Did you know that you can make money investing in other people’s lawsuits?
Over the last decade, alternative litigation finance (“ALF”) – the “funding of litigation activities by entities other than the parties themselves” – has taken off in the U.S., with capital pouring in from “income-starved” investors seeking strong returns largely uncorrelated to public markets.
Despite ALF’s growth and institutionalization, for some, the space remains controversial. Detractors, like the U.S. Chamber Institute for Legal Reform, argue that it “increases the probability that meritless claims will be brought.” Supporters counter that investors have zero incentive to finance spurious cases and, to the contrary, can provide an important market sorting function by allocating funds to resource-constrained parties’ meritorious claims while eschewing unviable matters.
In a sense, ALF hits on a core tension underlying our legal system. From a normative perspective, litigation is a system to right wrongs and promote fairness. Yet, descriptively, it is also a vast industry characterized by complex incentives and well-resourced “repeat players,” creating a dynamic that can exacerbate structural inequities.
For lawyers, ALF presents unique challenges implicating both professional responsibilities as well as practical commercial considerations.
To help provide guidance, on August 4, 2020, the ABA’s House of Delegates adopted the American Bar Association Best Practices for Third-Party Litigation Funding (“Best Practices”). The report “surveys the types of alternative litigation funding and proposes best practices to be consulted and factors to be considered by attorneys seeking to explore or utilize litigation funding in dynamic regulatory, judicial, and arbitral environments.”
What is Alternative Litigation Finance?
While, as the Best Practices report notes, “[a] single narrow definition . . . cannot encompass the range of funding activities that may arise” with respect to ALF, at its core, it “is a form of distributing risk.” In that regard, ALF is not unlike contingent fee arrangements, which for many plaintiffs represents the primary alternative for pursuing claims.
In 1897, Oliver Wendell Holmes wrote that “[w]hen we study law we are not studying a mystery but a well-known profession. . . The object of our study, then, is prediction.” In finance terms, this implies that litigation, and thus ALF, is not a matter of Knightian uncertainty – suggesting unquantifiable outcomes – but fundamentally subject to risk, a set of unknown but ultimately calculable outcomes.
Indeed, commercial clients typically come to lawyers with questions best answered in the form of a number – i.e., how much can we win (or lose)? What are the odds? How long will it take?
Legal analytics provides the tools for answering such questions, while litigation finance offers a vehicle for transferring the now-quantified legal risk to the parties best suited to bear it. Unsurprisingly, the Artificial Lawyer has observed at least four partnerships between legal prediction startups and litigation funders.
ALF transaction structures are complex and vary widely, though the core approach is transferring financial exposure to legal risk while minimizing basis and ensuring strict adherence to the rules of professional responsibility in respect of case control and otherwise.
The diagram below presents a simplified example of an ALF deal structure: