R. 23(c)(2) as applied
to class actions certified under R. 23(b)(3): see Gottlieb v. Wiles, 11 F.3d 1004
(10th Cir. 1993) at 1013. When a class action is certified for the sole purpose
of settlement (known as a “settlement class action”), a single, unified notice,
given to class members when a proposed settlement is reached, can inform
them of the certification of the action, their right to opt out, and the details of
the proposed settlement, thereby reducing the cost of notice. See generally In
re General Motors Corp. Pick-Up Truck Fuel Tank Products Liability Litigation, 55
F.3d 768 (3d Cir.), cert. denied, (sub. nom. General Motors Corp. v. French) 516
U.S. 824 (1995), setting out the legal standards for certifying a settlement-only
class action. See also Ortiz v. Fibreboard Corp., 527 U.S. 815 (1999).
63 Plaintiffs’ lawyers also bear the often high cost of notice published in a “widely
circulated, national business-oriented publication or wire service,” which is
required under the Private Securities Litigation Reform Act of 1995 to inform
members of the purported class of the filing of a securities class action and
advising them of the opportunity, which is time-limited, to seek appointment
as lead plaintiff. See the Private Securities Litigation Reform Act of 1995, Pub. L.
No. 104-67, 109 Stat. 737 (codified as additions and amendments to 15 U.S.C.
§§ 77u-4 et seq.).
64 Rule 11(c) of the Federal Rules of Civil Procedure authorizes courts to exer-
cise discretion and impose a variety of sanctions on lawyers and law firms
for violating the requirements specified by R. 11(b), for example, for making
frivolous claims. Sanctions imposed can be monetary and non-monetary in
nature, including a penalty paid to court and payment of the opponent’s legal
fees and other related expenses. See, for example, Baffa v. Donaldson, Lufkin &
Jenrette Securities Corp., 222 F.3d 52 (2d Cir. 2000) at 57, discussing a sanction
requiring the payment of lawyers’ fees. In the context of securities class actions,
however, imposition of R. 11 sanctions for frivolous litigation is mandatory. See
Private Securities Litigation Reform Act of 1995, ibid., § 77u-4(a).
112 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
b) Future Rewards: The Returns on Investment in Class
Action Law Enforcement
Consistent with the basic tenets of the theory of investment, plaintiffs’
lawyers’ investment of resources in class action law enforcement is trig-
gered by the prospects of obtaining future rewards.65 Lawyers’ fees are
an important component of investment in class action law enforcement
precisely because they represent the prospect of future returns on invest-
ment such that, along with other factors, they determine the magnitude
of plaintiffs’ lawyers’ incentives to invest — and hence the level of invest-
ment — in class action law enforcement.66 For this reason, the methods
used to determine lawyers’ fees and the magnitude of fee awards are an
extremely significant aspect of investment in class action law enforce-
ment.67
The discussion that follows briefly presents the methods used to
determine lawyers’ fees in class actions, substantiating the general propo-
sition that class action law enforcement is, in essence, an investment
opportunity. Further, the insights gained through this discussion are
germane to understanding key aspects of uncertainty about investment
in class action law enforcement, an issue which I discuss later in this
section.68
As a general rule, lawyers’ fees are contingent on the outcome of
the case69 — or, put differently, on the outcome of the investment they
65 Investment in class action law enforcement may be triggered by factors other
than the prospects of lawyers’ fees. I take specific account of these factors later
in this section.
66 Put another way, the deterrence and compensation obtained in class action law
enforcement are merely by-products of the plaintiff’s lawyer’s decision to invest
her resources in an investment opportunity, where she prosecutes legal claims
allegedly arising out of systematic wrongdoing.
67 Indeed, having recognized the effects of fees on plaintiffs’ lawyers’ law enforce-
ment incentives, the regulation of lawyers’ fees has been the subject of much
academic research and has inspired judicial attempts to induce plaintiffs’
lawyers to perform in a way that best serves the interests of the class. See, for
example, Reuven S. Avi-Yonah, “Developments in the Law: The Path of Civil
Litigation” (2000) 113 Harv. L. Rev. 1752 at 1827 and 1829–37, discussing
plaintiffs’ lawyers’ fees and their effect on incentives to invest in litigation.
68 See Section C(1)(c), below.
69 Plaintiffs’ lawyers provide their services and investment on a contingency
basis, such that they are not entitled to collect fees from representative or
absent members of the plaintiffs’ class they represent should they fail to obtain
a favourable outcome through either settlement or judgment. Further, unless
specifically authorized by statute, courts cannot impose the payment of plain-
tiffs’ lawyers’ fees on class action defendants. But see the Civil Rights Attorney’s
THE INVESTMENT THEORY OF CLASS ACTIONS 113
make — such that plaintiffs’ lawyers are entitled to a fee award only if
the litigation results in a favourable outcome for the plaintiffs’ class.70
This occurs either (i) where a judgment in favour of the class is rendered
or (ii) where a settlement is negotiated71 and approved by the court.72
Indeed, class settlements, rather than extensive trials and judgments, are
the more frequent result.
Having obtained a favourable outcome for the class, the precise
magnitude of the fee award may vary considerably across cases, in both
absolute (the sheer magnitude of the award) and relative terms (the rate
of return on investment). Generally, courts use two methods to compute
and determine fee awards in class action cases where a common fund
has been created:73 (i) the percentage-of-recovery method, and (ii) the
“lodestar” method. Under the former method, the rewards for investment
in class action law enforcement are derived from the aggregate value that
Fee Awards Act of 1976, Pub. L. No. 94-599, 90 Stat. 2641 (codified as amended
at 42 U.S.C. § 1988(b)), governing lawyers’ fees in civil rights litigation. When
a favourable outcome is obtained, however, plaintiffs’ lawyers’ rights to fees
arise from the common fund doctrine, according to which a lawyer whose
efforts conferred a benefit upon a class of people — in the form of a common
fund — is entitled to recover costs and fees from the fund thus created: see
Savoie v. Merchants Bank, 166 F.3d 456 (2d Cir. 1999) at 460. Lawyers’ rights
to their fee award are well established, despite the lack of contractual relations
with absent class members.
70 Judgments and, in particular, settlements may include both pecuniary and non-
pecuniary remedies to address the plaintiffs’ claims. Non-pecuniar y remedies
negotiated in class settlements often entail distribution of redeemable coupons,
distribution of securities, and creation of monitoring plans to detect and com-
pensate future harm. See Geoffrey P. Miller & Lori S. Singer, “Nonpecuniary
Class Action Settlements” (1997) 60 Law & Contemp. Probs. 97, discussing
various types of non-pecuniary remedies in class action settlements.
71 Obtaining a favourable outcome for the class, however, does not necessarily
mean that the defendant’s liability has been established. To the contrary, it is a
common practice that when settling claims brought against them, class action
defendants do not make any admission with respect to the alleged liability.
72 Unless judicial approval is granted, a proposed class action settlement does not
entail any binding or preclusive effects on absent class members, other than
the named plaintiff. See Fed. Rules Civ. Proc. R. 23(e), requiring that notice be
given to class members of a proposed class action settlement and that judicial
approval be obtained. See also In re Vitamins Antitrust Class Actions, 215 F.3d 26
(D.C. Cir. 2000), noting that settlement dynamics can cause even well-inten-
tioned representative parties to give insufficient weight to the interests of the
class as a whole, therefore justifying the supervisory role of the court under R.
23(e).
73 These computational methods are also applied where the remedies are non-
pecuniary.
