Op-Ed: The Problem of Cost Awards and Third Party Funding in Class Proceedings

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 small investors or consumers 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 serves a deterrent purpose, internalizing externalities. It gives big companies an economic incentive to fulfill their duty of care and 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.

Writing about the deterrent effect of tort law in general, Richard Posner has argued that “Such a system cannot function unless the damages assessed against the defendant are paid over to the plaintiff. That is the necessary inducement for the plaintiff to play his regulatory role of identifying violations of the applicable judge-made rule, proving them, and when appropriate pressing for changes in the rule.”^[1]

However, there is a significant gap in the equation where class proceedings are concerned. The class action, even though it represents a large group, always has to have one or a few individuals who to take the role of 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, 105 OR (3d) 364. 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 percent 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:

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 Proccedings 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.  (at para 28).

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 financing company 10 percent of the winnings, with no cap. (The hearing on the motion was before Mr. Justice Perell on July 22, and his reasons are not yet reported.)

There is a Class Proceedings Fund (CPF) in Ontario which is sometimes available, but it turned down the Kinross applicants.   However, the issue is not about the CPF versus third party funders.  The issue is how much is going to be left for the class claimants.   All too often, costs eat up most of the winnings, and the class members get a nominal award even if they win.

A solution to this situation is perhaps 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. This was recommended by the Law Reform Commission prior to the passage of the Class Proceedings Act, 1992, SO 1992, c 6. That is the approach taken in British Columbia and a number of other provinces.

This will lead to some cases where a winning defendant has to bear the burden of its own legal costs. There is some risk of unfairness to defendants if they win, and are not awarded costs, but this should be handled through other means. Currently, the threshold for cause of action in class actions is the same as in any other type of action: “plain and obvious” that the plaintiff cannot succeed, as stated in Fulawka v. Bank of Nova Scotia, 2012 ONCA 443 (para. 42). This threshold is arguably too low. Given the higher costs of class actions, it seems to be economically unwise to have the same criterion as for ordinary cases.

It is unlikely that the current legislative scheme is optimal.   As suggested by Drew Hasselback, legal columnist of the Financial Post, part of the problem is also the range of motions that create delays and drive up costs in class proceedings.

Is there a risk that this would increase litigation, including cases that lack merit?   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 more on factors such as how likely the defendant is to settle quickly.  

Legislative reform ought to be considered to regulate this issue, 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.