How Litigation Funders Have Improved the Quality of Settlements in America

Robert B. Fuqua

Abstract

Litigation finance is a form of specialty funding used by litigants and law firms to pay the high costs associated with maintaining a legal claim. In a typical agreement, a litigation funder pays a portion of a client’s litigation expenses in exchange for a share of the lawsuit’s recovery. The loan is non-recourse, so if the client loses the case, the funder will lose the investment.

This form of legal financing has rapidly grown throughout the United States. The practice is popular among clients for its risk-sharing benefits, popular among investors for its high returns, and popular among critics for its expansive ethical gray areas. This Article argues that litigation finance should be popular for one more thing: improving the quality of legal settlements. Because litigation funders use their capital and experience to reduce bargaining imbalances during pretrial negotiations, settlements in cases backed by litigation funders are more likely to reflect the merits of claims than economic disparities between the parties.

Today, various forms of litigation finance can be found throughout our legal system. Even newsworthy crowdfunding efforts by criminal defendants could qualify as a form of litigation finance. The scope of this Article, however, is limited to commercial lawsuits. The Article introduces the practice, discusses the implications of adding a third-party funder to a lawsuit, and concludes with a regulatory proposal for safely expanding the practice into the future.

Table of Contents

Introduction

I. Litigation Finance: A State of the Industry

A. Consumer Funding vs. Commercial Funding

B. The Rise of Litigation Funding

C. The Agreements

D. Limitations to Growth

i. Maintenance and Champerty

ii. Waiver of Privileged Information

II. How Litigation Funding Improves Settlement Quality

A. Litigation Funders as Unbiased Evaluators

i. A Look into the Future: Will Technology Give Funders an Advantage?

B. Shifting Risk to Litigation Finance Companies

i. Why a Litigation Funder Should Bear the Risk

III. The Costs of Litigation Finance

A. Spurred Litigation and Frivolous Suits

B. A Hurdle to Settlement

C. Agency Costs

IV. Proposed Regulations

A. Privileged Information Exchanges

B. Conflicts and Disclosure

V. Conclusion

Substantive laws are designed to shape human behavior: criminal laws punish conduct that is dangerous to society and civil laws safeguard the private rights of citizens. In the United States, these laws are, in theory, effective because the legal system offers a predictable process that consistently enforces legal standards in court. Bad actors are therefore deterred from breaking the law or treading on private rights because they know the legal system will punish wrongful acts with adverse consequences.

Today, however, most civil law disputes are not actually resolved by the U.S. legal system.[1] Litigants usually settle cases by negotiating privately instead of using the formal litigation process. In fact, many judges and scholars favor this outcome since settlements are more efficient and less expensive than resolving disputes through the trial process.[2] Some scholars even suggest that a trial is an example of our legal system failing because rational parties in a dispute can both benefit by settling out of court.[3]

Private settlements are widely favored for their efficiency, but we should not unanimously favor all settlement outcomes. Instead, we should only endorse settlement agreements that reflect expected trial outcomes, i.e., outcomes that are equitable given the facts of a case and the substantive law. The degree to which the settlement reflects the expected trial outcome is a measure of settlement quality. High-quality settlements mirror trials in advancing substantive law goals by compensating injured plaintiffs and deterring bad actors, while low-quality settlements are predicated not on expected trial outcomes, but on imbalances in bargaining power. Low-quality settlements should be discouraged because they could result in private agreements that circumvent the legal system and fail to achieve the law’s substantive goals. For instance, if a defendant convinces a plaintiff to accept an unreasonably low offer, or if a plaintiff extracts an unreasonably high offer, then the law’s goals have not been met, and the settlement system has failed.[4]

When litigants negotiate a settlement agreement, the outcome is a product of three factors: (1) the parties’ expectations of success at trial; (2) their projected litigation expenses; and (3) their attitudes toward risk.[5] If litigants have similar trial expectations, cost projections, and risk preferences, then a settlement is theoretically the best choice for both parties.[6] Settling avoids trial costs that diminish the parties’ aggregate wealth.

In practice, settlement is not so easily reached. A plaintiff’s estimated trial outcome may vary considerably from a defendant’s estimate because litigation can be highly uncertain. Disagreements over a case’s merits could reduce or erase the possibility of a settlement agreement.[7] Furthermore, unequal risk preferences can result in bargaining imbalances between parties. Some decisions may be colored by financial imbalances while others are affected by one-sided reputational risks. When litigants choose between a certain outcome (settlement) and an uncertain outcome (trial judgement), their attitudes toward risk will affect their choices.[8] Therefore, to improve the quality of settlements, we must design a process that both reduces differences in trial estimates and reduces the asymmetry of risk preferences between litigating parties.