114 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
was extracted from the prosecuted claims, through favourable settlement
or judgment, of which the plaintiffs’ lawyer internalizes an often-lucrative
percentage.74
Under the latter method, however, courts multiply the number of
hours actually worked by the plaintiffs’ lawyers in the course of the
litigation by an appropriate, court-approved hourly rate.75 Then, taking
into account several factors — including (i) the difficulty and complex-
ity of the factual and legal issues in the case; (ii) the complexity and
duration of the litigation; (iii) the quality of the legal services provided;
(iv) the efforts devoted by the plaintiffs’ lawyers; and (v) the risk of no
recovery — courts may apply a two-way “risk multiplier” (that is, greater
or smaller than one) to adjust the computed sum up or down.76 Similar
considerations are often given weight by courts in determining an appro-
priate fee percentage under the percentage-of-recovery method.77
In order to apply these computational methods, it is necessary to
determine an appropriate hourly rate (under the “lodestar” method)
or the fee percentage (under the percentage-of-recovery method) to
which the plaintiffs’ lawyers are entitled. This determination is generally
made ex post, after the claims have been prosecuted, recovery has been
74 Indeed, until recently courts often referred to 25 percent to 30 percent of the
common fund as a benchmark for awarding fees. See In re Activision Securities
Litigation, 723 F. Supp. 1373 (N.D. Cal. 1989), to the effect that fee awards
almost always hover around 30 percent of the fund created, but see Hanlon v.
Chrysler Corp., 150 F.3d 1011 (9th Cir. 1998) at 1029, stating that 25 percent is
the “benchmark award,” but awarding only 4.5 percent as lawyers’ fees out of a
fund valued at $115 million. In the wake of fee auctions and the impetus to use
sliding fee percentages, percentages have decreased substantially. See Theodore
Eisenberg & Geoffrey P. Miller, “Attorney Fees in Class Action Settlements: An
Empirical Study” (2004) 1 J. Empirical Legal Stud. 27, stating that the mean fee
award in common fund cases is well below the widely quoted one-third figure,
constituting 21.9 percent of the recovery across all cases for a comprehensive
data set of published cases covering 1993–2002.
75 See, for example, Goldberger v. Integrated Resources, Inc., 209 F.3d 43 (2d Cir.
2000) at 47, approving the lodestar method, but refusing to exclude the avail-
ability of the percentage-of-recovery method to determine fees in common fund
cases.
76 See Gunter v. Ridgewood Energy Corp., 223 F.3d 190 (3d Cir. 2000) at 195, n. 1,
stating a variety of factors to be taken into account when applying a risk mul-
tiplier. See also Goldberger v. Integrated Resources, Inc., ibid. at 53, to the effect
that contingency risk and quality of representation must be considered in set-
ting the reasonable fee.
77 See Hensler, above note 9 at 77–79, discussing factors taken into account by
the court when determining an appropriate fee percentage.
THE INVESTMENT THEORY OF CLASS ACTIONS 115
obtained, and a fee award is to be distributed.78 Few courts, in contrast,
have used an auctioning mechanism to determine these figures ex ante,
before class counsel was appointed by the court, the class claims were
actually prosecuted, and a considerable part of the investment had been
made.79 Whether this determination is made ex ante or ex post may bear
significantly on the level of uncertainty over investment in class action
law enforcement.80
The observation that investment in class action law enforcement
is triggered by the prospects of future rewards need not be further
explained. Yet, ancillary rewards, in addition to the lawyers’ fee award,
may also induce lawyers to invest resources in class action law enforce-
ment. Investment in class action law enforcement may also produce a
variety of short- and long-term benefits, which are likely to be taken into
account by lawyers when making investment decisions. These are likely
to include, for example, benefits derived from reduction in future costs
of investment in class action law enforcement, as the firm moves down
its learning curve and gains more experience and expertise.81 Likewise,
78 Fee percentages are often negotiated between the defendant and plaintiffs’ law-
yers and are included in settlement proposals submitted to the court. In review-
ing the proposed settlement, the court may also monitor fee awards negotiated
under severe conflict of interest and reduce them accordingly. Indeed, that law-
yers’ fees are negotiated contemporaneously with the settlement of class claims
creates an imminent opportunity for collusion between the plaintiffs’ lawyers
and the defendant.
79 See generally “Third Circuit Task Force on the Selection of Class Counsel,”
online: Third Judicial Circuit
report%20of%20third%20circuit% 20task%20force.pdf>, discussing the use
of fee auctions to appoint class counsel and determine lawyers’ fees. See also
Avi-Yonah, above note 67 at 1827 and 1837–45; Jill E. Fisch, “Lawyers on the
Auction Block: Evaluating the Selection of Class Counsel by Auction” (2001)
102 Colum. L. Rev. 650. The ex ante determination of hourly rates or fee per-
centages is a by-product of using an auction mechanism. Its primary objective,
however, is to align the diverging incentives of the court-appointed class coun-
sel and the members of the purported class and thus minimize the conflict of
interest (the agency problem). The most recent contributions to the literature
on fee auctions include Alon Harel & Alex Stein, “Auctioning for Loyalty:
Selection and Monitoring of Class Counsel” (2004) 22 Yale L. & Pol’y Rev. 69,
proposing rules that govern fee auctions and address the class action agency
problem; Lucian Arye Bebchuk, “The Questionable Case for Using Auctions to
Select Lead Counsel” (2002) 80 Wash. U.L.Q. 889, discussing pitfalls associ-
ated with the use of the fee auctions.
80 I discuss multi-dimensional uncertainty over investment in class action law
enforcement in Section C(1)(c), below.
81 Where a law firm faces a learning curve, current investment in class action law
116 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
the prospect of benefits from gaining strategic position in the plaintiffs’
bar vis-à-vis rival law firms, or otherwise establishing a social and profes-
sional reputation in handling specific types of class action, may equally
induce plaintiffs’ lawyers to invest.82
Unlike benefits obtained from fees awards, ancillary benefits from
investment in class action law enforcement are highly idiosyncratic or
otherwise firm-specific. While I recognize their existence for the sake of
theoretical precision and identify their potential effect on lawyers’ invest-
ment decisions, I do not intend to take further account of such benefits
throughout the analysis.
c) Investment Uncertainty: Cost- and Reward-Uncertainty in
Class Action Law Enforcement
Investment in class action law enforcement is made under conditions of
uncertainty, though the level of uncertainty may vary significantly across
different cases.83 The existence of uncertainty generally means that, at best,
plaintiffs’ lawyers can assign probabilities to alternative future outcomes
over which they are at any given time ex ante uncertain. Uncertainty, in
theory, may apply to multiple aspects of investment in class action law
enforcement. Hence, in addition to the magnitude of investment expendi-
tures and the magnitude of future returns on investment, investment deci-
sion-making is extremely sensitive to the level of uncertainty. Identifying
sources of investment uncertainty is therefore conducive to understand-
enforcement entails two distinct benefits. First, the firm may be successful in
obtaining a favourable outcome through settlement or judgment and therefore
be entitled to fees. Second, it moves the firm down the learning curve, thereby
reducing the future cost of investment in class action law enforcement such
that it would be able to increase its future level of investment. Compare Dixit
& Pindyck, above note 23 at 339–45.
82 See Peter H. Schuck, “Mass Torts: An Institutional Evolutionist Perspective”
(1995) 80 Cornell L. Rev. 941 at 952, observing that professional prestige and
ideology play an important role in fuelling mass tort litigation. See also Paul M.
Barrett, “Civil Action: Why Americans Look to the Courts to Cure the Nation’s
Social Ills” The Wall Street Journal (4 January 2000) A1, making the point that
plaintiffs’ lawyers often argue that their role is to supplement governmental
efforts to achieve vital social goals.
83 Uncertainty is intrinsic to the definition of investment as an act of incurring
immediate cost in expectation of future rewards, discussed in Section B(1),
above. That rewards are only realized at some point in the future renders any
investment uncertain, at least to some degree. While the level and dimension
of uncertainty may vary across investments, it is certain that investment uncer-
tainty is all but inextricable.
