The Indictment of the Milberg Weiss Law Firm and America's Love/Hate Relationship with Class Action Litigation

Last week, a federal grand jury in California handed down a 102-page indictment against the country's premiere plaintiffs' side class action law firm, Milberg Weiss, two firm partners, and others. The indictment alleges that Milberg Weiss provided the named plaintiffs in numerous class action lawsuits with kickbacks from the attorney fees in successful cases, thus giving those named plaintiffs incentives that diverged from those of the class members they had a fiduciary duty to represent--and allegedly violating a raft of laws in the process.

If the government can prove its case against Milberg Weiss, the firm will undoubtedly suffer. Indeed, the firm has already taken a huge reputational hit, from which it may never recover, simply by virtue of the indictment. Some commentators have thus questioned the government's decision to indict the firm itself, rather than just the individuals allegedly involved in the scheme. After all, the vast majority of Milberg Weiss lawyers and staff likely had no knowledge of the alleged illegal conduct.

Right or wrong, the Milberg Weiss indictment also raises broader questions about the class action itself. The same kind of harm allegedly done by the Milberg Weiss kickback scheme occurs on a much larger scale, albeit legally, in nearly every large class action lawsuit. The lawyers are typically the driving force behind class action litigation. That is part of what makes the class action such a useful vehicle, but it also creates the risk of abuse that so worries class action critics.

What is a Class Action?

The class action is a legal device for resolving numerous potential lawsuits in one single case. In federal court, class actions are governed by Federal Rules of Civil Procedure 23 and, for certain kinds of cases against corporate officers and directors, 23.1. A class action can involve a class of plaintiffs or a class of defendants, but typically involves only the former.

Over the years, the class action lawsuit has proved to be like Rasputin or the Energizer Bunny. No matter how many different ways opponents try to kill it, it just keeps going and going.

Congress has taken a leading role in limiting class actions. Although the Federal Rules of Civil Procedure are generally kept up to date by a committee of experts under the loose supervision of the Supreme Court, Congress has repeatedly intervened to amend Rules 23 and 23.1, usually to make it more difficult to bring class action suits.

And even in the rare instances when Congress has acted to expand class actions, it has remained hostile to the device. For example, the Class Action Fairness Act of 2005 created federal court jurisdiction for nearly all class actions worth $5 million or more, mostly in the hope that by funneling such cases into federal court, state courts would be left with fewer opportunities to grant large class action awards.

The federal courts themselves have also done their bit to constrain class action lawsuits. For example, in the 1974 case of Eisen v. Carlisle and Jacquelin, the Supreme Court ruled that a judge could not shift to the defendant the cost of notifying absent class members of their rights, even where the judge determined that the defendant was likely to be found liable, and even though failure to shift costs in this way would effectively prohibit class treatment.

And in the 1997 asbestos case of Amchem Products, Inc. v. Windsor, the Justices required that a class action strictly comply with most of the provisions of Rule 23, even where the parties have agreed, in advance of filing the case, to settle it.

When Is a Class Action Appropriate?

Why should a case proceed as a class action rather than as many individual lawsuits? Federal Rule 23(b) provides the main reasons.

Sometimes a class action is appropriate because the plaintiffs want an injunction against the defendant or defendants, and multiple individual lawsuits could lead to inconsistent results. To choose a not-at-all-hypothetical example, imagine that the customers of a telephone company want to sue the company to prohibit it from unlawfully divulging to the National Security Agency the phone numbers that individual customers called. By banding together in a class action, the millions of customers may be able to obtain an injunction that protects them all.

In other circumstances, a class action can help to ensure a fair distribution of the damages owed by a defendant with limited assets. The net worth of a manufacturer of a dangerous product, such as asbestos, may be substantially less than the total of its liabilities to prospective plaintiffs. If cases proceed one by one, then plaintiffs whose cases come to judgment early will recover their full damages, while plaintiffs whose cases are delayed will get nothing. By banding together as a class, each plaintiff receives his or her proportionate share.

Yet another kind of class action involves the aggregation of individually small but collectively large damages. Suppose a software company unlawfully monopolizes the market for operating systems, and as a result, it charges its customers the monopoly price rather than the lower price that it would have had to charge if it faced fair competition. The harm to any one consumer may be as little as ten or twenty dollars, an amount too small to warrant an individual lawsuit. (No lawyer will take a case with the prospect of such tiny damages. Indeed, it's not even worth representing yourself in small claims court.) However, if millions of consumers join together as a class, then tens or twenties of millions of dollars will be at stake--more than enough to enlist a skilled team of class action lawyers.

