The litigation finance contract.

• Author: Steinitz, Maya
• Position: II. The Economics of Litigation Finance C. Information Asymmetry and Agency Costs though Conclusion, with footnotes, p. 488-518

3. Information Asymmetry and Agency Costs

   Venture capitalists face extreme information asymmetry because the entrepreneurs have all the information about the invention. In particular, the fact that the company's technology often involves cutting-edge science creates substantial information asymmetries in favor of the entrepreneur, a specialist in said science, over the venture capitalist. Information asymmetries between investors and entrepreneurs are further expanded due to the fact that the intentions and abilities of the entrepreneurs are hard to observe and assess. (141)

   Litigation financiers face similar asymmetries, because the plaintiffs have private knowledge of the facts, including knowledge of potentially key facts, harmful "smoking gun" documents, potentially harmful or weak witnesses, and the like. (142) Current ethical rules act to reinforce plaintiffs' disincentive to share that private knowledge with anyone other than their attorneys by withholding privilege from communications to nonattorney parties. (143)

   The plaintiff's intentions and abilities are as hard to observe as those of an entrepreneur. For example, a plaintiff's willingness or capacity to cooperate effectively with counsel--for instance, by timely producing documents, or by ensuring that witnesses make themselves available for deposition--are unknown to the funder. Whether and to what degree the plaintiff is susceptible to "litigation fatigue" caused by the emotional stress of litigation, or is an effective witness, are similarly unknown. These information asymmetries are compounded by the deliberate information asymmetries that result from the attorney-client privilege, discussed above.

   Venture capitalists face extreme agency costs because the success of the venture depends on the efforts of the entrepreneurs, who have been compensated up front. (144) The importance of future managerial decisions in the early stage venture creates agency costs that are amplified by the fact that an entrepreneur's interest in the venture, which is now backed by VC, is appropriately understood--in the same manner as litigation--as an option. (145) Therefore, the entrepreneur is now in a conflict of interest vis-a-vis the VC investors with respect to such issues as the desirable level of risk and the investment duration. (146) The entrepreneur will now be inclined to assume more risk and hold the investment longer than she would have had the venture been self-financed. The venture capitalist, by contrast, will be incentivized to liquidate the investment as early as possible. (147) This latter agency problem has been referred to as "grandstanding" or the "early harvesting" problem. (148)

   The early harvesting problem in the VC context is identical to the early settlement problem--one of the most commonly cited concerns of both proponents and opponents of litigation funding. (149) Here, the concern is that funders are incentivized to settle early for a discounted but secure amount rather than proceed to a costly trial that may result in a loss or low recovery. They are also incentivized to underinvest in the litigation because they face diminishing returns the longer the litigation proceeds. (150) And the plaintiff, who no longer bears the risk of a loss, may now have an incentive to resist a reasonable and rational early settlement in favor of a late settlement or even a risky and expensive trial. (151) Litigation financiers also face extreme agency costs because success depends on plaintiffs' cooperation in the prosecution of the case after they have transferred the risk--litigation costs--and a large portion of the rewards--a significant percentage of the recovery. (152) This particular agency problem, or moral hazard, is well known from the insurance context in which insurers take on the burden of litigation but require, via contractual obligations, the cooperation of the insured. (153)

4. Legal Claims as Assets and Extreme Uncertainty

   Ventures backed by VC are characterized by great uncertainty and high failure risk and are therefore typically not financed by banks. (154) The general uncertainty inherent in financing is magnified in the VC context because the portfolio company is at an early stage and most of the important decisions bearing on the portfolio company's success remain to be made. The quality of the company's management has yet to be ascertained and investors do not have certainty regarding the technological soundness or science underlying the venture's business. (155) Further, one of the key risks associated with a VC portfolio company's investment returns is their variability. (156) Research has shown that while a small number of VC investments yield a very high return many more result in partial or complete loss. For these reasons, VC returns have been likened to options--both are characterized by a very small chance of a very large payout. (157)