THE INVESTMENT THEORY OF CLASS ACTIONS 117
ing plaintiffs’ lawyers’ incentives to invest and the investment decisions
they ultimately make in the course of class action law enforcement.
Class action law enforcement is often an extremely resource-intensive
process. Investment expenditures are continuously made throughout,
depending on the conditions and circumstances that are present at dif-
ferent stages. For this reason, the magnitude of investment expenditures
that may be necessary to sustain class action law enforcement until future
rewards are realized through settlement or judgment is rather uncertain.
The level of uncertainty, however, is likely to decrease over time, as plain-
tiffs’ lawyers move forward in the process and more information thus
becomes available.
Analytically, uncertainty over the magnitude of investment expen-
ditures arises from two distinct sources. First, plaintiffs’ lawyers may be
uncertain over the sheer magnitude of expenditures they will have to
incur in the course of law enforcement. This may be the case because
there is no way they can know in advance what procedural difficulties
and substantive hurdles are likely to lie ahead of them. Nor can they
predict the magnitude of costs that the court may impose on them, over
which they have virtually no control.84 Second, plaintiffs’ lawyers are
also uncertain as to whether they will be entitled to reimbursement for
the costs they incur and, where reimbursement is forthcoming, whether
recoverable costs will be equal to or less than their expended costs. These
determinations are made by the court at the end of the case, when fees
are determined.
A second critical aspect of uncertainty over investment in class action
law enforcement is the uncertainty over the magnitude of future rewards
on investment. Recall that, in general, plaintiffs’ lawyers are entitled
to contingent fees, provided that a favourable outcome to the class is
obtained, and that courts determine the fee award using either of two dif-
ferent computational methods. Some uncertainty pertains to both these
contingencies, namely, (i) the outcome of the case, and (ii) the magnitude
of the fee award, such that, ex ante, the ultimate magnitude of the fee
award remains uncertain.
Uncertainty over the outcome of class action law enforcement is to a
certain extent endogenous to the plaintiffs’ lawyers’ level of investment.
That is, it is likely that higher investment on the part of the lawyers to
assess the merits of the case will produce valuable information; such
84 These costs may include the cost of class notice, the cost of judicially-imposed
sanctions, and the like. An elaborate discussion is found in Section C(1)(a),
above.
118 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
information will reduce the level of uncertainty, for it may suggest which
outcome is more or less likely to occur. Further, it is also possible that
positive information externalities will be generated through competition
by rival plaintiffs’ lawyers, vying to prosecute similar claims on behalf
of putative plaintiffs’ classes.85 The level of uncertainty is also likely to
decrease as the parties move forward in the law enforcement process and
more information becomes available through discovery and trial.
There is also some level of uncertainty over the fees to which plain-
tiffs’ lawyers would be entitled in the event that a favourable outcome is
obtained. Unlike uncertainty over the outcome of the case, uncertainty
over the fees is exogenous to the plaintiffs’ lawyers’ investment, since
additional investment is unlikely to reduce the level of uncertainty in that
respect.86 More specifically, uncertainty pertains to various dimensions of
lawyers’ fee awards, which are determined ex post, at the conclusion of
the litigation. These dimensions may include (i) the method the court
is likely to use to compute the fee award; (ii) the hourly rate or the fee
percentage that the court will apply to determine the magnitude of the
fee award;87 (iii) the possibility that a two-way risk-multiplier will be
applied to adjust the computed sum up or down;88 (iv) the magnitude
85 Because plaintiffs’ lawyers obtain no proprietary interest in the information
they produce, they may decide — as the discussion of sequential investment
decisions demonstrates — to delay their investment and free-ride on infor-
mation externalities that are produced by their competitors or by public law
enforcement agencies. But see In re Enron Corp. Securities Litigation, 206 F.R.D.
427 (S.D. Tex. 2002), where the plaintiffs’ lawyers sought to obtain copyright
protection for their work product.
86 It is not entirely unlikely that legal research may reveal patterns that charac-
terize the award of fees by certain judges or in specific judicial districts and
circuits or states. See, for example, In re Activision Securities Litigation, above
note 74, indicating that fee awards almost always hover around 30 percent of
the fund created, but see Hanlon v. Chrysler Corp., above note 74 at 1029, stat-
ing that 25 percent is the “benchmark award,” but awarding 4.5 percent as fees
out of a fund valued at $115 million. See also Miller & Singer, above note 70 at
142–53, examining the methods used to award lawyers’ fees in common fund
cases across federal circuits and in each of the fifty states finding a high level of
variance. While information on rules governing the award of fees may reduce
the level of uncertainty about the choice of computational methods, it cannot
eliminate the uncertainty.
87 Even where the parties stipulate an agreed-upon fee award in a proposed
settlement they submit for the court’s approval, the court retains authority to
monitor the fairness and the adequacy of the terms of the settlement and the
reasonableness of the fee award: see Fed. Rules Civ. Proc. § 23(e).
88 In fact, courts often apply risk multipliers to adjust the computed award under
both computational methods.
THE INVESTMENT THEORY OF CLASS ACTIONS 119
of any such risk multiplier; and finally (v) the possibility that the court
will err (in either direction) in assessing the relevant factors for applying
such a multiplier.
Against this backdrop, judicial experimentation with lead counsel
auctions — where competing plaintiffs’ lawyers submit proposed fee
structures89 in an attempt to have the winning bid and obtain the lead
counsel appointment90 — shifts fee determination to the ex ante stage,
before claims are prosecuted and investment in litigation is made.91
Lead counsel auctions therefore reduce the level of uncertainty over fee
awards. Yet ex ante determination of fees does not eliminate uncertainty
altogether; a residual level of uncertainty stems from the court’s authority
to make ex post fee adjustments, up or down, to the fee structure that was
determined ex ante.
On the whole, investment in class action law enforcement is made
under multi-dimensional conditions of uncertainty. While the level of
89 Judicial experimentation with lead counsel auctions gave rise to a variety of
auction designs. Hence, fee proposals submitted by plaintiffs’ lawyers are tai-
lored according to a set of rules specified by the court in its order about the
lead counsel auction. Plaintiffs’ lawyers may compete on various dimensions,
including, for example, hourly rates, fee percentages, sliding fee structures, the
magnitude of expected recovery, and the like. See, for example, In re Oracle
Securities Litigation, 131 F.R.D. 688 (N.D. Cal. 1990), order modified 132
F.R.D. 538 (N.D. Cal. 1990), reconsideration denied 136 F.R.D. 639 (N.D. Cal.
1991). Judge Vaughn Walker of the District Court for the Northern District of
California, who was the first to conduct a lead counsel auction, has conducted
auctions in several subsequent cases: see In re Wells Fargo Securities Litigation,
157 F.R.D. 467 (N.D. Cal. 1994); In re California Micro Devices Securities
Litigation, 168 F.R.D. 257 (N.D. Cal. 1996); Wenderhold v. Cylink Corp., 188
F.R.D. 577 (N.D. Cal. 1999). In a recent case, a fee auction was conducted to
select lead counsel in a class action involving antitrust allegations. The court
designed an auction in which plaintiffs lawyers would receive no fee if the
recovery obtained fell below $X but would be entitled to a 25 percent fee for
any amount in excess of $X. Plaintiffs’ lawyers thus based their bids on the
value of X alone. See In re Auction Houses Antitrust Litigation, 197 F.R.D. 71
(S.D.N.Y. 2000) at 83–84. Clearly, this auction design eliminates uncertainty
over the rate of lawyers’ fees, though the magnitude of the fee award remains
uncertain because this depends on the amount recovered in the case.
90 The reduction in the level of uncertainty over fees is a mere by-product of lead
counsel auctions. Courts have primarily used these auctions as a means of
selecting lead class counsel.
