The Good, the Bad, and the Ethics

Litigation is expensive. Increasingly, especially in the commercial context, litigants or lawyers are turning to third parties for the financial resources to defray the costs and fees of litigation. The funder (usually a commercial entity) pays the costs and fees, and in return, if the case is won, receives an agreed-upon amount, often specified as a share of the proceeds of the claim or a multiple of the amount advanced. If the case is unsuccessful, the funder loses its money, and nothing is owed by the litigant. This article discusses the scope of litigation finance, the opportunities and challenges presented by litigation funding, and the myriad legal and ethical pitfalls that may befall the unwary in this rapidly changing environment. 

Growth

Litigation funding was well established in countries such as Australia and England long before it became prevalent in the U.S. around 2010. For consumers, litigation funding is often used for living expenses and is typically under $10,000 – a relatively small amount, with low associated risk for the funders if the plaintiff fails to win their case. By contrast, commercial litigation funding is typically provided to either corporate litigants or law firms, and the dollar amounts are more substantial. Often, commercial litigation funding arises in the context of class actions or mass tort actions, where law firms engage in protracted litigation for numerous plaintiffs and investors may be essential for the lawsuits to go forward. The funders may provide litigation funding to the individual plaintiffs, such that each plaintiff would be responsible to the funder to pay fees upon settlement. Alternatively, the funder may provide financial support to the law firm prosecuting the case so the funds may be used to support the class action generally. Most often, particularly in commercial funding, the litigation funder receives their money first and off the top of the settlement, and the remainder is split between the claimant(s) and the attorney as agreed.

Commercial third-party litigation has become a multimillion-dollar industry, experiencing significant growth in the last few years in terms of capital from investors and new commitments toward litigation finance deals. According to The Westfleet Insider, which has been collecting and reporting statistics about the field for the last several years, financial commitments rose by 16% in 2022 over 2021. The 2022 report identified 44 active commercial litigation funders, which together had a total of $13.5 billion in assets under management and had committed $3.2 billion to new litigation financing agreements in 2022.

Clearly, litigation funders have become more active and are expanding their portfolios to encompass a broader range of cases. As litigation funding has grown, so have both its supporters and detractors.

Pros

Proponents assert that providing litigants with the resources to prosecute their case promotes access to justice. The argument goes that litigation funding allows lawsuits to be decided on their merits, rather than on which party has deeper pockets to handle protracted litigation. Funding also shifts the financial risk of litigation from the plaintiff to the funder since the plaintiff is not personally liable for legal expenses in the event the plaintiff loses the case. Funding also can enhance legal strategy, since additional funding will enable parties to secure more experienced attorneys, expert witnesses, and the resources to build a stronger case – all of which ideally leads to better outcomes. Proponents also contend that litigation funding promotes the foundational premise of our legal system that access to the courts is not a privilege available only to those with substantial resources, but rather a fundamental right accessible to all.

The involvement of litigation funders arguably can promote social justice and fairness by increasing pressure on defendants to settle cases rather than engage in protracted legal battles, leading to faster resolutions and increasing efficiency in the administration of justice.

In addition, litigation funding may encourage accountability. Consider a David v. Goliath scenario, where an average person desires to bring a claim against an industry titan like Apple. Clearly, the disparity between the two, absent other funding sources, points to a high probability that Apple would prevail. Litigation funding not only levels the playing field by allowing that individual litigant to proceed, but equally important, litigation funding sends a message to the larger and more powerful entity that any untoward behavior will not be allowed to pass simply because they are the bully in the courtroom. Less affluent litigants will be empowered to pursue claims, and powerful individuals and entities may be deterred from bad behavior. 

Some commentators identify additional advantages for businesses. For example, corporate plaintiffs can benefit from the due diligence conducted by third-party litigation funders in assessing the merits of the case, which gives the plaintiff feedback on the case’s strengths and weaknesses. Third-party funding can allow corporate plaintiffs to take litigation costs off their balance sheets. Funding can benefit society at large by backing claims on legal issues that otherwise would not be heard by the courts, helping the development of the law. It can also be used for nonprofits’ impact litigation, and has been used to challenge or advance both liberal and conservative causes. If it functions as venture capital for new law firms, litigation funding may encourage competition in the market for legal services and innovation in the legal industry.

