9 THE AMERICAN LAW INSTITUTE Continuing Legal Education Third Party Litigation Funding: Pros, Cons, and How It Works November 1, 2012 Telephone Seminar/Audio Webcast Alternative Litigation Funding Conference Summary George Washington University Law School May 17, 2012 Submitted by Alan B. Morrison George Washington University Law School Washington, D.C.
10 Alternative Litigation Financing Conference Summary MAY 17, 2012 This summary of the conference held on May 2, 2012, was prepared by Tatyana Taubman, George Washington University, class of 2013, and edited by Associate Dean Alan Morrison and Professor Roger Trangsrud. The entire conference may be viewed on the conference website, www.law.gwu.edu/gwl/alf. Alternative Litigation Financing (ALF) involves a cash advance made to a party to a lawsuit, typically a plaintiff. There are generally two sectors of ALF, although there may be transactions that fall in between them. In one, called consumer ALF, a plaintiff receives a cash advance, usually to be used for living expenses. The second type of ALF is commercial legal funding, which typically invests in business-against-business litigation, with financing usually being used for litigation expenses. Both types of ALF are non-recourse, which means that the advance must only be repaid to the ALF provider if there are proceeds, including settlement, of the litigation. As described below, the easiest way to distinguish between consumer and commercial ALF is by looking at the size of the advance, the number of claims financed by the ALF company, and the needs of the customers. The differences between the two types suggest that there may be differences in how they should be treated by regulation and perhaps in how the ethical obligations of lawyers should be defined. Individual plaintiffs turn to consumer ALF in order to meet their financial needs while they wait for the outcome of their pending litigation. The average size of a consumer ALF cash advance is about $1,700, and most cases to date involve automobile accidents. The ALF company is usually willing to advance about 10-15% of the predicted value of the claim to the consumer. Because of the small amount of the
11 advance and the relatively high volume of transactions, the ALF company usually does very little investigation beyond reviewing the police report and determining that there is an attorney representing the plaintiff. The transactions are usually very uniform, involving a contract that the consumer fills out online with details of his case and information about the attorney. Many ALF companies will not advance funds to a consumer without the presence of an attorney who will contract to dispense funds to the ALF company out of the proceeds of the litigation. ALF companies structure their finance charges differently, some charging monthly interest, with frequent compounding, while others charge multipliers (fractions) of the cash advance, which increase as the litigation continues. One method of structuring cost is to inform consumers of the amount they will owe at each 6-month interval until their litigation concludes. Some ALF companies stop accruing charges after a certain time. Today, only Maine, Nebraska, and Ohio have passed legislation that regulates consumer ALF. Given the consumer protection concerns associated with consumer credit, many agree that some regulation for consumer ALF is needed. For example, a wide consensus exists that there should be some mandatory disclosure to consumers of the actual costs of litigation financing. A uniform system of disclosure would allow customers to easily understand and compare the charges of various ALF providers, eliminating deceptive practices and possibly bringing down the cost of ALF through fair competition. Another benefit of regulated disclosure of the ALF contract terms is that the regulation could legitimize the industry against the current stigma often attached to it. This stigma is fueled by stories of consumers being deceived by ALF companies, often those operating on the fringe of the industry. One model for mandatory disclosure may 2
12 be the Schumer Box, which provides consumers a concise summary of the cost of a credit card in an easily accessible and familiar way. Other desirable regulations include requiring that an attorney has been retained for the claim and registration with the state as a prerequisite for providing ALF services. Requiring that an attorney has been retained and is aware of ALF involvement would ensure that the attorney has an opportunity to advise his client on the fairness of the ALF contract terms and also whether ALF is appropriate for the client s specific case. For example, if the claim is expected to settle quickly, and the terms of the cash advance are such that a large charge accrues rapidly, ALF may not be advisable. Also, this requirement is beneficial to the ALF company because having the attorney sign the contract and agree to pay the ALF company out of the proceeds of the lawsuit ensures that the ALF funder will receive its fee. The requirement that the ALF company register with the state and meet minimum requirements would provide some assurance that the company is qualified to do business. Several states require that the ALF company have at least a certain amount of money available before they can be certified by the state to provide litigation cash advances, although the rationale for such an approach is unclear because the ALF provider pays out the money at the outset, and so insolvency is not a problem for the consumer. Another category of potential regulation involves placing limits on the fees charged by consumer ALF companies. One proposed restriction would prohibit additional charges from accruing if the litigation lasts beyond a certain point, such as 36 months. A more controversial regulation would involve limiting the cost of ALF, much as usury rates limit the interest rates charged for recourse loans. The consumer ALF 3
