The litigation finance contract.

• Author: Steinitz, Maya
• Position: Introduction to II. The Economics of Litigation Finance B. Ethical Bounds to Third-Party Profit Making in Litigation, p. 455-488

ABSTRACT

Litigation funding--for-profit, nonrecourse funding of a litigation by a nonparty--is a new and rapidly developing industry. It has been described as one of the '79iggest and most influential trends in civil justice" today by RAND, the New York Times, and others. Despite the importance and growth of the industry, there is a complete absence of information about or discussion of litigation finance contracting, even though all the promises and pitfalls of litigation funding stem from the relationships those contracts establish and organize. Further, the literature and case law pertaining to litigation funding have evolved from an analogy between litigation funding and contingency fees. Much of that literature and case law views both forms of dispute financing as ethically compromising exceptions to the champerty doctrine. On that view, such exceptions create the risks of an undesirable loss of client control over the case, of compromising a lawyer's independent judgment, and of potential conflicts of interest between funders, lawyers, and clients.

This Article breaks away from the contingency analogy and instead posits an analogy to venture capital (VC). It shows the striking resemblance of the economics of litigation funding with the well-understood economics of VC. Both are characterized by extreme (1) uncertainty, (2) information asymmetry, and (3) agency costs. After detailing the similarities and differences between these two types of financing, this Article discusses which contractual arrangements developed in the area of venture capitalism can be directly applied to litigation finance, which ones need to be adapted, and how such adaptation can be achieved. As much of the theory, doctrine, and practice of VC contracting can be applied or adapted to litigation finance, practitioners and scholars can be spared decades of trial and error in developing standardized contractual patterns.

In addition, the analogy turns most of the conventional wisdom in the field on its head. This Article argues that funders should be viewed as real parties in interest, funders should obtain control over a funded litigation, and attorneys should take funders' input into account. In return, funders should pay plaintiffs a premium for the control they receive, subject themselves to a compensation scheme that aligns their interests with those of the plaintiffs, and enhance the value of claims by providing noncash contributions. Indeed, on the suggested view, noncash contribution--as much as if not more than, capital contribution--should be seen as a key benefit of litigation finance. Courts and regulators should devise rules that enhance the transparency of the industry--in particular the performance outcomes of various litigation funding firms and their ethical propensities. Such a legal regime will foster the emergence of a reputation market that will police the industry and support contractual arrangements.

TABLE OF CONTENTS INTRODUCTION I. A CASE STUDY: BURFORD'S INVESTMENT IN THE CHEVRON/ECUADOR DISPUTE A. Background: The Chevron/Ecuador Dispute B. The Investment Structure C. The Distribution of Control Between Burford and the Ecuadorian Claimants D. Staged Financing and Right of First Refusal E. Information Sharing, Duty to Cooperate, and Common Purpose F. Negative Covenants, Representations, and Warranties G. Operational Efficiencies II. THE ECONOMICS OF LITIGATION FINANCE A. The Litigation Finance-Venture Capital Analogy in a Nutshell B. Ethical Bounds to Third-Party Profit Making in Litigation C. Information Asymmetry and Agency Costs D. Legal Claims as Assets and Extreme Uncertainty III. VENTURE CAPITAL'S LESSONS LEARNED: CONTROLLING EXTREME UNCERTAINTY, INFORMATION ASYMMETRY, AND AGENCY COSTS THROUGH ORGANIZATIONAL AND CONTRACTUAL ARRANGEMENTS A. Recommended Organizational Structure 1. Limited Partnerships and Syndication 2. Compensation 3. Noncash Contribution B. Recommended Contractual Structure 1. The Litigation Finance Fund-Investor Contract a. Control and Compensation b. Mandatory Distributions and Liquidation 2. The Litigation Finance Fund-Plaintiff Contract a. Staged Financing b. Role in Management c. Negative Covenants d. Highly Incentivized Compensation, Exit, and Reputation 3. The Attorney Retention Agreement CONCLUSION INTRODUCTION

Litigation finance--for-profit, nonrecourse funding of a litigation by a nonparty--is a new and rapidly developing industry globally, and in the United States in particular. (1) So much so, that the RAND Institute for Civil Justice has dubbed it one of the "biggest and most influential trends in civil justice," (2) and the New York Times has recently reported on it at length on its front page and in its "Betting on Justice" series. (3) More generally, litigation funding in all of its forms--law lending, contingency fees, and nonrecourse funding--is pivotal for understanding civil litigation as a whole: "[T]he most ... important phenomena of modern litigation are best understood as results of changes in the financing and capitalization of the bar." (4) For example, in the United States a market in bankruptcy claims emerged some twenty years ago and "nothing has changed the face of bankruptcy in the last decade as much as the new-found liquidity in claims." (5) Due to litigation funding's increasing salience, courts, legislatures, regulators, and academics have all, as of late, started grappling with the phenomenon head on. (6)

Litigation funding is largely understood as composed of two subindustries. One is usually referred to as "consumer funding"--the funding of relatively small personal claims, predominantly personal injury and divorce cases. (7) This subindustry has a somewhat longer history in the United States, going back approximately fifteen years, to what has in the past been called "law lending." The second, newer subindustry is "commercial funding." This industry relates to the funding of business disputes, such as disputes relating to intellectual property, antitrust, business contracts, and international commercial and investment arbitration--brought by sophisticated parties and involving larger stakes. (8) This Article focuses exclusively on commercial funding. (9) Specialized investment firms dedicated exclusively to litigation funding have pioneered it in the United States. However, in addition, what started as a trickle of investments by hedge funds--not specializing in litigation but rather investing opportunistically--has recently turned into a flood. (10)

But this growing industry is shrouded in secrecy (11) and, to make matters more complicated, its funding structures are "as various as snowflakes." (12) Commentators have identified a variety of possible investment structures. These include recourse and nonrecourse loans, which can be either secured or nonsecured. (13) Investments may take the form of a purchase, an assignment of a claim, or even the sale of an interest in the judgment. (14) These, in turn, may be directly or indirectly syndicated. (15) Funders may form joint ventures with other funders; law firms may cofinance with other law firms using cocounseling agreements; and insurance companies may offer litigation insurance products. Other forms of indirect investments in legal claims, which are beyond the scope of this Article, include law firm loans offered by banks and equity investment in law firms. (16)

One litigation funding firm has disclosed its investment structures to its investors in the following terms:

The Company intends to make use of a wide variety of investment structures.... 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 judgment 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. (17)

Even within the paradigmatic investment structure of the first bullet above, which is modeled on the contingency fee, variations abound. (18) How parties choose to structure their litigation funding agreements depends on a variety of factors such as: (1) the type of investor--ad hoc institutional investors, such as a hedge fund or bank, or specialized institutional investors, either private or public; (2) the investor's needs; (3) regulatory or ethical restrictions; and (4) tax considerations. (19)

Despite the increasing importance and growth of the industry, there is a complete absence of either information about or discussion of litigation funding contracting--both its theory and its practice. (20) Further study of litigation funding agreements is badly needed. To state the obvious, the litigation funding contract is the foundation and framework of the funding relationship. The absence of any guidance on how to contract for litigation funding significantly raises the transaction costs of such funding because parties must start from scratch when entering a litigation funding agreement. (21) This void also creates an uneven playing field for unsophisticated clients who cannot afford to negotiate a form contract presented by an experienced funder. In other words, there is both an efficiency-based and justice-based need for academic discussion of the litigation finance contract, both of which this Article seeks to address. Additionally, the void leads to a public policy discourse based, at least partially, on ignorance of how...