These differences can be reduced by welcoming the growth of a new financial services industryan industry known as "litigation finance." Litigation funders provide up-front capital to law firms or litigants to pursue legal claims in return for a portion of the payout, if any, from a trial or settlement. Litigation finance investments are similar to venture capitalism investments, and the analogy between the two serves as a helpful introduction to the litigation finance industry.[9] Both investor groups create a portfolio of high-risk investments, hoping that, even if many of them fail, a few will be "wildly successful" and generate a positive return for the portfolio overall.[10] Venture capitalists provide capital to meet the needs of high-growth companies, and litigation funders provide capital to meet climbing litigation costs in commercial lawsuits. Both groups also add non-cash contributions, like industry contacts, to help their investments succeed.[11] This Article analyzes the effects of litigation funders’ cash and non-cash contributions and concludes that funder involvement improves the quality of legal settlements.

Today, litigation finance is unregulated at the federal level. This lack of oversight has caused some commentators to voice concerns about the ethical and social desirability of the practice.[12] Critics argue that funder involvement increases meritless lawsuits and complicates the settlement process, burdening the entire legal system.[13] This Article, though, challenges these assertions and argues that the industry’s growth is socially desirable.

My analysis focuses on lawsuits from the plaintiff’s side,[14] and the scope is limited to large-scale commercial disputes that have become particularly expensive to litigate.[15] Generally, these disputes involve intellectual property rights, antitrust laws, or other complex commercial claims.[16] They make up only a small percentage of filed cases,[17] but their importance cannot be overstated. Protecting intellectual property is critical to fostering innovation, and antitrust laws promote and protect competitive markets. Because these substantive legal goals are fundamentally important to our economy, settlements in commercial cases should promote them.

The remainder of this Article is divided into five Parts. Part I describes the current state of the litigation finance industry and limitations on its growth in the United States. Part II discusses how litigation finance can improve the quality of settlements by improving trial estimates, providing litigation funding where needed, and evening out asymmetric risk preferences between opposing parties. Part III analyzes the potential social costs of allowing litigation funding arrangements. Part IV offers some regulatory solutions that minimize existing limitations and enable litigation finance to improve settlement outcomes. Part V concludes.

Litigation finance can be described as "a modern twist on the classic contingency fee agreement."[18] The litigation funder (a non-party) pays a portion of the litigant’s costs and expenses in exchange for a share of the claim holder’s recovery. Because the loan is non-recourse, if the litigant loses, the funder will lose the investment. This seems simple, but the various funding agreements can be as unique and complex as the cases being financed.[19] The following discussion distinguishes consumer funding from commercial funding, traces the rise of the litigation funding industry, and describes the nature of funding agreements in general.

Litigation finance is divided into two sub-industries: "consumer funding" and "commercial funding."[20] Consumer funding refers to relatively small personal claims by one-time plaintiffs, and the agreements typically advance a plaintiff’s living expenses while awaiting settlement or judgment.[21] Commercial funding, which is the exclusive focus of this paper, funds high-stakes business disputes brought by sophisticated parties.

Commercial funders approach the investing process much like hedge funds or venture capital firms approach their investments, i.e., by establishing a "structured and comprehensive review process" to evaluate the strength of an investment.[22] Due diligence of a complex claim is time-consuming and expensive. One industry-leading funder takes between sixty and ninety days to evaluate an investment and spends nearly $100,000 for each screening.[23] Funders often use artificial intelligence tools to enhance their trial estimates[24] and hire outside experts for a second opinion on damages estimates. The investment process is thorough and selective. Recently, one funder reported investing in only 6% of the funding requests it received.[25]

The litigation finance industry is still growing. What started with a few funders has grown into an international market of both public and private litigation finance companies. The U.S. is home to a number of these funds, but shares of public litigation finance companies are traded only in international markets. The U.S. has a universal prohibition on fee-splitting with non-lawyers,[26] and this rule prevents litigation finance companies from launching domestic public offerings.[27]

Even with this limitation in the U.S., some estimate the litigation-finance market size has grown to somewhere between $50 billion and $100 billion.[28] Funders have hastened this growth by drawing investors’ attention with internal return rates that sometimes exceed 30%.[29] This initial success has attracted a variety of investors such as hedge funds, private equity firms, wealthy individuals, and even large institutions like Harvard University.[30]

