Brave New World: The Impact of Third Party Litigation Funding on Commercial Litigation
By Peter Butler and Christine Tran, Herbert Smith Freehills
Recent years have borne witness to the nascent rise of third-party litigation funding (TPLF) of commercial litigation in legal markets across the globe. Beginning over a decade ago in Australia, TPLF spread quickly to the UK, the US, Canada, Europe and Asia. TPLF itself has undergone rapid changes in its short existence. Though the traditional model of single-funded cases is still the main modus operandi, funders have diversified their business model in the last 12 months, including investments in claims-aggregating firms, joint ventures with law firms directed at prosecuting certain claims, and post-judgment appeals funding. Commercial funders and commercial litigators are becoming increasingly consociated, however, the interests of funders and litigators necessarily diverge given that lawyers owe a fiduciary duty to their clients. TPLF represents the biggest change to the commercial litigation landscape, raising novel issues that focus in on the practice of law and, more broadly, the relationship between the justice system and the community it services. Indeed, standing as we are on the precipice of change, an arguably bold prediction is, TPLF has a wider impact on the practice of commercial litigators than the financial crises of late, with the potential to transform the manner and types of commercial litigation pursued.
Foundations for Third Party Litigation Funding
The narrowing of the rules against maintenance (improper encouragement of litigation) and champerty (receiving a share of proceeds for maintaining litigation) paved the way for TPLF in common law jurisdictions. Historically, third-party intermeddling in common law civil litigation was considered a crime and a tort. The predominant driver was the public interest in protecting the purity of justice, given fears that “the champertous maintainer might be tempted, for his own personal gain, to inflame the damages, to suppress evidence, or even to suborn witnesses” (Re Trepaca Mines (No 2)  Ch 199).
Public policy, however, is a fluid standard. The increasing complexity and reach of commerce and powers of corporate institutions saw a greater policy concern in ensuring access to justice, particularly for the impecunious and small-claims litigant. The access to justice benefits of financial assistance to litigation steadily gained precedence. In many common law jurisdictions, such as Australia and the UK, by the late 1900s the rules against maintenance and champerty were modified by statutes and substantially narrowed.
The Rise of Third Party Litigation Funding
Australia is generally recognised as the birthplace of specialised commercial TPLF. Indeed, the success of TPLF is owed wholly to the context of commercial litigation in Australia; and correlates directly with the advent of class action litigation.
First, in 1992, Australia introduced a federal class action regime described as “plaintiff-friendly” due to the low threshold for commencing proceedings. Near-identical regimes were later introduced in two state jurisdictions; collectively, the three jurisdictions oversee the largest volume of commercial litigation.
Second, Australia has strong mandatory disclosure rules for listed securities and strict product liability laws, both of which are particularly amendable to class action litigation (being broad-based harm affecting a large number of people in the same or similar manner).
Third, like most Western democracies, Australia utilises the “loser pays” rule (or English Rule) for allocating court costs. The claim value of a typical plaintiff in a class action is small; therefore, under a loser pays system, it is economically irrational for a plaintiff to commence proceedings, as it will be assuming risks (the costs and fees expended by a defendant in a large-scale litigation) that grossly outweigh the benefits (being damages and some compensation for time and effort awarded after the fact and at the court’s discretion).
Fourth, Australia prohibits lawyers from charging contingency fees or other damages-based fees (a practice prevalent in the United States, where a typical contingent fee is 33-45 per cent of any eventual recovery). Instead, from time to time, the plaintiff bar finances cases on a “no win, no fee” basis (conditional fee arrangements are statutorily permitted in certain circumstances). However, given the limited upside, not all meritorious claims survive a risk-benefit analysis, resulting in excess capacity.
Therefore, TPLF fulfils a market need, by providing immunity to plaintiffs against the “loser pays” rule and enabling fringe claims that may not otherwise be brought, in return for 25-40 per cent commission of any proceeds obtained in the litigation.
TPLF gained traction in 2006 when it was finally endorsed by the highest court in Australia (see Campbell’s Cash & Carry Pty Ltf v Fostif Pty Ltd (2006) 229 CLR 386). The success of commercial litigation funding was built on a single-case funding model, where each case is evaluated for coherence to the individual funder’s investment criteria (expected returns, levels of risk, duration, quality of legal team). Provided the criteria is met, the funder contracts with the law firm and each client. Based on claim size, the largest volume of funded claims have been, and continue to be, investor and shareholder class actions. The funding market was consequently marked by strong relationships between funders and certain plaintiff firms and institutional investors.
The Global Expansion of Third-Party Litigation Funding
The Australian experiment has proven to be exceedingly profitable for funders, particularly in class action claims, with funders routinely achieving more than 300 per cent return on investment. Such unusual returns, unlinked to the economy, have attracted attention and investor money.
The global funding market has been highly active in the last four years. New entrants, both local and international, have entered the Australian legal market (for example, UK-based Harbour Litigation Funding Limited has widened its investments to Australia and the Asia-Pacific). The largest and most prominent funder in Australia, IMF Bentham Ltd, expanded overseas, funding a range of commercial litigation in the United States, Canada, Asia and Europe, and establishing relationships with the local plaintiff bar. The United States is the site of the largest growth, with more than $2 billion openly invested in a range of commercial litigation as diverse as intellectual property, contract, antitrust, trade secrets and tortious interference claims. The true figure is likely to be much higher, as funding arrangements are rarely disclosed.