91 Investment in class action law enforcement, however, does not start with the
formal commencement of litigation. Rather, substantial expenditures may be
incurred at earlier stages. Hence, the uncertainty-reducing effect of ex ante fee
determination through lead counsel auctions does not capture the pre-filing
stages of investment in class action law enforcement.
120 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
uncertainty or its sources may vary from one case to another, the level
of uncertainty is a key factor in investment decision-making and is thus
expected to significantly impact plaintiffs’ lawyers’ incentives to invest
and the investment decisions they ultimately make in the course of class
action law enforcement.92
d) Investment Irreversibility: Sunk Costs in Class Action Law
Enforcement
A highly significant characteristic of investment in class action law
enforcement is that investment expenditures are largely or completely
irreversible; once expended, investment expenditures turn into a sunk
cost. Thus, should relevant conditions change and render investment in
class action law enforcement unprofitable, plaintiffs’ lawyers cannot dis-
invest or otherwise recoup their expenditures.93
Investment expenditures in class action law enforcement are irrevers-
ible because, for the most part, plaintiffs’ lawyers’ investment is highly
case-specific. Putting aside investment in infrastructure — such as
purchasing database technology or legal literature, incurring the cost of
professional training, and the like — and investment in gaining relevant
expertise, considerable expenditures that plaintiffs’ lawyers often incur
in the course of class action law enforcement are generally channelled
to discrete lines of investigation, to producing information on specific
wrongs and harms, and to developing particular legal theories.94 The
outcomes of such investigations and the information produced are valu-
able only in conjunction with the prosecution of specific claims. Further,
as plaintiffs’ lawyers move forward in the course of prosecuting a class
92 Investment decision-making in class action law enforcement is analyzed in
depth in Halfteck, above note 1 at Parts VIII and IX.
93 In some cases, investment in class action law enforcement is not entirely sunk.
For instance, plaintiffs’ lawyers are often able to pursue litigation on behalf
of individual victims they have identified in the course of their investigation
if maintaining class action law enforcement becomes unfeasible or otherwise
unprofitable. Thus, individual proceedings provide a fall-back option, albeit an
imperfect one, through which plaintiffs’ lawyers may be able to recover part of
the investment expenditures they incurred.
94 Nonetheless, lawyers’ investigation in one case may provide ancillary leads,
implicating the defendant (or other defendants) in unrelated wrongful conduct.
Thus, if the first case becomes unprofitable, spill-over effects of the investiga-
tion may provide new law enforcement opportunities, where with some prob-
ability plaintiffs’ lawyers may recoup part of the otherwise sunk investment
expenditures.
THE INVESTMENT THEORY OF CLASS ACTIONS 121
action, their expenditures become increasingly case-specific and thus
increasingly irreversible.
Precisely for this reason, and due in part to multi-dimensional uncer-
tainty over investment in class action law enforcement,95 investment of
resources entails high financial risk of non-recovery.96 The irreversibility
of investment in class action law enforcement interacts with other fea-
tures of such investment to determine the magnitude of plaintiffs’ law-
yers’ incentives to invest and the investment decisions they ultimately
make97 and, as a corollary, to affect the level of class action law enforce-
ment and the magnitude of liability and deterrence.98
Two immediate descriptive implications arise from the irreversibility
of these investment expenditures. First, plaintiffs’ lawyers’ investment
decisions are highly sensitive to the level of uncertainty. Hence, the more
the investment expenditure is irreversible, and assuming all else remains
equal, the less inclined will a plaintiffs’ lawyer be to invest in class action
law enforcement in the face of investment uncertainty.99 Second, as the
level of uncertainty decreases over time, controlling the timing of invest-
ment expenditures (that is, using the option to postpone investment
decisions) is a critical factor of which plaintiffs’ lawyers are expected to
take advantage.
2) The Multi-Stage, Sequential Nature of Investment
in Class Actions
Thus far, I have developed the general proposition that class action law
enforcement comprises, in essence, an investment opportunity under
95 Multi-dimensional uncertainty over investment in class action law enforcement
is discussed in greater detail in Section C(1)(c), above.
96 In theory, plaintiffs’ law firms can mitigate the effects of high financial risk
resulting from investment uncertainty and the irreversibility of investment
expenditures. To do so, they need to (i) diversify their litigation portfolio by
investing in additional class action cases and (ii) create an opportunity for
exploiting cross-case positive externalities and economies of scale, by investing
in class action cases that share some major common features. Indeed, the fact
that highly specialized practice areas can be observed in many plaintiffs’ law
firms reinforces this proposition.
97 Investment decisions are discussed in Halfteck, above note 1 at Parts VIII and
IX.
98 The effects of the level of investment on liability and deterrence are analyzed in
Section E, below.
99 For this reason, incentives to invest may vary across plaintiffs’ law firms,
depending, inter alia, on firm-specific relative degrees of irreversibility of
investment expenditures.
122 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
multi-dimensional conditions of uncertainty. A closer analysis also
reveals the sequential nature of this investment opportunity. It stems
from the general observation that class action law enforcement is, in fact,
a multi-stage investment project, comprising a particular sequence of
discrete investments, all of which must be completed in sequence before
returns on investment may, with some probability, be realized.100
More specifically, class action law enforcement consists of a series
of interrelated, discrete investment opportunities that require plaintiffs’
lawyers to make sequential investment decisions. In this sequence, an
initial investment opportunity and the corresponding investment are fol-
lowed, with some probability, by the next investment opportunity in the
sequence, at which point the plaintiffs’ lawyer must make another invest-
ment decision.101 This sequential investment pattern repeats itself all the
way through to the completion of the investment sequence.102
To exemplify this sequential nature, consider the class actions that
were filed against the Ford and Firestone corporations in the wake of
rollover accidents involving Explorer sport-utility vehicles. Suppose, for
example, that the plaintiffs’ lawyers’ initial investment in investigating
rollover accident risks may, with some probability, produce information
that implicates Ford or Firestone. The payoff for the initial, first-stage
investment lies therefore in the valuable information that the plaintiffs’
lawyers have obtained, which then generates the next investment oppor-
tunity in the sequence. Thus, having discovered this information, the
plaintiffs’ lawyers obtain a second-stage investment opportunity, namely,
the opportunity to invest in contemplating, preparing, and filing a class
action against Ford and Firestone. Again, the plaintiffs’ lawyers will have
to decide whether to invest, and if so, what share of their resources to
commit.
100 This definition is based on the theory of sequential investment developed by
Dixit & Pindyck, above note 23 at 21–22, 319 et seq.
101 That the plaintiffs’ lawyers may decide to stop investing, temporarily or perma-
nently, after each stage in the sequence suggests once again that the process of
class action law enforcement is a sequential, multi-stage investment opportu-
nity.
102 This is not to say, however, that the sequence of investment opportunities is
not time-limited. On the contrary, the time span of class action law enforce-
ment is unambiguously defined. The sequence commences with the initial
investment opportunity to investigate a potential systematic wrongdoing, and
culminates (at the extreme end) with the resolution of the case through settle-
ment or trial, where the plaintiffs’ lawyers obtain returns on their investment.
THE INVESTMENT THEORY OF CLASS ACTIONS 123
By contrast, an investment that fails to generate a payoff will, at any
stage, put an end to the potential investment sequence altogether. For
example, should the plaintiffs’ lawyers’ initial investment in the investi-
gation be unsuccessful, so that no implicating information is discovered,
subsequent investment in contemplating and filing a class action will not
be possible.
On a more general level, however, the sequence of law enforcement
investment opportunities, and the corresponding sequential investment
decisions, commences with the initial investment of resources by the
plaintiffs’ lawyers, undertaken to further the pursuit of class action law
enforcement. This sequence generally consists of a number of stages,
where the plaintiffs’ lawyers decide whether to invest in the given oppor-
tunity and what share of their resources to commit. More specifically, the
class action investment sequence may include an opportunity to invest in
(i) investigating alleged wrongdoing; (ii) contemplating, preparing, and
filing a class action; (iii) filing and defending pre-trial motions, including
a motion to dismiss and a motion for summary judgment; (iv) undertak-
ing discovery and in producing evidence, through expert scientific stud-
ies and otherwise; (v) obtaining class certification and in securing the
appointment as lead class counsel; and (vi) trial or settlement negotia-
tions to obtain a favourable outcome for the class.