Funders have helped fuel this growth by advertising the commodification of lawsuits to potential claim holders. In other words, funders recast lawsuits as measurable assets that can be priced and sold.[31] Industry advocates have encouraged companies to "sell" a portion of their claims because doing so can increase their certainty over legal budgets, improve cash flow for business operations, and enable the pursuit of claims that were previously considered too expensive.[32] Industry advocates have attracted investors too. Lawsuit values do not fluctuate with outside markets, so investing with a litigation funder is an appealing way to diversify a portfolio.[33]

Commercial funding agreements are inherently confidential. Funders use non-disclosure agreements to obscure investment amounts from the opposition and guard against inadvertent waivers of privilege.[34] To further complicate matters, each investment can have a different deal structure.[35] Funders can enter into agreements with the claim holder, the law firm, or both.[36] Funders can finance just one case or a portfolio of cases. Funding timelines also vary. Agreements can be formed at any point during the life of a case. Lawsuits can be funded before the complaint is filed, during the pretrial process, during the appeals process, or during the collection of a judgment. One public funding firm disclosed its menu of financing options to investors in the following terms:

Examples of possible structures include, inter alia:

–      funding the legal expenses associated with pursuing or defending a claim in exchange for a payment based on the claim’s outcome;

–      acquiring an interest in all or a part of a claim or claimant at various stages during the adjudication process, including after a judgement or award has been rendered;

–      lending money, either directly or through a law firm established by the Principals, to fund the activities of a law firm, the litigation of a portfolio of cases, or the litigation of a single case;

–      arranging and participating in structures that remove the risk of liability from companies’ balance sheets;

–      acquiring interests in intellectual property that is the subject of claimed infringement; and

–      participating in post-insolvency litigation trust structures.[37]

As with most investments, time is an important consideration for litigation financiers. Deal structures are "driven primarily by likely time to payout, plus overall risk."[38] Thus, a case’s procedural posture can weigh heavily on which terms are offered by a litigation finance company.

Although many deals are complex and issue-specific, agreements typically share a standard 10:1 funding ratio.[39] This means the litigation financier will usually fund up to ten percent of the claim’s estimated damages. Standard ratios like this emerge from industry experience, and they can be helpful to both clients and investors when evaluating the attractiveness of a proposed funding deal. Investors use similar benchmark ratios in other industries too. For example, stock market investors use a price-to-earnings ratio[40] to help determine the fair market price of a company’s stock and certain real estate investors use the 1% rule[41] to evaluate real property offerings.

The litigation finance industry has attracted attention not only for its growth but also for its blunders. In 2010, the world’s largest litigation finance company invested millions of dollars into a lawsuit that was riddled with corruption.[42] Initially, the judge issued a record-breaking $18 billion judgment, but a problem was uncoveredthe judgment was actually ghostwritten by the plaintiff’s attorneys, and the judge was bribed to sign it.[43] Once the fraud was discovered, the litigation finance company released all of its recovery rights and cooperated with investigators. Still, the investment generated multiple news stories that criticized the company and the legal finance industry.[44]

The industry was thrust into the public spotlight again in 2016 when billionaire Peter Thiel funded Hulk Hogan in a lawsuit against Gawker Media, Thiel’s longtime nemesis.[45] News reports suggested that his reason for funding the claim was "personal revenge."[46] The case went to trial, and the jury awarded Hogan a $140 million judgment, which sent Gawker into bankruptcy.[47] When Hogan’s funding source was discovered, media coverage was quick to criticize the ethical concerns of funding revenge lawsuits.[48]

Partly in response to similar concerns, the American Bar Association (ABA) formed a working group to study the legal ethics issues arising from lawyers’ involvement in the litigation finance industry.[49] In its report, the group absolved the funding industry of any direct ethical violations, but it cautioned lawyers to approach cases involving litigation finance "with care, mindful of several core professional obligations."[50] Still, courts have imposed limits on litigation financing.[51] Some of these limits stem from traditional common law doctrines of maintenance and champerty. Others related to attorney-client privilege and the work-product doctrine.

Maintenance and champerty[52] are two interrelated common law doctrines that developed in medieval England in order to prevent third parties from assisting in the pursuit of legal claims. Maintenance means "meddling in someone else’s litigation,"[53] while champerty is an agreement to maintain someone else’s lawsuit in return for a financial interest in the outcome.[54] The doctrines originated in order to prevent abuse of the litigation process. Today, however, the risks underlying these doctrines are primarily mitigated in other ways, such as malicious prosecution, court sanctions, and the model rules of professional conduct.[55]

Recently, some state supreme courts have explicitly ruled that "their common law permits agreements previously considered champertous."[56] In a 2011 opinion, the Ninth Circuit recognized a "consistent trend across the country . . . toward limiting, not expanding, champerty’s reach."[57] Today, "[o]ver half of jurisdictions in the United States now permit some form of champerty," but there are "a handful of states that still enforce prohibitions on champerty."[58] This inconsistency creates uncertainty on whether litigation finance agreements will always be enforceable, which impairs the expansion of the industry. Faced with this uncertainty regarding the boundaries of the changing champerty law, at least one litigation finance company has turned down deals.[59]

