Why are taxpayers helping companies pay for all their litigation?

Feb. 8, 2012 — For years, a wide range of business and business-supported groups have railed against what they describe as an out-of-control civil justice system. As the story goes, greedy individuals and their even greedier trial lawyers are given carte blanche to burden corporations with the costs generated by meritless lawsuits. Under the banner of “tort reform” or “civil justice reform,” critics of the current system seek to protect companies from these voracious predators by creating a series of disincentives that would deter those who now hunt for “windfalls.” These include provisions to make it more difficult to get into court, especially in connection with a class action or group lawsuit; to restrict the information that can be obtained during the discovery process in the course of a lawsuit; and to cap or eliminate various types of damages that are currently available to be awarded to a plaintiff that prevails.

But there hasn’t been a peep about an important benefit to one class of litigants that is deeply baked into the current system. Unlike individuals who have to bear their own litigation costs in all cases where they lose and in almost all categories of cases even where they win, the tax code provides that businesses may deduct all of their legal expenses (for lawyer and expert fees, and for discovery costs) in all cases — win or lose, meritorious or non-meritorious, plaintiff or defendant.

Among other things, those deductions mean less federal revenue than if a different system — one that did not grant 100 percent deductibility — were in place. Since the average effective corporate tax rate is 22 percent, according to Andrew Fieldhouse of the left-leaning Economic Policy Institute, the current system could mean substantial money is routinely lost to the Treasury.

Alternatives to the current system are possible, but little thought has thus far been given to them. The current system continues in place despite the fact that comprehensive estimates of business litigation costs are apparently not available, the very costs that would give the full measure of the deduction's impact on taxpayers.

Is the current system the only way to go?

Remapping Debate spoke with Joseph Bankman, a professor of law and business at Stanford Law School and an expert in tax law. Bankman confirmed that, in general, a company’s litigation expenses are deductible regardless of the litigation's outcome (he pointed out that in some cases, as with some types of litigation over property, the ability to take advantage of litigation expenses for tax purposes might be deferred).

Moreover, given the example of a David and Goliath battle where an individual prevails against a meritless claim brought against him by a corporation, Bankman confirmed that, the winning David would not be able to deduct any of his legal costs, whereas the losing Goliath would be able to deduct all of its legal costs (in narrowly drawn areas, pursuant to some civil rights laws, for example, a prevailing David is able to recover reasonable attorney’s fees from his opponent).

Bankman himself thought it would be “odd” to change the current system. He said that full deductibility was consistent with the “norm” that “if you’re engaging in a profit-making activity, everything is deductible.” He argued that it was incongruous that a corporation that prevails in litigation — a corporation that, in general, would be taxed on the monies it secures through the litigation — would not be able to offset that income with its litigation expenses. He also said that there could be operational difficulties if an alternative system of deductibility came to depend on factors like whether the litigation was between two businesses or between a business and an individual, whether one litigant could be identified as prevailing, or whether the costs were properly attributable to litigation or to pre-litigation legal services.

Bankman readily acknowledged, however, that the existing rule does represent a “social policy judgment,” and that other policy judgments are possible. For example, it is already the case that the tax code caps at $1 million per year the amount a public company may deduct for compensation paid to its chief executive officer and three other top officers, with some performance-based pay excepted (Bankman said that “most people think [the limitations] have been ineffective, although we could certainly make them effective”).

Other caps exist on the individual tax side of the ledger: for example, caps on the mortgage interest deduction.

Though reiterating his own opposition to making change in the rules relating to deductibility of business litigation expenses, Bankman agreed one could create a tax regime under which there could be a maximum deduction, or a maximum in relation to adjusted gross income, or have 70 percent of these expenses able to be deducted. There is “no question you could do it,” Bankman said. “We have a million limitations in the tax law, and we could add these — it wouldn’t have to be all or nothing.”

Bankman concluded by saying that, while he “wouldn’t support the proposal” to limit deductions, “one benefit would be [that companies] would use the courts less.”

How much do corporations spend on litigation?

The question here is not how much corporations spend on the outcome of litigation (where they have to pay damages as a result of a judgment or pay money to settle a case), but rather the scope of spending for the conduct of litigation (in-house and outside counsel fees, plus litigation expenses like experts fees and deposition costs).

There is not, so far as well can tell, a comprehensive answer to the question, although the limited surveys that have been done suggest that the aggregate amounts involved are likely to be quite large.

