January 21, 2014 Articles

Alternative Funding of Litigation

By spreading the costs of litigation and sharing the risks, this arrangement offers many benefits to cash-strapped firms.

By Victoria Lazear

Litigation is becoming an increasing part of a firm's costs. Increasingly, litigation has become more sophisticated, which has increased the required quality of expert testimony and, with it, the work and the expense required to provide such testimony. Similarly, other costs have escalated, necessitating a way to manage the financing of litigation. These increases in costs exacerbate the dilemma for a party facing an opponent with more money to spend on litigation. But even firms that can finance their litigation costs seek alternative financing to even out the payment of litigation costs and to share the risks. Many critics of alternative funding of litigation recognize that such funding can promote fairness and equalize access to the justice system.

Although not the primary cost of litigation, an important component of a firm's litigation cost is the cost of expert witnesses. A party can find that cash constraints severely limit its ability to obtain the requisite expert witness analysis, a particularly vexing problem when the opponent is not as cash constrained. The lack of funding can limit the amount of effort that can be expended on analyzing the party's position or force using a less than ideal expert. The more cash-constrained party may be faced with the option of settling early to limit its cash outlays or fighting the litigation knowing that the testimony of its expert witness is not as compelling as it could be.

However, the costs cannot be contingent on the outcome of the case. Further, in many jurisdictions, lawyers cannot advance the fees for an expert unless there is a clear understanding that the party will pay the costs regardless of the outcome. In class actions, the attorneys generally maintain a war chest that finances costs such as expert witness fees. But in other types of litigation, most attorneys require the party to pay the costs of experts even if they are willing to take the case on contingency. Alternative financing through third parties is a solution to this dilemma: The third party provides the needed cash and assumes at least some of the associated risk. This is generally the only option for defendants, particularly if their opponent has deeper pockets, as few firms are willing to undertake a defense where their fees are contingent on achieving certain milestones.

More and more firms are seeking to use alternative funding of litigation (as opposed to self-financing) either through third-party litigation, which is investment by an otherwise disinterested third-party firm, or through the traditional contingency arrangement with the law firm (or consortium of law firms) sometimes coupled with third-party financing for costs such as those for expert witnesses. Neither form of alternative financing requires that all of the financing be ex ante, and both extinguish at least some of the debt if the lawsuit is unsuccessful. Thus, alternative funding can offer a number of benefits: cash to finance litigation, cash to smooth out cash flows, and risk sharing. Even when a firm has entered into a contingency arrangement, a third party may be brought in to provide these same benefits to the law firm. The third party may also provide a benefit to the litigant by allowing the uncertainty of a contingent arrangement to be removed from the balance sheet. In addition, using third-party funding may allow a cash-strapped litigant to work with a law firm that is unwilling to enter into a contingency agreement or to secure adequate expert witness testimony.

Alternative financing is more common for plaintiffs because they are seeking a return (damages) on their investment (litigation costs). In recent years, firms that invest in litigation have offered products for defendants that provide predetermined cash payouts as certain litigation goals are attained. However, third-party funders are sometimes reluctant to fund a lawsuit completely and require that the litigating attorneys be paid on a contingency basis to ensure that the law firm has a stake in the litigation.

In the United States, contingency funding is a common form of non-litigant funding. Outside the United States, third-party litigation funding is more common, in part because many countries use a model whereby the losing party pays the litigation costs of the other side. Thus, the downside risk is substantially increased, making litigation untenable for many consumers and businesses without outside funding.

In the United States, procedures exist for handling plaintiff cases and class actions funded by contingency, as laid out in the ethical standards for attorneys, and many, if not most, class actions are funded in this fashion. There are plaintiff law firms that handle contingency class actions almost exclusively, and war chests and lines of credit are maintained to invest in these cases. In most large consumer class actions, there is a committee of attorneys from multiple law firms that contribute time and expertise, as well as money, for the litigation. In this way, risk is diversified. Because the committee members are attorneys, there is no ethical issue with their involvement in dictating legal strategy.

Third-party funders in the United States may be private or public firms devoted to funding litigation, as well as investment firms and hedge funds that invest only some of their funds in litigation—the attraction is investment diversification because litigation returns are uncorrelated with other investment vehicles. The risks, however, are high because the returns and timing are unpredictable and the asset is illiquid. Moreover, substantial due diligence is required to vet potential investments. At the moment, the information available indicates that litigation-funding firms accept only about 1 in every 10 cases.

Although there are approximately 15 large firms that provide most of the litigation funding worldwide, there may be multiple investment firms that fund any one case. At the moment, there are two publicly traded funding firms listed on the AIM, the United Kingdom stock exchange for emerging companies. They have each collected about $750 million from British investors, about half of the funds believed to be dedicated to third-party litigation funding, and an estimated $200 million dollars is focused on U.S. litigation. Currently, investment restrictions make it nearly impossible for U.S. citizens to invest in either of these companies. Two other firms with large investment portfolios have entered the field of financing complex litigation, and a third company has entered with the goal of providing financing primarily to defendants. All of these firms are focused on firm versus firm litigation and do not fund individual plaintiffs. A fourth firm has left the market because it was unable to achieve its funding goals allegedly because of a philosophical difference between the founders. One of the publicly traded firms has been involved in a class action while the others have expressly stated a reluctance to work with a class.

