Exploring the Shadows of Litigation Finance

Here’s a familiar story for litigators. A client calls you with a strong legal claim, but she can’t afford to pay your hourly rates. And your firm won’t let you take the case on contingency. You feel hard-pressed to tell your client to look elsewhere.

Enter litigation finance: the practice where a third party provides capital to a litigant or law firm in connection with a legal claim, frequently to help claimholders finance their lawsuits – in return for a share of the proceeds from a winning case. Ten or even five years ago, most lawyers and regulators had barely heard of litigation finance. Yet today, one scholar calls it “likely the most important development in civil justice of our time.”[1]

As the litigation finance industry grows – by some estimates, more than $1 billion in litigation funding are committed each year – legislators, bar associations, and judges are asking whether and how funding ought to be regulated. Proponents of litigation finance argue that funding promotes access to justice and increases the efficiency of our legal system, and thus any regulation should promote rather than hamstring funding. Opponents argue that litigation finance spurs the filing of frivolous lawsuits and interferes with the attorney-client relationship, and thus demands close regulatory oversight.

Our article, The Shadows of Litigation Finance, argues that the current debate is hamstrung by two crucial limitations, which we attempt to help policymakers and scholars overcome.[2]

The Awareness Problem

The first limitation is an awareness problem. Many people do not understand what, exactly, litigation finance is, what funding transactions look like, and why litigants and law firms seek funding. These lingering questions have put litigation finance in the shadows, leading to the untested assumption in some quarters that litigation finance is a radically new intrusion into our legal system that demands new regulation.

We question this assumption. We argue that third-party financing has long been a central feature of our legal system. The contingency fee agreement, where a lawyer (a third party to the lawsuit) finances a litigant’s legal claim in exchange for a share of case proceeds, is one common and well-accepted form of third-party financing. Other examples include pro bono litigation financed by non-parties to a lawsuit; a third-party paying the legal fees of a family member, friend, or employee; and even the simple practice of raising third-party equity or debt to accumulate the funds necessary to bring a legal claim.

In other words, our legal system has never required litigants to personally bear the full cost of litigation. Claimholders have long been permitted (and even encouraged) to share those costs with third parties who have economic, ideological, or other goals in supporting the litigants. Third-party litigation finance has always been a central and indeed welcome feature of our civil justice system.

While the modern commercial litigation finance industry may be different in degree, because it involves dedicated pools of capital available to finance the strongest legal claims, it is not different in kind. We argue that once policymakers recognize this fact, it becomes more difficult to argue that new regulations are needed to address modern commercial litigation funding, given that our system’s existing strictures have long accommodated these other forms of third-party funding without, for example, depriving claimholders of their right to control litigation or settle their claims.

The Analytical Void

The second limitation of the current policy debate is analytical. We argue that the debate and scholarship on litigation finance largely overlook important welfare effects that the practice has on our society. If we continue to ignore these welfare effects, the cost-benefit analyses conducted in statehouses, courthouses, and ethics committees across the nation will overlook huge swaths of financing’s impact and reach suboptimal policy conclusions.

The current debate over litigation finance focuses almost entirely on what we call litigation finance’s “post-claim” effects: its impact on behavior after a legal claim accrues and a litigant seeks funding. Scholars and regulators have explored how funding affects which claims are brought, how claims resolve, the price at which cases settle, and funding’s impact on the legal profession.

While these contributions are important, they tell only half the story. We argue that litigation finance casts a large shadow both behind and in front: It affects parties’ behaviors before, as well as after, a legal claim accrues. The current debate largely overlooks these “pre-claim” effects of litigation finance.

We explore these pre-claim effects through the context of a simple breach of contract action, and we identify three principal pre-claim effects. First, we argue that litigation finance makes a promisor less likely to breach its contract, because funding increases the likelihood that the promisee will successfully sue for a breach. Importantly, we illustrate that litigation finance is likely to deter inefficient breaches without deterring efficient breaches. Second, we argue that litigation finance will make parties more likely to contract with each other, because they will have greater confidence in contractual compliance or the availability of a damages remedy in the event of breach. Third, we argue that litigation finance will alter the contract bargaining process and contract design.

These arguments have standalone significance, but they also make more robust the existing debate about litigation finance’s “post-claim” effects. For example, there’s a common assumption that litigation finance will lead to an increase in the number of cases that are filed, because funding allows more litigants to access the courts. But our argument that litigation finance decreases the amount of contract breaches would suggest some offsetting decline in the amount of litigation. Meanwhile, if we are right that litigation finance leads to more contracting, this could result in a net increase in litigation simply because there is more commercial activity that might go awry – leading to the result predicted by scholars (more litigation) but for a very different reason (more commercial activity, not necessarily a greater rate of contract disputes).

Bringing Litigation Finance Out of the Shadows

As policymakers continue to debate litigation finance, we hope they will remain mindful of  the arguments we raise in our paper. Critics of litigation finance claim it promotes frivolous litigation, but proponents of funding argue it allows expanded access to the courthouse to litigants who cannot afford the mounting costs of litigation. We ultimately conclude that once we account for all of litigation finance’s welfare effects, both pre- and post-claim, funding ought to be promoted rather than discouraged.

ENDNOTES

[1] Maya Steinetz, Follow the Money? A Proposed Approach for Disclosure of Litigation Finance Agreements, 53 U.C. Davis L. Rev. 1073, 1075 (2019).

[2] Suneal Bedi & William C. Marra, The Shadows of Litigation Finance, 73 Vand. L. Rev. __ (forthcoming 2021).

This post comes to us from Suneal Bedi, an assistant professor at Indiana University’s Kelley School of Business and William C. Marra, investment manager at Validity Finance, a litigation finance company. It is based on their article The Shadows of Litigation Finance,” available here and forthcoming in the Vanderbilt Law Review.

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