Sometimes funders need confidential information about a client to evaluate a potential investment. Accurate and complete information is critical to predicting trial outcomes and appropriately rating investment risk. But if a party irresponsibly shares confidential information with a litigation finance company, that party may risk waiving its privilege protections.[60] If this privilege is waived, the information could be subject to discovery by the opposition. Therefore, how the privilege laws are applied to the triangular relationship of a client, lawyer, and funder is very important. Two legal theories become relevant: the attorney-client privilege and the work-product doctrine.

The attorney-client privilege protects confidential conversations between a client and an attorney if the communication is made to obtain legal assistance.[61] The privilege exists to encourage honest discussions between attorneys and clients.[62] But this protection can be inadvertently waived if the information is shared with a non-privileged party, like a litigation funder.[63] Thus, the only way funders can receive this type of privileged information is through an exception known as the common interest doctrine.

Like the attorney-client privilege, the common interest doctrine exists in order to encourage the free flow of information connected with legal advice.[64] Information will remain privileged if parties share a common legal interest and "exchange privileged information in a confidential manner for the purpose of obtaining legal advice."[65] Courts are divided over whether the common interest doctrine applies to litigation funders, which creates uncertainty for litigants.

Courts inconsistently apply the common interest doctrine to litigation funders because they use different standards to determine whether the legal interest requirement is satisfied. Communications with funders have not been protected when courts distinguish legal interests from commercial ones. For example, a Delaware court ruled that the common interest privilege did not exist between a plaintiff and a prospective funder when the information was shared, but ultimately, a deal was not consummated between the parties.[66] This approach was expanded by an Illinois district court to both prospective and actual litigation funders.[67] In the Illinois case, a finance agreement existed between the parties, but the court held that a litigation funder’s relationship with a client was still merely, "a shared rooting interest in the successful outcome of a case" and thus "not a common legal interest."[68]

Conversely, funder communications have been protected when courts apply a shared enterprise standard. Instead of making a distinction between legal and commercial interests, some courts ask only if the funder and the litigant share a common enterprise, and whether the communications at issue relate to the goal of the shared enterprise.[69] "Several courts have followed similar logic in upholding the attorney-client privilege with regard to litigation funders, citing a shared common interest in litigation strategy’ and actual cooperation toward a common legal goal’ as the bases for the common interest."[70]

The work-product doctrine is another form of privilege protection. It is similar to the attorney-client privilege, but its scope is "broader."[71] Under this theory, "documents and tangible things that are prepared in anticipation of litigation" are protected from discovery by the opponent.[72] Although broad in scope, the doctrine is limited to an attorney’s "creative intervention."[73]

Unlike the attorney-client privilege, the work-product doctrine is not easily waived if information is shared with a third party. Because the work-product doctrine is intended to protect information from "adversaries," "only disclosing material in a way inconsistent with keeping it from an adversary waives the work-product protection."[74] Therefore, work-product information shared with third parties, including litigation funders, is protected in most cases.[75] But these protections may not be enough if funders demand confidential information beyond what the attorneys or their assistants have created themselves.

The uncertainty attached to sharing confidential information with litigation funders has obstructed the funding process. Some funders claim to avoid confidential information altogether and trust the reputation of the law firm without inspection.[76] But other funders have devised creative ways to access the information. For example, some finance agreements may require a claim holder to hire a lawyer representative from the funder’s organization to create its own attorney-client relationship.[77] Other funders may wait and acquire information in person to avoid creating a "paper trail" of their discussions.[78] These unorthodox methods have distracted some critics from the benefits that litigation funders provide.

Pursuing a legal claim, especially a complex commercial one, has become so expensive that many companies and individuals choose to forgo protecting their legal rights.[79] Sometimes lawyers can cure this problem by advancing expenses under a contingency fee agreement, but sometimes they cannot. Cases can be too expensive and uncertain for law firms to assume the risk.[80] Moreover, some complex cases require highly specialized lawyers, and these lawyers may be unwilling to agree to a contingency fee arrangement. Thus, in these scenarios, where a plaintiff otherwise cannot afford to litigate, access to non-recourse litigation funding may be the only way a plaintiff can file a claim and initiate settlement negotiations.