It does not necessarily follow that the investment sequence always
begins with the plaintiffs’ lawyers’ investment in investigation of potential
corporate wrongdoing. Rather, depending on case-specific characteristics
— whether, for example, the alleged wrongdoing was investigated by
public authorities, such that sufficient information to file an action is
publicly available103 — the investment sequence and the number of stages
it comprises may vary across cases. Likewise, the investment sequence
103 Indeed, the National Highway Traffic Safety Administration and the state
investigators that examined accident-prone Explorer sport-utility vehicles
revealed that faulty Explorer tires, susceptible to a tread-separation problem,
provided the common cause, systematically leading to fatal accidents. See
John Greenwald, “Tired of Each Other” Time (4 June 2001) 50, reporting
that Firestone’s tires may be a factor in Explorer rollover accidents; Michael
Winerip, “What’s Tab Turner Got Against Ford?” N.Y. Times Magazine (17
December 2000) 46, discussing the fatal accidents in which defective Ford
Explorer tires were alleged to cause the accident and also the ensuing indi-
vidual and class actions. Thus, the publicly available information relieved
plaintiffs’ lawyers, at least to some extent, from the burden of producing this
information on their own, and thereby reduced the scope of investment they
had to make while pursing class action litigation against Ford and Firestone.
124 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
may also vary for rival plaintiffs’ lawyers who pursue similar claims.
Specifically, while the sequence of investment for some lawyers may
begin with investment in investigation followed by investment in prepar-
ing and filing a class action, other lawyers may free-ride on the efforts of
others and focus their investment on the latter stages of the sequence,
where they may invest, for example, in obtaining appointment as lead
class counsel.
Finally, the sequential nature of investment in class action law
enforcement yields several noteworthy implications. First, the most sig-
nificant implication is that any decision made by a plaintiffs’ lawyer in
the course of class action law enforcement could be structured in the uni-
fied terms of an investment decision and analyzed as such. For instance,
manifestations of the class action agency problem — namely, shirking or
collusion on the part of the plaintiffs’ lawyer — can also be portrayed in
investment terms. Along these lines, the decision whether to agree to a
collusive, “sweetheart” settlement entails, in essence, an investment deci-
sion, where the plaintiffs’ lawyer has to decide whether to incur cost (the
forgone profits from the collusive deal and the cost incurred in further
negotiation or trial) in expectation of possible future rewards (an award
of lawyers’ fees from a non-collusive settlement or judgment). Thus, hav-
ing identified the common investment features that underlie the myriad
manifestations of plaintiffs’ lawyers’ performance in the course of class
action law enforcement, the theory has the ability to generate comprehen-
sive insights, descriptive and normative in nature, concerning plaintiffs’
lawyers’ incentives to invest and their investment decisions.
Second, identifying the sequential nature of investment in class
action law enforcement divides the intricate law enforcement enterprise
into numerous sequential investment opportunities and investment deci-
sions, whose relative effects on the liability and deterrence results of
class action law enforcement can be studied and analyzed independently
of each other. For this reason, the general investment theory I advance
seems to be of high analytic precision.
Third, the sequential nature of investment in class action law enforce-
ment demonstrates the conceptual inclusiveness of the general theory.
Specifically, the foregoing discussion has made it clear that the class
action law enforcement enterprise is an all-encompassing process, includ-
ing, for example, plaintiffs’ lawyers’ early investment in investigation of
potential wrongdoing. Indeed, liability and deterrence results obtained
through class action law enforcement are contingent on the entire invest-
ment sequence, not merely on investment made for trial or for any stage
THE INVESTMENT THEORY OF CLASS ACTIONS 125
that follows the commencement of litigation. By contrast, existing class
action analyses, predominately relying on the intrinsic agency problem,
are significantly narrower in scope and are therefore incapable of accu-
rately capturing class action law enforcement in its complexity.
Finally, the sequential nature of investment in class action law
enforcement bears decisively on investment decisions plaintiffs’ lawyers
ultimately make. Specifically, the length of the investment sequence, the
number of investment stages, and the ability to start or stop investing
midstream interact to determine the magnitude of private incentives to
invest and the investment decisions made in the course of class action
law enforcement.
D. THE JUDICIAL ASSIGNMENT OF OPTIONS
TO INVEST IN CLASS ACTION LITIGATION
Investment activity in class action law enforcement is regulated by the
state,104 which delegates its regulatory authority to trial courts.105 Hence,
104 The fact that plaintiffs’ lawyers’ investment decisions may entail severe nega-
tive externalities provides a compelling justification for regulating the right to
invest in class action law enforcement. Specifically, the negative externalities
include (i) the administrative costs imposed on the legal system, and (ii) the
dilution of deterrence effects that results from sub-optimal recovery of dam-
ages.
105 Indeed, a variety of entrepreneurial and business activities are intensively regu-
lated by the state, and plaintiffs’ lawyers’ investment in class action law enforce-
ment is no exception. From an institutional perspective, regulatory oversight
over investment in class action law enforcement is entrusted to the courts,
though how they are situated to perform this regulatory function is subject to
deep scepticism. See generally William M. Landes, “An Economic Analysis of
the Courts” (1971) 14 J.L. & Econ. 61. See also Robert D. Cooter & Daniel L.
Rubinfeld, “Trial Courts: An Economic Perspective” (1990) 24 Law & Soc’y
Rev. 533.
Having recognized their insufficient capacity to perform rigorous regu-
latory oversight over investment in class action law enforcement, courts
have recently been willing to employ market mechanisms. See Note, “Class
Auctions: Market Models for Attorneys’ Fees in Class Action Litigation” (2000)
113 Harv. L. Rev. 1827; Fisch, above note 79; “Third Circuit Task Force Report:
Selection of Class Counsel,” above note 79. Indeed, the hotly-debated judicial
experimentation with lead counsel auctions are a creative initiative to alter the
institutional structure of regulatory oversight over investment in class action
law enforcement. The “lead plaintiff” provision introduced by the Private
Securities Litigation Reform Act of 1995 is yet another such attempt: above
note 63. The proposal underlying the “lead plaintiff” provision is presented in
Elliott J. Weiss & John S. Beckerman, “Let the Money do the Monitoring: How
126 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
plaintiffs’ lawyers who are interested in investing resources in prosecution
of claims on behalf of a pool of similarly-situated claimants must obtain,
at a given point during the investment sequence, the right (or licence)
to invest in class action law enforcement which, once granted, entails
the corresponding right to collect future rewards on investment, if any
materialize.106 The regulatory dimension of investment in class action law
enforcement may carry significant effects on plaintiffs’ lawyers’ invest-
ment in law enforcement, such that failing to take account of them would
render the present analysis incomplete.107
I therefore next analyze the regulatory dimension of investment in
class action law enforcement. To that end, I develop the general propo-
sition that the right (or licence) to invest in the class action sequential
investment opportunity qualifies, in essence, as a legal entitlement that is
assigned through a judicial-regulatory process.108 I also identify the implica-
tions for the general theory of investment in class action law enforcement.
My central proposition stems directly from the doctrinal require-
ment that plaintiffs’ lawyers, vying to invest financial wherewithal and
intellectual capital in the prosecution of claims on behalf of dispersed,
similarly-situated victims and to reap future returns, must satisfy two
procedural conditions. They must (i) have the lawsuit certified as a class
action109 and they must (ii) obtain an appointment as lead class counsel.110
Institutional Investors Can Reduce Agency Costs in Securities Class Actions”
(1995) 104 Yale L.J. 2053.