13 company represented at the panel estimates that it receives a 40-70% return on its advances, although the profit depends on how long the case lasts, and whether the ultimate outcome is as favorable as was originally predicted. To some, that suggests that consumers are being overcharged. In response, the ALF industry points out that ALF advances are non-recourse and that litigation is often unpredictable. According to that same consumer ALF company, in 47% of the cases, it gets less than contracted amount; in 22% it gets back only principal or less; and in 10% it gets nothing back. One reason for the reduced returns is that ALF companies often renegotiate the contract terms with their clients, sometimes after the settlement, and often agree to be paid less than the contracted for amount when the outcome of the litigation is lower than expected. Therefore, they contend that the risk to ALF companies, due to the non-recourse nature of the loan, justifies their exemption from traditional usury laws. That would not preclude specific rate regulations tailored to the risks associated with ALF, but there is also a possibility that adequate disclosure and fair competition could ensure fair prices for consumer litigation financing without actual regulation of the prices charged. If regulated, litigation financing could either be regulated at the state or the federal level or both. State regulation would provide more flexibility, and much financial regulation is currently at the state level. However, consumer credit is also regulated (or supplemented) at the federal level. The new Consumer Financial Protection Bureau (CFPB) appears to have jurisdiction to regulate consumer ALF, although the agency does not have the power to set usury rates, and it is unlikely that ALF would be the new agency s first priority. The Federal Trade Commission may also have jurisdiction over 4
14 certain allegedly unfair practices. As an alternative, the CFPB could work with the states to develop model legislation, which would have the advantage of uniformity and provide a level of legitimacy to the industry. Those inside and outside of the industry agree that public perception of ALF would improve if regulations existed which outlawed the horror stories associated with some consumer ALF transactions. Legislation and/or regulation in this area could also remove doubts about the application of state usury laws and doctrines such as champerty. Although many agree that some regulation is needed for the consumer ALF industry, most do not think that regulations are necessary for commercial ALF, although some would prohibit all forms of ALF. Commercial ALF companies finance a business entity s claim against another business, often investing millions of dollars in a single case to be used for lawyers fees and litigation expenses. In return for the financing, the commercial ALF company receives a percentage of the proceeds. As in consumer ALF contracts, the cost of the financing often increases with the time it takes for litigation to conclude, but unlike consumer ALF, the terms of the financing are individually negotiated for each investment. Because of the large amount of money invested by commercial ALF companies, the amount of due diligence on each claim is usually very significant, often running into the hundreds of thousands of dollars if not more. In some instances, financing is done is stages. For example, a client may agree to pay its lawyer directly through the motion to dismiss, and if the case gets beyond that point, it will turn to an ALF provider that may in turn invest in further stages if it so chooses. This strategy takes into account the fact that there are different risks involved in different stages of litigation and that the fees paid by clients should reflect that fact. The funder and the 5
15 client usually have their own lawyers to advise them (either in house or outside counsel or both), and for this reason the consumer protections for consumer ALF are not thought to be needed. One benefit of commercial ALF is that it provides companies with an additional option for financing litigation and choosing their representation. A company may wish to hire the law firm that handles its usual transactions to represent it in a litigation matter, but may be unable or unwilling to pay the law firm s regular billing rate. If the firm is unwilling to handle the case on contingency, the company can turn to ALF for financing instead of seeking out another law firm that works on contingency. This is also beneficial for the company because it would not have to spend its cash on litigation expenses, which in turn could drive down the company s earnings before the case produced offsetting revenues. In between consumer and commercial ALF, there may be other types of claims that may utilize litigation financing. Examples cited by a defense lawyer on the panel include medical malpractice and product liability or pharmaceutical claims. Neither the consumer ALF company nor the commercial ALF companies represented at the panel had financed such claims to date, but they also did not dispute the possibility that ALF could be used in these areas. To the extent that ALF financing starts to fill in the middle between routine consumer cases and sophisticated business litigation, there may be a need to draw lines when the distinction is less obvious. Despite this flexibility, it seems unlikely that ALF will be used in class action cases. One reason for this is that lawyers already have well-developed methods of financing class actions, and judges who would have to approve any such arrangement are 6
16 comfortable with these forms of financing and may be reluctant to change. Further, in class actions where individual members of the class receive a small amount, the ALF company would not provide a large cash advance to any individual plaintiffs or even their lawyers. Although there may be a large potential recovery for the class as a whole, it seems practically impossible for an ALF company to obtain the signatures of even a significant percentage of the class which is necessary because the named plaintiffs cannot bind the rest of the class when entering into an ALF transaction, at least without prior court approval. One controversy surrounding ALF is its impact on the legal system. Especially in the context of commercial litigation, there is a fear that ALF will result in frivolous litigation because claims that could not otherwise have been financed by the parties bringing them now have access to funding. ALF providers may not be adequately informed about the legal merits of a case, and may finance litigation that otherwise would not have gone forward. Also, the presence of ALF may push up the cost of settlement because the amount financed may become the baseline at which negotiations begin. In other words, the party receiving financing may refuse to settle for a rational amount because it is factoring in the payments on the ALF financing when calculating its desired settlement outcome. Others argue that ALF could actually have a positive effect on the legal system. The presence of a third party may provide a check that a case is meritorious, as it is unlikely that an investor would provide large sums of money to a matter that is unlikely to prove successful. As rational business people, investors will seek out the information necessary to determine whether a case has legal merit before investing in it. An extreme 7
