Third-party litigation funding or profiteering?

On Thursday, 29 March 2012, Cornell Law School Professor of Law Brad Wendel presented the following discussion paper on third party litigation funding as part of the University of Otago’s “Thinking Outside the (Lunch) Box Seminar”

“Man’s mind stretched to a new idea never goes back to its original dimensions.”
Oliver Wendell Holmes Jr

Imagine the following scenario: Joe Bloggs, a 43-year-old construction worker, is injured in an auto accident. He is unable to work because of his injuries, and while the prognosis is good for an eventual recovery, he has no source of income at the present time. He has no health insurance and is facing mounting bills for medical treatment and physical therapy. His expenses quickly deplete his family’s limited savings and he is having trouble coming up with enough money to pay the monthly rent; therefore, he faces the very real prospect of being evicted from his apartment, where he lives with his girlfriend and their two children. Bloggs has a lawsuit pending against the driver of the other automobile, but the docket of the state court in which his claim is pending is overcrowded and slow. His lawyer has said that his best case scenario is to begin trial in 18 months. The defendant’s lawyer (paid for by the defendant’s liability insurer) is familiar with the court and is in no hurry to talk about settlement, knowing that increasing financial pressure is likely to motivate the plaintiff to accept a lower amount to settle the claim.

One day, Bloggs is watching late-night TV and sees an ad for a company called LawCash. LawCash purchases lawsuits. Let’s say the plaintiff’s case (according to an experienced lawyer) is “worth” $75,000. That is, in that state court system, given the facts of the case and the nature of the plaintiff’s injuries, the mean damages award or settlement is $75,000. LawCash and similar companies offer to purchase all or a portion of a claim asserted in the lawsuit for a heavily discounted amount, relative to their reasonable settlement value. In this case, LawCash might offer to purchase Bloggs’s case for $15,000. In exchange, Bloggs agrees to continue to maintain the lawsuit and to repay a certain amount out of the proceeds of any resulting judgment or settlement. The amount owed to the funding company is usually calculated using a multiplier of the investment amount, and the multiplier usually increases steeply over time. The funder’s right to repayment is usually subordinated to the lawyer’s fee, but takes priority over the plaintiff’s right to receive a share of the proceeds. If the plaintiff recovers nothing, the funding company does not have recourse against the plaintiff’s personal assets; the funder simply writes off the investment.

Unfortunately for Bloggs, money has a time value. Receiving $75,000 after being evicted from his apartment and forced to file bankruptcy is almost no better than receiving nothing at all. However, receiving $15,000 today would be extremely valuable for Bloggs. He could pay his rent and medical bills until he has recovered from his injuries and can go back to work. Then he will be able to play the defendant’s waiting game and hold out for trial, or at least a fair settlement. The defendant will be required to pay the full cost of Bloggs’s injury, contributing to the deterrent function of the tort system. Assuming full disclosure and competent, adult parties on all sides, this transaction seems like a win-win.

Of course, this precise scenario could not occur in New Zealand because of ACC, and in sensible, humane countries with publicly funded health care, the plaintiff would not become destitute on account of medical expenses. Although the problem may be idiosyncratically American in its details, the problem it illustrates is a general one: someone may have a valid legal claim, but lack the financial resources to pursue it. Defendants can exploit this disparity in funding to prolong litigation in order to “starve out” the plaintiff. Contingency fee financing (in the US) and legal aid funding (in the UK and elsewhere) mitigates this problem to some extent, but there remain systemic asymmetries between claimants and defendants in many areas of the civil justice system.

If you like, change the facts of the hypothetical around so that Joe Bloggs is the inventor of a valuable piece of technology who has obtained a patent on it. A large, lavishly funded company is infringing his patent, but Bloggs lacks the financial wherewithal to maintain an infringement action against a company for whom $1,000,000 in defence costs is a drop in the bucket of its annual budget for legal services. This version of the hypothetical could arise in New Zealand and could present a problem if people in Bloggs’s situation were generally unable to afford to hire a lawyer to protect their rights.

So why not permit companies like LawCash to purchase lawsuits and bring them as the real party in interest? The defendant is no worse off, relative to the baseline scenario of an adequately funded plaintiff. (As a matter of justice, why should the defendant get a windfall if the plaintiff is impecunious?) Assuming Joe Bloggs is a competent adult, he has decided that a certain sum of $15,000 in the present is worth more than the prospect of a $75,000 recovery at some indeterminate time in the future.