Thus, in theory, the class action serves important social values of efficiency, fairness, and justice. It promotes efficiency by resolving, in one fell swoop, numerous claims that, if pursued individually, could lead to wasteful litigation and contradictory results. It promotes fairness by ensuring that claimants receive compensation in proportion to the harm they have suffered, not their luck in getting to the courthouse early. And it serves justice by ensuring that corporations and other defendants do not get away with inflicting large aggregate harms on the public simply by dividing those harms among a great many people.

A Cost of Class Actions: Loss of Your Day in Court

If all those benefits make the class action sound too good to be true, it is. The class action also has costs.

The class action is an exception to the principle that every person deserves his or her day in court. When a class contains thousands or even millions of members, there is no practical way for the class attorneys to consult with the class as a whole on the matters of strategic detail about which lawyers routinely consult their individual clients.

One solution to this problem is to permit potential class members to opt out of the class, but this approach frequently does not work. In some kinds of class actions, prospective plaintiffs are not even permitted to opt out, because the whole point of the class is to resolve the disputed issues once and for all.

In other class actions, in which opt-out is technically permitted, no sane plaintiff will in fact opt out: If you're offered a $20 discount on your next phone bill as payment in settlement of a class action, you would have no incentive to opt out simply so that you can bring your own individual lawsuit, even if that suit might win you $200, for you would need to invest much more than that just to get your individual case started.

The Representativeness Requirement, and the Allegations Against Milberg Weiss

Because opt-out is so frequently a bad option, Rule 23 tries to make up for the loss of the right to a day in court with another device: In every class action, there are one or more named plaintiffs who stand in for the class as a whole. The Rule requires that the interests of the named plaintiff must coincide with the interests of the class he or she represents, and before a case can be certified as a class action in federal court (and under parallel rules in state courts), the judge must determine that the named plaintiff or plaintiffs will, in fact, fairly represent the class as a whole.

Milberg Weiss stands accused of subverting the representativeness of the named-plaintiff process. According to the indictment, in case after case, a small number of the same named plaintiffs swore to the court that their interests were aligned with the underlying class, but they were secretly receiving large payments from Milberg Weiss attorneys and intermediaries to do so. These payments (if made) ensured that the named plaintiffs would do the bidding of Milberg Weiss, rather than insisting on the best possible terms for the class. For example, a named plaintiff receiving under-the-table payments from the law firm would have little incentive to object to a proposed class action settlement that paid large attorney fees to the firm, at the cost of smaller payments to the class members.

Why, Even Absent Corruption, Virtual Representation is Less than Ideal

But even when lawyers and named plaintiffs act honorably, the named-plaintiff device is highly imperfect. Reliance on the named plaintiffs to represent the interests of the class substitutes virtual representation for actual representation. And while we may tolerate that substitution as a necessary cost to attain the benefits of class actions, it is a steep cost nonetheless.

To see why, imagine that you were charged with a crime that you did not commit. Surely you would not be satisfied by an arrangement in which you were denied your own attorney on the ground that your co-defendant, who was charged with the same crime, had roughly the same interests as you in casting doubt on the government's case.

To be sure, part of your discomfort would be the worry that your co-defendant and his attorney will try to escape conviction by pointing the finger at you. But even apart from this concern, you would want to exercise your right to participate in your own defense. Virtual representation in the criminal context would be an unacceptable sacrifice of your right to your day in court. Accordingly, we tolerate this sacrifice in the civil class action context only grudgingly.

Corporation/Shareholder Agency Problems and the Class Action Response

Milberg Weiss built its class action practice chiefly on suits against corporate directors and officers alleging that they had violated their fiduciary duty to the shareholders of the corporation.

Corporate directors and officers make important decisions about what to do with billions of dollars of other people's money. As a legal matter, they are bound to put the interests of the corporation and its shareholders ahead of their own personal interests, but as we know from the experience of companies like Enron and Tyco, directors and officers sometimes find the temptation to self-deal irresistible.

Economists refer to the mismatch between the incentives of people like shareholders on the one hand, and corporate directors and officers on the other hand, as a "principal-agent problem," or sometimes just an "agency problem." The principal--here, the shareholders, collectively--employs agents--here, the corporate directors and officers--to do a job that the principal cannot or chooses not to do for itself.

