Regulation and Class Actions

This post comes to us from Eric Helland of Claremont McKenna College and Jonathan Klick of the University of Pennsylvania Law School.

Regulation and litigation do not occur in isolation. In almost every case of a harm which leads to litigation some regulatory agency had initially monitored the activity that lead to the harm. Thus pharmaceutical litigation does not occur in isolation of the FDA and auto accident litigation does not occur in isolation of the enforcement of traffic laws. While this point may seem obvious it has important implications of the design of regulatory systems as well as limitations placed on the ability of potential plaintiffs to seek redress using the civil justice system. In a series of papers Steve Shavell (“A Model of the Optimal Use of Liability and Safety Regulation.” RAND Journal of Economics, 1984 and. “Liability for Harm Versus Regulation of Safety.” Journal of Legal Studies, 1984) examines the tradeoff between regulation and litigation. The basic intuition is that litigation maybe a substitute or a complement to regulation. In the case of substitutes we would expect that an increase in regulation reduces the need for litigation at least at the margin.

In a new paper, The Relation between Regulation and Class Actions: Evidence from the Insurance Industry, which we recently presented at the Law and Economics seminar at Harvard Law School, we investigate the relationship between litigation and regulation, using a unique data source covering the experience of insurance companies with class action litigation. The dataset contains information on class actions against firms in the insurance industry from 1992 to 2002. We examine four different facets of the regulation litigation tradeoff. The first is to examine whether regulator’s interest in a particular cause of action reduces the likelihood that class actions covering this cause of action will be filed in the regulator’s home state. We examine several measures of regulatory stringency in the state to determine whether there is a substitution effect between regulatory action and litigation. We also examine whether class actions are less frequent when regulators issued an administrative decision on a particular issue previously or if there are no existing state laws on the particular issue. We examine the impact of electing judges on patterns of filing. The hypothesis is that elected judges are more sympathetic to plaintiffs and hence class actions are more likely to be filed in states that elect their judges. Lastly, we examine the impact of pervious litigation both in the state and the specific line of litigation.

We find little evidence of a tradeoff between litigation and regulation. We do find that success of previous litigation is important in determining filing location. Perhaps more surprisingly we find cases are more likely to be filed in states that elect their judges in partisan elections. In previous research one of the authors has found that in states that elect their judges in partisan elections tort awards against out of state defendants are significantly higher (see Helland, Eric and Alexander Tabarrok. (2002) “The Effect of Electoral Institutions on Tort Awards,” American Law and Economics Review. 4(2):341-370). The implications are the previous findings for public policy are perhaps ambiguous. Although the legal system is an inefficient method of transferring income given the high transaction costs there are likely other reasons why states might wish to elect judges. In the case of insurance class actions the finding is more troubling. If states that elect judges are relying on litigation to deter harm the Shavell model would suggest reducing regulation to offset the increase.

Clearly there are a number of dimensions to the tradeoff to litigation and regulation. This paper represents only a first step in understanding the relationship. As the country prepares to overhaul the financial regulatory system more research into relationship is clearly warranted.

The full paper is available for download here.

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One Comment

  1. Hannah
    Posted Monday, November 23, 2009 at 1:31 pm | Permalink

    Can regulation usefully supplement litigation in a model of optimal social control of harmful externalities. returns to activity are higher than private returns before taking harmful externalities into account. It seems that courts and regulators make errors in assessing whether it is efficient for a given firm to take precautions.

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