And LawCash is able to diversify the risk of uncertainty that a litigant would otherwise face, by holding a portfolio of investments in numerous different types of cases, in different jurisdictions, against different defendants. Because this portfolio is diversified, LawCash is predicted to have superior access to capital, as compared with any individual plaintiff. Thus, the cost of bringing a lawsuit will be lower, and access to justice will be enhanced. If there is no need for litigation funding, the industry will not exist in any given country. The fact that funding companies have sprung up in Australia, the United Kingdom, and the United States suggests there is an unmet need for access to justice in these countries, as a result of cuts to state-supported legal aid.

The UK and Australia have broadly permitted outside investors to acquire an interest in the cause of action being pursued by a party in a litigated matter.

The High Court of Australia, in the Fostif case (Campbells Cash and Carry Pty Limited v Fostif Pty Ltd [2006] HCA 41), even permitted an outside investor to exercise considerable control over the conduct of litigation, including the selection of counsel and the decision whether to settle. While an American court would probably not go as far as Fostif, many US states have cautiously begun to rollback the old common law doctrines of champerty and maintenance, which previously had prohibited third-party investments in litigation. (In general terms, maintenance is the provision of assistance to a party in litigation, by someone without a pre-existing interest in the subject matter of the lawsuit. Judicial decisions have sometimes narrowed the category of maintenance to “officious intermeddling” in a lawsuit, to exclude help (including financial assistance) provided by family members and friends. Champerty is simply maintenance in which the third party acquires an interest in the subject matter of the lawsuit.)

Something like the LawCash/Bloggs transaction would now be legal in around half of American jurisdictions. Lawyers remain extremely cautious of third-party litigation funding, however, believing (with some justification) that it creates conflicts of interest and threatens their ability to exercise independent professional judgement on behalf of their clients. (I recently served as co-reporter to a working group of the American Bar Association’s Ethics 20/20 Commission, and prepared a lengthy analytical paper on the effect of third-party financing on a lawyer’s ethical obligations.)

Nevertheless, with careful planning, disclosure of potential conflicts to clients, and informed consent, almost all of the substantive ethical issues presented by third-party financing can be dealt with, in a way that does not threaten the fiduciary nature of the lawyer-client relationship.

At least in the US, the trend toward liberalising investment in litigation has been met with determined opposition, mostly from business groups such as the Chamber of Commerce. The Chamber’s argument is that permitting outside investors to acquire an interest in a plaintiff’s claim will lead to an increase in frivolous litigation. Proponents of third-party finance respond that outside investors have no financial incentive to acquire an interest in losing claims, as their investments are without recourse in the event that the claim is dismissed or the plaintiff loses at trial. (Critics of the Chamber suspect that business groups are really opposed to all litigation, whether frivolous or meritorious, and are merely engaging in rent-seeking behaviour through the political process by resisting third-party litigation financing.) In addition to this empirical debate about the effect of third-party financing on the litigation system, there is another debate about whether there is something conceptually wrong with permitting non-parties to own an interest in a claim. Critics of third-party litigation finance argue that the civil justice system is supposed to be a forum for resolving disputes between two or more parties who have some kind of voluntary or involuntary relationship with one another. Allowing strangers to own shares of causes of action threatens to commoditise the parties’ legal rights and obligations, turning them into just another category of assets which can be bought and sold freely.

The issue
My radical proposal is to accept the conclusion of the critical conceptual argument, but to deny that it is a bad thing that lawsuits be freely alienable. Objections to third-party litigation finance are either strategic (like the Chamber of Commerce’s fairly transparent attempt to handicap the plaintiff’s bar) or sincere but the result of misplaced traditionalism and nostalgia. In an idealised picture, a lawsuit involves only the two parties and their counsel. This archetype is actually somewhat atypical, and many features of contemporary litigation, which are taken for granted as acceptable, are in substance difficult to distinguish from third-party financing.

