September 8th, 2008

Class Action, Contingency Fees, Litigation Funding, and All That Jazz – European Law à l’Américaine?

Posted at 4:30 PM ET

Thomas Herde, Senior Vice President

A lot of ink has already been spilt over Europe’s changing claims landscape and the possible consequences for insurers and reinsurers. Recent developments not only suggest that the doors are open for European investors to participate in (and have the benefit of) US securities class actions, but also that the very beast itself eventually will find its way into the European legal system.

Are we at the beginning of a litigation explosion where ambulance-chasers create and fight over a European claims market? Is it the insurance industry which ultimately will finance “affordable justice for all”?

Fortress Europe?

Legal theorists disagree over the question of whether the European legal system, with its peculiarity of fostering two distinguished legal traditions (common and civil law), can effectively prevent substantial Americanisation. It has been argued that although developments at the EU level may indicate a shift towards a US legal style, Europe’s fragmented legal culture will, at a minimum, delay drastic changes – if not prevent them entirely. Whilst countries with a common law tradition share the adversarial system of the US, the practice of juries determining awards has never been adopted. This is an important distinction, as the jury system often has been cited as one of the major reasons for exploding tort costs in the United States.

Class Actions

Nevertheless, the legal landscape in Europe is changing. The recent debate over the introduction and application of collective litigation may be seen as evidence that national legislators are embracing new concepts. Although collective redress may not be an altogether new concept, only in recent years has legislation made class action lawsuits possible in some European countries. Others are yet to follow. The likely cost, the prevalence of the “loser pays” concept (i.e., the principle that the losing side shouldbear the litigation cost of the prevailing party), and the opt-in system (i.e., the process where all claimants have to take positive steps if they are to be included in the class) are the main reason why this new mechanism has not yet been commonly adopted.

In the UK, a recent discussion paper of the Civil Justice Council suggests that the current opt-in system is a major barrier to potential claimants and, by extension, to the damages awarded. Switching to the US opt-out system (i.e., once a class is defined, all members are automatically included in all settlements and decisions unless they decide to exclude themselves from the class action) would certainly facilitate collective action. It is questionable whether this alone will be sufficient to change the liability landscape radically as long as another stumbling block – litigation risk – has not been
cleared on the way to “affordable justice for all.”

Litigation Funding

As with collective action, litigation financing is not a novel concept. Although improperly encouraging litigation was a tort and crime in England and Wales until the late 1960s, legal expense insurance products – including “before the event” and ”after the event” – have been sold successfully over the years.

In the late 1990s, the UK permitted Conditional Fee Arrangements (CFAs), a somewhat light version of the US contingency fee concept. In stark contrast to the United States, though, CFAs prohibit arrangements where the solicitor’s fee is based purely upon a percentage of the award. Under a CFA, a successful solicitor can only charge his usual charge rate, plus an uplift based on the outcome which is capped at 100 percent of the usual charge rate.

The commercialization of litigation funding, however, is a fairly new idea in Europe. However, the concept of a commercial entity paying the litigation cost and accepting the risk of paying the other party’s costs if the case fails, is already a reality in the United States and Australia. In the latter, for example, IMF, a publicly listed company, successfully funds legal claims where the claim size is over AUD2m, therefore excluding the majority of personal injuries claims.

It has been argued that, in tandem with a class action opt-out system, litigation financing indeed has the potential to change the European liability landscape significantly. In this respect, it will be interesting to see how the regulators will ensure the independence of the legal profession from companies funding such litigation by effectively preventing the introduction of contingency fees through the back door.

So, what does all this mean for the insurance and reinsurance industry? Is it time to throw away the existing rating models and revisit the current business strategy?

Liability Insurance: A Paradigm Shift in Sight?

Given the current uncertainties, it seems unlikely that the insurance and reinsurance industry will be forced into drastic changes, at least in the short-term. Although the introduction of a jury system is not on the agenda in Europe (at least for now), lowering the procedural barriers in cases of class actions, combined with a minimal financial risk achieved by way of litigation financing, will undoubtedly lead to an increasing number of claims.

Although the extent to which the insurance industry will have to deal with frivolous claims is debatable, the defence provision (i.e., the insurer’s acceptance of the duty to defend the claim) certainly will grow in importance. This will put further pressure on insurers facing already growing legal defence costs. Insureds and reinsureds would be well-advised to make sure that they are comfortable with the treatment of loss adjustment expenses within a reinsurance agreement.

The commercialization of litigation funding and the investment in such financial vehicles will provide the insurance and reinsurance industry with a mechanism for hedging the growing litigation risk, and the existence of a vibrant funding market will result in competitive legal fees, directly benefiting the insurance industry.

But this may not be the end of the story. The idea of litigation funding could evolve even further, ultimately resulting in a market where liability claims are freely traded.

In a rapidly changing landscape, with many uncertainties remaining, it is perhaps too early to predict doom and gloom for the insurance industry.

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