Executive Research Summary: The Future of Third-Party Litigation Finance

As mentioned, I have spent much of the past few weeks working on two research projects. One attempted to sketch a theoretical course of development for international environmental criminal law. See supra here. The other, the subject of this post, explored a possible analogy between third-party litigation finance and health insurance, and considered the consequences of such a relationship. As in the last post, the goal here is to offer an abstract and basic summary sufficient to allow for informed comments.

The thrust of this project is the presentation of an analogous relationship between emerging third-party litigation finance and the history and current establishment of the health insurance industry. Separated in time, the lessons of the latter– to the extent that the analogy holds– can be applied to shape and improve the development of the former. (All quoted portions omit citations.)

Third-party finance is a developing area in American civil litigation. It is common for potential personal injury plaintiffs to lack the resources to finance a lawsuit. Lawyers have adjusted to meet this market gap by offering clients contingent fee arrangements. Those arrangements allow clients to initiate and pursue litigation without fronting any money. They pay their legal fees only if they recover, and the payment comes out of that recovery.

Entities outside of the lawyer-client relationship are seeking to enter this and related markets by structuring funding arrangements with plaintiffs and defendants. This field is more developed in other countries, including Britain and Australia, although some new ventures are cropping up in the United States. By funding litigation, these firms facilitate risk transfer by the party. For a fee, the firms bear the risk of litigation, giving predictability to defendants and allowing otherwise unaffordable litigation on the plaintiffs’ side to proceed.

Part of the reason third-party finance has not caught on in the United States in the same way that it has abroad is legal uncertainty. State laws present hurdles to the expansion in litigation funding options. Many states have archaic champerty and maintenance laws that may limit the ability of nonlawyers to enter and take an interest in litigation. Experts are unsure about the applicability of these old laws and their bearing on new financial options.

The legal profession’s ethics rules also present a difficulty for third-party finance. To function effectively, a litigation finance firm presumably would need to be able to evaluate prospective cases. Such an investigation likely would require information in the hands of the attorney and litigant, however, and may encroach upon the lawyer’s disclosure restrictions and information privileged under the attorney-client privilege. Disclosure outside the lawyer-client relationship could violate professional responsibility rules and waive the attorney-client privilege at trial.

Laws and ethics rules are amendable, of course, should third-party finance prove fruitful, desirable, and beneficial. The normative question is more significant: Should we clear the way for third-party litigation finance? By making litigation more affordable and less risky, third-party funding could encourage trials. Making the necessary changes in the law and ethics rules could meaningfully alter the lawyer-client relationship and have other consequences for the legal profession.

Clearing the path for third-party funding also could lead to the rise of a new financial sector of substantial size. In some ways, the emerging field, together with proposals for its further development and expansion, resembles the health insurance industry. This paper presents an examination of the analogy between third-party litigation finance and health insurance beginning with a look at the history of each area.

A quick overview on the basics of litigation finance:

The current, uncontroversial model for litigation finance is the contingency fee arrangement…. Individuals with fewer resources, typically plaintiffs in a rare entry into the realm of litigation, are unable to make the up-front payments to a lawyer necessary to seek a civil remedy for their injury. In response, plaintiffs’ attorneys offer clients a contingency fee arrangement. Under such an arrangement, the client pays his or her attorney nothing out-of-pocket. If the lawyer is to receive any payment, it will be a portion of the client’s settlement or recovery at trial, and if the suit is unsuccessful, the lawyer receives nothing.

Contingent fee arrangements really are three bundled products: the lawyer’s legal services, credit, and legal-cost insurance. The credit extended is for the duration of the litigation, postponing payment until the client recovers a judgment, and then only if the lawyer wins a judgment for the client—the legal-cost insurance, through which the lawyer shares risk with the client. Plaintiffs’ attorneys developed this bundled arrangement and, presumably, were happy to do so (the choice being between having clients and not having clients). Some nonlawyer entrepreneurs and scholars believe there is value in unbundling these products, however, and are taking various steps—actual and theoretical—in that direction.