The dispersed shareholders of giant corporations cannot possibly be involved in the day-to-day decisions of these corporations. Shareholders benefit from the corporate form because it aggregates capital in a way that permits investments in profitable projects that would otherwise go unfunded, but they are always at risk of being bilked by their agents, the directors and officers.

The law addresses agency problems in the corporate context in a number of ways. One solution is transparency. State and federal law require honest reporting of a firm's assets and liabilities. Stock exchanges impose an additional level of regulation, as do requirements that financial statements be audited by professional accountants.

And criminal law backstops all of these measures. Dishonest directors and officers can go to prison for knowingly stealing corporate assets, as can accountants who aid and abet them.

Yet, as we know from too many recent examples of malfeasance, the threat of criminal sanction only goes so far. The Securities and Exchange Commission, the Justice Department, and state corporate law enforcement departments have finite resources. Consequently, criminal prosecution is only part of the package of official responses to the corporate agency problem.

Private enforcement also plays a large role, typically through class action lawsuits. If corporate directors and officers knowingly overstate (or understate) their earnings, trade on inside information, or otherwise violate their fiduciary duty, enterprising lawyers will sue to block the proposed deal or to demand that assets allegedly misappropriated be disgorged.

Such litigation can be extraordinarily lucrative for plaintiff class action attorneys, and equally costly for corporations. Indeed, class action critics frequently complain that firms like Milberg Weiss file class actions to block large deals simply to obtain a settlement for the very large nuisance value of the litigation. Critics point to the speed with which Milberg Weiss cases have been filed--sometimes within hours of the announcement of a major corporate deal or a stock's precipitous decline--as one indication that the firm's lawyers have not always been careful to ensure that their cases have merit.

Why did speed matter so much to firms like Milberg Weiss? Because prior to the enactment of the Private Securities Litigation Reform Act of 1995, the firm that filed the first class action typically got to speak for the class as a whole. After the change in the law, lead plaintiff status was presumptively awarded to the plaintiff with the largest stake in a case, often an institutional investor such as a pension fund.

Pre-1995, it was important for a class action law firm to have named plaintiffs at the ready to sign onto a case on a moment's notice, which partly explains why Milberg Weiss stands accused of paying named plaintiffs in the 1980s and early 1990s. Interestingly, however, the indictment alleges that the payments continued well after the law changed, thus suggesting that the 1995 Act was not fully effective in preventing firms from making tactical maneuvers to become lead counsel.

The Lawyer/Client Agency Problem in Class Action Litigation

Milberg Weiss and those who allegedly acted in concert with the firm stand accused of very serious wrongdoing. Under-the-table payments to named plaintiffs exacerbate the principal-agent problem that already exists whenever one party acts as the virtual representative of another.

But the bigger agency problem in class action litigation arises from the relation between the lawyer as agent for the class as principal. Lawyers working on a contingent fee basis--like real estate agents working for a percentage commission--have a financial incentive to make as many deals as possible while doing as little work as possible. That means settling each case quickly and moving on to the next one, even if additional negotiations, or even going to trial, could have resulted in more money for the clients.

Granted, judges must approve attorney fees in class action settlements, but that does not change the basic incentive structure. Indeed, it may exacerbate the problem: A fixed-percentage cut for the lawyer ensures that more money for the client also means more money for the lawyer, aligning the interests of the two to some extent; in contrast, by decoupling awards to clients from attorney fees, the requirement of judicial approval de-aligns the incentives of the lawyer and the class clients.

When the system functions as it is supposed to, the class representative will act as a check on the attorney as agent. And at least where the named plaintiff has a great deal at stake, this mechanism works tolerably well.

However, in most class actions, the lawyer is in the driver's seat, even without making illegal payments to the named plaintiff, for usually lawyers alone have the resources and expertise to evaluate and handle complex class actions.

Thus, even if the government proves its case against Milberg Weiss, the larger agency problem in class litigation will remain.

In sum, we have a system of class action litigation rife with principal-agent problems. Ironically, in the corporate context, we employ it as a mechanism for combating rampant principal-agent problems within corporations.

In these circumstances, one can hardly blame the government and the grand jurors in the Milberg, Weiss case for wanting to stop what they saw as an effort to add yet another layer of principal-agent problems.