Ethical Considerations
In England, funding by disinterested parties was prohibited beginning in the Middle Ages. Champerty (the funding of litigation by uninvolved parties for profit) and maintenance (the funding of litigation by third parties with the purpose of interfering in the outcome) were prohibited because rich landlords would often fund lawsuits against poor landowners to obtain land that would increase their coffers at the expense of rivals. These practices continued until 1967, when they were decriminalized in favor of third-party funding so that more people would have access to justice. In particular, the English rule that the loser was liable for the legal costs of the winner put legal action out of reach for many plaintiffs.

The prohibitions of champerty and maintenance also became part of United States law, although the loser is not always liable for the legal costs of the winner. Further, champerty and maintenance are part of the ethics code to which U.S. attorneys must adhere. These ethics rules were specifically modified to permit contingency funding as long as the contingent fee was reasonable—usually, 20 and 40 percent of the damages award—and bore some relationship to the fees incurred.

More recently, some jurisdictions in the United States have overturned champerty and maintenance. However, as of 2010, 32 states and the District of Columbia still had laws against these practices. In 2003, the Supreme Court of Ohio voided a contract in Rancman v. Interim Settlement Funding Corp., in which a plaintiff sought financial assistance from Interim to finance her lawsuit in return for a substantial payment (relative to the loan) to be paid first from any settlement. After receiving her settlement, the plaintiff refused to pay as she had agreed in the contract. Ultimately, the court sided with the plaintiff on the grounds that the contract violated laws against champerty, Interim having sought to benefit from the lawsuit, and laws against maintenance, and because the contract with Interim interfered with the plaintiff's incentive to settle. Needless to say, this case has had a chilling effect on third-party funding of lawsuits.

Even in jurisdictions where champerty and maintenance are permitted, contracts must explicitly state that the plaintiff has exclusive right to hire and fire the counsel of his or her choosing and not interfere with, or attempt to direct, the lawyer's professional judgment. Further, the court is required to review the contract to ensure that ethical standards are maintained.

Nonetheless, there are still concerns about non-attorney funding because there is currently no regulation of third-party litigation funding. In contrast, attorneys are bound by a code of ethics concerning contingencies. Attorneys are ethically bound to limit their recovery to what is reasonable and consistent with the unpaid hours expended on the lawsuit. There is concern that third parties may engage in unreasonable profiteering. This could be a problem if the third party were to fund a class action in an opt-out jurisdiction. However, this issue seems remote given that most third parties want to work with firms, not potentially naïve individuals. Further, class actions are usually before a judge, who will usually insist on approving any contract.

An important issue in non-contingency third-party funding is attorney-client privilege. Before a third party is willing to finance a lawsuit, it must vet the investment as part of its fiduciary duty. Doing so generally requires that the attorneys reveal confidential information that is protected by attorney-client privilege. However, revealing such information to a third party voids the privilege. In the United States, this problem is averted by having the client engage the third party as a legal consultant. In turn, the third party argues that it provides legal consulting as to the viability of different legal strategies and the likelihood of the lawsuit succeeding.

Other Issues in Alternative Litigation Funding
There are other issues that arise in the increased opportunities for alternative financing, particularly for plaintiffs.

Judges are sometimes reluctant to bind a class to a contract with a third party before one has even been certified. In the United States, alternative funding of class actions has been mostly confined to providing funds to contingency attorneys for a share of the award where the law on contingency funding for class actions is established.

Third parties may have different incentives to settle a case than do the plaintiffs. For example, the third parties may wish to settle a case early to recoup their investment. Alternatively, they may be willing to engage in a protracted battle to maximize their investment while the plaintiffs may prefer to obtain a smaller amount sooner. These same incentives exist with contingency funding; however, with contingency funding, the attorneys owe an ethical obligation to their clients. In contrast, the third-party investors are obligated to the best interests of their investors, not the plaintiffs, and can potentially enforce this by refusing to make additional investments. To circumvent this conflict, the contracts delineate the extent to which a third party commits to additional investments in the litigation.

There is a possibility that the contract will be reversed by litigation after the lawsuit is over, such as in the Rancon case, where the contract was voided. Such contracts may also be voided for reasons other than champerty or maintenance. Even in contingency cases, courts not infrequently change the terms of the contract where the attorneys receive less than the plaintiffs agreed to before the verdict.

Third-party funding alleviates the allocation of costs across multiple plaintiffs, particularly if the plaintiffs are ordered to pay costs. Courts have struggled to determine how costs should be spread across a class in both opt-in and opt-out jurisdictions. The problem is particularly acute when one jurisdiction requires that the loser must pay the legal fees of the winner. With third-party funding, the funder usually assumes these and other litigation costs. A third-party funder will distribute the proceeds if the funder's side is victorious according to the contract, usually first paying all fees and expenses. Non-attorney third-party funders usually contract with each plaintiff individually, thus making an opt-out jurisdiction an opt-in jurisdiction.