The most obvious example is liability insurance. Critics object to a plaintiff selling a share of a claim to a financing company, but have no problem with a defendant exercising a contractual right to shift liability to an entity which is a stranger, in some sense, to the underlying lawsuit. (After-the-event insurance, available in the UK as a hedge against the possibility of a costs judgment, even permits these contracts to be entered into after the commencement of a lawsuit.) Critics also generally do not object to the assignment of the proceeds of a lawsuit, or the exercise of a lien or right of subrogation against the funds received by a plaintiff in litigation. Medical insurers, for example, commonly exercise contractual and common law subrogation rights against plaintiffs’ judgments and settlements. Although, at least for the time being, this is an idiosyncrasy of the American litigation system, plaintiffs’ lawyers in the US effectively invest in their clients’ cases by working on a contingency fee basis. In short, the free alienability of causes of action is an established fact of life in the Anglo-American legal tradition, so why the opposition to third-party litigation financing?

The concerns
When asked what is wrong with third-party litigation financing, critics often respond that litigation involves a relationship between the plaintiff and defendant, with both sides advised by counsel. It is not clear how liability insurance should fit into this picture and, in fact, in the early stages of development of third-party liability insurance, some courts objected that it would inject the interests of a stranger into traditional litigation. Of course, the legal system eventually made its peace with liability insurance, because it serves the valuable social end of risk-pooling, making many activities more affordable.

Mitigating the problems created by the presence of ‘stranger’ parties in litigation became the task of insurance law, which responded by creating duties of good faith on the part of insurers, owed to their insureds, in the conduct of litigation. Insurers now have duties to accept reasonable settlement offers, for example, to avoid exposing their insureds to judgments in excess of policy limits. In the US, there was similar resistance to the development of the contingent fee, with critics objecting that it interposed the lawyer’s own financial interests into the traditional plaintiff v defendant structure of litigation. Conflicts of interest between lawyers and clients remain endemic in contingent fee representation, but, again, the legal system has chosen to regulate contingent fees rather than banning them outright. (Interestingly, the rules of professional conduct for lawyers in the US contain several prohibitions on champerty and maintenance which, by their express terms, would prohibit contingent fees. See, for example, Model Rule 1.8(e)(i) (prohibiting, respectively, providing financial assistance to a client and acquiring a proprietary interest in the subject matter of representation). The response of the drafters of the rules was to create exceptions stating that the prohibitions did not apply to contingent fees, which are identical in substance to the prohibited transactions.)

Any concerns about the effect of third-party litigation finance on the interests of claimants (or other recipients of funding) could similarly be addressed by sensible, targeted regulation rather than outright prohibition.

The concerns about third-party financers being ‘strangers’ to litigation may be recast in a way that makes it more understandable, and links it with other developments that have caused alarm among some sectors of the legal profession. The claim that litigation funders are ‘profiteering’ from their involvement in lawsuits is substantively similar to the familiar lament that the practice of law has transformed from a profession to a business. (Similar anxiety exists in most common law systems regarding contingent fees, which are prohibited outside the US. The UK has somewhat reluctantly permitted conditional fees, which are thought to further the ends of access to justice and aligning the interests of the lawyer and client, without creating the same potential windfalls which anger many critics of American-style contingent fees.)

In other words, an occupation that formerly was animated by an ideal of public service has become just another way of making a buck. My response is admittedly influenced by my perspective as a law teacher and former practising lawyer in the US: The ship of ‘professionalism’ has sailed a long time ago. The profession of barrister in England and Wales has traditionally been open only to those young men who had sufficient independent means of support to sustain themselves during a long period of unremunerated training. It is therefore plausible to characterise British barristers as motivated more by the desire to serve clients than to earn a living. (The situation has been somewhat different for solicitors, but the real normative heart of the English legal profession seems to me to centre on the bar.) In the US, by contrast, the legal profession has been seen since Colonial times as a route into the middle class for the children of farmers and urban workers. Public service has always been an important ideal, but it was never thought to entail a principle of economic self-abnegation. From what I have been able to gather, that is also the case in New Zealand and Australia. Thus, there is less antipathy outside of the UK for the idea of earning one’s living as a lawyer.