For several years, the law firm of Fulbright & Jaworski has produced an annual “litigation trends survey report.” The 2011 report received responses from approximately 275 mostly large or very large corporations in the United States (almost half had annual revenues of $1 billion or more; and another 29 percent had revenue of at least $100 million).

The exact question posed by the survey, according to Jessica Schwartz, a spokesperson for the firm, is: “What is your annual litigation spending, excluding cost of settlements and judgments.” Some 53 percent of U.S. survey respondents identified their costs as $1 million or more, with 11 percent identifying their costs as $10 million or more.

Remapping Debate asked for more detailed information concerning the aggregate costs for the companies in each of the “expenditure bands,” but Schwartz said the firm did not have that information. She also indicated that the firm did not wish to extrapolate from the survey data any broader sense of litigation costs for businesses.

A 2010 survey of Fortune 200 companies conducted by the Searle Center on Law, Regulation, and Economic Growth for three business advocacy organizations — Lawyers for Civil Justice, Civil Justice Reform Group, and the U.S. Chamber Institute for Legal Reform — also found significant litigation expenditures. The survey yielded a response rate of slightly less than 20 percent (that is, fewer than 40 companies), but, among those who did report, the average cost of outside litigation in 2008 was $114.9 million; in-house litigation costs among these firms averaged $17.9 million.

In the aggregate, the outside litigation costs for these companies was over $4 billion for the year. Because the range of costs was enormous — from a low of $3 million to one’s companies outside legal bill of $598 million — we wondered why the survey failed to report a median figure. We also wanted to see whether the groups that generated the survey or the Searle Center that administered it had any broader estimate of litigation costs based either on the survey or otherwise.

Barry Bauman, the executive director of Lawyers for Civil Justice, said that he was unable to provide a broader estimate of costs, and said that he did not have information on median cost, referring us to the Searle Center. (Bauman denied that his organization commissioned the survey, saying that Lawyers for Civil Justice — described on its web site as “created by defense trial lawyers and corporate counsel” — had “simply encouraged our members to participate in the survey.” Appendix 1-A to the survey stated that the survey was “formulated by” Bauman’s group along with the other business advocacy groups previously mentioned.)

Derek Gundersen, a coordinator at the Searle Center, said that the team that was responsible for the survey, led by then executive director Henry Butler, was no longer at the Searle Center. Neither Butler, now a professor at George Mason University School of Law, nor the U.S. Chamber Institute for Legal Reform responded to requests for interviews.

Darren McKinney, communications director of the American Tort Reform Association, another business advocacy group seeking limits on litigation including restrictions on class actions and caps on non-economic damages, characterized litigation costs to businesses as “gargantuan,” but said that ATRA, which was not involved in the survey, did not have specific numbers. He speculated that some academic colleagues might have such figures, but was himself unaware of any more comprehensive surveys.

In short, even in the absence of comprehensive data, it is apparent that the litigation spending of some companies enables those companies to take large deductions, and likely that the aggregate deductions for these expenses, even leaving out small businesses entirely, is substantial (American Lawyer magazine's annual survey of the nation’s 100 largest law firms in 2011 found that total revenue for these firms was $67 billion; much of that revenue, of course, is derived from activities other than litigation — American Lawyer’s research director, Rosemarie Clancy, told Remapping Debate that AmLaw did not have available data on the subset of firm revenue attributable to litigation).

What happens next?

Barry Bauman of Lawyers for Civil Justice said that his organization has “no position on the deductibility of expenses related to litigation.” Darren McKinney of the American Tort Reform Association said that, in the context of broader tax reform, “to the extent that such deductions are considered and reconsidered, there wouldn’t be any argument against that from ATRA certainly.”

Remapping Debate reached out to half a dozen organizations long involved in issues of tax fairness, consumer rights, or corporate responsibility. Christine Hines, consumer and civil justice counsel at Public Citizen’s Congress Watch, was struck by what she called the “hypocrisy” of corporations and their advocates who complain about litigation costs while simultaneously failing to acknowledge their ability to write all those expenses off on their taxes. The deduction was, she felt, an example of the significant assistance corporations get every day that remains largely shielded from public scrutiny.

But most of the other organizations had not considered and were not prepared to discuss the issue. And in one case, a long-time advocate of closing corporate tax loopholes, speaking on background, did not seem at all disturbed by the current arrangement, not seeing any difference between litigation expenses and other business expenses: “A business gets to deduct the cost of cars it purchases and operates to deliver its goods. I don’t get to deduct the cost of a car I buy to deliver myself to wherever I’m going. Should I be able to?”

He added only, “Maybe my thinking on this is limited by what’s always been.”