Taking a Financial Position in Your Opponent in Litigation

Plaintiffs sometimes have significant financial interests in their opponents, interests that extend beyond the boundaries of the lawsuits themselves.  In some situations, plaintiffs maintain a “long” financial position.  For instance, in securities litigation or direct or derivative litigation alleging a breach of fiduciary duties under state corporate law, the plaintiffs are typically a subset of the firm’s current shareholders.  When the defendant-firm loses at trial and pays damages—or, more commonly, avoids trial by retaining defense counsel and/or making a settlement payment to plaintiffs and their counsel—while the plaintiff-shareholders may receive a direct monetary benefit, they also suffer an indirect loss from the decrease in firm value.  In other situations, plaintiffs have a “short” financial position.  A recent controversy surrounding patent challenges brought by a hedge fund manager, Kyle Bass, and his Coalition for Affordable Drugs, a non-profit organization, is exemplary.  Kyle Bass has brought over 36 patent validity challenges against certain pharmaceutical companies while his hedge fund was shorting the companies’ stock.  (These challenges are brought as inter partes review petitions, which are filed before the Patent Trial & Appeal Board within the U.S. Patent & Trademark Office.)  If the patent is declared invalid and the stock price drops, while the non-profit organization will not realize any direct gain from the successful patent invalidation, the hedge fund will presumably be able to make a (sizable) profit.  Since the market value of a publicly-traded defendant reacts to new information, a plaintiff who holds a long or short financial interest in the defendant’s stock will have different litigation incentives than a plaintiff who does not.  In other words, the plaintiff’s financial interest in the defendant can radically change the course of litigation.

This paper explores the dynamics of litigation and settlement when a plaintiff maintains a financial position in a defendant firm.  Before filing suit, the plaintiff may take either a long or a short position against the defendant.  With a long position, the plaintiff would benefit if the defendant’s stock price goes up, and with a short position the plaintiff would benefit if the defendant’s stock price falls.  By selling the stock short, the plaintiff is actively betting against the firm, and will reap higher financial gains when the defendant suffers greater litigation losses.  If the capital market is unaware of the lawsuit at the time that the plaintiff takes the short position, then the plaintiff can of course profit from the financial investment.   If the capital market is aware of the lawsuit and has rational expectations, , the plaintiff does not capture any systematic, direct benefit from the financial position.  However, the plaintiff can secure indirect strategic benefits because, by the time of settlement or trial, the initial expenditure the plaintiff has incurred in taking the financial position is sunk and the plaintiff has an interim incentive to maximize the aggregate return from both litigation and the financial position.

We begin by analyzing a setting with symmetric information, where the plaintiff, the defendant, and capital market know all the relevant parameters, such as the size of the damages, cost of litigation, and the probability of plaintiff winning.  By taking a short position in the defendant’s stock, the plaintiff can transform what would otherwise be a negative expected value claim into a positive expected value one.  This, in turn, implies that more cases will be filed ex ante.  While some of these claims may be meritorious and socially valuable, others may not be.  Indeed, through a sufficiently short position, the plaintiff can credibly threaten to bring any suit to trial, even an entirely frivolous one where everyone agrees that the plaintiff’s chances of prevailing in litigation are (near) zero.  Short selling improves the plaintiff’s bargaining power for positive expected value claims as well, leading to larger settlement payments by the defendant.  Conversely, when taking a long position in the defendant’s stock, the plaintiff’s threat to go to trial and bargaining position are compromised.  After presenting the basic results, we consider five extensions of the symmetric information analysis: (1) a less efficient financial market that is initially unaware of the lawsuit; (2) differential litigation stakes in which the damages that the defendant pays are larger than the plaintiff’s recovery; (3) the loser-pays-the-costs rule; (4) endogenous litigation cost, where the amount of resources spent on litigation depend on the stake; and (5) plaintiff risk aversion.  We show, in particular, that the loser-pays-the-costs rule can function as an effective screening device that keeps plaintiffs from accumulating financial positions to file frivolous claims.

We also extend the analysis to allow the defendant to be privately informed about the likely outcome at trial.  We examine two possible bargaining structures: one in which the plaintiff gets to make a take-it-or-leave-it offer to the defendant (a screening protocol), and the other in which the defendant gets to make a take-it-or-leave-it offer to the plaintiff (a signaling protocol).  In a screening setting, we show that the plaintiff’s financial position has two basic effects.  First, when credibility is not a concern (for instance, because the damages are sufficiently large), taking a short (long) position makes the plaintiff more (less) aggressive in his settlement demands.  With a short position, for instance, a larger settlement produces an additional financial return.  Thus, a short position will lead to more trials and fewer settlements.  Second, when credibility is a concern (e.g., when the damages are sufficiently small), the plaintiff’s financial position will change the plaintiff’s incentive to drop the case when settlement fails.  A short financial position relaxes the credibility constraint.  Interestingly, this allows the plaintiff to become less aggressive and lower the settlement offer.  We show that the plaintiff’s optimal short position can actually benefit the defendant and lower the rate of litigation.  Finally, in a signaling setting, a short position by the plaintiff forces the defendant to make a more generous settlement offer but also reduces the probability of settlement.

The preceding post comes to us from Albert H. Choi, the Albert C. BeVier Research Professor of Law at the University of Virginia Law School, and Kathryn E. Spier, the Domenico de Sole Professor of Law at Harvard Law School.  The post is based on their recent paper, which is entitled “Taking a Financial Position in Your Opponent in Litigation” and available here.