Why the Class Action Remedy Proposed In the New Companies' bill Will Fail

The "Economic times" recently published a debate on the efficacy of the class action remedy proposed by the new Companies' Bill on January 6, 2010. (Found Here and Here).

In a nutshell, the pro/con seems to be,

1.) Yes; Class actions may be useful but possibilities of the misuse of the device ought to be foreclosed. Class Action remedies ought to be coupled with statutory prescriptions that limit speculative litigation.

2). The counterview, posited by the President of a regional investor association seems to be that class action is a remedy whose time has come and "defaulting promoters" ought to be held accountable.

Seems to be me that debaters missed a vital dimension; the incentive structure in the legal services market.

If one factors in this dimension, the class action remedy will most likely be under-utilized, and therefore fail, in most respects.

Here is a capsule low-down:

The Class action remedy is one of the latest transplants that India has borrowed from Anglo-Saxon corporate law and more particularly, the US. But while engaging in this eclecticism, precious little thought has gone into the peculiar institutional design that makes the class action remedy favourable in the US market.

The reason why class actions were successful in the US (in fact so, successful, that speculative litigation abounded, prompting the House to enact the PSLRA, 1995, to regulate causes of action and standi) was the incentive structure of the legal services market. In the US, unlike India, as most of us might be well aware, the incentive structure is characterized by contingency fees.

In their design, contingency fee arrangements replicate the risk-sharing model where the attorney of the plaintiffs takes an "equity interest" in the "litigation venture". Consequently, while the lawyer stands to reap windfall gains should the class action succeed, the returns may be substantially lesser if the action fails.

These rules of the game in the legal services reduce transaction costs, agency risk and result in a robust market for class actions; With her incentives aligned to those of the class acting plaintiffs, the lawyer is much more pro-active in faster "turn around" times.

Contrast this market design, with the "lodestar rule" prevalent in India that de-links the attorney's incentives from the outcome of the litigation to its process--the hours that she dedicates for the client/appearance that she makes for the clients in courtrooms. To make matters worse, institutional rules of the game forbid "opt-out" of this inefficient rule by foreclosing contingency fees as an option.

With the lode-star rule in place, I doubt that aggrieved investors will have appropriate motivations to pursue class action remedy. Admittedly, the class action device reduces the cost of litigation for the plaintiffs. However, the disincentives created by the lode-star rule will make it highly unlikely that the law firm that they engage, will advise them correctly as to which actions to pursue to trial and which actions to settle. And if so, they will prolong most actions that they should have settled earlier, adding to the cost of litigation. Class actions in securities fraud cases are likely to be complex (causation is notoriously difficult to prove, unless the rules of evidence are changed to reverse the burden of proof) and this information asymmetry between the principal(plaintiff investors) and the agent (attorney) coupled with the perverse incentive structure make this scenario much more likely.