A 10-Minute Primer on Litigation Finance

In Burford Capital’s 2017 Litigation Finance Survey, which presented an overall bullish outlook on the increased prevalence and importance of litigation finance in commercial litigation, a few lines in the introduction offered perhaps the most important insight of all. “Some respondents may reflect the well-known research phenomenon of social desirability bias, insofar as they perceive litigation finance as cutting-edge and may therefore have overstated their experience,” Burford explained. “We offer this caveat given the incongruence between some survey results and external data around capital flows and market size.”

When a prominent litigation financer admits that its survey respondents overstate their familiarity with its offerings, it’s clear that many lawyers wish they knew more than they do about litigation finance. This article will provide background information on what litigation finance is, how it works, and what every lawyer should know as it becomes increasingly common.

What is Litigation Finance?

In general terms, litigation finance is a non-recourse type of funding (either via a loan or an equity investment) offered to a litigant or potential litigant (or directly to their counsel) that is intended to cover the legal fees and/or expenses associated with a particular dispute. Its non-recourse nature is the main differentiator from other avenues by which an individual or entity might raise capital. Litigation finance is typically paid back only upon a successful outcome of the underlying matter it funded. Funding agreements allow the funder to have first priority of repayment of principal and interest, collect a pre-determined percentage of an award, or some combination thereof.

The litigation finance industry takes the view that a legal claim is an asset that, like any other, is subject to valuation and collateralization. Underwriting a potential investment thus becomes an exercise familiar to all litigators: assessing the merits of a claim and the likelihood of its success.

How Does it Work?

According to a number of recent surveys, litigation finance is most often employed in high-risk litigation such as intellectual property disputes. It is currently more common for the client to have a direct relationship with the litigation financer rather than to establish that relationship through a law firm, though law firms are increasingly aware of and involved in helping their clients obtain litigation finance. According to Burford Capital’s survey, the average value of a claim financed was $33.5 million, with the average amount of funding provided being about 10 percent of the assessed value of the claim.

While this model has been—and still is—the most common, a portfolio-based model is gaining traction. Under that model, a fund will back a portfolio of cases by supplying funding either to a corporate client with a portfolio of potential claims or directly to a law firm. The latter, though, poses potential ethical problems, which will be addressed below.

Why Does Litigation Finance Keep Coming Up?

Litigation finance is by no means new, though it has become an increasingly common topic of discussion of late. As most funds are privately held, there was historically little publicly available information about litigation finance and little public discussion about it. Interest picked up in earnest when it became public knowledge in May of 2016 that Peter Thiel had provided funding to Terry Bollea (better known as Hulk Hogan), among others, to pursue claims against a media company. The involvement of celebrities and the salacious issues in that litigation led to a sudden interest in litigation finance outside the legal world. Since then, an influx of capital, some of which is controlled by publicly traded entities, has contributed to increased public awareness. Additionally, a number of court decisions have directly addressed litigation finance, prompting wide discussion in the legal community.

What Have Courts Said About Litigation Finance So Far?

Without question, litigation finance is an area of the law that lacks cohesion and in which judicial opinion is constantly evolving. Still, a number of decisions and trends are noteworthy. These cover such general topics as whether funding sources must be disclosed, what degree of participation by funding sources is appropriate and permissible, and whether litigation finance should be considered a type of loan.

Most jurisdictions have no rule requiring automatic disclosure of litigation finance sources specifically, although many federal courts have included litigation finance sources as entities with a financial interest in the outcome of a matter under local versions of Fed. R. Civ. P. 26.1. Some jurisdictions have already enacted, or have at least drafted, rules directly addressing this requirement, including the U.S. District Court for the Northern District of California by rule and Wisconsin by statute.

The 2018 agenda of the federal Advisory Committee on Rules of Civil Procedure includes potential modifications to Rule 26 that would explicitly require disclosure of litigation finance arrangements. However, that committee previously considered this issue twice and took no action.

The U.S. Senate is also currently examining a bill titled the Litigation Funding Transparency Act of 2018, which would require disclosure of any funding sources backing class action and multidistrict litigation in federal courts. This bill is in the very early stages, but both courts and the Advisory Committee have been historically reluctant to pass rules concerning a topic when a legislative solution seems imminent, so even its introduction alone may have an impact.