106 In other words, the plaintiffs’ lawyer must first obtain an appropriate licence,
granted by state-authorized agents (judges). As noted, the fact that plaintiffs’
lawyers’ investment decisions may entail significant negative externalities on
social welfare provides a compelling justification for regulating the right to
invest in class action law enforcement.
107 More accurately, the licence to invest in class action law enforcement includes
a complex bundle of rights and obligations, all arising from courts’ continu-
ous regulatory oversight of the performance and conduct of plaintiffs’ lawyers.
These regulatory aspects, however, are not addressed in the present context.
They are conceptually treated as a source of investment cost rather than as per-
taining to the assignment of investment opportunities.
108 In the discussion that follows I use “right to invest in class action law enforce-
ment” and “class action investment entitlement” interchangeably.
109 This requirement is embedded in R. 23(a), (b), (c)(1), and (c)(4) of the
Federal Rules of Civil Procedure.
110 This requirement arises from R. 23(a)(4) of the Federal Rules of Civil
Procedure, which courts routinely employ to scrutinize the competence of a
potential plaintiffs’ lawyer to “fairly and adequately protect the interests of the
class.” See, for example, Greisz v. Household Bank (Illinois), N.A., 176 F.3d 1012
(7th Cir. 1999), holding that R. 23(a)(4) requires the court to assess the com-
THE INVESTMENT THEORY OF CLASS ACTIONS 127
Only when both of these conditions are duly satisfied are the plaintiffs’
lawyers legally entitled to invest in the class action sequential investment
opportunity, to the exclusion of rival plaintiffs’ lawyers.111
The present focus involves, therefore, the possible effects that the
regulatory assignment of the investment entitlement may have on the
plaintiffs’ lawyers’ incentives to invest.
Specifically, the fact that the right to invest is assigned through a
regulatory process may significantly impact plaintiffs’ lawyers’ incentives
to invest and the investment decisions they ultimately make. This is
likely to be the case because the regulatory assignment process induces
competitive forces among rival plaintiffs’ lawyers and increases the level
of uncertainty over the preceding stages of investment in class action law
enforcement, namely, those that take place prior to obtaining the right to
invest. In order to analyze the effects that are likely it is first necessary to
understand (i) exactly how the right to invest in class action law enforce-
ment is assigned to plaintiffs’ lawyers and (ii) the economic effects of
obtaining the right to invest in class action investment opportunity on the
plaintiffs’ lawyers’ incentives to invest. The discussion below addresses
both of these issues.
1) Obtaining the Class Action Entitlement: A
Judicially-Granted Monopoly over Investment
in Class Action Litigation
Vying to invest financial and intellectual resources and reap possible
future returns, the plaintiffs’ lawyers must obtain the right to invest in the
class action investment opportunity, or else previous investment would
be largely in vain.112 Specifically, to obtain this entitlement the plain-
petence of counsel for the class; In re Joint Eastern and Southern District Asbestos
Litigation, 78 F.3d 764 (2d Cir. 1996) at 778, holding that R. 23(a)(4) requires
that class counsel be qualified, experienced, and generally able to conduct the
litigation.
111 The entitlement to the class action investment opportunity is revocable, how-
ever. The courts are not relieved of their duty of oversight once class counsel is
selected, at the outset of the litigation. To the contrary, courts have a constant
duty to monitor the professional competency and performance of class counsel
throughout the litigation: see In re Fine Paper Antitrust Litigation, 617 F.2d 22
(3d Cir. 1980) at 27.
112 Of course, plaintiffs’ lawyers’ investment in class action law enforcement may
be beneficial, even if ultimately they fail to obtain the right to invest. This is
likely when the investment gives rise to ancillary benefits, entails possible spill-
over effects or reduces the cost of future investment in law enforcement. For
128 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
tiffs’ lawyer must have the lawsuit certified as a class action and obtain
appointment to the position of lead class counsel. Once granted, however,
this entitlement entails a compound right, specifically including (i) the
sole right to invest resources in the prosecution of the class claims and
(ii) the corresponding right to obtain future rewards which are realized,
with some probability, by making the investment.113 Put in legal parlance,
this compound right comprises (i) the right to represent the plaintiffs’
class until the conclusion of the case,114 whether through trial or settle-
ment,115 and (ii) the ensuing right to obtain returns on investment in the
form of often-lucrative fee awards.116
From a procedural perspective, no entitlement can exist, let alone be
assigned, unless the court determines that the action brought on behalf
of a pool of similarly-situated individual victims satisfies the prerequisites
for a class action117 and can be maintained as such.118 Upon this deter-
mination, the entitlement is assigned to the plaintiffs’ lawyers once the
court finds them professionally competent and financially well-situated
to represent the class.119
From an economic perspective, however, the class action entitlement
is assigned through a legally-regulated transaction, involving the would-
be class counsel, on the one hand, and the presiding court, on the other.
In this transaction, federal or state courts act as ex lege fiduciaries on
an elaborate account of possible ancillary benefits see the discussion in Section
C(1)(b), above.
113 Future rewards for investment in class action law enforcement, represented
by lawyers’ fee awards and possible ancillar y benefits, are discussed in Section
C(1)(b), above.
114 Of course, the court retains the discretion to revoke the right to invest and
replace the class counsel with another counsel should the court determine that
the former has failed to act adequately in furthering the interests of the class.
115 This transaction also features a judicially-granted licence to utilize the class
action device for the purposes of prosecuting legal claims on behalf of a dispa-
rate group of similarly-situated victims. In other words, the certification of the
action as a class action is a built-in component of this transaction.
116 Similar to other aspects of the class action, the plaintiffs’ lawyers’ entitlement to
reap returns on their investment is explicitly regulated. Specifically, the judicial
common fund doctrine establishes the lawyers’ rights to compensation from
a common fund created by their efforts for the benefit of others. See Savoie v.
Merchants Bank, above note 69 at 460; Hanlon v. Chrysler Corp., above note 74.
117 See Fed. Rules Civ. Proc. §§ 23(a)(1)–(4), the prerequisites to a class action.
118 See Fed. Rules Civ. Proc. § 23(b), identifying maintainable class actions, and §
23(c)(1).
119 Several trial courts have employed fee auctions at the outset of the case as a
means of selecting lead class counsel: see above note 89.
THE INVESTMENT THEORY OF CLASS ACTIONS 129
behalf of dispersed, similarly-situated victims (the putative class mem-
bers) whose legal claims are at stake.120 Specifically, courts are entrusted
with the authority to transfer the right to invest in the class action invest-
ment opportunity along with the right to collect future rewards on the
investment made in exchange for the plaintiffs’ lawyers’ commitment to
invest their resources on behalf of the class. Further, when transacting the
right to invest in class action law enforcement, courts often give weight
to earlier investment made by the plaintiffs’ lawyer.121 Hence, in exchange
for acquiring a right to invest in the class action investment opportunity
and to collect future rewards, if any, the plaintiffs’ lawyers commit to
invest their intellectual capital and financial wherewithal to extract the
value of the prosecuted claims.
The plaintiffs’ lawyers, on the other hand, obtain an exclusive right
to invest in the class action. In fact, the exclusive nature of this right
suggests that the plaintiffs’ lawyers obtain a judicially-granted monopoly
over investment in the prosecution of claims, to the exclusion of rival
plaintiffs’ lawyers. It is a monopoly over investment in law enforcement
precisely because no rival plaintiffs’ lawyers can formally deprive the
assigned class counsel of their right to invest.122 To that end, trial courts
may even issue an anti-suit injunction to prevent rival plaintiffs’ lawyers
from prosecuting identical actions which may threaten to undermine the
assigned class counsel’s monopoly.123
120 In two recent cases, the court relied on its ex lege fiduciary duty to justify its
decision to utilize fee auctions to select class counsel and determine their fees:
see In re Commtouch Software Ltd. Securities Litigation, Fed. Sec. L. Rep. (CCH)
P91,985 (N.D. Cal. 2002); In re Quintus Securities Litigation, 201 F.R.D. 475
(N.D. Cal. 2001).