Cons

Detractors argue that litigation funding is unlikely to expand access to justice because lawsuits selected for funding are often the strongest and most likely to yield lucrative awards, not the ones that would otherwise be passed over by traditional plaintiffs' lawyers. In addition, the arrangement diverts a substantial portion of any award away from the injured party to compensate the financier.

Third-party litigation finance can be costly to obtain. The GAO’s 2022 report on litigation funding states that consumer litigation funders rates start at 15% or 18% of the amount funded (applied every six months). Some commentators and courts observe that the fees charged by litigation funders are too high and plaintiffs are paying exorbitant rates that significantly cut into their recovery amount.

Many detractors also note that possible conflicts can ensue if a funder wants to continue the litigation or settle but the party does not, or if the funder desires a strategy that may harm an individual party’s case but may benefit the value of a funder’s portfolio.

Having a large portion of a potential settlement go to a third party may lead a party not to accept a settlement offer reasonably reflecting actual damages — and may influence the nature of advice given by the party’s attorney. Attorneys’ judgment and decision-making also may be influenced by a funder’s pressures, especially where attorneys have an ongoing relationship with the funder. Given that the funders are motivated to protect their financial investment, decisions made to address a funder’s interest could be counter to the client’s best interests.

There is potential unfairness to a defendant where litigation funding protracts the litigation and increases defendant’s costs. In addition, if cases are aggregated through portfolios or class/mass tort actions, it is potentially profitable for the funder to bundle non-meritorious with meritorious claims which would increase the perceived size of a potential loss and the actual costs a defendant will incur litigating the whole portfolio. In addition, it is possible defendant’s due process rights may be implicated by an undisclosed third-party funding agreement.

Finally, as a general rule, the integrity of the administration of justice calls for the real parties in interest to appear before the courts. This is obscured in third-party litigation financing where there is no transparency as to a funder’s role – especially important in mass torts or class actions where plaintiffs may be absent, unnamed, and/or unknowable.

The Legal and Ethical Pitfalls

The ethical considerations implicated vary by the type and structure of litigation funding, who is the funding recipient, and what jurisdiction the litigation is pending in — just to name a few. The rest of this article will orient practicing lawyers to spot the major ethical issues in the commercial litigation funding area.

Duty of Competence

Model Rule of Professional Conduct 1.1 notes that a lawyer has an ethical duty to provide competent representation to a client. This means that a lawyer who considers a client representation involving or likely to require a legal finance agreement must, as a preliminary matter, determine whether they have the transactional experience and sophistication required to negotiate a beneficial agreement with the funder or if an attorney with more specialized knowledge should be involved. If the lawyer acts as counsel to the client regarding the funding relationship, the lawyer should make sure that they are adequately familiar with litigation financing transactions to provide competent representation as required. Competence may include familiarity with related state or federal law issues. Depending on your jurisdiction, the common law doctrines of champerty, maintenance, barratry, or usury may come into play. Maintenance refers to helping another prosecute a suit; champerty is maintaining a suit in return for a financial interest in the outcome; and barratry is a continuing practice of maintenance or champerty. Many states have relaxed these prohibitions; be sure to check your jurisdiction. In addition, familiarity with litigation financing structures, how funding may be disbursed, and tax implications may be necessary. 

Duty of Diligence

Closely related to competence, Model Rule 1.3 requires a lawyer to act with diligence. A lawyer considering a litigation funding agreement may also need to conduct a reasonable inquiry into the funder and the terms being offered. In a jurisdiction where discovery may be permitted into the existence of the funding arrangement, and the adversary may find out who is funding the opposition’s case, the reputation of the funder may be important.

