Litigation Finance
Tags: Law, Cryptocurrency, Finance, Litigation Funding, Economics

Photo by Eduardo Soares on Unsplash

“Ignorance of the law excuses no man from practicing it.” - Addison Mizner

Litigation finance is a new and emerging asset class with a market size of over $10 billion. It is a controversial practice with strong opponents and supporters. While many have cited the potential for abuse of the legal system, others have lauded the increased access to justice. Fears of increased litigious behavior and vindictive parties fill the news about this field, alongside hopeful articles about law firms becoming more efficient. In order to determine what awaits us in the future we must first start with the past.

HISTORY & ECONOMICS

The field of law has always consisted of businesses with poor economics. This is because law firms were never intended to be businesses in the first place. In past societies, the lawyer was viewed as a public servant who was agnostic on the issue of money. He did not do his job for the reward of payment, but because he had a greater duty. As noble as this vision is, it has certainly not remained intact. Lawyers are the butt of most jokes, and for the most part are depicted as either blood-suckers or ambulance chasers.

Even in modern society where law is looked at as much more of a business, many law firms and lawyers try to hide the ball, and many of our modern access to justice issues can be traced back to this unrealistic view of lawyers. In law school, students and professors live in a disconnected reality where legal reasoning is king, and there is no need to dirty yourself with the actual practice of law, much less insinuate it is done for money. In practice, the field of law continues to hold itself out as a professional field that has no interest in moneymaking or financial innovations. Most law firms basically operate one of two ways: Either as a firm that derives most of its income from billing clients hourly or as a plaintiff side law firm that takes its cases on contingency fee. This is obviously a simplistic dichotomy and there exists a multitude of law firms along this spectrum, but for our purposes these two will do.

The first kind of law firm, the kind that bills all of their clients hourly, is usually a large law firm with mostly corporate clients. This essay deals primarily with litigation so we will designate these firms as being commercial litigators/defense firms. (In most commercial litigation both the plaintiff and defendant hire large firms that bill hourly). Their business model is one that operates in the same head space as law school, in that it is in a suspended reality. The law firm acts as if it is not a profit oriented corporation, yet billing hours at a high rate is the main objective. These law firms have little to no financing and operate essentially on a cost plus basis. Law firms are not allowed to structure themselves as traditional corporations; because they are professional corporations all of the owners of a law firm must be lawyers. This is usually done by establishing a partnership, LLC, professional association, or professional corporation, which means there is no corporate tax rate and therefore no incentive to retain cash or reinvest. This incentivizes law firms to try to use as many associates as possible as commodities to bill out hours so that the partners can take home as much income as possible each year. There is little to no reinvestment, and the main expense is hiring more attorneys to bill out more hours. These firms merely bill their clients for the litigation that they perform and take no risk themselves — with the exception of the loss of a client if they perform poorly. All of the costs of the litigation, and therefore risks, fall directly on the client.

On the plaintiff’s side the phenomenon is nearly the opposite and more dire. Plaintiff’s Attorneys (usually for individuals or small entities) fund the lawsuits themselves and recover based on contingency fees. This necessarily incentivizes the plaintiff lawyer to take the risk and therefore bring actions that he expects to win (or more commonly to receive a settlement hire than his costs). The main problem facing these lawyers and clients is again entity structure. These law firms are similarly forbidden from having nonlawyer owners. That prohibits outside investors, and basically limits the plaintiff attorney’s funding options to debt.

The most prominent issue on the plaintiff side is access to justice. Because the lawyer must fund the case himself with a limited amount of funds, he can only choose the cases with the highest merit and largest damages. That, by default, means there are some plaintiffs with meritorious cases who never see court because they are too difficult (requiring large upfront costs) or the recovery is too small to justify the lawyer taking the risk — even though the plaintiff is justly owed money. It can also result in plaintiffs running out of funds in a drawn out litigation, which puts them at a disadvantage to their well-funded opponent. The lack of funds in any one law firm often results in firms having to partner with each other simply to fund these cases.

This all started to change with the introduction of litigation finance — a process that has been going on in Australia and the United Kingdom for around 20 years, but only became available in the United States about 10–12 years ago. It involves another entity lending money to a party in litigation in exchange for high interest payments or a portion of the recovery.

ORIGINAL CORPORATE LITIGATION

Litigation funding was traditionally prohibited in most of the world due to rules against maintenance and champerty. These rules essentially forbid outside third-parties, whom have no direct interest in the legal claim, from funding litigation. Champerty specifically prevents the funding of litigation in exchange for some of the proceeds of the action. These doctrines were developed in medieval Europe as ways to prevent meddlers from stirring up strife with speculative litigation.

For most of the following centuries, outside financing of lawsuits was forbidden around the world. However, in the early 1990s Australia began loosening restrictions and experimenting with litigation funding. This resulted in litigation funders such as IMF Bentham popping up in Australia. In the early 2000s, Europe began to relax its champerty laws and litigation funding sprung up in many European countries. Essentially, the U.S. was the only country still not in on the new craze. That changed in 2009, when Jonathan T. Molot, a law professor at Georgetown University Law Center, published the paper A Market in Litigation Risk. Shortly thereafter, Mr. Molot co-founded Burford Capital with Chris Bogart.

