07/24/2013 04:00 EDT | Updated 09/23/2013 05:12 EDT

Class Action Lawsuits Fall Prey to the Speculators

The class action lawsuit is an important legal innovation. It allows many small players to get together and seek justice if they have been injured due to the negligence of a large company. It lets many individual consumers or small investors who have suffered a loss make a claim.

The class action lawsuit is an important legal innovation. It allows many small players to get together and seek justice if they have been injured due to the negligence of a large company. It lets many individual consumers or small investors who have suffered a loss make a claim.

Their individual losses are not large enough to make it worthwhile for any one of them to pursue the claim alone, and they would not have a hope against the resources of a large corporation. The class action legislation makes it possible for them to be certified as a group, and pursue the claim. Lawyers who represent the class work on a contingency fee basis. It overcomes a serious access to justice issue in our costly legal system.

It also makes the system work better overall. It gives big companies an economic incentive to behave well. The damage to each individual is small, but the total is a significant amount. Ensuring that this can come back as a cost to the perpetrator is generally a good thing.

However, there is one significant gap in the equation. The class action, even though it represents a large group, always has to have one or a few individuals who are called the representative plaintiff. The representative plaintiff faces a significant legal liability if the case is lost.

It is traditional in Canada's legal system that the losing side pays a substantial portion of the legal costs of the winning side. The rationale behind this is to discourage frivolous lawsuits. In the ordinary situation of relatively matched individuals, where each has a substantial amount at stake, this may be reasonable.

In the case of class actions, it makes no sense. Certifying a class to start an action requires the approval of the court, and that is the appropriate place for the judicial system to winnow out frivolous claims.

Placing such a burden on the representative plaintiff is clearly unfair. If he wins, he will get only a small fraction of what the class wins. However, if the class loses, the whole cost falls onto the representative plaintiff. That is likely to be enough to bankrupt most individuals.

The free market has a way of coming up with innovations in response to problems such as this, but they are not always socially beneficial innovations. The innovation here is called third-party funding. A number of companies have been formed to "invest" in lawsuits. These are very much like the vulture funds that buy distressed debt. They know that on some of their investments they will get zero back, but if they have a sufficiently large, diversified portfolio, on average they will do quite well.

There are now a number of international companies that provide such funding to guarantee the costs of the representative plaintiff, and they have started to come to Canada.

This issue was raised in a landmark case in 2011, Dugal v. Manulife. In that case, Mr. Justice Strathy approved a deal in which a third-party funder, an Irish Company named Claims Funding International, would guarantee the plaintiff's costs. In exchange, it would receive 7 per cent of any settlement won by the class, with an upper limit of $5 million. The judge clearly found the matter distasteful, but he reasoned that it was the lesser of evils. He stated some key issues as follows:

"In Ontario, the costs rules applicable to ordinary actions apply to class proceedings -- the loser pays. The costs of losing can be astronomical -- well beyond the reach of all but the powerful and very wealthy -- not exactly the group the legislature had in mind when the Class Proceedings Act was enacted. The grim reality is that no person in their right mind would accept the role of representative plaintiff if he or she were at risk of losing everything they own."

The stakes have risen further recently. Investors have launched a suit against Kinross Gold Corporation, which wrote down $2.5 billion on a mine in Africa. In this case, the plaintiffs had to accept a third-party funding agreement that could give the funder 10 per cent of the winnings, with no cap.

Under the rules set out by the court, the third-party funding company is not supposed to have any influence on litigation strategy, or whether a settlement takes place. That is fine in theory, but the practice is likely to be different. Class action lawyers will want to deal with the same company more than once, and that is bound to exercise an influence on the way they behave.

The solution to this situation is straightforward, and implicit in Justice Strathy's comments. Ontario's law should be changed so that the representative plaintiff is not liable for the other party's costs, which is already the case in some provinces. This will lead to some cases where a winning defendant has to bear the burden of its own legal costs. While these can run into the millions, the amounts involved would not be a significant item in the budget of the typical large corporate defendant.

Is there a risk that this would increase litigation, including cases that lack merit? This is doubtful. The class action lawyers themselves, who work for nothing if they do not win, are likely to be reasonably careful gatekeepers. A foreign vulture fund is unlikely to make its decision based on the merits of the case, and would base its decision on factors such as how likely the defendant is to settle quickly.

Having an ever larger percentage of the class winnings skimmed off to reward the third party funder will end up making the class procedure a waste of effort.

It is unlikely that justice will be best served by allowing speculators a say in the conduct of class actions. Legislation ought to be introduced to remove such parties, and to relieve representative plaintiffs of the risk of adverse cost penalties. The "grim reality" that Justice Strathy alluded to can be overcome through shrewd legislative reforms.