Financing lawsuits

There have been some posts from Conglomerate, PointofLaw and Evan Schaeffer, linking to this American Lawyer article on lawyers’ using loans to finance contingent fee cases, either individual cases or by portfolio. Anthony Sebok has some interesting articles here and here. Here I offer some quick thoughts. 

From a finance standpoint, this is pretty unremarkable. The cases are assets, and therefore subject to financing like other assets. The public markets reduce the costs of risk-bearing through diversification.

This isn’t just any asset – it’s law and lawyers. Lawyers are fiduciaries, meaning agency costs. Something that increases agency costs should be of concern to the client. Disclosure and consent arguably takes care of that, but perhaps, e.g., in personal injury cases, we’re worried about the client’s information and judgment.

Does financing lawsuits increase agency costs? This comes down to risk. The lawyer will invest effort and be willing to settle cases based on maximizing his risk-adjusted return from his portfolio of cases. Risk might cause incentives to diverge if the client is a publicly held corporation whose investors are diversified, but the lawyer is not. Allowing financing of cases may align risk-based incentives in the publicly held corporation situation.

On the other hand, financing by the lawyer may introduce disparity of incentives for individual clients because the lawyer will then be diversified but the client will not. This may be good in terms of effort – the lawyer may be willing to invest more effort in the claim if he gets a higher risk-adjusted return on the effort. It might be bad for the client on settlement because the client might want to settle for the bird in the hand while the lawyer is willing to go for two in the bush. (The incentives would seem to be reversed if the client finances but the lawyer does not.) One wonders whether an individual client will understand these implications of litigation financing, even with disclosure.

Financing litigation also involves potential incentive problems between the lawyer and the financier.  This will be worked out contractually as it is in other settings.

A couple of the posts linked above discuss the implications of these developments for tort reform. An expert on litigation financing, Anthony Sebok, is quoted in the American Lawyer article as calling this financing a “safety valve for tort reform.” In other words, as tort reform makes this litigation riskier, thereby decreasing suits on the margin, litigation financing reduces the risk, thereby increasing them.

On the other hand, litigation financing might increase the quality of litigation. Without this financing, lawyers may, in effect, diversify their risk by taking more cases, investing less effort and settling them faster. This may lead to more “strikes” for fees.

Note that litigation financing takes care of risk by financing the suits themselves, either individually or by portfolio. Why not finance the whole firm – that is, through publicly traded law practice? Or make the practice of law a division of a publicly held firm that is engaged in other, say, service businesses? This violates current ethical rules. Why, you say? Well, because it makes law practice too much like a profit-oriented business. Really, I’m not making this up. For more, see my article Ethical Rules, Agency Costs and Law Firm Structure, 84 Virginia Law Review 1707 (1998). Whatever the costs and benefits of these restrictions, it would seem that the developments discussed above are, in effect, arbitraging them away.

Third party litigation financing takes care only of risk. The contingent fee contract remains. In other words, there is, in effect, another layer of financing between the lawyer and the client. An incentive issue arises from the fact that the lawyer or financier only gets part of what the plaintiff gets. We might solve that by letting the plaintiff sell the claim to the lawyer. Obviously there’s a potential problem under lawyer ethical rules. Is it wrong as a matter of policy?

The problem for some people is that it turns litigation into a business rather than the search for corrective justice. The justice arguably happens when legal rules produce a payoff to the plaintiff at the front end, rather than when the court makes an award to a tearfully grateful plaintiff. A side benefit is that we would have injured plaintiffs with no motive to lie in court (other than the motive created by the imperfect contract between lawyer and client at the time of the sale).

A middle ground that Bruce Kobayashi and I are working on as I speak is “dumping and suing,” by which the lawyer in a securities or derivative suit in effect capitalizes the lawsuit by selling short the corporation that is the subject of the suit and then buying back after the suit is announced. More on that, e.g., here, and in an article with Bruce Kobayashi coming soon.

Comments

[Robert Schwartz]

To me the real issue is the lack of loser pays. If lawyers want to finance the litigation, they should be required to pay the other sides fees if they lose.