In selecting a funder, key factors to consider include the general financial stability of the funder; how much capital the funder has and how much is dedicated to litigation funding; the funder’s history and reputation; and the financial and contractual terms the funder is offering. A useful checklist of diligence items can be found in a report prepared by a Task Force of the International Council for Commercial Arbitration and Queen Mary University relating to litigation finance in international arbitration.

The contract terms of the litigation funding agreement should be carefully reviewed and fully understood by the lawyer and client before execution.

Duty of Communication

Under Rule 1.4, a lawyer who agrees to represent a client for the purposes of the client obtaining funding has an obligation to inform the client of the benefits, risks, and possible alternatives to the contemplated litigation funding agreement. The duty to keep the client informed continues throughout the representation, and issues requiring the client’s informed consent may be particularly acute depending on the funder’s involvement.

Duty to Protect the Client’s Confidences

Rule 1.6(a) provides that an attorney must protect the client’s confidences unless the client gives informed consent. An attorney’s duty to protect a client’s information where the client’s case is being funded by a third-party litigation funder has been interpreted to mean the lawyer must warn the client of potential risks in sharing confidential information with litigation funders, such as the risk that the client’s opposition may seek to compel discovery of communications between the funder and the client or lawyer and that a court may hold that the sharing effected a waiver of otherwise available evidentiary privileges.

The documents generated in connection with a litigation funding arrangement typically include a non-disclosure agreement signed by the funder as it begins its evaluation of a case and other information provided by the client to facilitate the funder’s evaluation of the case’s strengths and weaknesses. If the funder decides to invest in the case, the funder and plaintiff will execute a funding agreement. The funding agreement, like the due diligence documents shared with prospective funders, often includes sensitive information related to litigation strategy.

Upon financing the plaintiff, the funder typically will continue to communicate with the party about the budget, strategy, and developments in the case. Naturally, the plaintiff and the funder will want to keep all these communications confidential and protected from discovery during litigation. The opponent will want to know what those documents contain. The issue of whether funding documents are discoverable generally is brought to the court in the form of discovery motions. Whether litigation funding documents should be discoverable is the subject of debate and an increasing number of court decisions. However, as concluded by the authors of the most comprehensive recent analysis we have seen on this issue, courts generally have decided in favor of litigation funders and respondents who are trying to preserve the confidentiality of their litigation funding arrangements. Westfleet Advisors’ “Litigation Funding and Confidentiality: A Comprehensive Analysis of Current Case Law” is a must read for any practitioner in this area.

A respondent to a motion to compel disclosure has three main arguments against disclosure: lack of relevance; attorney-client privilege; or work-product privilege.

A. Relevance

Under Federal Rule of Evidence 401 and state counterparts, courts must deny requests for third-party litigation information unless they are relevant to an element of an existing claim or defense in the action. The court in Eastern Profit Corporation Ltd. v. Strategic Vision US (18-cv-2185 (LJL) (S.D.N.Y. Oct. 13, 2020)) explained the rationale, noting that "courts in this Circuit have rejected claims for [litigation funding] documents where the only asserted relevance is that they will permit the requesting party to peer into its adversary's strategy" or "the adversary's rationale for accepting or rejecting settlement offers." See GoTV Streaming, LLC v. Netflix, Inc. (2023 U.S. Dist. Lexis 91168) (denying Defendant’s request for discovery of third-party funder related documents because Defendant had “not shown how this information relates to a claim or defense.”) See also MLC Intellectual Prop., LLC v. Micron Tech, Inc. (N.D. Cal. 2015) (Lexis 13462) (rejecting on relevance grounds Defendant’s argument that disclosure of funding agreements was necessary to identify possible bias issues, for potential jurors and witnesses).

B. Attorney-Client Privilege

The attorney-client privilege protects confidential oral or written communications between a client and his or her lawyer. Either the client or the attorney can waive this privilege by disclosing the content to a third party. In the litigation funding context, if privileged information is shared with a funder, then sharing with the litigation funder would waive the privilege unless an exception applies. The party asserting the privilege bears the burden of proving an exception to a waiver of the privilege exists (as well as the existence of privilege in the first instance). Two exceptions to waiver of the attorney-client privilege may apply: the common interest doctrine and the agency doctrine.

