Institutional Capital is Finding its Way Into Litigation Finance

 

A recent Wall Street Journal article entitled: Investors Put Up Millions of Dollars to Fund Lawsuits written by Jennifer Smith may spark further interest amongst investors into funding lawsuits.  The term most commonly used for this investment type is Litigation Finance but Litigation Funding, Legal Financing, Settlement Funding, Third Party Funding and Professional Funding are also used.

Legal Financing is the mechanism or process through which litigants (and even law firms) can finance their litigation or other legal costs through a third party funding company. These third party funding companies provide cash advances to litigants in exchange for a percentage share of the judgment or settlement. Since the advances are provided in the form of non-recourse loans, usury laws do not apply.

If the case proceeds to trial and the litigant loses, the third party funding company receives nothing and loses the funds they have invested in the case.  In other words, the investor assumes the full risk for their investment in the lawsuit and the litigant is not required to repay any of the invested capital if he case is lost.  Obviously the investor will only risk their capital if they believe the litigant to have very strong merits to their case.

In those situations where the plaintiff prevails in their litigation, the funder’s share of the settlement may be calculated from several factors:

  1. the sum of money involved;
  2. the length of time until recovery;
  3. the expected value of the plaintiff’s claim;and
  4. whether the claim settles, proceeds to trial, or is appealed.

Although litigation funding is available in most common law jurisdictions throughout the United States, at least two states (Maine & Ohio) have enacted laws imposing restrictions on the funders.  In Maine, funders must register with state authorities, disclose the fees and interest rates charged, and represent that the funder will not make any decision respecting the course of litigation.

Ohio passed an almost identical provision in 2008. The Ohio law reverses a 2003 Ohio Supreme Court decision that struck down a third-party financing agreement as champertous (A sharing in the proceeds of a lawsuit by an outside party who has promoted the litigation).

The increased popularity in third party litigation funding has resulted in renewed interest in almost forgotten prohibitions on maintenance, champerty and barratry:

  • Maintenance is defined as “officious intermeddling” (a term of art defined to include meddling with the affairs of others where such involvement is neither asked for nor needed) in a lawsuit which in no way belongs to the intermeddler (i.e. the third party funder) by maintaining or assisting either party to the action with money, or otherwise, to prosecute or defend the lawsuit
  • Champerty s a species of maintenance in which the intermeddler makes a bargain with one of the parties to the action to be compensated out of the proceeds of the action.  A champertous agreement divides the proceeds of litigation between the claim’s owner and the third-party supporting the claim
  • Barratry is frequently exciting or stirring up lawsuits and quarrels between others. It is considered to be both a “tort” and a “crime”.  To be considered as a “tort”, the frivolous lawsuit must have been brought maliciously.

Another significant consideration in third party litigation funding are the Rules of Professional Conduct, Ethics Opinions, and Questions of Privilege.  American Bar Association Model Rule of Professional Conduct (“Model Rule”) 1.8(f) prohibits a lawyer from accepting compensation for representing a client from a third-party unless the client gives informed consent, there is no interference with the lawyer’s professional judgment or client-lawyer relationship, and client information is kept confidential. Model Rule 5.4(a) prohibits an attorney or law firm from sharing legal fees with a non-lawyer except in limited circumstances.

Under Model Rule 5.4(c), a lawyer shall not permit a person who recommends, employs, or pays the lawyer to render legal services for another to direct or regulate the lawyer’s professional judgment in rendering such legal services. Model Rules 1.8(f) and 5.4 combine to suggest that the funder should: (1) remain a passive investor and (2) contract directly with the client.

Unfortunately atttorney-client privilege laws are not very well defined when it comes to sharing information with third party funding sources.  Generally, the common-interest privilege protects communications when two or more clients consult with an attorney on matters of common interest.

For the common-interest privilege to apply, the clients must share an identical, or nearly identical, legal interest as opposed to a merely similar interest. The common-interest privilege has been extended to other situations such as the communications between an attorney and a client’s insurer.

Never-the-less, the law relating to third party funders is less clear and at least one court has ruled that a client’s and a lender’s interests are not identical, and thus, the privilege will not protect documents shared with a funder.

 Third party litigation funding is mostly commonly used in personal injury cases, but may also apply to commercial disputes, civil rights cases, workers’ compensation cases and in structured settlements. While the amount of money that a plaintiff may receive through legal financing varies widely, but often is around 10 to 15 percent of the expected value of judgment or settlement of their personal injury lawsuit.

 Proponents of litigation finance argue that litigation is expensive and that funders play a valuable role by providing increased access to justice for plaintiffs who otherwise could not afford representation. They argue that since funding sources are sophisticated investors who will typically avoid financing weak or meritless claims, litigation abuse is unlikely.

The due diligence conducted by funders can be used by plaintiffs to evaluate the merits of their litigation through various forms of risk analysis and economic valuation models that are typically not available at most law firms.

Finally, those in favor of litigation finance argue that the capital provided to plaintiffs and/or their law firms level the spending playing field with a corporate defendant with significant financial resources.

Critics against third party funding make the following arguments:

  • The number of frivolous lawsuits will increase dramatically
  • Litigation funding is unnecessary as the United States market has a long tradition of contingency fee litigation
  • It creates a conflict of interest and jeopardizes the relationship between attorneys and their clients

Regardless of which arguments you believe, litigation funding is gaining in popularity as institutional investors are seeking higher investment returns, lower risk and volatility and diversification within their investment portfolio.

In a future blog post, we will identify some of the companies who are providing litigation funding.

 


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