This analysis illustrates the relative merits of different cost structures on the plaintiff’s settlement decision making and his or her incentive to concede and reach a settlement. The analysis makes use of our proprietary game theoretic model of litigation and settlement which examines the total expected wealth of a legal claim (gains from both settlement and trial) as a function of the litigant’s settlement offer or demand under conditions of uncertainty.¹
Legal Dynamics Chart
Hourly vs Contingent Fees Structure
Shift Hourly to Contingent: 0 %
In the analysis, the expected wealth of the legal claim as a function of settlement policy is measured across a range of different fee structures. At one extreme the legal expense is considered all “fixed” (i.e., based on some estimate of hours billed) with no portion of the fee on a contingent basis. At the other extreme, the legal expense is all contingent with no portion of the legal expense based on hours billed.²
Between these two extremes are hybrid cost structures comprised of some combination of a fixed estimate of hours billed and a contingent fee. Note, the trial contingent fee is assumed to be matched with an equal contingent fee on any proceeds of settlement. The reader can demonstrate the comparative effect of different cost structures on the settlement offer/wealth curve using the Dynamics chart widget at right.³ Sliding the blue button from fully fixed (left) to fully contingent (right) will gradually increase the portion of total legal expense charged on a contingent basis and simultaneously decrease the portion based on a fixed estimate of hours.
The Polarising Effect of High Contingent Fees
This analysis of cost structure yields some interesting insights that are only revealed using our game theoretic model of litigation and settlement. First, note that as fees are transferred from a fixed hourly estimate to a contingent basis, this has the effect of pushing the plaintiff’s optimum settlement demand to a more aggressive position. The reasons for his are twofold:
- as the cost structure becomes more contingent, the average cost risk of going to trial is diminished because of the potential that the plaintiff will pay nothing if he loses at trial on the portion of his fees that are contingent; and
- the contingent fee on any settlement proceeds diminishes the relative attractiveness of settlement compared to trial.
There is thus a tilting of the plaintiff’s wealth curve and not surprisingly this influences the location of the plaintiff’s optimum demand within the zone of uncertainty.
Contingent fee structures then can have a polarising effect on the plaintiff’s bargaining position – causing the plaintiff to favour trial to a greater extent. That is, the plaintiff has an economic incentive to advance a settlement demand that is more likely to be rejected by the defendant. This is illustrated by the “flattening” of the plaintiff’s settlement offer/wealth curve as more of his cost structure has a contingent basis.
Industry Standard Pricing – It’s No Accident
This analysis illustrates why it is no accident that the industry in the US has converged on a typical contingent fee of about 33%. The reason is clear to see from our Dynamics Chart above. At a contingent fee of 33% there is still a meaningful incentive for the plaintiff to make concessions and settle the case relative to bargaining intransigence that would result in a trial. However, at contingent fee levels much over 33% the benefits to the plaintiff from concession and settlement become increasingly marginal. And at about 48% the plaintiff is almost completely indifferent between a conciliatory bargaining position and an aggressive settlement demand that would certainty be rejected by the defendant. For any particular case, there is clearly a level of the contingent fee percentage where the wealth curve is completely flat and the plaintiff would be completely indifferent between concession / settlement and intransigence / trial. We call this the “Settlement Indifference Point”.
In short, contingent cost structures can, in certain circumstances, literally “attack” – or eat away at – a plaintiff’s incentive to settle. Cost structures alone can make plaintiffs indifferent as between trial or settlement and as such they can make legal cases more trial-prone. But while the plaintiff may be making a rational (wealth-maximizing) decision to be intransigent about his settlement demand, it would certainly not be desirable if it was the cost structure itself that was pushing the plaintiff towards trial. And as bad as this situation is for the plaintiff, it can also be suboptimal for his law firm. To illustrate the point with a hypothetical: Is the law firm better embroiled in a 4-year dispute that is highly trial-prone with, say, a 35% contingent fee structure, or a shorter dispute that will very likely settle with, say, a 30% contingent fee structure? If the case is near a Settlement Indifference Point, our models show that the trajectory of the case can turn on such fine adjustments.
Case-Specific Cost Structure Analysis
In the chart above we have only been able to illustrate one particular hypothetical case. While it serves to illustrate a point, the particular contingent fee structure at which a plaintiff will become economically indifferent between trial and settlement will depend very much on the unique financial economic attributes of the particular case. For example, our research shows that the Settlement Indifference Point can occur at substantially lower levels of contingency fee percentages in cases where:
- the defendant’s cost of capital is higher than the plaintiff’s
- the plaintiff is less risk averse
- there is a greater degree of uncertainty as to the award
- the estimate of the defendant’s liability is higher
The unique economic characteristics of each case will combine and compound to influence the contingent fee that leads to settlement indifference. To develop a complete understanding of how cost structure is influencing settlement behaviour, a complete game theoretic analysis of settlement versus trial is essential on a case by case basis. This analysis can yield significant benefits for both client and counsel alike. Undoubtedly there are some individual cases that can benefit significantly from customized contingent fee structures (or hybrid structures) that are specifically tailored to the unique economic dimensions of the case. Case specific analysis of the relationship between fee structure and settlement bargaining behaviour can ensure that plaintiffs have the correct economic incentives.
Benefits for Law Firms
Understanding how cost structure motivates settlement behaviour in each individual case is also vitally important for law firms. In some situations it might explain a plaintiff’s bargaining intransigence with respect to settlement. In others, this analysis may suggest a more balanced hybrid cost structure that incentivizes an earlier settlement and a higher rate of return for both client and counsel.
More generally, detailed analysis across an entire case portfolio could explore the relationship between a law firm’s pricing policy for legal services, client settlement behaviour and the resulting impact on the firm’s efficiency ratio of revenue-to-hours billed. Careful analysis of this issue using our game theoretic model of litigation and settlement can add financial economic insights on pricing policies. And in hard-to-settle disputes, it may “take the bite out of” contingent fee structures while enhancing the economic return for all concerned.
Conditional Fee Structures
Thus far we have only explored formally analysed this issue for contingent fees structures – a fee structure which is more typical in the United States. In the United Kingdom, however, the more common performance-based fee structure is “conditional”, wherein the uplift is tied to the base hourly fee as opposed to the award. Using our game theoretic model, we believe it is likely that we will see a similar dampening of the settlement incentive as the cost structure becomes more conditional — and for much the same reasons. However, further work is required with respect to conditional fees.
Performance Based Fees are Not Bad
We should emphasise that the results of this work do not lead to any conclusion as to some inherent goodness or badness of one fee basis over another. In and of themselves, contingent and conditional fee structures are not bad. In fact there is a good deal of research that supports their role in increasing access to justice and aligning the interests of clients and counsel. Rather, the point is that every fee structure – be it hourly, contingent, conditional, or some hybrid – influences the client’s incentives and their settlement bargaining behaviour. Understanding these incentives and their influence on behaviour can only help litigants and their law firms to achieve greater economic efficiency and a closer alignment as to expectations.
To inquire about our game theoretic analysis of cost structure and settlement incentives, please use the Contact form.
¹ Data for the Legal Dynamics charts are produced using our proprietary software application called OptiSettle™. To learn more about OptiSettle, click here.
² In the analysis, the contingent fee is varied across a range from 0% to 54%. We use this exaggerated range to provide a more vivid illustration of the point and ensure that the analysis passes through the Settlement Indifference Point.
³ We are building up a library of these sensitivity analyses. To look at other ways that financial assumptions about lawsuits can impact the pricing of legal claims and the economics of settlement, click to visit our Legal Dynamics library.