   Litigation funding has a similar degree of extreme uncertainty as does VC. In the case of litigation funding, the litigation is usually at an early stage and discovery of facts is preliminary at best. Furthermore, when the subject matter of the litigation requires specialized know-how--for example, in intellectual property cases, which can be technology-centered, or in antitrust cases, which can involve advanced economic theory--or when the case involves new legal frontiers where doctrine and precedent are undeveloped--such as in cross-border human rights and mass tort cases (158)--subject matter uncertainty can increase overall uncertainty in the same manner that scientific uncertainty operates in the VC context.

   The client's and the attorney's control over the litigation create further uncertainty for the financier. The attorney's influence over the litigation, as discussed below, (159) is not dissimilar to management's influence over a portfolio company. In other words, the quality of the attorney's decision making, a relative or complete unknown to the funder, contributes to the uncertainty, especially when the attorney has been retained prior to the funder's involvement and without the funder's input. (160)

   But the most significant source of uncertainty for litigation funding is the nature of litigation itself. According to a new body of literature that applies financial theory to law, litigation should be analyzed as an option, because during the course of a case each party has an option to settle or select trial. This choice suggests the application of an option pricing model to legal valuation: "The case assessment of a civil action follows a random walk like that of a stock. The up-down movement of probability (expectations [of the parties]) is a function of information dissemination." (161)

   Similarly, according to financial theorists of law, legal probability is not statistical or objective. It is logical and subjective, changing over the lifetime of a litigation as facts unfold. Thus, while the law and economics literature models probability as an empirical and quantifiable concept, when mathematicians considered the application of probability to legal action they rejected the notion that statistical probability could apply or that such probability was measurable. (162)

   Further, while classical economic theory of law assumes that decision standards of deliberative bodies--such as courts and arbitral tribunals--are a fixed point of reference, both financial theorists and behavioral economists of law argue, and show, that the assumption that these bodies apply consistent standards in similar disputes is unrealistic. This is because judicial proceedings are not predictable and because the ability of parties and their lawyers to predict such outcomes are inherently, and deeply, flawed. (163)

   In particular, behavioral economic analysis of the law literature, which emerged in the late 1990s and the 2000s and has focused in no small part on litigation, shows that litigation behavior can be expressed in terms of three important "bounds" on human behavior: bounded rationality, willpower, and self-interest. (164) Each of the three bounds has a documented effect on the ability to generate sound predictions of the litigation process. (165)

   For example, parties, lawyers, judges, and juries operate based on heuristics and biases, creating uncertainty as to a dispute's outcome. Further, empirical evidence reveals that litigants are not optimal processors of information. Consequently, parties' assessments of the likely outcome of the litigation diverge, rather than converge, as more facts are disclosed--usually, through the discovery regime. (166) It turns out that in reality shared information is likely to be interpreted egocentrically by disputants. (167) Parties tend to "either be overoptimistic in the assessments of cases or construe the fairness of the situation in a self-serving fashion." (168) Self-serving inferences and the sunk costs bias have been shown to explain why certain procedural mechanisms designed to cause more upfront information sharing and evaluation, "like liberalized summary judgment ... standards and mandatory disclosures ... may not have the desired pro-settlement effects" intended. (169)

   Several studies have demonstrated that even experienced litigators are not good predictors of claim value. "The results are consistent: lawyers, insurance adjusters, and judges all err by very substantial amounts when asked to estimate either the settlement value or predicted trial outcomes." (170) Empirical research shows that lawyers tend to be generally overconfident, and especially so in cases in which they initially made highly confident predictions. (171)

   Additionally, most lawyers are not experienced trial lawyers since the vast majority of cases settle. (172) They therefore do not have the required experience that would, perhaps, have afforded them the ability to soundly assess the likelihood of how a judge or a jury would decide. The rarity of trials also...