On May 7, 2018, Judge Polster of the U.S. District Court for the Northern District of Ohio issued an order in the multidistrict opioid litigation requiring any attorney that obtained litigation finance to submit their contracts for an in camera review; to submit a letter describing the nature of the agreement to the court; and to submit a sworn affidavit from both counsel and the source of financing stating that the arrangement does not create any conflict of interest, impact the decision-making process of the attorney, or give the source of funding any control over strategy or any settlement. This approach to disclosure was generally praised by litigation finance companies as balanced. The prominence of the opioid litigation, and the fact that multidistrict litigation is a common area in which litigation finance is employed, may lead other courts to adopt Judge Polster’s approach.

Courts have shown a bit more consistency in how they have viewed the underlying finance agreements. These agreements almost universally contain confidentiality provisions and arbitration clauses to ensure that there is no breach of confidentiality. Some reported decisions, however, have generally upheld such funding agreements going back to at least 2010 in Lynx Strategies LLC v. 
Ferreira, 957 N.Y.S.2d 636 (N.Y. Sup. Ct. 2010). Almost all courts that have addressed disputes have upheld litigation finance agreements under general contract principles.

Courts have also thus far generally agreed with the parties’ characterizations of the agreements as something other than loans. This is particularly important because the effective interest rates under litigation finance contracts would frequently run afoul of state usury laws, as the non-recourse nature of the financial transaction creates risk that is built in to the repayment structure.

Several courts have cited the non-recourse nature of litigation finance to differentiate it from a loan. Some courts have described the deals as a purchases and/or assignments of anticipated proceeds, while others have described them as investments, depending on the structure of the underlying transaction. Still, there have been instances in which a court treated even a non-recourse agreement as a loan when recovery was certain, and then held the effective interest rate to be usurious, such as in Echeverria v. Estate of Lindner, 2005 NY Slip Op 50675(u), at *4-5 (N.Y. Sup. Ct. 2005).

Other jurisdictions, including North Carolina and Colorado, have also at times held that litigation finance agreements were loans, when prevailing parties—who were facing effective interest rates on the advanced capital of 40 percent and above—raised usury as a reason to invalidate the agreements. At present, however, the majority of jurisdictions that have addressed the usury question seem to not consider non-recourse financial transactions as loans.

Are There Any Relevant Ethical Considerations?

The ethics issues most commonly associated with litigation finance are potential conflicts of interest, privilege issues, and fee sharing. Lawyers likely have a strong interest in obtaining a funding source to ensure their fees are paid, but to the extent a lawyer recommends litigation finance to a client, that lawyer must consider whether the transaction serves their client’s best interests. As noted above, effective interest rates can be drastically higher than in other financial transactions.

If the lawyer’s interest in getting paid is potentially in conflict with the client’s desire to not pay huge interest rates, the lawyer would need the client’s informed consent. This might entail the client having independent counsel to advise on the finance agreement. And while the non-recourse nature of the transaction might supply ample justification, lawyers must be extremely cautious in how involved they become with the decision to seek funding and what guidance they provide to clients considering litigation finance.

Additionally, lawyers must be cautious not to allow the funding source affect settlement negotiations. This seems to be the primary concern of courts that have insisted on disclosure of litigation finance agreements. A funding source is not a party to the litigation and therefore must not be seen as having any influence on strategy, lest a perceived conflict of interest arise.

On a similar note, while some courts have afforded privilege or work product protections to the financial transactions themselves, lawyers must be cautious not to share privileged information with a non-party funding source. Sharing privileged information even with a funding source might well constitute a waiver of privilege that could adversely affect clients.

Lastly, every jurisdiction’s rules of professional conduct prohibit sharing a fee with a nonlawyer, and litigation finance carries the potential to run afoul of this prohibition under certain circumstances. It has become increasingly common for litigation finance to directly fund a portfolio of cases managed by a law firm. To the extent that a firm’s repayment obligations are contingent on the receipt of legal fees, that funding arrangement might be considered fee-splitting with a nonlawyer.

In fact, New York City Formal Ethics Op. 2018-5 (July 30, 2018) said that exactly such an arrangement would be ethically prohibited. While this opinion is advisory, the rationale underlying the decision may be influential as a direct-to-lawyer funding model becomes more common.

Conclusion

The continuing influx of capital all but ensures that litigation finance will continue to grow in relevance. Businesses that engage in litigation and commercial litigators would do well to keep abreast of developments in this arena, as it could help clients mitigate their risk while simultaneously ensuring lawyers are compensated for their work. Employing litigation finance effectively, however, requires navigating the ethical ramifications and relevant local rules. Only an informed lawyer can identify the appropriateness of outside funding.