Conclusion
It is one thing to earn a living, and quite another to seek to earn obscene profits. It may be the case that greed and the pursuit of astronomical salaries has distorted the ethics of the legal profession. Anthony Kronman makes that argument in The Lost Lawyer: failing ideals of the legal profession (Harvard University Press, 1995), with reference to large, elite law firms in major cities. One also might observe that less elite practitioners, including the plaintiffs’ personal-injury bar, are just as susceptible to corruption by the unrestrained pursuit of wealth. (Recent scandals such as the disbarment of mass tort lawyer Stanley Chesley for stealing client funds show that it is not only large corporate firms who can be accused of avarice.) But surely the response to the excessive concern with profits should be to seek a balance between earning a reasonable living and contributing to the public welfare. Here, too, the American profession has long since deviated from the pure ideal of public service. American lawyers believe they are serving the public interest indirectly. The dominant ideology of the profession can be summarised with the slogan “zealous advocacy within the bounds of the law”. That is, lawyers should represent the interests of their own clients with vigour and diligence, and not be concerned about the interests of opposing parties or society as a whole. The mechanism of the adversary system works as a kind of invisible hand of justice, ensuring that the public interest benefits in the long run. Individual lawyers, however, have no obligation to aim directly at serving the public interest. In fact, excessive concern for the public interest can lead to charges that lawyers are neglecting the fiduciary dimension of their ethical obligations. Lawyers are supposed to be loyal and competent representatives of individual clients, not quasi-judges who seek to do what is best for the public as a whole.

Service ideals thus coexist with a highly individualistic conception of legal ethics.

The resolution of this tension, at least in the US, has generally been institutional and procedural. Lawyers are ethically obligated to look after their clients, while courts, legislatures, administrative agencies, and other public institutions look after the interests of society. Lawyers work within a public-regarding system, but are not themselves required to act directly in a public-regarding way. I see no reason why an appropriately regulated litigation financing industry cannot further the social interest in access to justice, while leaving lawyers in the same fiduciary role vis-à-vis their clients.

Professor of Law at Cornell University, Ithaca, New York, Brad Wendel is a leading legal ethicist and the author of The Law Governing Lawyers (Wolters Kluwer/Aspen, 2005), Professional Responsibility (Wolters Kluwer/Aspen, 2010), and Lawyers and Fidelity to Law (Princeton University Press, 2010). He is also co-author of the leading American text on lawyer’s professional responsibility, The Law and Ethics of Lawyering (Foundation Press, 2010), and was involved in the vigorous debate in the United States over the ethics of interrogation used at Guantanamo Bay. Brad Wendel joined the Cornell faculty in 2004, after teaching at Washington and Lee Law School from 1999-2004. Before entering graduate school and law teaching, he was a product liability litigator at Bogle & Gates in Seattle and a law clerk for Judge Andrew J Kleinfeld on the US Court of Appeals for the Ninth Circuit. His teaching interests are in the regulation of the legal profession and torts, and his research focuses on the application of moral and political philosophy to problems of legal ethics.

Further reading
I apologise for the predominance of American sources here, but many of them contain extensive references to the litigation funding industry and relevant legal regulations in Australia and the UK.

Academic articles:
Elizabeth Chamblee Burch, “Financers as Monitors in Aggregate Litigation,” NYU Law Review (forthcoming), available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1968961.

Steven Garber, “Alternative Litigation Financing in the United States: Issues, Knowns, and Unknowns”, RAND Corporation Occasional Paper (2010).

Susan Lorde Martin, “Litigation Financing: Another Subprime Industry That Has a Place in the United States Market”, 53 Villanova Law Review 83 (2008).

Jonathan T Molot, “Litigation Finance: A Market Solution to a Procedural Problem”, 99 Georgetown Law Journal 65 (2010).

Anthony J Sebok, “The Inauthentic Claim”, 64 Vanderbilt Law Review 61 (2011).

Other sources:
Finn Brooke and Andreas Heuser, “Litigation Funding: Two Perspectives – the funder
and the lawyer”, issue 180, NZLawyer, 23 March 2012, pp.24-26. Also available at:
http://www.nzlawyermagazine.co.nz/CurrentIssue/Issue180/180F5/tabid/4120/Default.aspx.

Roger Parloff, “Have You Got a Piece of This Lawsuit?”, Forbes, 28 June 2011.

Christopher Hodges, John Peysner and Angus Nurse, Litigation Funding: Status and Issues (Centre for Socio-Legal Studies, Oxford and Lincoln Law School, January 2012), available at: http://www.csls.ox.ac.uk/documents/ReportonLitigationFunding.pdf.

Lord Justice Jackson, Review of Civil Litigation Costs: Final Report (December 2009), available at: http://www.judiciary.gov.uk/publications-and-reports/review-of-civil-litigation-costs/reports/civil-litigation-costs-review-final-report.

NZLawyer extra, edition 46, 30 March 2012