The opportunity to share costs with a litigation funder is attractive for other reasons, too. If a plaintiff feels overwhelmed by its opponent, it can partner with a funder to reduce bargaining imbalances during pretrial negotiations.[81] Support from a well-known finance company implies that the plaintiff’s claim has merit and could persuade an overly confident defendant to reassess the quality of its settlement offer.[82] Furthermore, pairing with a funder delivers a more credible trial threat, and this could incentivize a defendant to settle a case on the merits instead of using delay tactics. Lastly, a business may prefer to partner with litigation funders for internal growth reasons. Businesses can use the non-recourse advances to cut legal costs and reinvest the saved money directly into the business. Without litigation funding, some businesses could face cash-flow issues while trying to protect their legal rights.[83] In the situations described above, litigation finance can reduce bargaining imbalances and enable plaintiffs to confidently reject discounted settlement offers.

The growing popularity of litigation finance could also have a macro effect on settlements by resolving funder-backed claims more quickly. This effect could arise from a funder’s experience gained as a repeat litigant in a specific type of cases. Over time, funders may become experts in predicting certain trial outcomes early in the litigation process. This expertise could lead to confident claim appraisals before a case progresses to judicial intervention. And if reasonable parties agree on a claim’s value from the outset, they will likely settle the dispute for a reasonable amount instead of incurring additional litigation costs.[84]

However, enlisting the help of a litigation funder is not the only way to improve trial estimates. Some law firms might have the required experience to add the same value as repeat-litigant funders.[85] But it’s likely most law firms will not have this experience or expertise.[86] Law firms usually handle a variety of cases, whereas funders typically finance the same types of cases with similar damages expectations.[87] Also, the largest law firms with the most collective experience typically represent defendants, not plaintiffs.[88] Representing a plaintiff could create actual conflicts with a law firm’s concurrent client base. And if no actual conflicts exist, a law firm may still be reluctant to represent a plaintiff if it would upset existing relationships with institutional clients. Lastly, a lawyer may not add the same value as a funder if the lawyer’s firm prohibits contingency fee arrangements. Risk-averse clients represented by hourly-fee lawyers could be more willing to accept discounted settlement offers instead of proceeding to trial.

A funder, on the other hand, can offer a non-recourse loan that pays the law firm’s hourly rates and allows the claim holder to proceed to trial with increased confidence, knowing that the loan is repayable only if they are successful. Therefore, the addition of a litigation funder can reduce inherent risk asymmetries, sometimes by a little, but other times by a lot. The following discussion analyzes the continued benefits provided by funders as a dispute matures, explores technological advancements in the industry, and explains why funders are better suited to handle litigation risk.

The accurate evaluation of a claim is the first step toward settling on the merits. An opinion from a detached third party can be helpful, especially when the added party is separated from the personal emotions inevitably tangled with a legal dispute. Often, plaintiffs can be subject to unintentional biases when discussing their own cases.[89] Psychological research has uncovered the existence of inherent biases "[w]hen people estimate quantities that are relevant to their self-image."[90] For example, when people are asked to evaluate things like how well they drive, how well they performed a task, or how much credit they deserve for a collaborative job, their estimates tend to favor themselves.[91]

Typically, a plaintiff’s lawyer starts his or her relationship to a case as a detached third party who can objectively analyze the merits of a claim, but this objectivity may be temporary. Once a lawyer decides to represent a client, his or her impartiality could be obstructed by the same biases described above. After hours of work as an advocate, the case can become a part of the lawyer’s self-image. Pretrial rulings or additional case developments could reflect the lawyer’s work, which raises the question of whether lawyers can continue making unbiased estimates as a lawsuit progresses toward trial or settlement.[92]

A study investigating biases in the settlement process further supports the existence of lawyer biases. In the study, participants were assigned roles of plaintiff and defendant, and they attempted to negotiate the settlement of a tort case arising from a car accident.[93] The study’s results confirmed that participants had a significant bias when asked to list and rate the importance of arguments favoring both sides.[94] "Both defendants and plaintiffs recalled more arguments from the case favoring their own position and believed that a judge or jury would find arguments favoring themselves to be more important than those favoring the other side."[95] These results suggest that lawyers can be biased in evaluating the merits of a claim.

In contrast, litigation funders are less likely to develop biases as a case matures. Funders are not incentivized to look beyond provable evidence.[96] Unlike lawyers, they do not involve themselves in all areas of a lawsuit. For example, suppose a lawyer is tasked with developing a novel argument to admit a questionable piece of evidence. A funder will approach the lawyer’s argument with skepticism, but the lawyer may view her own argument differently. For these reasons, a funder is likely in a better position to re-evaluate the strength of a claim as a lawsuit develops.

