How third-party litigation financing works, and who benefits

“Litigation financing” (also known as litigation funding or legal funding) basically describes the provision of money by a third-party litigation financer unrelated to the lawsuit, to a plaintiff in litigation in return for a portion of the financial recovery (settlement, award, judgment, verdict or otherwise) the plaintiff obtains. If the plaintiff recovers nothing, the litigation financer also receives nothing, as these are “non-recourse” transactions. Such transactions are not considered loans but rather investments, a form of an asset purchase or venture capital. What third-party litigation funding (TPLF) does is transfer the risk from the plaintiff and attorney to the financer.

There are two types of litigation financing: commercial third-party litigation financing and consumer third-party litigation financing. Corporate plaintiffs and law firms typically use commercial third-party litigation financing to fund legal expenses and costs or to supplement their general operating budgets. Commercial funders usually invest in litigation with damages worth $10 million or more, with a minimum investment of $2 million.

Compare that to consumer third-party litigation funders who invest small amounts, with typical amounts of $1,000 to $10,000. Single-case funding arrangements for individual plaintiffs are their primary funding option. The average amount funded is usually 7% to 10% of the estimated value of the case. Consumer TPLF clients mainly use the funds to pay for living expenses (such as the mortgage or rent and medical expenses) during the pendency of their claim. They generally do not use the funds to finance the litigation itself.

Litigation funding was prohibited by a number of states because of champerty and maintenance laws. California, however, never adopted the common law doctrines of champerty and maintenance. (Mathewson v. Fitch (1863) 22 Cal. 86, 94-95 (“The offense of maintenance was created by statute in England in early times, in order to prevent great and powerful persons from enlisting in behalf of one party in a lawsuit, by which the opposite and feeble party would be oppressed and prevented from obtaining justice. … In the absence of a statute creating it, the offense of maintenance does not exist in American law as a part of the common law. In the absence of … a statute, the offense of maintenance is unknown to the laws of this state.”); Abbott Ford, Inc. v. Superior Court (1987) 43 Cal. 3d 858 fn. 26; Muller v. Muller (1962) 206 Cal. App. 2d 731, 735; Cain v. Burns (1955) 131 Cal. App. 2d 439, 443; Estate of Cohen (1944) 66 Cal. App. 2d 450, 458.)

Because the costs and expenses to investigate, prepare, and prosecute personal injury and wrongful death cases can easily run into thousands, even tens of thousands or more of dollars to properly prepare and try a case, the injured client would have to provide some or all of the financing to prosecute the case. But since the seriously injured plaintiff in a civil tort action is rarely the president of a bank or CEO of a Fortune 500 firm, they are usually unable to provide much if any financial resources to the lawyer to handle the case. The costs inherent in major litigation can be crippling, and a plaintiff lacking the resources to sustain a long fight may be forced to abandon the case or settle on distinctly disadvantageous terms.

Traditionally, the firm representing the plaintiff would have to advance the costs and expenses of litigation on behalf of the client, requiring that plaintiff firms have large “war chests” or seek other means of financing the case. If the defendant prevailed in the action, the plaintiff’s attorney stood little chance of recouping any of the costs and expenses advanced for the client’s benefit. In situations where the plaintiff’s attorney looked to banks for a traditional loan to cover the monetary output necessary to adequately prepare a case for trial and to try it if the case was unsuccessful, the plaintiff’s attorney would nevertheless still be on the hook to the bank for principal of and interest on the loan amount.

Litigation financing levels the playing field between the plaintiff – whose funds are limited – and the liability insurance carrier, which has a seemingly endless supply of funds available to it. With TPLF, the risk is transferred from the plaintiff and his or her attorney to the litigation financer. Of course, a litigation financer will not simply make a loan upon the plaintiff’s or attorney’s application. The third-party litigation financer will do an extensive and intensive evaluation of the case and review all documents and evidence to minimize its risk. Litigation financers are so thorough and meticulous in their decision to “invest” in a lawsuit that 90% of their transactions prove successful (i.e., the plaintiff achieves a settlement or judgment that pays off the litigation financer), while 10% are resolved in favor of the defendant. Litigation financers take a big risk in investing in cases, but they pick their cases very carefully.

There is some talk about third-party litigation financing increasing the number of frivolous cases being filed. This argument is fallacious; because of the risk they take, third party litigation financers vet their cases very carefully. Funders select only the most meritorious cases to invest in because they receive returns only when claims are successful, thus refuting any notion that litigation financing leads to frivolous litigation. Several large third-party commercial litigation funders disclosed that they only fund about 4% to 5% of the total requests for funding they receive after conducting due diligence. The three major factors a litigation funder looks act when conducting its due diligence are (1) the merits of the potential case; (2) the potential client’s legal team, and (3) the ability of the defendant to pay.