The entrepreneurial spirit driving the growth in commercial litigation funding has also seen vast changes to the traditional model of single-funded cases. The innovations are predominantly occurring in the United States, where the commercial legal market differs sufficiently, engendering different market needs. The gravity of an unsuccessful prosecution is reduced, as each party bears its own costs with no avenue for reallocation (subject to certain statutory exceptions). Lawyers are also able to charge a contingency fee, incentivising an active plaintiff bar that in effect finances cases. As such, the imperative of TPLF is less obvious compared to other jurisdictions. Nonetheless, TPLF of commercial litigation has attracted plaintiff firms and claimants due to the financing and risk-management advantages presented. Corporate claimants benefit from low-risk access to litigation finance. Contingency work is inherently risky, and plaintiff firms are able to share that risk (and benefit) with third party funders. Similarly, not all viable claims are pursued by the plaintiff bar. Some of that excess capacity are capitalised by funders, and plaintiff firms benefit from fees for services rendered. This has enabled funders to pursue new arrangements, such as direct investments in claims-aggregating firms, joint ventures with law firms aimed at prosecuting certain claims, and funding at different stages (such as post-judgment appeals funding).
Impact of Third Party Litigation Funding on Commercial Litigation
The most obvious advantage of TPLF is improved access to justice. TPLF enables a wider range and greater volume of claims to be pursued, especially as the funding market grows. The benefits of increased commercial litigation may not be readily apparent to those outside the bar. Normatively, litigation is valued as a private form of regulation. The promotion of meritorious claims, particularly in industries involving under-resourced public regulators, can overall improve the behaviour of corporate actors. The risk of meritless suits is believed to be low, on the assumption that funders are economically rational. TPLF are indeed commercial enterprises, predicated on commercially viable cases (maximising returns while minimising risks). However, the rational conduct of funders itself is an insufficient safeguard against non-optimal claims.
Most commercial lawsuits settle, enabling companies to avoid the expense, uncertainty and distraction of litigation. The normative view of litigation as private regulation fractures if justice is not actually dispensed through judgments (ie, the establishment of law). The propensity to settle, coupled with a deepening of the funding market, compounds concerns of “greenmail” litigation. We have seen in Australia instances where marginal claims investigated, but not pursued, by established funders have been subsequently supported by emerging funders. More recently, claims made by emerging funders are increasingly subject to legal challenges (some of which have been successful). This prompts questions of what “justice” is genuinely being accessed and whether the judicial system is being used merely to further speculative entrepreneurialism.
The burgeoning relationship between funders and plaintiff firms also raises red flags. The potential repeat business of a funder can incite actual or perceived conflicts of interest, where loyalty to the funder takes precedence over the fiduciary duty owed to the client. Typically, funders extract their costs and commission from any settlement or judgment proceeds first, prior to distribution among funded claimants. In a settlement context, funders may be happy with an outcome enabling it to recoup sufficient returns in a timely fashion, when it behoves the practitioner to reject on behalf of their clients for an estimated better offer at a later time, and vice versa. Though funders assert a hands-off approach to settlement discussions, they are nonetheless involved in the process. In some cases, preliminary settlement discussions have taken place solely between corporate defendants and funders.
These concerns are not theoretical. The increasing role and influence of commercial litigation funders observed by Australian practitioners and corporate defendants were reinforced in a 2016 empirical study on Australian class actions (see Morabito, Vince, An Empirical Study of Australia’s Class Action Regimes, Fourth Report: Facts and Figures on Twenty-Four Years of Class Actions in Australia (29 July 2016)). In the last six years, almost 50 per cent of federal class actions commenced are supported by commercial litigation funders. Funders have had a direct impact on the type of class action claims being brought, with a notable increase in the number of investor claims and consumer protection claims; a notable decrease in the number of product liability and mass tort claims and no cartel class actions brought in the last nine years. The trend is explained by the fact that product liability, mass torts and cartel actions take up to twice as long to resolve compared with investor claims and consumer protection claims, and are therefore less attractive to funders. Funded class actions also had a higher settlement rate (92 per cent) compared to unfunded actions (48.9 per cent).
TPLF is an established facet of commercial litigation in many jurisdictions. This trend is likely to continue, as the UK and parts of Europe and Asia contemplate the introduction of class actions or aggregate litigation mechanisms. Corporate claimants are availing themselves of TPLF, as an off-balance-sheet and low risk means of pursuing business disputes. Where TPLF is client-driven, commercial litigation practitioners will be unable to avoid interactions with funders. The key is being aware of the risks presented in a tripartite funder-firm-client arrangement, from dealing with potential conflicts of interest to managing the firm’s liability exposure in the event of a loss (for example, a funder in the failed $1.65 billion Excalibur suit brought a professional negligence claim against the plaintiff firm).
The impact of TPLF on commercial litigation is already evident in its birthplace (Australia), influencing the types of claims being brought, the litigation strategy of corporate defendants and, more broadly, affecting the civil justice system by inhibiting the development of law (due to higher rates of settlement).
TPLF remains largely unregulated across the globe. How to best address the concerns raised by TPLF, without hampering the “access to justice” policy aims, is the most pressing short-term issue in the commercial litigation landscape.