The basic notion of third-party litigation finance comes from an unbundling of these three products—legal services, credit, and legal-cost insurance—and the belief that there are efficiency gains and other benefits from a system that allows for third-party provision of legal-cost insurance. “At its core,” litigation funding is “a contractual arrangement whereby a third party pays the cost of litigation and in return, if the case succeeds, receives a percentage of the proceeds.” Broadly speaking, litigation finance options can take a variety of forms, including a simple line of bank credit for a law firm, venture capital loans to plaintiffs (and sometimes their lawyers), and venture lenders for defendants. While…the majority of the third-party financing market focuses on options for the plaintiffs’ side, there [also] is a case to be made for making available similar opportunities on the defense side.

Third-party litigation finance has taken off abroad, especially in Australia and the United Kingdom, but it has lagged in the U.S. due to two types of legal uncertainty:

The first is uncertainty about possible legal bars to these arrangements within state law, and the second has to do with the ethical and professional rules surrounding the lawyer-client relationship.

Champerty involves an agreement between a litigant and a party that assists the litigant in pursuit of the claim in exchange for a portion of the proceeds of the judgment. Some, but not all, states prohibit champerty…making entry a confusing and complicated endeavor. A thorough sift through the applications of this arcane doctrine across the country may indeed show that the prohibition is fading.…The obstructing effect of the second uncertainty, the legal profession’s ethics rules, may be a more vital and challenging hurdle, however.

The lawyer-client relationship is one of the most important relationships the law seeks to protect. Communications between attorney and client are confidential, and cannot be compelled as evidence at trial. Work product immunity is related, and it protects from discovery the lawyer’s notes, drafts, research, and other preparatory work. These two protections are necessary to foster open and honest dialogue between client and attorney, but involving a third party—by sharing communication otherwise privileged—can be enough to waive the privilege. Third-party funding firms need to investigate cases before investing in them, and it is likely that the lawyer and client posses the information most relevant to the investment decision, including information that will help determine the likelihood of success and value of the suit.

…

Involvement of a third-party financing firm threatens waiver of the attorney-client privilege and the work-product immunity. It also conflicts with lawyers’ duty to protect the privilege and safeguard confidential information. Concerns about waiver and professional duties have led some reformers to propose amendments to these rules and the champerty rules that would clear the path for third-party litigation finance. Even if the rules and laws that constrain full-fledged third-party litigation finance are incompatible with the modern impulses of civil litigation, amending them to address financing concerns may have unintended consequences for the values behind the relationships they are supposed to protect.

The world of modern health care is one that health insurers dominate, leading to undesirable realities for patients.

American health care is a “national dilemma of runaway costs and poorly covered millions” of people, and insurance is the basis of the system. Much of the problem is due to what David Goldhill calls the “moral-hazard economy.” The moral hazard economy has three interacting features. First, due to the ubiquity and primacy of insurance as a payment method for health care, it is “implicit that someone else will be paying most or all of” the bill, and “that means we give less attention to prices for medical services than we do to prices for anything else.” Second, doctors “benefit financially from ordering diagnostic tests, doing procedures, and scheduling follow-up appointments.” Third, extensive training gives physicians an informational advantage over their patients that gives them authority in their relationship with their patients. The combination of these three creates “a system where physicians can, to some extent, generate demand at will.” They can, and, Goldhill writes, they do: “physician supply often begets patient demand.” Controlling costs in this economy is difficult because “moral hazard has fostered an accidental collusion between providers benefitting from higher costs and patients who don’t fully bear them.

My argument is that there is an analogy between the developed health insurance industry and the relatively new litigation cost insurers:

Lawyers and doctors both are sophisticated, highly trained professionals offering technical services to their unsophisticated clients and patients. The relationship between professional and client in each situation is highly prized, both formally and informally. Formally, a code of ethics and responsibility guides each profession and its duty to its clients. Informally, the popular perception, from the clients’ perspective, is a relationship of confidence and trust in which the client’s interests are of first importance, subject, of course, to professional advice. Doctors and lawyers were solo, general practitioners during the early days of each profession, and plaintiffs’ attorneys, of particular focus here, remained that way longer than did their defense-side counterparts. Both professions largely have coalesced into group practice, which has allowed for the rise of the specialist. Plaintiffs’ attorneys had already established a type of financing by offering to work for a contingent fee, which encouraged a portfolio approach to the pool of client claims they were handling. The formal and informal expectations of the profession remain in place, however, despite these and other changes in professional reality. The entrance into these relationships by a separate insuring entity could not help but alter the dynamic of the relationships.