Third-party, non-contingency funding makes forum shopping across countries feasible. One difficulty with contingency funding is that different countries tend to have different rules about such funding. Thus, a contingency contract in one country may be subject to different laws in another. In contrast, in non-contingency situations, a third-party funder is likely to have a contract that spells out the relationship between the funder and the plaintiff that will be recognized in other jurisdictions.

The proliferation of class actions internationally increases the exposure of any company that trades internationally. Some jurisdictions have established their ability to represent citizens of any country as long as the class includes at least some citizens within its jurisdiction.

An example of such a case is the Shell Petroleum case, in which shareholders alleged securities fraud. The suit was originally filed in the United States and included both U.S. citizens and foreign nationals. Plaintiff attorneys were engaged under U.S. rules governing contingency funding. While the case slowly made its way through the U.S. courts, Shell sought settlement in the Netherlands through the Dutch Collective Settlements Act, known as WCAM, a mechanism established for the settlement of class actions. Under WCAM, Shell settled with everyone except the American investors who had purchased shares in the United States. After more wrangling, the U.S. courts refused jurisdiction over everyone except the U.S. citizens, after which Shell effected a settlement with the U.S. citizens.

The plaintiff attorneys who had been engaged by both the U.S. plaintiffs as well as the foreign nationals successively were paid by both sets of plaintiffs out of both settlements, and Shell paid out $353 million. This illustrates the potential for global settlements as well as the ability to cart cases from one country to another.

An Increase in the Number of Frivolous Lawsuits
Ultimately, the primary concern is that permitting third parties to fund litigation will increase the number of frivolous lawsuits. Firms are concerned that a substantial portion of their capital is going toward defending themselves against frivolous lawsuits. Many would agree that justice is best served when deserving plaintiffs can seek redress in the judicial system, but most would also agree that a firm defending itself against a plaintiff that should not prevail has a chilling effect on the economy. Of course, the problem is how to differentiate a frivolous lawsuit from a lawsuit that is attempting to right a wrong.

 At the moment, there are two reasons why third parties are unlikely to invest in frivolous class actions. First, the decision to invest is a business one; thus, the firms financing a lawsuit should be unwilling to invest in cases that likely have a low expected return. This is borne out by the low acceptance rate of about 1 in 10 cases. Second, firms invest substantial amounts in vetting their cases, employing attorneys and other experts to evaluate the potential success of these cases. Cases that are frivolous are unlikely to make the cut because they are poor investments. Funds for which information is available have historically invested their money very slowly, indicating either a reluctance to invest without adequate information or a paucity of cases that appear to be good investments.

Critics argue that investment firms will be willing to undertake high-risk investments with the potential for large returns. There is limited data available on class action outcomes to compare the outcomes of those funded by a third party and those funded on a contingency arrangement. Existing data suggest, however, that third-party funded cases are less likely to be overturned and are more likely to be cited, suggesting that they are higher in quality than the average contingency case.

Further, while third-party funders compete with contingency law firms, they are also working with contingency-funding law firms. Because most litigation-funding investment firms have a requirement that the plaintiffs and their attorneys maintain at least a 50 percent interest in a case, most class actions will require that attorneys be fronting some of the money. The risk to a single firm, however, is reduced, and for that reason, more law firms may find contingency funding to be even more attractive.

Because the industry is relatively new in the United States, there is the potential for entry by more investors given that the perceived average returns are very high. As in most situations, the winners are likely to receive more publicity than the losers. These entrants may have different standards for undertaking the funding of cases or may choose to utilize a business model that invests less in vetting potential cases. For example, they may conclude that the returns are sufficiently random that return is maximized by maintaining a large portfolio of cases, rather than investing in a complicated vetting process that may not be successful in identifying the winners. This problem of investors with different risk profiles may be aggravated by the natural progression from investment in a particular case or portfolio of cases to investment in derivative products where the underlying product is the lawsuit but the return (as well as the risk) is magnified.

Uncertain Future
Despite the potential for growth—Gerchen Keller estimates the litigation market in the United States to be more than $200 billion (Wall Street Journal, April 7, 2013)—the litigation-funding industry is still very small. In 2006 Crédit Suisse was one of the first to begin offering third-party funding for firms, and Juridica followed late in 2006. However, to date there appears to be only about $1 billion in funding available for litigation funding across the major third-party funders, according to the same Wall Street Journal article. It is unclear what is stymying the growth. Potentially, investors are reluctant because the legal hurdles have yet to be resolved or because the investment is illiquid with an uncertain timetable for recovery or because information about the extent of such funding is difficult to quantify. However, the substantial capital requirements for litigation, particularly when a successful outcome is often dependent on a substantial investment to cover costs such as expert witness fees, continue to spur solutions for firms seeking funding and risk sharing of litigation.

Keywords: litigation, expert witnesses, alternative funding, contingency, risk sharing

Victoria Lazear is a vice president at Cornerstone Research. The views expressed in this article are solely those of the author, who is responsible for the content, and do not necessarily represent the views of Cornerstone Research.

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