[Editor’s Note: This and the piece that immediately follows offer a point/counterpoint on litigation finance.] The past decade has witnessed a steady stream of innovative capital markets products. Among these developments is litigation finance – a transaction form where a non-party to a dispute provides capital to finance a litigation. Litigation finance seeks efficiently to transfer the financial risk of litigation from those who cannot (or do not wish to) bear it, to capital providers who seek to profit from voluntary exposure to the risk. But, like many other financial products, litigation finance also carries nonfinancial risks that must be understood and addressed.
Some Preliminary Observations
At the outset, we identify some attributes of litigation finance that, we suggest, should influence any analysis of litigation finance as a product.
First, litigation finance is a form of financial market – not dissimilar from the more “traditional” markets for securities, commodities, or mortgages. The participants in litigation finance markets are sometimes the same participants in these latter and better-known markets, such as hedge funds and other investment vehicles where litigation finance is only one component of their overall investment strategy. In other cases, litigation funders specialize exclusively in that arena.[1] In either event, these market participants are motivated by profit – to earn a significant positive return on their investment. The U.S. economic system generally encourages capital markets innovations that facilitate efficient risk transfer. Litigation finance accomplishes that. At the same time, however, historical experience with financial markets reminds us that markets without sufficient legal oversight or regulation create the potential risk of manipulation and abuse. Indeed, such concerns are what prompted the creation, during the past century, of federal regulatory agencies such as the SEC, the CFTC, and the CFPB to regulate the securities, commodities, and consumer finance markets, respectively.
Second, the underlying activity for which litigation finance provides capital – litigation – itself occurs within a highly regulated environment. Litigation is brought by lawyers who are licensed and bound by ethical rules, both to their clients and to the court. The judicial system may properly be viewed as a public good funded by taxes, so there are sound policy reasons to ensure that the system operates consistently with its purpose and is not abused or manipulated. In this context, it is fairly arguable that activities that directly facilitate (and in some cases enable) litigation should also be subject to regulation to eliminate or mitigate those same risks.
Third, although we as a free society generally lean in favor of allowing consenting individuals and enterprises to create trading markets and “financialize” various assets, that entitlement is not unlimited. For example, we do not currently allow citizens to sell to others their right to vote or to pay others to serve their jury duty obligations.[2] Presumably, systemic harm would result if individuals could freely transfer these rights or duties because the system’s legitimacy depends on each individual’s personal participation. Concededly, litigation finance is not directly analogous to these civic activities. But even so, litigation finance involves a partial transfer of a legal claim to a third party, and in that respect arguably implicates the same concerns that arise where a litigant transfers the entirety of its claim to a third party that otherwise has no stake in the dispute (a practice that, where allowed, is legally regulated and constrained).
To be sure, for many decades certain elements of litigation finance have been permitted, such as plaintiffs’-counsel contingent fee arrangements and legal counsel working pro bono. But third-party litigation funding has financial market characteristics that create unique issues not present in those other arrangements. We focus here on two of those issues: (1) inherent conflict of interest and (2) the so-called “venture capital effect.”
Inherent Conflict of Interest
It is well established that litigation counsel owes duties to his or her client, as distinguished from a non-client third party such as a litigation funder. Nevertheless, it seems unlikely that, in practice, counsel would be totally insensitive to the wishes of the entity paying its bills – particularly if the capital provider is a frequent player in the litigation space and is in a position to retain (or recommend the retention of) that lawyer in future litigation. A litigation funder’s interests will often and in many respects align with those of the real party-in-interest (the client) – i.e., both seek to reap the economic benefits of winning the case. But even so, the alignment of these interests will often be incomplete. A plaintiff-litigant’s interest is to obtain redress for some harm done to it; a litigation funder’s interest, on the other hand, is to maximize the return on its investment portfolio. These differing objectives inherently create a conflict of interest. A litigation funder could, by way of example, be motivated to press for a settlement for less value than what the client plaintiff could otherwise achieve, because the funder might be willing to accept any outcome that meets its return hurdle and enables it to redeploy capital. The litigation financier may also have an incentive to maximize the internal rate of return[3] it reports to its own investors – an incentive that could lead it to press for a premature and suboptimal settlement. As a real-world matter, how the terms of the litigation funding agreement are drafted will dictate what leverage (if any) the funder will have to influence or coerce an improvident settlement. That self-evident observation suggests one way to eliminate that conflict between the litigant and the funder is by contract – at least where the client has bargaining power sufficient to negotiate contractual terms at arm’s length and understands the practical implications of the funding agreement and the leverage points it contains.
We recognize, of course, the reality that unequal bargaining positions are nothing new in litigation relationships. For example, we permit plaintiffs’ counsel to litigate on a contingent fee basis, even though counsel may also have economic interests that conflict with those of their client. We allow that, however, because lawyers are bound by ethical duties to their clients, and are also subject to disciplinary and judicial oversight. Litigation funders owe no such duties and are not subject to such institutional oversight.
The Venture Capital Effect
The second category of risk created by litigation finance could threaten, more broadly, the integrity of the justice system. In particular, litigation capital could, in some circumstances, be deployed improperly to manipulate litigation outcomes. Developments in the market for venture capital funding are illustrative, and so as a shorthand we refer to this dynamic as the “venture capital effect.” Observers have noted that in recent years, some venture capital firms have adopted, as a competitive strategy, the practice of flooding their portfolio companies with capital[4] to facilitate rapid growth (sometimes described as “blitzscaling”[5]). The logic apparently motivating this approach is that, by “weaponizing” their capital, VCs can increase their power to pre-ordain market winner portfolio companies. This hyper-funding would enable the advantaged portfolio companies to out-grow and out-last their disadvantaged competitors funded at more “customary” lower levels, such as engaging in sustained unprofitable activities for extended periods.[6] That playbook creates a broader risk of enabling product and services market manipulation that undermines fundamental societal values.