17 version of this point posits that the availability of third party financing should be required in all commercial cases to decrease the number of frivolous lawsuits. In any case, the term frivolous is one that may be better left to the courts to evaluate, as they have the capacity to dismiss claims that are without legal merit. Another issue is whether a party should be obligated to disclose the fact of funding to its adversary. Although the fact of funding may prejudice a jury, one option may be to disclose ALF only to the other side, which is how the fact of insurance coverage is handled. There are two conflicting views on how disclosure of the fact of funding may affect settlement. On the one hand, disclosure may help the financed party because it will lead the opposing party to infer that the financed party s claim is worth more, given that a third party has risked its own funds to invest in the claim. On the other hand, the opposing party may infer that the financed party had to seek out funding because the claim is weak, and the party was not willing to risk financing it alone. Further, the opposing party may believe the settlement amount being asked for is inflated, as the financed party is incorporating its expenses to the ALF company as a baseline amount. If the fact of funding is disclosed, this could, in theory, lead to the disclosure of other details of the financed party s case. Once the opposing party knows of the existence of third party financing, it may subpoena the ALF company for the information it knows about the case. ALF companies, especially in the commercial context, ask for considerable detail in order to make an informed investment decision, and therefore some privilege and confidentiality issues may arise. One option for a commercial ALF company fearing the risk of waiver is not to ask for any privileged information. This may 8
18 be a safe course as some believe the law in this area is unsettled. However, others believe that the information is only work-product, and that privilege is not waived unless a party acts in a way that substantially increases the chance of the adversary getting hold of the information. Therefore, the information should remain privileged despite being made available to the ALF company. While the law regarding work-product is sometimes unclear, that privilege has been upheld consistently in insurance cases where similar issues arise. Because litigation insurance companies also receive privileged information in order to evaluate the cost of litigation, arguably the same standards should be applied to ALF. The ABA White Paper generally concludes that ALF is not unique in this regard, and the issues of privilege and confidentiality may be handled the same way as in insurance and other similar situations. For this reason, it is unlikely that mandatory disclosure of the fact of funding will necessarily lead to disclosure of the details of funding or the disclosure of significant confidential information. Another professional responsibility issue is whether the ALF provider will have any control over the case, and how the attorney should handle demands of the investor as opposed to the client. First, consumer ALF companies have said their only two contacts with the client are when they disburse the money and when it is repaid at the conclusion of the case. Given the large number of small cash advances made by consumer ALF companies, it seems economically infeasible for them to exert control over individual cases, except in the context of participating in settlement discussions in which they accept less so that the case can be resolved. Second, it is important to remember that it is not unique to consumer and commercial ALF financed cases that a third party may have an independent interest in the 9
19 outcome of the case. One example is a health insurance company that may have subrogation rights if the claim comes out in favor of the injured party, through judgment or settlement. Also, lawyers have long been allowed to take out bank loans to finance a case. Third party interest, therefore, does not necessarily mean control of the case. Control of settlement may be even less of an issue in the ALF context than it is in cases where the defendant has litigation insurance in that ALF financing does not contribute to the amount offered in a settlement, while litigation insurance might. Some believe that concern about ALF control over litigation is a red herring, especially in large commercial cases where sophisticated parties can be expected to make rational decisions about litigation strategy. Because the interests of the client, attorney, and third party financier are parallel in most instances, disagreements and conflicts should be rare, and these issues are appropriate subjects of pre-investment bargaining with lawyers on both sides to protect their interests. One suggestion to solve some of the problems associated with ALF, including predatory contracts and third party interference, may be to eliminate the restrictions in Rule 1.8(e) of the Model Rules of Professional Conduct that forbids lawyers from making advances to their clients. This prohibition is one reason why ALF has flourished, especially in the consumer context, because plaintiffs often have nowhere to turn for living expenses. If attorneys were allowed to advance the money, consumers could use that fact to negotiate for better terms for an ALF contract. Even if the attorney is not willing to make an advance directly to the client, she may assist the client with understanding the terms and renegotiating on the client s behalf for a better deal from the ALF provider. If the lawyer provides the financing, this would eliminate an unnecessary 10
20 third party from the attorney-client relationship and settlement agreements. However, if the lawyer charges for the advance (beyond repayment, as is done for litigation costs), a conflict of interest may arise because the lawyer is, in effect, entering a business transaction with the client, which raises issues under Rule 1.8(a). Although ALF has existed for at least 20 years, the practice has recently become more prevalent, growing in size and scope. While some concerns are specific to ALF, others seem analogous to issues that arise in other forms of litigation financing and third party involvement in lawsuits. With the industry growing and more litigating parties turning to ALF, it seems that the practice is here to stay. In order to harness the benefits of ALF s presence in litigation, practical solutions should be developed to address specific problems as they arise. 11