In both cases, the third-party insurer entered, in part, to respond to a resource need on the part of the patient or client. In terms of relationship dynamics, the conceptual position of the insurer is on the side of the client. The insurer’s ostensible role is to help the client pay for the service he or she has selected after consultation with the professional. These services are expensive and, in most cases, difficult to anticipate. Client support is not the only reason insurers are invited into these relationships, however, which complicates their role in the relationships.

Insurers entered doctor-patient and lawyer-client relationships to respond to needs from the professional side as well as the client side. When taking on clients of humbler means, or when they are unaware of their clients’ resources, the professionals risk late payment and nonpayment. A well-capitalized, third-party payer is more likely to be able to assure the professionals a steady and reliable payment stream. By making the professional’s services more affordable, the insurer’s presence can create more potential clients.

Where large amounts of money and consumer interests are at stake, government usually appears as well. For health insurance, a public role has been on the table since the first days, and the government’s role continues to be a matter of debate to this day. Perhaps unsurprisingly, reformers have advocated a role for government in third-party litigation finance as well. One model is a “public option” in the form of a government fund that would spur entry and competition in the market for litigation-cost insurance. In addition to direct participation, government plays a more traditional regulatory role in the health insurance market. As the litigation-cost insurance market grows, this type of passive participation seems likely.

This analogy, and its consequences, play out along a number of lines, including the professional-client relationship (cutting out the client, preferred service providers, and funding and coverage limitations), deprofessionalization, the role of government, economic concerns (increased costs in insurance-dominated markets and growth of industry and the possibility of exclusivity), as well as a number of practical challenges:

It is difficult to anticipate just what a mature litigation finance market will look like, but if it were to grow to resemble today’s health insurance industry, practical problems would arise if the same third party was funding and exercising some measure of control over adverse parties to the same litigation. It is easy to say, in terms of theory, that one insurer cannot represent both sides of a case, but if litigation-cost insurance becomes as prevalent and engrained as health insurance, it is likely that the insurer may already cover the two sides prior to the litigation. The difficulty is in developing a policy to decide which party should have to surrender its coverage.

Health insurance works as a business model, in large part, because actuaries are able to make accurate predictions about health risks, and especially when they have information about individuals’ health and lifestyle. Responses to diseases and injuries are relatively undifferentiated from person to person. Treatment for a broken arm or cancer does not vary wildly from patient to patient, and insurers usually restrict coverage to mainstream, well-understood treatments and exclude new and experimental approaches.

Litigation may not be susceptible to the same sort of actuarial prediction, however. The relevant facts of each case can vary significantly, and the riskiness of a particular case may not be immediately obvious. Unless insurers impose coarse coverage restrictions, the difficulties of broad risk prediction may necessitate a different model for a broader application of legal-cost insurance.

In distinguishing between different types of risk, though, Painter argues that most of the risks of litigation are of the sort that a third-party funder can reduce through diversification. While systematic risk is risk that affects the market as a whole and is much more difficult to diversify away, an investor can avoid unsystematic risk easily through diversification. In litigation, most of the risks are unsystematic because they involve the specifics of individual cases and are unlikely to affect other cases, especially those with unrelated facts, law, or parties. Systematic risks (e.g., the widespread appointment of judges hostile to plaintiffs or the enactment of laws to that effect), on the other hand, exist in litigation but are comparatively rare. Those who assume litigation risk therefore should be able to eliminate much of that risk with a diverse portfolio of cases, something Painter argues it would be easy for third-party legal-cost insurers to do.

To the extent that this analogy is valid, it counsels caution to those pushing the financing envelope, and it encourages a reexamination of the lawyer-client relationship and the reasons and means by which we protect it.

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