A major concern is what role the TPLF will have in the conduct and prosecution of the case. Will the TPLF want the client to settle the case quickly, or will it want to drag the litigation out? TPLF may influence which cases are brought, how long they continue, and when and how they are settled. These decisions are not necessarily based on the plaintiff’s best interests, but instead on how the funder can make the most money. Attorneys are ethically bound to put the client’s interests paramount. Except in very rare circumstances agreed to by the client in advance in the legal finance agreement, third-party legal financing agreements provide that the funder will neither control nor seek to control strategy, settlement, or other litigation-related decision-making, nor direct the client to settle a case at all, or for a particular amount. Settlement decisions remain entirely with the client.

Senate Bill 581

Because the field of litigation financing has not been regulated in California, on Feb. 15, the Third-Party Litigation Financing Consumer Protection Act was introduced in the California Senate as SB 581. The Act was amended on April 17 and April 27, and on May 8 it was placed on the appropriations committee suspense files. This Act would regulate many areas of TPFL and require TPFL enterprises to be registered with the Secretary of State.

Because litigation financing is not considered a loan, usury laws do not apply. In California, there is currently no legal limit on how big of a chunk the litigation financer can take and the interest rates it can charge. The Act would prohibit a litigation financer from charging the consumer a fee in excess of 36%, compounded annually, of the original amount of money provided to the consumer for the litigation financing transaction. (Section 1788.315, subd. (a).)

In the latest iteration of the bill (as of May 10), proposed Civil Code Section 1788.313, subd. (a) would be enacted to prohibit litigation financers from:

1. Paying or offering commissions, referral fees, or other forms of consideration to any legal representative, medical provider, or any of their employees for referring a consumer to a litigation financer;

2. Accepting any commissions, referral fees, rebate or other forms of consideration from a legal representative, medical provider, or any of their employees;

3. Advertising false or misleading information regarding its products or services;

4. Referring a consumer or potential consumer to a specific legal representative, medical provider, or any of their employees;

5. Failing to promptly supply copies of any complete litigation financing contracts to the consumer and the consumer’s legal representative;

6. Attempting to secure a remedy or obtain a waiver of any remedy, including, but not limited to, compensatory, statutory or punitive damages, that the consumer might otherwise be entitled to pursue;

7. Offering or providing legal advice to the consumer regarding the litigation financing or the underlying dispute;

8. Assigning, which includes securitizing, a litigation financing contract in whole or in part;

9. Reporting a consumer to a credit reporting agency if insufficient funds remain from the net proceeds to repay the litigation financer;

10. Receiving or exercising any right to direct, control, or otherwise influence the conduct of the consumer’s legal claim or action, including, but not limited to, any settlement or resolution.

Disclosure and discovery of TPLF agreements

Discovery of a third-party litigation funding agreement and communications between the attorney and the third-party funder may be protected by the attorney-client privilege or the work-product privilege, as they have been prepared “because of” the prospects of litigation, even though they may also have been prepared for a business purpose.

Insurance companies contend that third-party legal financing agreements and related documents should be disclosed on the same basis as insurance policies so that settlement and litigation strategies are based on knowledge and not speculation. Insurers argue that disclosure of third-party litigation finance agreements will encourage settlement and avoid protracted litigation in some cases, although in others it may have the opposite effect. Consumer attorneys object to this on the basis the disclosure requirement would give defendants in all cases the unprecedented and unintended advantage of knowing which claimants lack the resources to weather a lengthy litigation campaign.

Earlier versions of the Act required the plaintiff, within 30 days of receipt of a written request, to disclose to any party to a legal claim whether the consumer has entered into a litigation financing transaction. Litigation financing contracts would have been rebuttably presumed to be discoverable in a civil action, while such transactions disclosed or discovered would have been rebuttably presumed to be inadmissible as evidence. Since discovery requires the disclosure of evidence reasonably calculated to lead to admissible evidence, the fact that litigation funding contracts are discoverable but inadmissible would serve no legitimate purpose and would be in contradiction of the policy and evidentiary rules of discovery procedures.

As originally drafted, the Act also would have provided that communications between a consumer’s attorney and a legal financier necessary to ascertain the status of a legal claim or a legal claim’s expected value would not be discoverable by a party with whom the claim is filed or against whom the claim is asserted. Additionally, a previous version of the bill would have provided that it would not limit, waive, or abrogate the scope or nature of any statutory or common-law privilege, including the attorney-client privilege and the work-product doctrine.

A legal representative retained by a consumer, or a medical provider for a consumer, or any of their employees, cannot have a financial interest in litigation financing and cannot receive a referral fee or other consideration from any litigation financer, its employees, owners, or its affiliates. (Section 1788.313, subd. (b).)

