Should Insurers Be Concerned About Litigation Funding

By Denise Johnson | May 20, 2013

Though third party litigation funding has just started to grab headlines in the U.S., the funding method has been used in Europe for some time.

According to Jonathan Molot, chief investment officer and co-founder of Burford Capital, people in the U.S. didn’t see a need for litigation financing because lawyers can get contingent fees, whereas in England it was a necessity because up until recently lawyers weren’t allowed to work for a share of the recovery.

Also, while personal injury and class action lawyers work for a contingent fee – they don’t get paid unless they win – commercial litigators generally don’t work that way, said Molot, a former practicing attorney and current Georgetown University Law School professor.

The third party funding vehicle was reconsidered in the U.S. in order to enable commercial disputes to be brought by businesses, he said.

Molot has studied how commercial parties, both plaintiffs and defendants, handle litigation risk. He identified a problem that can happen for both sides if there is a lack of resources to pursue litigation.

“I guess on either side, the problem is where there’s an imbalance between the parties in resources or risk preferences. That one party can afford to go to trial and the other party can’t,” Molot said.

He formed Litigation Risk Solutions to focus on situations where litigation risks were interfering with business –such as when a merger or deal between companies is hampered because the company being purchased or acquired is involved in litigation.

Soon after, he formed Burford Capital, which looks at both defense and plaintiff risks.

Use of Third Party Funding Rising

Although third party lawsuit funding vehicles are likely on the rise, there’s no way for an opposing party to know for sure, according to a 2011 paper published by the National Association of Mutual Insurance Companies (NAMIC).

We think that it is on the rise, although one of the difficulties with this issue is that…we don’t really know. If one is up against a plaintiff whose lawsuit is being financed by a third party litigation funder, one usually doesn’t know that,” said Robert Detlefsen, vice president of public policy for NAMIC.

In most instances the court doesn’t know whether a third party funder is financing the litigation either.

“That makes it difficult for us to know just to what extent, how prevalent it is, or whether it’s on the rise. We think so, but we don’t have figures, and we don’t know,” Detlefsen said.

States Taking Action

Though a few bills have been introduced by states attempting to address third party litigation funding, there are currently no states that ban it outright.

Detlefsen points out there are two types of third party litigation lending.

“In principle, they’re very much the same, but in practice they tend to operate somewhat differently. They have different actors involved, and they tend to apply to different types of lawsuits,” said Detlefsen.

He said bills introduced thus far have mainly addressed the type of third party litigation loan that is utilized by either lawyers or plaintiffs themselves that are involved in relatively small claims litigation.

“Usually the suit, it’s a slip‑and‑fall type of a thing, or very often it’s an auto accident case, and the loan is made very often directly to the plaintiff in the case, but usually for an amount of several thousands of dollars,” Detlefsen said. “The terms of the arrangement are such that the borrower, the recipient of the funds, gets money upfront and is required to pay interest, usually on a monthly or maybe even a weekly basis‑interest that accumulates on a weekly or a monthly basis‑to the funder, until a settlement is reached or the case goes to court and a damage award is ordered by the court,” he explained.

These are non‑recourse loans, meaning the borrower is under no obligation to repay the funder if the lawsuit doesn’t result in a favorable judgment or settlement, Detlefsen said.

The legislation introduced so far mainly takes aim at the lack of transparency and interest rates charged.

The U.S. Chamber of Commerce’s Institute for Legal Reform (ILR) has drafted a model act. Detlefsen said his organization and others in the insurance industry are working closely with the ILR to encourage states to introduce legislation based on the model.

“The ILR model act would require that a party notify the party that it is suing, as well as the court, if there was a litigation funder financing the lawsuit,” Detlefsen said.

Molot said the Chamber of Commerce’s position on litigation funding is antithetical to its position on other issues, which emphasize free enterprise and freedom from government regulation.

“I think the only explanation for why the Chamber is trying to suppress litigation funding is a fear of precisely what litigation funding is intended to do, which is to level the playing field so that cases are resolved based on their merit, rather than based on unequal resources or risk preferences,” Molot said.

The other kind of third‑party litigation lending involves funders that are large institutional investors, like hedge funds. Detlefsen said they are mostly interested in commercial litigation because there’s more money at stake.

He said that instead of charging interest on the loan proceeds they advance, they negotiate an arrangement with the plaintiff party whereby the plaintiff agrees to share a certain percentage of whatever the recovery is with the funder. There hasn’t been any legislation at the state level introduced to specifically address this type of funding.