The concern here is that third-party litigation funders could create a similar dynamic in the litigation space. As funders become larger (and repeat) players and develop reputations for providing “outsized” funding, their very involvement in the litigation could induce the party adverse to the funded litigant to settle for amounts, or at a time, not justified by the case’s merits and potential for recovery: Even if the adverse, less advantaged party reasonably believes it should ultimately prevail on the merits, the flood of capital injected into the litigation-financed party could compel the disadvantaged adverse party to make uneconomic expenditures to achieve that ultimate merits-based success. Stated differently, the adverse, non-funded party’s interest in avoiding a funding arms race could induce it to settle suboptimally. In such circumstances, the risk of harm is to the integrity of the litigation process and to the justice system itself.
To keep this in perspective: No one can dispute that asymmetric funding levels have always been a reality of U.S. litigation – one that the better-funded party can (and very often will) use to its tactical advantage[7]. The new and important element here, however, is that litigation funders, as repeat players, may develop an incentive to engage in conduct that is systemically manipulative – behavior that is uneconomic in the short term (such as “overspending” on a particular lawsuit) as a strategy to maximize their aggregate litigation funding portfolio returns over the long term.[8]
A Proposed Modest Regulatory Framework
At this stage, none of these concerns will or should preclude litigation financing as a market phenomenon. The litigation funding train has left the station and is now mainstream. But, as with other financial markets, the potential for manipulation or abuse should counsel policymakers to formulate and implement minimally invasive “rules of the road” before any abuse becomes widespread or systemic (or before a particularly egregious case of abuse leads to inefficient and heavy handed oversight). Moreover, those rules should be adopted prospectively rather than on an ad hoc, after-the-fact-basis.
Well-accepted tools that have been used to address conflicts of interest in other markets could be brought to bear in this arena as well. These might include mandates for clear disclosure to, and informed consent of, the funded party about the potential import of unfavorable terms of the litigation capital arrangement. Concerns about litigation funders’ exerting improper control over the litigation could be addressed by mandatory provisions in litigation funding agreements or prohibitions against specific categories of terms. For example, litigation financiers could be prohibited from withdrawing their funding (or threatening to do so) except in specified circumstances and prohibited from communicating directly with the client’s counsel during the course of the litigation. We note these only as examples of activities that, if left unregulated, could interfere with the attorney-client relationship.
An alternative regulatory approach might be enabling rather than prohibitive. Under that framework, safe harbor rules – in legislative, administrative, or judicial procedural form – could provide that litigation funding agreements containing specified terms or satisfying stated criteria would be deemed valid and not subject to judicial review.
Another form of regulation, albeit more intrusive, would mandate judicial or ethical administrative review[9] and approval of litigation funding arrangements. The policy justification for advance review would be that, because litigation funding is itself a mechanism that operates within the larger judicial dispute resolution process, it should be subject to the same regulatory scheme. Under such a regime, review and approval of the source, amount, and other terms of funding – as well as settlement agreements where third parties have funded the underlying litigation – could filter out conduct that would otherwise operate unfairly to litigants or constitute a misuse of the dispute resolution system.
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Two final points. First, the foregoing discussion is intended to suggest a regulatory approach that is invasive only to the extent required to enable the litigation funding market to operate in a socially desired manner. Second, minimally invasive regulation is better implemented prospectively rather than after the fact. The aphorism “hard cases make bad law” translates to the likelihood that, when individual clear cases of litigation finance abuse arise, the absence of a pre-existing legislative or other rulebound regulatory scheme will consign the remedy to the default ad hoc common law judicial process. The needs of an ordered economy make it preferable for the cure to be preventive, prospective, and comprehensive and not remedial and piecemeal.
ENDNOTES
[1] https://www.lexshares.com/blog/litigation-finance-growth-2030/
[2] See, e.g., Michael Abramowicz, On the Alienability of Legal Claims, 114 Yale L.J. 697, 734 (2005).
[3] A lesser payment received earlier could have a higher internal rate of return than a larger payment received later. IRRs are among the metrics that investors in funds with private equity-type structures focus on.
[4] https://www.cnbc.com/2019/05/17/softbanks-100-billion-vision-fund-reshapes-world-of-venture-capital.html.
[5] https://www.strategy-business.com/article/The-Blitzscaling-Basics?gko=3ebb0.
[6] If, however, multiple VCs fund competitor portfolio companies at similar levels, that form of competition could diminish or eliminate these advantages.
[7] This asymmetry is also an effective argument deployed in favor of litigation finance – to level the playing field.
[8] Certain commodities traders have been accused of engaged in similar manipulative activity as a strategy – intentionally losing money on their derivatives positions to benefit their physical positions, or vice versa, for example. E.g., https://www.reuters.com/article/usa-total-cftc-idAFL1N13W1VA20151207.
[9] By way of example: Counsel for the funded party could potentially be “deputized” by rules of professional conduct to review litigation funding agreements before accepting engagements in which the client has a third-party litigation funder. These ethical rules could prohibit lawyers from participation in litigations where such agreements violate specified agreed norms.
This post comes to us from Andrew S. Jacobs, who has served in senior operating, financial, and legal roles at several hedge funds in New York and is currently founder and principal of Propero Advisory and chief operating officer of Green Tiger Markets, and from his father, Jack B. Jacobs, who has served as a vice chancellor of the Delaware Court of Chancery and justice of the Delaware Supreme Court and is currently senior counsel at the law firm of Young Conaway Stargatt & Taylor in Wilmington, Delaware.