The common interest exception allows parties to maintain the attorney-client privilege for documents shared with a third party who has a common interest. The definition of common interest varies by jurisdiction; practitioners should be aware of how the courts in their jurisdiction approach allowing the common interest exception to the waiver of attorney-client privilege. Some courts narrowly construe the exception, finding it applies only where the parties have a common legal interest. Under this analysis, although funders and litigants share a common interest insofar as communications with funders are necessary for some litigants to receive legal advice and because funders have an interest in the successful litigation of a claim, funders do not stand in the same legal position as the party and therefore are precluded from invoking the exception.

Other courts define the interest more broadly as a “common enterprise” or a “substantially similar legal interest” which may cloak disclosure to a funder with the exception. The court entertained a broad view of the common interest doctrine in Impact Engine v. Google (S.D. Cal. 2020) (Lexis 70534) where the defendant moved to compel discovery of all “documents regarding any contracts or agreements between Plaintiff and any Third Party concerning (1) this litigation and/or (2) any Asserted Patent or Related Patent.” Among arguments for protection in this case, the plaintiff relied on the common interest doctrine. The court reviewed the NDA and funding agreement and found work product protection existed.

As mentioned previously, commercial litigation finance tends to be prevalent in mass torts and class actions. Under Federal Rule of Civil Procedure 23, judges play an active role in approving settlements and attorneys’ fees. In this context, federal judges may, and do sometimes, insist on disclosure of third-party funding at the time of settlement.

For example, before approving a settlement of more than $5 billion in a mass tort action against 3M for its earplugs that allegedly failed to prevent hearing damage to military troops, a federal judge recently required all third-party litigation funding agreements be disclosed for the court’s review under seal. In the order, U.S. District Court Judge M. Casey Rodgers asserted that “…settlements of this size and nature have often attracted the attention of third-party litigation funding entities intending to prey on litigants…” and went on to note that often such funding was made “with exorbitant fees and rates of interest.” Judge Rodgers subsequently ordered that no additional litigation funding may be procured without court approval.

Some courts and state statutes have waded into the area of proactively requiring parties to disclose litigation finance arrangements, but an analysis of these more isolated approaches is beyond the scope of this article.

C. The Work Product Doctrine

The work product doctrine is a common ground on which courts have held funding documents not discoverable. As set forth in FRCP 26(b)(3) (and state counterparts), documents prepared “in anticipation of litigation” or “for another party or its representative” ordinarily are not discoverable.

Because litigation funding agreements are prepared in anticipation of litigation and often contain information about attorney impressions and litigation strategies, courts often hold that documents regarding these agreements are protected work product. For example, in Mondi’s Technology, Ltd. v. LG Electronics, Inc., (2:07-CV-565-TJW-CE, consolidated with: 2:08-CV-478-TJW (2011)), the Eastern District of Texas found that “documents and slide presentations created for potential investors…prepared in assistance with [plaintiff's] counsel for the purpose of aiding future litigation” were protected by the attorney work product doctrine and, accordingly, undiscoverable.

Practitioners should be aware of two exceptions to the work product doctrine: substantial need with no substantial equivalent by other means, and waiver. In both situations, the party seeking disclosure has the burden of proving the exception.

The substantial need exception is set forth in Rule 26(b)(3), which provides that materials prepared in anticipation of litigation may be discovered if “the party shows that it has substantial need for the materials to prepare its case and cannot, without undue hardship, obtain their substantial equivalent by other means.” This threshold was met, for example, in a case where the defendants demonstrated a substantial need for the plaintiff’s valuation of patents at issue in an infringement suit because they had no other information on the plaintiff’s valuation of the patents, which was crucial information for their damages case and where a debtor argued the litigation financing agreement was key to determining whether the creditor transferred some or all of his claim in exchange for financing. In both cases, the court held all the funding documents requested were protected work-product except for the portions relevant to the narrow issue on demonstrated need.