Communications between a consumer’s attorney and a legal financier necessary to ascertain the status of a legal claim or a legal claim’s expected value would not be discoverable by a party with whom the claim is filed or against whom the claim is asserted. (Section 1788.316, subd. (e).) This section would not limit, waive, or abrogate the scope or nature of any statutory or common-law privilege, including the attorney-client privilege and the work-product doctrine. (Section 1788.316, subd. (f).

Federal legislation

Federal legislation in the form of the proposed Litigation Financing Transparency Act of 2021 was introduced to the 117th Congress in February 2021 (H.R. 2025; S. 840). That Act would have provided that in class actions, class counsel had to disclose in writing to the court and all other named parties to the class action the identity of any commercial enterprise, other than a class member or class counsel of record, that had a right to receive payment that was contingent on the receipt of monetary relief in the class action by settlement, award, judgment, or otherwise. It also would have required class counsel to produce for inspection and copying any agreement creating the contingent right, except as otherwise stipulated or ordered by the court. The proposed Act would have required the same disclosure and production for inspection and copying any agreement creating the contingent right in multidistrict litigation. This Act was not voted on by Congress and died at the end of the 117th Congressional session in January, 2023.

However, some federal district courts have local rules requiring the disclosure of TPLF agreements. For instance, the District Court for the Northern District of California has a Standing Order for All Judges of Joint Case Management Statement that provides “[i]n any proposed class, collective, or representative action, the required disclosure includes any person or entity that is funding the prosecution of any claim or counterclaim.”

The Northern District Court also has local rule 3-15, which requires that upon making a first appearance, a party “must disclose any persons, associations of persons, firms, partnerships, corporations (including parent corporations), or other entities other than the parties themselves known by the party to have either (i) a financial interest of any kind in the subject matter in controversy or in a party to the proceeding; or (ii) any other kind of interest that could be substantially affected by the outcome of the proceeding” and “must supplement its certification if an entity becomes [financially] interested . . . during the pendency of the proceeding.” (See also Central District of California Local Rule 7-1-1: “All non-governmental parties shall file with their first appearance a Notice of Interested Parties, which shall list all persons, associations of persons, firms, partnerships, and corporations … that may have a pecuniary interest in the outcome of the case . …”

Discovery of TPLF agreements and related documents have been held to be relevant and discoverable in patent infringement cases to (1) establish the value of the patents at issue; (2) obtain statements made by the plaintiff regarding the patents at issue; and (3) refute potential trial themes. However, one district court observed that any privilege or protection from disclosure was not before the court and that potentially applicable privileges and protections from disclosure (such as the attorney-client privilege and the attorney work-product doctrine) may apply to litigation funding agreements and related documents. (Impact Engine, Inc. v Google LLC (2020 S.D. Cal.) Lexis 145636, at 4-5 n.2 (S.D. Cal. Aug. 12, 2020). See also Finjan, Inc. v. SonicWall, Inc. 2020 WL 4192285, at *4 (N.D. Cal. July 21, 2020) (in patent infringement action, the magistrate judge held that the attorney-client privilege would not protect disclosure of information shared with a third party litigation funder).

In Odyssey Wireless, Inc. v. Samsung Electronics, Co., Ltd., ((2016 WL 7665989, at *6-7 (S.D. Cal. Sept. 20, 2016)), a magistrate judge in patent infringement action stated that “[s]everal courts have found that the attorney work-product protection that attaches to litigation financing documents is not waived when these documents are disclosed to third-party litigation funders,” and found no waiver of the attorney work-product privilege, but defendants showed a substantial need for documents regarding the valuation of plaintiff’s patents and were entitled to those documents. Hence the court concluded that disclosure was permitted but with portions of the documents that did not address those valuations redacted before production.

Conclusion

Third-party litigation funding is a booming industry that puts injured, financially constrained plaintiffs on the same level with insurance companies. In California, it has been free of regulations, which gives litigation funders the ability to bind injured consumers to predatory contracts. No doubt investors are taking a risk by providing this type of investment, but 90% of the time the third party litigation funder recoups their investment with a return of 100% or more.

Often, the injured consumer is so in need of funds that they will enter into a litigation financing contract without really understanding what it means. It is up to the consumer’s counsel to be or become knowledgeable and competent in this type of transaction, and if not, either associate with or refer the client to a lawyer who is competent in this area, so the client can be properly advised of the consequences of signing a third-party litigation funding agreement and what options the client may have.

Regulation of third-party funding agreements is sorely needed to allow the investors a fair return on their investment, but not to an exorbitant amount that can mean more money in the investor’s pocket rather than adequate compensation to the injured consumer. There is no need for the defendant and their insurance company to know the existence and terms of such a funding.