121 Courts often examine the quality of the pleadings submitted.
122 Rival plaintiffs’ lawyers can nevertheless undermine the investment monopoly
of the representative class counsel, simply because their entitlement is not uni-
versally protected. One way this could be done is by filing a competing class
action, concerning the same wrongful conduct, in a state court. Having done
so, the state court plaintiffs’ lawyers could be able to negotiate a global settle-
ment, where they settle not only claims asserted in the state court class action
but also claims asserted in the federal class action, notwithstanding that the lat-
ter are under original federal jurisdiction.
123 See Henry P. Monaghan, “Antisuit Injunctions and Preclusion Against Absent
Nonresident Class Members” (1998) 98 Colum. L. Rev. 1148.
130 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
2) The Temporal Watershed: Ex Ante versus Ex Post
Investments
Having analyzed the regulatory assignment of the right (the licence) to
invest in class action law enforcement, I turn to discuss its effects on the
plaintiffs’ lawyers’ incentives to invest and the investment decisions they
ultimately make in the course of class action law enforcement.
Recall, first, the multi-stage sequential nature of investment in class
action law enforcement.124 The sequence of investment often commences
with the plaintiffs’ lawyers’ initial investment in investigation of potential
wrongful conduct, followed by additional investment in contemplating,
preparing, and filing legal action on behalf of a pool of similarly-situated
individual victims. Prior to obtaining the right to invest in the remaining
stages of the sequence, the plaintiffs’ lawyers may also incur additional
investment expenditures which may be necessary to launch a class action
or obtain the right to invest.
Hence, the regulatory assignment of the right to invest in class action
law enforcement clearly demarcates a temporal watershed, distinguishing
between ex ante (pre-assignment) investment opportunities and corre-
sponding investment decisions, on the one hand,125 and ex post (post-
assignment) investment opportunities and investment decisions, on the
other.126 Identifying this temporal watershed is significant to analyzing
liability and deterrence results of class action law enforcement because it
is theoretically possible that the magnitude of plaintiffs’ lawyers’ incen-
tives to invest and the magnitude of the resources they ultimately do
invest will vary considerably across the ex ante and ex post phases of the
investment sequence.
More specifically, such variance in the magnitude of incentives to
invest is expected simply because the regulatory assignment of the right
to invest increases the level of uncertainty during the ex ante phase of the
124 For an elaborate account of the multi-stage sequential nature of investment in
class action law enforcement, see Section C(2), above.
125 Ex ante investment opportunities are those available to the plaintiffs’ lawyers
prior to consummating the transfer of the class action entitlement. Consider,
for example, the investment opportunity to undertake an initial investigation
into potential systematic wrongdoing.
126 Ex post investment opportunities are those available to plaintiffs’ lawyers fol-
lowing the transaction under which they obtained exclusive rights in the class
action. To take one example, consider the opportunity to launch an extensive
discovery campaign.
THE INVESTMENT THEORY OF CLASS ACTIONS 131
investment sequence.127 Once, however, the right to invest is obtained
— such that the plaintiffs’ lawyers obtain a judicially-granted monopoly
over investment in the remaining stages of the class action investment
sequence — the level of uncertainty decreases substantially, though not
entirely.128
Recall, further, that future rewards on investment in class actions
are only realized at the end of the investment sequence, when the award
of lawyers’ fees is determined by the court. For this reason, should the
plaintiffs’ lawyers fail to obtain the right to invest, they would not be
able to complete the investment sequence and their ex ante investment
would be lost. Hence, insofar as the regulatory assignment process cre-
ates uncertainty over whether the plaintiffs’ lawyers will be successful in
obtaining the right to invest, then assuming that all else remains equal,
plaintiffs’ lawyers’ ex ante incentives to invest are expected to be consider-
ably weaker than their ex post incentives to invest.
Three distinct factors interact to determine the level of uncertainty
over the plaintiffs’ lawyers’ likelihood of obtaining the right to invest: (i)
whether the court will determine that the action brought can be main-
tained as a class action; (ii) whether the court will find the plaintiffs’ law-
yers professionally competent to represent the class; and (iii) competition
between rival plaintiffs’ lawyers over the right to invest in prosecuting
claims on behalf of the same victims.
Given this analysis, there can be little doubt that, broadly defined,
the class action law enforcement enterprise encompasses investment
opportunities and decisions at both the ex ante and ex post phases of
the sequence.129 The liability and deterrence results of class action law
enforcement heavily depend on investment made in both these phases.
Indeed, both ex ante and ex post investment decisions affect (i) the prob-
127 Some level of uncertainty over ex ante investment exists independently of
the (added) uncertainty induced by the regulatory assignment process. For
instance, investment in investigation of potentially wrongful conduct is made
under uncertainty, simply because at the time investment is made it is not
known whether the investigation will discover information that substantiates
the alleged wrongful conduct.
128 There may be some residual level of uncertainty over ex post investments.
Plaintiffs’ lawyers’ investment in trial, for example, is made under uncertainty,
since alternative outcomes of the trial can only be assigned some probability at
the time the investment is made.
129 This reinforces my proposition that class action law enforcement is a sequen-
tial, multi-stage investment opportunity: a series of discrete investment oppor-
tunities and investment decisions, commencing in the ex ante state of the
action and spanning its ex post state.
132 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
ability of detecting wrongful corporate conduct; (ii) the probability of
prevailing in litigation; and (iii) the value extracted from the claims.
Combined together, these factors determine the expected liability expo-
sure for wrongdoing and the magnitude of deterrence achieved. It follows
that ex ante and ex post investment decisions jointly interact to determine
the magnitude of liability and deterrence obtained through class action
law enforcement.
Finally, it ought to be noted that the validity of this general proposi-
tion is due precisely to the sequential nature of investment in class action
law enforcement, which suggests that absent sufficient ex ante investment
in investigation, the class action investment sequence may come to an
end prematurely — because successful ex ante investments are precisely
the prerequisite on which ex post investment opportunities depend — and
thereby work to the detriment of achieving the deterrence objectives of
class action law enforcement. Precisely for these reasons, variance in the
magnitude of ex ante and ex post incentives to invest may carry extreme
consequences on the magnitude of liability and deterrence in class action
law enforcement.
E. NORMATIVE ANALYSIS: INVESTMENT-
ORIENTED REGULATION OF CLASS
ACTION LAW ENFORCEMENT
Viewed from a normative vantage point, the option theory and the meth-
ods developed by investment theorists provide the necessary tools and
requisite intellectual underpinnings to design sound investment-oriented
regulatory measures.
As noted earlier, policy-makers and courts ought to be mindful of
the fact that (i) any decision made by plaintiffs’ lawyers and, later, by the
court-appointed class counsel is nothing but an investment decision; and
(ii) the magnitude of incentives to invest and of the investment decisions
ultimately made are the most important determinant of defendants’ liabil-
ity exposure and, in turn, the magnitude of deterrence and compensation
effects of class action law enforcement. Thus, all regulatory measures
(including legislative reforms, rule-based measures, and judicial rule-
making) ought to focus on the properties of investment in class action
law enforcement and, in turn, shape incentives to invest and investment
decisions in socially desirable ways.
The normative appeal of the option theory derives from its capacity
to prescribe welfare-enhancing legal reforms and regulatory measures
THE INVESTMENT THEORY OF CLASS ACTIONS 133
that focus on any of the various properties of investment in class actions,
including (i) the magnitude of investment expenditures; (ii) the mag-
nitude of future rewards on investment (fee awards); (iii) the level of
investment uncertainty; (iv) the irreversibility of investment expenditures
(the problem of sunk costs); and (v) the sequential, multi-stage nature
of investment decisions. Ultimately, regulatory measures that utilize the
insights above can affect the magnitude of deterrence and compensation
from class action law enforcement and, consequently, bear significantly
on individual well-being and social welfare.
While the design of regulatory measures is bound to be context-
specific, so as to require a wealth of context-specific information, the
following examples demonstrate different types of investment-oriented
regulatory measures. These measures are bound to have an effect (in
either direction) on the magnitude of incentives to invest and, in turn,
on the level of investment in class actions. Thus, depending on whether
the social planner (or the court) is concerned with encouraging or dis-
couraging investment in class actions, these measures could be adopted
or prohibited, as appropriate.
(1) Measures affecting the rewards on investment in class actions: the
computation of lawyers’ fees, the use of risk multipliers to compute fees,
and possible caps on fee awards, among other measures, affect the mag-
nitude of fee awards and, ultimately, the magnitude of incentives to invest
in class actions.
(2) Measures affecting the cost of investment in class actions: the alloca-
tion of litigation costs between the parties may affect the cost of invest-
ment shouldered by plaintiffs’ lawyers and the court-appointed class
counsel and thus bear on the incentives to invest. Further, imposing
burdensome procedural requirements and restricting plaintiffs’ lawyers’
ability to raise the necessary capital or otherwise access low-cost capital
increases the cost of investment in class actions and weakens incentives
to invest.
(3) Measures affecting uncertainty over the cost of investment: the use of
fee auctions to appoint class counsel and determine fees at the outset of
the litigation will reduce the level of uncertainty concerning the rewards
on investment, should plaintiffs prevail through judgment or settlement.
(4) Measures affecting uncertainty over the rewards on investment: the
availability of anti-suit injunctions to enjoin overlapping, free-riding
class actions reduces the level of uncertainty concerning the expected
134 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
rewards on investment. In contrast, the ability of one legal forum (state
or federal) to approve a settlement that discharges claims asserted in a
class action pursued in a different forum increases the level of uncertainty
over the magnitude of reward on investment. Further, the design of the
class action process, namely, the procedures and standards governing the
screening, selection, and appointment of class counsel, affects the level of
uncertainty over the expected reward on investment.
F. C ONCLU SION: D IRECT IO NS FOR
FUTURE STUDY OF CLASS ACTION LAW
ENFORCEMENT
The option theory developed in this article offers a methodologically-
organized and conceptually-inclusive approach to thinking about class
actions in general. Equally important, the theory provides a compre-
hensive analytic framework in which various problems arising in the
domain of class action law enforcement become amenable to systematic
and coherent analysis at a high level of rigour, from both descriptive and
normative perspectives.
The option theory thus seems to have accomplished a threefold objec-
tive. First, the theory responds to — and, indeed, rectifies — the critical
shortcoming of the academic literature on class actions which failed to
provide any comprehensive theory of the structure or functioning of class
actions as a law enforcement mechanism. Second, the theory advances
a rigorous, conceptually-inclusive analytic framework and offers novel
insights that, taken as a whole, provide the requisite intellectual under-
pinnings for making informed social policy decisions in the area of class
action law enforcement. Third, the theory develops guidelines for design-
ing effective investment-oriented regulatory measures across the broad
range of areas of law where class actions are used to enforce the law.
In addition, the option theory is likely to affect the future study of
class action law enforcement. Having advanced this theory, it becomes
readily apparent that additional theoretical inquiry is necessary to fur-
ther our understanding in several directions, all of which are condu-
cive to designing more effective regulatory measures that can enhance
the capacity of class actions to serve law enforcement objectives.
First, it is necessary to closely examine and gain explicit under-
standing of how the magnitude of incentives to invest and the level of
investment made throughout the class action investment sequence affect
defendants’ liability exposure in class actions and, in turn, the attainment
THE INVESTMENT THEORY OF CLASS ACTIONS 135
of deterrence and compensation objectives.130 Second, while it is now
apparent that the specific properties of investment in class action law
enforcement shape plaintiffs’ lawyers’ incentives to invest and, ultimately,
their investment decisions, this knowledge is far from complete. Thus,
gaining further understanding of the various determinants of the magni-
tude of incentives to invest in class action law enforcement is essential.
In particular, it is necessary to inform the analysis with insights con-
cerning possible market effects, namely, the effects of the market for class
action legal services on plaintiffs’ law firms, their incentives to invest, and
the level of investment in class action law enforcement. The theoretical
premise and, indeed, the motivation underlying such an analysis, is that
class action law enforcement, like many other economic activities, is car-
ried out in a market environment. Thus, the fact that plaintiffs’ lawyers
(as private law enforcement agents) function within a market suggests
that the magnitude of incentives to invest, the level of investment, and,
more generally, the social output of class action law enforcement might
all be affected by (i) the level of competition in the market; (ii) the level
of market concentration; (iii) existing barriers to entry; (iv) information
costs; (v) positive and negative externalities (between competing class
action law firms); (vi) the pricing mechanism used, and like consider-
ations that make up the market mechanism. Furthering our knowledge
in this specific direction calls for, among other things, the development of
a positive model of the market for class action legal ser vices and gaining
explicit understanding of the market, including its supply side (the class
action bar) and its demand side (federal and state courts that “procure”
and price these services on behalf of absent class members).
130 A preliminary analysis of this issue is presented in Guy Halfteck, “The Effects
of Incentives to Invest and the Level of Investment in Class Action Law
Enforcement on the Magnitude of Liability for Harm” (Discussion paper
No. 452, 2003) (unpublished, archived at the John M. Olin Center for Law,
Economics, and Business, Harvard Law School), online: .law.harvard.
edu/programs/olin_center/papers/452_halfteck.php>. The analysis in that
paper shows how the magnitude of incentives to invest affect investment deci-
sions and, consequently, the magnitude of expected liability and deterrence.
Identifying the four factors that determine the magnitude of expected liability
and deterrence, this paper examines the correlation between incentives to
invest, the level of investment, and (i) the probability of detection of wrongdo-
ing; (ii) the probability of imposing liability for wrongdoing; (iii) the magni-
tude of damages (compared with the actual cost the wrongdoing externalizes
on society); and (iv) the size of the represented class (compared with the actual
number of victims).
136 LITIGATING CONSPIRACY: AN ANALYSIS OF COMPETITION CLASS ACTIONS
Absent an analysis of possible market effects, normative prescriptions
for regulatory intervention are bound to be qualitatively and analytically
inaccurate. Thus, studying the market for class action legal services and
informing the analysis with related insights is essential to the overall
objective of using class action law enforcement to enhance individual
well-being and social welfare. This is precisely because, conceivably, any
investment-oriented regulatory measure is likely to directly impact the
magnitude of plaintiffs’ lawyers’ incentives to invest and, at the same
time, indirectly impact the market for class action law enforcement
(including the level of competition, concentration, and like factors).131
Overall, these effects suggest that crafting and designing effective,
welfare-enhancing regulatory measures depends on explicit understand-
ing of (i) the class action incentive structure (which this article has
sought to provide); (ii) the effect of regulatory measures on the market
for class action legal services and, in turn, on the magnitude of incentives
to invest; and (iii) the correlation between incentives to invest and the
level of investment on expected liability and deterrence.132
131 For example, a regulatory measure that increases or decreases (i) the cost of
class action law enforcement; (ii) the rewards on investment; or (iii) the multi-
dimensional level of uncertainty over investment in law enforcement is bound
to have differential effects on plaintiffs’ firms active in the market. A regulatory
measure can affect costs, rewards, and the level of uncertainty both directly and
indirectly, which makes the task of identifying the effects of contemplated regu-
latory measures all the more complex and all the more important.
132 See Halfteck, above note 130.

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