Waiver of the protections afforded by the work product doctrine may occur if the materials are disclosed to a third party and disclosure substantially increased the opportunities for potential adversaries to obtain the information; however, this most often is not the case when disclosing materials to a funder. Because a party usually executes a non-disclosure agreement before sharing confidential documents with a funder, courts typically do not find waiver by disclosure to a litigation funder.

In Miller UK Ltd. v. Caterpillar, Inc. (N.D. Ill. 2014) 17 F.Supp.3d 711, the plaintiff obtained funding from a third-party funder and sought to protect documents provided to that funder. The court determined that (although attorney-client privilege was waived), attorney work-product privilege applied, primarily because disclosure of the information by Miller to the litigation funders did not substantially increase the likelihood that an adversary would obtain the materials shared with potential or actual funders.

Duty of Professional Independence

A lawyer representing a client should not allow his or her interest, or that of a funder, to override the interest of the client. As a fiduciary of the client, the lawyer is bound to act in the client’s best interest and cannot put the lawyer’s own interest or that of another above the interest of the client. This duty is grounded in common law and the Rules of Professional Conduct.

Model Rule of Professional Conduct 2.1, titled “Advisor,” exhorts the attorney to exercise independent professional judgment and render candid advice to clients. As pointed out by the State Bar of California Standing Committee on Professional Responsibility and Conduct in Formal Opinion No 2020-204 (on Litigation Funding), a lawyer’s duty of exercising professional judgment and rendering candid advice “dovetails with a lawyer’s duty of loyalty to a client.” In its opinion, the bar relied on Pollack v. Lytle, (1981) 120 Cal.App.3d 931, 946 [175 Cal. Rptr. 81], for the proposition that the duty of loyalty to clients should not be diluted by obligations owed to third parties, as that would be inconsistent with an attorney’s duty to exercise independent professional judgment for the client.

Bearing in mind the primary duty is owed to the client, not the funder, a lawyer who is asked by a client to recommend a source of third-party funding or negotiate or analyze a non-recourse funding agreement must provide candid advice as to whether it is in the client’s best interest, and should advise the client to consider the costs and benefits of non-recourse financing as well as possible alternatives. In terms of costs, a common criticism of non-recourse financing is that the fees charged to clients may be excessive relative to other financing options and reduce the client’s recovery. In terms of benefits, the lawyer should advise the client to consider whether funding is necessary to cover litigation or living expenses, or whether it could prematurely force a disadvantageous settlement. Commercial claimants might consider whether they lack the resources to pursue the claim without funding or may be able to use the financing of some or all the litigation costs to meet their business needs more effectively.

Non-recourse financing agreements often require the party’s lawyer to keep the funder apprised of developments in the litigation or to seek the company’s consent before making or responding to settlement offers. These provisions may cause concern that the funder would seek to protect its own interest in maximizing the fee it may earn by objecting to litigation steps the client desires, such as additional discovery or accepting a settlement offer that is different than the company’s expectations for the return on its investment. Throughout the matter, the attorney must guard against the funder having control over litigation strategy or settlement decisions.

When the lawyer or law firm, rather than the litigant, seeks litigation financing, different ethical considerations are in play. The volume of litigation finance being extended to lawyers is significant. In 2022, of the $3.2 billion in capital committed for new third-party litigation finance, 61% was deployed to law firms as opposed to clients; and 28% of the funding recipients were members of the AmLaw200.

Rule 5.4(a), adopted in most jurisdictions, provides that “[a] lawyer or law firm shall not share legal fees with a nonlawyer.” The gravamen of the rule is to prevent a nonlawyer from crossing the line from being an agent of the lawyer to becoming a principal vis-à-vis the client’s legal representation. The issue is whether the payment of law firm receipts to a third-party funder (not an attorney) who provided non-recourse funding contingent on those receipts constitutes improper fee sharing under Rule 5.4. Courts that have addressed this issue have concluded that Rule 5.4(a) does not preclude a financing interest in a future attorneys’ fees or law firm revenue.