Technological advances are changing the way lawyers work.[97] Today, most lawyers have access to computer programs with integrated artificial intelligence tools, like legal research engines.[98] But some tools are not widely available. For instance, one litigation finance company, Legalist, was founded on a proprietary algorithm developed by two Harvard dropouts.[99] Legalist identifies investment opportunities by algorithmically predicting outcomes based on federal and state court records.[100] The company has been wildly successful, raising $100 million and recruiting retired appellate judge Richard Posner as an advisor.[101]

Like Legalist, other litigation finance companies could develop data systems to predict trial outcomes with a higher degree of accuracy. Whether these tools will be available to non-funded claimants is unclear. It is likely these funding companies will offer consultation services. However, doing so adds yet another cost, and conflicts of interest could eventually limit consultation options.[102] It is too early to determine whether technological advances will give funders an edge over traditional lawyers when it comes to predicting case outcomes, but so far, it seems as if litigation funders are leading the development of this technology.

Before litigation finance, liquidity-constrained companies had few options when they considered whether to pursue a legal claim. They could sue and settle, hoping to avoid the cost of an actual trial; invest in the legal claim, which is inherently high risk; or they could absorb whatever damages were suffered and use their funds to invest in the company’s growth instead.[103]

Today, litigation finance presents a new option for pursuing meritorious claims, and companies can negotiate a custom litigation funding agreement that reduces their risk exposure to an acceptable level.

Litigation funders invest in lawsuits when they value claims higher than litigants and contingency fee lawyers do. Part of this value difference stems from the funder’s ability to mitigate risk.[104] A company with just one claim is unable to diversify in order to mitigate its overall risk, but a funder with many claims can reduce its risk in this way.

Investments have two categories of risksystematic and idiosyncratic. "Systematic risk, also known as undiversifiable risk,’ . . . affects the overall market, not just a particular stock or industry."[105] For example, any investment in auto manufacturing could be affected by oil prices, consumer preferences, or international trade agreements. As the market changes, the value of all stocks in an industry that relies upon that market can change too. This kind of risk is both unpredictable and impossible to avoid completely.

Conversely, idiosyncratic risk is the possibility that the value of an investment may decline due to a specific event that affects one asset but not the market as a whole.[106] For example, if a natural disaster closes the plant of one auto manufacturer and significantly impacts its production, this event could hurt the value of the company’s stock. But this effect would not be felt by the entire auto industry. Because idiosyncratic risk arises from individual or local events, it can be reduced through proper diversification. For example, a portfolio with shares of multiple auto manufacturers will mitigate idiosyncratic risk because the risk is spread amongst all of the auto companies.

Legal claims are unique because they are rarely affected by systematic risk.[107] The variables of a legal claim are constrained by facts that already occurred under rules that already exist. From the funder’s perspective, a case may lose at trial (idiosyncratic risk), but there are no market forces that would cause all cases in a portfolio to lose at trial (systematic risk). Therefore, a funder with many claims under management is in a better position to make rational settlement decisions because a portfolio of cases can insulate him or her from possible losses at trial.

The growing popularity of litigation finance has prompted many to analyze its costs and benefits. Critics have raised red flags, alleging that litigation finance needlessly spurs litigation, encourages frivolous suits, treads into ethical gray areas, and discourages reasonable settlement opportunities. These potential costs are analyzed below.

Some critics argue that litigation finance will cause unnecessary lawsuits to be filed because the influx of investments will raise the number of lawsuits brought by plaintiffs.[108] Empirically, however, "most [funding] agreements are entered into after a case has been filed."[109] While it is possible that plaintiffs could file claims they otherwise would not have in hopes of retaining financing, the number of parties willing to take this risk is likely insignificant.[110] Furthermore, even if litigation finance were to spur more lawsuits, this increase would not necessarily be a problem. Because funders are compensated only if a dispute is settled or a favorable judgment is rendered, they have no incentive to help plaintiffs bring meritless lawsuits. If funders finance only claims that potential plaintiffs ought to be bring but cannot afford to pursue without outside funding, then more lawsuits would mean only that the system is working better. Substantive legal goals are advanced when more rights are vindicated, more injured parties are compensated, and more bad actors are deterred.

To be sure, some critics argue that litigation funders support meritless suits with hopes of forcing a quick settlement. Funders can distribute risk across a portfolio of investments, so the risks associated with funding a frivolous claim are insignificant.[111] Critics point to revenge suits in the media as proof that strategic suits are being filed under illegitimate pretenses.[112] However, this argument is difficult to accept. Because litigation funders offer non-recourse loans, financing a meritless case is a sure way to lose money. Most funders vet cases through an extensive and expensive due diligence process before funding terms are even considered.[113] It is highly unlikely that a funder dub a claim frivolous and yet subsequently take it on as an investment.

