Access to Justice and Credit Constraints: Credit Rationing in Personal Injury Litigation

Stiglitz and Weiss (1981) made one of the most significant contributions to modern microeconomic theory by showing that when asymmetric information exists in credit markets, raising interest rates does not solve the problem. Instead, lenders ration credit because higher interest rates attract riskier borrowers. This rationing of credit provides a theoretical explanation not only for why banks behave as they do, but also for why personal injury lawyers charge contingency fees for their services.

The cost of litigating a personal injury case can be quite high. Filing fees, expert witness fees, deposition costs, discovery costs, and attorney time can quickly accumulate to tens of thousands of dollars before a case ever goes to trial. For someone who has been injured, often experiencing lost wages and mounting medical bills, these costs represent a significant barrier to pursuing justice.

Litigation as a Credit Market Problem

A legal claim is considered an uncertain asset from an economic perspective, and its value depends on its probability of success, the potential damages, and whether it can be enforced against a defendant. Why do banks not typically lend to individuals based on their injury claims? Banks face several problems:

1. Information asymmetry – Lenders cannot adequately determine how strong a claim may actually be.
2. Adverse selection – Higher interest rates would tend to attract weaker claims.
3. Enforcement risk – Repayment depends on the outcome of a potential lawsuit, meaning repayment may be uncertain.

Consequently, due to the Stiglitz–Weiss credit rationing effect, even cases with strong legal merit may be rationed out of credit markets because lenders cannot differentiate between strong and weak claims. In the absence of other avenues for funding, many legitimate claims remain unresolved because plaintiffs lack the financial resources necessary to pursue them.

Contingency Fees as Litigation Finance

Landver Law and other firms that work on a contingency-fee basis serve as specialized financial intermediaries. Rather than charging an hourly rate, these firms take a percentage (usually between 30–40%) of the damages recovered if the case succeeds. If the case does not succeed, the firm receives no compensation.

The economic relationship between the law firm and the plaintiff can be classified as a risk-sharing contract.

For the law firm, this arrangement means:

• It pays all litigation expenses in advance.
• It invests attorney time into the case.
• It bears the risk of not succeeding at trial.

For the plaintiff:

• No upfront litigation costs are required.
• The plaintiff shares the potential recovery with the law firm.

In effect, contingency-fee law firms substitute for missing credit markets. They perform the role that banks would normally play by screening cases and providing the working capital necessary to pursue litigation.

Screening and Diversification

Personal injury firms assess the legal risk of cases differently from traditional lenders and do so before accepting cases into their portfolios. In other words, they accept only cases whose expected value is high enough to justify funding. Cases with little chance of recovery are rejected because they expose the firm to excessive risk.

This ex ante screening process significantly reduces adverse selection in the financing of legal claims.

Additionally, firms can diversify across many different cases, which reduces the overall variance associated with litigation outcomes. This allows a firm to absorb losses on some cases while generating profits on others.

An individual plaintiff cannot benefit from this diversification effect, but a law firm that finances many cases can.

Bargaining Power and Deterrence

Credit constraints may influence how settlement bargaining occurs. Most large corporate defendants have their own legal counsel and often carry insurance coverage. However, without contingency representation, plaintiffs would be at a significant disadvantage relative to defendants.

By obtaining contingency representation, the plaintiff gains a credible threat of taking the case to trial. This changes the equilibrium of settlement bargaining because the defendant must now consider the possibility that the plaintiff has sufficient financial resources to pursue litigation.

These implications have important economic consequences. One of the primary economic functions of tort law is to internalize externalities. When a negligent corporation expects that injured individuals cannot obtain funding to pursue a lawsuit, its expected liability declines. As a result, the deterrent effect of tort law weakens.

Contingency agreements help restore the enforcement capability of tort law and preserve incentives for negligent corporations to take proper precautions and comply with applicable laws.

Ramifications

The economic incentives that produce the current system are based on several factors:

• Differences in information about the facts of a case
• Large upfront litigation costs
• Plaintiffs’ lack of financial resources to fund a lawsuit
• Law firms’ ability to diversify and reduce risk across many cases

Some critics argue that contingency-fee arrangements may encourage attorneys to litigate cases more aggressively than necessary. Others respond that attorneys typically accept only those cases with a high probability of success because they must finance the litigation themselves and bear the risk of losing.

From a credit-rationing perspective, contingency fees in personal injury litigation are not merely a billing arrangement. They reflect the inability of the judicial system to provide a formal mechanism for financing legal claims. Where traditional credit markets refuse to lend against uncertain assets such as lawsuits, intermediary institutions emerge that assume the risk, shift bargaining power, and provide access to justice that might otherwise be unavailable.