This created one of the first and largest litigation finance companies in the U.S. Burford Capital focused nearly all of their litigation funding efforts on commercial litigation. This consisted of them funding a portion of a company’s lawsuit in exchange for a portion of their recovery in what would likely be 3–8 years. In this basic model of litigation finance, Burford would provide funding to large companies who wanted to bring a lawsuit (usually against another company). Instead of this company having to pay all of the legal fees and hoping for a win, Burford would cover some or all of these fees for a portion of the future recovery from the action. Therefore, Burford would pay the lawyers on behalf of the clients. These were the largest cases with the most prestigious law firms assisting, where companies simply wanted to reduce their legal risk. Burford was willing to alleviate that risk for these companies, which was a great innovation in the American Legal System. However, most of the money in the litigation financing space seemed to be flowing to large corporate entities for risk mitigation, not parties who desperately needed it.

EMERGENCE OF NEW PLAYERS

Even though the commercial litigation finance market seemed to be growing with the addition of Burford, IMF Banthom, Gerchen Keller, and multiple hedge funds filling in the ranks, the law firm and plaintiff side funding was relatively slim. The only known and mostly maligned occurrence of plaintiff side funding was Peter Theil’s funding of Hulk Hogan’s lawsuit against Gawker. This was most people’s introduction to the world of Litigation Finance. The lawsuit ended in 2016 with an award of $100 million in damages to Hulk Hogan. An award that bankrupted Gawker and was generally thought of as good for the planet was soon decried as a form of free speech restriction and abuse of power by billionaire’s when it was discovered that Theil funded the suit. For more information on the lawsuit, I highly recommend Ryan Holiday’s book Conspiracy: Peter Thiel, Hulk Hogan, Gawker, and the Anatomy of Intrigue.

As the field grew so did the financing options available to law firms. Gerchen Keller (eventually bought by Burford) began factoring law firms receivables (specifically late stage litigation or settlements that had not come in), and LexShares had begun investing in class action and personal injury lawsuits. Gerchen Keller also made high interest rate loans to Mass Tort firms as described in this article.

This was originally the only way these plaintiff side investments appeared to be made — as loans with high interest rates — because firms were weary of violating ethical and ABA rules about sharing fees with nonlawyers. You see, under Burford’s model the funder was investing in the client’s lawsuit and splitting awards with the client, but in most noncommercial litigation the plaintiff cannot afford to bring the lawsuit so the plaintiff’s lawyer (not the plaintiff) funds the case and is paid on contingency fee. Plaintiff firms that bring these lawsuits can get loans but some ABA rules and state bar rules seemed to prevent these firms from splitting fees with nonlawyers who invested in the litigation.

For a while it seemed like yet again plaintiffs, who already lacked financial access to the legal system, were deprived of another advantage that large defendants and corporations possessed. But litigation financing companies soon began to test these rules by partnering with law firms to fund a portfolio of their cases in exchange for a portion of the lawyer’s recovered fees. LexShares, Pravati Capital, and others (here) began investing in specific lawsuits to finance the plaintiff’s lawyers bringing the lawsuits for a portion of their recovery. The ABA and courts appeared to not care about, or at least not want to push back against, this trend — one that appeared to be providing access to justice for underserved plaintiffs.

Recently, at least 29 jurisdictions have issued ethics opinions pertaining to litigation finance, with many states allowing it under certain conditions and most preventing the funding company from directing or influencing the litigation.

SECONDARY MARKET

The trend of investing in lawsuits has continued to grow and may receive the dry powder it needs to expand into a secondary market. I have long envisioned a market where a multitude of companies invest in litigation, and these investments can then be securitized by a large firm that is essentially an investment bank for this industry. “Shares” of these lawsuits could then be sold to investors and traded on a secondary market. I believed Burford, which was the largest firm and seemed to have the highest returns, would fill that position because they were a first mover in the American litigation finance industry. However, recently, they have been embroiled in controversy when short seller Carson Block came out with a report on their accounting practices. The report appears damning and it is hard to make sense of their returns on individual lawsuits, except that it appears many of their investments have not been resolved and they have merely estimated the value of a recovery at a high margin (marked to market). There appear to have been changes at Burford since the report and hopefully they can get back on track.

In the midst of all this, a secondary market seems to be forming in cryptocurrencies. Roche Cyrulnick Freedman LLP is issuing a cryptocurrency that allows investments in a lawsuit they are bringing in California (a copy of the complaint here). They are raising $5 million through the initial coin offering, and they are claiming $1 billion in damages. Even if they only get half of that at $500 million, then 50% of the attorney’s fee (at 30%) would be $75 million. This is 15 times the original investment. The litigation will likely take 2–6 years, so there is a decent holding period, and it looks like a binary issue of whether this violates the Takings Clause, so it could be decided sooner rather than later. My main interest is in how fast they can raise these funds, and what the secondary market for these lawsuit coins/shares will look like.

We hope this creates a way to provide liquidity for investors in litigation. The secondary market would allow initial investors to sell their shares and not have to wait until the end of the lawsuit for a liquidity event.

A large hurdle I see in the offering of these securities to the public is the disclosure requirement. If these coins are treated as securities, the SEC will likely want to regulate them and these law firms will have to disclose the facts of the litigation. And while litigation is not about hiding the ball, there may be situations where law firms looking for funding may not want to release all of their information to the public. Other issues include confidentiality requirements and privacy concerns for the clients.

I still think most of the public would have a very difficult time valuing a lawsuit, and as a result there might be limited interest from retail investors. But this is something the cryptocurrency portion of this financing would likely make up for as these assets seem to be very volatile and inflate very fast. Maybe that is how Roche Cyrulnick Freedman is hoping to raise funds and they just plan to cash in on the cryptocurrency bubble. But it would be strange for a law firm that has made its money by suing disreputable crypto exchanges to issue coins that aren’t valid or don’t involve full transparency.

CONCLUSION

Overall, this is a very exciting move in the right direction for litigation funding, and one that will level the playing field for plaintiffs and their lawyers.