This article suggests that litigation finance increases the quality of settlements, but if a funding deal is improperly structured, a rational litigant might be incentivized to reject a reasonable settlement offer. This outcome will likely be rare because funders will strive to structure deals in ways that let them avoid these situations.

A claim holder could be incentivized to reject a reasonable settlement offer if the value of a case is severely downgraded in certain situations. For example, suppose a business (Plaintiff) has a patent infringement claim and the expected damages are $50 million. The cost to litigate the case is $2 million, but Plaintiff is unable or unwilling to front the costs alone.[114] Plaintiff contacts a litigation funder (Funder) and agrees to the following terms: Funder will front all costs in return for 40% of the judgment or settlement amount (40% x $50 million = $20 million), but if the case settles for anything less than $50 million, Funder will receive the first $10 million paid to Plaintiff, regardless of the specific settlement amount.[115] Thus, Plaintiff is incentivized to demand more than $10 million; otherwise, all of the recovery goes to Funder, and Plaintiff gets nothing. Suppose the case develops poorly for Plaintiff, and as a result, Plaintiff’s new expected damages amount is just $8 million. Defendant offers Plaintiff a reasonable settlement of $8 million, but instead of accepting a guaranteed payout of nothing, Plaintiff is better off rejecting the offer and hoping to get lucky at the trial and receive more than $10 million. (Because the funding agreement is non-recourse, Plaintiff faces no cost in adopting this strategy.) Situations like this would push suits into the resource-constrained courts and encourage plaintiffs to avoid settling on the merits. Proper due diligence and deal structuring would avoid this outcome by ensuring that all parties are incentivized to settle a case reasonably.[116]

Critics of litigation finance also argue that adding a third party to the lawyer-client relationship will multiply agency costs.[117] Most concerns relate to the funders’ de facto control over the case and whether lawyers will have an allegiance to their clients or to funders if conflicts arise.[118]

First, it is important to understand that agency costs already exist between a lawyer and a client. Lawyers representing clients under contingency fee agreements are still motivated to maximize their effective hourly rates. Put differently, some lawyers have multiple contingency fee cases but a limited number of hours to allocate between them. Instead of using the available time to maximize the payout for one client, a rational contingency fee lawyer is incentivized to perform minimally acceptable work on many cases to diversify the risk of a non-recovery.

Hourly-fee attorneys have similar perverse incentives. Under the hourly fee structure, lawyers are incentivized to maximize the amount of time spent on a client’s case. Sometimes more time will result in better representation, but other times it could encourage the use of delay tactics and inefficient lawyering.

Involving a litigation funder will not multiply these costs; instead, a funder can serve as a monitor and possibly minimize conflicts of interest. A funder’s main goal is to maximize his or her return on investment. To achieve this goal, a funder aims to maximize the client’s settlement or judgment and to minimize costs. Under contingency fee arrangements, a funder can assess if enough work is being done to maximize the claim’s value. Likewise, under the hourly fee rate, a funder can monitor and possibly limit the number of hours being billed to the client.[119] Any extra hours billed will diminish a funder’s return. This increased efficiency would benefit both clients and the legal system.

Furthermore, lawyers will likely listen to a funder serving as a monitor since a healthy relationship can be good for business. In some situations, a lawyer may need a funder’s assistance financing concurrent or future cases. And, in other situations, a funder could seek out the lawyer for future business opportunities, such as representing a client in another case or being appointed as special co-counsel to oversee the funder’s investment. These underlying incentives will encourage the law firm to defer to the funder.

In 2014, the Advisory Committee on the Federal Rules of Civil Procedure considered a rule amendment to address concerns about the litigation finance industry.[120] The Committee chose to do nothing, stating, "[w]e do not yet know enough about the many kinds of financing arrangements to be able to make rules."[121] They decided that it was too early for them to intervene in this developing field: "[T]hird-party financing practices are in a formative stage. They are being examined by others. They have ethical overtones. We should not act now."[122]

The Advisory Committee has not revisited the issue, but different sources have proposed other litigation finance regulations. At the federal level, members of the Senate proposed the Litigation Funding Transparency Act of 2019 ("LFTA"), which would have required disclosure of litigation funding arrangements in class actions and multidistrict litigation.[123] LFTA was not adopted, but some federal courts have developed their own rules regarding litigation finance. Through local rules, at least twenty-four of ninety-four federal districts require disclosure of litigation funding in civil cases.[124]

