Is Litigation Financing the Future of Law?

Topics: American Bar Association, Business Development & Marketing Blog Posts, Data Analytics, Law Firms, Legal Innovation

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Litigation finance—the practice of allowing third-party entities to help plaintiffs fund their litigation efforts, usually for an agreed-upon portion of the final award—is being discussed as a viable strategy more openly than ever before, but acceptance has not been universal thus far. Some states such as California, New York and Texas allow for the practice (to varying degrees), while many others limit its use for three important reasons:

  • First, the legal concept of champerty, which derives from ancient Greece and Rome and is defined as the splitting of fees between the litigating party and a nonparty who funds or supports the lawsuit, is a formidable barrier to entry for litigation financing in the United States.
  • Second, Maintenance, which is the interjection of a third party who wields undue influence on a case. (The concepts of both champerty and maintenance are intertwined and were codified in English Common Law to prevent the English elite from furthering and profiting on the lawsuits of commoners by overwhelming the courts with their clout.)
  • And finally, Model Rule 5.4 of the American Bar Association’s Model Rules of Professional Responsibility provides that a lawyer or firm may not share fees with a non-lawyer. Litigation financing circumvents this restriction by financing the plaintiff (or possibly the defendant) and not the law firm, with the funder taking a contingent reward in exchange for partial or full funding.

The argument against litigation financing is that it will lead to an increase in frivolous lawsuits, and while that may have been true in the chaotic and corrupt judicial system of medieval England, the threshold for litigation financing in our modern market is relatively high. And although these three hurdles are daunting, they are not insurmountable. Today, more plaintiff groups, law firms and funding partners are starting to analyze this strategy further.

Because litigation financing is non-recourse, financing firms closely examine the different probabilities of each case to decide whether it is worth financing. The case must yield either a high enough reward or a certain enough reward to make the expected value of the case large enough to warrant investing. Generally, a litigation financing firm will not invest if their expected probability of winning in less than 60%.

litigation-finance-decision-tree

A crude decision tree of an example case, posted above, shows some of the various pitfalls of litigation financing. Only three listed avenues, whose total probability is slightly greater than 50%, lead to a positive return on investment (ROI) for the litigation financing company. If we expect the case to potentially yield a $100 million award or settlement and only yield $2.5 million in the case of an unsubstantial settlement or award, then the expected value for the litigation financing firm taking a 20% contingency fee should be just under $10 million. Still, that margin would likely be insufficient for a litigation financing firm for good cause; litigation financing is both a long-term and illiquid asset, and any firm can only have a finite number of cases pending at once.

Because of the substantial risk involved for litigation financiers, litigation financing will not likely lead to an increase in “frivolous” lawsuits, at least purposefully. Seeking financing involves a process called adverse selection, whereby those who pursue funding vigorously are often less desirable clients for financing firms.

Because funders and litigants work with asymmetric information, at least from the outset, it is possible for a litigation financing firm to broach the possibility of financing a weaker lawsuit than expected. However, most firms will undergo an exhaustive amount of due diligence before agreeing to finance a case, oftentimes spending six figures to ensure a lawsuit is meritorious.

The real danger lies in the securitization of litigation. New crowdfunding platforms have been established for litigation finance. These services suffer from the similar conflict of interests as Standard and Poor’s and Moody’s. By passing the moral hazard to a multitude of investors, these platforms allow for risky litigation at the cost of faceless investors. Standard litigation financing companies have access to privileged information that is not discoverable under the work product doctrine; whether this protection extends beyond secondary investors is unknown, but is unfeasible anyways.

Litigation financing will likely emerge as an effective tool for companies to mitigate uneven cash flows. Many companies are hesitant to pursue even meritorious litigation at the risk of expending significant reserve or future capital. Litigation financing allows them pursue these claims with the risk underwritten by the financing firms. Litigation financing can also prove a boon for law firms, allowing firms to normalize cash flows from cash-strapped clients without eating into their profitability. Rules allow for counsels to disclose the option of litigation financing to their clients.

Litigation financing could also spur partners to leave failing firms. Cash flows are an immediate barrier to opening a spin-off firm, but with litigation financing, a partner can take his client and colleagues, then use a staffing agency to fill the ranks and start their own firm.

Though its future is unclear, and its practice still young, the future of litigation financing looks promising as vehicle and insurance policy for both litigants and law firms.