In Lawsuit Funding, LLC v. Lessoff, 2013 N.Y. Slip Op. 33066 (N.Y. Sup. Ct. 2013), a law firm received an advance secured by contingency fees through a litigation funding agreement called a “Sale of Contingent Proceeds.” The agreement called for the funder to receive a portion of the contingent legal fee that the attorneys expected to receive if five specific lawsuits were decided in favor of the claimants. The lawyers reneged on their payments to the funder and attempted to void the transactions as improper fee-sharing. The New York trial court, noting several other jurisdictions were in agreement, found no ethical violation.

Lessoff relied heavily on PNC Bank, Delaware v. Berg, where the Delaware Superior Court rejected the lawyer’s argument that it was inappropriate for a lender to have a security interest in the attorney’s contract rights. The court noted that it was common practice for lenders to take security interests in the contract rights of business enterprises, including an attorney’s accounts receivable. The court noted that:

“[T]here is no suggestion that it is inappropriate for a lender to have a security interest in an attorney’s accounts receivable. In fact, it is common practice. Yet there is no real “ethical” difference whether the security interest is in contact rights (fees not yet earned) or accounts receivable (fees earned) insofar as Rule 5.4, the rule prohibiting the sharing of legal fees with a nonlawyer is concerned. It does not seem to this Court that we can claim for our profession, under the guise of ethics, an insulation from creditors to which others are not entitled.” PNC Bank, Delaware, at *10 n.5.

However, there is authority cutting the other way. In 2018, the New York City Bar Association issued a non-binding ethics opinion saying it violated Rule 5.4(a) for a lawyer to enter into a litigation finance agreement with a non-lawyer if a portion of the financer’s fees is contingent on the lawyer’s receipt of fees. The opinion acknowledged that lawyers repay recourse loan agreements to nonlawyers from legal fees without violating Rule 5.4 but explained the distinction as ground in the notion that an attorney’s professional independence is compromised when funders have an interest in particular matters. “Rightly or wrongly, the rule presupposes that when nonlawyers have a stake in legal fees from particular matters, they have an incentive or ability to improperly influence the lawyer.”

The opinion was widely criticized, and a working group was formed to study third-party litigation funding and provide a report to the bar association. The report asserted that Rule 5.4 should be revised to reflect contemporary commercial and professional needs and realities and set forth two rule proposals allowing litigation funding to lawyers or law firms with slightly different parameters. No action has been taken on the proposals.

Duty to Avoid Conflicts of Interest

Legal finance contracts may generate a concurrent conflict of interest between a lawyer and client, putting the lawyer in the crosshairs of Model Rule 1.7. A concurrent conflict of interest exists when representing one client is averse to another client or if there is a significant risk that the representation of one client may be materially limited by responsibilities to another client. Conflicts may occur in this context when the lawyer has a lawyer-client relationship with the funder as well as the client. This type of relationship is similar to the relationship between lawyer, client and a liability insurer who pays the lawyer’s fees pursuant to an insurance contract. A lawyer can avoid confusion or charges of conflicts by clarifying to the funder that none of his or her acts or communications are legal services done on behalf of the funder.

Lawyers must also remain apprised of whether they, or any attorney in their firm, has a financial interest in a funder that is advancing money to the lawyer’s client. Such investments may constitute a business transaction with a funder that is averse to a client in violation of Model Rule 1.8.

Conclusion

Litigation funding comes with both benefits and hazards; however, it appears that its use will continue to grow. It is essential for lawyers using or contemplating the use of litigation finance to stay current on new and significant developments in this area, and to ensure that they can satisfy their ethical duties to their clients. The challenges of maintaining an ethical practice are elevated in the face of potential conflicts of interest, concerns about confidentiality and waivers of privilege, concerns about attorneys’ independent legal judgment, and a rapidly shifting legal landscape. It is incumbent on us all to ensure, for our clients and for ourselves, that we tread cautiously.