State legislatures have developed regulations as well. Although most state efforts are outside the scope of this article because they address consumer funding, one state has adopted a broad disclosure regulation that affects commercial funders. In 2018, Wisconsin passed a rule that requires a party to "provide to the other parties any agreement under which any person, other than an attorney permitted to charge a contingent fee representing a party, has a right to receive compensation that is contingent on and sourced from any proceeds of the civil action, by settlement, judgment, or otherwise."[125]

In light of this regulatory pressure, some funders have voluntarily placed ethical duties on themselves through codes of conduct. For example, one large commercial funder released its "Code of Best Practices," which highlights "fairness," "transparency," "accountability," and "responsibility" as its founding principles.[126] Additionally, a self-regulating body known as the Commercial Litigation Finance Association (CLFA) emerged as a voluntary membership group for commercial funders.[127] These efforts are a step in the right direction, but the vague principles and guidelines imposed thus far are far different from the specific rules imposed by various state bar associations.

The remainder of this paper is not a comprehensive regulatory proposal; instead, it analyzes possible regulatory action from the perspective of improving settlement quality. I suggest that privileged information exchanges between funders and clients are required to fully reap the benefits that litigation funders provide. I also suggest that funders, just like lawyers, should be subject to conflict of interest rules if they access confidential information. To enforce conflicts rules, we must know what cases are being funded. Consequently, disclosure of funding agreements to the court and all parties is needed in order to monitor both financial and informational conflicts. The funding amounts, however, should be redacted to avoid giving a strategical advantage to opposing parties.

The work-product doctrine should shelter information exchanges between litigation funders and potential or actual clients. As discussed above, most funders have developed a sophisticated due diligence procedure to evaluate their investments. But the usefulness of a due diligence system hinges on the accuracy and completeness of information flowing into the process. If funders are missing critical information, they will be unable to use their experience to increase the accuracy of trial predictions, which could shrink or erase the possibility of an early settlement.[128] Also, if a funder has more information about a particular case, he or she will be able to tailor funding terms with greater accuracy and avoid the "hurdle to settlement" situation described above. The uncertain application of the privilege rules should not force litigants to tell their lawyers one thing and their funders another.[129]

The Supreme Court described the work-product doctrine as "an intensely practical one, grounded in the realities of litigation in our adversary system."[130] The Court expanded the privilege protection to include the work of attorneys’ agents, explaining that "attorneys often must rely on the assistance of investigators and other agents," and "[i]t is therefore necessary that the doctrine protect material prepared by agents for the attorney as well as those prepared by the attorney himself."[131] Today, climbing litigation costs are a reality of our adversary system, and these cost issues are often best handled by litigation funders. An attorney conducting a complex litigation increasingly must rely on funders, so they too should be protected.

Confidential information is a cornerstone of the concurrent and future conflicts rules imposed on lawyers.[132] If litigation funders are afforded privilege protections when gaining a client’s confidential information, then they too must be subject to these same conflicts rules. For example, it would be unethical to "allow" a funder to gain confidential information about Client A, and then use the acquired information to fund a new client, Client B, against Client A in a different proceeding. Today there are no regulations in place to prevent this scenario from happening.

To implement this conflicts regime, the existence of funding agreements must be disclosed to the court and all parties.[133] This idea is commonly resisted by funders and those who use litigation financing.[134] They claim that disclosure will encourage abusive practices by opponents such as distracting from the merits of the case by putting on a discovery "side-show."[135] However, it is unlikely that a burdensome "side-show" would result in practice because discovery has its own rules that limit the scope of discovery requests.[136] Funder identities should be revealed, and this disclosure should not be limited to the court. Judges rarely identify conflicts for lawyers. Instead, other parties usually enforce the conflict rules through disqualification motions. To facilitate this same type of environment, a disclosure system that provides transparency is required.

It is unclear why disclosure is opposed at all. Maybe funders and clients are playing it safe instead of exploring the advantages of disclosure. If litigation opponents know a claim made it through the rigors of a funder’s diligence process, they will likely assume the claim has merit. Similarly, funders should favor disclosure because the publicity will help market their services. The current silence in the industry could be a result of confidentiality agreements signed by funders and clients, but avoiding disclosure seems unwise for both parties.

Most arguments against litigation finance have a common thread: they accuse the industry of harming legal consumers. If these arguments prevail, however, legal consumers will suffer the greatest harm of alldiminished access to formal court proceedings.

Therefore, we must weigh criticisms of the industry against its many advantages. Should future lawmakers decide to intervene, they must recognize the relationship between increasing settlement quality and advancing substantive law goals. Proposed regulations should not only protect legal consumers but also foster the industry’s growth. If litigation finance continues to grow and affect more cases, more consumers will benefit and the quality of settlements will improve.