Tilted Scales of Justice? the Consequences of Third-party Financing of American Litigation

• Publication year: 2013

Tilted Scales of Justice? The Consequences of Third-Party Financing of American Litigation

Joshua G. Richey

TILTED SCALES OF JUSTICE? THE CONSEQUENCES OF THIRD-PARTY FINANCING OF AMERICAN LITIGATION

Abstract

Third-party financing of commercial litigation is a relatively new phenomenon in the United States. Recently, there has been a substantial increase in the amount of money that third parties have invested in commercial lawsuits. Many new investment management groups have been formed in cities such as New York, London, and Sydney looking to finance the endless stream of American litigation. These groups are for-profit entities that fund all or a portion of a plaintiff's legal fees in exchange for a share of any recovery that might result from the underlying lawsuit. The third-party litigation funders, as they are often called, put their "skin in the game " by risking the loss of their investment if the underlying claim is unsuccessful. The calculated risk these third-party litigation funders take has systematically resulted in astronomical returns for the companies and their investors.

In the process of seeking these astronomical returns, third-party litigation funders are causing a disparate impact on the American legal system by tipping the scales of justice in favor of plaintiffs at the expense of defendants. Supporters of third-party litigation financing in the legal community argue that, by allowing plaintiffs to seek outside financial support, barriers to justice are reduced because the funding enables cash-strapped plaintiffs to have their day in court. However, in reality, third-party litigation funders have little incentive to fund plaintiffs facing substantial barriers to justice. Third-party litigation funders invest in cases where the risk is the lowest and the possible return is the highest. Using the law to their favor, third-party litigation funders invest in cases where the underlying law giving rise to the plaintiff's claim already gives substantial advantages to plaintiffs in the form of low evidentiary thresholds and large statutory damage awards. Third-party litigation financing only magnifies these advantages by allowing plaintiffs to offload risk, increasing the number of cases adjudicated in the courts and raising the threshold amount required for plaintiffs to settle a case because of third-party funders' return requirements. Overall, third-party litigation financing threatens the compensatory and deterrent functions of the legal system while increasing inefficiency in the process.

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This Comment addresses third-party litigation financing's threat to the legal system by proposing three possible solutions. First, this Comment argues that caps should be imposed on the percentage of any damage award a third-party litigation funder could receive. The result of a cap on recovery for third-party litigation funders would be a decrease in the concentration of funding for only the lawsuits with the highest potential damages, which, in turn, would decrease the amount required for settlement. Plaintiffs would be less likely to go to court because their well-funded backers would have lower investment limits in order to keep their return targets on track, and many plaintiffs could not afford the cost of pursuing litigation themselves. Second, this Comment suggests that a national registration requirement be imposed for third-party litigation funders to increase accountability within the industry and inform potential consumers of third-party financing. Third, this Comment advocates for the expansion of already enacted state regulations of third-party litigation funders to protect consumers in the commercial litigation context. Overall, the caps, registration requirements, and expansion of enacted legislation balance efficiency, deterrence, and compensation while still allowing for financially constrained plaintiffs to seek the outside funding they may need to pursue a meritorious claim.

Introduction..............................................................................................491

I. The Current State of Third-Party Litigation Financing......495

A. Background and Overview of Third-Party Litigation Financing...................................................................................495
B. Arguments in Favor of Third-Party Litigation Financing..........498
C. Problems Caused by Third-Party Litigation Financing in Practice ...................................................................................... 499

II. Maintenance and Champerty......................................................502

A. Historical Treatment of Maintenance and Champerty...............502
B. Maintenance and Champerty in the United States.....................504

1. States' Treatment of Maintenance and Champerty..............505
2. Issues with the Variation in States' Treatment of Maintenance and Champerty............................................... 507

III. The Risk Imbalances Created by the Interaction of Third-Party Litigation Financing and Treble Damages....................508

A. Existing Risk Imbalances Caused by Treble Damage Statutes .. 509
B. Attractiveness of Statutory Treble Damage Cases for Third-Party Investors ...........................................................................512

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C. Consequences of Third-Party Litigation Financing and Treble Damage Awards ......................................................................... 512

IV. States' Attempts to Regulate Third-Party Litigation Financing.........................................................................................513

A. Current Status of State Laws Regulating Third-Party Litigation Financing ................................................................... 514
B. Downfalls of the Enacted Legislation Regulating Third-Party Litigation Financing ................................................................... 515

V. Proposals to Regulate Third-Party Litigation Financing .... 517

A. Limiting the Recovery of Third-Party Litigation Funders..........518
B. Enacting Registration Requirements for Third-Party Litigation Funders ...................................................................... 522
C. Extending Already-Enacted State Legislation Regulating Third-Party Litigation Financing ............................................... 523

Conclusion..................................................................................................524

Introduction

As Michael Cannata, principal of Patent Monetization Inc., has stated, "[a]s long as the US [litigation] market continues to be one of the world's largest . . . and the biggest pay-outs are available, this is going to be attractive for [third-party] investment."¹ The attractiveness of the U.S. litigation market is evident from the amount of money third-party funders are willing to invest in various lawsuits. On average, third-party funders invest between $2 million and $15 million in a single complex commercial litigation lawsuit.² This substantial investment is made in the hope of multimillion-dollar payoffs,³ which often occur, resulting in a rate of return of up to 200% on a single lawsuit asset.⁴

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Third-party litigation companies can keep as much as 40% of the proceeds that result from the underlying litigation asset,⁵ which often causes plaintiffs to receive very little recovery from their claims. One example of disproportionate plaintiff recovery involves DeepNines, a Texas-based security company, which obtained $8 million in third-party financing to pursue patent infringement litigation against a competitor.⁶ In the end, the parties agreed on a settlement of $25 million, $10.1 million of which went to the third-party litigation funder.⁷ Almost the entire remaining damage award went to legal fees, resulting in DeepNines's net recovery of only $800,000.⁸ The third-party litigation funder ended up with a return of over 126% while the plaintiff received barely 3% of the total recovery.⁹ Overall, third-party litigation funders are focused on where they can get the highest rate of return,¹⁰ with some of the largest third-party litigation funders seeing annual returns of up to 91% on their U.S. litigation investments.¹¹

The growth of third-party litigation finance has most negatively impacted defendants. The huge sums being invested in commercial litigation results in distorted incentives for plaintiffs.¹² As James E. Tyrrell, Jr., regional managing partner at Patton Boggs LLP, has pointed out, "[t]he abundance of funds now available to plaintiffs may have 'tipped the funding scales' toward plaintiffs, creating an imbalance of resources,"¹³ which raises some concern about access to justice for defendants. Plaintiffs may be less likely to settle disputes if they can off-load much of the risk that usually accompanies a trial onto third-party

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litigation funders.¹⁴ Further, these plaintiffs may bring frivolous lawsuits, resulting in inefficiencies in the legal system and higher costs for both parties.¹⁵ For the plaintiffs, these higher costs are often borne by the third-party litigation funders, but defendants must shoulder the costs themselves. Consequently, litigation costs rise because plaintiffs can prolong litigation due to their extensive third-party backing.¹⁶ Even more significant is that third-party litigation funders do not seem to invest in the types of cases where plaintiffs are in need of access to justice.¹⁷ Instead, these funders invest in the cases that are the most likely to be successful and have the highest potential damage awards, which are primarily patent infringement and antitrust lawsuits.¹⁸

The growth of third-party litigation financing is a threat to the judicial system. This Comment proposes putting caps on the amount a third-party litigation funder can recover, similar to contingency caps for attorneys' fees, which are already in place in some states.¹⁹ By reducing the...