With respect to transparency, Molot sees no reason for anyone to know who is funding a lawsuit.

“There’s no reason for it for a couple of reasons. Companies all the time have to decide how to finance their legal fees. Most big companies finance it from retained earnings,” Molot said.

Other options, he said, include raising funds by issuing bonds, through an equity or debt raise or through retained earnings.

He said courts would never inquire into how money was raised to fund a lawsuit.

Another reason funding transparency is unnecessary, said Molot, is that opponents inquiring into financing arrangements could get into the head of the opposing party and acquire the work product and strategy for the litigation, Molot said.

“It’s sacrosanct in our system that each side should be able to strategize with their lawyer and come up with a strategy for the case that is protected from the other side’s…getting access to their strategy,” he said.

Financing discussions could reveal the litigant’s optimism or pessimism about the case, he said.

“It’s going to reveal what their budget is. You don’t want the other side to know that they have $5 million to spend, and if that runs out, they’re not going to have any more. Then the other side will just force them to run up $5 million in expenses. You don’t want the other side to know that if it comes in at a settlement above X, the litigation finder gets one percentage, and if it comes in at Y, it gets a different percentage. That’s just not something the other side should have access to,” said Molot.

Chaos in the Civil Court System

An increase in third party litigation financing in large commercial litigation cases could cause an increase in frivolous lawsuits, Detlefsen said.

He said a cause for concern is a large, well-capitalized institutional investor who could hedge their risks over a broad portfolio of investments. Similar to junk bond investment risk where there is a good chance of default, but with a potentially big payout, third party litigation funders financing high‑stakes, large‑scale commercial litigation, including class action cases, could invest in a case that might not have been filed because the likelihood the suit would fail was relatively high.

“A law firm that’s operating on a contingency fee basis, for example, probably wouldn’t want to take such a case. But a third party litigation funder might look at a case like that and say, “Well, when you consider it against the backdrop of all the other investments that we have, this is a risk that’s worth taking because the potential payout is very large,”” said Detlefsen. “A case that looks weak on its face, if you manage to get the case certified in a certain jurisdiction and you manage to get a certain kind of jury to hear the case, even though the case is weak on the merits there is a chance that it could go in favor of the plaintiff, and the payout could be very large.”

He said there’s a fear that because third‑party litigation financing may be involved, more of those types of cases will be filed and settlements negotiated could be higher than what might otherwise be the case.

Molot disagrees.

“The surest way for a litigation funder to lose money is to fund a losing lawsuit. It’s doesn’t make any sense that someone would fund a suit that’s a bad suit… there is a respect in which litigation funders are going to be even pickier than contingent fee lawyers in deciding whether to take a suit,” he said. “I think that the people who are saying litigation funding is going to lead to an increase in frivolous litigation are dead wrong. They’re really doing it in order to protect themselves from meritorious claims.”

Detlefsen said class action lawsuit abuse is foreseeable.

“You could imagine that kind of abuse escalating if you have a third party funder and the law firm that’s representing the plaintiff class working together to try to pursue the litigation in a way that delivers an outcome that is mutually advantageous to the funder and the firm or the attorney that’s bringing the lawsuit,” he said.

“I’ve heard people wonder about mass torts. Where there’s some drug defect. Is someone going to finance plaintiffs? I don’t see a need for third party litigation finance there. I don’t see that that’s the market because there’s already a contingent fee plaintiff’s bar that handles those cases,” said Molot.

Insurers have little cause for concern when it comes to large-scale litigation funding, according to Molot.

“I can’t remember a case where an insurance company would have to pay out that was funded. The reason for that…is generally, contingency lawyers deal with personal injury suits. They deal with product defects. They deal with class actions, the sorts of things that might be insured,” he said. “The cases where there’s not contingency lawyers…generally commercial litigators who work by the hour, are cases where there’s not insurance. It’s commercial disputes, a contract breach between two parties. I think from an insurer’s perspective, this is largely irrelevant.”

Molot said the only time Buford has encountered insurers on a case involving third party litigation financing is when the company has been on the same side of the suit as the insurers.

“In fact, in Europe, litigation funding is integrally related to insurance. It’s insurance companies that historically have provided litigation funding. In fact, Burford owns the largest provider of after‑the‑event insurance in the UK, and it has a very close relationship with Munich Re, which provides reinsurance. Burford is an insurer in some respects in the UK,” Molot added.

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